“When credit growth fuels asset price bubbles, the dangers for the financial sector and the real economy are much more substantial. The damage done to the economy by the bursting of credit boom bubbles is significant and long lasting.” – Òscar Jordà, Moritz Schularick, and Alan Taylor (Leveraged Bubbles)
“Each fed governor likes to live on the edge, further out on a limb where she can see more, then hope against hope that limb will not break until she leaves office.” – Kurt Vonnegut
Minsky moment is the synonym of financial crisis — the moment when excessive leverage that was inevitably created by the financial system during the boom phase of the cycle, starts collapsing and financial system enter the state of deep crisis with many banks becoming insolvent due to the level of leverage they accumulated. Government bailout of financial institutions under neoliberalism follows (because as Senator Durbin noted, “banks own the place” — the Congress) and then overhand of excessive debt depress the economy that enters the stage of prolonged stagnation.
The view developed in this volume identifies both real and financial causes for the Great Recession, including the real income stagnation suffered by households across most of the income distribution on one hand, and deregulation and institutional change in the financial sector on the other.
The interplay of these factors led to massive debt accumulation, particularly by U.S. households seeking to supplement stagnant incomes in their pursuit of increasing consumption aspirations. Household borrowing was spurred on by a financial sector rendered ever freer of inter- and postwar financial regulations. These regulations came to be seen as unnecessary fetters on an inherently self-regulating “free market,” an idealized notion in which financiers and policy makers placed increasing trust and confidence.
Ultimately, the self-reinforcing developments in the real and financial sectors proved deadly.
Minsky should be the most admired economist in the second half of the 21st. Century. His views are now partially accepted even by neoclassical economists with their stochastic equilibrium of supply and demand nonsense. This is mainly because they have no other choice. But Minsky was more than an astute researcher of business cycle and the Great Depression. Perhaps his writings on eradicating poverty will earn the respect that it may deserve with time as well.
|Financialization is inherent in capitalism and is the key to its instability. Minskyconsidered the rising of private debt to GDP ratio an immanent feature of capitalism that lead to financial crisis. The idea of Minsky moment is related to the fact that the fractional reserve banking periodically causes credit collapse when the leveraged credit expansion goes into reverse.|
In any case he was one of the first researchers who understood (after Keynes) that financialisation is inherent in capitalism and is the key to its instability:
“Capitalism is essentially a financial system, and the peculiar behavioral attributes of a capitalist economy center around the impact of finance upon system behavior.” Minsky (1967)
Fifty years ago, Minsky, following Marx, viewed instability as the central flaw of the financial system under capitalism, as its inherent flaw. But unlike Marx, who thought that the periodic crisis of overproduction is the source of instability (as well as impoverishment of workers), Minsky assumed that the key source of that instability in the cycles of business borrowing and fractional bank lending, when “good times” lead to excessive borrowing and overproduction (The Alternative To Neoliberalism )
Minsky on capitalism:
- He followed Marx stating that “capitalism is inherently flawed, being prone to booms, crises and depressions.
- This instability is due to characteristics the financial system must possess and will inevitably acquire, if it is to be consistent with full-blown capitalism.
- Such a financial system will be capable of both generating signals that induce an accelerating desire to invest and of financing that accelerating investment.” (Minsky 1969b: 224)
- “The natural starting place for analyzing the relation between debt and income is to take an economy with a cyclical past that is now doing well.
- The inherited debt reflects the history of the economy, which includes a period in the not too distant past in which the economy did not do well.
- Acceptable liability structures are based upon some margin of safety so that expected cash flows, even in periods when the economy is not doing well, will cover contractual debt payments.
- As the period over which the economy does well lengthens, two things become evident in board rooms. Existing debts are easily validated and units that were heavily in debt prospered; it paid to lever.”
- It becomes apparent that the margins of safety built into debt structures were too great. ans should be reduced…
- As a result, over a period in which the economy does well, views about acceptable debt structure change. In the dealmaking that goes on between banks, investment bankers, and businessmen, the acceptable amount of debt to use in financing various types of activity and positions increases.
