Building Back Better—Economically

November 29, 2021

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Democrats and Republicans are even more divided over President Biden’s “Build Back Better” bill than they were over the infrastructure bill. When BBB passed the House last week, all Democrats except one supported it, while every Republican opposed it. House Speaker Nancy Pelosi called it “historic, transformative and larger than anything we have ever done before.” Minority Leader Kevin McCarthy called it “the single most reckless and irresponsible spending bill in our nation’s history.” The bill now goes to the Senate, where it will need the support of every Democratic senator to pass.

The benefits

Of the concerns about the bill I have heard, far more raise doubts about whether the country can afford it than about the substance of the proposals. Most of the specific provisions are popular with the general public, although we do hear some of the usual complaints about Big Government “taking over” health care or child care or whatever. Here are the bill’s main components:

Universal preschool: The bill would subsidize preschool and child care programs for three- and four-year-old children. Any public or private program could qualify if it met federal standards. The cost to families earning less than 2.5 times a state’s median income would be no more than 7% of their personal income, much less than many families are paying today.

Child tax credit: The bill extends the child tax credit for another year. It also makes it permanently refundable for low-income families, which means that they can continue receiving it even if they have no tax liability.

Family and medical leave: The bill would provide four weeks of paid leave to be used for caregiving or personal illness. The pay would be up to 90% of regular pay, with higher percentages for lower earners than higher earners.

Expanded ACA funding: The bill increases the subsidies for those who obtain health insurance through the Affordable Care Act. It also provides coverage for the low-income people who were previously excluded by their state’s refusal to participate in the expansion of Medicaid.

Expanded home care: The bill provides additional funding for Medicaid’s home health care program, in order to alleviate a backlog of applicants who qualify but are on waiting lists.

Drug price control: The bill would allow Medicare to negotiate lower prescription drug prices, but only for drugs that have been on the market for at least nine years. It also sets a new $2,000 limit for out-of-pocket expenses under Medicare Part D and caps the price of insulin at $35 a month.

Affordable housing: The bill will contribute to the construction and preservation of low-cost housing units, and also provide assistance with down payments and rent.

Clean energy: The bill authorizes grants, loans and tax credits to encourage businesses and consumers to develop and use clean energy, such as wind turbines, solar panels and electric vehicles. It also funds a Civilian Climate Corps to create 300,000 jobs in environmental protection and restoration.

Costs and revenues

The Build Back Better bill would pay for these new or expanded programs mainly by imposing new taxes and improving the enforcement of existing tax law. For personal income taxes, it would place a 5% tax surcharge on income above $10 million, as well as an additional 3% surcharge on income above $25 million. For corporate taxes, it would set a minimum tax of 15% on companies with over $1 billion in profits, aimed especially at corporations that have been managing to avoid paying any taxes at all. It would also place a 1% tax on corporate stock buybacks, a response to concerns that companies were using their 2017 tax cut to boost stock prices for shareholders instead of investing in economic growth.

The bill provides funding for stricter tax enforcement, to recover hundreds of billions of taxes lost to tax evasion. IRS audits have dropped substantially due to Republican budget cuts, a “penny-wise and pound-foolish” exercise if there ever was one.

A “scoring” of the bill by the Congressional Budget Office concluded that tax revenue would pay for about 85% of the bill’s $1.75 trillion cost over ten years. The White House was aiming for 100%, with the discrepancy due mainly to uncertainty about the increased revenue from stricter tax enforcement. Any shortfall would add to the annual budget deficits.

Although the CBO evaluated the budgetary impact over a ten-year period, as is customary, many parts of the bill call only for temporary funding for proposed programs. Universal preschool is funded only for six years, and increased ACA subsidies only for four years. If Congress were to continue these programs through the full ten years, it would either have to impose new taxes or accept larger deficits than currently projected.

Concerns about the bill focus mainly on the question of fiscal responsibility. Conservative politicians and some economists worry that it calls for too much taxing, too much borrowing, and/or too much spending. Let’s consider each of these in turn.

Too much taxing?

Most voters support raising taxes on the rich. Americans with the highest incomes and accumulated wealth have been the main beneficiaries of economic trends and public policies over the past 40 years. Corporate profits and executive compensation have risen faster than general wages. Top-bracket income tax rates have been cut, along with estate taxes and capital gains taxes. Corporate tax cuts have mainly benefited corporate shareholders, and the richest 10% of households hold about 90% of the corporate stock. Since 1990, the share of the national wealth held by the richest 10% has increased from 60% to 70%, as the U.S. has become one of most unequal countries in the developed world.

