The legal theory of finance and the financial instability hypothesis: Convergences and possible integration

ABSTRACT

This article presents the legal theory of finance (LTF) and compares it with the financial instability hypothesis (FIH), identifying points of convergence and divergence. The study aims to contribute to the literature by connecting these theories and provides the following main conclusions. First, the LTF incorporates aspects of the FIH, as the theories share several key elements, particularly the presence of fundamental uncertainty, the constraint of liquidity, and the necessity for governments to act as lenders of last resort. Second, the liquidity concept used in the LTF can be better comprehended with the use of Keynesian and post Keynesian literature on the topic. Third, the LTF aims to advance and update certain aspects of Minsky’s theory, particularly with regard to the globalization of markets, power relations, and the interdependencies of the political economy of finance. The study concludes that the theories are more complementary than divergent and future studies should create an analytical framework that integrates the theories’ most insightful aspects.

KEYWORDS:

• Financial instability hypothesis
• financial regulation
• legal theory of finance

JEL CLASSIFICATIONS:

• E12
• K00
• G28

Notes

¹For an analysis of how the subprime crisis started in America and became global, see Eichengreen et al. (2012). For a historical narrative, see Blinder (2013).

²This view is common among authors in the post Keynesian tradition. See, for instance, Wray (2011) and Bellafiori and Halevi (2009).

³Most of the new work on this research program was published in an issue of the Journal of Comparative Economics in 2013. See Pistor (2013b) for a brief exposition of the papers on this subject in that issue.

⁴The margins of safety provide protection against unexpected losses in every period of the project-funded events. According to Minsky (1986), these margins are set according to the cash flow to the capital value of the firm and the balance sheet. The “cushion” covers the margin of error in the anticipated returns from an investment project. On this subject and its relation to the subprime crisis, see also Kregel (2008).

⁵Specifically, for speculative agents, expected returns are lower than the total interest expense (principal amortization plus interest) but are sufficient to cover the interest for one or more periods. Any cash deficits are offset by surpluses in other periods such that at the end of the term of the contract the agent can settle any debts and still have additional net income. The solvency condition is respected; however, the liquidity condition is not respected. The viability of a speculative financial structure depends on both the revenue stream to pay interest on debts and the functioning of the financial market in which such debts are negotiated. For Ponzi agents, however, the payment of amortization needs to be completed during periods with new borrowings. Such agents do not meet liquidity or solvency conditions.

⁶Quoting Minsky on this instability as a function of a growing proportion of speculative and Ponzi financial postures in the economy: “For any given regime of financial institutions and government interventions the greater the weight of hedge financing in the economy, the greater the stability of the economy, whereas an increasing weight of speculative and Ponzi financing indicates an increasing susceptibility of the economy to financial instability” (Minsky, [1980] 1982a, p. 22). As noted by Knell (2014), when Ponzi agents are highly prevalent in the economy, as was evident in the subprime crisis of 2008, the financial demise of such individuals can bring about speculative agents and even hedge agents, who will lose their financial position after a sudden change in economic conditions.

⁷As Minsky states: “It follows that the fundamental instability of a capitalist economy is upward. The tendency to transform doing well into a speculative investment boom is the basic instability in a capitalist economy.” (Minsky, 1982, p. 66; emphasis added).

⁸On financial layering, see also Papadimitriou and Wray (2010), Kregel (2010), Nasica (2010).

⁹For an earlier treatment on this subject from this author, see also Minsky (1960, 1969). According to Cooper (2008, p. 171), “Credit creation is the foundation of the wealth-generation process; it is also the cause of financial instability.” On this issue, of particular importance to Minsky’s FIH is the presence of fundamental uncertainty in the economy, in the same fashion as proposed by Keynes (1937). Minsky (1982b, p. 65) further highlights the role of uncertainty: “An economy with private debts is especially vulnerable to changes in the pace of investment, for investment determines both aggregate demand and the viability of debt structures. The instability that such an economy exhibits follows from the subjective nature of expectations about the future course of investment, as well as the subjective determination by bankers and their business clients of the appropriate liability structure for the financing of positions in different types of capital assets. In a world with capitalist financial usages, uncertainty—in the sense of Keynes—is a major determinant of the path of income and employment.”

¹⁰Regarding rationality, Kindleberger (1978) notes, as does Minsky, that financial crisis are recurrent in the economy. The author argues that an initially rational movement of price increases can turn into a fundamentally irrational speculative process (euphoria), necessarily leading to a stage of panic. The situation is only controlled by a drop in commodity prices, market regulation, or external intervention. However, in contrast to Minsky’s proposal, this argument highlights the possibility that markets become irrational, which would be manifest in price bubbles.

