Nice Country You Got. Shame if Someone Structurally Adjusted It: On the Bretton Woods Institutions

The story of the Bretton Woods conference is the story of Harry Dexter White, Keynes, and the representatives of fifty other counties holed up in a relatively inaccessible hotel in New Hampshire hammering out the details of the postwar economic order. This was a mirror of their political peers in Potsdam and Yalta who put together the postwar political order. Laying out an aggregable postwar order was crucial because it was not hard to look around and see what happened without multilateral institutions. After WWI, the League of Nations was fairly weak in part because though Wilson was the main driver behind the formation of the League of Nations, there was not buy in. The newly powerful US wanted to go their own way. So what happened economically was busts in the immediate postwar years with a sharp and now forgotten recession as the belligerent powers moved into a peacetime economy – then the roaring twenties in the US) though even that hid regional troubles as farms failed and there was a property bubble in Florida.  And then of course the fear of the spread of far-left parties in Europe with genocidal fascism as well as a rising Japan invading its regional neighbors (dispossessing English and French imperialists in the process) all led to the war that our actors were trying to resolve.

For me that context is important in thinking of the modern IMF and its sister institutions – which is an evolved version as an institution of those agreements – is open to criticism. I first became aware of these multinational, multilateral institutions in 1999 when there were protests for the WTO negotiations in Seattle. The media focused on people dressed up like sea turtles, but it was more broadly a protest against the path that globalization proceeded on. Now when I think of that era, I think of this picture of “International Monetary Fund (IMF) managing director Michel Camdessus (left) looks on as Indonesian President Suharto signs an agreement in Jakarta in this January 15, 1998 file photo. When the IMF last held its annual meeting in Asia, in Hong Kong in 1997, it was leading the rescue of the region`s wrecked economies.”

This picture for a lot of people really cements the idea of the IMF as a neocolonial project. Why neocolonial? Mainly because what the IMF had done in its second iteration was to become a source of funds for poor countries who had gotten into trouble somehow. Often a previous administration would over-borrow and ransack the state treasury, and then the next group of people would come in and say that they had no capacity to grow their country thanks to the previous fellows. The IMF would come in and offer help in terms of loans. The problem is that in the international financial system, a country can’t just say that the other fellows were just making themselves rich and we couldn’t be on the hook for what they did and the people who lent to them did so at their own risk, so we will just repudiate those loans and start with a clean slate. Nope. The new guys have to make whole what the other guys did, facing the debt burden. So, what the IMF does is come in and say we can help you out. But there are strings attached. You can get some of our money, but you need to open up your markets and privatize your state holdings. This is a problem because just maybe these one-size-fits-all recommendations are not actually effective in all contexts, and it just reinforces the neoliberal “Washington Consensus”. Then the next time there’s a problem the country the results are the same. The other big issue with the IMF is that it is nominally a democracy. The problem is that it operates on the one-dollar-one vote rule, giving rich countries much more power than smaller countries. At any times, this is a bad deal, since what it does is allows the rich countries to try to adjust the poor countries in their image. But it becomes an especially bad deal when you have people in power in the rich countries who are acting in bad faith. This locks out from the international order nations that might not agree with the Washington Consensus for whatever reason. It gives the powerful exorbitant and unearned control and sets us up for problems like we saw above. The US controls the payment system and trade disputes right up until it doesn’t. They’re trying to pressure Iran and Venezuela through control of the dollar payment system. Other countries can just say “never mind” and create parallel and isolated systems so that they don’t have to use SWIFT. The IMF at the very least has recently realized that their structural adjustments may have been overly onerous, but the story of the rest of the institutions has not been written yet.










Cited:

https://timesofmalta.com/articles/view/imf-back-on-stage-in-asia-role-less-certain.42467

A Movable Contradiction: David Harvey and Capitalism's Multiple Crisis Points

I must admit to a soft spot for David Harvey. He was one of the first capitalism-skeptics I came across after the crisis, so I read “The Enigma of Capital” (2010) and then “Seventeen Contradictions and the End of Capital” (2014) in hardcover and reviewed them favorably on Amazon. I even got him to follow me on Twitter somehow. I do not think he is the one who controls the account, but I am still going to use this space to brag about David Harvey following me on Twitter. I revisited Harvey in my readings recently, and it excited me. It also was a chance to watch his interviews, and then I found that there were a lot of David Harvey interviews on YouTube, so I watched several back-to-back and my wife came home to find me in a trance to his Kentish accent.

