Minsky and Financial Reform’s “Never Ending” Struggle

Michael Stephens | April 18, 2014

In a new policy brief, Jan Kregel looks at a lesser-known, early period of Minsky’s work on financial reform. In the ’60s, Minsky was a consultant to a number of government agencies, including the Federal Reserve, on issues related to financial regulation. In this context, he came up with a new approach to bank examination, which he called “cash-flow based.” The new approach evaluated bank liquidity, not as an innate feature of a particular class of assets, but as a function of the balance sheet of the institutions under examination, the markets for those assets, the state of the macroeconomy and the financial system as a whole, and much else. In fact, as Kregel explains, what Minsky was after here was related to an early form of what we now call “macroprudential regulation.”

The evolution of Minsky’s thought on this approach to bank examination is interesting enough in itself, but it’s also a reflection of Minsky’s broader thinking about financial regulation and reform. Minsky developed his regulatory proposals in the ’60s and ’70s with an eye to what was to become his well-known “financial instability hypothesis,” which is to say, his proposals were informed by a theory of endogenous financial instability: a theory in which financial crises are not only possible, but are to be expected; generated as a result of the “normal” functioning of the financial system. Without such a theory, as Kregel points out, it’s hard to formulate effective regulation:

As Minsky was fond of pointing out, the bedrock of mainstream theory is a system of self-adjusting equilibrium that provides little scope for the discussion of a systemic crisis, since, in this theory, one could not occur. It was thus extremely difficult to formulate prudential regulations to respond to a financial crisis if one could only occur as the result of random, external shocks, or what Alan Greenspan would consider idiosyncratic, nonrational (fraudulent) behavior. The only basis for regulation would be to concentrate on the eradication of the disruptive behavior of bad actors or mismanaged financial institutions. From this initial presumption, the formulation of regulations and supervisory procedures required the assessment of the activities of individual banks—without any reference to their relations with other institutions or the overall environment in which they functioned.

One consequence of being informed by a proper theory of financial instability, Minsky maintained, is that regulation has to be responsive to innovations in the financial system; innovations that are often reactions to new regulatory frameworks. What this calls for, then, is not just the right set of rules, whether your preferred model is Glass-Steagall or something else, but also an adaptive, “dynamic” framework that’s attuned to the evolution of the financial system. This is from the preface:

the challenge for reform is not just the proper formulation and implementation of specific rules, but the development of an approach that is sensitive to the potential of actors in the financial system to adapt and innovate, creating new practices that threaten the stability of the system in ways that may not become apparent until the next crisis hits. Financial regulation and examination procedures need to be constantly reassessed in order to avoid becoming obsolete. And in that sense, as Minsky recognized, “the quest to get money and finance right may be a never ending struggle.”

There’s a lot more here, including Kregel’s take on the ongoing debates about imposing specific capital and liquidity ratios on financial institutions:

While the imposition of minimum liquidity and capital ratios is an improvement over the prior risk-based approach, such target ratios are not macroprudential regulations in Minsky’s sense. Similarly, stress tests of banks’ capital positions are applied to banks individually, rather than in a systemic interaction. Neither approach to macroprudential regulation takes into account the dynamic macro factors that impact the bank’s position-making assets and liabilities and the secondary markets in which they trade, or the ongoing institutional and policy changes that are a natural part of the economic system.

Download it here: “Minsky and Dynamic Macroprudential Regulation


Charles Evans on Missing the Fed’s Targets

Michael Stephens | April 17, 2014

Chicago Fed President Charles Evans spoke at last week’s Minsky conference, and news reports have focused on his comments regarding the expectation that the Federal Reserve will wait at least six months after the end of QE before beginning to raise interest rates (Evans: “It could be six, it could be 16 months”; “If I had my druthers, I’d want more accommodation and I’d push it into 2016,” but “the actual, most likely case I think is probably late 2015″).

But his speech might also be of interest to those who have been following the debate over whether the Federal Reserve is, let’s say, equally passionate about the two sides of its “dual mandate” (price stability and maximum employment). Right now, the Fed is missing both of its ostensible targets, with inflation below 2 percent and unemployment above the Fed’s estimate of the “natural” rate, which ranges from 5.2 to 5.6 percent (for Evans, it’s 5.25 percent). Many have suggested that the Fed appears much more concerned about inflation rising above 2 percent than it does about high unemployment, or below-target inflation, for that matter.

