Does the Current Financial Crisis Vindicate the Economics of Hyman Minsky?
The currently observed turmoil in financial markets, which is believed to have been ignited by the collapse of the subprime mortgage market, has recently brought to prominence the ideas of Hyman Minsky (1919–1996), a prominent member of the post-Keynesian school of economics. Many commentators are of the view that Minsky's framework of thinking accurately anticipated the current financial crisis.
While most mainstream economists are of the view that economic busts are the outcome of various external shocks to the economy, Minsky held that, even in the absence of such shocks, the capitalistic economy has an inherent tendency to develop instability, which culminates in severe economic crises. The key mechanism that pushes the economy towards a crisis is the accumulation of debt. Here is why.
During "good" times, businesses in profitable areas of the economy are handsomely rewarded for raising their level of debt. In short, the more one borrows, the more profit one seems to make.1 The rising profit attracts other entrepreneurs to join in and encourages them to raise their level of debt. Since the economy is doing well and borrowers' financial health shows visible improvement, this makes lenders more eager to lend. As time goes by, the pace of debt accumulation starts to rise much faster than borrowers' ability to repay and serve the debt. It is at this stage that the foundation for an economic bust is set in motion.
Minsky makes a distinction between three types of borrowers. The first type he labels hedge borrowers who can meet all debt payments from their cash flows.
The second type are speculative borrowers who can meet interest payments but must constantly roll over their debt to be able to repay the original loan.
The third group of borrowers Minsky labeled Ponzi borrowers; they can repay neither the interest nor the original loan. These borrowers rely on the appreciation of the value of their assets to refinance their debt.
According to Minsky, the financial structure of a capitalist economy becomes more and more fragile during the period of prosperity. In short, the longer the prosperity, the more fragile the system becomes. Minsky argued,
In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance.2
This framework of thinking comprises the essence of what Minsky dubbed the "Financial Instability Hypothesis" (FIH).
Another aspect of the FIH is that, during good times, banks and other intermediaries strive to innovate with regard to the assets they acquire and the liabilities they market.3 This means that, during good times, financial intermediaries (Minsky labeled them as "merchants of debts") try to lure investors to buy the debt by means of sophisticated innovations. The chase for making more profits causes players in financial markets to place their money in various investments that have very little substance — such as subprime-mortgage-backed securities. What makes these investments attractive is sophisticated packaging and the relatively high rate of return.4
But, once economic conditions change, the true state of many borrowers comes to the surface and leads to a crisis. Lenders curtail their supply of funds and borrowers are pushed to bankruptcy, for they cannot renew their borrowing to pay debts — a financial crisis emerges.
According to Minsky's story, then, as time goes by, both borrowers and lenders tend to become reckless, which ultimately leads to a financial crisis. But why should it be this way?
Does the Expansion of Credit lead to Instability?
Contrary to popular thinking, the heart of credit is not money as such but saved final goods and services. If John the baker produces ten loaves of bread and consumes one loaf, his saving is nine loaves of bread. Saving is the baker's real income (his production of bread) minus the amount of bread that the baker consumes. The baker's saving now permits him to secure other goods and services.
For instance, the baker can now exchange his saved bread for a pair of shoes with a shoemaker. Observe that the baker's saving is his real means of payment — he pays for the shoes with saved bread. Likewise, the shoemaker pays for the nine loaves of bread with the shoes that are his real saving.
The baker can also engage in a different transaction with the shoemaker. He can lend him nine loaves of bread in return for ten loaves of bread in one week's time. Note that the loaned bread sustains the shoemaker and allows him to continue making shoes. After one week, hopefully, the shoemaker has produced enough shoes to be able to secure the ten loaves of bread to repay the baker the loan of nine loaves of bread plus the interest of one loaf.
The introduction of money in our story doesn't alter what has been said so far. By means of money, people can channel real savings, which in turn permits the widening of the process of real wealth generation.
Whenever an individual lends some of his money, he in fact transfers his claims on real savings to a borrower. The borrower can now, by means of money, secure real savings (final goods and services) that will support him while he is engaged in the production of other goods and services.
In the same way that real savings sustain the producers of final consumer goods, such as the shoemaker in our example, savings also fund the production of tools and machinery. In this sense, loaned real savings are the key for economic expansion. It is real savings that fund the production of tools and machinery, which in turn permits the expansion of final goods and services. This increase permits a further increase in savings that can now support the buildup of a more sophisticated production structure.
Obviously, when a saver lends his savings, he takes a risk. However, the facts of reality tend to straighten things out fairly quickly.
Let us assume that, as a result of incorrect expectations, too much real savings have been invested in the production of cars, and too little invested in the production of houses. The effect of the overinvestment in the production of cars is to depress profits, because the excessive quantity of cars can only be sold at prices that are low in relationship to the costs that went into making them. The effect of underinvestment in the production of houses, on the other hand, will lift their prices in relation to costs, and will thus raise housing profits.
