Minsky’s interpretation of the history of capitalism rested heavily on his understanding of capitalist finance. He associated each stage of capitalism with a distinctive financial structure.
From commercial to finance capitalism
This distinction corresponds to the distinction between commercial and investment banking described previously. During the nineteenth century, commercial banking was the dominant source of financing. Banks made mainly short-term loans to businesses so that they could hire labor and purchase raw materials for production. Banks relied on interest-earning deposits for their cash flow.
The growth of big business in the late nineteenth century required financing for more expensive, long-term investments. Investment banks developed for that purpose, and by the early twentieth century they came to dominate the financial system. That, in turn, helped the big companies grow even bigger and dominate their industries, as Wray explains:
The investment banks played an important role in helping the “trusts” to consolidate power and oligopolize markets. Indeed, to obtain long-term external finance through the investment banks, the borrower really needed market power—for otherwise the lending was too risky. Borrowing firms needed to demonstrate that they had sufficient price-setting power to ensure that they could survive the long-term debt issued to finance positions in complex and long-lived plant and equipment.
Finance capitalism was still riskier than commercial capitalism for a couple of reasons. The financiers themselves were at risk because they had to bet on the long-term success of the businesses they financed. And the investment banks—not yet constrained by modern financial regulations—could offer their own shares in dubious financial enterprises to the public. Many of these were essentially Ponzi schemes, named for the famous swindler of the 1920s.
Unregulated finance capitalism proved to be unsustainable. “This phase of capitalism collapsed into the Great Depression—which Minsky saw as the failure of finance capitalism.”
Managerial welfare-state capitalism
The New Deal ushered in a new phase of capitalism, characterized by a larger role for the federal government. Regulations like the Glass-Steagall Banking Act and the Securities Exchange Act reined in some of the riskiest financial behavior.
The government’s fiscal policies also had important financial implications, which Minsky saw as largely positive. Government spent much more, first on economic relief projects and then on World War II, which had the effect of stimulating production and employment by increasing aggregate demand. To the extent that it financed this spending by selling government bonds, it provided lenders a secure, high-quality form of savings. As long as the government ran deficits and accumulated debt, it followed that the private sector could run surpluses and accumulate more financial assets than liabilities. (In the system as a whole, financial assets and liabilities must balance, while real assets like homes and factories can keep growing.) Large companies engaged in less risky borrowing, and financed their operations more from retained earnings.
Compared to the periods before and since, the period from the 1940s to the 1970s stands out as an era of relative financial stability, high economic growth, and broadly shared benefits of prosperity. [The benefits flowed mainly to white, male breadwinners, but by no means just the wealthy ones.]
Money manager capitalism
The last two decades of the twentieth century saw the rise of a new kind of capitalism that Minsky regarded as less stable. Here is where Minsky’s saying that “stability is destabilizing” most applies. While the Depression had discouraged risk-taking and produced a longing for stability, the postwar prosperity had the opposite effect. As incomes rose and a sense of economic security spread, people regained some of their tolerance for risk. Households that could now afford to save more were less content to keep their savings in federally insured but low-interest bank deposits, or in safe but boring government bonds.
Enter the money managers. Money manager capitalism was driven by “huge pools of funds under management by professionals—pension funds, sovereign wealth funds, hedge funds, university endowments, corporate treasuries, and so on.” Foreign money also contributed to a “global glut of managed funds,” as foreigners took the dollars they earned by selling goods to American consumers and reinvested them.
Leading the way were the “shadow banks,” which provided financial services but did not have federally insured deposits and were not regulated as banks. They were free to attract money by offering higher interest rates, and they were willing to take on the risks necessary to achieve higher returns. More traditional financial institutions, such as savings & loans, also sought and received more regulatory freedom so that they could remain competitive. As a result, they were no longer as safe as they used to be either, as the S & L crisis of the 1980s revealed.
Wray describes the growth of the financial services industry:
From the 1980s, the financial sector grew relative to the non-financial sectors (manufacturing, agriculture, and nonfinancial services, including government)—by the time of the GFC [global financial crisis], the financial sector accounted for 20 percent of U.S. national value added and 40 percent of corporate profits. By itself, it was an autonomous source of growth and also of rising inequality because of high compensation in the sector. Up to half of the college graduates from the elite colleges went into the financial sector because rewards there could be far higher than in other sectors. Compensation at the very top quite simply exploded.