In the video below, Evans shares his view of how the Fed should “score” its hits and misses on unemployment and inflation:

the 9 percent unemployment rate we faced back in September 2011 can be depicted in “inflation-loss equivalent units” by showing the inflation rate that gives an equivalent loss when unemployment is at its sustainable rate. So what is that rate? If unemployment was at its natural rate, what would be the inflation rate that would make you equally uncomfortable as if you were facing the 9 percent [unemployment] rate? The answer is 5-1/2 percent inflation. [...]

I think we need continued strongly accommodative monetary policy to get inflation back up to 2 percent within a reasonable time frame. After all, notice that the red and green regions of the bull’s-eye chart [posted below] show modest inflation above 2 percent is much more acceptable than even 6 percent unemployment.

BullsEye Accountability_Evans

Here he is on the outlook for inflation:

Despite current low rates, I still often hear people say that higher inflation is just around the corner. I confess that I am somewhat exasperated by these repeated warnings given our current environment of very low inflation. Many times, the strongest concerns are expressed by folks who said the same thing back in 2009, and then in 2010, and … well, you get the picture. [...]

[A]nother potential source of inflationary pressures would be rising inflation expectations. Here, I mean a breakout of inflation expectations separate from any fundamentals that might accompany the previously discussed cases of rising commodity prices and stronger bank lending. One could think of this as the spontaneous combustion theory of inflation. The story goes like this: Households and businesses simply wake up one day and expect higher inflation is coming without any further improvement in economic fundamentals. Without appealing to esoteric economic theories of sunspots, these expectations don’t seem sustainable in the current environment.

The rest of the videos of speakers and panelists from the conference will be posted here.


Working Paper Roundup 4/15/2014

Michael Stephens | April 15, 2014

Minsky and the Subprime Mortgage Crisis: The Financial Instability Hypothesis in the Era of Financialization
Eugenio Caverzasi
“The aim of this paper is to develop a structural explanation of the subprime mortgage crisis, grounded on the combination of two apparently incompatible financial theories: the financial instability hypothesis by Hyman P. Minsky and the theory of capital market inflation by Jan Toporowski. …
… we firmly reject the idea that ‘black swans’ or exogenous shocks of any type might have caused the crisis. We believe that the pathogens which led to the crisis were congenital to U.S. capitalism and that the bursting in the mortgage market happened for specific reasons. This is what is meant in this paper by ‘structural interpretation’: the identification and the understanding of the endogenous forces which made the U.S. economy progressively reach an unsustainable financial position, making the crisis an inescapable event.”

Growth with Unused Capacity and Endogenous Depreciation
Fabrizio Patriarca and Claudio Sardoni
“This paper contributes to the debate on income growth and distribution from a nonmainstream perspective. It looks, in particular, at the role that the degree of capacity utilization plays in the process of growth of an economy that is not perfectly competitive. The distinctive feature of the model presented in the paper is the hypothesis that the rate of capital depreciation is an increasing function of the degree of capacity utilization. This hypothesis implies analytical results that differ somewhat from those yielded by other Kaleckian models. Our model shows that, in a number of cases, the process of growth can be profit-led rather than wage-led. The model also determines the value to which the degree of capacity utilization converges in the long run.”

Structural Asymmetries at the Roots of the Eurozone Crisis: What’s New for Industrial Policy in the EU?
Alberto Botta
“In this paper, we analyze and try to measure productive and technological asymmetries between central and peripheral economies in the eurozone. We assess the effects such asymmetries would likely bring about on center–periphery divergence/convergence patterns, and derive some implications as to the design of future industrial policy at the European level. … All in all, future EU industrial policy should be much more interventionist than it currently is, and dispose of much larger funds with respect to the present setting in order to effectively pursue both short-run stabilization and long-run development goals.”

