What Would Minsky Do Now?
February 1, 2016
by Laurence B. Siegel
In his first-quarter letter to investors of Greenlight Capital, David Einhorn lashed out at regulators. He claimed that the market is "fractured and possibly in the process of breaking completely." Q1 2021 hedge fund letters, conferences and more Einhorn claimed that many market participants and policymakers have effectively succeeded in "defunding the regulators." He pointed Read More
In the two decades since his death, Hyman Minsky’s stature has grown enormously. He foresaw the great financial crisis of 2007-2009, and economists routinely refer to “Minsky moments” as the tipping point when seemingly stable financial markets collapse with catastrophic consequences. It’s instructive to speculate on how Minsky would view our post-crisis economic recovery, and a new book allows us to do just that.
Although Minsky emerged from the liberal political tradition, he was deeply respected by capitalists and right-leaning economists. Minsky, who lived from 1919 until 1996, promulgated the “financial instability hypothesis” that shows how, paradoxically, the root cause of instability is stability. He synthesized ideas from many walks of economic life: the Chicago School’s love of data and methodology; a careful study of money, banking and the financial system; and the development of policies for alleviating poverty. Almost every topic on which he wrote is relevant to today’s challenges.
In Why Minsky Matters, his student and acolyte, L. Randall Wray — a professor of economics at the University of Missouri–Kansas City and senior scholar at the Levy Economics Institute of Bard College, where Minsky did much of his work — provides readers with an indispensable guide to Minsky’s thought. Commendably, Why Minsky Matters is written for the educated amateur. It is not a technical economics book. Wray’s language is crisp and lucid. Almost everyone with a strong interest in investing, the financial system or economic policy will both benefit from reading it and enjoy the experience.
Minsky was brilliant and farseeing, and his insights cut across the political and tribal boundaries that characterize modern economics; most of them are well outside the box that liberal thought now occupies. We would do well to study, and in some cases implement, Minsky’s recommendations for a more stable and fairer financial system. But policies based on a superficial understanding of his work can lead to economic paralysis, a topic to which I’ll return.
Hyman Minsky – The financial instability hypothesis
Minsky is best known for his financial instability hypothesis. He says that the root cause of financial instability is stability. What does this mean? Investors, accustomed to stability and good times, start to take greater risks as lesser ones begin to produce disappointing returns. They find it hard to believe that, in such a benign environment, these greater risks might not pay off – despite financial theory that tells them greater return must be accompanied by greater uncertainty.
And for a while, they are right. The reward from increased risk-taking spurs investors on to even riskier behavior. Profits abound, stock prices rise, credit spreads shrink… until the “Minsky moment” when, catalyzed by an unforeseen bad event, the whole process begins to reverse, at first “gradually and then suddenly” (as Hemingway’s character Mike Campbell said when asked how he went bankrupt).
Sound familiar? If the global financial crisis of 2008 had a prophet, it was Minsky, who formulated the instability hypothesis as early as 1960, in the middle of the postwar boom when it seemed as though the curse of the Great Depression and its precursors had been lifted forever.
The instability hypothesis is so self-evidently correct that I am surprised it isn’t part of the ancient lore of finance. I suspect that a careful study of the history of ideas in finance would turn up examples of the hypothesis in literature much older than Minsky’s.
Not everything Minsky said or did was brilliant. He famously grouped financing schemes into three categories, “hedge” (where the cash flow from a project is sufficient to pay down principal as well as cover interest), “speculative” (cash flow sufficient to pay interest but not principal), and “Ponzi” (cash flow so meager that the debtor needs to borrow just to cover interest).
But this triage – hedge better than speculative better than Ponzi – has no real content. While the accounting split between principal and interest is clear, the economic split is essentially arbitrary; how do we inflate the principal? By the CPI? By the rate of appreciation or depreciation of the asset being financed? Not at all? Moreover, while a true Ponzi scheme involves no investment at all, with the operator paying old “investors” with the funds raised from new ones, what Minsky calls Ponzi financing is just a negative-cash-flow deal, which real estate investors undertake as a standard practice during periods of inflation, usually with profitable results.