One thing about Harvey that I have found over the years is that he tries to be very precise in his language. This makes him prolix, a trait that I can identify with. For years, I had one of his quotes as the header for my personal blog and Facebook pages: “We are, in fact, surrounded with dangerously oversimplistic monocausal explanations.” This is was an anchor for me as I try to understand the dynamics of the economic system that we live in. As students we are often taught to think of linear causes to processes – a form of “first this, then that.” I like to boil Harvey down to the idea that “It’s more complicated than that!” My current header quote is “There is only one true answer to any economic question: "It depends",” from Dani Rodrik. These two quotes illustrate my personal take-away from over a decade of studying the economy that everything is complicated and conditional in a dynamic process. 

Photo by sergio souza from Pexels

Which is to say that Harvey’s conceptions of multiple points of failure for the capitalistic system really resonates with me. From his interviews and writings since the crisis, the big takeaway from Harvey is not that capitalism is broken. Of course, it is broken. The very concept of the business cycle, where there is growth and then suddenly not growth in spite of the same people in the world should show that it is broken, but we’ve been looking at the business cycle as a thing for over two centuries and those who question the very system that creates those cycles are people on the fringe of the discipline because there’s no Koch money in raising the red flag (or a Red Flag). Harvey points to these multiple points of failure. And here’s what really hits for me. Harvey emphasizes that at times any of these seventeen contradictions he identifies in his book on the contradictions can be a point of failure that will tip the economy over. What capital excels at is moving around the crisis points. One fails, gets resolved temporarily, but sooner or later the weakness at the other points will be exposed. This makes me think of the concerns I have had with some of the other view of crisis we have looked at over the course of the class, especially with Minsky. If the financial instability hypothesis holds, the question becomes where do we intervene to make sure that the Hedge form of debt structure is the one that predominates, and the economic system does not tip over into the Ponzi form? If you try to prevent leverage you prevent growth and the people with the megaphone will not like that, and it would be hard to get the voters to settle for a steady-state economy (though we might have to think about that as we come up to the planet’s limits on absorbing carbon pollution). Or, if you look at the structural explanations like Crotty does, you have to change the entire paradigm of the new financial architecture because the options you have to clean up the crisis is essentially handing money over for bad debt and overpriced assets because the only thing worse than bailouts is systemic failure. What Harvey’s enumeration of multiple contradictions shows is that even a judicious and thoughtful regulator under capitalism sets themselves too hard a task as the crisis points move, and what you would find yourself doing is playing regulatory whack-a-mole. As one crisis point was temporarily resolved, yet another shows its face.

What are these crisis points? Harvey identifies seven foundational contradictions, with an additional seven more “moving” contradictions along with three “dangerous” ones to make up the titular seventeen of them in his 2014 book. In an earlier talk from 2010, he identifies these contradictions at a high level based on the Marxian observation that “the circulation and accumulation of capital cannot abide limits,” and once these limits are reached, capital tries to subvert them (1). It is these points where the blockages arise, and the crises are produced. In this circulation, it cannot aim for a steady state. One of the foundational rules for capital in circulation is that it must find growth. And not just growth. It needs to grow three percent one year. The next year it needs to grow three percent on that prior year, to infinity.   This can be hard to conceptualize. However, I saw recently a good example. China’s growth in the last year slowed to about 6%. This was alarming to some commentators because it represented a slowdown in the recent expansion, and this might mean a more general global slowdown. But even six percent growth means that China added the equivalent of all of Australia’s output in the last year. Looking at exponential growth it is easy to follow onto Malthusian thinking and imagine that at some point we will hit some physical limit and see that perhaps Malthus was not wrong in his predictions, just too early. These ceilings and blockages are the limits to profitability that Harvey identifies: “Any slow-down or blockage in capital flow will create a crisis” (2). They do not have to be world-historical Malthusian traps, but can also be temporary and local.

One example that Harvey uses to illustrate as potential blockage points is the need to accumulate initial capital. Actors in the financial system need to be able to assemble the financial capabilities in order to invest funds at scale. This creates the need for a financial system at all instead of the convenient fiction that firms invest without any intermediaries. This system itself can be the point of crisis, as Harvey identifies: “Crises have frequently centered on the financial sector and associated state powers either because finance is over-regulated or not innovative enough […] or because it is too powerful and to uncontrollable for the good of the system” (3). This is one of the points of contention with the last crisis. As much as we focus on the financial system as the source of the crisis, and do what we can to regulate the banks and to make sure that the shadow banks are not selling derivatives that they do not have enough capital to invest, this is not the only point of potential crisis. 

