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.

Looking Toward the Next Recession

I don't know when the next recession will hit. One of the things about studying economics is that it makes you less certain about making pronouncements about the world.

It is why Truman wanted a one-handed economist. That economist would not be able to talk about on one hand and then the other, being limited by only having one hand.

What I do know is this - we are running out of policy options to prevent it. 

I think this is why Trump is breaking norms to lean on the Fed. He wants rates lowered because either he or his advisors can see the rot that is underlying the system.

But he's trumpeting the good news. Jobs numbers are up. The unemployment level is flat. The stock market is up.

Photo by Vladislav Reshetnyak from Pexels

Like I said though, we're running out of standard policy options. On fiscal policy, what can you normally do? You spend money. Shovel money out the door to people.

Get money in the hands of people who want to spend it. Bush did this. Remember getting a random six hundred dollars from the treasury over a decade ago?

That was nice. It wasn’t sufficient to stop the slide, but it was nice. I paid down my credit cards.

The problem with this is that there are still sufficient people in congress who speak ill of deficit spending in any form. 

Many came to power complaining about profligate spending during the last recovery. I guess if Trump does it it will be fine though.

Another way to combat a falling economy is to cut taxes. Instead of distributing funds, have people and corporations keep it in the bank.

Problem here is that we already did that. The tax law cut the top marginal rates and sliced the corporate rate. 

We saw a pop in earnings, this is what helped juice the market. It does not change the rate of growth though. It just raises the level.

If you own stock, this is good, but the vast majority of the securities in this country are ultimately owned by the top 10% - over 80% of stocks, and what the bottom 90-% own are mostly tied up in retirement funds.

The other way to juice the economy is through monetary policy. You lower the rate the central bank charges. You stop paying interest on reserves. This makes banks lower their rates.

Companies, in turn, see this cheap money and decide to make an investment in building capacity. Consumers make those big purchases, like houses or cars (or Boats!).

Problem here is that the interest rates the Federal Reserve sets, the federal funds rate, was stuck at zero for a decade. The recovery, over two presidents, has been the longest on record, but it was a shallow recovery.

Average growth was under 3%. That's better than a recession, but it makes you look at past expansions with envy. 

The rate now is near historical lows if you don't look at the recent recovery. There are very few investments that make sense now but are waiting for a quarter point drop in the fed funds rate to make your internal hurdle rate lower.

That leaves unconventional policy - quantitative easing or helicopter money or direct debt monetization to move the needle. 

The bottom line is that there are signals flashing now.

Manufacturing is slowing. The yield curve has inverted, meaning that it is cheaper to borrow money for a long time than a short time. 

This has in the past been a signal of slumping market confidence and recession on the way.

And recessions come. The mechanism may vary, but once the broad market turns, then it becomes a self-reinforcing process.

One thing the market does like is certainty, and that's the policy variable that our president is the worst with.

Globalization has grown and supply chains are put in place, and then he makes a pronouncement that changes incentives, until he changes his mind.

In a lot of ways, he is his own worst enemy, as these trade wars of his choosing are not fun and easy to win. 

Manufacturing is hard to bring back onshore. If it comes back, it will be capital intensive because the job market is tight, and hiring is hard.

This has been true for a while now. Look at manufacturing output versus employment for the last 40 years. They are moving against each other. 

We need to look to the past and be ready for a future that is uncertain. There will be a downturn, and of course the president will look for scapegoats.

The policy team will be unprepared for only finding that scapegoat. "If only Powell didn't raise rates in December!" They'll say as people go hungry and lose their houses, and die of preventable diseases.

We know where he won’t point the finger though.