The tax code is mildly progressive, in that the wealthy pay a somewhat higher rate of tax when all taxes are considered. But the superrich pay a lower-than-average rate because they are very good at taking advantage of loopholes (which is legal) and opportunities for tax evasion (which is not). One study found that the 400 richest families paid only 8.2% in income taxes from 2010 to 2018. That’s a lower rate than a person earning only $10,000 a year has to pay.

Defenders of low taxes on the rich argue that they help the economy by leaving the rich with more money to invest. In Arguing with Zombies, Paul Krugman makes a case that tax cuts for the wealthy have been a “fizzle” because too much of the money has gone to boost the price of existing assets instead of financing new investment. The Keynesian view is that investment is driven more by aggregate demand, and that government spending stimulates the economy more than tax cuts. In any case, economic and public opinion seems to be turning against the Republican policy of generosity toward the rich and austerity for the rest of us.

Too much borrowing?

Whenever the government spends more than it collects in taxes, it runs a budget deficit. Stephanie Kelton’s The Deficit Myth is a good source for correcting common misconceptions about deficits, and it has informed my recent thinking on this topic.

When the government runs a deficit, it normally raises money by selling government obligations like treasury bonds. Although people often think of the resulting public debt as analogous to private debt, there are important differences. A private household or business that accumulates debt runs the risk of default—or even bankruptcy—should its income fall below expectations. A government with monetary sovereignty like the U.S. government need never default on an obligation or go bankrupt, since it has the authority to issue currency and collect it in taxes. Also, U.S. bonds are in great demand because of their security, and people will buy them even when they pay low rates of interest. The government does not have to pay off its debt, but can continue rolling it over from lender to lender indefinitely if it chooses to. The national debt is a public sector liability on which the government pays interest, but it is also a private sector asset on which bondholders earn interest.

According to neoclassical thinking, government borrowing can “crowd out” private investment by competing with businesses for a limited supply of savings. Government borrowing adds to the demand for “loanable funds,” pushing up interest rates (the price of money) and making it more costly for businesses to finance investment. Keynesians counter this argument mainly by focusing on the situation where the economy is running below full capacity. Then deficit spending can boost national output and income, which also increases the savings from which government can borrow. As Krugman and Wells explain:

When the economy is at far less than full employment, a fiscal expansion will lead to higher incomes, which in turn leads to increased savings at any given interest rate. This larger pool of savings allows the government to borrow without driving up interest rates. The Recovery Act of 2009 was a case in point: despite high levels of government borrowing, U.S. interest rates stayed near historic lows.

Modern Monetary Theory adds the argument that any increase in the public-sector deficit must be balanced by an increase in the private-sector surplus, other things being equal. (The relevant other thing held constant here is the current account balance with our trading partners.) As the gap between government spending and tax revenue widens, so does the excess of private-sector income over spending, and that’s where the money to buy treasury bonds comes from. What makes that hard to see is that the connection is indirect, since the immediate recipients of the government spending are not usually the ones buying the bonds. A long chain of financial links may intervene, such as that government spending increases employment, which increases consumer income, which increases consumer spending, which increases business revenue, which increases business profit, which increases investor income, which provides extra savings with which to buy treasury bonds.

In this scenario, the government’s demand for loanable funds does not have to crowd out private investment. Instead, government spending increases the loanable funds. And interest rates do not have to rise, unless the Federal Reserve chooses to raise them in order to fight inflation.

Too much spending?

What keeps this constructive use of government borrowing and spending from becoming a definitive solution to economic problems is the threat of inflation. Economists generally agree that additional government spending becomes inflationary when the economy reaches its potential output, the point where it is producing as much as possible with the available resources and technologies. Then spending more than taxing drives up prices by creating too much demand for too few goods and services. Taxing the rich to spend on the nonrich—which is Biden’s main way of financing his plan—could have a similar effect, since it takes from those more likely to save in order to spend on those more likely to consume.

Although the idea of stimulating the economy with government spending has come back into fashion since the global financial crisis of 2007, economists still debate how often and how much to use it. Many accept a cyclical Keynesianism that supports a stimulus only when the economy is very weak and inflation is under control. From this perspective, the government may want to cycle between stimulus and austerity, engaging in more deficit spending in a contracting economy, but running a surplus and paying down debt to slow an “overheated” economy. (These fiscal fluctuations would be in addition to the Fed’s monetary policy of manipulating interest rates, which has become the most common way of influencing the economy.) But how does one tell whether an economy has reached its potential output? “Full employment” is a common answer, but how exactly is that defined?

Mainstream economists associate potential output not with zero unemployment, but with a “natural rate of unemployment” that includes some frictional and structural unemployment. Workers who are currently between jobs are classified as frictionally unemployed, while those who live in the wrong place or lack the skills employers want are classified as structurally unemployed. The argument is that during an economic expansion, the economy can reach a limit on real growth in output even when unemployment remains as high as 5 or 6 percent. Then further stimulus is inflationary, since it just increases what employers have to pay for qualified labor or what consumers have to pay for goods and services.

