As an economist I find our current economic meltdown equal parts frightening and fascinating and, as of late, I have been thinking a lot about my macroeconomic courses from college. At the time I had a very tough professor — Dr. Louis Philippe Rochon. He was a post Keynesian, essentially economic nihilism, and as a result we read a lot of obscure original texts and papers. One of the papers we read was by Hyman Minsky.

In light of today’s economic meltdown a lot of researchers have been looking for clues from the past, and many have settled on Minsky’s “Financial Instability Hypothesis.” As I understand it — I never spent much time with Minsky as he is a bit of an obscure economist — the theory tries to bring speculative bubbles and their subsequent popping into the orthodoxy of market dynamics. This insight was likely pretty accurate for our meltdown in 2001, however it is the wrong theory for today.

Right economist, wrong theory!

If we are looking to understand today’s meltdown we instead need to look to Minsky’s theory of “Financial Innovation” (I’m trying to dig up my old notes and will post a link to the paper once I find it). The crux of Minsky’s argument — its worth noting that he was a bit of a pessimist — was that regulatory bodies, no matter how well meaning, cannot regulate as fast as financial institutions innovate. Therefore at a high enough interest rate banks and other lenders have the incentive to “create” money through financial innovation.

I would argue that the option ARMs and other exotic mortgages created in the last 10 years were just the financial innovations that Minsky was theorizing about and in essence built an infinite money supply. That money supply (in the guise of the housing market) was driving the economy most of the last 7 years.

What we are experiencing now is the crumbling of all that “innovation” upon which we built our economy, and the money supply is “correcting” back to a more realistic level. In the process a lot of wealth is getting destroyed. My guess is Minsky is happy he died well before his theories proved as prescient as they have.

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