Question 1035 Minsky financial instability hypothesis, leverage
Which of the following statements about 'The Financial Instability Hypothesis' (Minsky, 1992) is NOT correct? Borrowers with income that's:
Borrowers with insufficient income to pay either interest expense or principal repayments might be forced to default, but it's usually in their interests to sell some or all of their assets and repay the debt, or borrow more new debt to make payments on their existing debt.
Forced default is more likely when the assets' value has decreased so they can't borrow more without exceeding the maximum LVR (loan-to-valuation or debt-to-asset ratio) written in the debt covenants, and the asset is indivisible such as real estate, so a small part can't be sold off to meet the agreed debt payments.
Question 1036 Minsky financial instability hypothesis, leverage
Hyman Minsky, author of 'The Financial Instability Hypothesis' (1992), wrote:
In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy with a sizeable body of speculative financial units is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make position by selling out position. This is likely to lead to a collapse of asset values.
Which of the below statements explaining this quote is NOT correct?
The collapse of asset values would be caused by an increase in the supply of assets, not demand, by those 'Ponzi units' that are forced to sell their assets to meet their debt repayments. This is called a 'fire sale'.
Question 1038 fire sale, leverage, no explanation
Listen to 'Lessons and Questions from the GFC' on 6 December 2018 by RBA Deputy Governor Guy Debelle from 17:58 to 20:08 or read the below transcript:
Guy Debelle talks about the GFC and says that the Australian government’s guarantee of wholesale debt and deposits on 12 October 2008 was "introduced to facilitate the flow of credit to the real economy at a reasonable price and, in some cases, alleviate the need for asset fire sales, which have the capacity to tip markets and the economy into a worse equilibrium... The crisis very much demonstrated the critical importance of keeping the lending flowing. The lesson is that countries that did that fared better than countries that didn't. That lesson is relevant to the situation today in Australia, where there is a risk that a reduced appetite to lend will overly curtail borrowing with consequent effects for the Australian economy." (Debelle, 2019)
When assets are sold in a fire sale, there’s usually a large increase in the:
No explanation provided.