Research Topics

Before the global financial crisis, the assistance of a lender of last resort was traditionally thought to be limited to commercial banks. During the crisis, however, the Federal Reserve created a number of facilities to support brokers and dealers, money market mutual funds, the commercial paper market, the mortgage-backed securities market, the triparty repo market, et cetera. In this paper, we argue that the elimination of specialized banking through the eventual repeal of the Glass-Steagall Act (GSA) has played an important role in the leakage of the public subsidy intended for commercial banks to nonbank financial institutions. In a specialized financial system, which the GSA had helped create, the use of the lender-of-last-resort safety net could be more comfortably limited to commercial banks.

However, the elimination of GSA restrictions on bank-permissible activities has contributed to the rise of a financial system where the lines between regulated and protected banks and the so-called shadow banking system have become blurred. The existence of the shadow banking universe, which is directly or indirectly guaranteed by banks, has made it practically impossible to confine the safety to the regulated banking system. In this context, reforming the lender-of-last-resort institution requires fundamental changes within the financial system itself.

This monograph is part of the Levy Institute’s Research and Policy Dialogue Project on Improving Governance of the Government Safety Net in Financial Crisis, a two-year project funded by the Ford Foundation.

In the current financial crisis, the United States has relied on two primary methods of extending the government safety net: a stimulus package approved and budgeted by Congress, and a massive and unprecedented response by the Federal Reserve in the fulfillment of its lender-of-last-resort function. This monograph examines the benefits and drawbacks of each method, focusing on questions of accountability, democratic governance and transparency, and mission consistency. The aim is to explore the possibility of reform that would place more responsibility for provision of a safety net on Congress, with a smaller role to be played by the Fed, not only enhancing accountability but also allowing the Fed to focus more closely on its proper mission.

This paper begins by recounting the causes and consequences of the global financial crisis (GFC). The triggering event, of course, was the unfolding of the subprime crisis; however, the paper argues that the financial system was already so fragile that just about anything could have caused the collapse. It then moves on to an assessment of the lessons we should have learned. Briefly, these include: (a) the GFC was not a liquidity crisis, (b) underwriting matters, (c) unregulated and unsupervised financial institutions naturally evolve into control frauds, and (d) the worst part is the cover-up of the crimes. The paper argues that we cannot resolve the crisis until we begin going after the fraud, and concludes by outlining an agenda for reform, along the lines suggested by the work of Hyman P. Minsky.

This paper examines the causes and consequences of the current global financial crisis. It largely relies on the work of Hyman Minsky, although analyses by John Kenneth Galbraith and Thorstein Veblen of the causes of the 1930s collapse are used to show similarities between the two crises. K.W. Kapp’s “social costs” theory is contrasted with the recently dominant “efficient markets” hypothesis to provide the context for analyzing the functioning of financial institutions. The paper argues that, rather than operating “efficiently,” the financial sector has been imposing huge costs on the economy—costs that no one can deny in the aftermath of the economy’s collapse. While orthodox approaches lead to the conclusion that money and finance should not matter much, the alternative tradition—from Veblen and Keynes to Galbraith and Minsky—provides the basis for developing an approach that puts money and finance front and center. Including the theory of social costs also generates policy recommendations more appropriate to an economy in which finance matters.

Before we can reform the financial system, we need to understand what banks do—or, better yet, what banks should do. Senior Scholar L. Randall Wray examines Hyman Minsky’s views on banking and the proper role of the financial system—not simply to finance investment in physical capital but to promote the “capital development” of the economy as a whole and the improvement of living standards, broadly defined.

The 2008 global financial crisis was the consequence of the process (1) of financialization, or the creation of massive fictitious financial wealth, that began in the 1980s,; and (2) the hegemony of a reactionary ideology—namely, neoliberalism—based on self-regulated and efficient markets. Although laissez-faire capitalism is intrinsically unstable, the lessons of  the 1929 stock market crash of 1929 and the Great Depression of the 1930s were transformed into theories and institutions or regulations that led to the “30 glorious years of capitalism” (1948–77) and that could have helped avoid a financial crisis as profound as the present one. But it did not, because a coalition of rentiers and “financists” achieved hegemony and, while deregulating the existing financial operations, refused to regulate the financial innovations that made these markets even  riskier. Neoclassical economics played the role of a meta-ideology as it legitimized, mathematically and “scientifically,” neoliberal ideology and deregulation. From this crisis a new democratic capitalist system will emerge, though its character is difficult to predict. It will not be financialized, but the glory years’ tendencies toward a global and knowledge-based capitalism in which professionals  have more say than rentier capitalists, as well as the tendency to improve democracy by making it more social and participative, will be resumed.

The current financial crisis has been characterized as a “Minsky” moment, and as such provides the conditions required for a reregulation of the financial system similar to that of the New Deal banking reforms of the 1930s. However, Minsky’s theory was not one that dealt in moments but rather in systemic, structural changes in the operations of financial institutions. Therefore, the framework for reregulation must start with an understanding of the longer-term systemic changes that took place between the New Deal reforms and their formal repeal under the 1999 Financial Services Modernization Act. This paper attempts to identify some of those changes and their sources. In particular, it notes that the New Deal reforms were eroded by an internal process in which commercial banks that were given a monopoly position in deposit taking sought to remove those protections because unregulated banks were able to provide substitute instruments that were more efficient and unregulated but unavailable to regulated banks, since they involved securities market activities that would eventually be recognized as securitization. Regulators and the courts contributed to this process by progressively ruling that these activities were related to the regulated activities of the commercial banks, allowing them to reclaim securities market activities that had been precluded in the New Deal legislation. The 1999 Act simply made official the de facto repeal of the 1930s protections. Any attempt to provide reregulation of the system will thus require safeguards to ensure that this internal process of deregulation is not repeated.