(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…

Philip Pilkington shares a discussion he had with Dean Baker about, among other things, the Post-Keynesian take on the limitations of some conventional economic models (of the “LM” part of IS-LM, in particular.  And if that just looks like an arbitrary string of letters to you, Pilkington has an accessible explanation at the beginning of his post).  His description of the “self-justifying” dynamics of the IS-LM view of money and central banking is worth quoting:

By assuming an upward-sloping LM-curve – that is, a fixed supply of funds – there is an implicit assumption that actions on the part of the central bank are somehow neutral. ISLM enthusiasts implicitly assume that the central bank is simply responding to some otherwise ‘equilibrating’ market conditions and adjusting its rates in line with this. …

… [The standard ISLM model] buries the fact that the central bank is actually taking a specific stance on policy and then tries to pass off this stance as a sort of quasi-market response (i.e. as if there were a market for a fixed supply of funds). But the central bank’s policy stance is nothing of the sort. Instead it is a sort of a simulation of what a market response is thought to be. Thought to be by whom? By economists that adhere to models similar to the ISLM, of course!

In a related vein, Greg Hannsgen points me to the latest volume of essays published in honor of Wynne Godley, “Contributions to Stock-Flow Modeling,” in which Marc Lavoie highlights this Godley quotation on the fixed stock of funds assumption in IS-LM:

Godley was always puzzled by the standard neoclassical assumption, found in both the IS/LM model and among monetarists, of an exogenous or fixed stock of money, the worse example of which is Friedman’s money helicopter drop. As Godley says, ‘governments can no more control stocks of either bank money or cash than a gardener can control the direction of a hosepipe by grabbing at the water jet’.

This is one of the questions Marshall Auerback tackles in a piece at Counterpunch.  His answer, as you might expect, is “no.”  He also addresses the concern that the ECB risks an impaired balance sheet if it steps up and plays a larger role in buying member-state debt:

… if the ECB bought the bonds then, by definition, the “profligates” do not default. In fact, as the monopoly provider of the euro, the ECB could easily set the rate at which it buys the bonds (say, 4% for Italy) and eventually it would replenish its capital via the profits it would receive from buying the distressed debt (not that the ECB requires capital in an operational sense; as usual with the euro zone, this is a political issue). At some point, Professor Paul de Grauwe is right :  convinced that the ECB was serious about resolving the solvency issue, the markets would begin to buy the bonds again and effectively do the ECB’s heavy lifting for them. The bonds would not be trading at these distressed levels if not for the solvency issue, which the ECB can easily address if it chooses to do so.  But this is a question of political will, not operational “sustainability.”

So the grand irony of the day remains this: while there is nothing the ECB can do to cause monetary inflation, even if it wanted to, the ECB, fearing inflation, holds back on the bond buying that would eliminate the national [government] solvency risk but not halt the deflationary monetary forces currently in place.

A great series of videos at INET collecting clips from Robert Johnson’s interview of Steve Keen, who is among those (few) credited with seeing the financial crisis coming.  Hyman Minsky’s work has played a large role in Keen’s own thinking on this.  In this particular clip, Keen talks about the ways in which economists have been taught to assume an unhelpful story about the way in which banks operate and touches on the basic idea of endogenous money.

Along similar lines:  this working paper by Randall Wray looks at what banks actually do (and what role the financial sector should ideally play in an economy) in the context of examining Minsky’s later work at the Levy Institute on restructuring the American financial system.  (Policy brief version here).

Also, take a look at the last video in which Keen talks about developing a monetary model of capitalism.  For non-economists, this has to be among the more confusing claims to theoretical advancement.  (“Wait … you mean there are economic models that don’t include money?  Wh…”)

About a year ago, supply-side economist Arthur Laffer (known for the “Laffer curve,” a graph that depicted tax revenue first rising, then falling as tax rates increased) published an op-ed piece in the Wall Street Journal predicting sharply higher inflation and nominal interest rates over the next four to five years. The justification given for this claim was the rapid growth of the money supply, as measured by the Fed’s monetary base statistic, since the fall of 2008.