¹¹Financial fragility is measured by the ratio Hedging / (Speculating + Ponzi). In a growing and optimistic economy, hedging postures decrease, and speculating plus Ponzi postures increase, thus increasing overall fragility.

¹²For a detailed discussion on the role of Big Government in the Minskian perspective, see Vasconcelos (2014).

¹³In this sense, one can argue that LTF is not yet a theory but a set of hypotheses from which a theory might be built. Regarding this possible objection, in this work we use the word theory in the sense of Pistor’s work.

¹⁴The sovereign state, through the central bank, is the most qualified LLR agent in modern capitalist society but has not historically been the most qualified such agent. See Tallman and Moen (1990).

¹⁵This means that in situations where a full blown crisis (in Minsky’s [1982] words: “It”) is close to occurring.

¹⁶The unfolding of the subprime crisis presents several examples of the law of elasticity. To rescue several financial institutions, the U.S. government relied entirely on ad hoc considerations, and even within a “central” power group of financial institutions, the government rescued some agents but not others, indicating the existence of a hierarchy within subgroups as well (the insurance giant AIG was saved; the investment bank Lehman Brothers was not; on this subject, see Sorkin [2010]). Nevertheless, the owners of the properties under mortgage, who were the trigger for the crisis, were not aided by the government, and their mortgages were executed, in accordance with their previously entered agreements. In the case of the crisis in the eurozone, the European Central Bank (ECB) has proved inflexible with regard to the problems experienced by “peripheral” countries (those designated by the market with the unfortunate acronym PIIGS—Portugal, Ireland, Italy, Greece, and Spain).With the deepening of the crisis, the ECB decided to act, specifically through the European Financial Stability Facility (EFSF), which was launched in 2010, and the European Stability Mechanism (ESM), which was implemented in 2011. One explanation for the ECB’s late response is that the ECB acted once it became clear that financial institutions from the “center,” particularly German and French banks that were exposed to public and private bonds issued by PIIGS, would suffer substantial losses if these countries experienced a financial collapse. An example of inelasticity of the law against a peripheral country can be seen in Argentina’s “default” in 2014. Argentina was prevented by an American federal judge from following through with payment to creditors who accepted the restructuring of debt caused by the default of 2001. Because some creditors—so-called vulture funds—did not accept the debt negotiation, the judge ruled that the country could not follow through with payment to creditors who accepted the agreement. Stiglitz and Guzman (2014) observe that this case demonstrates the inflexibility of the system in favor of the central agents, insofar as the federal judge protected the interests of American investment funds.

¹⁷Mehrling (2013) notes that in the foreign exchange markets the dollar is the reference currency for all transactions, even for transactions held in other countries. As the dollar has higher demand and therefore higher liquidity than other currencies in the market, the demand for the dollar increases even in panic situations when the American economy itself is responsible for market apprehension. A crisis generated by the United States affects the whole market. Given the increased uncertainty, investors seek safer assets and greater liquidity. Ironically, such an asset is the dollar itself and the securities issued by the American government, which generates a paradoxical situation whereby even a weaker but central country experiences greater demand for its currency and bonds.

¹⁸As we will see, following Keynes’s seminal treatment, liquidity is a relative attribute of assets; it is not a stable attribute but one dependent on a confidence state.

¹⁹Keynes’s liquidity-preference theory has been well discussed in the post Keynesian literature, but the principal references to this discussion remain the writings of Keynes himself ([1936a]1973a, [1936b]1973b, 1937).

²⁰In doing so, individuals and firms operates under some state of expectation and confidence built on a very complex environment and complex behavior, as stated in Keynes’s General Theory, chapter 12 (Keynes, [1936]1973).

²¹It is worth remembering that, according to Minsky’s reading of Keynes’s General Theory, Keynes deals with two pricing systems: the price of a physical product and wages on the one hand, and the price of capital and financial assets on the other. The theory of liquidity preference is the source of the pricing explanation in this second market (Minsky, 1977, pp. 60–61).

²²Obviously, this is subject to inflation because high inflation rates can affect the preference for money.

²³In the subprime crisis, fire sales of subprime securities stopped when the Fed started to accept these assets (with a haircut) in bail-out operations. The commercial banks of the United States stopped selling these assets, and their proportion of banks’ total assets grew after the Fed’s action (Vasconcelos, 2014). It was not an operation of issuing money, but of using the power of the state (or the law, in LTF terms), ensuring that the kind of assets the Fed accepts as collateral get relative liquidity. Moreover, if the lender of last resort accepts it, the other economic units will accept it too. This is typical of LLR actions. The liquidity, here, results from the new convention that the Fed brings to the market, acting as the LLR.

²⁴In addition, the LTF has to consider whether the way laws are interpreted and/or enforced changes the liquidity of all financial assets, particularly in regard to the issue of whether this interpretation/enforcement is a more stabilizing or destabilizing force.