WHY MINSKY MATTERS: Part One
Author: L. Randall Wray
In particular Krugman’s equilibrium approach and primitive dynamics was 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–for example, here which previewed a talk he was to give entitled “The night they reread Minsky”, here
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 up 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?
HYMAN P. MINSKY
Hyman Minsky (1919-1996) studied at the University of Chicago and after a stint in WWII earned his PhD at Harvard University. His biggest influences were the Chicago school’s intuitionalist tradition (especially Henry Simons, but he also worked with Oscar Lange, Paul Douglas and Frank Knight) and Harvard’s Josef Schumpeter. He taught at Brown University, the University of California at Berkeley, and Washington University. When he retired from teaching in 1990, he moved to the Levy Economics Institute as Distinguished Scholar, where he remained until his death.
While he served as Alvin Hansen’s teaching assistant at Harvard, he later remarked that the “mechanistic” approach of what Joan Robinson called the “Bastard Keynesians” did not appeal to him. Although J.M. Keynes clearly influenced him, he did not have much affinity with the postwar American “Keynesians”. From his earliest work, he was more interested in dynamic, evolutionary change with institutional constraints. Indeed, in one of his first papers he took Paul Samuelson’s linear-accelerator model and added institutional “ceilings and floors”. Minsky’s approach to banking drew heavily on Jack Gurley and E.S. Shaw while adapting Schumpeter’s theory of innovation to analysis of the financial sector. During the 1960s he was involved in major studies of monetary policy formation and banking regulation, doing research for the Federal Reserve’s Board of Governors and for the California state banking commission. Later, after moving to Washington University, he served on the board of a Missouri bank holding company, and he developed close relations with financial markets participants, among whom he counted Henry Kaufman as friend. All of this provided a deep understanding of real world financial institutions and practices that influenced his writing and thinking. After he moved to the Levy Institute, he used Wall Street connections to establish a long-running research project titled “The Reconstitution of the Financial System” that led to the creation of the annual “Minsky Conference” held every year in April. This year’s version will be held at the Ford Foundation in NY on April 11 and 12.
Minsky is best known for his development of the “Financial Instability Hypothesis” (FIH), but it was by no means his only contribution. This week we will also examine his work in three other areas: his analysis of money and banking; his Employer of Last Resort proposal; and his views on the longer-term evolution of the economy.
a) Money and Banking
Minsky (1957a) analyzed the development of the “fed funds” market in the US—the interbank market for lending reserves–arguing that banks economize on reserves, making it difficult for the Fed to influence lending activity, or “money creation”, which is actually determined by the willingness of banks to lend, and of their customers to borrow. If the central bank wants to influence bank lending, it must affect that decision. For example, it can raise required underwriting standards—forcing banks to require more collateral and better credit histories. Stemming from his research conducted for the Fed, Minsky came to the conclusion that reserves should be provided mostly at the discount window—forcing banks to borrow them directly from the central bank, rather than obtaining them from other banks or through open market purchases by the central bank. This would allow the central bank to more closely supervise banks, and to favor safer bank activities by choosing what could serve as collateral against loans of reserves.
Minsky took a broad approach to money creation, arguing that “everyone can create money; the problem is to get it accepted”. (2008b p. 255) Money is really just an IOU denominated in the money of account, but there is a hierarchy of monies—some are more widely accepted than others—with the monetary IOUs issued by the treasury and the central bank sitting at the top of the money pyramid. He saw banking as essentially the business of “accepting” IOUs, making payments on behalf of customers and holding their liabilities. Banks make payments in their own IOUs, which are then cleared using the central bank’s reserves. Further, “(b)ecause bankers live in the same expectational climate as businessmen, profit-seeking bankers will find ways of accommodating their customers; this behavior by bankers reinforces disequilibrating pressures. Symmetrically, the processes that decrease the prices of capital assets will also decrease the willingness of bankers to finance business.” (2008b p. 255) In other words, the “money supply” expands and contracts as bankers accommodate the demands of their customers in a pro-cyclical manner.
b) Financial Instability Hypothesis
This pro-cyclical behavior amplifies the business cycle, increasing the thrust toward instability. Minsky’s theory can be summarized as “an investment theory of the cycle and a financial theory of investment”; the first is the usual Keynesian view, and the second stresses that modern investment is expensive and must be financed—and it is the financing that generates structural fragility. During an upswing, profit-seeking firms and banks become more optimistic, taking on riskier financial structures. Firms commit larger portions of expected revenues to debt service. Lenders accept smaller down-payments and lower quality collateral. Financial institutions innovate new products and finesse rules and regulations imposed by supervisory authorities. Borrowers use more external finance (rather than retained earnings), and increasingly issue short-term debt that is potentially volatile (it must be “rolled-over” so there is risk that lenders might refuse to do so). As the boom heats up, the central bank hikes its interest rate—and with greater use of short-term finance, borrowers face higher debt service costs.
