“In late 2007,” writes Peter Orszag, “the midpoint of the range that the Fed projected for real gross-domestic-product growth in 2008 was more than 2 percent.” Most analysts were still expecting the fallout from the subprime crisis to be largely contained because, as Orszag puts it, their models “had at best a very rudimentary financial sector built into them.” What would it have looked like to have taken finance more seriously? In late 2007, Jan Kregel wrote the following in a Levy working paper:
The stage is set for a typical Minsky debt deflation in which position has to be sold to make position—that is, the underlying assets have to be sold in order to repay investors. This will take place in illiquid markets, which means that price declines and, thus, the negative impact on present value will be even more rapid. In this environment, declining short-term interest rates can have little impact. . . .
The damage from a debt deflation will be widespread—borrowers who lose their homes, hedge funds that fail, pensions that are reduced—so the net overall impact will be across a number of different sectors. However, in difference to what Alan Greenspan argued in defense of financial engineering to produce more complete markets—that it provided for a better distribution of risk across those who are willing to bear it—the risk appears to be highly concentrated in core money center banks who, at present, are increasingly unable to bear it. The Fed’s survey of lending conditions currently suggests that banks are curtailing lending and tightening credit conditions. This suggests that lending to households, whose spending in the current recovery has been financed by structured finance, is likely to decline dramatically. If the availability of household finance collapses, it is also likely that the long predicted but never realized retrenchment of consumer spending may become a reality, buttressed by the continued decline in the dollar, producing rising import prices. That, along with rising petroleum prices, will further reduce real incomes and make meeting mortgage debt service that much more difficult. The system thus seems poised for a Minsky-Fisher style debt deflation that further interest rate reductions will be powerless to stop. . . .
Given that the crisis appears to be similar to that which led to the breakdown of the financial system through debt deflation in the 1930s, a similar remedy in the form of a Reconstruction Finance Corporation and reregulation of the system would seem to be the most efficient means to prevent, in Hy Minsky’s words, “IT” from happening again.
The working paper can be found here. For more, see Beyond the Minsky Moment, an ebook recently released by the Levy Institute’s program on monetary policy and financial structure (downloadable in pdf and epub).