AM09 Minsky

Introduction to "Why Minsky Matters" by Wray -- outlines basics of Minsky's ideas, and the Financial Instability Hypothesis.

Question # 01 Explain why Minsky believes Stability itself is a de-stabilizing force. What does this imply about the notion of "Equilibrium" in economic theory and conventional thinking about this concept? Provide the Minsky explanation for the GFC 2007.

Answer According to Minsky, the degree that the economy achieves what looks to be robust and stable growth, is setting up the conditions in which a crash becomes ever more likely. It is the stability that changes behaviors, policy making, and business opportunities so that the instability results. Examining the history of financial crises furnishes empirical evidence for this thesis that crashes are often preceded by long period of stability.

Conventional Thinking: Back in 1929, the most famous American economist, Irving Fisher, announced that the stock market had achieved a “permanent plateau,” having banished the possibility of a market crash. In the late 1960s, Keynesian economists such as Paul Samuelson announced that policy makers had learned how to “fine-tune” the economy so that neither inflation nor recession would ever again rear their ugly heads. In the mid-1990s, Chairman Greenspan argued that the “new economy” reflected in the NASDAQ equities boom had created conditions conducive to high growth without inflation. In 2004, Chairman Bernanke announced that the era of “the Great Moderation” had arrived so that recessions would be mild and financial fluctuations attenuated.

In every case there was ample evidence to support the belief that the economy and financial markets were more stable, that the “good times” would continue indefinitely, and that economists had finally gotten it right. In every case, the predictions were completely wrong. In every case, the “stability is destabilizing” view had it right. In every case, Minsky was justified.

Minsky about GFC 2007: Minsky not only saw it coming, but all along the way he warned that “it” (another Great Depression) could happen again. The crisis was foreseeable and avoidable. It did not “just happen,” and it had nothing to do with “black swans with fat tails.” It was created by the biggest banks under the noses of our regulators. This contrasts with what economists at LSE told the Queen – that these things just happen and no one can foresee them – like earthquakes. According to the report, the GFC represents a dramatic failure of corporate governance and risk management, in large part a result of an unwarranted and unwise focus on trading (actually, gambling) and rapid growth (a good indication of fraud), as William Black argues). Indeed, the biggest banks were aided and abetted by government overseers who not only refused to do their jobs but also continually pushed for deregulation and de-supervision in favor of self-regulation and self-supervision.

Question # 02 Explain the three reasons for the GFC according to Krugman. Why do Krugman's beliefs differ from Minsky?

Answer On the one hand, Minsky has been transformed from diverse outsider to a darling of the mainstream after the crisis. On the other hand, Krugman and others have failed to appreciate the central insights of Minsky, just as they did with Keynes. The mainstream economists like Krugman admit to being at fault in not predicting the GFC, but blame it on external factors, rather than central weaknesses in mainstream theories. Three external factors which account for the failure of economists to “see it coming” are:

1. The GFC was Black Swan Event. A period of stability led to under-estimation of risks and a discounting of the probabilities of crisis.

2. The Fed kept interest rates low for too long. This allowed massive credit creation, which led to bubbles.

3. Rise of Shadow Banking Industry went un-noticed. The unregulated financial sector created a crisis by making high leverage gambles, using derivatives as insurance.

Why Krugman's beliefs differ from Minsky? In fact, Krugman analysis fails to understand the central insights of Minsky. The mainstream, deceived by theories of intermediation, does not understand the central role of private sector credit creation in generating crises. Even more important, Minsky attacks the central religious belief in “equilibrium”. While Krugman believes that market forces are stabilizing, Minsky promotes the heresy that “equilibria” are inherently unstable. In modern financial economies, the very stability of the equilibria generates the forces which de-stabilize the economy. Very briefly, stability encourages risk taking behavior, which increases until a crisis occurs. This view is truly deeply unconventional because it attacks the founding pillars (optimization/equilibrium) of mainstream orthodoxy.

Question # 03 Explain three policy choices according to mainstream view which actually caused damage instead of helping. Explain Minsky's alternative policy choices and how they could have prevented the GFC 2007.

Answer When Krugman fails to understand Minsky, then the mainstream economists propose three solutions, none of which require re-thinking traditional Macroeconomics.

1. We should pay more attention to the possibility of black swan events, and allow for distributions with fat tails in our stock market models.

2. We should pay more attention to monetary policy

3. We should do more regulation of shadow banking

But, when leveraging is high, then one failed payment has a multiplied impact on contraction of credit, and this can rapidly multiply defaults throughout the system, leading to a financial crisis. A financial crisis collapses the economy via the following mechanisms:

1. Debtors cut back spending to make payments

2. This leads to fall in Aggregated Demand, hence fall in income, jobs, wages

3. To make loan payments asset are sold, which leads to fall in asset prices.

Because of asset price collapse, and defaults by financial institutions, wealth is wiped out. Inability to make payments leads to widespread bankruptcies. Output and employment collapse. Debt increases further from efforts to pay it off.

Minsky Policy Choices: It was thought that the development of the inter-bank Funds market would facilitate credit creation. Minsky argued against this. It is not true that banks first acquire reserves and then they make loans. Rather, Banks make loans and then borrow reserves to meet reserve requirements. The Inter-bank market weakens the regulatory capacity of the central bank, it does not create additional capacity for lending. If the Central Bank is the sole source for reserve funds, it can monitor the quality of assets being used for collateral throughout the system, and thereby control systemic risks much more efficiently.