“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).

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.

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.

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…

Below is the abstract of a presentation to be delivered by Frank Veneroso on Monday April 30th (1:30pm) at the Levy Institute:

Most orthodox explanations of what we call asset bubbles and financial crises attribute them to exogenous shocks to the economy.  For example, a Fed monetary policy error supposedly caused the Great Depression with its three great banking crises, and a Greenspan monetary policy excess led to the asset bubbles and eventual financial crisis of the last two decades.

For Hyman Minsky financial fragility and eventual financial crisis was endogenous to capitalist economies.  Minsky saw this process occurring over two time frames.  First, over the course of a single business cycle, fading memories of the cash flow shortfalls of the most recent recession led to more positive profit expectations, greater fixed investment, a higher reliance on debt finance, and an overall condition of greater financial fragility.  In addition to this “financial instability” hypothesis appropriate to a single business cycle, Minsky also saw an endogenous process of ever greater financial fragility from business cycle to business cycle throughout the post war period.  This endogenous process resulted from ever greater bailouts by Big Government and the Big Central Bank in the recurrent post war recessions that threatened financial crisis and debt deflation.  In effect, an interplay between private risk taking and public sector bailouts resulted in mounting moral hazard across business cycles which distorted risk perceptions to an ever greater degree.  This led to ever increasing private indebtedness and consequent financial fragility.

Hyman Minsky largely limited his focus on these two endogenous processes that fostered rising financial fragility to the world of banks and their corporate borrowers.  In his later writings on money manager capitalism, he transferred this thinking to the realm of markets in traded securities.  His principal focus was the market for traded debt securities.   He discussed stock markets and exchange markets only tangentially and commodity markets not at all.

Over the last twenty years we have seen the emergence of extreme financial fragility and subsequent financial crisis.  Traded asset markets have been paramount.  Stock markets and commodity markets have  played critical roles. How does Hyman Minsky’s thinking about the endogeneity of financial instability within economic cycles and across successive economic cycles help explain the rise of speculation and bubbles in traded asset markets like those for stocks and commodities over the last two decades?

One can start with Minsky’s writings on money manager capitalism and fold into them complimentary contributions from many other notable economic theorists to flesh out a Minsky-like theory of an endogenous process of speculation and asset bubble propagation in such traded asset markets.  This broadens the scope of Minsky’s seminal thinking on the financial instability process and helps explain the entire serial bubble era of the last two decades as well as all the facets of the Great Crisis of 2008-2009 which followed.

From the Introduction to Beyond the Minsky Moment, a recent publication of the Levy Institute’s program on Monetary Policy and Financial Structure:

A new era of reform cannot be simply a series of piecemeal changes. Rather, a thorough, integrated approach to our economic problems must be developed; policy must range over the entire economic landscape and fit the pieces together in a consistent, workable way: Piecemeal approaches and patchwork changes will only make a bad situation worse.

—Hyman P. Minsky, Stabilizing an Unstable Economy

It’s been almost five years since the outbreak of the global financial crisis. Stepping back and surveying the last half decade’s worth of policy responses in the United States, what we see before us looks very much like the “piecemeal” and “patchwork” pattern of reform that Minsky cautioned against in Stabilizing an Unstable Economy (1986). What’s more, if there ever was any real political space for fundamental reform of the financial system, it has since disappeared, even as the economic wounds left by the crisis continue to fester. The battle to shape the rule-making and implementation process of the 2010 Dodd-Frank Act is ongoing, but as this monograph attempts to clarify, Dodd-Frank—indeed, the whole host of policy reactions (and nonreactions) since 2007—is largely undergirded by an approach to financial regulation that is incomplete and inadequate.

Another serious financial crisis, another so-called “Minsky moment,” may be required to reopen the window of opportunity for reform of the financial structure that goes beyond the piecemeal and patchwork. Understanding Minsky’s work can help us to evaluate the existing policy responses to the global financial crisis, to understand how the crisis emerged, and to help prepare us to better seize the next opportunity to fundamentally restructure and reregulate the financial system.

Despite the well-known phrase, Minsky’s approach had little to do with “moments.” It was about the sustained, cumulative processes in which periods of stability induce an endogenous increase in potential financial fragility. Fragility provides the fertile ground for financial instability, leading to a process of debt deflation and a full-blown Minsky crisis. …

Beyond the Minsky Moment traces the roots of the 2008 financial meltdown to the structural and regulatory changes leading from the 1933 Glass-Steagall Act to the Financial Services Modernization Act of 1999, and on through to the subprime-triggered crash. It evaluates the regulatory reactions to the global financial crisis—most notably, the 2010 Dodd-Frank Act—and, with the help of Minsky’s work, sketches a way forward in terms of stabilizing the financial system and providing for the capital development of the economy. Download it here.

(cross posted at EconoMonitor)

Since Paul Krugman kicked-off a heated discussion about Minsky’s views on banks, and because the annual “Minsky Conference” co-sponsored by the Ford Foundation and the Levy Economics Institute occurred this past week, I thought it would be useful to run a couple of posts laying out what Minsky was all about. This first piece will detail his early work on what led up to development of his famous “financial instability hypothesis.”