- This increase in the weight of debt financing raises the market pnce of capital assets and increases investment. As this continues, the economy is transformed into a boom economy…”
- This transforms a period of tranquil growth into a period of speculative excess
- “Stable growth is inconsistent with the manner in which investment is determined in an economy in which debt-financed ownership of capital assets exists, and the extent to which such debt financing can be carried is market determined.
- 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.”
He called his model the “Financial Instability Hypothesis”. According to Steve Keen, Minsky model boils down to three statements:
- The employment rate will rise if economic growth exceeds the sum of population growth and growth in labor productivity;
- The wages share of output will rise if money wage demands exceed the sum of inflation and growth in labor productivity; and
- The private debt to GDP ratio will rise if the rate of growth of private debt exceeds the sum of inflation plus the rate of economic growth.
He considered the rising of private debt to GDP ratio an immanent feature of capitalism that lead to financial crisis. While the ultimate feature of neoliberalism is redistribution of wealth up (rising of inequality) it can continue only while private debt can compensate that sliding share of labor wages in GDP.
Several other sources of financial instability were pointed out by others:
- The logic of markets gets extended to “fictitious commodities”—land, labor, and money. Polanyi (1944) famously zeroed in on the way that the logic of markets gets extended to “fictitious commodities”—land, labor, and money—and the way that society reacts defensively to that illegitimate extension. Today, arguably, it is the logic of finance that has been so extended, turning everything it touches into an asset with a speculative price.
- Excessive accumulations of financial wealth — “other people’s money”—tend to undermine democratic institutions and lead to the gradual shift to totalitarianism, often of national socialist type. Brandeis (1914) thought that excessive accumulations of financial wealth — “other people’s money”—tends to undermine democratic institutions (among other problems). Today, arguably TBTF financial institution threatens democracy.
The idea of Minsky moment is related to the fact that the fractional reserve banking periodically causes credit collapse when the leveraged credit expansion goes into reverse. And mainstream economists do not want to talk about the fact that increasing confidence breeds increased leverage. So financial stability breeds instability and subsequent financial crisis. All actions to guarantee a market rise, ultimately guarantee its destruction because greed will always take advantage of a “sure thing” and push it beyond reasonable boundaries. In other words, marker players are no rational and assume that it would be foolish not to maximize leverage in a market which is going up. So the fractional reserve banking mechanisms ultimately and ironically lead to over lending and guarantee the subsequent crisis and the market’s destruction. Stability breed instability.
Fractional reserve banking based economic system with private players (aka capitalism) is inherently unstable
That means that fractional reserve banking based economic system with private players (aka capitalism) is inherently unstable. And first of all because fractional reserve banking is debt based. In order to have growth, it must create debt. Eventually the pyramid of debt crushes and crisis hit. When the credit expansion fuels asset price bubbles, the dangers for the financial sector and the real economy are substantial because this way the credit boom bubble is inflated, which eventually burst. The damage done to the economy by the bursting of credit boom bubbles is significant and long lasting.
«When credit growth fuels asset price bubbles, the dangers for the financial sector and the real economy are much more substantial.»
So M Minsky 50 years ago and M Pettis 15 years ago (in his “The volatility machine”) had it right:
«In the past decades, central banks typically have taken a hands-off approach to asset price bubbles and credit booms.»
If only! They have been feeding credit-based asset price bubbles by at the same time weakening regulations to push up allowed capital-leverage ratios, and boosting the quantity of credit as high as possible, but specifically most for leveraged speculation on assets, by allowing vast-overvaluations on those assets.
Central banks have worked hard in most Anglo-American countries to redistribute income and wealth from “inflationary” worker incomes to “non-inflationary” rentier incomes via hyper-subsidizing with endless cheap credit the excesses of financial speculation in driving up asset prices.
Not very hands-off at all.
Steve Keen clearly understands this mechanism. See http://www.debtdeflation.com/blogs/manifesto/ John Kay in his 5-Jan-2010 FT column very aptly explained the systemic instability of financial sector hypothesis:
The credit crunch of 2007-08 was the third phase of a larger and longer financial crisis. The first phase was the emerging market defaults of the 1990s. The second was the new economy boom and bust at the turn of the century. The third was the collapse of markets for structured debt products, which had grown so rapidly in the five years up to 2007.