While the governmental priority is looking at the financial system to fix the problems there, we can be brewing the next potential crisis not just at overreaction and over-regulation at within the financial system, but elsewhere in the economy. Harvey identifies the Labor market as a second place where we can find these structural contradictions that can lead to crisis.   If labor is too organized and too powerful, it slows down the circulation of capital in the economy and can lead to crisis. We saw this as a potential cause of slowdowns in the 70s, where strike waves were met with repression and opened the way for the neoliberal turn represented by Reagan and Thatcher that we saw in the discussion of Crotty’s structural identification. This reaction of course opened the crisis of 2007-8 where the financial system crashed the economy. So, we can see with just these two examples in Harvey how the crisis points can vary and fixing an issue at one point just creates new weaknesses.

There are other choke points as well. Nature can be one. If a particular resource is needed, but it becomes hard to obtain, then the whole system can fall out of balance. Here the obvious culprit is oil, and in the future it might be cobalt. Another is the creation of demand. If consumers feel satiated, an economic system that is based on continual growth will falter. Therefore, we need new cars and phones. Ford sold the Model T for decades until General Motors started introducing yearly product cycles. The creation of the new new thing helps drive capitalism, and if that fails, then the whole system can fail (6). Ultimately, Harvey emphasizes that there is no one single point of failure, no unified point of crisis like a falling rate of profit. The analyst’s job is to try to figure out what the contradiction point is that is inhibiting the flow of capital and stopping growth (7).   As Harvey points out, the crisis tendencies are never solved, they just get moved around. I likened crisis prevention to whack a mole earlier, and like in that game, the crises keep popping up with no pattern. Crisis comes, it spreads, and is treated in the ways the neoliberal governments know how to treat it, and it moves through time and space until the next crisis. It is never fully resolved. And it can’t be – “Compound growth forever is not possible” (11). We will meander from crisis to crisis until the final one hits. Or: we address these issues and move beyond capitalism towards a different form of “social coordination, exchange and control that can deliver an adequate style and standard of living for the 6.8 billion people living on planet earth” (12-13). Unfortunately, though this class and looking at previous crises and responses and theorizations about them, I’m afraid we will not be prepared for the next crisis. Or the one after that one. Or the one after that one. Causes and cures are hard to pin down.

Harvey, David. “The Enigma of Capital and the Crisis This Time” (2010) The Monthly Review

Structural Causes to the Financial Crisis and their Discontents

James Crotty has argued that the crisis of 2007-8 was cause by structural issues in the economy, mainly derived from the deregulation in financial markets that came into being during the Reagan and Thatcher years which were given rhetorical firepower and ideological backing from economics theorists like Milton Friedman and Eugene Fama.  In both “The Realism of Assumptions Does Matter: Why Keynes-Minsky Theory Must Replace Efficient Market Theory as the Guide to Financial Regulation Policy” (2011) and Crotty an earlier 2008 paper,  “Structural Causes of the Global Financial Crisis: A Critical Assessment of the ‘New Financial Architecture,” Crotty develops these arguments. In 2008, Crotty wrote “Central banks and other regulatory bodies will be forced to take whatever interventions are required to stop the financial and possible economic collapse – no matter how high the cost” (53). In the next sentence he says, “the dynamic of deregulation leading to financial booms that eventuate in crisis that lead to bailouts and thus to yet larger booms roll on.” Here we find the root of the argument that he makes in the papers. The ideology surrounding finance is such that architecture leads to people working in the margins, doing what they can to generate more cash for themselves. And then periodically it will blow up. The playbook then is not to use the crisis as an impetus to reform the system, but instead to shovel more money at the very system that just failed in order to paper over the real problems and to let the rot continue. 

Crotty calls this structural rot the “New Financial Architecture” or the “NFA”. Under the NFA, what we have is a system of banks and other financial institutions such as Hedge funds, special investment vehicles that operate under light regulation or no regulation at all. Crotty argues that this arrangement persists because of the theory of efficient markets. Economists and financial professionals have pushed the idea that the best regulatory intervention in the financial market is no regulation at all. A truly efficient market works out the kinks itself through the assumptions made in making the argument for the efficient market theory. Crotty argues that this ideology has led to greater and more destructive crises because of flaws inherent in the NFA. In the 2008 paper he argues that the efficient market hypothesis is itself flawed. The paradigm creates perverse incentives for actors in the financial sector; the root cause of the crash in mortgage backed securities were deliberately made to be opaque products; this built up unknown and excessive risk; and the risk-taking led to highly leveraged institutions that were unstable and prepared to crash (Crotty 2-4).

