The Economics Book

300

An agent shows a couple around a

home. In the US housing boom banks

were lending on the expectation of rising

prices. People who could not afford

mortgages were encouraged to buy.

FINANCIAL CRISES

the loan over a period of time.
Minsky called these hedge units,
and they create little risk for
the lender or borrower. If people
felt more confident about the future,
they might buy a larger interest-
only mortgage, where their income
could pay back the interest on the
loan but not the loan itself. The
hope would be that a stable period
of positive economic growth would
increase demand so that the value
of the house would be greater at the
end of the period than at the start.
Minsky called these people
speculative borrowers.
As time passed, if stability and
confidence continued to last, the
desire to take greater risks would
encourage people to buy a house for
which their income could not even
pay the interest, so that the total
level of debt would increase, at
least in the short run. The
expectation would be that house
prices would rise fast enough to
cover the shortfall in the interest
repayments. This third type of
investment would create the

greatest amount of instability

in the future. Minsky named

this third type of investor Ponzi

borrowers after Charles Ponzi, the

Italian immigrant to America who

was one of the first to be caught

running the financial scam that

now bears his name. “Ponzi

schemes” attract funds by offering

very high returns. Initially, the con

men use new investors’ money to

pay the dividends. In this way

they can maintain the illusion that

investment is profitable and attract

new customers. However, soon the

scheme collapses due to its failure

to meet the high level of returns

that were promised. Investors in

such schemes are likely to lose a

large proportion of their money.

Housing bubble

The recent history of the US

housing market is an example of

how an economy that has had a

long period of stability creates

within itself the conditions for

instability. In the 1970s and 80s

the standard mortgage was sold

in a way that made sure that the

interest and the capital could be

paid off, in what Minsky viewed

as hedge units. However, by the

end of the 1990s a sustained

period of growth had pushed

house prices up, persuading an

increasing number of people to

use interest-only mortgages as

they speculated that prices would

continue to rise. The financial

system then began to supply a

whole array of “Ponzi”-style

mortgage deals to borrowers who

had incomes so low that they could

not afford to pay even the interest

on the loan—these were the

“subprime” mortgages. The

monthly shortfall was to be added

to their total debt. As long as house

prices continued to rise, the value

of the property would be worth

more than the debt. As long as new

people kept entering the market,

prices kept rising. At the same time

the finance industry that sold the

mortgages bundled them up and

sold them on to other banks as

assets that would deliver a stream

of income for 30 years.

The end of the game arrived in

2006. As the US economy stalled,

Low-risk

investments

With more time prices

rise too much, then

confidence disappears

As time passes,

asset prices rise

In early years
of stability
asset prices
are reasonable

Low-risk +

high-risk investments

Low-risk + high-risk +

reckless investments

During a period of stability, confidence
in the future grows, which leads people to
make increasingly risky investments. This
causes an asset price bubble, which will
eventually burst.