The manifestation of the problem in each phase was different – first emerging markets, then stock markets, then debt. But the mechanics were essentially the same. Financial institutions identified a genuine economic change – the assimilation of some poor countries into the global economy, the opportunities offered to business by new information technology, and the development of opportunities to manage risk and maturity mismatch more effectively through markets. Competition to sell products led to wild exaggeration of the pace and scope of these trends. The resulting herd enthusiasm led to mispricing – particularly in asset markets, which yielded large, and largely illusory, profits, of which a substantial fraction was paid to employees.
Eventually, at the end of each phase, reality impinged. The activities that once seemed so profitable – funding the financial systems of emerging economies, promoting start-up internet businesses, trading in structured debt products – turned out, in fact, to have been a source of losses. Lenders had to make write-offs, most of the new economy stocks proved valueless and many structured products became unmarketable. Governments, and particularly the US government, reacted on each occasion by pumping money into the financial system in the hope of staving off wider collapse, with some degree of success. At the end of each phase, regulators and financial institutions declared that lessons had been learnt. While measures were implemented which, if they had been introduced five years earlier, might have prevented the most recent crisis from taking the particular form it did, these responses addressed the particular problem that had just occurred, rather than the underlying generic problems of skewed incentives and dysfunctional institutional structures.
The public support of markets provided on each occasion the fuel needed to stoke the next crisis. Each boom and bust is larger than the last. Since the alleviating action is also larger, the pattern is one of cycles of increasing amplitude.
I do not know what the epicenter of the next crisis will be, except that it is unlikely to involve structured debt products. I do know that unless human nature changes or there is fundamental change in the structure of the financial services industry – equally improbable – there will be another manifestation once again based on naive extrapolation and collective magical thinking. The recent crisis taxed to the full – the word tax is used deliberately – the resources of world governments and their citizens. Even if there is will to respond to the next crisis, the capacity to do so may not be there.
The citizens of that most placid of countries, Iceland, now backed by their president, have found a characteristically polite and restrained way of disputing an obligation to stump up large sums of cash to pay for the arrogance and greed of other people. They are right. We should listen to them before the same message is conveyed in much more violent form, in another place and at another time. But it seems unlikely that we will.
We made a mistake in the closing decades of the 20th century. We removed restrictions that had imposed functional separation on financial institutions. This led to businesses riddled with conflicts of interest and culture, controlled by warring groups of their own senior employees. The scale of resources such businesses commanded enabled them to wield influence to create a – for them – virtuous circle of growing economic and political power. That mistake will not be easily remedied, and that is why I view the new decade with great apprehension. In the name of free markets, we created a monster that threatens to destroy the very free markets we extol.
While Hyman Minsky was the first to clearly formulate the financial instability hypothesis, Keynes understood the same dynamic pretty well. He postulated that a world with a large financial sector and an excessive emphasis on the production of investment products creates instability both in terms of output and prices. In other words, it automatically tends to generate credit and asset bubbles. The key driver of taking excessive risk is the fact that financial professionals generally risk other people’s money and due to this fact have asymmetrical incentives:
- They get big rewards when bets go right
- They don’t have to pay when bets go wrong.
The key driver of taking excessive risk is the fact that financial professionals generally risk other people’s money and due to this fact have asymmetrical incentives:
This asymmetrical incentives ensure that the financial system is structurally biased toward taking on more risk than what should be taken.
This asymmetry is not a new observation of this systemic problem. Andrew Jackson noted it in much more polemic way long ago:
“Gentlemen, I have had men watching you for a long time and I am convinced that you have used the funds of the bank to speculate in the breadstuffs of the country. When you won, you divided the profits amongst you, and when you lost, you charged it to the bank. You tell me that if I take the deposits from the bank and annul its charter, I shall ruin ten thousand families. That may be true, gentlemen, but that is your sin! Should I let you go on, you will ruin fifty thousand families, and that would be my sin! You are a den of vipers and thieves. I intend to rout you out, and by the grace of the Eternal God, will rout you out.”
This asymmetrical incentives ensure that the financial system is structurally biased toward taking on more risk than what should be taken. In other words it naturally tend to slide to the casino model, the with omnipresent reckless gambling as the primary and the most profitable mode of operation while an opportunities last. The only way to counter this is to throw sand into the wheels of financial mechanism: enforce strict regulations, limit money supplies and periodically jail too enthusiastic bankers. The latter is as important or even more important as the other two because bankers tend to abuse “limited liability” status like no other sector.