What we see under the NFA is a perfect illustration of people responding to incentives. Crotty speak in this paper of the foundations of the NFA being the “assertion that the realism of assumptions does not matter in evaluating the validity of the conclusions” (12). This set up feels extremely unscientific. It is an ex-post justification in service of capital. It is an argument by the criminals against policing. Were it not made by already-established voices in the service of making people richer, it would be questioned. Of course, all models are by necessity simplifications of reality – but this predominate paradigm of financial economics makes the assumptions first. In the real world leaning on false assumptions leads to crashes that could not have happened because the VAR model was working with faulty assumptions, and structural linkages bring everything down. It’s not a good system, but it seems to persist. As Crotty writes, “the methodological debate, therefore, is not about whether abstraction is necessary, but whether or not we should favor theories whose assumptions are not excessively and unnecessarily at odds with the reality we wish to theorize” (13).  Deregulation happens because of these motivated false assumptions lead to faulty models. This makes the entire system more fragile to shocks. 

By 2011, Crotty had a little more distance from the full-depth urgency of the crisis in progress. In his newer paper, he extends his argument from his earlier 2008 paper in more detail, looking the effect of the deregulation and consequences of mindlessly following the NFA in the financial system. Deregulation led to increases in complexity, size, volatility, and linkages of the global financial system. These facts increased size and depth of the crisis of 2007-8 when it hit. Crotty proposes that we need to move away from the “NFA” and towards a theory of regulation that is based on the thinking of Keynes and Minsky. Minsky and Keynes both had views that said unregulated markets are unstable and vulnerable to crashes. As in his prior paper, Crotty is critical of the efficient market based new financial architecture, continuing to argue the assumptions behind the efficient market theory do not reflect reality and should be abandoned. In this 2011 paper, he looks deeper at the “positivist” methodology as defined my Milton Friedman in 1953, where Friedman claims that realism of assumptions doesn’t matter, and even if they did the potential realism of the assumptions would not be able to be parsed out (7).  For Crotty, basing your entire financial architecture on these foundations is the fundamental basis for crisis formation. Instead, he argues, we should look back to Keynes, who argued that we need to look to reality for the basis of our theories and look to Minsky’s structural models of the economy in a growth phase and be prepared for the next crash. 
Crotty had moved on from the initial crisis in 2011, and the next part of his project is in building a new paradigm: “Rather than searching for an assumption set that can demonstrate that financial markets are efficient, economists should construct a set of realistic assumptions about financial markets and ask: what hypotheses about the behavior of financial markets can be derived from these assumptions? (10). And that’s what he does, building a set of ten key assumptions emphasizing “endogenous dynamic processes” (17), assumptions like “The future is unknowable” and “liquidity changes over time” (17). These are assumptions that we have seen as fundamental building blocks of what the financial economy does as it moves through time in a dynamic process. The real challenge, Crotty says, is to “understand how sensible agents make decisions under conditions of uncertainty or un-knowledge” (18-19), a huge change from the dominate paradigm which assumes perfect knowledge from economic actors. 

If the we a society persist so that the paradigm that dominates is the New Financial Architecture, then it makes it so that there are no strong regulations. This to me validates the Minskian and Keynesian view where it feels like crashes are inevitable, as Crotty argues. As we saw above, even a stable financial system contains the seeds of its own destruction and borrowers keep reaching for yield and overpaying for assets as they increase in price (Something that can of course never bee identified but in retrospect; bubbles always have happened in the past but the assets price increase in the current moment always represents a new paradigm).  Unfortunately, what seems to have happened is that the vast rulemaking apparatus that was supposed to go into effect with Dodd-Frank, itself watered down by the existence of a new class of legislators, will not be put in place. Instead we have tax cuts and continued increases in the American stock markets that justify the boom. I’m afraid the next crisis is sooner than any of us would like it to be, since fealty to the NFA in the financial economy has feedback effects to the real economy. Thinking the market is efficient not only poisons the financial markets, but it also means that people look at the labor market and see not the need for intervention, but workers who need to accept less in wages while those who crashed the economy get bailed out and the cycle starts again because we have no answers on how to fix it in the NFA. It has been eight years since the last missive, and Crotty’s books will go out of print as we go about our process of forgetting. 

