Why Minsky Matters (part 5)

November 3, 2021

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To conclude this summary of L. Randall Wray’s Why Minsky Matters, I turn to Wray’s description of Minsky’s policy proposals. These proposals are grounded in Minsky’s understanding of the capitalist economy as an inherently unstable system. In order to function well, it needs more than the occasional nudge from government to counter departures from equilibrium arising from external shocks. It needs a set of institutionalized constraints to keep business cycles from spinning out of control, especially because they are amplified by financial cycles of speculation and panic.

Minsky’s approach to policy is based on a broad conception of capital development: “Minsky used the term ‘capital development’ in a very broad way to include public and private infrastructure investment, technological advance, and development of human capacities (through education, training, and improvements to health and welfare).”

Minsky saw two main ways that capital development could go wrong. One is that the economy might not be investing enough to utilize its productive capacity and keep workers fully employed. That was the problem that preoccupied most Keynesian economists. The other is that the financial system was financing the wrong investments, especially speculative investments that are doomed to fail. Overinvesting in lavish office buildings and mansions while failing to build affordable housing would be an example. This problem relates more to Minsky’s distinctly financial brand of Keynesian economics.

To address both problems, Minsky envisioned a larger role for government than orthodox economists have traditionally envisioned. This applies not only to neoclassical economists, but also to Keynesians who sacrificed too many of Keynes’s original insights in their effort to accommodate neoclassical thinking.

Limitations of postwar policy

Minsky regarded the economy of the postwar era as more stable than either the economy of the earlier Roaring Twenties or that of the more recent Reagan era. Nevertheless, because he believed that stability could lead to overconfidence and instability, he saw the seeds of future problems in postwar policy, especially the standard form of Keynesian policy at that time.

As an example, I’ll use what has been called “military Keynesianism,” the heavy reliance on defense spending to keep the economy running at high capacity. It did stimulate production, as did the wartime spending often credited with ending the Great Depression. But Minsky had several concerns, which also applied to other ways that government encouraged private investment. First, the economic benefits went especially to corporate shareholders and high-skilled workers. Second, the high incomes of those groups encouraged their high consumption—as well as “emulative consumption by the less affluent, creating the potential for demand-pull inflation.” When inflation did occur, government would tighten fiscal or monetary policy to fight it, slowing the economy and making sustained progress against unemployment impossible. Finally, booms in private investment could produce business overconfidence and debt-financed speculation, according to Minsky’s instability theory.

Minsky was very interested in reducing poverty, but he was a critic of the War on Poverty launched by the Johnson administration in the 1960s. His main concern was that it did not sufficiently address the underlying problem of job creation. Instead, it focused on income assistance through such programs as food stamps and Aid to Families with Dependent Children, and on job training programs. Minsky objected to the assumption that the barrier to employment was the worker’s qualifications instead of industry’s demand for workers and its incentive to train them.

The idea was that the War and Poverty would prepare those who could work, upgrading their skills, and it would provide welfare and food stamps to those who could not, would not, or should not work. Finally, it would rely on the private sector to create jobs for the new workers seeking them.
Still, unemployment rates (and especially jobless rates) have trended upward since the 1960s, long-term joblessness has become increasingly concentrated among the labor force’s disadvantaged, poverty rates have remained rigid, real wages for most workers have declined since the early 1970s, and labor markets and residential neighborhoods have become increasingly segregated as the “haves” construct gated communities and the “have-nots” are left behind in the crumbling urban core. In other words, the War on Poverty not only failed to reduce poverty, but it also failed to provide jobs on a sustained basis to those who wanted them.

Of course, Minsky was even less enthusiastic about the policies of the Reagan-Bush era, which continued to stimulate the economy through defense spending, but prioritized inflation-fighting over full employment and largely abandoned the effort to raise wages or reduce poverty. The results of returning to laissez-faire economics were just what Minsky expected—greater economic inequality and more financial instability.

