The Wall Street Journal recently featured a lead article on economist Hyman Minsky: In Time of Tumult, Obscure Economist Gains Currency.
Minsky is increasingly cited by leading financial figures such as PimCo bond fund manager Paul McCulley and Prudent Bear‘s Dave Noland. According to the WSJ article, the Levy Economics Institute of Bard College plans to reprint his major works. The recent sub-prime crisis is described by some as the markets “having a Minsky moment”.
Minsky’s central idea is the Financial Instability Hypothesis, which holds that the periodic crises that afflict “capitalist” economies are endogenous to the capitalistic financial system, that once a crisis has started the natural tendency of the system is toward amplification rather than equlibrium, and that “stability breeds instability”. From Minsky’s paper, “over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system.”
In short, during periods of stability, the perception of risk among financial players is diminished, leading to more risk taking. The risky structures that are established during a period of stability eventually start to topple, leading to a self-feeding process in which they bring each other down:
- In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy with a sizeable body of speculative financial units is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make position by selling out position. This is likely to lead to a collapse of asset values.
Minsky has in common with the Austrian school that monetary phenomenon are responsible for the cyclical behavior of modern financial economies, in particular the banking system, inthat he finds the strict quantity theory of money insufficient to explain inflationary processes:
- In contrast to the orthodox Quantity Theory of money, the financial instability hypothesis takes banking seriously as a profit-seeking activity. Banks seek profits by financing activity and bankers. Like all entrepreneurs in a capitalist economy, bankers are aware that innovation assures profits. Thus, bankers (using the term generically for all intermediaries in finance), whether they be brokers or dealers, are merchants of debt who strive to innovate in the assets they acquire and the liabilities they market. This innovative characteristic of banking and finance invalidates the fundamental presupposition of the orthodox Quantity Theory of money to the effect that there is an unchanging “money” item whose velocity of circulation is sufficiently close to being constant: hence, changes in this money’s supply have a linear proportional relation to a well defined price level.
After reading the paper posted to the Levy site, it seems to me that the existence of fractional reserve banking and central banking is essential to his hypothesis. Indeed, the above quote is a pretty good description of how fractional reserve banking works.
Suppose we start out from a period of “stability” or “equilibrium”. The perception of risk is low, so financial market players start creating more securities. In a system of on 100% reserve banking, the interest rate is a price that balances present savings against the demand for future goods. In the absence of a mechanism for creating more claims to assets unbacked by any real assets, and without more actual savings being drawn into the market to fund the assets, the price of these assets would fall fairly quickly, limiting further investment. The decline in asset prices represents the increasing cost of fund future consumption out of the finite pool of present savings.
This is known in Austrian theory as “the interest rate brake”. But a central bank can fix the rate of interest and create out of nothing unlimited quantities of debt without the interest rate moving. The cycle plays out according to the Austrian school as the perception of savings is greater than the reality, enabling more investment to be undertaken than can be funded out of actual savings.
While the Great Austrian Critique of Minsky has yet to be written, the critique will focus on a difference over the nature of economic-financial crises in a capitalistic economy: endogenous (Minsky) or exogenous (Austrians)? Are fractional reserve banking and central banking inherent to a market economy, or are they a destructive form of central planning?