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Source link: http://archive.mises.org/7478/does-the-current-financial-crisis-vindicate-the-economics-of-hyman-minsky/

Does the Current Financial Crisis Vindicate the Economics of Hyman Minsky?

November 27, 2007 by

The currently observed turmoil in financial markets, which is believed to have been ignited by the collapse of the subprime mortgage market, has recently brought to prominence the ideas of Hyman Minsky (1919–1996), a prominent member of the post-Keynesian school of economics. Many commentators are of the view that Minsky’s framework of thinking accurately anticipated the current financial crisis.

While most mainstream economists are of the view that economic busts are the outcome of various external shocks to the economy, Minsky held that, even in the absence of such shocks, the capitalistic economy has an inherent tendency to develop instability, which culminates in severe economic crises. The key mechanism that pushes the economy towards a crisis is the accumulation of debt. FULL ARTICLE

{ 30 comments }

Nelson November 27, 2007 at 10:13 am

Consequently, the threat of bankruptcy is likely to deter banks from pursuing the expansion of unbacked credit.

Maybe, but I doubt it. Executives get paid for performance. The only way to increase performance after high efficiency is achieved is to take risks. In this case they’re risking other peoples’ money so they’re not likely to factor in the full costs of those risks into their calculations.

Ty November 27, 2007 at 10:29 am

It doesn’t matter what bank execs think, bad fiscal policy would put them out of business.

Nelson November 27, 2007 at 10:57 am

It doesn’t matter what bank execs think, bad fiscal policy would put them out of business.

It does matter that them going out of business means you lose your savings. And the cost to them of losing your savings isn’t as high for them as it is for you.

Michael A. Clem November 27, 2007 at 12:02 pm

Obviously, it doesn’t matter so much to bank execs while the government is there to bail them out, but it would matter much more to them without that safety net.

Anthony November 27, 2007 at 12:15 pm

Moral hazard comes to mind.

Fundamentalist November 27, 2007 at 12:34 pm

I’m no fan of central banks, and they clearly allow the banking system to inflate more than they could in a free banking system, but some history I have read makes me wonder about assigning all the blame to CB’s. Venice experienced some severe financial crises in the early modern period, and the culprit was nothing but credit expansion via accounting entries. No paper money was involved. Later, bills of exchange caused similar business cycles. In the 19th century, the US experienced some severe business cycles without a central bank and those were due to independent banks expanding credit. Yes, the banks failed, but the economy also went through serious gyrations and caused a lot of non-bankers to go broke, too. The panic of 1820 is a good example.

I wonder if business cycles are just a fact of life with money? I think the only way to eliminate them is to go back to barter.

Greg November 27, 2007 at 1:07 pm

Forgive me but I’m testing my philosophical argument here. Isn’t the subprime problem once again the fed? The current money policy (i.e. inflation) is inherently anti-poor. Here’s why I say that:

First, what is poverty. What some bureaucrat with the government says it is? Just to start somewhere I’d say it is the subjective line below which a person can no longer afford the minimum goods to avoid their own personal economic collapse. It really doesn’t matter where that line is, just that it is somewhere.

For those living below the line there will be a percentage who climb out of poverty, a percentage that keep up with inflation (wow, thanks), a percentage that stays the same and a percentage that decline (i.e. the poor will always be with us).

What would happen without inflation? A larger percentage would have the opportunity to climb out of poverty since it’s not a moving target. Some would stay the same and some would still decline.

So, here’s what I think is really happening. Credit is easy to get. People think they will have more money because their income inflates. I’m sure all the nice mortgage people told them ‘Hey, in three years you’ll be making 2 or three hundred more bucks anyway, right’.

Fundamentalist November 27, 2007 at 2:02 pm

Greg: “What would happen without inflation? A larger percentage would have the opportunity to climb out of poverty since it’s not a moving target. Some would stay the same and some would still decline.”