One year later, inflation has not taken off. Meanwhile, the stock of currency and bank reserve deposits at the Fed has continued to grow rapidly, though growth has slowed markedly over the past year. The chart to the left (click on it for a better look) shows that Laffer’s preferred measure of money-supply growth has trended downward recently. It remained at about 100 percent, year-on-year, in the three months immediately following the op-ed piece. Since then, money-supply growth has remained in the double-digit range. However, there has been no discernible and sustained upward trend in nominal interest rates or inflation. Many recent events have conspired to keep these numbers at low levels. On the other hand, an argument can be made that the money supply itself is mostly a somewhat unreliable indicator of what is happening, rather than a crucial mover of the economy.

About 40 years ago, economists Nicholas Kaldor and James Tobin, both followers of Keynes, published important articles arguing that changes in the “money supply” in themselves were probably not causes of economic growth or inflation, but instead a product of those forces. (This claim does not mean that interest rates do not play an important role.) Monetarists like Milton Friedman, who had long argued that the growth rate of the money supply determined the growth rate of nominal income in the short run and inflation in the long-run, had it almost completely backwards, according to this post-Keynesian view. Granted, the Fed chooses in a literal sense the size of its balance sheet by making voluntary asset trades, loans, etc., but as a practical matter it cannot consistently maintain an arbitrarily chosen money-supply growth rate. For example, the Fed usually targets the federal funds rate. This forces it to buy or sell just enough bonds to stay at the targeted interest rate, which affects the supply of Fed liabilities in often-unpredictable ways. Attempts by central banks around the world to set and meet targets for the growth rate of the money supply have been repeatedly frustrated and, worse, have often led to recessions.

The Fed has recently expanded the range of assets it buys and sells in order to guide the economy, in what might seem more like a deliberate policy decision. (Mortgage-backed securities, longer-dated bonds, and some distressed assets obtained from failing firms and institutions are important examples of the types of assets currently held by the Fed in significant amounts.) One might assume that such purchases are well within the Fed’s power to control. But there is less discretion even in these actions than many observers seem to think. For example, in the Fed’s view and that of the federal government, a decision to ignore the AIG situation could have led to a wider financial panic, because it would have threatened investment banks and other companies with which AIG had done business. As Hyman Minsky pointed out repeatedly in his writings, working to alleviate and prevent financial crises by helping failing banks may be the most crucial of the Fed’s duties—more important even than setting interest rates. The recent crisis seems unusual only because it was by some measures the most serious challenge of its type in many years. Despite the unusual scope and size of the bailout efforts, the Fed’s overall approach set very few precedents, and wide-ranging efforts to stabilize financial institutions and markets could not possibly have been avoided without serious economic consequences, though perhaps the task could have been accomplished at a much lower cost.

Such efforts have ineluctably led to the huge money-supply growth rates that are shown in the figure. Laffer pointed out that most of this growth was due to a dramatic increase in bank reserves. However, high levels of reserves will not lead to significantly increased lending unless financial institutions believe that more loans will be repaid with a profitable return, an eventuality that in the current situation will await stronger demand for American goods and services. Anyway, because of the weakness and fragility of the recovery, many fewer economists worry about excessive lending now than one year ago.

Actions that the Fed is in effect compelled to take—either to meet an interest-rate target or to fulfill its lender-of-last resort function and similar obligations to stabilize the financial system—cannot be seen as fundamental causes of inflation. Doubtless, a failure to perform either of these key central-bank functions effectively could lead to a deeper recession and/or deflation. But even to the extent that the Fed is responsible for adverse economic outcomes, these are likely to be the result of mistakes in interest-rate policy and in stabilizing the financial system, which are best not thought of as erroneous decisions about the proper growth rate of the money supply.