The Financial Instability Hypothesis & The 2007-2008 Financial Crisis.

What is the financial instability hypothesis of Hyman Minsky? It is a theory of the business cycle, a theory where he describes “the readily observed empirical aspect is that, from time to time, capitalist economies exhibit inflations and debt deflations which seem to have the potential to spin out of control” (1). In his paper “The Financial Instability Crisis”, Minsky uses a framework that is based on a theory of the economy not with the Knightian version where the purpose of the economy is based on an allocation of resources, but the Minsky model of the economy is one where the economy exists in time  as a developer of capital, one where there is an exchange of present money for future money (2). For Minsky in his model, the ownership of capital is a claim on money, not of real assets themselves: “in a capitalist economy the past, the present, and the future are linked not only by capital assets and labor force characteristics but also by financial relations” (4). This is an economy not as a snapshot, but as part of a process in time. Investment happens, Minsky claims, because businessmen expect investment to continue to happen in the future (6). The animal spirits are alive on the ground.

The core relationship of the financial instability hypothesis is based around this debt relationship.  Banks act not only as middlemen. Firms are not just trading with other productive firms, but there is a model where the financial sector is a profit-seeking entity itself, and these “merchants of debt” (6) do what they can to innovate the products they sell. 

Minsky described three different kinds of debt relationships as time passes. The first is “Hedge Financing,” where the debt can be paid by the borrowers with working cash flows. This is the most sustainable model. Firms borrow and they can pay off their debt easily with the money they get in the bank from operations. The second debt relationship is what he called “Speculative Finance.” In this relationship, the borrower is a little more stretched. They can afford to pay the interest, but the only the interest is paid out of cash flows, but the principle is not paid down. Net debt for the firm therefore does not decrease but stays constant. Finally, in the third form we reach what Minsky identifies as “Ponzi” units. If a borrower is in this phase of the debt relationship, it means that their cash flows are not enough to pay any of the debt. Net debt is growing as even the interest payments swamp the absolute size of incoming cash flows. The only ways a firm would be able to pay off their liabilities once the Ponzi phase is reached is to either keep borrowing so that your new loans pay off your old loans or to sell off your assets to generate cash to pay the debt coming due (7). For Minsky, there are two modes of being for the financial system. One is that the hedge finance relationship can be predominate, and the economic system will be stable. The second mode is that continued stability sows the seeds for a movement from a stable system to an unstable one where Ponzi financing predominates. When these Ponzi modes predominate in the system, it is then that set the stage for the crash. For Minsky, as borrowing increases growth by continued leverage this helps triggers inflation which in turn pulls once more stable structures into the Ponzi mode. Once more and more firms are pulled into Ponzi mode, growth cannot continue forever. One firm will not be able to continue borrowing, and they will be forced to liquidate assets to be able to pay off the debt that is coming due. This becomes a problem because once liquidation is forced on the most highly leveraged, then they will help crash asset values as other firms will need to in turn liquidate their holdings to be able to make their debt payments (8). Thus, long steady growth develops the conditions for the crash.

The Minsky Financial Instability Hypothesis is a compelling enough model that Charles Kindleberger used it to map out what he described as a typical crisis in his book “Manias, Panics, and Crashes, where he described the tipping point: “The panic feeds on itself until prices have declined so far and have become so low that investors are tempted to buy the less liquid assets, or until trade in the assets is stopped by setting limits on price declines, shutting down exchanges or otherwise closing trading, or a lender of last resort succeeds in convincing investors that money will be made available in the amounts needed to meet the for cash and that hence security prices will no longer decline because of a shortage of liquidity” (32-3). In his book Kindleberger uses the chapter where he outlines Minsky to talk about a generalized crisis, one that can be modeled and of use to economists. He balances that up against the historians, who want to look at the specifics of each. Personally, my take is somewhere in the middle because my interest in the discipline of economics was derived through personal experience of the crisis, and then I abstracted from the part to try to understand the whole – a journey still in progress.