Minsky developed a famous classification for fragility of financing positions. The safest is called “hedge” finance (note this is not related to so-called hedge funds). In a hedge position, expected income is sufficient to make all payments as they come due, including both interest and principle. A “speculative” position is one in which expected income is sufficient to make interest payments, but principle must be rolled-over. It is “speculative” in the sense that income must increase, or an asset must be sold to cover the principle payment. Finally, a “Ponzi” position (named after a famous fraudster, Charles Ponzi, who ran a pyramid scheme—much like Bernie Madoff’s more recent fraud) is one in which even interest payments cannot be met, so the debtor must borrow to pay interest (the outstanding loan balance grows by the interest due). Speculative positions turn into Ponzi positions if income falls, or if interest rates rise. Ponzi positions are inherently problematic as default is avoided only so long as the lender allows the loan balance to grow. Beyond some point, the lender will cut losses by forcing default.
Over the business cycle, fragility rises, exposing the system to the possibility of a crisis—coming from a variety of directions: income flows turn out to be lower than expected, interest rates rise, lenders curtail lending, or a prominent firm or bank defaults on payment commitments. Just as finance accelerates the boom, it fuels the collapse as debtors need to cut back spending and sell assets to make contractual payments. As spending falls, income and employment fall; as assets are sold, their prices fall. In the extreme, debt-deflation dynamics that Irving Fisher saw in the Great Depression can be generated—asset values plummet and wide-spread bankruptcies occur.
However, following his early training in Chicago, Minsky recognized that institutional “ceilings and floors” can help to attenuate the cycle. The most obvious ones come from government, although there are also private institutional constraints, such as stock market rules that suspend trading when prices fall too far. The two most important constraining institutions are the “Big Government” (national treasury) and the “Big Bank” (central bank). The first helps to stabilize the economy through a countercyclical budget: spending falls and taxes rise in a boom, while spending rises and taxes fall in a bust—so surpluses in expansion and deficits in recession constrain the cycle. The central bank can try to constrain lending in a boom (although Minsky was skeptical since profit-seeking banks innovate around constraints), but more importantly it can act as lender of last resort when a financial crisis hits. This prevents a run on financial institutions, which reduces pressure on banks to engage in firesales of assets to meet withdrawals.
c) Employer of Last Resort
While Minsky’s work on poverty and unemployment is not well-known, from the 1960s through the mid 1970s he actually wrote as much on this topic as he did on financial instability. At Berkeley he worked with labor economists to formulate an anti-poverty strategy focusing on employment rather than welfare. Minsky criticized the Kennedy-Johnson War on Poverty, warning that without a significant job creation component it would fail to reduce poverty even as it created a welfare-dependent and marginalized class. He showed that offering one full-time job per low income household instead–even at the minimum wage—would raise two-thirds of all poor families above the poverty line. Further, he estimated that the output created by putting people to work would more than provide for the extra consumption by increasing GDP by a multiple of the extra wages.
Minsky argued a legislated minimum wage is “effective” only with an “employer of last resort”, for otherwise the true minimum wage is zero for all those who cannot find a job. Hence, he proposed that the national government stand ready to fund a job for anyone ready and willing to work at the minimum wage. Only the national government can afford to offer an “infinitely elastic” supply of jobs at the minimum wage. The government as employer of last resort serves as a bookend to the central bank as lender of last resort–just as the lender of last resort sets a floor to asset prices (by lending so that banks do not have to engage in firesales), the employer of last resort sets a floor to wages (anyone willing to work can get the minimum wage) and thus also to aggregate demand and consumption. In this manner countercyclical fiscal policy is enhanced (government spending rises in recession and falls in expansion when workers are hired away by the private sector) and supplements countercyclical monetary policy interventions.
