AM10 Minsky Ch 1
Questions
1. Explain how Minskian Instability of Equilibrium leads to business cycles. Describe how booms go out of control and how attempts to manage them leads to busts, as precisely as you can.
Ans: According to Minsky, stability is destabilizing because in the period of boom people expect the boom to last forever and they start taking even more risks. This creates the demand for credit for their risky ventures and bank’s level of easement in lending also increases in boom period. Since central bank gurantees bailout of these “ too big to fail” institutions this further perpetuates risk takingby banks and financial institutions. This leads to po
nzi finance in which the speculators try to make a quick buck through borrowed money because of easement of lending. Since they don’t have the money to back up their investments and when they are not able to sell or make profit on their investment and they also have to pay the interest on the borrowed money then they are bound to default. When the number of individuals default then the economy goes onto a downturn.Secondly due to heavy lending consumers try to pay back their debts which decreases their spending. Central Bank in times of boom also tries to control inflation by raising the interest rates then the banks make losses on their risky investments.When the business cycle moves from boom to recession then counter cyclical lending is needed by the financial institutions in order to decrease the severity of the recession and bring it back to boom. However this doesn’t happen and it is observed that in boom more lending is done and when there is an imminent recession then the banks stop lending or become strict in lending due to fear of default. This leads to recession in the economy and all the efforts of decreasing lending and increasing interest rates further perpetuates the recession.
2. Explain how the Job Guarantee would create a natural buffer stock which would prevent the damage to economy caused by the business cycle.
When the economy goes into recession then AD decreases which forces the firms to cut back and lay off workers. A JG program by the government will help the economy at this time because when a person gets unemployed he cuts back on spending which further decreases AD. By JG program these unemployed individuals will have a job and will be able to spend which will shift the AD to the right. This will help the economy to get back on its feet again. When this happens then these individuals can find better job opportunities than in JG program. In order for the JG program to work it should give only minimum wage and should not compete with the private sector on wages.
3. Explain the stages of evolution of capitalism described by Minsky, and how/why the Money Manager capitalism is among the most fragile and crisis prone versions.
Answer 3-According to Minsky commercial capitalism was the first stage where banks made short term loans to the firms and issued deposits. These loans were made so that the firms can hire labor or pay for raw materials. The repayment of the loans was done by selling of goods and services by the firm. Investment done by the firm was usually through retained profits. Thus banking was relatively safe at that time and bank runs were stopped by CB who acted as a lender of last resort.
The second phase was of finance capitalism in which banks financed the capital assets of the firms. Thus in this stage firms didn’t use their own money rather they borrowed from the banks to finance their investments. This was riskier because the repayment of borrowed funds depended upon the success of the investment over a period of time. This system collapsed during the great depression.
After WWII the managerial welfare state capitalism emerged in which financial institutions were restricted by New Deal reforms (e.g. Glass-Stegall Act) and last firms financed their investments through retained earnings. In this era private debt was small while government debt was large due to financing of war.Unemployment was low and social safety net was created for the poor and the elderly. Big government was there for counter cycle budget(increase spending during recession and decrease spending during boom) and big bank was there to act as a lender of last resort for institutions in times of economic downturn.This was a stable capitalist system which worked for decades.
Due to this stable economic system a large sum of savings was done and they didn’t know where to invest. This led to the rise of money manager capitalism where pension funds and hedge funds (shadow banks) were created who invested these savings for greater returns. These shadow banks were not regulated and could do as they pleased. They in turn created new financial assets like collateralized debt obligation and also enticed people to borrow beyond their limits. This increase in private debt and low regulation of the financial sector was disaster in the making.The first criss occurred in 1966 in the municipal bond market but due to swift government intervention this disaster was staved off. This in turn prompted financial institutions to take more risks because they were confident that the government will bail them out. This set the premise for the GFC of 2007.
Therefore money manager capitalism is more prone to crisis because in this system the financial institutions are not that much regulated and financial institutions take more risk than they should. Due to this crisis occur and GFC is evidence given for the detrimental effects of money manager capitalism.
Minsky Matters Ch 1 - Adv Macro II, Lec 10 on Intro & Ch 1 of L Randall Wray's Why Minsky Matter.