A working site for research and writing on the thinkers who developed the system that works.

Thursday, April 30, 2009

Thursday, April 9, 2009

Hyman Minsky 03.20

And we go back to the algebra derived from Michal Kelecki's most simple assumption -- that workers consume all their income -- and see how Minsky develops it.  Of course the assumption is not completely true, but it is not fatal to the analysis when it deviates the way, for example, the assumption of Neoclassical economics that all firms are price takers or the assumptions of rational expectations that market participants, indeed all economic actors, are imbued with economic omniscience.

Kalecki showed that when his assumption was allowed and in an economy with small government and little trade, investment equals profits, or profits equal investment.

By nothing more controversial than simple algebra, Minsky then demonstrated first that price is positively related to the wage rate and to the ratio of investment goods to consumption goods production, and negatively related to labor productivity.  We went over that a couple of weeks ago, when we then digressed on the inappropriately prominent place the quantity theory of money has in the primitive orthodoxy that rules economics today.

But let's consider what Minsky's relationships mean.  It's a no-brainer that prices vary in the opposite direction as productivity, because, productivity simply means producing more with the same labor.  We at Demand Side recently demonstrated that productivity also goes up when the unemployment rate goes down.  (I was so excited.)  And since wages and unemployment also vary inversely, there is some amelioration of the labor cost impact on price, that is, on inflation.  Put simply, prices do not rise in proportion to wages in periods of falling unemployment.  This is, of course, opposite to the information derived from the famous Phillips Curve.

But the second part of this finding is very instructive.  The algebra shows what we might also derive from common sense.  As investment goods are emphasized over consumer goods, the price of consumer goods tends to rise, because, basically, workers in both sectors are bidding for the output of the consumer goods sector.  So when the ratio favors investment goods more, demand for consumer goods is higher and output is lower.

But the implications are not all so common-sensical.  The Kalecki demonstration that profits equal investment combines with this revelation that as new investment goes up, so do prices, to produce a condition in which higher prices, higher investment and higher profits coexist.  Since investment also connects positively with output and income, we can expect these two -- output and income -- to be in the same virtuous soup.

This indeed was a somewhat surprising empirical finding of our research on economic performance by president.  We found that in the postwar period employment is higher, unemployment lower, investment higher, corporate profits higher and GDP growth better when a Democrat is in the White House.  It surprised us somewhat that with all the effort by Republicans to push companies into profitability, some would say at the expense of others, that  is, the whole supply side idea, that they were not able to accomplish profits better than Democrats.  The Kalecki-Minsky analysis demonstrates why it has to be.  You can find it on pages 140 and following in Stabilizing an Unstable Economy

Prices, Minsky says, carry profits, the raison d'etre for investment.  In my micro courses we had fixed costs and variable costs and average costs.  Prices were determined by marginal costs and where the marginal cost curve intersected the demand curve.  This may be true, Minsky says, for price takers.  But a whole great swath of the economy, by far its major part, is composed of firms which more or less set prices and vary output according to demand.

These firms operate on the basis of a set of nesting average cost curves, the highest of which includes capital asset validation cost, or profits in the normal use of the word.  Such firms keep prices at the requisite level when demand falls by their market power, pricing power.  Without this ability to constrain price movements, they may not be able to employ expensive and highly specialized capital assets and large-scale debt financing, Minsky observes.

We include that mention here not because we expect you to get it, the nesting average cost curves and so on, but just to let you know it is there in Minsky, as it is in the real world, and it informs what follows.

Returning to the propositions derived from the insights of Kelecki.  Minsky expanded these by introducing big government and trade and workers who save.  Elegant and simple algebra yields some remarkable insights.

Note here and we'll explain more in a minute that Minsky's profit is not the same profit with which we are familiar, nor that which we measured in our comparisons of economic performance by president. 

Nevertheless, when government and taxes and deficits are introduced, something remarkable appears.  It can be shown that after-tax profits equal investment plus the government deficit.  When there is no investment, profits equal the deficit.  See the details on page 148.

What are the implications of this?  One implication is certainly that the big business types who encouraged the tax cuts to promote business should not now be bellyaching about the deficits.  They are supporting profits.  Now let's look at exactly what profits they are supporting.