Asset inflation over the past 10 years and the subsequent catastrophe incurred is a way classic behavior of dynamic system with strong positive feedback loop. Such behavior does not depends of personalities of bankers or policymakers, but is an immanent property of this class of dynamic systems. And the main driving force here was deregulation. So its important that new regulation has safety feature which make removal of it more complicated and requiring bigger majority like is the case with constitutional issues.
Another fact was the fact that due to perverted incentives, accounting in the banks was fraudulent from the very beginning and it was fraudulent on purpose. Essentially accounting in banks automatically become as bad as law enforcement permits. This is a classic case of control fraud and from prevention standpoint is make sense to establish huge penalties for auditors, which might hurt healthy institutions but help to ensure that the most fraudulent institution lose these bank charter before affecting the whole system. With the anti-regulatory zeal of Bush II administration the level of auditing became too superficial, almost non-existent. I remember perverted dances with Sarbanes–Oxley when it was clear from the very beginning that the real goal is not to strengthen accounting but to earn fees and to create as much profitable red tape as possible, in perfect Soviet bureaucracy style.
Deregulation also increases systemic risk by influencing the real goals of financial organizations. At some point of deregulation process the goal of higher remuneration for the top brass becomes self-sustainable trend and replaces all other goals of the financial organization. This is the essence of Martin Taylor’s, the former chief executive of Barclays, article FT.com – Innumerate bankers were ripe for a reckoning in the Financial Times (Dec 15, 2009), which is worth reading in its entirety:
City people have always been paid well relative to others, but mega-bonuses are quite new. From my own experience, in the mid-1990s no more than four or five employees of Barclays’ then investment bank were paid more than £1m, and no one got near £2m. Around the turn of the millennium across the market things began to take off, and accelerated rapidly – after a pause in 2001-03 – so that exceptionally high remuneration, not just individually, but in total, was paid out between 2004 and 2007.
Observers of financial services saw unbelievable prosperity and apparently immense value added. Yet two years later the whole industry was bankrupt. A simple reason underlies this: any industry that pays out in cash colossal accounting profits that are largely imaginary will go bust quickly. Not only has the industry – and by extension societies that depend on it – been spending money that is no longer there, it has been giving away money that it only imagined it had in the first place. Worse, it seems to want to do it all again.
What were the sources of this imaginary wealth?
- First, spreads on credit that took no account of default probabilities (bankers have been doing this for centuries, but not on this scale).
- Second, unrealised mark-to-market profits on the trading book, especially in illiquid instruments.
- Third, profits conjured up by taking the net present value of streams of income stretching into the future, on derivative issuance for example.
In the last two of these the bank was not receiving any income, merely “booking revenues”. How could they pay this non-existent wealth out in cash to their employees? Because they had no measure of cash flow to tell them they were idiots, and because everyone else was doing it. Paying out 50 per cent of revenues to staff had become the rule, even when the “revenues” did not actually consist of money.
In the next phase instability is amplified by the way governments and central banks respond to crises caused by credit bubble: the state has powerful means to end a recession, but the policies it uses give rise to the next phase of instability, the next bubble…. When money is virtually free – or, at least, at 0.5 per cent – traders feel stupid if they don’t leverage up to the hilt. Thus previous bubble and crash become a dress rehearsal for the next.
Resulting self-sustaining “boom-bust” cycle is very close how electronic systems with positive feedback loop behave and cannot be explained by neo-classical macroeconomic models. Like with electronic devices, the financial institution in this mode is unable to provide the services that are needed.
As Minsky noted long ago (cited from Stephen Mihm Why capitalism fails Boston Globe):
Modern finance, he argued, was far from the stabilizing force that mainstream economics portrayed: rather, it was a system that created the illusion of stability while simultaneously creating the conditions for an inevitable and dramatic collapse.…our whole financial system contains the seeds of its own destruction. “Instability,” he wrote, “is an inherent and inescapable flaw of capitalism.”