Exactly! The Fed serves banks. It doesn’t care about the poor who fall further and further behind because their wages don’t keep up with inflation. In fact, mild deflation would benefit the poor.

Socialists are too ignorant to get this. They claim to speak for the poor, but champion the Fed because it represents financial socialism.

Vindicated NOT!!! November 27, 2007 at 2:25 pm

The mechanism for these evil banks changing their behavior is never defined or explained. Banks just together as one group behave the same and make progressivley risky loans while the economy improves and less risky loans when the economy does poorly. This assumes all banks are in the same position which is not true. It also assumes that the economy affects the condition of all banks uniformly. This is not true as well.

Only the Austrian theory of inflation and the business cycle has it right.

A central bank expands the amount of credit at a higher rate than the growth of the economy. It gives this credit to banks who can either do nothing and watch competitors loan cheap money from the government or participate themselves. Big suprise they all participate.

This is all hunkey dory until one of these debtors can not pay back the money. Banks then react by stopping lending to similar risky potiential debtors. Now there is an asset free fall as buyers see this and bid down asset prices.

All thanks to the central bank.

Nelson November 27, 2007 at 5:03 pm

The Federal Reserve System is just an economic device that can be used wisely or foolishly like any other device. But it certainly isn’t the cause of all banking woes. You don’t need a central bank to make risky loans or to lend out more money than it takes to cover a bank run.

Fundamentalist November 27, 2007 at 5:29 pm

Nelson: “You don’t need a central bank to make risky loans or to lend out more money than it takes to cover a bank run.”

That’s true, but if you read de Soto’s book on banking you’ll see how a central bank makes it possible for individual banks to inflate far beyond what they could alone. Also, mergers have about the same effect.

Paul Edwards November 27, 2007 at 6:34 pm

“I’m no fan of central banks, and they clearly allow the banking system to inflate more than they could in a free banking system,”

That is their purpose – to cartelize the banking industry so that the banks can inflate in unison and avoid the problem of more sound banks redeeming specie from less sound banks more deeply involved in fractional reserved lending.

“but some history I have read makes me wonder about assigning all the blame to CB’s.”

Correct. The blame goes to shady bankers who wish to partake in the fraud of fractional reserve banking in the first place. Central banks are merely an apparatus of the banks used to create the cartel that makes frbanking more subtle and lucrative.

“Venice experienced some severe financial crises in the early modern period, and the culprit was nothing but credit expansion via accounting entries. No paper money was involved. Later, bills of exchange caused similar business cycles. In the 19th century, the US experienced some severe business cycles without a central bank and those were due to independent banks expanding credit. Yes, the banks failed, but the economy also went through serious gyrations and caused a lot of non-bankers to go broke, too. The panic of 1820 is a good example.”

Yup. It is the issue of fraudulent receipts, and/or frbanking that is at the root of these cycles.

“I wonder if business cycles are just a fact of life with money? I think the only way to eliminate them is to go back to barter.”

Business cycles are a fact of life as long as fractional reserve banking persists. Central banks exasperate the problem by allowing insolvent and bankrupt banks to remain in operation after their insolvency is discovered.

If courts, contracts, bank runs and bank failures were left to the free market, central banks would not exist, and fractional reserve banking would be reduced to a tiny niche credit market – where their bills were not currency, but debt – or possibly the practice would be eliminated altogether. That would put an end to credit expansion induced business cycles. No need to dispense with money, and degenerate to barter – thankfully.

Paul Edwards November 27, 2007 at 6:35 pm

“I’m no fan of central banks, and they clearly allow the banking system to inflate more than they could in a free banking system,”

That is their purpose – to cartelize the banking industry so that the banks can inflate in unison and avoid the problem of more sound banks redeeming specie from less sound banks more deeply involved in fractional reserved lending.

“but some history I have read makes me wonder about assigning all the blame to CB’s.”