The Financial Instability Hypothesis came back on the radar because, so few prominent economists saw the crash coming. Pre-2007, dialogue at the macro-level was about the so-called “Great Moderation”. The crisis caught enough people off guard there is a story about the Queen walking down to the London School of Economics and asking the learned Mandarins there “Why did no one see this coming?”. The problem was that the people who saw it coming were not part of the right schools and did not have influence with the right journalists or even their professional peers. So that when someone wanted to talk about the financial instability hypothesis after the crisis, Minsky’s books were out of print. There is no prize for calling recessions in the profession. There are financial gains to be made, but even Michael Lewis in “The Big Short” only found a handful who were able to profit in the market by seeing the particulars that Minsky outlined in general form in his paper. As Keynes said, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” The Great Moderation in fact hid the move from hedge finance to the Ponzi finance that banks and other financial institutions were undertaking, and it went on right up until the point the housing market peaked in 2006 and then slowly as some funds closed in 2007 and then all at once as the crisis came into the real world in 2008. Hopefully, Minsky’s books will not go out of print again, and people will not forget the lessons of 2008. I have my doubt. Looking at long waves, we see major crises happen every seventy years or so. I have my own hypothesis that enough people die off to lose the fear, so crises are just stories in books. Our children will feel the fear again in their lifetimes.

Cited:

Aliber, R. Z., & Kindleberger, C. P. (2015). Manias, panics and crashes: A history of financial crises. Houndmills, Basingstoke, Hampshire: Palgrave Macmillan.

Minsky, Hyman P. The Financial Instability Hypothesis (1992) The Jerome Levy Economics Institute of Bard College

The Minsky Minute: The Financial Instability Hypothesis

Upstairs on my nightstand, I have a copy of Minsky’s “Stabilizing an Unstable Economy”. My mother in law got it for me one Christmas soon after the crash, when in hushed undertones on blogs it was spoken of as the real key to understanding the crisis. I tried to read it when I got it, but I think at the time it was a bit above my understanding, so I put it down after a hundred pages. 

I picked it back up last year and read more than half of it but also abandoned it before I finished. I still have it on the nightstand, just in case though. I have not fully given up. In between 2009 and 2018. I learned a lot and studied a lot, but I think part of why I put the book down last summer was that in that time span, Minsky went from being a marginal figure to someone who did have a good understating of the crisis mechanism. Krugman said that we’re all Minskyites now, and the Economist was writing up articles on him.  I think the fact that the basics of the financial instability hypothesis had become so ingrained in the discourse to stop being novel, and thus reading more seemed redundant. Who knows why books are abandoned? I knew r>g and still read the new Capital twice, but I digress.

Photo by Tim Mossholder from Pexels

What is the financial instability hypothesis of Minsky? Well, it is a view of the business cycle, or as he says, “the readily observed empirical aspect is that, from time to time, capitalist economies exhibit inflations and debt deflations which seem to have the potential to spin out of control” (1). To describe this, Minsky uses a framework that is based on a theory of the economy as an allocation of resources, but the economy as a developer of capital, one where there is an exchange of present money for future money (2). Thus, the ownership of capital is a claim on money, not of real assets themselves: “in a capitalist economy the past, the present, and the future are linked not only by capital assets and labor force characteristics but also by financial relations” (4). This is an economy not as a snapshot, but as part of a process in time. So much for your comparative statics! Investment happens, Minsky claims, because businessmen expect investment to continue to happen in the future (6).

The nut of the financial instability hypothesis is based around this debt relationship with banks as middlemen. Here firms are not just trading with firms, but there is a model where the financial sector is a profit-seeking entity itself, and these “merchants of debt” (6) do what they can to innovate the products they sell. Minsky described three different kinds of debt relationships. In hedge financing, the debt can be paid with working cash flows. In speculative finance, the interest is paid out of cash flows, but the principle is not paid down. Finally, in what he calls Ponzi units, cash flows are not enough to pay any of the debt. The only way to pay off your liabilities are to keep borrowing or to sell off your assets (7). For Minsky, there are two modes of being for the financial system. One is that the hedge finance relationship can be predominate, and the economic system will be stable. The second mode is that continued stability sows the seeds for a movement from a stable system to an unstable one where Ponzi financing predominates. It is these Ponzi systems that set the stage for the crash because growth by leverage helps triggers inflation which pulls once more stable structures into the Ponzi mode. And if liquidation is forced on the most highly leveraged, then they will help crash asset values (8).

Thus, long steady growth develops the conditions for the crash.

