Guest Post: A Minskian Explanation Of The Causes Of The Current Crisis

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Submited by L. Randall Wray, Courtesy of Benzinga

A Minskian Explanation of the Causes of the Current Crisis

In recent weeks, the explanation for the financial and economic
crisis that has gripped the world economy has shifted sharply from
deregulation and lack of governmental oversight of financial
institutions to fraud and criminal activity. In truth, the US Federal
Bureau of Investigation began to warn of an “epidemic” of mortgage fraud
back in 2004, and my colleague Bill Black has been pointing to the role
played by fraud since the crisis began. (See our recent two part series
at www.huffingtonpost.com.)
To be sure, there was ample fraud in the “pump-and-dump” schemes during
the dot-com bubble at the end of the 1990s, which was closely followed
by the commodities market speculative boom and bust. (See my article at http://www.levyinstitute.org/publications/?docid=1094.
) And before those episodes we had in quick succession the developing
country debt crisis of the early 1980s, the US Saving and Loan fiasco of
mid 1980s (with bank crises in many other nations), the Japanese
meltdown and the Asian crisis, the Mexican peso crisis, Long Term
Capital Management and Russian default, and the Enron affair.

Seemingly, the crises have become more frequent and increasingly
severe until almost the whole world was infected. It is obvious that
there must be some link among these crises and that while fraud played a
role in most or even all of them, it is not sufficient to lay blame on
“bad apples”, bad policy, insufficient foresight, and outright
stupidity. We must find a more comprehensive explanation.

When the crisis began in the US in 2007, many commentators called it a
“Minsky moment” or even “Minsky crisis”, after the late economist Hyman
Minsky who had developed what he called a “financial instability
hypothesis” over the years after 1960 and to his death in 1996. Minsky
was my PhD dissertation advisor and I had already used his approach to
analyze the Saving and Loan crisis. Unlike the typical explanation that
invokes Minsky's theories, I recognized that Minsky did not simply
provide a “euphoric bubble” approach. Rather he argued that the
transformation of the economy and especially its financial system from
“robust” toward “fragility” took place over a very long span of time,
indeed, over the entire postwar period. The increasingly frequent and
severe crises, as well as the growth of fraud as practically normal
business practice were a consequence of that transformation. Hence, we
should not call this a Minsky moment or crisis but rather a Minsky
half-century.

Much of the world emerged from the Great Depression and World War II
with a combination of institutions, regulations, financial practices,
and memories that together encouraged relatively rapid economic growth,
high employment, growing incomes, and growing confidence in our future.
Private debt was low (mostly wiped out in the bankruptcies of the
1930s), government debt was high (war finance), and the financial system
had been “simplified” (in Minsky's terminology). Big Corporations
mostly used retained profits to finance expenditures; Big Unions kept
wages growing so that workers could spend out of income rather than
relying on debt; Big Government had filled portfolios of banks and
savers with safe government bonds. Finance was kept small, constrained,
and relatively irrelevant. Besides, memories of the Great Depression
discouraged lending as well as borrowing. Strict regulation—especially
in the US—kept risky financial practices segregated outside commercial
banking.

Over time a complex combination of factors changed all that—memories
faded, regulations were relaxed or financial institutions defeated them
with innovations (including new types of instruments and institutions
that took market share away from highly regulated banks). Private debt
grew. Risky practices emerged. Financial crises resumed. However, the
crises were contained by swift intervention of Big Government and the
Big Bank (central bank)—that bailed-out institutions and prevented
recessions from becoming sufficiently severe to eliminate the risky
behavior. Relatively robust growth combined with stronger labor led to
growth of pension funds and other private saving—money that needed to be
invested to get high returns to support a private retirement system.
Clever managers of that money developed increasingly esoteric and
complex ways to make—and to lose—money.

The age of what Minsky called “money manager capitalism” had
arrived—a form that put finance first. And, importantly, this new
capitalism took a global form—a new globalization of finance developed.
Again for complex reasons, the interests of money managers did not
coincide with those of Big Corporations and Big Unions—the “leveraged
buy-out” was used to strip firms of assets, load them with debt, and
bust their unions. Wages stopped growing; consumers relied on debt to
maintain living standards. Globalized finance also helped to globalize
production—with low wage workers in developing nations helping to
depress incomes in developed nations. Thus, “financialization” of the
economies concurrently meant both “globalization” as well as rising
inequality.

