Stabilizing an Unstable Economy—Part 3

(Part 1 🙵 2)

The theories of Hyman Minsky have attracted a lot of attention because of the financial component he imparted to Keynesianism. Unlike other economic descriptions of the economy, Minsky's writings have paid great attention to the market for credit and income-bearing securities.   Arguably, his analysis is attractive because he
(a) connects his hypotheses with a major body of practical knowledge about money markets;
(b) explains his ideas in ways that don't require extraordinary specialized expertise;
(c) limns his description of the economic world with recognizable developments.
Most people who read Minsky can see the historical landmarks that he describes: the stream of new tools for leverage, the cycles of financial instability, the tendency for tools for controlling the economy to become less effective over time, even as authorities become more sure of themselves.

In addition, he discusses shortcomings of the other schools of economics.

MINSKY VS NEOCLASSICISM: ASSET MARKETS

The neoclassical model that had come to dominate economics, he argues (Minsky 1986, p.114), ignores money and idealizes an economy of efficient barter ("abstract exchange").  Economic models have arbitrary divisions between representative models and firms, and money has no role to play.  "Using an artificial construction of trading relations, the theory demonstrates that a decentralized market economy achieves a coherent result."  The reactions of the system to external changes are predictable (p.116), and interventions are not required.

Minsky observes that, when a system is shown (in this case, through mathematical analogies) to be coherent, then incoherence needs to be explained.  Factors outside the model must be the cause of extraordinary shocks, such as a purblind state—or technology shocks.  If the model is properly specified, then shocks will not arise from within the system.

He mentions that neoclassical research papers often identify scapegoats, such as the monetary authorities, labor unions, and political events.¹ It logically follows that, "If the pricing mechanism of a decentralized capitalist economy can lead to coherent results only if proper policy or institutions rule, then intervention is necessary even though the market mechanism can be relied upon to take care of details" (p.117). Indeed, this can be seen in the endless demands by economists in the wake of the GFC for the government to "align incentives" for financial markets.  To be clear, a fundamental proposition of economic thought is that markets are spontaneous and respond effectively, if not instantaneously, to real world conditions.  If the climate naturally changes, then supposedly the markets will adapt successfully to the new conditions. But if the government does something incorrect (according to the theory) then all hell breaks loose.

A second dilemma arises from the overlooked, real-world importance of financial markets on the decision to invest.  If markets are volatile, the risk goes up relative to the actual, real-economy returns of the investment (for example, if an investment bank is required to underwrite new securities for the investment to take place).  Moreover, the behavior of actors in a market for financial assets is very different from that in a market for regular goods. If the prices of things like, say, electric cars goes down, then there will be more sales of electric cars.  If the price of shares goes down, the quantity demanded may go down even more.  Because the price of financial assets is already driven by expectations, which have oversized feedback effects, this can introduce instability (or incoherence) from within the system.

On top of that, shares of several firms in the same business sector may rise steeply in tandem with each other because of the expected windfall to the one that gets market power.  In the dotcom bubble of the late 1990s, this famously led to an absurd concentration of investment into a corner of the economy that could never hope to pay off at the rates embodied in the share prices. Boosters may have claimed that e-commerce would completely revolutionize the way in which the entire rest of the economy worked, but I doubt the delusion was that popular with hard-nosed venture capitalists.  More likely, this was like a Lotto jackpot, where the probability of buying the winning ticket rises as non-winning combinations are sold off (or as more an more of the startups in a particular technology fail, leaving a shrinking pool of probable winners).

Some of Minsky's criticisms can be answered with the argument that the different valuations of financial assets are precisely the sort of thing that markets are good at sorting out.  But both in logic and in practice, the prices of financial assets are not coherent and their extreme hourly fluctuations are emerging from the market, and also have a strong impact on the real economy.  While this is a logical consequence of any realistic multi-period model of asset prices (the prices are emergent and volatile), and also an observed fact, it is not allowed for in neoclassic economics.

MINSKY VS NEOCLASSICISM: THE QUANTITY THEORY OF MONEY

Neoclassical economics does not actually have a role for money, because it is abstracted from a pure barter economy. Models do not account for money effects, because most of the underlying premises exclude monetary effects: inflation, for example, is not expected to influence investment or hiring decisions, saving or consumption, and so on.  Even though inflation played a major role in the downfall of Keynesian economics in the late 1970s, RBC seems to have little interest in it.²

The quantity theory of money can be represented thus:

MV = PT,

where M is the money supply, V is the velocity (the average rate at which transactions occur), P is the price level, and T is total output. In the advanced areas of monetarism, the velocity is understood to have some variance, and to be different with different monetary aggregates:

(M_αV_α)+(M_βV_β)+(M_γV_γ)+(M_δV_δ) = PT

where all those Greek letters refer to different components of the money supply and different corresponding velocities.  Minsky's concern is not with the validity of the formula, but with the lack of interest in the institutional arrangements whereby money is created.  He notes that the actual money supply is endogenous to the banking system, which converts various grades of debt into reserves (usually this is government debt, but not always). 