Quality of Statistical Match and Employment Simulations Used in the Estimation of the Levy Institute Measure of Time and Income Poverty (LIMTIP) for South Korea, 2009 *
Thomas Masterson
“The quality of match of the statistical match used in the LIMTIP estimates for South Korea in 2009 is described. The match combines the 2009 Korean Time Use Survey (KTUS 2009) with the 2009 Korean Welfare Panel Study (KWPS 2009). The alignment of the two datasets is examined, after which various aspects of the match quality are described. The match is of high quality, given the nature of the source datasets. The method used to simulate employment response to availability of jobs in the situation in which child-care subsidies are available is described. Comparisons of the donor and recipient groups for each of three stages of hot-deck statistical matching are presented. The resulting distribution of jobs, earnings, usual hours of paid employment, household production hours, and use of child-care services are compared to the distribution in the donor pools. The results do not appear to be anomalous, which is the best that can be said of the results of such a procedure.”
* Related: Time Deficits and Hidden Poverty in Korea (pdf) Kijong Kim, Thomas Masterson, and Ajit Zacharias


On the Alleged Pains of the Strong Euro

Jörg Bibow | April 9, 2014

Since its most recent low of $1.20, reached in the heat of the summer of 2012, the euro has appreciated by 15 percent against the US dollar and by more than 10 percent in inflation-adjusted terms against a broad basket of currencies representative of the euro area’s main trading partners. Amounting to a significant loss in international competitiveness, representatives from a number of euro area member states aired fears that euro strength might undermine the area’s recovery from gloom. Members of the ECB’s governing council too expressed concerns about the euro’s exchange rate. ECB president Mario Draghi recently argued that the strengthening of the euro was partly responsible for the bank’s conspicuous miss of its 2-percent price stability norm by an embarrassingly large margin, adding that the euro’s strength was “becoming increasingly relevant” in the ECB’s assessment of price stability.

In truth euro appreciation should attract neither fears nor blame. The euro area’s dangerously low rate of inflation owes primarily to domestic sources. Instead of debating the euro’s external value, it is high time for euro policymakers to concentrate on getting their own house in order.  A sober assessment reveals that the supposedly too strong euro is at risk of turning into yet another scapegoat. Covering up euro policymakers’ unenviable record of staggering policy blunders is unwarranted.

Ultimately the single most relevant factor for price stability in an economy as large as the euro area is wage inflation corrected for productivity growth. The outstanding fact is that euro area wage inflation is approaching zero. Unit labor costs and business costs more generally are flat or falling. It is therefore no surprise at all that the ECB is failing on its price stability mandate. Rather, what is surprising is that euro policymakers keep on clobbering wages without remorse, apparently wishing to drive them ever lower. Seemingly justified by some holy calling to please the gods of austerity and competitiveness, euro policymakers keep on digging the hole they are trapped in ever deeper. continue reading…


A Minsky Moment on the BBC

Michael Stephens | April 1, 2014

For those of you who haven’t seen it already, Duncan Weldon did a feature on Hyman Minsky for the BBC last week, including this short article and a 30-minute piece for BBC radio.

In the radio segment, Adair Turner says this about Minsky’s contribution and his departure from the mainstream (a description of the pre-crisis orthodoxy which is probably baffling to many unfamiliar with the field):

“The dominant strain of modern economics had assumed, before the crisis, that you could largely ignore the details of the financial system and banks in particular. The phrase that was used was that finance was simply a sort of veil through which relationships between savers and borrowers passed and it didn’t have an influence, and at the … core of Minsky’s analysis is the fact that financing contracts and banks in particular have a crucial influence.”

Weldon devotes a great deal of the program to the “financial instability hypothesis,” for which Minsky is, perhaps, best known, but Minsky also offered an approach to re-regulating the financial system that makes his work as useful as a prescription for a more stable capitalism as it is as a diagnosis of financial crises. (The Levy Institute’s short ebook, Beyond the Minsky Moment (pdf), includes a survey of Minsky’s views about how to reconstitute the financial structure and explains why Dodd-Frank falls well short. The Minsky archive has also been digitized to provide access to many of Minsky’s unpublished papers and notes.)

The annual conference inspired by Minsky’s work will be held at the National Press Club in Washington, DC next week.


Modern Money In Six Short Videos

L. Randall Wray | March 31, 2014

I recently did an interview for Euro Truffa on six topics related to MMT. The website is here. They are transcribing my interview to Italian (I think that only two are up so far) and putting up the videos. They have also posted all of the videos to YouTube.

As you can tell, I did not realize they were recording the video—I might have tried to sit still if I had known. Also, the coffee had not quite kicked in so I was not entirely awake. Here are the links with just a brief indication of the topic for each.