This process will lead to a withdrawal of real savings from cars and a channeling of it toward houses, implying that, if investment goes too far in one direction, and not far enough in another, counteracting forces of correction will be set in motion.5
So far we have seen that the expansion of credit, which is part and parcel of the increase in real savings, cannot be bad for the economy. On the contrary, such credit, which is fully backed up by real savings, is the agent of economic growth. Note that, in the process we have described, there is no natural tendency for the good times to be followed by bad times. Contrary to Minsky, during good times, the economy, via an accumulation of capital, actually becomes more robust.
Unbacked Lending and Economic Instability
Trouble erupts, however, when real savings do not back up lending. Lending that is not backed up by real savings emerges when a lender creates fictitious claims on final consumer goods and lends these claims out. Now, the borrower who holds the empty money, so to speak, exchanges it for final consumer goods. Note that the borrower takes from the pool of real savings without any additional real savings having taken place, all other things being equal. The genuine wealth producers who have contributed to the pool of final consumer goods — the pool of real saving — discover that the money in their possession will get them fewer final goods. The reason for that is that the borrower has consumed some of the final goods. What we have here is the diversion of real wealth (final consumer goods) from wealth-generating activities towards the holders of new money, which emerged "out of thin air."
As the pace of unbacked credit expands, relative to the supply of real savings, less becomes available to genuine wealth generators, all other things being equal. Consequently, with less real savings, less real wealth can now be generated. (Remember that real savings are required to support the life and well-being of individuals who are engaged in the various stages of production.) In the extreme case, if everybody were to just consume without making any contribution to the pool of real saving, then eventually no one would be able to consume anything.
Surely, then, doesn't this prove that capitalism might indeed have inherent tendencies of self-destruction, just as Minsky suggested? After all, what is to prevent lenders from creating fictitious claims?
Free Market Economy and Unbacked Credit Expansion
In a free-market economy, intermediaries such as banks will have difficulty expanding unbacked credit. For instance, Farmer Joe sells his saved 1 kilogram of seeds for $100. He then deposits this $100 with Bank A. Note that the $100 is fully backed up by the saved 1 kilogram of seeds. Also, observe that Joe is exercising his demand for money by holding cash in the demand deposits of the Bank A. (Joe could have also exercised his demand for money by holding the money at home in a jar or keeping it under the mattress.)
Let us say that Bank A lends $50 to Bob by taking $50 out of Joe's deposit. Remember that Joe still exercises his demand for $100. No additional real savings back up these $50. What we have here is $150 that is backed by $100.
Now, Joe demands money not to hold it as such but to use it as a medium of exchange. So let us say that Joe decides to use $100 to buy goods from Sam who banks with Bank B. Let us also assume that Bob, who borrowed $50 from Bank A, uses them to also buy goods from Sam. (Both Joe and Bob pay Sam with checks.) All this, however, will pose a problem to Bank A. On the following day Bank B will ask Bank A to honor the checks for $150. Bank A will have difficulty honoring the checks since he has only $100 in cash. In short, Bank A is "caught" here, so to speak.
In a free market, then, if a particular bank engages in an unbacked expansion of credit this bank runs the risk of being "caught." Consequently, the threat of bankruptcy is likely to deter banks from pursuing the expansion of unbacked credit.6 We can thus conclude that there is no inherent tendency in the capitalistic economy to generate unbacked credit that destabilizes the economy.
For post-Keynesians such as Minsky, what matters is the particular institutional setup of the economy. They argue that Minsky's Financial Instability Hypothesis (FIH) is only applicable to a modern capitalist economy. In short, the FIH is not a general theory as such but is institutionally specific. In a less complex capitalist economy the transformation toward fragility would not occur, so they hold. The post-Keynesian school however, advises that this does not mean that a simpler capitalism could not experience instability.7
For post-Keynesians such as Minsky, what matters here is that, in the present institutional setup, banks can create unbacked credit; this fact validates Minsky's theoretical framework. But what is it in the modern capitalistic framework that enables banks to engage in the reckless expansion of credit that makes this system unstable? Careful examination will show that it is the existence of the central bank.
Why the Central Bank is the key to Financial Instability
By means of monetary policies, the central bank makes it possible for banks to engage in the expansion of unbacked credit. Thus if Bank A is short of $50, it can sell some of its assets to the central bank for cash, thereby avoiding being "caught." Bank A can also secure the $50 by borrowing it from the central bank. Where does the central bank get the money? It just makes it "out of thin air." (Obviously, Bank A could also attempt to borrow the money from other banks. However, this will push interest rates higher and will slow down the demand from borrowers, which will diminish the creation of credit "out of thin air".)
