Economies evolve, and so, too, must economic policy: Minsky

As debate rages over the Rudd Government stimulus package I can’t help but think that much broader changes need to occur in order to bring stability back into the global financial system.  Legion would probably say ‘if you can’t make an accurate diagnosis of the illness, how can you ever expect to provide a cure’.  I tend to agree.

In fact, Keynes expressed the problem well when he said:

When the capital development of a country becomes the by- product of the activities of a casino, the job is likely to be ill-done.

Which leads me to the work of Hyman Minsky, and because economic theory can be cumbersome and daunting I went in search of an article that references his work and that can be easily digested and applied to the current crisis. I found this: Minsky Moment:The New Yorker

by John Cassidy
February 4, 2008

Twenty-five years ago, when most economists were extolling the virtues of financial deregulation and innovation, a maverick named Hyman P. Minsky maintained a more negative view of Wall Street; in fact, he noted that bankers, traders, and other financiers periodically played the role of arsonists, setting the entire economy ablaze. Wall Street encouraged businesses and individuals to take on too much risk, he believed, generating ruinous boom-and-bust cycles. The only way to break this pattern was for the government to step in and regulate the moneymen.

Many of Minsky’s colleagues regarded his “financial-instability hypothesis,” which he first developed in the nineteen-sixties, as radical, if not crackpot. Today, with the subprime crisis seemingly on the verge of metamorphosing into a recession, references to it have become commonplace on financial Web sites and in the reports of Wall Street analysts. Minsky’s hypothesis is well worth revisiting. In trying to revive the economy, President Bush and the House have already agreed on the outlines of a “stimulus package,” but the first stage in curing any malady is making a correct diagnosis.

Minsky, who died in 1996, at the age of seventy-seven, earned a Ph.D. from Harvard and taught at Brown, Berkeley, and Washington University. He didn’t have anything against financial institutions—for many years, he served as a director of the Mark Twain Bank, in St. Louis—but he knew more about how they worked than most deskbound economists. There are basically five stages in Minsky’s model of the credit cycle: displacement, boom, euphoria, profit taking, and panic. A displacement occurs when investors get excited about something—an invention, such as the Internet, or a war, or an abrupt change of economic policy. The current cycle began in 2003, with the Fed chief Alan Greenspan’s decision to reduce short-term interest rates to one per cent, and an unexpected influx of foreign money, particularly Chinese money, into U.S. Treasury bonds. With the cost of borrowing—mortgage rates, in particular—at historic lows, a speculative real-estate boom quickly developed that was much bigger, in terms of over-all valuation, than the previous bubble in technology stocks.

As a boom leads to euphoria, Minsky said, banks and other commercial lenders extend credit to ever more dubious borrowers, often creating new financial instruments to do the job. During the nineteen-eighties, junk bonds played that role. More recently, it was the securitization of mortgages, which enabled banks to provide home loans without worrying if they would ever be repaid. (Investors who bought the newfangled securities would be left to deal with any defaults.) Then, at the top of the market (in this case, mid-2006), some smart traders start to cash in their profits.

The onset of panic is usually heralded by a dramatic effect: in July, two Bear Stearns hedge funds that had invested heavily in mortgage securities collapsed. Six months and four interest-rate cuts later, Ben Bernanke and his colleagues at the Fed are struggling to contain the bust. Despite last week’s rebound, the outlook remains grim. According to Dean Baker, the co-director of the Center for Economic and Policy Research, average house prices are falling nationwide at an annual rate of more than ten per cent, something not seen since before the Second World War. This means that American households are getting poorer at a rate of more than two trillion dollars a year.

It’s hard to say exactly how falling house prices will affect the economy, but recent computer simulations carried out by Frederic Mishkin, a governor at the Fed, suggest that, for every dollar the typical American family’s housing wealth drops in a year, that family may cut its spending by up to seven cents. Nationwide, that adds up to roughly a hundred and fifty-five billion dollars, which is bigger than President Bush’s stimulus package. And it doesn’t take into account plunging stock prices, collapsing confidence, and the belated imposition of tighter lending practices—all of which will further restrict economic activity.

In an election year, politicians can’t be expected to acknowledge their powerlessness. Nonetheless, it was disheartening to see the Republicans exploiting the current crisis to try to make the President’s tax cuts permanent, and the Democrats attempting to pin the economic downturn on the White House. For once, Bush is not to blame. His tax cuts were irresponsible and callously regressive, but they didn’t play a significant role in the housing bubble.

If anybody is at fault it is Greenspan, who kept interest rates too low for too long and ignored warnings, some from his own colleagues, about what was happening in the mortgage market. But he wasn’t the only one. Between 2003 and 2007, most Americans didn’t want to hear about the downside of funds that invest in mortgage-backed securities, or of mortgages that allow lenders to make monthly payments so low that their loan balances sometimes increase. They were busy wondering how much their neighbors had made selling their apartment, scouting real-estate Web sites and going to open houses, and calling up Washington Mutual or Countrywide to see if they could get another home-equity loan. That’s the nature of speculative manias: eventually, they draw in almost all of us.

