Minsky on financial capitalism
Hyman Minsky (1919-1996) was a leading authority on monetary theory and financial institutions. For much of Minsky’s career, mainstream economics paid little attention to the role of the financial system in macroeconomic theory. But in recent years, there has been an outpouring of new research, both theoretical and empirical, much of which validates his remarkable insights.
Following is a digest of a paper* by Papadimitriou and Wray, briefly outlining Minsky’s views on modern capitalist systems.
Capitalism’s Many Stages
Capitalism is constantly evolving. We can identify several distinct stages in its evolution going back to the early 1600s. Today, capitalism is quite different from what it was just 30 years ago, and it may now be in the process of evolving into a new stage through globalization. The one constant throughout is the profit -seeking motive in money terms that leads to continual innovation, especially in finance. Firms spend money to earn more money.
Financial institutions play a critical but delicate role, since they are themselves profit-seeking enterprises. They not only supply the funds, but may have a direct stake in the potential profits of the enterprise. Banks increase the money supply whenever they share the belief of the borrower that positions in assets or financed activity will generate sufficient cash flows. Money is thus created as a result of normal economic processes.
The Key Role of Firms
A modern economy is ultimately dependent on the viability of its firms, all of which are owned by the household sector, and which provide the main source of household income as wages. The focus should therefore be on firms, not households, and on investment and its finance, not on consumption and saving out of household income flows. This is in sharp contrast to the exposition found in text- books, which begins with households and their consumption vs saving decision, with thrift determining investment and therefore growth.
Two Price Model
Minsky’s analysis involves two sets of prices. One set consists of the prices of current output — consumption, investment, government, and export goods and services. The other set is the prices of assets— capital assets used by firms in production and financial instruments that firms issue to gain control of fixed and working capital. The second set of prices is critical in determining how much investment will be undertaken. The two sets of prices reflect what happens in two different sets of markets, and will vary independently. This is in marked contrast to the single price system of the consumption versus investment model typically used in textbooks.
The spending on investment depends on the demand price of capital assets (what firms are willing to pay) relative to supply prices (what suppliers require to produce them). For capital assets to be produced and thus generate profits, demand prices must exceed supply prices by enough to cover the risks. The resulting investment will then validate previous investment. Investment today determines whether investment yesterday was a good idea, but also depends on expectations about the future regarding demand and supply prices of investment goods. Whether there will be aggregate profits to distribute depends on aggregate capitalist spending.
The Role of Profits
Capitalism involves the acquisition of expensive assets that usually require financing of positions in those assets. A firm must have sufficient market power to assure lenders that it will earn enough to service its financial liabilities. Thus a goal of every firm is to gain market power in order to control its markup. The ability to set price is critical in determining who gets credit.
At the micro level, each firm must be able to obtain a markup on labor costs. However at the macro level there won’t be any profit unless there is spending in excess of aggregate wages in the consumption sector. Aggregate profit of firms equals the sum of investment plus consumption out of profits, plus government’s deficit, plus the trade surplus, less saving out of wages.
In the simple case with no government deficit, no trade imbalance, and no saving out of wages, capitalist profit equals the sum of investment and capitalist consumption. As long as the price is set high enough that workers cannot buy all the output, capitalists can get the rest so long as they spend. The amount of surplus available at the aggregate level depends on the aggregate markup. It is aggregate spending on investment that generates the profit, and validates the accumulated capital. Neither thriftiness nor technology has anything to do with capital accumulation.
Financial Positions of a Firm
Minsky defines three financial positions of increasing fragility:
- Hedge finance: income flows are expected to meet financial obligations in every period.
- Speculative finance: the firm must roll over debt because income flows are expected to only cover interest costs.
- Ponzi finance: income flows won’t even cover interest cost, so the firm must borrow more or sell off assets simply to service its debt.
Over a protracted period of good times, economies tend to move from a financial structure dominated by hedge financing to a structure with increasing speculative and Ponzi financing. The shift toward speculative positions occurs intentionally and more or less inevitably because of the way in which success in a boom enhances expectations. However the shift from speculative toward Ponzi finance is usually unintentional.
Business cycles are endogenously generated, and are not due to shocks. In large part they are due to the interplay between the two price systems and the way the financial system naturally evolves toward fragility. Any exogenous effects can precipitate a crisis, but only when the system has already evolved to a fragile position.
Conventional wisdom argues that an economy is naturally stable, with the invisible hand guiding the economy towards equilibrium. Rather than treating institutions as contributing to stability, orthodoxy views them as barriers to achieving equilibrium. Minsky argues that institutions and interventions thwart the inherent instability of financial capitalism by interrupting the endogenous process and restarting the economy under more favorable conditions.
As Minsky observed, capitalism is inherently unstable. Even if each crisis is successfully contained, it encourages greater speculation and risk taking in borrowing and lending. Financial innovation makes it easier to finance various schemes. To a large extent, borrowers and lenders operate on the basis of trial and error. If a behavior is rewarded, it will be repeated. Thus stable periods naturally lead to optimism, to booms, and to increasing fragility.
A financial crisis can lead to asset price deflation and repudiation of debt. A debt deflation, once started, is very difficult to stop. It may not end until balance sheets are largely purged of bad debts, at great loss in financial wealth to the creditors as well as the economy at large.
Big Government and Big Bank
Before World War II, government spending was no more than 3% of GNP. Whenever the economy faltered, there was little countercyclical deficit spending to offset the loss in private spending. Thus the era was marked by a number of depressions. Since then, government spending has grown to a size exceeding 20% of GNP. This spending effectively sets both ceilings and floors on prices of current output, helping to constrain the natural tendency of aggregate demand toward boom and bust cycles. It is notable that there has been no depression in the Big Government era.
Government deficits may not be sufficient to prevent a debt deflation. If one occurs on a large enough scale, asset prices may become so depressed that revenue from sales of assets does not permit servicing of debt. Defaults can spread and bring down more creditors. Minsky argues that the prevention of such a financial crisis is the primary purpose of the central bank and not, as orthodoxy assumes, control of the money supply or inflation. To reduce the moral hazard effects, any lender of last resort activity must be accompanied by Big Bank supervision of balance sheets.
* Working Paper No. 275, Minsky’s Analysis of Financial Capitalism, by Dimitri B. Papadimitriou & L. Randall Wray, of Jerome Levy Economics Institute, July 1999.
Source: William Hummel’s website on money – http://wfhummel.cnchost.com/minsky.html