Research Topics

The Unit of Account, Inflation, Leverage, and Financial Fragility

We hope to model financial fragility and money in a way that captures much of what is crucial in Hyman Minsky’s financial fragility hypothesis. This approach to modeling Minsky may be unique in the formal Minskyan literature. Namely, we adopt a model in which a psychological variable we call financial prudence (P) declines over time following a financial crash, driving a cyclical buildup of leverage in household balance sheets. High leverage or a low safe-asset ratio in turn induces high financial fragility (FF). In turn, the pathways of FF and capacity utilization (u) determine the probabilistic risk of a crash in any time interval. When they occur, these crashes entail discrete downward jumps in stock prices and financial sector assets and liabilities. To the endogenous government liabilities in Hannsgen (2014), we add common stock and bank loans and deposits. In two alternative versions of the wage-price module in the model (wage–Phillips curve and chartalist, respectively), the rate of wage inflation depends on either unemployment or the wage-setting policies of the government sector. At any given time t, goods prices also depend on endogenous markup and labor productivity variables. Goods inflation affects aggregate demand through its impact on the value of assets and debts. Bank rates depend on an endogenous markup of their own. Furthermore, in light of the limited carbon budget of humankind over a 50-year horizon, goods production in this model consumes fossil fuels and generates greenhouse gases.

The government produces at a rate given by a reaction function that pulls government activity toward levels prescribed by a fiscal policy rule. Subcategories of government spending affect the pace of technical progress and prudence in lending practices. The intended ultimate purpose of the model is to examine the effects of fiscal policy reaction functions, including one with dual unemployment rate and public production targets, testing their effects on numerically computed solution pathways. Analytical results in the penultimate section show that (1) the model has no equilibrium (steady state) for reasons related to Minsky’s argument that modern capitalist economies possess a property that he called “the instability of stability,” and (2) solution pathways exist and are unique, given vectors of initial conditions and parameter values and realizations of the Poisson model of financial crises.

A Minskyan Approach

This paper presents a method to capture the growth of financial fragility within a country and across countries. This is done by focusing on housing finance in the United States, the United Kingdom, and France. Following the theoretical framework developed by Hyman P. Minsky, the paper focuses on the risk of amplification of shock via a debt deflation instead of the risk of a shock per se. Thus, instead of focusing on credit risk, for example, financial fragility is defined in relation to the means used to service debts, given credit risk and all other sources of shocks. The greater the expected reliance on capital gains and debt refinancing to meet debt commitments, the greater the financial fragility, and so the higher the risk of debt deflation induced by a shock if no government intervention occurs. In the context of housing finance, this implies that the growth of subprime lending was not by itself a source of financial fragility; instead, it was the change in the underwriting methods in all sectors of the mortgage markets that created a financial situation favorable to the emergence of a debt deflation. Stated alternatively, when nonprime and prime mortgage lending moved to asset-based lending instead of income-based lending, the financial fragility of the economy grew rapidly.

What is called “capitalism” is best understood as a series of stages. Industrial capitalism has given way to finance capitalism, which has passed through  pension fund capitalism since the 1950s and a US-centered monetary imperialism since 1971, when the fiat dollar (created mainly to finance US global military spending) became the world’s monetary base. Fiat dollar credit made possible the bubble economy after 1980, and its substage of casino capitalism. These economically radioactive decay stages resolved into debt deflation after 2008, and are now settling into a leaden debt peonage and the austerity of neo-serfdom.

The end product of today’s Western capitalism is a neo-rentier economy—precisely what industrial capitalism and classical economists set out to replace during the Progressive Era from the late 19th to early 20th century. A financial class has usurped the role that landlords used to play—a class living off special privilege. Most economic rent is now paid out as interest. This rake-off interrupts the circular flow between production and consumption, causing economic shrinkage—a dynamic that is the opposite of industrial capitalism’s original impulse. The “miracle of compound interest,” reinforced now by fiat credit creation, is cannibalizing industrial capital as well as the returns to labor.

The political thrust of industrial capitalism was toward democratic parliamentary reform to break the stranglehold of landlords on national tax systems. But today’s finance capital is inherently oligarchic. It seeks to capture the government—first and foremost the treasury, central bank, and courts—to enrich (indeed, to bail out) and untax the banking and financial sector and its major clients: real estate and monopolies. This is why financial “technocrats” (proxies and factotums for high finance) were imposed in Greece, and why Germany opposed a public referendum on the European Central Bank’s austerity program.

The world’s worst economic crisis since the 1930s is now well into its third year. All sorts of explanations have been proffered for the causes of the crisis, from lax regulation and oversight to excessive global liquidity. Unfortunately, these narratives do not take into account the systemic nature of the global crisis. This is why so many observers are misled into pronouncing that recovery is on the way—or even under way already. I believe they are incorrect. We are, perhaps, in round three of a nine-round bout. It is still conceivable that Minsky’s “it”—a full-fledged debt deflation with failure of most of the largest financial institutions—could happen again.

Indeed, Minsky’s work has enjoyed unprecedented interest, with many calling this a “Minsky moment” or “Minsky crisis.” However, most of those who channel Minsky locate the beginnings of the crisis in the 2000s. I argue that we should not view this as a “moment” that can be traced to recent developments. Rather, as Minsky argued for nearly 50 years, we have seen a slow realignment of the global financial system toward “money manager capitalism.” Minsky’s analysis correctly links postwar developments with the prewar “finance capitalism” analyzed by Rudolf Hilferding, Thorstein Veblen, and John Maynard Keynes—and later by John Kenneth Galbraith. In an important sense, over the past quarter century we created conditions similar to those that existed in the run-up to the Great Depression, with a similar outcome. Getting out of this mess will require radical policy changes no less significant than those adopted in the New Deal.

Financial Fragility Indexes

With the Great Recession and the regulatory reform that followed, the search for reliable means to capture systemic risk and to detect macrofinancial problems has become a central concern. In the United States, this concern has been institutionalized through the Financial Stability Oversight Council, which has been put in charge of detecting threats to the financial stability of the nation. Based on Hyman Minsky’s financial instability hypothesis, the paper develops macroeconomic indexes for three major economic sectors. The index provides a means to detect the speed with which financial fragility accrues, and its duration; and serves as a complement to the microprudential policies of regulators and supervisors. The paper notably shows, notably, that periods of economic stability during which default rates are low, profitability is high, and net worth is accumulating are fertile grounds for the growth of financial fragility.

Before we can reform the financial system, we need to understand what banks do; or, better, what banks should do. This paper will examine the later work of Hyman Minsky at the Levy Institute, on his project titled “Reconstituting the United States’ Financial Structure.” This led to a number of Levy working papers and also to a draft book manuscript that was left uncompleted at his death in 1996. In this paper I focus on Minsky’s papers and manuscripts from 1992 to 1996 and his last major contribution (his Veblen-Commons Award–winning paper).

Much of this work was devoted to his thoughts on the role that banks do and should play in the economy. To put it as succinctly as possible, Minsky always insisted that the proper role of the financial system was to promote the “capital development” of the economy. By this he did not simply mean that banks should finance investment in physical capital. Rather, he was concerned with creating a financial structure that would be conducive to economic development to improve living standards, broadly defined. Central to his argument is the understanding of banking that he developed over his career. Just as the financial system changed (and with it, the capitalist economy), Minsky’s views evolved. I will conclude with general recommendations for reform along Minskyan lines.