d) Long Term Evolution of the Economy
While Minsky’s FIH is usually interpreted as a theory of the business cycle, he also developed a theory of the long-term transformation of the economy. Briefly, capitalism evolves through several stages, each marked by a different financial structure. The 19th century saw “commercial capitalism” where commercial banking dominated—banks made short-term commercial loans and issued deposits. This was replaced by the beginning of the 20th century, with “finance capitalism”, after Rudolf Hilferding, where investment banks ruled. The distinguishing characteristic was the use of long-term external finance to purchase expensive capital assets. The financial structure was riskier, and collapsed into the Great Depression—which he saw as the failure of finance capitalism. We emerged from WWII with a new form of capitalism, “managerial welfare-state capitalism” in which financial institutions were constrained by New Deal reforms, and with large oligopolistic corporations that financed investment out of retained earnings. Private sector debt was small, but government debt left over from war finance was large—providing safe assets for households, firms, and banks. This system was financially robust, unlikely to experience deep recession because of the Big Government and Big Bank constraints discussed above.
However, the relative stability of the first few decades after WWII encouraged ever-greater risk-taking as the financial system was transformed into “money manager capitalism”, where the dominant financial players are “managed money”—lightly regulated “shadow banks” like pension funds, hedge funds, sovereign wealth funds, and university endowments—with huge pools of funds in search of the highest returns. Innovations by financial engineers encouraged growth of private debt relative to income, and increased reliance on volatile short-term finance.
The first US postwar financial crisis occurred in 1966 but it was quickly resolved by swift government intervention. This set a pattern: crises came more frequently but government saved the day each time. As a result, ever more risky financial arrangements were “validated”, leading to more experimentation. The crises became more severe, requiring greater rescue efforts by governments.
Finally, the entire global financial system crashed in fall 2008—with many calling it the “Minsky Moment” or “Minsky Crisis”. Unfortunately, most analyses relied on his FIH rather than on his “stages” approach. If, as Minsky believed, the financial system had experienced a long-term transformation toward fragility then recovery would only presage an even bigger collapse—on a scale such as the 1929 crash that ended the finance capitalism stage. In that case, what will be necessary is fundamental—New Deal style—reforms.
Following his institutionalist roots, Minsky argued there are “57 varieties” of capitalism, so the death of money manager capitalism might be replaced with a new, more stable form. However, as he insisted, there is no final once-and-for-all solution for the inherent tendency to instability of capitalism.
For Further Reading
Chancellor, E. 2007. Ponzi Nation. Institutional Investor, 7 February.
Minsky, H. P. 1957. Central banking and money market changes. Quarterly Journal of Economics, 71(2), 171.
Minsky, H. P. 1965. The role of employment policy. In: Poverty in America (ed. M. S. Gordon). Chandler Publishing Company, San Francisco, CA.
Minsky, H. P. 1975 (2008a). John Maynard Keynes. Columbia University Press, New York.
Minsky, H. P. 1982. Can it Happen Again? M. E. Sharpe, Armonk, NY.
Minsky, H. P. 1986 (2008b). Stabilizing an Unstable Economy. Yale University Press, New Haven and London.
Minsky, H. P. 1996. Uncertainty and the Institutional Structure of Capitalist Economies. The Levy Economics Institute of Bard College, Working Paper No.155.
Minsky, H. P. 1987 (2008c). Securitization. Levy Economics Institute of Bard College, Policy Note No. 2, 12 May.
Nersisyan, Y. and Wray, L. R. 2010. Transformation of the financial system: financialization, concentration, and the shift to shadow banking. In Minsky, Crisis and Development (eds. D. Tavasci and J. Toporowski), pp. 32–49. Palgrave Macmillan, Basingstoke.
Papadimitriou, D. B. and Wray, L. R. 1998. The economic contributions of Hyman Minsky: varieties of capitalism and institutional reform. Review of Political Economy, 10(2), 199–225.
Whalen, C. 2007. The U.S. credit crunch of 2007: a Minsky moment. Levy Economics Institute Public Policy Brief, No. 92. http://www.levy.org/.
Wray, L. R. 2009. The rise and fall of money manager capitalism: a Minskian approach. Cambridge Journal of Economics, 33(4), 807–828.