The weight of finance moved away from institutions—that were guided
by a culture of developing relations with customers—toward “markets”
(the “originate to distribute” model of securitizing pools of mortgages
is a good example). This virtually eliminated underwriting (assessing
credit worthiness of customers) and also favored the “short view”
(immediate profits) of traders (you are only as good as your last trade)
over the long view of financial institutions that hold loans. In
addition, the philosophy of “maximization of total shareholder returns”
as well as the transition away from partnerships in investment banking
toward public holdings promoted pump and dump schemes to increase the
value of stock options that rewarded CEOs and traders. A “trader
mentality” triumphed, that encouraged practices based on the “zero sum”
approach: in every trade there is a winner and a loser. As practiced,
the bank would be the winner and the customer would be duped.

This transformation helps to explain why fraud became rampant as
normal business practice. Competition among traders and top management
to beat average returns led to ever lower underwriting standards to
increase the volume of trades—with fees booked on each one—and with
strong incentives to “cook the books” (record false accounting profits).
Once accounting fraud is underway, there is a strong incentive to
engage in ever more audacious fraud to cover the previous crimes. In the
end, the US financial system (and perhaps many others) became nothing
but a massive criminal conspiracy to defraud borrowers (through such
instruments as “liar's loans”, NINJAS—no income, no job, no assets, no
problem!—and “no doc” loans) as well as investors in securitized
products (mortgage backed securities, collateralized debt obligations
that were securities of the worst MBSs, and on to CDOs squared and
cubed). All of this led to layering and leveraging of debt on debt and
debt on income. At the peak, US indebtedness was five times national
income—meaning each dollar of income was pre-committed to service five
dollars of debt! This was, of course, impossible. The pyramid of debt
collapsed like a house of cards.

Where are we now? Many governments reacted with fiscal stimulus
packages as well as bail-outs of financial systems. While many have
proclaimed that the worst is behind, by all objective measures, nearing
the end of 2010 the financial system is probably in worse shape than it
was at the end of 2007 when it collapsed. Debt ratios have not come down
appreciably. Defaults and delinquencies are up by huge amounts. In the
US foreclosures have come to a virtual standstill as it has been
recognized that many or perhaps most foreclosures that have taken place
were almost certainly illegal. Holders of securitized products like MBSs
and CDOs have begun to sue banks for fraud, demanding they take them
back. While banks have reported strong earnings, almost all of these
have been in trading activity or have resulted from reducing loss
reserves (ironically, as defaults rise). In other words, none of the
normal bank activity is generating revenue—all profits are accounting
profits where it is easy to “cook the books”. Where it will all end is
unknown but a complete collapse of the financial system is not out of
the question.

This time around, it is not clear that governments will save the
banks--having been burned last time around, voters are not sympathetic.
Especially in the US the feeling is that Main Street's needs have been
ignored while Wall Street has been favored. And in most nations,
government has adopted austerity policies to reduce spending and where
possible to raise taxes. In some countries this appears to be
necessary—such as the so-called “PIIGS” (Portugal, Ireland, Italy,
Greece, Spain) that are heavily indebted with hands tied due to
constraints imposed by the currency union. In others, such as the UK and
the US it is mostly political—a reaction against the bail-outs of
financial institutions. How this will all turn-out I do not know, but
another crash and even deeper downturn seems likely.

L. Randall Wray is a Professor of Economics, University of
Missouri—Kansas City. A student of Hyman Minsky, his research focuses on
monetary and fiscal policy as well as unemployment and job creation. He
writes a weekly column for Benzinga every Tuesday.

He also blogs at New Economic Perspectives, and is a BrainTruster
at New Deal 2.0. He is a senior scholar at the Levy Economics
Institute, and has been a visiting professor at the University of Rome
(La Sapienza), UNAM (Mexico City), University of Paris (South), and the
University of Bologna (Italy)