Minsky's profits he also terms the "surplus," and it is not only the return on capital we normally think of as profit, but all the returns which are not technologically determined costs of production.  These include advertising and professional services, executive salaries and overhead costs, costs of financing and the aforementioned costs to validate capital assets.

Two things jump out at me.  One is that the profit or surplus feeds the white collars and presumably the big salaries as opposed to the blue collars on the production side.  The other is that price-taking firms are disciplined into being more lean and less top heavy.  It appeals to me as justification for taxing incomes progressively.

But let's go back to the price takers versus the price makers.  What happens when demand falls?  In the case of price takers, demand is reflected by a price that runs back along the marginal cost curve.  In the case of price makers, who set the price and prevent its falling by market power, something else happens.

If output drops below the first critical average cost curve, capital asset prices are no longer validated and investment in new capital assets stops -- with implications across the economy for incomes and output.  If output drops below the second critical curve, fixed debt payments can no longer be supported, and the various financing instruments come under pressure.  Of course, the overhead and executive costs are compressed to some extent, but these may be resistant.  For example, firms may increase advertising in attempts to gin up demand.

And when overall demand affects many firms, the same kinds of financial instruments come under pressure and we walk into the kind of crisis we have today.

See that the deflation is resisted by such firms on their products, because they have individual pricing power, but that the drop in output affects incomes and investments and financial arrangements dramatically -- without affecting price.

So my take here is that we ought not to be too ecstatic that deflation is not spiraling.  The cost-cutting and absence of investment and the pressure on the financial sector, all too evident in the current stagnation and apparent in declining payrolls may likely mean more bad jujus.

AND of course, business cash flow is being supported mightily by government deficits.

Hyman Minsky on Speculative Finance and Instability 08.11.09

Hyman Minsky writing in 1985

p. 5

... Fundamental institutional changes similar in scope to the basic reforms of the first six years of the Roosevelt presidency are necessary if we are to recapture such relative tranquility.

For a new era of serious reform to enjoy more than transitory success it should be based on the understanding of why a decentralized market mechanism -- the free market of the conservatives -- is an efficient way of handling the many details of economic life, and how the financial institutions of capitalism, especially in the context of production processes that use capital-intensive techniques, are inherently disruptive. Thus, while admiring the properties of free markets we must accept that the domain of effective and desirable free markets is restricted. We must develop economic institutions that constrain and control liability structures, particularly of financial institutions and of production processes that require massive capital investments. Paradoxically, capitalism is flawed precisely because it cannot readily assimilate production processes that use large-scale capital assets.


p. 6

oscillation between imminent collapse and rampant speculation


The financial fragility that led to the instability so evident since the 1960s was ignored. The deregulation drive and successful effort to bring the inflation rate down by large-scale and protracted monetary constraint and unemployment exacerbated the financial instability that was so evident in 1967, 1970, 1974-75 and 1979-80. Lender-of-last-resort interventions, which had papered over the problems of the fragile financial structure in the intermittent crises of the late 1960s and 1970s, became virtually everyday events in the 1980s.


The protracted unemployment and bankruptcies and near bankruptcies of firms and banks radically transformed the labor force from being income-oriented to being job-security oriented. Job security is no longer being guaranteed by federal macroeconomic policy; the only guarantee that labor now enjoys seems to be the right to make concessionary wage settlements.

These concessions by workers mean that the cost push part of the business cycle is attenuated -- but it also means that consumer demand due to increasing wage income will be less buoyant during an expansion. If anything, the Reagan reforms made prospects for instability worse -- but like many things in the economy and politics the full effects of the reforms will not be felt for some time. Even as a deficit-aided strong recovery leads to an apparent success for Reaganomics, the foundations for another round of inflation, crises, and serious recession are being laid.

p. 7

The major contours of our present institutional setup were put in place during the Roosevelt reform era, particularly in the second New Deal, which was completed by 1936. This structure was a response to the failures of the emergency legislation of 1933 to foster a quick recovery and to the spate of Supreme Court rulings invalidating various portions of the first New Deal that had been enacted during the one hundred days of 1933.

p. 8

footnote: There is a policy ineffectiveness theorem in contemporary economics. (See Thomas J. Sargent and Neil Wallace, "Rational expectations and the Theory of economic Policy," Journal of Monetary Economics, 1976, pp. 169-83.) Such theorems can be maintained only as the in fact institutional structure is ignored.