Minsky’s Early Contributions

In his publications in the 1950s through the mid 1960s, Minsky gradually developed his analysis of the cycles. First, he argued that institutions, and in particular financial institutions, matter. This was a reaction against the growing dominance of a particular version of Keynesian economics best represented in the ISLM model. Although Minsky had studied with Alvin Hansen at Harvard, he preferred the institutional detail of Henry Simons at Chicago. The overly simplistic approach to macroeconomics buried finance behind the LM curve; further, because the ISLM analysis only concerned the unique point of equilibrium, it could say nothing about the dynamics of a real world economy. For these reasons, Minsky was more interested in the multiplier-accelerator model that allowed for the possibility of explosive growth. In some of his earliest work, he added institutional ceilings and floors to produce a variety of possible outcomes, including steady growth, cycles, booms, and long depressions. He ultimately came back to these models in some of his last papers written at the Levy Institute. It is clear, however, that the results of these analyses played a role in his argument that the New Deal and Post War institutional arrangements constrained the inherent instability of modern capitalism, producing the semblance of stability.

At the same time, he examined financial innovation, arguing that normal profit seeking by financial institutions continually subverted attempts by the authorities to constrain money supply growth. This is one of the main reasons why he rejected the LM curve’s presumption of a fixed money supply. Indeed, central bank restraint would induce innovations to ensure that it could never follow a growth rate rule, such as that propagated for decades by Milton Friedman. These innovations would also stretch liquidity in ways that would make the system more vulnerable to disruption. If the central bank intervened as lender of last resort, it would validate the innovation, ensuring it would persist. Minsky’s first important paper in 1957 examined the creation of the fed funds market, showing how it allowed the banking system to economize on reserves in a way that would endogenize the money supply. The first serious test came in 1966 in the muni bond market and the second in 1970 with a run on commercial paper—but each of these was resolved through prompt central bank action. Thus, while the early post-war period was a good example of a “conditionally coherent” financial system, with little private debt and a huge inherited stock of federal debt (from WWII), profit-seeking innovations would gradually render the institutional constraints less binding. Financial crises would become more frequent and more severe, testing the ability of the authorities to prevent “it” from happening again. The apparent stability would promote instability. continue reading…

Debts left over on consumers’ balance sheets from the mortgage crisis have had particularly serious and long-lasting effects on the economic health of those localities where the crisis hit the hardest, according to what appears to be some  interesting and important evidence discussed in an article in today’s New York Times. Of course, the notion that such balance-sheet issues are crucial is a key part of the macroeconomics we work on here, and very much in the tradition of Godley, Minsky, and other heterodox economists.

In his latest policy note, C. J. Polychroniou argues that the political and economic dominance of finance is pushing advanced liberal societies to a breaking point:

The main problem is the power that finance capitalism exerts over domestic society and the abuses that it inflicts. Finance capitalism is economically unproductive (it does not create true wealth), socially parasitic (it lives off the revenues produced by other sectors of the economy), and politically antidemocratic (it restricts the distribution of wealth, creates unparalleled inequality, and fights for exclusive privileges). At the turn of the 20th century, finance capitalism … was still seeking to bring industry under its control and exercised its brutal power largely on undemocratic societies overseas. By the late 1970s, it can safely be said that finance capitalism had subjugated industry at home and took control of government power in the same manner that the great industrialists of the 19th and 20th centuries were able to influence public policy. The difference is that finance capitalism has no vested interest in seeing the living standards of ordinary people improve, and regards any public intervention as an attack on its freedom to exploit society’s economic and financial resources as it sees fit. Industrial capitalism was a progressive stage of economic development relative to agrarian capitalism and feudalism. …. But the dominance of finance capitalism represents a setback for society as a whole.

Read the rest here.

My friend Steve Keen recently presented a “primer” on Hyman Minsky; you can read it here.

In his piece, Steve criticized the methodology used by Paul Krugman and argued that Krugman could learn a lot from Minsky. In particular, Krugman’s equilibrium approach and primitive dynamics were contrasted to Minsky’s rich analysis. Finally, Krugman’s model of debt deflation dynamics left out banks—while banks always played an important role in Minsky’s approach. Krugman responded here.

I found two things of interest in this exchange.

First, Krugman argued: “So, first of all, my basic reaction to discussions about What Minsky Really Meant — and, similarly, to discussions about What Keynes Really Meant — is, I Don’t Care.” This is not the first time Krugman has mentioned Minsky—see, for example, here, which previewed a talk he was to give titled “The night they reread Minsky.”

Amazingly, Minsky only appears in the title of the talk. It is pretty clear that Krugman has not cared enough to try to find out what Minsky wrote, much less “what Minsky really meant.” Minsky always argued that he stood “on the shoulders of giants”—and he took the time to find out what they had said. So while Minsky probably would have agreed with Krugman that arguing about what the “master” really meant was less interesting, he did believe it was worthwhile to try to understand the writings of those whose shoulders you stand on.

Second, at the end of his most recent blog it is pretty clear that Krugman leaves banks out of his model because he doesn’t understand “what banks do.” He starts by saying ”If I decide to cut back on my spending and stash the funds in a bank, which lends them out to someone else…” Well, if he had actually read Minsky, he would understand that this is the description of a loan shark, not a bank.

So what I want to do today is to quickly summarize Minsky’s main areas of research. Then next week I will post more on Minsky’s view of “money and banking.” For those who want to read ahead, you can see the more “wonkish” piece at the Levy Institute, where I summarize Minsky’s later (mostly unknown) work on banks.

So, who was this Minsky guy and what was he all about? continue reading…