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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?
Robert Blumen
Robert Blumen is an independent
software developer based in San Francisco, California
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