Minsky’s vision might have been dark, but he was not a fatalist; he believed it was possible to craft policies that could blunt the collateral damage caused by financial crises. But with a growing number of economists eager to declare the recession over, and the crisis itself apparently behind us, these policies may prove as discomforting as the theories that prompted them in the first place. Indeed, as economists re-embrace Minsky’s prophetic insights, it is far from clear that they’re ready to reckon with the full implications of what he saw.
And he understood the roots of the current credit bubble much better that neoclassical economists like Bernanke:
As people forget that failure is a possibility, a “euphoric economy” eventually develops, fueled by the rise of far riskier borrowers – what [Minsky] called speculative borrowers, those whose income would cover interest payments but not the principal; and those he called “Ponzi borrowers,” those whose income could cover neither, and could only pay their bills by borrowing still further.As these latter categories grew, the overall economy would shift from a conservative but profitable environment to a much more freewheeling system dominated by players whose survival depended not on sound business plans, but on borrowed money and freely available credit.
Minsky’s financial instability hypothesis suggests that when optimism is high and ample funds are available for investment, investors tend to migrate from the safe hedge end of the Minsky spectrum to the risky speculative and Ponzi end. Indeed, in the current crisis, investors tried to raise returns by increasing leverage and switching to financing via short-term — sometimes overnight — borrowing (Too late to learn?):
In the church of Friedman, inflation was the ol’ devil tempting the good folk; the 1980s seemed to prove that, let loose, it would cause untold havoc on the populace. But, as Barbera notes:
The last five major global cyclical events were the early 1990s recession – largely occasioned by the US Savings & Loan crisis, the collapse of Japan Inc after the stock market crash of 1990, the Asian crisis of the mid-1990s, the fabulous technology boom/bust cycle at the turn of the millennium, and the unprecedented rise and then collapse for US residential real estate in 2007-2008. All five episodes delivered recessions, either global or regional. In no case was there a significant prior acceleration of wages and general prices. In each case, an investment boom and an associated asset market ran to improbable heights and then collapsed. From 1945 to 1985, there was no recession caused by the instability of investment prompted by financial speculation – and since 1985 there has been no recession that has not been caused by these factors.
Thus, meet the devil in Minsky’s paradise – “an investment boom and an associated asset market [that] ran to improbable heights and then collapsed”.According the Barbera, “Minsky’s financial instability hypothesis depends critically on what amounts to a sociological insight. People change their minds about taking risks. They don’t make a one-time rational judgment about debt use and stock market exposure and stick to it. Instead, they change their minds over time. And history is quite clear about how they change their minds. The longer the good times endure, the more people begin to see wisdom in risky strategies.”
Current economy state can be called following Paul McCulley a “stable disequilibrium” very similar to a state a sand pile. All this pile of stocks, debt instruments, derivatives, credit default swaps and God know corresponds to a pile of sand that is on the verse of losing stability. Each financial player works hard to maximize their own personal outcome but the “invisible hand” effect in adding sand to the pile that is increasing systemic instability. According to Minsky, the longer such situation continues the more likely and violent an “avalanche”.
The late Hunt Taylor wrote, in 2006:
“Let us start with what we know. First, these markets look nothing like anything I’ve ever encountered before. Their stunning complexity, the staggering number of tradable instruments and their interconnectedness, the light-speed at which information moves, the degree to which the movement of one instrument triggers nonlinear reactions along chains of related derivatives, and the requisite level of mathematics necessary to price them speak to the reality that we are now sailing in uncharted waters.
“… I’ve had 30-plus years of learning experiences in markets, all of which tell me that technology and telecommunications will not do away with human greed and ignorance. I think we will drive the car faster and faster until something bad happens. And I think it will come, like a comet, from that part of the night sky where we least expect it.”
This is a gold age for bankers. As Peter Boone Simon Johnson wrote in New Republic (The Next Financial Crisis ):
Banking was once a dangerous profession. In Britain, for instance, bankers faced “unlimited liability”–that is, if you ran a bank, and the bank couldn’t repay depositors or other creditors, those people had the right to confiscate all your personal assets and income until you repaid. It wasn’t until the second half of the nineteenth century that Britain established limited liability for bank owners. From that point on, British bankers no longer assumed much financial risk themselves.