You might think that the best solution is to prevent manias from developing at all, but that requires vigilance. Since the nineteen-eighties, Congress and the executive branch have been conspiring to weaken federal supervision of Wall Street. Perhaps the most fateful step came when, during the Clinton Administration, Greenspan and Robert Rubin, then the Treasury Secretary, championed the abolition of the Glass-Steagall Act of 1933, which was meant to prevent a recurrence of the rampant speculation that preceded the Depression.

The greatest need is for intellectual reappraisal, and a good place to begin is with a statement from a paper co-authored by Minsky that “apt intervention and institutional structures are necessary for market economies to be successful.” Rather than waging old debates about tax cuts versus spending increases, policymakers ought to be discussing how to reform the financial system so that it serves the rest of the economy, instead of feeding off it and destabilizing it. Among the problems at hand: how to restructure Wall Street remuneration packages that encourage excessive risk-taking; restrict irresponsible lending without shutting out creditworthy borrowers; help victims of predatory practices without bailing out irresponsible lenders; and hold ratings agencies accountable for their assessments. These are complex issues, with few easy solutions, but that’s what makes them interesting. As Minsky believed, “Economies evolve, and so, too, must economic policy.” ♦

Over To You

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17 Responses

  1. N’

    You inspired me to try and simplify Minsky’s modal and it’s relevance to the current crisis.

    Cheers

  2. Good stuff John. It’s important to provide interpretations of theories/models that can be understood by the general public, and apply them to specific & contemporary situations…always remembering the political, economic goals, biases etc. of the writer/speaker. Reductionist perhaps, but sometimes useful. Can assist those unacquainted w/ certain terminology & theories to find meaning in familiar contexts.

    “Perhaps the most fateful step came when, during the Clinton Administration, Greenspan and Robert Rubin, then the Treasury Secretary, championed the abolition of the Glass-Steagall Act of 1933, which was meant to prevent a recurrence of the rampant speculation that preceded the Depression.”

    One must not forget the role of Phil Gramm and the Gramm-Leach-Bliley Act of 1999…changes to bankruptcy laws…surge in petrol prices…deliberate pumping up of price of certain foodstuffs (partially as a result of warring energy factions)

    and of course the media response to 9/11 & buildup to war in Iraq…(Minsky might say there were “displacements injected thruout the period”)…the spread of 24hr cable news and the repitition, hype and advertising that came as they competed for audiences to pay their bills and fulfil the demands of shareholders from various arms of their horizontally integrated businesses:

    Media terms
    Media critics, such as Robert McChesney, have noted that the current trend within the entertainment industry has been toward the increased concentration of media ownership into the hands of a smaller number of transmedia and transnational conglomerates. [1] Media nowadays tend to be in the hands of those who are rich enough to buy the media such as Rupert Murdoch.

    Horizontal integration, that is, the consolidation of holdings across multiple industries, has displaced the old vertical integration of the Hollywood studios. The idea of owning many media outlets, which run almost the same content, is considered to be very productive, since it requires only minor changes of format and information to use in multiple media forms. For example, within a conglomerate, the content used in broadcasting television would be used in broadcasting radio as well, or the content used in hard copy of the newspaper would also be used in online newspaper website.

    What emerged are new strategies of content development and distribution designed to increase the “synergy’ between the different divisions of the same company. Studios seek content that can move fluidly across media channels.
    (Wikipedia)

    back to ‘In Treatment’. HBO sure produced some brill shows.

    N’.

  3. It’s interesting N’ but every now and again you come across a theory that really fit’s. Minsky did it for me.

    And it was Turnbull who recently said:

    “Those people who say, oh this was caused by an excess of capitalistic free-market activity are quite wrong,” The catalyst for the crisis – the US sub-prime collapse – was the result of interfering with and subsidising the housing market, he said.
    “The fundamental error was … lending money to people who can’t afford to pay it back.”
    “You do that on a large scale, you’ll end up with these problems.”

    It makes me wonder what planet he comes from?

  4. N’

    “Perhaps the most fateful step came when, during the Clinton Administration, Greenspan and Robert Rubin, then the Treasury Secretary, championed the abolition of the Glass-Steagall Act of 1933, which was meant to prevent a recurrence of the rampant speculation that preceded the Depression.”

