Stabilizing an Unstable Economy—Part 2

(Part 1 🙵 3)

It would probably strike most people that the financial instability hypothesis (FISH) is hardly much of a hypothesis.  You can improve your situation by doing more of B, so you do.  Soon, everyone else is doing B as well, requiring you do even more B, until eventually you wind up doing an insane amount of B just to stay in business.  At some point, it all blows up and everyone is upset. In this case, the thing consists of borrowing money until you're literally borrowing more just to cover the interest payments.

However, the FISH is not the whole book.  Minsky seems well aware of the fact that it's senseless to scold the business managers, who do the borrowing, and it's not a whole lot more sensible to scold the financiers, who at the end of the day are motivated by the need to be competitive with other financial managers or institutions.  He does do an excellent job of critiquing bank supervision ("Institutional Dynamics," pp.249-282), mainly outlining what he knows.  The downside, of course, is that there have been over 28 years since he wrote this, and those 28 years have witnessed cataclysmic changes to the financial sector.  It's not just massive deregulation; the structure of the industry has experienced deliberate reconstruction by executives who engineered a regulatory revolution, and then there was the (mostly unexpected) wave of upstart non-bank financial firms like Countrywide.¹ The Global Financial Crisis will probably leave its own mark on the practice of banking.

Minsky's book is mostly about banking as a macroeconomic force. After an introductory chapter I'd advise most readers to skip (vague generalities), he starts off on an exploration of the 1973-1975 recession (Minsky 1986, pp.17ff)  .  This began as a mild downturn before the financial system exploded and the economy fell off a cliff.  Between September 1974 and March 1975, unemployment shot upward, production plummeted, and banks began to fail.² Minsky naturally projects this forward another two quarters and compares it to what actually happened.  "Price-deflated GNP shifted from a 9.2 percent annual rate of decline in the first quarter of 1975 to a 3.3 percent annual rate of increase in the second quarter of 1975, and a larger 11.9 percent rise in the third quarter."

This was indeed an amazing turnaround, but not unique.  Something similar had happened in 1966 and 1970.



Minsky attributed the quick recovery (and the relatively limited effect on unemployment and GDP) to Big Government (BG) and the Lender-of-Last-Resort (LoLR).  Big Government is understood, here, as en entity whose expenditures constitute a major line item in national income and product accounting.  In 1929, federal government outlays were approximately 3% of GDP; by 1983, they were 22.4% of GDP (and they have mostly been declining ever since).  The permanent change mostly came about after the Korean War (1950-1953), and largely trailed that of the UK, as well as other countries.

BG and LoLR are not duplicates; state governments are a major component of BG that have little fiscal discretion, and there have been periods in our history where the government simply refused an LoLR role because of ideology.  During the 20th century, the government of Japan was certainly large enough to be an LoLR, but declined this role: it carried out bank rescues by transferring deposits from the the Postal Savings Bank to distressed banks to prevent runs.³ For European countries, the LoLR functions were traditionally performed by banks of issue, while in the USA no such entity [formally] existed until 1934 (in so far as the nascent Federal Reserve avoided this job until 1958, and the FDIC was created to prevent runs).

LENDERS OF LAST RESORT

The LoLR, once available, was a minor source of moral hazard to the banking sector.  This began to change in the 1960s, so that by 1974 there were five serious problems with the banking system (Minsky, 1986, p.57):

• attenuation of the banking system's base of equity capital
• increasing reliance on volatile funds
• heavy loan commitments with respect to resources
• deterioration in quality of assets (real estate)
• increased exposure to foreign exchange risk

These weaknesses were enumerated by then-chair of the Federal Reserve System, Arthur Burns; Minsky chides Burns for his myopia: "The critical weakness in Burns's analysis is that he imputes the difficulties he sees to either a laxness of regulatory zeal or, perhaps, some rather trivial mistake in how the regulatory bodies were organized, rather than to a fundamental behavioral characteristic of our economy."

Let me paraphrase here: Minsky accepts Burn's description of the situation, but objects that it is a
superficial description that ignores long-standing, integral attributes of our economy.

Rather than come out and say it, he launches into a case study of real estate investment trusts (REITs).  Readers may want to take note here, that banks held a lot of real estate loans on property that was worth less than the outstanding loans.  A solution was to carry the real estate on the books as being worth more than the market value.  The REITs were created in the 1960s as a result of a new income tax provision that allowed the creation and sale of (shares in) entities that bought and sold non-paper securities like real estate. In effect, REITs were an early version of the CDO (I am oversimplifying here) in which holdings of real estate could be traded like shares of stock.

Minsky's point is that the REITs were created to serve as a lender of last resort to the banks themselves, since they raised a lot of money using preferential tax treatment. The REITs effectively bailed out banks by allowing them to unload real estate from their own portfolios, while the REITs created an alternative universe-market for assets. REITs had a distinct financial structure: they were highly leveraged and relied on the commercial paper market for constantly rolling over their longer-term obligations. Eventually there was a run on REIT commercial paper (1974), which Minsky sees as part of a broader tendency for the banking sector to create fall-back entities that eventually because a liability in need of bailout.