Government spending

While Minsky was no Marxist, he did want a larger role for government in the economy. Given the large fluctuations in private investment as business confidence rises and falls, the government’s budget must be large enough to offset investment declines when they occur. The government’s fiscal deficit must also be at least as large as the country’s current account deficit (which is the surplus of dollars held by the country’s trading partners when the U.S. imports more than it exports). Otherwise, the country’s private sector will be running a deficit and accumulating more financial liabilities than assets. Since private debt is riskier than federal debt, that increases the risk of financial bubbles and busts.

Minsky wanted more from government spending than national defense or “welfare” in the narrow sense of the term. He wanted it to grow the economy more from the bottom up.

[G]overnment spending—especially on wages—should play a major role in generating growth. This is because a sovereign government can increase its spending—even if that results in a budget deficit—without increasing risk of insolvency and default. In contrast, if private spending leads the way, it will tend to outpace income of households and firms, meaning that private indebtedness will grow. That is risky and ultimately unsustainable

Minsky’s preferred method for keeping the economy going without encouraging speculative and unsustainable investments was targeted government spending. He wanted to spend on things that simultaneously boosted incomes and added to the productive capacity of the economy, such as improvements in infrastructure. The model for this was the New Deal programs that put people to work doing socially useful things. As Keynes said, “To set unemployed men to work on useful tasks does what it appears to do, namely, increases the national wealth.”

At the heart of his program is the idea of government as the Employer of Last Resort (ELR). A government jobs program would automatically stabilize the economy by maintaining full employment in times of low private-sector demand, but provide some job experience for workers who could enter or re-enter the private sector in times of economic expansion. Stephanie Kelton’s Public Service Employment proposal, which I discussed recently, was inspired by Minsky’s work.

Financial reform

The general goal of financial reform is to encourage prudent banking, but not riskier financial speculation. “Banking should not be like gambling because the bank needs to ‘win’ around 98 percent of the time whereas a casino can be profitable if the house wins 52 percent of the bets.” The prudent banker is committed to repaying all depositors and expecting repayment from the vast majority of borrowers. Some segmentation of prudent banking from speculation is desirable, so that people can obtain financial services without taking on more financial risk than they want.

Minsky wanted the government to promote small community banks that knew their customers well enough to perform good underwriting. He was willing to let banks expand their financial services beyond federally insured accounts, as long as they reserved their insured accounts for the safest investments. He wanted the Federal Reserve to supervise the banks more closely. For example, instead of creating additional reserves for any bank willing to borrow them, he wanted the Fed to see evidence that the bank had the cash flow to service the additional lending.

Minsky was not a fan of the huge financial institutions he saw emerging in his time.

Minsky worried that the trend to megabanks “may well allow the weakest part of the system, the giant banks, to expand, not because they are efficient but because they can use the clout of their large asset base and cash flows to make life uncomfortable for local banks: predatory pricing and corners [of the market] cannot be ruled out in the American context.”

Minsky was concerned both that the financial sector was growing so large, and that it was dominated by such big and highly speculative firms. Letting them grow too big and then protecting them from their failures created a “moral hazard,” rewarding socially irresponsible behavior. Financial institutions should not be able to claim deposit insurance or other forms of government protection for high-risk investments. If they did get into financial trouble, their owners and their uninsured creditors should bear the losses. Minsky did not live to see how the government had to protect “too-big-to-fail” financial firms during the global financial crisis, but he would have seen it as a sad result of an era of financial excess.

Closing remarks

I found Wray’s presentation of Minsky’s economics very enlightening, although I thought the book could have been better organized. I found the introductory and concluding chapters too long and detailed, resulting in the same topics being discussed several times in somewhat different ways. When I came to summarize a topic, I found the information I needed scattered around the book. What is more important, however, is that Wray introduces readers to a critic of contemporary capitalism whose views need to be a part of the economic debate going forward, as I am confident they will be. Minsky’s economics seems more realistic than the highly idealized picture of the economy painted by more orthodox theory.

