The current economic curriculum has mostly neglected the active role of money and financial institutions and the destabilizing effect that speculative practices have on business cycles.
In truth, these issues have long been neglected by mainstream economists who argue that business cycles and financial crises result from misguided economic policies, particularly over-spending by governments. For instance, Milton Friedman said that financial crises are monetary phenomena that result from central banks’ wrong decisions. At the root of a financial crisis, the central bank is active in increasing the money supply in order to maintain the domestic income level higher than its non-inflationary level. Thus, the solution to end the crisis should be a restrictive monetary policy to stabilize prices and, therefore, the income level. Friedman’s theoretical approach emphasizes the distortions caused by monetary policy on the interest rate equilibrium level (natural rate). Focus is also given on government controls in credit markets which main effect is the reduction of loanable funds. Indeed, mainstream economists argue that financial deregulation is necessary to enhance efficiency in the allocation of funds towards the non-inflationary income level.
Critical of mainstream economics, Hyman Minsky considered the role of finance in the business cycle and developed the financial instability hypothesis which states that financial crises are inherent to the capitalist economy. From the Keynesain tradition, Minsky considered the capitalist economy as a set of interrelated balance sheets and cash flows among income-producing companies, households and banks.
Minsky adds to our understanding that banks play a crucial role in determining the path of sustainable economic growth since investment decisions are, therefore, affected by available finance. Through the period of boom, entrepreneurs borrow from banks and accumulate debts. A sentiment of euphoria takes over and entrepreneurs begin to be over-optimistic in their short-term expectations while financial innovations impact upon banks’ assets and liabilities.
During the expansionary period of the business cycle, investment demand increases, so does the demand for finance and funding. However, as financial fragility grows, lower levels of loans increase uncertainty and pessimism in the economy. Banks become unwilling to lend money because of higher credit risk since income flows turn out to fall short of debt repayment plans. As investment decisions collapse, through the multiplier process, employment, income and consumption fall leading to a recession. If the financial crisis also leads to a sharp decline in prices, debt deflation can occur, where asset prices fall.
In short, while considering the relevance of investment as the unstable component of aggregate demand, the Minskyan approach also points out how banks’ strategies and a weak financial regulation turn to induce financial fragility. The recent global crisis revealed that current global finance, as a historical set of institutions, behaviours and policies, has increased the systemic risk with deep negative consequences for real economies and societies. In order to support sustainable economic growth, the economic curriculum should not neglect how current economic processes and social changes have been subordinated to trading private money.