Money manager capitalism increased the incentives for risky behavior. The financial reforms of the New Deal had prohibited bankers from offering very high returns on deposits. That eliminated any need to pursue high-risk, high-return investments, and encouraged only the most prudent of loans. For the new money managers, touting high returns was the way to get more assets under management. Given the normal fluctuations and uncertainties of markets, high returns were an elusive long-term goal, but short-term success could be very profitable. The managers could rake in management fees while making their investments with their clients’ money, so that they did not suffer the long-run losses from any bad bets they did make. On the average, mutual funds with high fees are more likely to underperform than outperform the market, but their clients either failed to grasp those odds or thought that they could beat them. Another implication was that corporate executives who could boost their company’s stock price with short-term profits attracted more capital from the financial managers. Executive compensation soared along with that of the financial managers, and both were increasingly tied to short-term performance.
Financial assets are always somebody else’s obligations. The economy becomes more fragile as the underlying obligations become harder to fulfill. If money flows into “hot” funds investing in “hot” companies whose long-term outlook is poor, then assets are overvalued and some collapse of values is likely.
The growth of the financial sector was largely driving the economy, but it was increasingly disconnected from the creation of real wealth.
The problem was that the sheer volume of financial wealth under management outstripped socially useful investments. To keep returns high, money managers and bankers had to turn to increasingly esoteric financial speculation—in areas that not only did not serve the public purpose but actively subverted it.
An example would be the rise of index speculation in commodities markets that drives up global prices of energy and food, leading to hunger and even starvation around the world.
Money manager capitalism distributed its economic benefits more unequally, compared to the postwar era. The largest benefits went to the financial management firms themselves and the wealthiest households. Income from executive compensation and capital gains far outstripped general economic growth or wage growth. Little increase in spending was possible for the less affluent without taking on more debt, which was readily available at high interest. Wray describes a “self-reinforcing” cycle, in which increasingly powerful financial institutions used their political clout to perpetuate and expand their freedom from regulation. Caps on interest rates charged on consumer loans were one of the restrictions that disappeared.
The “esoteric financial speculation” Wray refers to includes innovative but risky ways that financial managers made money. In the leveraged buyout, they would buy companies using other people’s money, then run them mainly for short-term profit, selling off useful assets and alienating workers with cuts in wages and benefits. If the companies failed, it was mainly someone else’s loss.
Minsky was especially critical of securitization, as exemplified by mortgage-backed securities. It begins as something benign, an attempt to reduce risk by buying a package of mortgage loans instead of owning just one. One mortgage might fail, but a package of loans should mostly be repaid. The trouble is that traditional underwriting may go out the window. Unlike a traditional banker making a loan, a money manager packaging and reselling loans may not know or care as much about the original borrower’s ability to make the payments, especially if the loan itself is a riskier adjustable-rate loan instead of a traditional fixed-rate mortgage. Some financial companies routinely made risky loans intended for resale. Securitization—an ironic name if it results in less secure obligations—resulted in multiple layers of debt, such as mortgage-backed securities further packaged into collateralized loan obligations and insured by credit default swaps. Financial firms that created and sold such securities participated in a network of obligations to one another, each making new speculative bets on the basis of dubious assumptions.
In the late 1990s, as economists and policymakers applauded the elimination of the federal deficit by the Clinton administration, few grasped the implications for the private sector. With the public sector moving into surplus, and the trade deficit worsening (which means a surplus of dollars in the hands of foreign countries), the private sector had to be in deficit, spending more than its income and going more deeply into debt. The wealthy were accumulating more financial assets than liabilities, but more of the private sector was doing the opposite. And while Americans were obsessing over federal debt, private-sector debt was actually less secure. That’s because the federal government has never defaulted on an obligation, and never really has to. (Congress can make it default by refusing the raise the debt ceiling, as Republicans are threatening to do solely to score political points.) Private and increasingly risky debt was what was really putting the economy at risk. The housing boom of 2003-2006 depended heavily on it.
Although he didn’t live to see the system crash in 2007, Minsky saw the weaknesses of money manager capitalism early on. The crash was the worst since 1929, but rapid responses from the federal government mitigated the damages and avoided another Great Depression. Minsky’s policy proposals remain relevant to the challenge of creating a less fragile and more productive form of capitalism for the twenty-first century. That will be the topic for the final post.