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Source link: http://archive.mises.org/7114/minsky-having-a-moment/

Minsky Having a Moment?

September 9, 2007 by

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?


John September 9, 2007 at 1:09 pm

If the existence of a central bank is fundamental to his analysis (and fractional reserve banking), then really whether it is endogenous or exogenous really doesn’t appear to be a big difference. If an Austrian said that fractional reserve banking is inherent to the capitalist system, then the Austrians theory would be endogenous as well. Minsky doesn’t attempt to explain what a capitalist system should be the way Austrians do. Therefore, I’m willing to accept the Austrian definition as it is much more completely developed and the exogenous nature of financial crises.

Fundamentalist September 9, 2007 at 3:09 pm

“…he finds the strict quantity theory of money insufficient to explain inflationary processes…”

I don’t understand. How does Austrian econ differ from the “orthodox Quantity Theory of Money”?

Anthony September 9, 2007 at 3:31 pm

John makes a good point. Does Minsky even question the premise that the central bank is a sine qua non of capitalism?

Robert Blumen September 9, 2007 at 6:52 pm

Question: “How does Austrian econ differ from the “orthodox Quantity Theory of Money”?”

The strict quantity theory posits a linear relationship between the quantity of money and all prices in the economy. Increase the money supply by 10% and you get 10% inflation in all prices. Relative prices to not change.

The Austrian view emphasizes that a change in the quantity of money changes not only the level of all prices, but relative prices as well. The new money is created at a particular point in the economy, and it spreads out from there. Those who receive it first are able to spend it on some goods, whose prices will rise; then the second-round recipients are able to spend it, and so forth.

This idea is central to Mises theory of the business cycle. Mises pointed out that when money is created through bank credit, that the interest rate is affected (lowered) because credit no longer depends on the availability of savings, so more of it can be created, and therefore at a lower price.

Daniel September 9, 2007 at 9:48 pm

Straw man definition of capitalism. Not much to see here.

Fundamentalist September 10, 2007 at 7:54 am

Thanks for the clarification, Mr. Blumen. I should have known that. Monetarists have always held that an increase in the money supply affects everyone equally and affects only prices, while in reality it disrupts the production structure.

Allen Dalton September 10, 2007 at 10:53 am

To be fair to Monetarism – No Monetarist that I know of has ever said that (1) an increase in the money supply affects everyone equally, or (2)that relative prices do not change when the money supply changes. Rather they argue that relative price changes are secondary or tertiary in importance to the effect of changes in nominal income. They may be wrong on this score, but let’s accurately portray their arguments.

Stephane May 20, 2008 at 12:06 pm

I have almost finished Minsky’s opus “Stabilizing an unstable economy”. It is striking how much his observations about monetary instability resemble the Austrians’, and how much his conclusions differ.

He focuses more on private banking as the source of instability, rather than on central banking. But this endogenous vs. exogenous difference between Minsky and the Austrians shouldn’t be overrated, because there is also an endogenous part in Austrian monetary theory. Minsky distinguishes between commodity pricing and asset pricing, as well as between labor wages on the commodity and asset markets. This looks like a hayekian triangle, or what? Of course, there is a lot of keynesian blah blah about prices driving wages driving prices, thus triggering inflation, etc.

The most curious is that he considers that an unstable banking system is a normal feature – and, it seems, almost a necessary feature – of a dynamic capitalist economy. The ‘necessary’ part, however, is given without any argument as far as I can see. He also takes note that we now live in a Big Government environment, and describes some of the consequences. This begs the question : shouldn’t such dysfunctional institutions (fractional reserve banking, central banking, Big Government) be changed? But Minsky doesn’t seem to ask this kind of question.

Minsky was not quoted in Pr Garrison’s Time and Money. Well… it would be great to have his Austrian critique of Minsky!

Factoid : when I tried to purchase Minsky’s book on Amazon a few months ago, it was out-of-print and prices for old copies were skyrocketing (between $1000 and $3000!!!). These prices then started to fall slowly when a reprint was announced for May, but they are still above $500. Scarcity and fetishism, no doubt…

Whitehawk April 24, 2011 at 5:04 pm

I just came across this post, researching the topic of endogenous money and monetary theory(ies). I am a proponent of the Austrian school, particularly of Mises work.

To Mr. Blumen:

I read Minsky’s short paper “The Financial Instability Hypothesis,” and I don’t think it implies your conclusion that “the existence of fractional reserve banking and central banking is essential to his hypothesis.” Fractional reserve lending can occur without the existence of a central bank, and financial crises can occur without fractional reserve lending. Perhaps the existence of the latter makes financial crises more likely under certain conditions, and I’d certainly agree with that.

One of the issues that confuse me about the modern Austrian school of thought is that central banks are considered exogenous drivers of economic cycles, including economic-financial crises, something you state in your last paragraph. If that is true, then why is it so hard for a central bank (such as the Fed) to target inflation? Historically, the Fed’s attempt to target inflation ends up missing the mark completely and either helps create asset or commodity bubbles or rapid asset or commodity disinflation. Do we not agree that the money multiplier model cannot be used as a predictor of inflation, that the model is irrelevant, that existing monetary aggregates contradict this model?

I’d venture to say that the endogeneity of the central bank and its monetary control cannot be disregarded. That I know of, this does not contradict Mises view of money and credit. Financial crises can occur “from within” if one defines a system of participants that engage in speculative and then Ponzi unit financing, as Minsky hypothesizes. The Austrian business cycle honored system of 100% legal reserve financing is at odds with such financing, and would bring greater financial stability. In reality, we will always have speculative and Ponzi finance unit participants, or even hedge finance unit participants that are seemingly stable in terms of capital structure, but upon further examination are really speculative or Ponzi participants. Minsky’s paper appears to be a gedanken milestone, and is not at odds with free banking or participants that choose to adhere to 100% legal reserve lending.