In the United States, there was great experimentation with banking during the 1800s, but those involved in the enterprise typically made a substantial commitment of their own capital. For example, there was a well-established tradition of “double liability,” in which stockholders were responsible for twice the original value of their shares in a bank. This encouraged stockholders to carefully monitor bank executives and employees. And, in turn, it placed a lot of pressure on those who managed banks. If they fared poorly, they typically faced personal and professional ruin. The idea that a bank executive would retain wealth and social status in the event of a self-induced calamity would have struck everyone–including bank executives themselves–as ludicrous.
Enter, in the early part of the twentieth century, the Federal Reserve. The Fed was founded in 1913, but discussion about whether to create a central bank had swirled for years. “No one can carefully study the experience of the other great commercial nations,” argued Republican Senator Nelson Aldrich in an influential 1909 speech, “without being convinced that disastrous results of recurring financial crises have been successfully prevented by a proper organization of capital and by the adoption of wise methods of banking and of currency”–in other words, a central bank. In November 1910, Aldrich and a small group of top financiers met on an isolated island off the coast of Georgia. There, they hammered out a draft plan to create a strong central bank that would be owned by banks themselves.
What these bankers essentially wanted was a bailout mechanism for the aftermath of speculative crashes–something more durable than J.P. Morgan, who saved the day in the Panic of 1907 but couldn’t be counted on to live forever. While they sought informal government backing and substantial government financial support for their new venture, the bankers also wanted it to remain free of government interference, oversight, or control.
Another destabilizing fact is so called myth of an invisible hand which is closely related to the myth about market self-regulation. The misunderstood argument of Adam Smith , the founder of modern economics, that free markets led to efficient outcomes, “as if by an invisible hand” has played a central role in these debates: it suggested that we could, by and large, rely on markets without government intervention. About “invisible hand” deification, see The Invisible Hand, Trumped by Darwin – NYTimes.com. One of the most important counterargument against financial market self-regulation is the existence of so called “Minsky Moments”:
“Minsky” was shorthand for Hyman Minsky, an American macroeconomist who died over a decade ago. He predicted almost exactly the kind of meltdown that recently hammered the global economy. He believed in capitalism, but also believed it had almost a genetic weakness. Modern finance, he argued, was far from the stabilizing force that mainstream economics portrayed: rather, it was a system that created the illusion of stability while simultaneously creating the conditions for an inevitable and dramatic collapse.
In other words, the one person who foresaw the crisis also believed that our whole financial system contains the seeds of its own destruction. “Instability,” he wrote, “is an inherent and inescapable flaw of capitalism.”
Minsky believed it was possible to craft policies that could blunt the collateral damage caused by financial crises. As economists re-embrace Minsky’s prophetic insights, it is far from clear that they’re ready to reckon with the full implications of what he saw.
Minsky theory was not well received due to powerful orthodoxy, born in the years after World War II, known as the neoclassical synthesis. The older belief in a self-regulating, self-stabilizing free market had selectively absorbed a few insights from John Maynard Keynes, the great economist of the 1930s who wrote extensively of the ways that capitalism might fail to maintain full employment. Most economists still believed that free-market capitalism was a fundamentally stable basis for an economy, though thanks to Keynes, some now acknowledged that government might under certain circumstances play a role in keeping the economy – and employment – on an even keel.
Economists like Paul Samuelson became the public face of the new establishment; he and others at a handful of top universities became deeply influential in Washington. In theory, Minsky could have been an academic star in this new establishment: Like Samuelson, he earned his doctorate in economics at Harvard University, where he studied with legendary Austrian economist Joseph Schumpeter, as well as future Nobel laureate Wassily Leontief.
But Minsky was cut from a different cloth than many of the other big names. The descendent of immigrants from Minsk, in modern-day Belarus, Minsky was the son of Menshevik socialists. While most economists spent the 1950s and 1960s toiling over mathematical models, Minsky pursued research on poverty, hardly the hottest subfield of economics. With long, wild, white hair, Minsky was closer to the counterculture than to mainstream economics. He was, recalls the economist L. Randall Wray, a former student, a “character.”
So while his colleagues from graduate school went on to win Nobel prizes and rise to the top of academia, Minsky languished. He drifted from Brown to Berkeley and eventually to Washington University. Indeed, many economists weren’t even aware of his work. One assessment of Minsky published in 1997 simply noted that his “work has not had a major influence in the macroeconomic discussions of the last thirty years.”