The modern banking system can be seen as one huge monopoly bank, which is guided and coordinated by the central bank. Banks in this framework can be regarded as branches of the central bank. Through ongoing monetary management, i.e., monetary pumping, the central bank makes sure that all the banks engage jointly in the expansion of credit "out of thin air." The joint expansion in turn guarantees that checks presented for redemption by banks to each other are netted out. In short, by means of monetary injections, the central bank makes sure that the banking system is "liquid enough" that banks will not bankrupt each other.
Contrary to Minsky and the other post-Keynesians, it is the existence of the central bank that makes the present capitalistic framework unstable and susceptible to financial turmoil. It is not the expansion of credit as such that leads to an economic bust but the expansion of credit "out of thin air," since it is through unbacked credit that real savings are diverted from productive activities to nonproductive activities, which in turn weakens the process of real wealth expansion. We thus conclude that Minsky's Financial Instability Hypothesis doesn't prove that the capitalistic system is inherently unstable. The instability that Minsky has identified has nothing to do with capitalism, per se, but rather with the institution (the central bank) that prevents the efficient functioning of capitalism.
Minsky's Framework describes: It does not explain
So while Minsky's story accurately describes the present financial-market turmoil, it does not provide any satisfactory explanation based on previously established and identified phenomena. It arbitrarily puts the blame for instability on the capitalistic economy without even making the slightest attempt to establish a logical verification for this claim. We have seen, however, that it is the existence of the central bank that lays the foundation for financial instability. This means that, contrary to Minsky and the other post-Keynesians, the source for current financial turmoil is likely to be the central bank, i.e., the Federal Reserve's monetary policies.
It is the loose monetary policy of the Fed between December 2000 and June 2004 that laid the foundation for the emergence of various nonproductive activities, or bubble activities. (The federal funds rate target was lowered from 6.5% to 1%.) It is this loose monetary stance that gave rise to various bubble activities.
Between June 2004 and September 2007, the Fed reversed its stance by raising the federal funds rate from 1% to 5.25%. Once the Fed embarked on a tighter stance, this undermined various nonproductive activities that had emerged on the back of the previous loose monetary stance. In short, bubble activities came under pressure.
Now, the effect from a monetary policy change on various parts of the economy operates with a time lag that varies with respect to various sections of the economy. As a result of this, the effect from past changes in monetary policy can continue to dominate despite more recent changes. It is quite likely that the tighter stance since 2004 is only now starting to gain pace with the housing market being hit first. This means that sooner or later the various other parts of the economy are likely to exhibit difficulties.
Contrary to Minsky, there is nothing wrong with capitalism. To avoid the menace of boom-bust cycles what is needed is to close all the loopholes for the creation of money "out of thin air." Not so, argue Minsky and the post-Keynesians. They hold that any attempt to revert to a proper free market — a laissez-faire economy — is a prescription for economic disaster.8 This response is not surprising; Minsky began with the assumption that capitalism is unstable and never questioned this premise. Obviously, then, for Minsky, the only way to fix apparently unstable capitalism is through larger doses of government and central-bank interference with the economy.
Note that the issue discussed here is whether capitalism is stable or unstable. The term "economic stability" is somewhat misleading. What matters at the end of the day is an economic framework that provides the best scope for the improvement of individuals' living standards. We have demonstrated that free-market capitalism is likely to generate more real wealth per capita than a controlled economy. The so-called "friendly capitalism" that both Minsky and the post-Keynesians are advocating is a recipe for progressively slowing the buildup of real wealth and hence lowering the living standards of individuals.9
The current financial-market turmoil, which is believed to have been ignited by the collapse of the subprime mortgage market, has brought to prominence the ideas of the post-Keynesian school of economics and in particular of economist Hyman Minsky. Many commentators believe that Minsky's framework of thinking accurately anticipated the current financial crisis. The heart of Minsky's framework is that capitalism is inherently unstable and has self-destructive tendencies. An important mechanism for this destructive tendency is the accumulation of debt. Contrary to Minsky, our analysis shows that it is the existence of the central bank that makes modern capitalism unstable. It is this factor alone that is responsible for the current financial instability.
- 1. Charles J. Whalen, "The US Credit Crunch of 2007: A Minsky Moment."
- 2. Hyman P. Minsky, "The Financial Instability Hypothesis".
- 3. Minsky, Ibid., p. 6.
- 4. Whalen.
- 5. George Reisman, The Government Against the Economy, p. 5.
- 6. Murray N. Rothbard, The Mystery of Banking, Richardson & Snyder, 1983, pp. 111–124.
- 7. Dimitri B. Papadimitriou and L. Randall Wray, "The Economic Contribution of Hyman Minsky: Varieties of Capitalism and Institutional Reform," The Levy Institute, Working Paper No 217, December 1997.
- 8. Hyman P. Minsky and Charles J. Whalen, "Economic Insecurity and the Institutional Prerequisites for Successful Capitalism," The Levy Institute, Working Paper No 165, May 1996.
- 9. Ibid.