The first two videos have already been embedded here. (1) The first one addresses all the (silly) (non)-controversy about “consolidating” the Government’s central bank and treasury for the purposes of analysis of fiscal and monetary policy operations. I provide three responses to the critics. (2) The second video tackles the belief that the Euroland crisis is due to current account “imbalances.” As I explain, the real problem is the abandonment of sovereign currency. No one describes the USA financial crisis as a problem of current account imbalances between, say, Alabama and New York. Why? We unified our currency—the dollar—but under Uncle Sam in Washington. The EMU only partially unified, without a central fiscal authority that issues the euro.

(3) In this one, I argue that a floating currency provides more domestic policy space. A country that floats does not need to accumulate reserves of foreign currency. Still, I do not argue that a floating exchange rate is always and everywhere the best strategy.

(4) This one addresses the Job Guarantee (or ELR) and questions about inflation and labor discipline. I argue that the JG provides a job to anyone who wants to work, but without sparking inflation or eliminating discipline. Note that Minsky, like Heinz, argues there are 57 varieties (I think I said 52—again, too early in the morning for me to be doing interviews) of capitalism and pickles.

(5) This segment continues discussion of the JG, arguing that it is morally reprehensible to keep people unemployed, poor, and hungry on the argument that this is necessary to avoid a trade deficit. I do not agree with Tom Palley, who objects to the JG on the argument that “the poor will want meals.” Give them jobs, let them eat. If you do not like trade deficits, then reduce imports of luxury goods bought by the wealthy.

(6) How to save the EMU? Some suggest a unified central bank system—like the Fed. I argue that the problem is fiscal policy, not monetary policy.

Here are the original questions, in English and Italian: continue reading…


Galbraith on Piketty’s “Capital”

Michael Stephens | March 27, 2014

From Senior Scholar James Galbraith’s review of Thomas Piketty’s much-discussed Capital in the Twenty-First Century:

Although Thomas Piketty, a professor at the Paris School of Economics, has written a massive book entitled Capital in the Twenty-First Century, he explicitly (and rather caustically) rejects the Marxist view. He is in some respects a skeptic of modern mainstream economics, but he sees capital (in principle) as an agglomeration of physical objects, in line with the neoclassical theory. And so he must face the question of how to count up capital-as-a-quantity.

His approach is in two parts. First, he conflates physical capital equipment with all forms of money-valued wealth, including land and housing, whether that wealth is in productive use or not. He excludes only what neoclassical economists call “human capital,” presumably because it can’t be bought and sold. Then he estimates the market value of that wealth. His measure of capital is not physical but financial.

This, I fear, is a source of terrible confusion. [...]

Piketty wants to provide a theory relevant to growth, which requires physical capital as its input. And yet he deploys an empirical measure that is unrelated to productive physical capital and whose dollar value depends, in part, on the return on capital. Where does the rate of return come from? Piketty never says. He merely asserts that the return on capital has usually averaged a certain value, say 5 percent on land in the nineteenth century, and higher in the twentieth.

The basic neoclassical theory holds that the rate of return on capital depends on its (marginal) productivity. In that case, we must be thinking of physical capital—and this (again) appears to be Piketty’s view. But the effort to build a theory of physical capital with a technological rate-of-return collapsed long ago, under a withering challenge from critics based in Cambridge, England in the 1950s and 1960s, notably Joan Robinson, Piero Sraffa, and Luigi Pasinetti.

Read the rest at Dissent magazine.


Can a Parallel Financial System Solve the Greek Crisis?

Michael Stephens | March 26, 2014

In a new article, Dimitri Papadimitriou looks at the possibility of creating a parallel financial system — dubbed the “geuro” (following Thomas Mayer) — to help rescue the Greek economy:

Geuros would essentially be small denomination zero-coupon bonds: transferable instruments with no interest payment, no repayment of principal, and no redemption, that would be acceptable at par for tax payments. This kind of arrangement is well-known in public finance.

The government would use the alternative currency to pay domestic debts, unemployment benefits, and a portion of wages for public employees. And it would demand that a share of taxes and social benefits be paid in geuros.

Foreign trade would still require euros, which would remain in circulation, and Greece’s private sector would still do business in euros. The currency would be convertible only in one direction, from euro to geuro.