This line of reasoning is not without its critics. One problem is that potential output is a moving target, since it changes with increases in productivity. Estimates of the rate of natural unemployment also vary, and some economists reject the concept altogether. Modern Monetary Theory argues that we can employ as many workers as we are willing to train to do something useful, so the level of unemployment is mainly a matter of social policy.

Although Paul Krugman accepts the idea that stimulating the economy when it has reached potential output creates inflation, he warns against turning to austerity prematurely when the economy still has room for growth. This is the mistake many countries made in the aftermath of the global financial crisis, which made the recovery longer and harder that it needed to be. While the threat of inflation is always a concern, cutting government spending and raising interest rates at the first sign of inflation is a formula for subpar economic performance or even recession.

In the present situation, we can hardly say that the economy is already running at full capacity. Unemployment is below 5 percent, but that number leaves out many people who have yet to return to the labor force since the pandemic. Much of the current inflation seems to be due to temporary shortages of supply, not overstimulation of demand. Krugman compares the situation to 1947, when the postwar demand for consumer goods temporarily got out ahead of producers’ capacity to convert to peacetime production. Producers abhor empty shelves as much as nature abhors a vacuum (which is why the makers of Beanie Babies are chartering airplanes to bring them in from China, avoiding the bottleneck in container shipping). Inflation is not always a result of government spending, as critics of Big Government would like us to believe. Time will tell, but we can hope that inflation will subside even as government spending increases, if we spend wisely.

A deeper issue

A more fundamental question than where we are in the current business cycle is what we should be doing to address our structural problems, which I would describe more generally as mismatches between what markets supply and what today’s society actually needs.

Consider structural unemployment, when the labor market isn’t supplying enough workers with the qualifications that employers need. The orthodox perspective sees it as a pricing problem that arises because the supply of unskilled or poorly located workers exceeds the demand. The orthodox solution is to lower the price of such labor, on the assumption that anyone can get hired if they will work cheaply enough. Krugman and Wells’ macroeconomics text reflects that thinking when they say, “Until the mismatch is resolved through a big enough fall in wages of the surplus workers that induces retraining or relocation, there will be structural unemployment.” Trouble is, price rigidities in the labor market like minimum wage laws, unemployment compensation, and union contracts—and maybe just plain refusal of workers to work for peanuts—keep surplus workers from being hired. So we can’t really have full employment without inflation, and must settle for a “natural rate” of unemployment. But this argument assumes that if we removed the price rigidities, the unemployed could get what they needed to qualify themselves for today’s jobs.

A less orthodox macroeconomics text, by Mitchell, Wray and Watts, puts the responsibility for the mismatch on employers, saying that “the notion of structural unemployment arising from ‘skills mismatch’ can be understood as implying an unwillingness of firms to offer jobs, with attached training opportunities, to unemployed workers whom they deem to fall short of their ideal profile.” Employers prefer to “externalize” the costs of human capital development, expecting society to send them qualified workers from whom they can profit at low cost. But from the workers’ perspective, the goods and services market isn’t supplying enough education and training (and other human development services like affordable health care, drug treatment programs and mental health services) to enable them to become the kinds of workers employers want. The market is also failing to provide enough affordable child care and affordable housing in the cities where the jobs are. Under these market conditions, the idea that we must lower wages to force devalued workers to improve themselves is a cruel joke. Government, however, can use its spending power to increase economic demand for what society really needs.

The challenge of transitioning to cleaner energy is also a structural problem, a mismatch between what we produce and what we need. The current spike in energy prices is partly a result of temporary shortages, as energy producers resume production in the aftermath of the COVID recession. But it’s also a sign that the transition to cleaner energy is not going very well. Investments in fossil fuel production are falling faster than investments in renewable energy are rising. If the resulting inflation becomes an excuse not to spend on the transition, that would be seriously counterproductive. As The Economist editorialized recently:

The panic has…exposed deeper problems as the world shifts to a cleaner energy system, including inadequate investment in renewables and some transition fossil fuels, rising geopolitical risks [especially global dependency on energy-producing countries with autocratic regimes] and flimsy safety buffers in power markets. Without rapid reforms there will be more energy crises and, perhaps, a popular revolt against climate policies.”

Government spending doesn’t just have cyclical consequences—a stimulus when an economy is slumping and possible over-stimulus and inflation when it reaches potential output. It also has structural consequences, since it can create more potential by developing human and natural resources. This is consistent with Stephanie Kelton’s conception of Modern Monetary Theory: “MMT is about identifying the untapped potential in our economy, what we call our fiscal space.” Think of the fiscal space as the room to grow before we reach the limit of our economic potential. If we can produce more with a well qualified labor force and new forms of energy, we can also spend more without inflation. We practice a false economy if we refuse to consider the spending that would develop the potential.