... when the difficulties encountered by giant corporations ad financial institutions are central to the instability that plagues the economy, the very largest concentrations of private power should, in the interest of efficiency as well as stability, be reduced to more manageable dimensions.

p. 9

The major flaw of our type of economy is that it is unstable. This instability is not due to external stocks (sic) or to the incompetence or ignorance of policy makers. Instability is due to the internal processes of our type of economy. The dynamics of a capitalist economy which has complex, sophisticated, and evolving financial structures leads to the development of conditions conducive to incoherence -- to runaway inflations or to deep depressions. But incoherence need not be fully realized because institutions and policy can contain the thrust to instability. We can, so to speak, stabilize instability.

Minsky's point so far is that the stability of the economy after 1966 was due to two things. First the presence of Big Government whose purchases and programs tended to be counter-cyclical, but whose debt being secure tended to act as ballast to the portfolios of private actors. Second, the Fed acted as backstop to the speculative financing that grew up during the good times. As lender of last resort, it became the de facto alternative financing when the first line of financing faced trouble. Only the Fed was big enough and had the money to stand up when the demand for backstop financing became enormous.

Here, from Chapter 2:

Chapter 2

p. 13

In the first quarter of 1975 (and again in midyear 1982), it seemed as if the American and the world economy was rushing toward a depression that might approach the severity of the Great Depression of the 1930s. Not only was income declining rapidly and the unemployment rate exploding, but virtually each day saw another bank, financial organization, municipality, business corporation, or country admit to financial difficulties.

p. 14-15

What, then, prevented a deep depression in 1975 and 1982? The answer centers on two aspects of the economy. The first is that Big Government stabilizes not only employment and income, but also business cash flows (profits) and as a result asset values. [FN: This is a proposition derived from the work of Kalecki. See Michael (sic) Kalecki, Selected Essays on the Dynamics of the Capitalist Economy (1933-1970) ...] The second aspect is that the Federal Reserve System, in cooperation with other government agencies and private financial institutions, acts as a lender of last resort. It will be argued that the combined behavior of the government and of the central bank, in the face of financial disarray and declining income, not only prevents deep depressions but also sets the stage for a serious and accelerating inflation to follow. The institutions and usages that currently rule have not prevented disequilibrating forces from operating. What has happened is that the shape of the business cycle has been changed; inflation has replaced the deep and wide trough of depressions.

You may say there have been no long periods of inflation since Minsky wrote in 1985. Here I would substitute "bubble" for inflation. Bubble is essentially an inflated asset price. These may not appear in CPI, but they are inflations. This would then lead into some of Soros work.

I do want to clarify here that "speculative financing" is simply that financing which is not a straightforward loan arrangement. I will buy a machine and borrow the money from you and pay you back with the cash flow generated by the machine. Much or most of modern corporate finance entails interim financing arrangements, where some borrowing is done to pay off the capital investment loan. This is speculative and has to have a backup if it is not going to be completely unstable.

Minsky Rises from Obscurity, per Stephen Mihm

Hyman Minsky saw it happening. To say "he saw it coming" is not correct, because what was happening washappening right under his nose. Everybody's nose, for that matter. But Minsky's glass saw into the workings. Like seeing a tree coming out of the ground and predicting fruit one day, it's not really a matter of foresight, it's a matter of recognition.

Here from the Boston Globe is an account. composed more of the conclusions than the description of the activity, it is nonetheless instructive. How appropriate and ironic that the non-Nobelists Minsky, Joan Robinson, John Kenneth Galbraith, should be right on the mark, while Nobelists Milton Friedman, Robert Lucas and too many others have been a monumental waste of time. The latter are like the pilots looking for the Northwest Passage before the ice melted, except that they led convoys of ships with the productive capacity of the world. Now forced to retreat, or more often, resisting that and insisting on continuing in futility, these are more self-important sirens than any sort of guide.