Respectfully, S.L.

Robert Blumen April 24, 2011 at 5:50 pm

@SL – I’m not entirely sure that I understand your point starting “? Historically, the Fed’s attempt to target inflation ends up missing the mark completely and either helps create asset or commodity bubbles or rapid asset or commodity disinflation” but what I think you are asking is why does the Fed’s attempt to control monetary aggregates not show up 1:1 in the CPI measure of inflation? I’m going to assume that is what you mean, but feel free to add another blog post if I’ve not interpreted your question accurately.

The Austrian view is that while money over the long enough term is neutral – affecting only the general price level, not relative prices — that monetary injections are not neutral. Monetary injections affect relative prices, depending on where in the system the new money comes in and the expectations of market actors. These are referred to as Cantillon effects. These expectations may be partly or entirely based on flawed or illogical models of how the economy works, yet they may act on the all the same. In particular, the injection of money into the bond markets and/or the banking system in order to defend a target (non-market) interest rate has a series of effects based on the illusion, which can last for some time, that there are more actual resources available for investment than savers have voluntarily set aside. If these illusory saved resources actually existed, this would result in a revaluation upward of some sectors of asset markets. And it’s not only the quantity of money. During the Greenspan era an attempt was made by the Fed to eliminate any downside volatility in markets at all, leading to an under-pricing of risk.

To summarize, asset bubbles come about because the new money does not affect all prices evenly. It is injected into asset markets in such a way as to create the illusion that the fundamental conditions for higher asset prices have been met.

I also take issue with the usual conception of inflation. I don’t know whether you share this or not so this is not necessarily aimed at you. The CPI measures consumer goods prices. Yet every price in the economy is a money price, and a change in the supply of money can affect the prices of assets, capital goods, and commodities as well as the prices of consumer goods. We heard consistently through the 90s and the 2000s that Fed policy was not too lose because inflation was low. If they came up with an index of prices that included consumption goods, capital goods, financial assets, and houses, it would have shown considerable inflation.

In general, modern Austrians do not think that you can have an “Austrian” business cycle without fractional reserve lending. You are correct that fractional reserves can occur without a central bank, though the central bank certainly encourages it. A strict reading of the Austrian literature shows that it is only fractional reserves, not a central bank, that are necessary for the mal-investment process. A central bank only takes it to a higher degree of centralization and allows the process to continue longer.

I dispute that a speculative Ponzi-financed business cycle could occur in a system with a stable money supply and no ability to create credit by fractional reserves. Financial bubbles are characterized by low interest rates, overconsumption, and under-saving. Without fractional reserves, more and more money cannot be borrowed without more and more money being saved. In order to motivate savers to save an increasing portion of their income for investment, interest rates would have to be higher, which would in fairly short order choke off any bubble before it got started. Dr. Reisman has a nice article on Mises.org in which he makes this point in another way: if people are purchasing more and more assets at higher prices, then with a fixed money supply, goods markets should show a strong deflation.

Whitehawk April 26, 2011 at 4:52 pm

Thanks for your response and references, Robert.

My question was not specifically about the monetary mechanisms that drive inflation in asset and commodity prices vs. the government’s version of the CPI. I don’t think we disagree on the impact of the Fed’s monetary injections, artificially fixed interest rates, etc. on inflationary effects and relative prices – I follow the Austrian view (as you have stated) on this. I particularly believe that FFR targeting is perniciously violating the interest rate braking that would be expected in a functioning system that is not so manipulated, creating all sorts of consequences, including mal-investment. As for the CPI construction, I follow John Williams’ version at SGS (http://www.shadowstats.com); his version reverts to the pre-90’s version of the CPI, and is showing an overall YoY rate of 10% at present. Negative real interest rates are having their impact.

The issue I raised is over the view that the Fed –exogenously– controls inflation, monetary aggregates, bond rates/spreads, etc. through their injections, FFR targeting, and other various facilities. My point was that if they held complete exogenous control, the efficacy of their actions would be quite different than they are in reality. Many at the Fed (including Bernanke) are neoclassical Monetarists, and apparently still believe in exogenous monetary theories – otherwise, why would they continue to press monetary policy measures that are so obviously inadequate and that create ‘unintended’ consequences? My further point was that the Fed is really just another endogenous player in the system, and that even though they have monopoly control, that this control is not absolute or exogenous, that the endogenous system of monetary supply and demand affects, feeds back, etc. on their actions.

I don’t know how important the endogenous vs. exogenous debate is in the modern Austrian community; to me it does seem like an important distinction and not just semantics, since financial crises can be driven and exacerbated endogenously: endogenous financial innovations can affect the demand for money (and vice versa).

Your point that speculative and Ponzi driven bubbles or instabilities cannot occur without some sort of (overdriven) fractional reserve credit mechanism involved is well taken. Most of the large systemic bubbles (Mississippi, South Sea, 1929, 1980s Japan, dot.com, real estate-mortgage credit, etc.) were associated with reckless extensions of credit or the underpricing of risk through low interest rates. Kindleberger (a contemporary of Minsky’s) gives some exceptions in his Manias, Panics and Crashes, though his assumptions for stable money supply might not be the same as yours.

Best Regards, S.L.

pravin September 14, 2011 at 9:39 am

the central bank is exogenous to the capitalist system . in our current world-which is characterized by govt monopoly over money,the fed is an endogenous player -but austrians dont call it capitalism ,they call it central planning.i think your misunderstanding is as simple as that

Tommy Quartararo September 16, 2011 at 3:24 am

I have to express my appreciation for your kindness giving support to people who really want assistance with your subject matter.

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