I daresay this can be generalized to the whole scope of existence: humans develop a method for dealing with a problem, and eventually it becomes a major burden in itself.

BIG GOVERNMENT

While big government is a big topic for Minsky, I think most of his remarks can be boiled down to a few key points.

One is that Minsky self-identifies as a leftist, but there's very little common ground between him and ordinary leftists.  In particular, he doesn't much approve of any of the modern liberal (or social democratic) policies for dealing with economic problems of capitalism.  He doesn't like labor unions, he doesn't like "entitlement spending," and he isn't populist.  He keeps saying the problem goes deeper than just a policy error here and there, that it's intrinsic to capitalism, and maybe he's a flavor of anarchist, but I just don't know.

Two, he thinks that big government, by running deficits, does prevent recurring depressions by supplying banks with huge reserves of bonds .  He seems to think the government's role in mitigating business cycles, as well as countercyclical welfare programs (e.g.., unemployment benefits, food stamps) impart an inflationary bias to the economy; he also thinks old age pensions like Social Security are bad because they, too, impart an inflationary bias to the economy.

Three, he says that large pools of government debt can be traded by non-financial businesses in order to secure a portfolio of secure, default-proof securities.  "As businesses liquidated inventories, they decreased their indebtedness to banks and acquired government debt. Banks and other financial institutions acquired liquidity by buying government debt rather than by decreasing their assets and liabilities" (Minsky, 1986, p.46).

Minsky's analysis of how the economy works places a high value on the importance of securities holdings as stores of value. Portfolio stability reduces the marginal efficiency of capital, i.e., at the margins of investment a lower rate of return will exist for a given supply price, because a lower rate of return is needed.  This means the rate of capital investment will likely be higher (according to the theory).

(Part 3)

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NOTES:

1. Connie Bruck, "Angelo's Ashes," The New Yorker (22 June 2009), a profile of Angelo Mozilo and his firm Countrywide Financial. Countrywide is in some respects a bad example because it blew up—it's famous mainly for being a sort of credit market Krakatoa.  Nevertheless, the banking sector has been transformed by a host of nonbank lenders and other quasi-banks that are not only flourishing, but proliferating. See, for example, Brad Tuttle, "CFPB’s First Move with a Director in Place: Confront ‘Nonbanks’" Time (5 Jan 2012). 


2. Also, while not mentioned at this time: Communist-led insurgencies took over in Vietnam, Cambodia (April '75), Angola, and Mozambique (July '75).  While the wars against Communism in those countries were very unpopular with the public, financial and business leaders in the West generally seemed to believe that Communist victories represented a disturbing lack of competence on the part of the West to preserve capitalism.  This is hard to document directly, but a steady stream of articles in the popular press indicated a growing panic that the USA was definitely losing the Cold War.
   
   At the same time, closer to home, a decades-long era of labor peace was ending. Collective bargaining was being superseded by the wildcat strike as labor unions in the USA became increasingly distant from their rank and file. See Aaron Brenner, Robert Brenner, Calvin Winslow, Rebel Rank and File: Labor Militancy and Revolt from Below During the Long 1970s, Verso Press (2010) (or my review!)


3. Minsky doesn't mention the approaches of other countries and their successes or failures, and he certainly never mentions Japan.  Even the fact that the USA lagged well behind developed countries in Europe in, say, social protection programs (despite needing them more because of our history of racial injustice) doesn't warrant a mention.  Minsky is slightly Nietzschean in outlook, I think; he claims to think BG is inherently destabilizing, so he feels it should be drawn back a lot.  But he could have cited alternatives, like strengthening public services so that constant economic growth is less urgently needed, while strengthening protections for labor unions so people don't need so much welfare (which he also dislikes).  So he favors make-work programs. 

SOURCES 🙵 ADDITIONAL READING:

• Hyman P. Minsky, John Maynard Keynes, Columbia University Press (1975)
  __ , Stabilizing an Unstable Economy, McGraw Hill (2008/1986) link updated 
• Basil J. Moore, Horizontalists and Verticalists: The Macroeconomics of Credit Money, Cambridge University Press (1988); this is a very dense volume outlining his theory of endogenous, or horizontal, money. Another source is his paper, "Unpacking the Post Keynesian Black Box: Bank Lending and the Money Supply" (PDF), Journal of Post Keynesian Economics V.4, pp.537-556 (1983). 
• John Maynard Keynes, "The General Theory of Employment" (PDF),  Quarterly Journal of Economics, 51 (1937).  For people who have difficulty making much sense out of the 1936 book General Theory of Employment, Interest, and Money (links will lead to the Marxist.org text, although it lacks page numbers), his short 1937 paper is very worthwhile as a succinct explanation.  In fact, it's extremely engaging and unusual for a formal paper in economics.