Why capitalism fails
The man who saw the meltdown coming had another troubling insight: it will happen again

By Stephen Mihm
Boston Globe
September 13, 2009

Since the global financial system started unraveling in dramatic fashion two years ago, distinguished economists have suffered a crisis of their own. Ivy League professors who had trumpeted the dawn of a new era of stability have scrambled to explain how, exactly, the worst financial crisis since the Great Depression had ambushed their entire profession.

Amid the hand-wringing and the self-flagellation, a few more cerebral commentators started to speak about the arrival of a “Minsky moment,” and a growing number of insiders began to warn of a coming “Minsky meltdown.”

“Minsky” was shorthand for Hyman Minsky, a hitherto obscure macroeconomist who died over a decade ago. Many economists had never heard of him when the crisis struck, and he remains a shadowy figure in the profession. But lately he has begun emerging as perhaps the most prescient big-picture thinker about what, exactly, we are going through. A contrarian amid the conformity of postwar America, an expert in the then-unfashionable subfields of finance and crisis, Minsky was one economist who saw what was coming. He predicted, decades ago, almost exactly the kind of meltdown that recently hammered the global economy.

In recent months Minsky’s star has only risen. Nobel Prize-winning economists talk about incorporating his insights, and copies of his books are back in print and selling well. He’s gone from being a nearly forgotten figure to a key player in the debate over how to fix the financial system.

But if Minsky was as right as he seems to have been, the news is not exactly encouraging. He believed in capitalism, but also believed it had almost a genetic weakness. Modern finance, he argued, was far from the stabilizing force that mainstream economics portrayed: rather, it was a system that created the illusion of stability while simultaneously creating the conditions for an inevitable and dramatic collapse.

In other words, the one person who foresaw the crisis also believed that our whole financial system contains the seeds of its own destruction. “Instability,” he wrote, “is an inherent and inescapable flaw of capitalism.”

Minsky’s vision might have been dark, but he was not a fatalist; he believed it was possible to craft policies that could blunt the collateral damage caused by financial crises. But with a growing number of economists eager to declare the recession over, and the crisis itself apparently behind us, these policies may prove as discomforting as the theories that prompted them in the first place. Indeed, as economists re-embrace Minsky’s prophetic insights, it is far from clear that they’re ready to reckon with the full implications of what he saw.

In an ideal world, a profession dedicated to the study of capitalism would be as freewheeling and innovative as its ostensible subject. But economics has often been subject to powerful orthodoxies, and never more so than when Minsky arrived on the scene.
That orthodoxy, born in the years after World War II, was known as the neoclassical synthesis. The older belief in a self-regulating, self-stabilizing free market had selectively absorbed a few insights from John Maynard Keynes, the great economist of the 1930s who wrote extensively of the ways that capitalism might fail to maintain full employment. Most economists still believed that free-market capitalism was a fundamentally stable basis for an economy, though thanks to Keynes, some now acknowledged that government might under certain circumstances play a role in keeping the economy - and employment - on an even keel.

Economists like Paul Samuelson became the public face of the new establishment; he and others at a handful of top universities became deeply influential in Washington. In theory, Minsky could have been an academic star in this new establishment: Like Samuelson, he earned his doctorate in economics at Harvard University, where he studied with legendary Austrian economist Joseph Schumpeter, as well as future Nobel laureate Wassily Leontief.

But Minsky was cut from different cloth than many of the other big names. The descendent of immigrants from Minsk, in modern-day Belarus, Minsky was a red-diaper baby, the son of Menshevik socialists. While most economists spent the 1950s and 1960s toiling over mathematical models, Minsky pursued research on poverty, hardly the hottest subfield of economics. With long, wild, white hair, Minsky was closer to the counterculture than to mainstream economics. He was, recalls the economist L. Randall Wray, a former student, a “character.”

So while his colleagues from graduate school went on to win Nobel prizes and rise to the top of academia, Minsky languished. He drifted from Brown to Berkeley and eventually to Washington University. Indeed, many economists weren’t even aware of his work. One assessment of Minsky published in 1997 simply noted that his “work has not had a major influence in the macroeconomic discussions of the last thirty years.”

Yet he was busy. In addition to poverty, Minsky began to delve into the field of finance, which despite its seeming importance had no place in the theories formulated by Samuelson and others. He also began to ask a simple, if disturbing question: “Can ‘it’ happen again?” - where “it” was, like Harry Potter’s nemesis Voldemort, the thing that could not be named: the Great Depression.