Insights into money and banking
Minsky had an idiosyncratic view of what banks do. (You’d think that this would be one of the basics on which all economists agree, but it isn’t.) Most people, including most bankers and economics professors, think that banks accept deposits and then lend out the money that has been deposited. Minsky turned this concept on its head, claiming, “[A] bank first lends or invests and then ‘finds’ the cash to cover whatever cash drains arise.” He also said that banks create money through book entries, whereas most economists believe that only central banks can create money.
As Wray boasts, Minsky’s view of banks “has the advantage of being correct.” What can we learn from it?
If banks acquire assets and pay for them by issuing liabilities, then they are just like any other business unit and can be understood that way: “We can analyze any economic unit (firm, household, or government) as if it were a bank that issues liabilities and takes positions in assets,” Wray writes. And Minsky persistently advised his students to “discipline your analysis with balance sheets.”
In other words, as Wray suggests, “Every economic unit…has a balance sheet and if we begin with assets, liabilities, and net worth of each, we have a better chance of getting the analysis correct.” Many finance professors recommend this approach, which is typically shunned by non-finance economists, journalists and amateurs trying to understand the economic environment. Fortunately, investment professionals are usually comfortable with balance sheets, even if they spend too little time actually studying them.
Banks, Minsky argues, create money in the same sense that anyone can create money. If you write “IOU” on a piece of paper, that’s an attempt at creating money; the trick is in getting it accepted. IOUs of the Treasury and Fed are universally accepted. Money-market fund (MMF) shares also trade as money, but have less “moneyness” than currency; the MMF “buck” has occasionally been broken. A bank’s book entries increasing someone’s available balance (when they take out a loan) are likewise money. And, while most people’s IOUs are not likely to be acceptable as money, an IOU from Bill Gates would be.
This view of money is profoundly Chicagoan, and is the correct way to understand money creation. Minsky’s insights in this regard are particularly valuable because they explain the actions and risks of non-bank banks, including not only money market funds but also hedge funds and broker-dealers. If one applies the balance-sheet principle (understand the balance sheet and everything becomes much clearer), non-bank banks can be understood like any other business: they acquire assets that they expect to be profitable, they finance these acquisitions by issuing liabilities and they create money in the process.
During the global financial crisis, non-bank (“shadow”) banks put the financial system at risk because the money they created was less acceptable as settlement for debts than Treasury- and Fed-created money but was treated as if it were just as good. When the lessened acceptability of money issued by non-bank banks became obvious, the financial system nearly collapsed and would have collapsed if not for the government’s emergency injection of liquidity. We can thank Minsky for the clarity with which this process can now be understood and perhaps prevented in the future.
The alleviation of poverty
Minsky would have loved to participate in today’s debate on inequality although, unlike some on the left, he was intensely focused on poverty and only indirectly concerned with inequality. He “opposed Aid to Families with Dependent Children…as well as the Food Stamp program. Instead, he advocated removing barriers to work.” He favored programs that would foster “labor force attachment.” Wray recalls, “To me, he sounded a bit like then-President Reagan, who argued for work, not handouts.”
What does this mean? Was Minsky a crypto-libertarian, believing that removing barriers to work, such as minimum wages and labor regulations, would achieve a social optimum? No. An admirer of Franklin Roosevelt’s Works Progress Administration and kindred programs, Minsky thought that persistent unemployment could only be remedied by having the government itself hire people whom private enterprise would not rationally hire, and that marketable skills and a work ethic could be built that way. He particularly favored government jobs programs for low-skilled African Americans.
There is something to be said for such direct government involvement in the labor market. The present system of intricate regulation and expensive mandates has fostered a seemingly permanent high level of unemployment when one counts discouraged and part-time workers; the labor participation rate has been plunging. The so-called War on Poverty, which Minsky disdained as a “conservative” response to the allegation that capitalism generates “poverty in the midst of plenty,” produced a distinctively un-conservative result: a large population dependent on government.
In contrast, Roosevelt’s programs – while not immediately successful in ending the Great Depression – ushered in a generation of low unemployment and high labor-force participation that many Americans now look upon with nostalgia. Policymakers of any political stripe should consider the possibility that Minsky’s cures for poverty are better than the complex and ineffective ones we now have.
Why Minsky Matters: An Introduction to the Work of a Maverick Economist by L. Randall Wray