This quote from Minsky himself goes to the heart of his policy position:

When designing and advocating policies economists and practical men alike have to choose between the Smithian theory, that markets always lead to the promotion of the public welfare, and the Keynesian theory, that market processes may lead to the capital development of the economy being ill-done, i.e., to other than the promotion of the public welfare.

Wray concludes that Minsky’s economics is a step in the direction of a more humane “shared-prosperity” capitalism, a path which contemporary democracies have yet to take.

Why Minsky Matters (part 4)

October 31, 2021

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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.


Why Minsky Matters (part 3)

October 27, 2021

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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.

Financial cycles

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.


Why Minsky Matters (part 2)

October 25, 2021

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Here I summarize L. Randall Wray’s description of Hyman Minsky’s theory of the investment cycle, which is the part of his economics most based on Keynes. Keynes and Minsky viewed the investment cycle as an endogenous phenomenon generated from within the economy, not an exogenous phenomenon triggered by external events. As Wray puts it, “it is in the nature of capitalism to cycle due to ‘whirlwinds’ of optimism and pessimism.”

Think macro

Making a shift from microeconomic thinking to macroeconomic thinking is essential for understanding Minsky. This is mainly a matter of avoiding the fallacy of composition, which is the logical error of assuming that whatever is true on the individual level is also true at the aggregate level.

When most people think about building wealth at the individual level, they think about the importance of thrift. People who spend their entire income on current consumption cannot build wealth, but people who save and invest can. But in the aggregate, thrift can work against economic growth, a phenomenon Keynes called the “paradox of thrift.” If all the households in the economy were to become more thrifty at once, businesses would respond to the lack of aggregate demand for their products by running at less than full capacity and employing fewer workers. That would reduce national income and the capacity to build national wealth.

Macroeconomic thinking also has implications for what really drives the economy. In the national accounting, the income side of the economy must balance the spending side, if all forms of spending are included. Everybody’s income is tied to somebody’s spending—if not consumer spending then business investment, government spending, or foreign purchases of our exports. But when income and spending both grow or shrink, which is driving which?

At the personal level, income seems to drive spending, since you don’t usually spend what you don’t have. You can buy things on credit, but how much credit a bank will extend to you also depends on your income. But macroeconomists like Keynes and Minsky argue that spending is what drives income. If businesses don’t spend on the means of production like land, labor and factories, they don’t create income for individual households. Notice also that capitalist enterprises do not just invest from their existing profits. They often borrow to build their businesses, even before they have turned a profit. And they are not necessarily just borrowing from someone else’s income either, since borrowing often involves the creation of money. Capitalist firms, in cooperation with the banking system (and, as we’ll see, with government), function as creators of income and wealth, not just spenders of income. This creative function is not automatic—automatic creativity would be a contradiction in terms—but is subject to endogenous fluctuations, the boom and bust cycles that are endemic to capitalism.

Not surprisingly then, a macroeconomic theory of capitalism must focus on the investment decisions of capitalists!

Investment decisions

Wray’s economics text, coauthored with William Mitchell and Martin Watts, defines investment as the “flow of spending which is devoted to increasing or maintaining the stock of productive capital.” Suppose a firm is considering an investment in new equipment. Minsky argued that the decision to invest depends on a comparison of two prices:

  • The demand price is how much the firm would be willing to pay for the equipment, given the firm’s expectations about how much the equipment would add to future revenues;
  • The supply price is the price the firm would have to pay for the equipment, including the cost of financing the purchase if it is to be made with borrowed money.

If the demand price exceeds the supply price, the firm will normally make the investment. However, the calculation of a demand price depends on expectations of future revenue, which the firm cannot know with certainty. Optimism—a positive business outlook—plays an important role. One firm’s optimism helps create income for others because its spending puts money in the hands of other firms and their workers. In the aggregate, investment is one factor in the determination of overall business profit. Minsky incorporated Michal Kalecki’s macroeconomic theory of profit that derived this result mathematically. In the aggregate, it is investment that drives profits, not profits that necessarily fund or limit investment.