    Agreed N’, yet as Soros’ explains the process of created expansion dates back around 60 years and when Reagan became President deregulation started to really get some legs:

    Every time the credit expansion ran into trouble the financial authorities intervened, injecting liquidity and finding other ways to stimulate the economy. That created a system of asymmetric incentives also known as moral hazard, which encouraged ever greater credit expansion. The system
    was so successful that people came to believe in what former US president Ronald Reagan called the magic of the marketplace and I call market fundamentalism. Fundamentalists believe that markets tend towards
    equilibrium and the common interest is best served by allowing participants to pursue their self-interest. It is an obvious misconception, because it was the intervention of the authorities that prevented financial markets from breaking down, not the markets themselves. Nevertheless, market fundamentalism emerged as the dominant ideology in the 1980s, when financial markets started to become globalised and the US started to run a current account deficit. ”

    Globalisation allowed the US to suck up the savings of the rest of the world and consume more than it produced. The US current account deficit reached 6.2 per cent of gross national product in 2006. The financial markets
    encouraged consumers to borrow by introducing ever more sophisticated instruments and more generous terms. The authorities aided and abetted the process by intervening whenever the global financial system was at risk. Since
    1980, regulations have been progressively relaxed until they have practically disappeared. ”

    The Roaring Nineties: Why We’re Paying the Price for the Greediest Decade in History by Joseph Stiglitz also offers a very insightful view of how the system ran amuck in the 1990’s
    http://www.amazon.co.uk/gp/reader/0141014318/ref=sib_fs_top?ie=UTF8&p=S01D&checkSum=kjLGr4s7jBLUgxdNG%2FFPrA%2Bf%2BzquAGdKcWI0zme61Zw%3D#reader-link

  5. Correction: Agreed N’, yet as Soros’ explains the process of created expansion [I meant credit expansion]

  6. John

    Intervention and control by government is heresy to capitalists who demand less than what is currently controlled.

    It never ceases to amaze me the number of people who want the government to get out of the F***ing road and let me run my business, who are the same ones that scream the loudest for government intervention when things collapse. Or expect less taxes to be paid yet the government must be responsible for and pay for everything in society.

  7. Shane

    Lol I agree.

    This must have really hurt. It’s the old story, ‘we knew the would end some day but not the way it has, so suddenly and ferociously, we simply were not ready’

    Ex-bank chiefs sorry for crisis
    http://www.news.com.au/dailytelegraph/story/0,22049,25038873-5014099,00.html
    THE former heads of two of Britain’s biggest banks have offered their “profound” apologies for their role in the nation’s financial crisis.
    The four bankers who used to run Royal Bank of Scotland (RBS) and HBOS – both of which have needed to be bailed out by the British Government – also conceded the industry’s controversial practice of paying out massive bonuses to executives needed urgent changes.

  8. John

    Almost all the CEO thieves are gone, retiring last or this year being replaced by another set until the vote of shareholders is the decision on wages for CEOs and the Board things will not change. the board decides wages and who on the board is going to vote down a wage rise for themselves. Never seen it done yet in private company.

    It also amazes me that right wing extremists insist it is all the fault of Bill Clinton and one lousy bill.

    For Gods sake if that was correct then the only eceonomy that should be suffering world wide is the USA.

    Any blind idiot can see what is truly to blame “GREED”

    Greed is not isolated to Right or Left. Difference is the Right want a few wealthy to won everything and have surf employees. The Left want the Government to own everything and have surf employees.

    The only way to stop “GREED” is legislation to protect the vulnerable, which we had until the Reagan and Thatcher eras of extremem capitalist which changed our sociteties from capitalist with a social conscience to capitalist with absoultely no social conscience.

    Somewhere in the middle is the correct mix of ownership and control. This is where the government comes into play. To ensure government is not corrupted there need to be a few things implemented.

    1) Donations to all political parties must cease immediately.
    2) All gifts , favours, and any incentive from anyone or business must cease immediately.
    3) All politicians wherether they are part of a party or not should vote on their conscience and how their constituencywould expect them to vote. After all they represent their area which may have individual needs and requirements.
    4) All major changes to our country, including the sale of assets previously owned by all of us should be put to a referendum.
    5) I agree governments need to make hard decisions, however many of their hard decisions are hidden in closets until they are elected, and once rushed through are very difficult to unwind. This is why the need for a referendum, voting them out at the next election may not permit the unwinding of something the public were against ( EG GST )
    6) Lobby groups may only meet those who are involved in their actual industry and not be referred by backdoor politicians to their mates in the relative industry.

  9. Shane

    I find it a little amazing that Stevens has sat on the sidelines for so long.

    Use rates to curb booms: RBA governor Glenn Stevens
    http://www.theaustralian.news.com.au/business/story/0,28124,25038134-5018001,00.html
    INTEREST rates should be used not only to control inflation but also to prevent future share and house price booms from getting out of control, Reserve Bank governor Glenn Stevens said last night.

    Mr Stevens said the regulatory response to the world financial crisis should respect the role of risk-taking.