There’s a certain view that, if Greece weren’t in the eurozone, the ideal solution would be to devalue its currency and grow its way out of depression through exports. But since Greece doesn’t have its own currency, we’re left with “internal devaluation” — trying to boost exports through reducing unit labor costs. As Papadimitriou and some other members of the Levy Institute’s macromodeling team (Michalis Nikiforos and Gennaro Zezza) have pointed out, that internal devaluation strategy isn’t working — even though Greece “succeeded” in reducing its relative labor costs.

But what if it were possible for Greece, while remaining firmly in the eurozone, to create a financial instrument (the geuro) that would effectively operate as a parallel currency? Would export-led growth through devaluation of the new currency then become a viable possibility? The answer, according to Papadimitriou, is no, not really:

Why not stress exports? Price elasticity in Greece’s trade sector is low, our analysis shows, which explains why there hasn’t been much evidence of success in export growth. Of course exports are important, but even China, with its gigantic export-guided economy, has recognized the need to increase and stabilize domestic demand.

The value of creating an alternative currency like the geuro is not that it would enable devaluation, but that it would allow Greece to regain a measure of control over its fiscal policy: it could be used to fund the sort of stimulative policies that aren’t forthcoming under the reigning austerity regime. Papadimitriou explains in the article that a geuro-funded direct job creation program targeting 550,000 jobs (not counting the indirect employment creation) could boost GDP in Greece by 7 percent at a net cost of around 3.5 billion geuros per year. And as he points out, “there would still be a sizable euro surplus.” Read the whole thing here.

The article is based on the recent strategic analysis for Greece by Papadimitriou, Nikiforos, and Zezza, which uses the Levy Institute’s stock-flow consistent modeling approach.


MMT, the Consolidation Hypothesis, and Why Louisiana Won’t Leave Its Currency Union

Michael Stephens | March 18, 2014

In this interview with Euro Truffa, L. Randall Wray responds to some recent critiques of Modern Money Theory (MMT).

In the first segment, Wray defends the idea that we can, for the purposes of simplifying the analysis of affordability constraints faced by modern governments, safely disregard many of the self-imposed constraints on Treasury-Central Bank cooperation (this is sometimes referred to as the “consolidation hypothesis.” For more on this topic, see “Modern Money Theory 101: A Reply to Critics,” by Randall Wray and Éric Tymoigne, as well as Tymoigne’s recent working paper on Fed-Treasury operations in the United States).

In this next segment (sorry, video quality is bad, but audio is fine), Wray challenges the idea that the eurozone crisis is chiefly a balance of payments crisis.


Inflation, Deflation, and ECB Asymmetry

Jörg Bibow | March 13, 2014

It is quite interesting to see how popular myths can live on in the public’s mind and continue to cause harm and irritation even when the facts speak to totally different language. How can education fail so badly?

The particular example I have in mind here is Germans’ supposed exceptionalism in matters of inflation hyper-sensitivity. Whether or not Germans really are special in this regard, even internationally many observers seem to feel that Germans would be truly justified to be that way. Hence Germans are readily excused for doing stupid things because they seem to be justified that way. There is a highly relevant context to this today: the ECB’s asymmetry in mindset and approach.

I recently argued in a Letter to the Editors, “Beware what you wish for when it comes to ECB measures,” published by The Financial Times on February 26 2014, that there was actually nothing really new about the ECB’s revealed asymmetry regarding inflation versus deflation risks. At issue is a genetic defect inherited from the Bundesbank. In fact, there can be absolutely no doubt anymore about the ECB being asymmetric in mindset and approach, and more and more observers have come to realize that in more recent times. But there is also a long track record of asymmetric “stability-oriented” monetary policy that includes and precedes the ECB’s own life.

My letter prompted a response from a Mr Han de Jong, the Chief Economist of ABN AMRO Bank in Amsterdam, arguing that there would be a solid basis in history for Americans to fear deflation over inflation while the opposite is true for Germans, pointing to the Great Depression as the biggest trauma in US economic history of the last 100 years and contrasting it with Germany’s hyperinflation of 1922-23 (“Economic trauma scarred both the US and Europe,” Letters, March 3 2014).

This is surely right about America. While some US economists speak of the “Great Inflation” of the 1970s, which was followed by the Volcker shock and a double-dip recession in the early 1980s, this episode truly pales in comparison to the calamitous Great Depression experience of the 1930s. The memory of the Great Depression lives on in modern America. US policymakers are haunted by the ghosts of that historical episode. And that is a good thing!

When it comes to Germany, however, the story is less straightforward than is popularly held. continue reading…