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.

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.

The annual Minsky conference, co-sponsored by the Levy Institute and the Ford Foundation, was held this past week in NYC. The audio transcripts of all the presentations (including one by yours truly) are online here. (I will also add my powerpoint below so you can look at it while listening to the audio.)

My presentation quickly summarized results of a project I am directing that examines democratic governance and accountability of the Federal Reserve, focusing on its response to the global financial crisis. You can read our first report here.

I won’t go into that today. I just wanted to very quickly summarize two quite interesting statements made by others over the course of the conference.

First, Joe Stiglitz had a great analogy about derivatives. Recall that part of the reason for the creation and explosion of derivatives was to spread risk. For example, mortgage-backed securities were supposed to make the global financial system safer by spreading US real estate risks all over the world. He then compared that to, say, a deadly flu virus. Would you want to spread the virus all over the world, or quarantine it? Remember Warren Buffet’s statement that all these new financial products are “weapons of mass destruction”–like the 1914 flu virus. And, indeed, just as Stiglitz said, spreading those deadly weapons all over the world ensured that when problems hit, the whole world financial system was infected.

The other observation was by Frank Partnoy, and also addressed the innovations in the financial sector. 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…

Matthew Goldstein and Jennifer Ablan report on the latest US investment craze:  buying up large bundles of foreclosed homes from Fannie Mae and renting them out to take advantage of the hot rental market.  Randall Wray is among the critics quoted in the article who contend that, as Goldstein and Ablan put it, “the federal government is fostering a transfer of wealth of sorts by selling big pools of foreclosed homes to big fund investors and high-net-worth individuals. There’s also concern that some of the players who helped create the housing crisis will now benefit by buying foreclosed homes at a steep discount.”

Wall Street benefited from the ballooning indebtedness of American households on the way up, and now on the way down they’re taking advantage of the flipside of that indebtedness, as families’ assets are seized, transferred, and rented out … likely to some of the same people who just lost their homes.  That feedback loop is galling enough.  But as Wray has pointed out, it’s also a cycle that’s been greased by foreclosure fraud.

Felix Salmon is surprised at the continued success of the financial industry in pushing legislation (in this case, he’s talking about the proposed “JOBS Act,” a key provision of which involves a nice dose of financial deregulation):  “a bill which was essentially drafted by a small group of bankers and financiers has managed to get itself widespread bipartisan support, even as it rolls back decades of investor protections.”

At this point, it’s very difficult to imagine what could possibly change these dynamics.  Clearly, triggering a global economic collapse hasn’t made a dent in the sway the industry holds.  There was a lot of enthusiasm surrounding the Occupy movements, but it’s hard to see it amounting to a countervailing political force (even if it intended to be one, which isn’t clear).  Dodd-Frank, for all its faults (and they are legion:  see this new Levy Institute working paper by Bernard Shull, and Chapter 1 of this analysis) appears to be the only game in town.  If it’s able to shrink the sector a little that may change the political economy—but only at the margins.  And that’s likely the best case scenario.

Perhaps we’re back to our old ways. For many moons, the household savings rate has again been falling, though it is still above the levels reached in the years leading up to the home loan crisis of 2007–2009. There are even some signs of a resurgence of the mortgage-backed securities industry. Could the economy be riding a merry-go-round familiar to students of economic history, as concerns about financial fragility, risky borrowing, and small nest eggs ebb and flow with the headlines of the day?

There is an economic term for this type of historical pattern that has not been prominent in recent debates. In loose terms, an epistemic cycle is an economic cycle of learning, knowing about, or understanding certain issues or facts; for example, the dangers of reckless consumer borrowing. The late Hyman Minsky of our Institute wrote authoritatively about the tendency of financial risk-taking to build up over time in the years following a crisis, as people gradually let their guard down after a fight to save the financial system. Eventually such trends would bring on a crisis and a subsequent return to more cautious behavior, especially on the part of banks and regulators.

This leads to the question of whether policymakers can reduce the danger that risky levels and types of borrowing will return over the coming years, as people begin to put the financial turmoil of the past few years into perspective. Economists of all stripes tend to be pessimistic about such issues, ironically in many cases because of a belief that human behavior is generally rational in one way or another.

One concept that often comes up in discussions of policies for dealing with the aftermath of the crisis is moral hazard, which was the subject of an interesting essay in yesterday’s New York Times. continue reading…

The Financial Times got its hands on a confidential “debt sustainability analysis” that was circulated among eurozone finance ministers.  The gist of the analysis is that the austerity measures being imposed on the Greek population will depress growth so brutally that the government will almost certainly not meet its debt reduction targets:

…even under the most optimistic scenario, the austerity measures being imposed on Athens risk a recession so deep that Greece will not be able to climb out of the debt hole over the course of a new three-year, €170bn bail-out.

It warned that two of the new bail-out’s main principles might be self-defeating. Forcing austerity on Greece could cause debt levels to rise by severely weakening the economy while its €200bn debt restructuring could prevent Greece from ever returning to the financial markets by scaring off future private investors.

In other words, the latest rescue plan for Greece could be classified (if one were feeling deeply generous) under the category of “buying time.”  But buying time for what exactly?

In this policy brief, Dimitri Papadimitriou and Randall Wray tell us that the eurozone must ultimately move in one of two directions:  either toward a coordinated breakup or toward the development of some real fiscal and monetary policy capacities, which means having the European Central Bank step up as a buyer of last resort for member-state debt and increasing the fiscal space of the European Parliament so that it is able to stimulate growth.  The Union, in other words, must be severed or completed. continue reading…