My paper “Instability in Financial Markets: Sources and Remedies” for the INET conference “Paradigm Lost: Rethinking Economics and Politics”, to be held in Berlin on April 12–14, is now available via the INET website.
If you’d like to download it, you can get it either from my INET page, or from a link on the conference program. For copyright reasons I can’t reproduce it here, but I can provide a quick synopsis and some excerpts, so here goes.
A Primer on Minsky
The paper starts with a synopsis on Minsky, since his “Financial Instability Hypothesis” is one of the key foundations of my approach to economics. He has come into vogue these days of course, but to people who’ve known his work for several decades rather than ever since the “Minsky Moment” of late 2007, a better expression would be that he’s “come into vague”. I read papers like Krugman’s “Debt, Deleveraging, and the Liquidity Trap: A Fisher-Minsky-Koo approach”, and for the life of me, I can’t see Minsky there. As I note in my paper:
Now, after the crisis that his theory anticipated, neoclassical economists are paying some attention to his hypothesis, and there has been at least one attempt to build a New Keynesian model of a key phenomenon in Minsky’s hypothesis, a debt-deflation (Krugman and Eggertsson 2010). However, to those of us who are not new to Minsky, it is hard to recognise any vestige of the Financial Instability Hypothesis in Krugman’s work.
My good friend and long term fellow rebel in economics Professor Rod O’Donnell once remarked that neoclassical economists are incapable of reading Keynes: they look at his words and then spout Walras instead. A similar phenomenon applies here: neoclassicals like Krugman read Minsky, and then proceed to build equilibrium models without banks, and think they’re modelling Minsky.
No they’re not: they’re creating an equilibrium-obsessed Walrasian hand puppet and calling it Minsky—just as they did to Keynes with DSGE modelling.
I used the word “equilibrium” twice above, because one clear methodological aspect of Minsky’s thinking is that macroeconomics is about disequilibrium. Neoclassical economists have the world precisely (to use an evocative piece of Australian slang) arse about tit. They believe that if it’s not an equilibrium model it’s not economics.
Nonsense! The precise opposite is the case: if it isn’t disequilbrium, then it isn’t economics.
There’s nothing “radical” about this, which is often the way that neoclassical economists react when I press this point: “assume disequilibrium? How dare you!?”. I dare because “disequilibrium” is so common in real sciences that they don’t even call it that: they call it dynamics. Any dynamic model of a process must start away from its equilibrium, because if you start it in its equilibrium, nothing happens. It’s about time that economists woke up to the need to model the economy dynamically—and to give Krugman his due here, he does admit at the end of his paper that his dynamics are dreadful, and need to be improved:
The major limitation of this analysis, as we see it, is its reliance on strategically crude dynamics. To simplify the analysis, we think of all the action as taking place within a single, aggregated short run, with debt paid down to sustainable levels and prices returned to full ex ante flexibility by the time the next period begins. This sidesteps the important question of just how fast debtors are required to deleverage; it also rules out any consideration of the effects of changes in inflation expectations during the period when the zero lower bound remains binding, a major theme of recent work by Eggertsson (2010a), Christiano et. al. (2009), and others. In future work we hope to get more realistic about the dynamics.
Hurry up Paul: you’re already eight decades behind Irving Fisher, who put the case for dynamics even for those who assume that equilibrium is stable:
‘We may tentatively assume that, ordinarily and within wide limits, all, or almost all, economic variables tend, in a general way, toward a stable equilibrium… But … New disturbances are, humanly speaking, sure to occur, so that, in actual fact, any variable is almost always above or below the ideal equilibrium…
Theoretically there may be—in fact, at most times there must be—over-or under-production, over- or under-consumption, over- or under-spending, over- or under-saving, over- or under-investment, and over or under everything else. It is as absurd to assume that, for any long period of time, the variables in the economic organization, or any part of them, will “stay put,” in perfect equilibrium, as to assume that the Atlantic Ocean can ever be without a wave.’ (Fisher 1933, p. 339)
One key component of Minsky’s thought is the capacity for the banking sector to create spending power “out of nothing”—to quote Schumpeter. As well as explaining endogenous money, I show that Minsky’s analysis leads to the conclusion that aggregate demand is greater than aggregate supply arising from the sale of goods and services alone—and therefore that rising debt plays a crucial role in a capitalist economy:
If income is to grow, the financial markets, where the various plans to save and invest are reconciled, must generate an aggregate demand that, aside from brief intervals, is ever rising. For real aggregate demand to be increasing, … it is necessary that current spending plans, summed over all sectors, be greater than current received income and that some market technique exist by which aggregate spending in excess of aggregate anticipated income can be financed. It follows that over a period during which economic growth takes place, at least some sectors finance a part of their spending by emitting debt or selling assets. (Minsky 1963; Minsky 1982) (Minsky 1982, p. 6)
This aggregate demand is spent not just on goods and services, but also on buying financial assets—hence economics and finance are inextricably linked, in opposition to the failed neoclassical attempt to keep them separate in two hermetically sealed jars. This in turn transcends Walras’ Law to give us what I call the Walras-Schumpeter-Minsky Law:
Aggregate demand is income plus the change in debt, and this is expended on both goods and services and financial assets. Therefore in a credit-based economy, there are three sources of aggregate demand, and three ways in which this demand is expended:
1. Demand from income earned by selling goods and services, which primarily finances consumption of goods and services;
2. Demand from rising entrepreneurial debt, which primarily finances investment; and
3. Demand from rising Ponzi debt, which primarily finances the purchase of existing assets.
Neoclassical Misinterpretations of Fisher, Minsky & Banking
“How do you misinterpret me? Let me count the ways…”
There are so many ways in which neoclassical economists misinterpret non-neoclassical thinkers like Fisher and Minsky that I could write a book on the topic. This section focuses on just one facet of how they get it wrong: by ignoring banks, and treating loans as transfers from “savers” to “spenders” with no bank in between.
This is precisely how Krugman models debt in his recent paper:
In what follows, we begin by setting out a flexible-price endowment model in which “impatient” agents borrow from “patient” agents, but are subject to a debt limit. If this debt limit is, for some reason, suddenly reduced, the impatient agents are forced to cut spending… (Krugman and Eggertsson 2010, p. 3)
This is debt without banks—and without the endogenous creation of money—and it explains why neoclassical economists don’t think that the level of private debt matters.
With that vision of debt, a change in the level of debt isn’t important, because the borrower’s increase in spending power is counteracted by the lender’s fall in spending power. Here’s the lending process as neoclassicals like Krugman see it:
Krugman therefore reassures his blog readers that there’s nothing to worry about when private debt levels rise or fall:
People think of debt’s role in the economy as if it were the same as what debt means for an individual: there’s a lot of money you have to pay to someone else. But that’s all wrong; the debt we create is basically money we owe to ourselves, and the burden it imposes does not involve a real transfer of resources.
That’s not to say that high debt can’t cause problems — it certainly can. But these are problems of distribution and incentives, not the burden of debt as is commonly understood. (Krugman 2011)
That would be reassuring if true, since we could then ignore data like this:
Unfortunately, real lending is better described by the next table:
|Bank Assets||Bank Deposits (Liabilities)|
In the real world, a bank loan increases “Impatient“‘s spending power without reducing “Patient“‘s, so that the level of private debt does matter.
Applying Minsky to Macroeconomic Data
In particular, the rate of change of debt matters because that tells us how much of demand is debt financed. When you add the change in debt to GDP, you get total aggregate demand, and that makes it exceedingly clear why the economic crisis occurred: the growth of debt collapsed, and took the economy with it:
Since change in debt is part of aggregate demand, the acceleration of debt—the rate of change of its rate of change—affects change in aggregate demand. This in turn has impacts on the change in employment.
It also impacts on change in asset prices. The relationship between accelerating debt and rising asset prices is clear even in the very volatile world of the stock market:
It is undeniable in the property market:
Since asset market volatility is driven by the acceleration of private debt, the Minskian solution to instability in finance markets is to somehow sever the link between debt and asset prices. I put forward two ideas.
Currently, shares last for the life of the issuing company, and 99% of the trade on the stock market is in the secondary market. The Jubilee Shares proposal would allow shares to last forever as now when purchased on the primary issue market, but would have them switch to a defined life of (say) 50 years after a limited number of sales on the secondary market (say 7 sales). This would encourage primary share purchases, and also make it highly unlikely that anyone would use borrow money to buy Jubilee shares on the secondary market.
Property Income Limited Leverage
Currently lending to buy property is allegedly based on the income of the borrower—which gives borrowers an incentive to actually want higher leverage over time. “The PILL” would limit the amount that can be lent to some multiple (say 10 times) of the income generating capacity of the property itself.
End of Synopsis
There’s much more detail in the paper itself, and when the conference is held my talk on it will also be available on the INET website.
Attending the conference
The conference itself has only 300 invitees, and INET had overwhelming demand from students for the 25 places they reserved for them. Rather than letting the over 500 other applicants miss out, these other applicants can watch the conference live from a special live video broadcast room at the Adlon Hotel, right next to the conference venue itself in Berlin. Click here for details if you’re one of those 563 applicants.