Yet he was busy. In addition to poverty, Minsky began to delve into the field of finance, which despite its seeming importance had no place in the theories formulated by Samuelson and others. He also began to ask a simple, if disturbing question: “Can ‘it’ happen again?” – where “it” was, like Harry Potter’s nemesis Voldemort, the thing that could not be named: the Great Depression.
In his writings, Minsky looked to his intellectual hero, Keynes, arguably the greatest economist of the 20th century. But where most economists drew a single, simplistic lesson from Keynes – that government could step in and micromanage the economy, smooth out the business cycle, and keep things on an even keel – Minsky had no interest in what he and a handful of other dissident economists came to call “bastard Keynesianism.”
Instead, Minsky drew his own, far darker, lessons from Keynes’s landmark writings, which dealt not only with the problem of unemployment, but with money and banking. Although Keynes had never stated this explicitly, Minsky argued that Keynes’s collective work amounted to a powerful argument that capitalism was by its very nature unstable and prone to collapse. Far from trending toward some magical state of equilibrium, capitalism would inevitably do the opposite. It would lurch over a cliff.
This insight bore the stamp of his advisor Joseph Schumpeter, the noted Austrian economist now famous for documenting capitalism’s ceaseless process of “creative destruction.” But Minsky spent more time thinking about destruction than creation. In doing so, he formulated an intriguing theory: not only was capitalism prone to collapse, he argued, it was precisely its periods of economic stability that would set the stage for monumental crises.
Minsky called his idea the “Financial Instability Hypothesis.” In the wake of a depression, he noted, financial institutions are extraordinarily conservative, as are businesses. With the borrowers and the lenders who fuel the economy all steering clear of high-risk deals, things go smoothly: loans are almost always paid on time, businesses generally succeed, and everyone does well. That success, however, inevitably encourages borrowers and lenders to take on more risk in the reasonable hope of making more money. As Minsky observed, “Success breeds a disregard of the possibility of failure.”
As people forget that failure is a possibility, a “euphoric economy” eventually develops, fueled by the rise of far riskier borrowers – what he called speculative borrowers, those whose income would cover interest payments but not the principal; and those he called “Ponzi borrowers,” those whose income could cover neither, and could only pay their bills by borrowing still further. As these latter categories grew, the overall economy would shift from a conservative but profitable environment to a much more freewheeling system dominated by players whose survival depended not on sound business plans, but on borrowed money and freely available credit.
Once that kind of economy had developed, any panic could wreck the market. The failure of a single firm, for example, or the revelation of a staggering fraud could trigger fear and a sudden, economy-wide attempt to shed debt. This watershed moment – what was later dubbed the “Minsky moment” – would create an environment deeply inhospitable to all borrowers. The speculators and Ponzi borrowers would collapse first, as they lost access to the credit they needed to survive. Even the more stable players might find themselves unable to pay their debt without selling off assets; their forced sales would send asset prices spiraling downward, and inevitably, the entire rickety financial edifice would start to collapse. Businesses would falter, and the crisis would spill over to the “real” economy that depended on the now-collapsing financial system.
From the 1960s onward, Minsky elaborated on this hypothesis. At the time he believed that this shift was already underway: postwar stability, financial innovation, and the receding memory of the Great Depression were gradually setting the stage for a crisis of epic proportions. Most of what he had to say fell on deaf ears. The 1960s were an era of solid growth, and although the economic stagnation of the 1970s was a blow to mainstream neo-Keynesian economics, it did not send policymakers scurrying to Minsky. Instead, a new free market fundamentalism took root: government was the problem, not the solution.
Moreover, the new dogma coincided with a remarkable era of stability. The period from the late 1980s onward has been dubbed the “Great Moderation,” a time of shallow recessions and great resilience among most major industrial economies. Things had never been more stable. The likelihood that “it” could happen again now seemed laughable.
Yet throughout this period, the financial system – not the economy, but finance as an industry – was growing by leaps and bounds. Minsky spent the last years of his life, in the early 1990s, warning of the dangers of securitization and other forms of financial innovation, but few economists listened. Nor did they pay attention to consumers’ and companies’ growing dependence on debt, and the growing use of leverage within the financial system.