Once an economic expansion begins, what Minsky called the “peculiar circularity of a capitalist economy” can accelerate it. Optimism feeds investment; aggregate investment creates income; income enables consumer spending; spending creates profit; and profit helps maintain optimism. Profit does not automatically lead to more investment, but it does invite firms to infer that they are doing something right, and that more of the same kind of investment may lead to more profit.

Macroeconomics also includes the role of government, and the analysis of profits by Kalecki and Minsky takes that into account. In Kalecki’s profit equation, G – T (government spending minus taxes) is a positive determinant of profit along with I (investment). Think about it. If government spends more than it taxes, that creates more income for the private sector, some of which ends up as profits in the hands of capitalists. What winds up as wages for workers gets subtracted from the profit equation. This is, of course, relevant to Kelton’s The Deficit Myth, which pleads for a macroeconomic understanding of deficit spending. It can have more positive effects than a deficit in your household budget!

From boom to bust

What could possibly go wrong with an economic expansion driven by investment spending and fueled by optimism?

As optimism is validated by increasing profits, firms are tempted to engage in riskier behavior. They continue to invest, even if that means going more deeply into debt. They may reduce their margins of safety, such as the collateral they provide to qualify for financing, the positive net worth they can show on their balance sheet, and the liquid assets they can fall back on if revenues fall short of expectations. As the economy booms, some overoptimistic firms run into trouble and default on their obligations.

Once an economic boom has raised expectations sky high, “…anything that lowers expected future profitability can push today’s demand price of capital below the supply price, reducing investment and today’s profits below the level necessary to validate past expectations on which demand prices were based when previous capital projects were begun.” The price that firms are willing to pay for new capital goods declines because firms aren’t so sure they want to take on more debt for the sake of dubious future returns. At the same time, the supply price of capital rises if lenders charge higher interest rates to firms with more existing debt.

What would lower expected future profitability? Maybe markets for many goods have become saturated because consumers have already bought as much as they want or can afford. That suggests a lesson for firms: Creative investment requires imagination, not just producing more and more of the same thing.

Another factor that helps turn boom to bust is a reduction in fiscal stimulus by government. As an economic expansion proceeds, government collects more tax revenue from rising incomes and spends less on things like unemployment compensation and public assistance. It may also adopt a more restrictive monetary policy to prevent inflation, with higher interest rates that raise the cost of borrowing.

As confidence in future profits erodes, businesses shift their priorities from investing at all cost to improving their margins of safety to avoid financial problems. The decline in investment then reduces aggregate income and consumer spending. Not only does optimism turn to pessimism, but pessimism feeds on itself by producing poor aggregate results that validate the pessimism. Acceleration turns into deceleration, until expansion turns into contraction.

The role of the financial system in amplifying such boom and bust cycles will be the topic of the next post.


Why Minsky Matters

October 20, 2021

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L. Randall Wray. Why Minsky Matters: An Introduction to the Work of a Maverick Economist. Princeton: Princeton University Press, 2016.

This book is an introduction to one of the most important critics of mainstream economics in the twentieth century. Although he did not live to see the 2007 global financial crisis, Minsky’s understanding of the economy led him to anticipate how it would unfold. His work is getting a lot of attention now that the crisis has generated some reassessment of economic theory, as crises usually do. Minsky’s ideas are part of the foundation for the emerging Modern Monetary Theory, now well represented not only by the author of this book, but also by Stephanie Kelton, whose The Deficit Myth I reviewed recently.

Hyman Minsky (1919-1996) studied mathematics at the University of Chicago and economics at Harvard. He taught at Berkeley from 1957 to 1965 and at Washington University in St. Louis from 1965 to 1990. After retiring from teaching, he was associated with the Levy Economics Institute at Bard College, a nonprofit research and policy organization specializing in alternatives to mainstream economics. Wray, who was once Minsky’s teaching assistant, calls Minsky “the smartest guy in the room, in every room.”

