Business Cycles in Capitalist Economies

"Business Cycles in Capitalist Economies" is a 1994 publication by economist and financial wizard Hyman Minsky. The following excerpt from Wikipedia highlights the genius of the man who theorized on the economy of Wall Street and the fluctuations on financial markets.

"Hyman Minsky has proposed a simplified explanation that is most applicable to a closed economy. He theorized that financial fragility is a typical feature of any capitalist economy. High fragility leads to a higher risk of a financial crisis. To facilitate his analysis Minsky defines three types of financing firms choose according to their tolerance of risk. They are hedge finance, speculative finance and Ponzi finance. Ponzi finance leads to the most fragility.

Financial fragility levels move together with the business cycle. After a recession firms have lost much financing and choose only hedge, the safest. As the economy grows, and expected profits rise, firms tend to believe that they can allow themselves to take on speculative financing. In this case they know that profits will not cover all the interest all the time. Firms, however, believe that profits will rise and the loans will eventually be repaid without much trouble. More loans lead to more investment and the economy grows further. Then lenders also start believing that they will get back all the money they lend. Therefore they are ready to lend to firms without full guarantees of success. Lenders know that such firms will have problems repaying. Still, they believe these firms will refinance from elsewhere as their expected profits rise. This is Ponzi financing. In this way the economy has taken on much risky credit. Now it is only a question of time before some big firm actually defaults. Lenders understand the actual risks in the economy and stop giving credit so easily. Refinancing becomes impossible for many and more firms default. If no new money comes into the economy to allow the refinancing process, a real economic crisis begins. During the recession firms start to hedge again and the cycle is closed." - Wikipedia