In his writings, Minsky looked to his intellectual hero, Keynes, arguably the greatest economist of the 20th century. But where most economists drew a single, simplistic lesson from Keynes - that government could step in and micromanage the economy, smooth out the business cycle, and keep things on an even keel - Minsky had no interest in what he and a handful of other dissident economists came to call “bastard Keynesianism.”

Instead, Minsky drew his own, far darker, lessons from Keynes’s landmark writings, which dealt not only with the problem of unemployment, but with money and banking. Although Keynes had never stated this explicitly, Minsky argued that Keynes’s collective work amounted to a powerful argument that capitalism was by its very nature unstable and prone to collapse. Far from trending toward some magical state of equilibrium, capitalism would inevitably do the opposite. It would lurch over a cliff.

This insight bore the stamp of his advisor Joseph Schumpeter, the noted Austrian economist now famous for documenting capitalism’s ceaseless process of “creative destruction.” But Minsky spent more time thinking about destruction than creation. In doing so, he formulated an intriguing theory: not only was capitalism prone to collapse, he argued, it was precisely its periods of economic stability that would set the stage for monumental crises.

Minsky called his idea the “Financial Instability Hypothesis.” In the wake of a depression, he noted, financial institutions are extraordinarily conservative, as are businesses. With the borrowers and the lenders who fuel the economy all steering clear of high-risk deals, things go smoothly: loans are almost always paid on time, businesses generally succeed, and everyone does well. That success, however, inevitably encourages borrowers and lenders to take on more risk in the reasonable hope of making more money. As Minsky observed, “Success breeds a disregard of the possibility of failure.”

As people forget that failure is a possibility, a “euphoric economy” eventually develops, fueled by the rise of far riskier borrowers - what he called speculative borrowers, those whose income would cover interest payments but not the principal; and those he called “Ponzi borrowers,” those whose income could cover neither, and could only pay their bills by borrowing still further. As these latter categories grew, the overall economy would shift from a conservative but profitable environment to a much more freewheeling system dominated by players whose survival depended not on sound business plans, but on borrowed money and freely available credit. Once that kind of economy had developed, any panic could wreck the market. The failure of a single firm, for example, or the revelation of a staggering fraud could trigger fear and a sudden, economy-wide attempt to shed debt. This watershed moment - what was later dubbed the “Minsky moment” - would create an environment deeply inhospitable to all borrowers. The speculators and Ponzi borrowers would collapse first, as they lost access to the credit they needed to survive. Even the more stable players might find themselves unable to pay their debt without selling off assets; their forced sales would send asset prices spiraling downward, and inevitably, the entire rickety financial edifice would start to collapse. Businesses would falter, and the crisis would spill over to the “real” economy that depended on the now-collapsing financial system.

From the 1960s onward, Minsky elaborated on this hypothesis. At the time he believed that this shift was already underway: postwar stability, financial innovation, and the receding memory of the Great Depression were gradually setting the stage for a crisis of epic proportions. Most of what he had to say fell on deaf ears. The 1960s were an era of solid growth, and although the economic stagnation of the 1970s was a blow to mainstream neo-Keynesian economics, it did not send policymakers scurrying to Minsky. Instead, a new free market fundamentalism took root: government was the problem, not the solution.

Moreover, the new dogma coincided with a remarkable era of stability. The period from the late 1980s onward has been dubbed the “Great Moderation,” a time of shallow recessions and great resilience among most major industrial economies. Things had never been more stable. The likelihood that “it” could happen again now seemed laughable.

Yet throughout this period, the financial system - not the economy, but finance as an industry - was growing by leaps and bounds. Minsky spent the last years of his life, in the early 1990s, warning of the dangers of securitization and other forms of financial innovation, but few economists listened. Nor did they pay attention to consumers’ and companies’ growing dependence on debt, and the growing use of leverage within the financial system.

By the end of the 20th century, the financial system that Minsky had warned about had materialized, complete with speculative borrowers, Ponzi borrowers, and precious few of the conservative borrowers who were the bedrock of a truly stable economy. Over decades, we really had forgotten the meaning of risk. When storied financial firms started to fall, sending shockwaves through the “real” economy, his predictions started to look a lot like a road map.

