This is the second part of Lecture 9 in Advanced Macro II, Spring 2019, at PIDE by Dr. Asad Zaman. The first part (L09A: Why Minsky Matters) covers the first 27m of the YouTube lecture linked below. The second part, L09B, starts 27:22m is about 1hr long:
A 1500 word summary/outline of the key points covered in L09B is given below:
Krugman fails to understand Minsky
On the one hand, Minsky has been transformed from an eclectic outcast to a darling of the mainstream after the crisis. On the other hand, Krugman and others have failed to appreciate the central insights of Minsky, just as they did with Keynes. While Keynes had completely rejected mainstream theories on solid grounds, Hicks and Samuelson constructed a neoclassical synthesis which conceded the short-run to Keynes on the basis of short run wage rigidities, but kept the fundamentals of mainstream theories intact. Similarly, today mainstream economists like Krugman admit to being at fault in not predicting the GFC, but blame it on external factors, rather than central weaknesses in mainstream theories. Three external factors which account for the failure of economists to “see it coming” are:
- The GFC was Black Swan Event. A period of stability led to under-estimation of risks and a discounting of the probabilities of crisis.
- The Fed kept interest rates low for too long. This allowed massive credit creation, which led to bubbles
- Rise of Shadow Banking Industry went un-noticed. The unregulated financial sector created a crisis by making high leverage gambles, using derivatives as insurance.
Accordingly, mainstream economists propose three solutions, none of which require re-thinking traditional Macroeconomics.
- We should pay more attention to the possibility of black swan events, and allow for distributions with fat tails in our stock market models.
- We should pay more attention to monetary policy
- We should do more regulation of shadow banking (Macro-Prudential Regulations)
In fact, this analysis fails to understand the central insights of Minsky. The mainstream, deluded by theories of intermediation, does not understand the central role of private sector credit creation in generating crises. Even more important, Minsky attacks the central religious belief in “equilibrium”. While Krugman believes that market forces are stabilizing, Minsky promotes the heresy that “equilibria” are inherently unstable. In modern financial economies, the very stability of the equilibria generates the forces which de-stabilize the economy. Very briefly, stability encourages risk taking behavior, which increases until a crisis occurs. This view is truly deeply heretical because it attacks the founding pillars (optimization/equilibrium) of mainstream orthodoxy.
Mainstream Views on Money
The standard story of money, taught worldwide in conventional textbooks, is that the Central Bank controls the High Powered Reserves, and the total money supply is determined as a simple multiple – M = kR, where M is money supply, k is the money multiplier, and R is the High Powered Reserves. Monetarists argue that the Money supply has no effect on the real economy except for determining prices. Accordingly, Friedman recommended the simple monetary policy rule that the Central Bank should aim for 6% per annum growth in the money supply. Setting a fixed target, and achieving it would anchor expectations about future money and prices, allowing inter-temporal trade without frictions created by uncertainty. Attempt by Central Banks to follow this policy proved to be a complete failure. The reason is that the process of credit creation by private banks is not under the control of the Central Bank. This depends on the investment climate and business expectations. Central Banks would routinely fail to meet announced policy targets, since the money supply depended on factors outside their control. This failure would damage credibility of the central bank, further weakening the impact of monetary policy.
This failure of the Friedman rule led to the use of Minsky’s preferred and recommended policy: the use of the overnite discount rate (and not reserves) for monetary policy. In addition, Minsky recommended the elimination of the interbank borrowing of reserves. The theory behind the creation of the inter-bank market was that this allows extra liquidity to the banks. However, Minsky thought that reserves should only be borrowed from the Central Bank, because this will allow the Central Bank to monitor the quality of loans being offered as collateral. The inter-bank borrowing market allows a general decline in quality of loans, as occurred prior to the GFC. Had Minsky’s idea been implemented, it would have been possible for the Central Bank to forestall the crisis by refusing to accept high risk mortagages as collateral for borrowing of reserves. The Fed would have been aware of risky debt portfolios accumulating in the Private Banks, because that is used as collateral for reserves.
