As a self-described “financial Keynesian,” Minsky incorporated an analysis of the banking system into his theory of investment cycles. The result was a more creative and dynamic conception of capitalism than more orthodox theories had achieved.
In Minsky’s macroeconomics, spending is what drives income, a reversal of the way most people think about their personal finances. In particular, investment spending is an autonomous decision not determined by a firm’s existing revenue. Instead, investment creates revenue and profits, as well as income for households.
Minsky’s macroeconomics requires us to think differently about banks as well. Here the key capitalist decision is the decision to lend. From an individualistic point of view, a household deposits income into a bank, and then the bank lends money to borrowers from such deposits. The process seems income-driven. But that does not fully capture the banking system’s creative role in the capitalist economy. Minsky looks at the process the other way around, saying that “a bank first lends or invests and then ‘finds’ the cash to cover whatever cash drains arise.”
How banks create money
What does a bank do when it agrees to make a business loan? It issues a promissory note, which is a promise by the firm to repay the loan. It also gives permission for the business to make cash withdrawals by creating a balance in the business’s bank account. Presto! Money is created.
The business’s balance sheet shows the debt as a liability and the cash account as an asset. The bank’s balance sheet shows the loan as an asset and the cash account as a liability. All the money in the economy is somebody’s liability as well as someone else’s asset. Economic institutions create financial assets by simultaneously creating financial obligations. Even the dollar bills in your wallet represent the obligation of the government to accept them as payment for taxes, giving them an established national value.
Of course, the bank has to worry about its cash flow as well as its balance sheet. As Minsky says, it has to find the cash to cover whatever cash drains arise. The bank maintains a positive cash flow by receiving at least as much in deposits as it pays out in withdrawals. It attracts deposits by offering to pay interest on them, which it can do because it charges (even higher) interest to its borrowers. It must always have a reserve on deposit with the central bank to cover likely withdrawals.
If a bank should need additional reserves, it can obtain them by borrowing from another bank on the federal funds market. If banks need more reserves than other banks want to lend, they can get them from the Federal Reserve itself. This is even more obviously a creation of money, since the Fed simply credits a bank’s reserves in an amount corresponding to the obligation the bank is assuming. Presto again!
One implication is that the Federal Reserve does not control the money supply completely and directly. It does influence it through its power over the interest rate that banks charge each other and the rate it charges the banks. The Fed can encourage or discourage the creation of money by making it more or less expensive for banks to borrow. But the decisions of bankers themselves also expand and contract the money supply. Modern monetary theorists say that the money supply is not controlled exogenously by the Federal Reserve, but endogenously from within the capitalist system. It responds to fluctuations in business’s willingness to invest and banks’ willingness to lend. While the exogenous view has been the orthodox neoclassical view, and is still found in many textbooks, Wray says that Minsky’s view is now becoming the dominant one among economists and policymakers.
Types of banks
A commercial bank makes short-term loans to finance a firm’s production and distribution of goods. When the goods are sold, the loan can be repaid. The bank relies on depositors for its cash flow.
An investment bank provides long-term financing of more expensive capital assets. It may act as an intermediary, marketing a company’s stocks or bonds to investors and charging a fee for that service. It may also act as an investor itself, assembling its own portfolio of stocks and bonds. Investment banks are generally riskier operations than commercial banks. While commercial bank depositors can place their savings in federally insured cash accounts, purchasers of stocks and bonds are vulnerable to market fluctuations and loan defaults. And whenever an investment bank is holding securities itself, it can get stuck with devalued assets or try to stick its customers with them.
New Deal banking reforms tried to protect consumers from being taken advantage of by investment banks. The Glass-Steagall Banking Act of 1933 required a clear separation between commercial and investment banking. Minsky did not live to see its repeal in 1999, but he probably would not have approved.
The massive expansion of the financial sector in recent years has created many institutions that provide financing without being regulated as banks. These so-called “shadow banks” include hedge funds, money market funds, mortgage lenders, payday lenders and private equity funds. Many of them played a role in the global financial crisis.
The ability of the financial system to create money enables it to expand and contract the money supply. These fluctuations then amplify the business cycles created by variations in investment.
Minsky’s theory can be summarized as “an investment theory of the cycle and a financial theory of investment.” The first is the usual Keynesian view, which sees fluctuations of investment spending as driving the business cycle. When firms are optimistic, investment in plant and equipment grows, creating jobs and income. When expectations turn around, spending and employment fall.
Minsky’s extension was to add the financial theory of investment, stressing that modern investment is expensive and must be financed—and it is the financing that generates structural fragility. During an upswing, profit-seeking firms and banks become more optimistic, taking on riskier financial structures. Firms commit larger portions of expected revenues to debt service. Lenders accept smaller down payments and lower quality collateral.
Minsky classified the financial positions of firms according to risk. A “hedge” position is one in which a firm can make both principle and interest payments on any debts. A “speculative” position is one in which the firm pays only interest, but must periodically rollover the principle to a new loan in order to remain solvent. A “Ponzi” position is one in which a firm cannot even pay the interest due without taking on new loans or other obligations. As firms take on more debt and banks approve more questionable loans, the safer financial positions evolve into riskier ones, and an economic boom ends in financial crisis.
Minsky believed that capitalist institutions were especially vulnerable to instability in the most recent phase of capitalism. He had already reached that conclusion before the global financial crisis. I turn next to Minsky’s interpretation of economic history.