“This wasn’t a Minsky moment,” explains Randall Wray. “It was a Minsky half-century.”

Minsky is now all the rage. A year ago, an influential Financial Times columnist confided to readers that rereading Minsky’s 1986 “masterpiece” - “Stabilizing an Unstable Economy” - “helped clear my mind on this crisis.” Others joined the chorus. Earlier this year, two economic heavyweights - Paul Krugman and Brad DeLong - both tipped their hats to him in public forums. Indeed, the Nobel Prize-winning Krugman titled one of the Robbins lectures at the London School of Economics “The Night They Re-read Minsky.”

Today most economists, it’s safe to say, are probably reading Minsky for the first time, trying to fit his unconventional insights into the theoretical scaffolding of their profession. If Minsky were alive today, he would no doubt applaud this belated acknowledgment, even if it has come at a terrible cost. As he once wryly observed, “There is nothing wrong with macroeconomics that another depression [won’t] cure.”

But does Minsky’s work offer us any practical help? If capitalism is inherently self-destructive and unstable - never mind that it produces inequality and unemployment, as Keynes had observed - now what?

After spending his life warning of the perils of the complacency that comes with stability - and having it fall on deaf ears - Minsky was understandably pessimistic about the ability to short-circuit the tragic cycle of boom and bust. But he did believe that much could be done to ameliorate the damage.

To prevent the Minsky moment from becoming a national calamity, part of his solution (which was shared with other economists) was to have the Federal Reserve - what he liked to call the “Big Bank” - step into the breach and act as a lender of last resort to firms under siege. By throwing lines of liquidity to foundering firms, the Federal Reserve could break the cycle and stabilize the financial system. It failed to do so during the Great Depression, when it stood by and let a banking crisis spiral out of control. This time, under the leadership of Ben Bernanke - like Minsky, a scholar of the Depression - it took a very different approach, becoming a lender of last resort to everything from hedge funds to investment banks to money market funds.

Minsky’s other solution, however, was considerably more radical and less palatable politically. The preferred mainstream tactic for pulling the economy out of a crisis was - and is - based on the Keynesian notion of “priming the pump” by sending money that will employ lots of high-skilled, unionized labor - by building a new high-speed train line, for example.

Minsky, however, argued for a “bubble-up” approach, sending money to the poor and unskilled first. The government - or what he liked to call “Big Government” - should become the “employer of last resort,” he said, offering a job to anyone who wanted one at a set minimum wage. It would be paid to workers who would supply child care, clean streets, and provide services that would give taxpayers a visible return on their dollars. In being available to everyone, it would be even more ambitious than the New Deal, sharply reducing the welfare rolls by guaranteeing a job for anyone who was able to work. Such a program would not only help the poor and unskilled, he believed, but would put a floor beneath everyone else’s wages too, preventing salaries of more skilled workers from falling too precipitously, and sending benefits up the socioeconomic ladder.

While economists may be acknowledging some of Minsky’s points on financial instability, it’s safe to say that even liberal policymakers are still a long way from thinking about such an expanded role for the American government. If nothing else, an expensive full-employment program would veer far too close to socialism for the comfort of politicians. For his part, Wray thinks that the critics are apt to misunderstand Minsky. “He saw these ideas as perfectly consistent with capitalism,” says Wray. “They would make capitalism better.”

But not perfect. Indeed, if there’s anything to be drawn from Minsky’s collected work, it’s that perfection, like stability and equilibrium, are mirages. Minsky did not share his profession’s quaint belief that everything could be reduced to a tidy model, or a pat theory. His was a kind of existential economics: capitalism, like life itself, is difficult, even tragic. “There is no simple answer to the problems of our capitalism,” wrote Minsky. “There is no solution that can be transformed into a catchy phrase and carried on banners.”

It’s a sentiment that may limit the extent to which Minsky becomes part of any new orthodoxy. But that’s probably how he would have preferred it, believes liberal economist James Galbraith. “I think he would resist being domesticated,” says Galbraith. “He spent his career in professional isolation.”

Stephen Mihm is a history professor at the University of Georgia and author of “A Nation of Counterfeiters” (Harvard, 2007).