The Financial Instability Hypothesis
One of the key contributions of Minsky, which advances on Keynes, is the recognition that the Business Cycle is caused by Pro-cyclical Credit Creation. In booming economy, there is a huge demand for credit, and everybody is lending, substantially expanding the supply of credit to the economy. Financial assets are used as basis for loans, and easy availability of credit can lead to rise in the prices of these assets, creating a bubble. When all banks are lending, accepting high-risk assets as collateral, no one bank can afford to get left behind, because they would lose market shares. When the music is playing, everyone must dance. BUT, when music stops, you are caught holding assets no one wants. In more prosaic terms, pro-cyclical lending exacerbates the cycle.
To explain the business cycle, Minsky offers us a pair of related theories. The first is the Keynesian theory of Investment as the driver of the business cycle. The second is Minsky’s contribution, the Financial Theory of Investment. These are explained further below.
Keynesian Theory of Investment: What differentiates Keynesian views from modern macro is the idea that investment is driven by “animal spirits” – expectations about the future which are not ‘anchored’ by any past events (and hence not ‘rational’). This corresponds to the Keynesian view that the future is DEEPLY and INHERENTLY uncertain. Because it is COMPLETELY unpredictable – rational expectations cannot exist. If all investors are optimistic, this will create a self-fulfilling prophecy, and similarly for pessimism. Random fluctuations in investor sentiments can lead to an upswing maintained for sufficiently long to lead to creation of extra credit. Now the pro-cyclical behavior of financial institutions further fuels the fire, providing extra credit with high leverage, high risk, weak collaterals. Then the Central Bank Responds to the increasing aggregate demand by raising interest rates. In the expansion phase, firms have short term debt which is to be rolled over. Now this becomes more costly than anticipated and creates losses, possibly bankruptcies. This leads to a minor downswing which is further exacerbated by financial response created by tightening credit, and reducing money supply.
Minsky’s Typology of Finance: In this context, it is useful to learn the Minsky Classification of financing:
- Hedge Finance (not related to Hedge Funds): earnings enough to repay interest and principal.
- Speculative Finance (earnings sufficient for interest payments, but not for principal)
- Ponzi Finance (earnings not even sufficient for interest – more borrowing to pay off interest)
Speculative Finance is based on the speculation that asset values will increase in the future, allowing repayment of the principal – for example, this could happen in market where property values are rising rapidly. However, if incomes decrease or interest rates increase, then speculative finance can turn into Ponzi finance, where one has to borrow to make interest payments. This is problematic because loans may not be available, leading to bankruptcies. Many households took Ponzi financing to purchase houses in 2000-2007, speculating that rising house prices would cover their costs. To some extent, Lenders lend to protect past loan, but they will cut losses at some point by going for loan default and collecting collateral.
Causes of Crisis: As the expansion continues, financial fragility continues to increase, as riskier loans are extended, with more leveraging. There are multiple sources which can create a crisis which bursts the bubble:
- income ﬂows turn out to be lower than expected,
- interest rates rise,
- lenders curtail lending,
- prominent firm or bank defaults on payment commitments.
When leveraging is high, then one failed payment has a multiplied impact on contraction of credit, and this can rapidly multiply defaults throughout the system, leading to a financial crisis. A financial crisis collapses the economy via the following mechanisms:
- Debtors cut back spending to make payments
- This leads to fall in Aggregated Demand, hence fall in income, jobs, wages
- To make loan payments,Asset are sold, which leads to fall in asset prices.
In extreme cases, this can lead to the Debt-Deflation seen by Irving Fisher in the aftermath of the Great Depression. Because of asset price collapse, and defaults by financial institutions, wealth is wiped out. Inability to make payments leads to widespread bankruptcies. Output and employment collapse. Debt increases further from efforts to pay it off.
Minsky’s Policy Recommendation: It was thought that the development of the inter-bank Funds market would facilitate credit creation. Minsky argued AGAINST this. It is not true that banks first acquire reserves and then they make loans. Rather, Banks make loans and then borrow reserves to meet reserve requirements. The Inter-bank market weakens the REGULATORY capacity of the central bank, it does not create additional capacity for lending. If the Central Bank is the sole source for reserve funds, it can monitor the quality of assets being used for collateral throughout the system, and thereby control systemic risks much more efficiently.
Course Website: bit.do/az4macro – contains lectures for both Adv Macro I and II.