Stability leads to leverage that leads to instability

“Investment must be financed, and how it is financed makes a difference. As the portion of investment that is externally financed grows, fragility increases. However, leveraging by using external funds increases profits so long as things go well. In a run of good times, such as those experienced in the early post-war period, most undertakings are successful. This encourages greater leverage, and margin of safety are reduced as the value of liquidity in such a period declines. Financial relations become more complex, with more layers of debts are interposed between income generation and income receipt. If one debtor defaults, a snowball of defaults can result since each creditor is also a debtor to some other creditor – and so on up through a long chain of commitments. To the extent that the institutional structure and swift intervention can constrain the crisis, risky financial practices are validated and still riskier innovations are encouraged. Fragility will rise on a long-term trend, with increasingly severe financial crises. If deep recessions can be avoided, the system is never cleansed of excessive debt – what Minsky termed “financial simplification” that used to occur in depressions, when all debt is wiped out and only equity ownership remains.”

Excerpt from the Introduction to “John Maynard Keynes” by Hyman Minsky