    “We need policies that can be effective on the assumption that private financial systems are periodically prone to irrational exuberance, but without being predicated on the fallacious assumption that regulators will always know best,” he said.

    Addressing a banking conference in Malaysia yesterday, Mr Stevens said there should not be a “retreat to the financial repression of the 1940s and 1950s”; rather there should be greater distrust of debt and a more sceptical view of financial innovations.

  10. Just on another tangent for a minute John.

    regarding donations for the bushfire appeal which are amazing. I find the following interesting.

    A person on $50,000 donating $500 is donating 1% of their total yearly gross income.

    The CBA donating $1,000,000 while it seems a large amount is donating 0.03% of their total yearly profit.

    Despite looking like large amounts, it once again shows how stingy big business really is.

  11. Shane

    That’s an excellent point $1,000, 000 sounds impressive to the average person until you actually do the sums. Bankers really need to start having a really good look at themselves.

    Also,

    “The only way to stop “GREED” is legislation to protect the vulnerable, which we had until the Reagan and Thatcher eras of extremem capitalist which changed our sociteties from capitalist with a social conscience to capitalist with absoultely no social conscience.”

    I sincerely believe as well, that this is exactly what occurred.

    More openness, transparency and honesty within government ? Well thought out Shane!

    “Somewhere in the middle is the correct mix of ownership and control. This is where the government comes into play. To ensure government is not corrupted there need to be a few things implemented.

    1) Donations to all political parties must cease immediately.
    2) All gifts , favours, and any incentive from anyone or business must cease immediately.
    3) All politicians wherether they are part of a party or not should vote on their conscience and how their constituency would expect them to vote. After all they represent their area which may have individual needs and requirements.
    4) All major changes to our country, including the sale of assets previously owned by all of us should be put to a referendum.
    5) I agree governments need to make hard decisions, however many of their hard decisions are hidden in closets until they are elected, and once rushed through are very difficult to unwind. This is why the need for a referendum, voting them out at the next election may not permit the unwinding of something the public were against ( EG GST )
    6) Lobby groups may only meet those who are involved in their actual industry and not be referred by backdoor politicians to their mates in the relative industry.”

  12. John

    I forgot another one.

    The states are all part of Australia and as such they may not undercut each other regarding discounts and tax breaks to businesses to lure them form another state.

    My reason is simple. In the US this is now a cancer on income for all of the states. Big business are getting tax free status for 3 or 4 years in one state. About 12 months before the tax free status ends they contact other states and see who offers the best bargain for the next 3 or 4 years and simply shut up their business in their current state and move for another 4 years.

    The original state loses any prospect of getting any return for their citizens and it is their citizens taxes that have subsidised a profit making orgy of immense proportions.

    This has been happening in the USA for over 30 years now and is a cancer spreading resulting in ordinary rate payers subsidising the wallets of management and the shareholders of companies. It was reported in Time Magazine a number of years ago and blew my mind. I cannot seem to locate the story on their website but am searching hard.

    John I hope you viewed the last link regarding Wal Mart I posted yesterday, a story filmed in 2004 very interesting indeed.

  13. John

    CBA has announced 9% increase in net profit. So $1,000.000 donation is now only 0.02% of net profit for the year.

  14. Shane

    “The states are all part of Australia and as such they may not undercut each other regarding discounts and tax breaks to businesses to lure them form another state.

    My reason is simple. In the US this is now a cancer on income for all of the states. Big business are getting tax free status for 3 or 4 years in one state. About 12 months before the tax free status ends they contact other states and see who offers the best bargain for the next 3 or 4 years and simply shut up their business in their current state and move for another 4 years.

    The original state loses any prospect of getting any return for their citizens and it is their citizens taxes that have subsidised a profit making orgy of immense proportions.

    This has been happening in the USA for over 30 years now and is a cancer spreading resulting in ordinary rate payers subsidising the wallets of management and the shareholders of companies. It was reported in Time Magazine a number of years ago and blew my mind. I cannot seem to locate the story on their website but am searching hard”

    “Perhaps the greatest threat to capitalism is the unholy alliance between government and business” says George Soros. Is this not the most stupid set-up you’ve ever come across? F%$k it’s got to rank right up there.

    Cancer or cannibalism are both apt descriptions of the utter folly!

  15. John I hope you viewed the last link regarding Wal Mart I posted yesterday, a story filmed in 2004 very interesting indeed.

    Can you post the link again here Shane?

  16. John

    The story regarding the states and the income lost in the hundreds of billions over the years should be mandatory educational material showing the lengths and manipulation of business.

    Here is the Wal Mart link. Click on the top righ hand side where it says “watch the full programme online”.

    An amazing story in 5 parts. takes a while to watch but had me amazed and what tactics are being used.

    http://www.pbs.org/wgbh/pages/frontline/shows/walmart/

  17. Thanks Shane, I’ll put aside some time and have a good look.

    Cheers

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