arket, where the subprime loan crisis took its toll, to see the implications of little regulation. The Economist examined the derivatives market on November 12, 2009 and found that the over the counter (OTC) market, was close to $4 trillion. This market, full of customized, little-understood financial instruments, did not help the financial system during the height of the crisis. Derivatives “concentrated risk as much as they spread it, and amplified bad judgments,” the magazine writes. “Their leverage magnified losses on underlying assets like mortgages and crippled even the biggest firms” (1-2), it continues. The article explains that since the crisis, some suggest clearing OTC derivatives through “central counterparties (CCPs)” to ensure transparency and avoid further meltdowns.

The most convincing evidence that activity during the boom set the stage for the downturn can be found in Hyman Minsky’s Financial Instability Hypothesis. Minsky’s argument is simple but compelling. He starts by saying that capitalist societies feature financial intermediaries which are constantly pursuing higher profits. As the business cycle continues, more opportunities for profit emerge, and these corporations tend to take on debt in order to expand and compete. Minsky identifies three forms of debt financing used by corporations: hedge, speculative, and Ponzi. In hedge financing, corporations can fulfill all of their contractual payment obligations by their cash flows” (Minsky 7). Here, there is a healthy balance of debt to equity. But as it becomes more difficult to finance profit opportunities, corporations must take on more debt, and they enter a speculative financing phase. Companies who engage in speculative finance, “meet their payment commitments on “income account” on their liabilities, even as they cannot repay the principle out of income cash flows” (Minsky 7). These companies use their cash flow to pay off interest on their debt. Finally, Minsky suggests corporations ultimately turn to Ponzi financing, named after the famous swindler. Corporations that operate with Ponzi financing are not able to make their interest payments, and often borrow more to cover their old debt. Minsky explains that “A unit that Ponzi finances lowers the margin of safety that it offers the holders of its debts” (Minsky 7), making it inherently unstable. What Minsky has to say next seems to mirror the long boom and the bust that followed:

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 (Minsky 9).

To apply Minsky’s theory, as the long boom continued, financial institutions took on a great amount of debt to continue financing their operations. But when the markets began to collapse, these corporations found themselves with dangerously low reserves, and some went bankrupt, while others were bailed out. Minsky would likely argue for increased regulation of financial institutions, including higher reserve ratios and some form of debt management that would allow them to survive serious downturns. As the U.S. learned at the end of the long boom, there is a price for success.

Booms and busts are a way of economic life. While there doesn’t seem to be a cure for business cycles, a more intelligent mix of regulation and free-market principles could help make the next bust less painful. But perhaps a little preventative medicine could help too – the nation’s financial gurus in the Federal Reserve and Treasury need to be on alert for a boom that is accelerating out of control. Take green energy for example. A recent TIME magazine article points out that government support for alternative-energy technology could mean economic profits down the road: “The venture capitalists behind the high-tech and bio-tech booms see clean teach as the next big score. The necessary engineers, scientists, accountants, lawyers, marketers, and other knowledge workers are already there” (Grunwald 30). The dilemma, of course, for policymakers is when to time their actions appropriately, so as to not short-circuit an expansion. History has shown that policymakers like the Federal Reserve are reluctant to step in, which unfortunately may mean additional pain down the road. But whenever analysts suggest a new technology is the “next big score,” this means the money will start flowing in – and regulators had better be ready.