Minsky outlines the horizontal theory of money in the section "Lender of Last Resort Concepts" (p.54), which holds that the money supply is not determined exogenously by the central bank, but rather, by the overall financial sector.   I am not going to explain this here, right now, because I think there are lots of other places where the horizontal theory has been discussed.  I have included a link to Basil Moore's article in "Sources 🙵 additional reading," below.


SUMMING UP

Hyman P. Minsky drops a few clues about his policy prescriptions in this book. I mean this unironically: there are clues, but not many, and they're just clues.  Minsky has a critical view of capitalism—viz., that it's prone to violent, destructive swings that have been tamed (for the time being) with the twin tools of Big Government (BG) and the Lender of Last Resort (LoLR).

He doesn't like either, for the following reasons:

Click for larger image

1. Big Government has, he thinks, an endogenous tendency to get bigger.  He is very confident of this tendency, so much so that he feels instead the need to explain why he thinks the inevitable expansion of BG to be a bad thing.  This is an understandable point of view, especially since he was writing in 1984, and the peak size of US government expenditures was the previous year.  But since then, the size of government has shrunk.  
2. He doesn't seem to be interested in any plausible connection between the government's size, as such, and any social need for it to do stuff. We actually have a lot of experience observing the comparative growth of different government functions in different countries, and one could contrive an endogenous [gov't] growth hypothesis, but I guess that's asking way too much.  
3. He would surely object to my chart, which shows government expenditures, as failing to capture the problem.  He disapproves of transfer payments (which are mostly reciprocal obligations on the government, like SSA) even more than government expenditures.  He believes that inflation is "a cruel tax," and he thinks the tendency of government to ensure continuity of consumption during economic crises is inflationary.
4. He sees the LoLR entities as mitigating each crisis in one period and worsening it in the next (creating the need for a bigger, and more inflationary, LoLR entity).   

For the record, I disagree with all of these points.  There's no reason why you should care, but Greider (1987, pp. 41-44) cites a wealth of evidence that inflation is not very bad.  The passage cited is a survey of studies performed by several researchers on the effect of inflation on household wealth, and the results are mixed.

He goes to say that Keynesianism requires a bunch of policy ideas that Keynes never spelled out.  These include:

1. Markets are fine for making "myriad unimportant" decisions, it doesn't supply equity, efficiency, and stability (p.324);
2. Financial system generates instability; it cannot be left to a free market;
3. Since capital  investment constitutes a significant portion of private national product, the market mechanism is even more unstable and inefficient than points 1 & 2 imply
4. "As a result, legislated and institutionally legitimized monopolies and oligopolies are necessary if such industries are to be private. Capital-intensive monopolies ... are best interpreted as special forms of tax farmers. Public control, if not out-and-out public ownership, of large-scale capital-intensive production units is essential."
5. Big-Government capitalism is more stable than small government capitalism...BUT it must be compelled to run a budget surplus in times of inflation.
6. The tax structure has to be capable of running a surplus as required by #5.

Minsky then adds a few positions that he feels are self-evidently necessary (in addition to being true corollaries of Keynesianism).  These include:

• Focus on economic growth and investment is a mistake. Policies to date erroneously focus on capital-intensive enterprises.  It leads to substituting capital for workers.
• Transfer payments are excessive and bad (what's a good level?).   
• It's better to "use and rig markets" than regulate and control details of the economy.

After this, I think Minsky is basically just enjoying himself at our expense.  He writes as if he's achieved a level of dictatorial control that God could only dream of.  It's a bit like somebody said, "next, I think the oceans should be cherry cola and there ought to be real dancing polar bears with singing penguins..."  And I think that's about it.

---

NOTES:

1. Examples of what Minsky is talking about are readily at hand:  Luca Pensieroso, "Real Business Cycle Models of the Great Depression" (PDF), 4th BETA Workshop in Historical Economics, Strasbourg (2008).  This is a very well-written survey of the literature, so readers can see what efforts have been made by neoclassical economists since 1977 to explain major catastrophic events in economics. A typical example in the paper is Harold L. Cole and Lee E. Ohanian, "New Deal Policies and the Persistence of the Great Depression: A General Equilibrium Analysis" (PDF), Journal of Political Economy, 112, 779–816 (2004) who blame the National Industrial Recovery Act (NIRA) and the National Labor Relations Act (NLRA).  


2. Minsky, 1986, p.125, Footnote 13: AntiKeynesians such as Milton Friedman (see "The Role of Monetary Policy" (PDF) American Economic Review 56 (March 1968), pp. 1-1 7), and Robert E. Lucas, see Studies in Business Cycle Theory (Cambridge: MIT Press, 1981), adopt various expedients to achieve transitory nonneutrality of money even as they assert that longer-run neutrality reigns.

---

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). 


• William Greider, Secrets of the Temple: How the Federal Reserve Runs the Country, Simon 🙵 Schuster (1987); please note the subtitle is misleading and the author did not appear to believe that "the Federal Reserve runs the country."  The last chapter, "The Triumph of money," can be construed as "How banks run [roughshod over] the Federal Reserve."


• 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.