And of course, this was compelling to people trying to make sense of the crisis in 2008. People got over leveraged in both the consumer sector and in the financial sector. The music was playing, so every had to dance. And then the punchbowl was taken away and the emperor had no clothes. The question is what’s brewing now to create the conditions of the next crisis that will seem inevitable in retrospect. What it also makes me wonder is what is the proper point for intervention in the economy if you want to prevent crashes or to make them shallower. You could argue that what must be prevented is long growth, so intervene to keep interest rates high and jobs scarce, but that is not going to win you any elections. Maybe I should finish that book.

Cited:

https://www.economist.com/economics-brief/2016/07/30/minskys-moment

https://jacobinmag.com/2018/11/the-minsky-millennium


Hyman P. Minsky, The Financial Instability Hypothesis (1992)

Modeling a Typical Financial Crisis

Last week, I came across someone mentioning Bagehot's law, which is essentially “Lend without limit, to solvent firms, against good collateral, at a penalty rate”.  Bagehot was most well known in his time for being the editor of the Economist, a newspaper Lenin called “a journal which speaks for British millionaires”. But I think that we should not dismiss him for his class position. He was worried about the same things we’re worried about in the material well being of the country. He wrote this in the shadow of the panic of 1873, which led to what is known as the Long Depression or alternatively the Great Depression before the one sixty years later stole that title. This downturn is forgotten today except for in the minds of nineteenth history historians and some economists, but Bagehot’s rule lives on. He was cited for the bailouts after 2008, even if we didn’t know how solvent the firms were, or how good the collateral was, or if we used a high enough penalty rate to make the backstop hurt enough. 

That we can still invoke Bagehot’s law means that we can still see the outlines of the business cycle and see the ups and downs of the cycle as a broader phenomenon that can be modeled. Though, as Charles Kindleberger argues in his book “Manias, Panics, and Crashes,” the historians want to look closely and describe each crash in detail – and for those who have lived through a crash, it feels like a uniquely malevolent event that is specifically targeting you, especially in the west as there have been fewer crashes in recent generations.

We can pull back and describe a typical crash in broad outlines, and that is what Kindleberger does in chapter two of his book. Kindleberger uses the work of Minsky to draw his model. In this view, the crash is based on the flows of credit. As the economy is growing, leverage is growing, and people are more optimistic about the value of assets and the future path of growth. So, the economy is growing, and banks are handing out money. The growth comes from an exogenous event. Some sort of positive shock from outside the system makes people rethink their positions, and the future path of growth and the riskiness of the assets they have borrowed to hold. This positive shock keys a boom; a sense that this time is different. Kindleberger notes that the shocks have varied, from highway growth to internet technology. Credit and the boom go hand in hand, a self-reinforcing cycle. This might tip the economy into a euphoric state where demand outpaces supply, driving up prices and creating inflation. Though in retrospect it seems that these steps should have been obvious that they were leading to ruin, to not participate in the boom and even the mania leaves you open to the charge that you are leaving money on the table. As a businessperson or even just an individual, the worst thing in the world isn’t not getting rich. The worst thing is to not get rich while those around you are getting rich. The boom can spread – money flows outward from the manias, as cash is thrown off by the investments. Lots of capital sit there waiting for something to do. The Japanese bought real estate in Manhattan, AOL merged with Time Warner, every time, this was the new economy that could do no wrong.

The mania finds a top though. It always has. People who were late to the game start buying in, the shoeshine boy is passing stock tips around. Everyone gets sucked into the point where the first movers start looking for opportunities to take their profit. Fewer people on the sidelines means the prices aren’t being bid up as fast anymore. People start to wonder if this is the top. So, they sell out. Others see that and they sell out. The credit tsunami has crashed, people start trying to sell out. There are more sellers than buyers and asset prices slump. People who had borrowed based on higher prices start to see their debt obligations as insurmountable, so they must sell. The crash happens, either all at once or in slow motion. I leave the bottom to Kindleberger in this beautiful sentence: “The panic feeds on itself until prices have declined so far and have become so low that investors are tempted to buy the less liquid assets, or until trade in the assets is stopped by setting limits on price declines, shutting down exchanges or otherwise closing trading, or a lender of last resort succeeds in convincing investors that money will be made available in the amounts needed to meet the for cash and that hence security prices will no longer decline because of a shortage of liquidity” (32-3)

