Archive for May, 2012

Taking Finance Seriously in 2007

Michael Stephens | May 8, 2012

“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).


It’s Hard to Fix What You Don’t Think Is Broken

Michael Stephens | May 7, 2012

In last week’s Bloomberg column, Peter Orszag (former head of CBO and OMB) lamented that most “official forecasters” relied (and still rely) on economic models that led them to completely underestimate the severity of the downturn that resulted from the subprime mortgage crisis.  These “bad models,” as Bloomberg‘s headline writers call them, whiffed badly on the most critical economic question of the day, says Orszag, because they ignored financial leverage.

Jared Bernstein points to Hyman Minsky as an economist whose work stands out for taking finance seriously.  But although Minsky’s account of financial fragility is fairly well known nowadays, less attention is being paid to his related proposals for reregulating and restructuring the financial system.  And as Jan Kregel and Dimitri Papadimitriou point out, there is an intimate connection between how we think about the generation of financial fragility and how we approach financial reform.  The limitations of the Dodd-Frank approach to regulation, we might say, are in part a reflection of our continuing neglect of the implications of the endogenous creation of instability:

As Minsky emphasized, you cannot adequately design regulations that increase the stability of financial markets if you do not have a theory of financial instability. If the “normal” precludes instability, except as a random ad hoc event, regulation will always be dealing with ad hoc events that are unlikely to occur again. As a result, the regulations will be powerless to prevent future instability. What is required is a theory in which financial instability is a normal occurrence in the system.

… While best known for his analysis of financial fragility, Minsky was primarily concerned with providing guidance for proposals to create a financial structure that ensures a stable transaction system and provides for the capital development of the economy. Until we internalize his vision of financial fragility, however, we are unlikely to be able to design a financial architecture that more reliably meets these twin objectives. Whether the next crisis delivers a more convincing lesson remains to be seen—the limitations of the Dodd-Frank approach make it likely that we won’t have to wait long to find out.

Read the one-pager here.


Galbraith: Addressing Inequality Means Addressing Instability

Michael Stephens | May 3, 2012

Levy Institute Senior Scholar James Galbraith was interviewed by the Washington Post‘s Brad Plumer about his new book Inequality and Instability:  A Study of the World Economy Just Before the Great Crisis.  Galbraith explains that the rises in inequality we’ve witnessed globally since the 1980s can be traced to changes in finance and the macroeconomy (“when something’s happening at the same time around the world, in different countries that are widely separated, that’s a macro issue”):

Between the end of World War II and 1980, economic growth in the United States is mostly an equalizing force, and job creation isn’t dependent on rising economic inequality. But after 1980, economic booms and rising inequality go hand in hand. So what’s going on? In 1980, we really went through a fundamental transformation. We stopped being a wage-led economy with a growing public sector that was providing new services. Programs like Medicare and Medicaid were major drivers of growth in the 1970s.

Instead, we became a credit-driven economy. What the evidence in the U.S. shows is that the rise in inequality is associated with credit booms, which are often periods of great prosperity. We had one in the late 1990s with information technology and one in the 2000s with housing, before everything fell apart. But this is also a sign of instability — the crash that follows is very ugly business. If we’re going to go forward with growth on a more sustainable basis, then controlling inequality and controlling instability are the same issue. One is an expression of the other.

Read the interview here.

The Real News Network also featured a three-part interview with Galbraith (videos assembled here).


What’s Happening Now at the Fed?

Greg Hannsgen |

If there is a pundit on the topic of the Federal Reserve, surely William Greider is one. (Recall his famous book, Secrets of the Temple.) This recent piece from Greider in the progressive magazine the Nation offers  some helpful historical perspective on the role of the nation’s central bank in recent years.


Martin Wolf’s Liquidity Traps and Free Lunches Through Fiscal Expansion

L. Randall Wray | May 2, 2012

In a good blog post for the Financial Times that did get money (mostly) right, Martin Wolf promised a Part II on the topic of appropriate monetary and fiscal policy in a “liquidity trap,” which he has provided here. Wolf also indicated he would write a piece on Modern Money Theory, an approach he does not address in either of these two articles. I look forward to that.

Meanwhile, let me say that I do not disagree with the substantive points made in his Part II—which examines an article by Brad DeLong and Larry Summers. The main argument is this: when there is substantial excess capacity and unemployed labor, fiscal expansion is a “free lunch”. There really should be no surprise about that—it was a major conclusion of J.M. Keynes’s 1936 General Theory, and indeed already had some respectability even before his book. Expansionary fiscal policy can put otherwise unemployed resources to work, so we can enjoy more output.

So what DeLong and Summers do is to show that given assumptions about the size of the government spending multiplier as well as a link between income growth and tax revenues (so that economic growth increases revenues from income taxes and sales taxes, for example) then it is entirely possible for a fiscal expansion to “pay for itself” in the sense that tax revenue will rise. If the “real” interest rate is low, then one can show that the “debt burden” of servicing additional government debt due to an increase of budget deficits does not rise. Hence “the fiscal expansion is self-financing.” (I have problems with all the terms in quotation marks, but will deal with only the first of these here, the notion that expansion can “pay for itself”.)

Let me skip to Wolf’s summary conclusion, with which I wholeheartedly agree: “Policy-makers have allowed a huge financial crisis to impose a permanent blight on economies, with devastating social effects. It makes one wonder why the Obama administration, in which prof Summers was an influential adviser, did not do more, or at least argue for more, as many outsiders argued. The private sector needs to deleverage. The government can help by holding up the economy. It should do so. People who reject free lunches are fools.”


But….. well, you knew there had to be a catch. continue reading…


How to Measure Financial Fragility

Michael Stephens | May 1, 2012

We may not have a high degree of success at predicting precisely when a financial crisis will occur or exactly how big it will be, but what we can and should do, says Éric Tymoigne, is develop effective ways of detecting and measuring the growth of financial fragility in a system.  “[S]ignificant economic and financial crises do not just happen,” he writes, “there is a long process during which the economic and financial system becomes more fragile.”

One of the purposes of the Financial Stability Oversight Council (FSOC) that was created by Dodd-Frank is to provide regulators with an early warning system regarding threats to financial stability.  In light of this, Tymoigne provides his latest contribution to the construction of a measure of systemic risk and identifies specific areas in which we need better data.  With the aid of Hyman Minsky’s theoretical framework, Tymoigne has developed an index of financial fragility for housing finance in the US, the UK, and France.  The point is not to attempt to predict when a shock to the system is likely to occur, but to measure the degree to which such a shock would be amplified through a debt deflation.  From the abstract of his latest working paper:

… instead of focusing on credit risk … financial fragility is defined in relation to the means used to service debts, given credit risk and all other sources of shocks. The greater the expected reliance on capital gains and debt refinancing to meet debt commitments, the greater the financial fragility, and so the higher the risk of debt deflation induced by a shock if no government intervention occurs. In the context of housing finance, this implies that the growth of subprime lending was not by itself a source of financial fragility; instead, it was the change in the underwriting methods in all sectors of the mortgage markets that created a financial situation favorable to the emergence of a debt deflation. Stated alternatively, when nonprime and prime mortgage lending moved to asset-based lending instead of income-based lending, the financial fragility of the economy grew rapidly.

Tymoigne also distinguishes between measuring financial fragility in this way and detecting bubbles: continue reading…