Correct. The blame goes to shady bankers who wish to partake in the fraud of fractional reserve banking in the first place. Central banks are merely an apparatus of the banks used to create the cartel that makes frbanking more subtle and lucrative.

“Venice experienced some severe financial crises in the early modern period, and the culprit was nothing but credit expansion via accounting entries. No paper money was involved. Later, bills of exchange caused similar business cycles. In the 19th century, the US experienced some severe business cycles without a central bank and those were due to independent banks expanding credit. Yes, the banks failed, but the economy also went through serious gyrations and caused a lot of non-bankers to go broke, too. The panic of 1820 is a good example.”

Yup. It is the issue of fraudulent receipts, and/or frbanking that is at the root of these cycles.

“I wonder if business cycles are just a fact of life with money? I think the only way to eliminate them is to go back to barter.”

Business cycles are a fact of life as long as fractional reserve banking persists. Central banks exasperate the problem by allowing insolvent and bankrupt banks to remain in operation after their insolvency is discovered.

If courts, contracts, bank runs and bank failures were left to the free market, central banks would not exist, and fractional reserve banking would be reduced to a tiny niche credit market – where their bills were not currency, but debt – or possibly the practice would be eliminated altogether. That would put an end to credit expansion induced business cycles. No need to dispense with money, and degenerate to barter – thankfully.

Paul Edwards November 27, 2007 at 8:17 pm

“The Federal Reserve System is just an economic device that can be used wisely or foolishly like any other device.”

Actually, it’s a key apparatus of the fraudulent US banking cartel. Its existence is an affront to justice as it facilitates a subtle transfer wealth from the productive of this nation, to the parasitic elite on Wall Street and in Washington. Next to the US constitution, it has got to be the biggest and most successful con job ever pulled over the American people and it is still running as designed after almost 100 years. It relies on the state for its false legitimacy, and it isn’t any sort of economic device that would exist in a free market.

Francisco Torres November 27, 2007 at 8:40 pm

I simply do not believe Minsky ignored the role of central banks and fractional reserve banking in boom-bust cycles, thus placing the blame in capitalism per se. I believe he simply dismissed their role in order to attack capitalism directly, unencumbered by facts.

Unless he was blind or stupid, the only explanation for this fault is that he was simply an anti-capitalist.

Alex November 27, 2007 at 9:54 pm

I really enjoyed the first part of Frank’s article, but then he overstated the case in the “$100 deposit example”, where he concluded that the banks would be very much constrained in their credit expansion if not for central bank backing. When all $150 worth of deposits were called upon, essentially money demand was assumed to drop to zero. I think Paul Edwards point is correct in that it’s not central banks that permit money and credit to be created out of thin air but instead fractional reserve banking.

G.T. Kysor November 28, 2007 at 1:05 am

I agree that CBs do cause this problem, but I can’t help but think that if there were no CBs, then the mortgage default situation would be the same, even in a free market, because poverty increases when the production of consumer goods diminishes. The difference in pay between average manufacturing and service jobs is not met by the decrease in the price of imported consumer goods.

Nelson November 28, 2007 at 10:29 am

“The difference in pay between average manufacturing and service jobs is not met by the decrease in the price of imported consumer goods.”

This has nothing to do with the topic, but good jobs and even the highest paid jobs are service jobs. Teachers, Engineers, Architects, Executives, Lawyers, Doctors, Musicians, Authors, Actors… primarily have service jobs. The notion that putting a car together is the ultimate middle class job is absurd.

G.T. Kysor November 28, 2007 at 1:36 pm

What I meant by the statement Nelson quoted was that workers laid off from the manufacturing sector usually take lower-paying jobs in the service sector, i.e., they don’t become “Teachers, Engineers, Architects, Executives, Lawyers, Doctors, etc.”

Fundamentalist November 28, 2007 at 4:06 pm

Paul: “If courts, contracts, bank runs and bank failures were left to the free market, central banks would not exist, and fractional reserve banking would be reduced to a tiny niche credit market – where their bills were not currency, but debt – or possibly the practice would be eliminated altogether.”