The question is if you accept this sort of model of growth to mania to crash is how to you prevent it? In the run-up there is all sorts of malinvestment, capital that is in hindsight poorly invested but made sense to throw at the projects. For example, in Chicago there is a hole in the ground by the river where they were going to build a 2000-foot corkscrew, the worlds tallest all-residential tower. The plans looked nice, until the real-estate bubble crashed. Do you intervene to stop the bubble, and can you even identify one as it is running up? Greenspan warned of “irrational exuberance” in 1996 and he still let it run. It is hard policy-wise to step in and say you are creating too much wealth right now, let me stop it - -even if that is part of the central bank’s job. The other thing to do is wait around until the crash and try to make it as soft a landing as possible. Even then, we have the problem we saw above. Bagehot said to solvent business against good collateral – both of those can be hard to find as the world starts burning. If you don’t do something then you’re doing nothing, stepping aside until the bottom is found and letting the cycle run again and again until the world ends.

Re-Center the Stakeholder: For a New Capitalism

In the 70s, Milton Friedman wrote a famous essay that argued against the prevailing mode of social organization in corporations. At the time, the prevailing mode was one of stakeholder capitalism. Everyone who had a part in the corporation were important in how it ran, and the managers of the corporation were meant to balance the needs of everyone involved in the running of the operation. This meant that the workers, and the customers, and the managers, and the local community all were important. The owners were also important.

Photo by Yogendra Singh from Pexels

 What Friedman argued was that everything except for the maximization of shareholder value was what mattered. As long as the corporation was making money for the shareholders, everything else was secondary. This was a popular view amongst those running corporations, but the new ideology took a while to trickle down to everyone. 

People had been used to the idea of a corporation that did a lot of things for its workers. Kodak, in Rochester, NY, built dance halls and movie theaters for the people who worked for them. When they polluted, they were anticipated to clean up the pollution. They sponsored little league teams. Alas, the forces that Friedman was writing for took over the view of what a corporation was supposed to do. Though the example of Kodak might be the high point of what corporations did, a lot of what they did for their workers specifically was to stave off the threat of unionization. As long as there were countervailing powers against corporations, they would then work towards making life better for everyone involved. Unions and government bureaucracy could make their lives worse and harder, so the incentives were shaped to make it work for everyone. 

Friedman was influential in changing this, but it was not just the one economist. There were a lot of social forces pushing for a rethinking of how the economic system was shaped. Thatcher came to power in the late 70s and Reagan came in not much later, and combined they created the world of big hair and big shoulder pads and Gordon Gekko saying, “Greed is Good”. The expansion in the 80s was the antidote for the stagflation of the 70s, and it justified for a time the ethos of doing everything for shareholders.

Though there was a crash in 1987, there was not much pushback against this idea as time moved into the 90s. Bill Clinton came into office and the internet boom happened, justifying not just a corporate turning away from social responsibilities, but also a turning away from the social responsibilities of the state. Clinton signed legislation to change welfare to become much less supportive of needy populations and signed bills to allow financial institutions to do what they pleased. His government ran a surplus on the back of the stock market boom that he enjoyed, and he enjoyed high approval ratings in spite of his personal discretion. 

The next decade passed to George W. Bush, who continued the move towards a social ethos of everything for profit and then let the rest of the chips fall where they may. He signed two bills cutting taxes on rich people even though he was also starting wars in the shadow of 9/11. 

Everything was working fine, until the crash in 2008. What happened was that people had been buying houses and those prices were going up and the financial system was taking the money generated and then speculating with it. This was all fine until prices stopped increasing, and people couldn’t afford payments anymore and the punch bowl was taken away. The financial crisis exposed the fact that people had not been taken care of during the long boom of corporate favoritism. Median incomes had been stagnant. Households were supported by more people entering the labor force, or through borrowing. The minimum wage had not been increased reliably, and it kept losing buying power. For most people, houses had been the majority of their wealth, and it was just wiped out. This led to a reevaluation of how corporations and the state needed to act towards the people who worked for them. Obama was elected with the idea of hope and change away from the scary downturn that at the time most people couldn’t tell you why it was happening but only that it was scary.

Alas, the promise of hope may not have been realized. The Obama agenda was stymie by the Republicans and then in 2010, seats started slipping away from the Democrats. This led in part to protests like Occupy Wallstreet, where the voices were loud in arguing for a more inclusive society, and a rethinking of the corporate form. We’re still far away from that, as the election of 2016 brought in Donald Trump, a personification of all that was bad about the 80s, as president. A new reevaluation will come, I only hope it is not with the next crash.