AM16 M6 GFC

This lecture provides Minsky's Views on GFC, which are very much linked to excess money creation by financial institutions, leading to heavy private debt financed expansions, which is inherently unstable.

For current controversies raging over MMT, see MMT Controversy

Questions

1.Explain how the incentives of the money manager are very different from the incentives of owners of money, and how this affects the way money is invested in money manager capitalism. Explain why the incentive structure is harmful, and suggest how we might improve performance by using different types of criteria to judge performance of managers of financial funds.

Owners of money want a descent but secure return on their money for a long period. But in money manager system incentives of money managers are tied to their performance in short run. For this money managers have to perform above average which is impossible as everyone can’t be above average. To gain maximum benefits they start betting in risky assets with high leverage ratios while focusing on short run profits instead of long run profits and survival of company. Their objective was not to maximize the wealth of owners of money but to increase the stock prices (agency problem) as they were compensated in form of stock options.

It is wrong practice that performance of money managers was quantified and evaluated on basis of short run average returns. Anyone who performs above average was considered a good manager (which is impossible for everyone). To beat the average they would do anything even cheating (like pump and dump).

As a result, with no regulations on shadow banks, quest for high returns and stock options encouraged money managers to invest in risky assets (even illegal). Once they get stock options they start ‘pumping’ (purchasing their own assets and raising the stock prices) and ‘dumping’ (selling out their own stock at higher prices before the prices collapse) (this is exactly ripping off their own customers). Problem with these kind of investments was that they made top management extremely rich and caused increase in inequality as these didn’t involve any social investment.

Another drawback of this system is that it moved from partnership (where money owners run their business) to corporations (managed by money managers) creating principal (owner of money) agent (manager) problem. Agents don’t have interest in survival of the firm which encourages them to invest in risky assets that yield high short term returns.

What should be done? Instead of looking at the outcome only (short run returns) and linking their compensation with the outcome money owners should look for integrity of the money manager. Managers should be evaluated on basis of their decision making ability and the way they are handling the money (safe and long run returns). Incentives should be attached to diversification of portfolio to get healthy long run profits (giving importance to firm’s survival) instead of putting money in risky assets which yield higher short run profits but put firm’s survival at risk. More value should be attached with investments that serve social purposes also besides private returns.

2. Explain how wrong macroeconomic theories prevented a fiscal policy response to the GFC. Explain how a fiscal policy response could have prevented the Great Recession which followed, but monetary policy response which was made (quantitative easing), could not prevent the recession.

Economists perceived that budget surpluses are good for economy while deficits are problematic. They believed that growth in Clinton’s area was due to surpluses generated during that period. But in reality these surpluses lead to collapse because these surpluses were unstable. Unstable, because these surpluses were built on unstable private deficits (government surplus means private deficits). As the bubble burst in GFC, borrowing stopped and private sector became unstable hence the government surplus went into automatic deficit (10% of GDP in Obama’s administration). This increase in deficit raised concerns regarding deficits, which according to economists was problematic. That is why fiscal stimulus was not made at the right time and right scale.

What was done to restore economy was quantitative easing. Besides purchasing troubled assets of insolvent financial institutions (which encouraged financial institutions to continue risky practices), Fed decreased interest rate but this measure was problematic too as it raised private debt even further to finance housing.

What was needed at that time was fiscal stimulus at right scale. When an economic slowdown is expected in future then a timely discretionary fiscal stimulus (in sectors where there is unutilized productive capacity) will increase employment. This will increase spending and tax revenues (without increasing inflation) and government will have to bear smaller deficit compared to deficit it will have to bear automatically if response is too late.

3. Explain the difference between Lack of Liquidity and In-Solvency. Explain why the correct policy is to rescue ILLIQUID institutions but allow collapse on INSOLVENT institutions. Explain the harmful consequences of the policy which was actually followed, which rescued all the insolvent and illiquid institutions both.

Being illiquid (lack of liquidity) means that bank is unable to meet its daily requirements for cash withdrawals (because reserves might be too low and assets that bank owns can’t be converted into cash quickly). In this scenario bank can get loan from other banks and in a liquidity crises central bank can act as lender of the last resort. But being insolvent is when liabilities are greater than assets which means bank is unable to pay its liabilities.

During GFC the feature of central bank of being lender of last resort was helpful as it was supposed to stop runs on insured deposits (demand deposits, saving deposits, time deposits). So public will be unaffected from lack of liquidity. But this feature was misused. Before crises due to deregulations financial institutions started financing assets through uninsured deposits and non-deposit liabilities. Why would they do that? Because, although these were risky but these came with high returns and on default, banks went into being insolvent. Government is supposed to seize (nationalize) or restructure (panelizing and changing top management) the insolvent institutions (as was done in Great Depression) (because they play with the money). But as stated earlier lender of last resort feature was misused and central bank protected saved insolvent institutions by purchasing their troubled assets. So instead of regulating they tried to save them. Government shouldn’t have done that because regulations stop institutions from continuing risky investments. But as it is evident that these practices continued even after crises because, government saved insolvent institutions.

As far as institutions with liquidity crises are concerned Fed did right in saving them. Before and during GFC financial institutions were indebted to each other (layering). So in liquidity crises if any bank is unable to raise funds it won’t be able to make payments to other bank(s) and this knock-on effect (secondary) effect will continue till whole financial system will collapse. This is why liquidity should be provided during liquidity crises but it does not mean that insolvent institutions should be saved.