I don’t think so. That was my point in citing history. Bills of exchange didn’t involve fractional banking, yet cause huge fluctuations in the money supply and severe financial crises. Fractional banking has been popular since it began in Venice over 600 years ago. I don’t see how you would eliminate it; it’s too lucrative. Look at the history of the US in the 19th century. When no central bank existed, fractional banking was wide spread. Besides banks, fractional banking is practiced today by mutual funds and life insurance companies, too. If freedom exists, there always will be someone willing to loan more than they have. There is simply too much money to be made by doing so. Hayek made this same point.

AFasih November 29, 2007 at 8:04 am

I was asking myself a question that both Fundamentalist and Paul Edwards address. I for one am all for keeping my (hopefully asset-backed) money in fraction-free bank and paying a nominal fee for services like ATMs and debit cards. I’ll do my own investing if I want my money to be exposed to risk with the hope of some return (and I’ll pick REIT-like instruments if the demand for mortgages is high). Fractional reserve is counterfeit, pure and simple, and one day will be made illegal.

newson December 1, 2007 at 12:44 am

note to fundamental: whilst history is full of credit booms and busts, prior to the advent of central banking, collapse of one or more banks would not necessarily bring the whole system down. and the regularity of bank runs (thanks to fractional reserve banking) rightly made the public more wary about banks in general. the federal reserve system has only hidden the systemic risks from the public gaze and ensures when the levy breaks, the damage will be catastrophic.

fundamentalist December 1, 2007 at 8:28 am

newson: “prior to the advent of central banking, collapse of one or more banks would not necessarily bring the whole system down.”

That’s true, but the suffering was real, deep and wide spread. Check out Rothbard’s book on the depression of 1820.

newson: “the regularity of bank runs (thanks to fractional reserve banking) rightly made the public more wary about banks in general”

And caused people for fall for the nonsense of creating a central bank.

newson: “…federal reserve system has only hidden the systemic risks from the public gaze and ensures when the levy breaks, the damage will be catastrophic.”

Couldn’t agree more. I don’t think the Great Depression could have happened without the Fed, and the next one will be disastrous.

mikey December 1, 2007 at 1:31 pm

Fundamentalist writes;

“Fractional banking has been popular since it began in Venice over 600 years ago. I don’t see how you would eliminate it; it’s too lucrative. Look at the history of the US in the 19th century. When no central bank existed, fractional banking was wide spread.”

In the absence of any government intervention at all, how would fractional banks avoid losing gold to solvent banks? The only option is to curtail lending, raise interest rates on loans,and retire their over-issued notes from circulation. This is
spelled out by Mises in Human action.

Also, there were two central banks in in America
before the Fed was created.The second in particular caused an inflationary bubble in land prices.The end was painful.Absent a central bank,
this would have been avoided, or greatly lessened.

In all my reading on banking and money I find one dreary example after another of fractional bankers either going bust, curtailing their issuance of notes, or enlisting government for protection in one form or other.(their favorite.)

fundamentalist December 1, 2007 at 5:07 pm

mikey: “In the absence of any government intervention at all, how would fractional banks avoid losing gold to solvent banks? The only option is to curtail lending, raise interest rates on loans,and retire their over-issued notes from circulation.”

When I wrote “When no central bank existed…”, I didn’t mean that the US had no central banks in the 19th century. I was referring to the periods in the 19th century when we did not have central banks.

You should read Rothbard’s history of the 1820′s crisis. Banks in the NE US remained solvent. Banks in the South and West printed money like crazy. This happened before the creation of the central bank. Of course, its creation only made things worse. The Western and Southern banks did lose gold to the NE banks, but rather than rein in their runaway monetary inflation in ways you suggest, they simply went broke. Then they blamed greedy businessmen and speculators. While the banks in the NE remained solvent, their communities suffered terribly. One source I read on the crisis estimated unemployment at 80% in Philadelphia, New York and Boston. Hundreds of factories went bankrupt. I believe it might have been worse than the depression of the 1930′s.