When the House Budget Committee passed the Biden plan, it issued a statement, “The Build Back Better Act: Transformative Investments in America’s Families & Economy.” The statement included these claims about the economics of the plan:

The Build Back Better Act makes essential investments in family care, health care, and combatting climate crisis. It will overhaul and reimagine sectors of our economy and society so that everyone – not just those at the top – benefit from a growing economy. The Build Back Better Act will implement key reforms to make our tax system more equitable. This plan is prudently paid for by ensuring the wealthiest Americans and most profitable corporations pay their fair share of taxes. Americans making less than $400,000 a year will not see their taxes increase by a penny. Additionally, it is estimated that the Build Back Better Act will ease longer-term inflationary pressures and stimulate future economic growth, further offsetting the cost of the plan.

Building Back Better is not just about getting back to the phase of the business cycle that preceded the COVID recession. It’s about using the democratic process—what’s left of it—to assert what people need, and using government spending to help make it happen. If that entails a wiser use of our human and natural resources, it can be economical in the best sense of the term.

Bipartisanship Lives—Barely

November 8, 2021

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Congress has now passed the so-called “bipartisan” infrastructure bill proposed by President Biden. This is the physical infrastructure bill, not to be confused with the “Build Back Better” bill containing proposals to help working families, such as funding for preschool and paid parental leave. This bill includes money for a wide range of infrastructure projects: roads and bridges, public transit, passenger and freight railways, airports and ports, electric vehicles, universal broadband access, electric grid modernization and environmental remediation.

How bipartisan was the support, really? When the bill came to a vote in the Senate, 19 Republicans joined all 50 Democrats to pass it. However, that was only after Republicans had united to block consideration of the original bill by filibustering it. The result was a smaller bill, not funded by tax increases. In the House of Representatives, Democrats supported the bill 215 to 6. They needed 3 Republican votes to put it over the top, and they got 13. The other 200 Republicans voted against it.

Combining the two houses of Congress, 98% of Democrats (265 of 271) voted yes, while 88% of Republicans (230 of 262) voted no. If this is bipartisanship, it is a bipartisanship of a very minimal kind. Fortunately, it was enough to get something done—this time.

The physical infrastructure bill has solid majority support among the public, although with a noticeable partisan divide, and most economists think it will be good for the economy. Why then would such a large percentage of Republican politicians oppose it?

Republicans routinely oppose tax increases, so their opposition to Biden’s original spending proposals is understandable. (Most of the public, however, now supports raising taxes on the wealthy.) What is interesting is how few Republicans changed their minds even when Democrats proposed to fund the bill by other means, especially repurposing money left over from various pandemic relief programs. Many were concerned that the Congressional Budget Office still found that the bill would add to the budget deficit. But that explanation doesn’t hold much water, considering how happy Republicans were to put their deficit concerns aside when they wanted to cut personal and corporate income taxes. The idea that tax cuts are good, while spending increases are bad is not very good economics. Economist Paul Krugman has accused Republicans of perpetuating “zombie” ideas “that should have been killed by contrary evidence, but instead keep shambling along, eating people’s brains.” Some forms of deficit spending are actually good, especially when the economy is recovering from a recession. Economists do agree that excessive deficits can be inflationary, but infrastructure spending is less dangerous in that respect, since it adds to the nation’s productive capacity as well as its income and aggregate demand. It is exactly the kind of targeted spending that economists like Minsky have recommended, since it can stimulate both the supply side and demand side of the economy.

I don’t think that the Republican opposition to infrastructure spending has much to do with economics at all. What it reveals is that Republicans are more interested in making this administration fail than in addressing pressing national needs. They can’t wait to blame Biden for his failure to deliver the bipartisanship he promised, so they can return to power and get on with their project of one-party rule. Democrats can be frustrating too, as when they delayed the infrastructure bill because they hoped to tie it to other legislation that had even less Republican support. But at least they now have a coherent economic agenda, with proposals that are generally popular and economically useful.

I wish I could see the infrastructure bill as a new beginning for bipartisanship. Instead, it may represent the end of bipartisanship for this Congress and this administration. If Republicans cannot get behind a no-brainer like infrastructure repair—which President Trump advocated but didn’t accomplish—what chance do any other progressive proposals have? I do not expect Republican cooperation with even the most reasonable and popular of President Biden’s initiatives, such as allowing Medicare to negotiate lower prescription drug prices, or joining the rest of the developed world in providing paid family leave. Some bills could squeak through if Democrats can get around the filibuster with the tricky budget reconciliation procedure. Most will probably require more Democrat success at the ballot box.

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.