By the end of the 20th century, the financial system that Minsky had warned about had materialized, complete with speculative borrowers, Ponzi borrowers, and precious few of the conservative borrowers who were the bedrock of a truly stable economy. Over decades, we really had forgotten the meaning of risk. When storied financial firms started to fall, sending shock waves through the “real” economy, his predictions started to look a lot like a road map.
“This wasn’t a Minsky moment,” explains Randall Wray. “It was a Minsky half-century.”
Minsky is now all the rage. A year ago, an influential Financial Times columnist confided to readers that rereading Minsky’s 1986 “masterpiece” – “Stabilizing an Unstable Economy” – “helped clear my mind on this crisis.” Others joined the chorus. Earlier this year, two economic heavyweights – Paul Krugman and Brad DeLong – both tipped their hats to him in public forums. Indeed, the Nobel Prize-winning Krugman titled one of the Robbins lectures at the London School of Economics “The Night They Re-read Minsky.”
Today most economists, it’s safe to say, are probably reading Minsky for the first time, trying to fit his unconventional insights into the theoretical scaffolding of their profession. If Minsky were alive today, he would no doubt applaud this belated acknowledgment, even if it has come at a terrible cost. As he once wryly observed, “There is nothing wrong with macroeconomics that another depression [won’t] cure.”
But does Minsky’s work offer us any practical help? If capitalism is inherently self-destructive and unstable – never mind that it produces inequality and unemployment, as Keynes had observed – now what?
After spending his life warning of the perils of the complacency that comes with stability – and having it fall on deaf ears – Minsky was understandably pessimistic about the ability to short-circuit the tragic cycle of boom and bust. But he did believe that much could be done to ameliorate the damage.
To prevent the Minsky moment from becoming a national calamity, part of his solution (which was shared with other economists) was to have the Federal Reserve – what he liked to call the “Big Bank” – step into the breach and act as a lender of last resort to firms under siege. By throwing lines of liquidity to foundering firms, the Federal Reserve could break the cycle and stabilize the financial system. It failed to do so during the Great Depression, when it stood by and let a banking crisis spiral out of control. This time, under the leadership of Ben Bernanke – like Minsky, a scholar of the Depression – it took a very different approach, becoming a lender of last resort to everything from hedge funds to investment banks to money market funds.
Minsky’s other solution, however, was considerably more radical and less palatable politically. The preferred mainstream tactic for pulling the economy out of a crisis was – and is – based on the Keynesian notion of “priming the pump” by sending money that will employ lots of high-skilled, unionized labor – by building a new high-speed train line, for example.
Minsky, however, argued for a “bubble-up” approach, sending money to the poor and unskilled first. The government – or what he liked to call “Big Government” – should become the “employer of last resort,” he said, offering a job to anyone who wanted one at a set minimum wage.
It would be paid to workers who would supply child care, clean streets, and provide services that would give taxpayers a visible return on their dollars. In being available to everyone, it would be even more ambitious than the New Deal, sharply reducing the welfare rolls by guaranteeing a job for anyone who was able to work. Such a program would not only help the poor and unskilled, he believed, but would put a floor beneath everyone else’s wages too, preventing salaries of more skilled workers from falling too precipitously, and sending benefits up the socioeconomic ladder.
While economists may acknowledge some of Minsky’s points on financial instability, it’s safe to say that even liberal policymakers are still a long way from thinking about such an expanded role for the American government. If nothing else, an expensive full-employment program would veer far too close to socialism for the comfort of politicians. For his part, Wray thinks that the critics are apt to misunderstand Minsky. “He saw these ideas as perfectly consistent with capitalism,” says Wray. “They would make capitalism better.”
But not perfect. Indeed, if there’s anything to be drawn from Minsky’s collected work, it’s that perfection, like stability and equilibrium, are mirages. Minsky did not share his profession’s quaint belief that everything could be reduced to a tidy model, or a pat theory. His was a kind of existential economics: capitalism, like life itself, is difficult, even tragic. “There is no simple answer to the problems of our capitalism,” wrote Minsky. “There is no solution that can be transformed into a catchy phrase and carried on banners.”