Why will banks go broke rather than raise interest rates or curtail printing money, which you would think would be the reasonable thing to do? Because bankers have always followed, and still follow today, some version of John Law’s Real Bills Doctrine; that’s why the RBD is sometimes called the “banking school” of monetary theory, as opposed to the quantity theory. As a result, they don’t believe they are the problem. For the four centuries since John Law’s debacle in France, including today, bankers always have blamed every crisis on greedy businessmen and speculators. They are never at fault in their minds, just as the Fed never finds any fault with what it does.

As long as bankers subscribe to some from of the RBD, fractional reserve banking will exist and will continue to cause financial crises as it has for over six centuries. Economists haven’t been able to convert a single banker to the quantity theory in 200 years; I doubt there is much chance of it happening in the next 200.

mikey December 4, 2007 at 3:21 pm

Fundamentalist wrote-

“Why will banks go broke rather than raise interest rates or curtail printing money, which you would think would be the reasonable thing to do?”

One possible explanation- the initally higher profits of FRB decline as more and more bankers
practice FRB. Competition drives profit margins down to levels that are no higher than in any other endevour.
There is one solution for this that FR banks cannot resist- expand the size of lending.

In the debate between the Currency School and the
Banking school, the latter trotted out The Law of the Reflux, as put forward by Fullarton, it says that FRB will not cause inflation as any money that is loaned into existence will be liquidated as the loans are repaid and the money retired out of circulation.
This would be true only if lending by banks did not expand continually.And of course they have a powerful incentive to do just that.

Fundamentalist December 4, 2007 at 3:30 pm

Mikey: “…The Law of the Reflux, as put forward by Fullarton, it says that FRB will not cause inflation as any money that is loaned into existence will be liquidated as the loans are repaid and the money retired out of circulation.”

Interesting. I didn’t know that. I think the Banking School is more right than they know, but not for the reasons they think. It is true that the new money will be liquidated as the loans are repaid; that’s called a recession.

Paul Andrews October 27, 2008 at 5:27 am

Something that doesn’t ever seem to be mentioned much: off-balance-sheet vehicles (such as those utilized for mortgage securitization) are a form of fractional reserve lending, but with essentially zero reserve requirement. Hence they allow the creation of an unlimited amount of (bad) credit. This is a large part of what happened to cause the current crisis. This did not require a central bank, just brazen capitalists, not subject to constraints on credit “creation”.

Regardless of whether there is a central bank or not, society needs a sensible rule framework around creation of credit. The free market needs to operate withinh those rules.

Oliver Cooke August 7, 2009 at 12:15 pm

Interesting and deeply flawed. The Fed “caused” the current financial malaise? First, if the economics profession has learned anything over the course of the past century, it is that such once-in-a-generation events are incredibly complex, i.e., they largely escape simplistic explanations–which “Blame the Fed” certainly is. Indeed, if this type of argument held any validity then such events would be bound to erupt much more frequently than they do. Second, the argument implicitly suggests that a “Fed-less” world would be ideal or at least more optimal than one with it. But, this forgets nearly a century’s worth of U.S. economic history. Indeed, it was this history (19th century) that eventually led–following several waves of massive financial sector breakdown–to the creation of the Fed as a lender of last resort. Finally, and most importantly, the logic implicitly suggests that agents are irrational, viz., they don’t understand and don’t anticipate the implications of ficticious money.

Bors September 14, 2009 at 5:05 pm

“The so-called “friendly capitalism” that both Minsky and the post-Keynesians are advocating is a recipe for progressively slowing the buildup of real wealth and hence lowering the living standards of individuals. The simple question is who are these individuals. All individuals or some individuals? And of course what are the living standards requirement and how much consumption is involved?

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