L. Randall Wray is a Professor of Economics at Bard College and Senior Scholar at the Levy Economics Institute.

The nature of the economy

Minsky’s disagreements with mainstream neoclassical economics were fundamental. He objected to its portrayal of a free-market economy as a self-stabilizing machine seeking equilibrium. Market forces supposedly move the economy toward a state in which supply equals demand, everything that is produced can be sold, and resources are allocated most efficiently. Deviations from equilibrium come from exogenous (externally caused) shocks, such as a global shortage of some commodity or excess spending by government. The economy is something like a climate-control system regulated by a thermostat. During the so-called “Great Moderation,” the 25 years preceding the financial crisis, many economists came to think of the central bank as the thermostat, raising or lowering the interest rate if the economy was either too hot (high inflation) or too cold (high unemployment). Some economists even proposed making such decisions more automatic by devising a rigid rule to govern them.

By the way, I have been noticing how scientists in a variety of disciplines have been challenging mechanistic models lately: biologists who say that an organism is more than a molecular copying machine, or neuroscientists who say that a brain is more than a computing machine. Sociologists have long questioned whether the machine metaphor is very useful for understanding societies and their institutions, which are creators of new culture and organized behavior. Minsky’s work is in the tradition of institutional economists like Thorstein Veblen, who was a sociologist as well as an economist. Minsky praised the University of Chicago for teaching economics as “part of the study of society…vastly superior to the usual practice of teaching economics in isolation in a specialized course.” That was before the ideas of Austrian economists and Milton Friedman came to dominate the Economics Department.

Minsky rejected the assumption that the economy is naturally stabilizing. He argued that market forces generate instability endogenously (internally). In fact, he said that “stability is destabilizing,” since a period of stable growth tends to alter expectations, policies and behaviors in ways that undermine stability itself. For example, confidence in continued profits can breed overconfidence and riskier behavior. Minsky saw this happening in a big way in the 1980s and 90s.

Society needs a variety of institutions to constrain instability and keep the economy working in the service of societal goals. That means especially the whole government, not just the central bank. Minsky said that “the institutions established through public policy play a vital role in determining what form capitalism takes; and…laissez faire is a prescription for economic disaster.”

Although he held an undergraduate degree in mathematics as well as a doctorate in economics, Minsky was skeptical of formal mathematical models that were devoid of historical and institutional context. He said “to be useful, analytical tools have to be embedded in an understanding of the institutions, traditions and legalities of the market.” Wray makes a similar criticism in his own macroeconomics textbook (coauthored with William Mitchell and Martin Watts):

Over the past half century mainstream macroeconomics has become increasingly devoid of relevance to our understanding of how modern monetary economies operate. In part this is due [to] an increased emphasis on mathematical models underpinned by simplistic assumptions that reduce human behaviour to that of a ‘rational agent’ who maximizes simple goals in at worst a ‘risky’ economic environment.

A revolutionary Keynesian

Minsky considered himself a follower of John Maynard Keynes, having been a teaching assistant to Keynesian Alvin Hansen at Harvard. However, he was disappointed in how Hansen, Paul Samuelson and others had integrated Keynesian ideas into the mainstream “neoclassical synthesis.” Minsky regarded Keynes as a revolutionary thinker whose revolution had been aborted. Mainstream economists acknowledged that government fiscal policy could be useful in combating recessions, but they did not take seriously enough his analysis of why recessions kept happening. Rather than moving toward an equilibrium where resources are optimally allocated, an economy could get stuck at a low level of utilization where producers lack the confidence to spend on production, and workers lack the income to spend on consumption. Minsky took chronically high unemployment as a sign that capitalism wasn’t working very well.

After the stagflation of the 1970s, the monetary school led by Milton Friedman discredited Keynesian fiscal policy as it was then practiced and minimized the role of government in the economy. At a time when Keynes was largely out of fashion, Minsky preserved and elaborated on Keynes’s analysis of investment cycles. Calling himself a “financial Keynesian,” he added the idea that the financial system amplifies those cycles, endogenously producing dangerous swings between financial booms and busts.

The following posts will start with Minsky’s theory of investment cycles and financial cycles, and then go on to discuss his take on the history of capitalism and his proposals for making it work better.