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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)

 


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Thu, 11/04/2010 - 13:14 | Link to Comment OnTheWaterfront
OnTheWaterfront's picture

Austerity Bitchez

Thu, 11/04/2010 - 13:43 | Link to Comment theXman
theXman's picture

END THE FED

Thu, 11/04/2010 - 14:33 | Link to Comment Chris Jusset
Chris Jusset's picture

END THE FED NOW

Thu, 11/04/2010 - 17:20 | Link to Comment Mako
Mako's picture

Ending the Fed will do nothing... the present system will collapse and then liquidate.  Lemmings will then start the same system back up.

The article is stupid and that is not the cause of the crisis. 

No amount of regulation or enforcement is going to change the Truth... Math... a system is unable to expand exponentially growth forever.... you can get about 6-8 decades then collapse and liquidation of the Lemmings.

 

Thu, 11/04/2010 - 19:16 | Link to Comment tip e. canoe
tip e. canoe's picture

Like previous games in the Lemmings series, the object of the game is to guide the lemmings characters to an exit by giving them specific skills.

The storyline of Lemmings Revolution revolves around Weasel characters that once entertained themselves by watching the old adventures of the lemmings. Wanting more, they have captured the lemmings and created new puzzles and mazes, so they can watch the lemmings as they suffer trying to survive the puzzles.

http://en.wikipedia.org/wiki/Lemmings_Revolution

Thu, 11/04/2010 - 13:14 | Link to Comment SilverIsKing
SilverIsKing's picture

And when the dollar bubble bursts, it will forever be referred to as the "Bernanke Nanosecond."

Thu, 11/04/2010 - 13:18 | Link to Comment hugolp
hugolp's picture

Regulations have increased since the 50's. I dont understand what this guy is talking about.

Also, I like Minsky. He seems like an honest thinker, which is something you can not say about all the economists, but he only looked at aggregates and did not check the relation and coordination between the different parts of the markets. That was a big mistake on his part and lead him to wrong conclussions.

Thu, 11/04/2010 - 14:35 | Link to Comment Ripped Chunk
Ripped Chunk's picture

Take another look.

In addition, regulation is only effective if there is enforcement.

Thu, 11/04/2010 - 14:43 | Link to Comment hugolp
hugolp's picture


Take another look.

No, seriously. The amount of regulations in the USA have grown exponentially in the USA specially since the 50's. In the 2000 there have been more regulations than in the 90's, in the 90's more than in the 80's and (contrary to popular believe) in the 80's there were as well more regulations than in the 70's, and you could keep going. Just check the data.

Where is this legend about reduced regulation coming from? Its false.

In addition, regulation is only effective if there is enforcement.

Well, but that is what regulations are for, to benefit the big industries and save them from competition. The more you regulate the more corporatist the regime becomes.

Thu, 11/04/2010 - 14:51 | Link to Comment tip e. canoe
tip e. canoe's picture

excellent point

Thu, 11/04/2010 - 16:34 | Link to Comment Ripped Chunk
Ripped Chunk's picture

That is a good way of looking at it. Increasing the barriers of market entry for competitors while simultanously having the regulations that cost you profit relaxed.

Fri, 11/05/2010 - 08:35 | Link to Comment fallst
fallst's picture

Try googling...." Regulatory Capture", Einstein..

Thu, 11/04/2010 - 21:34 | Link to Comment midtowng
midtowng's picture

Regulations haven't increased for the financial industry. They've been cut dramatically since the 50's.

Thu, 11/04/2010 - 13:19 | Link to Comment Spalding_Smailes
Thu, 11/04/2010 - 13:23 | Link to Comment israhole
israhole's picture

Hyman?

Thu, 11/04/2010 - 13:21 | Link to Comment Something Wicke...
Something Wicked This Way Comes's picture

I am gonna be one austere sumbitch. I think I'm turning Japanese. I really think so.

Thu, 11/04/2010 - 13:27 | Link to Comment Logans_Run
Logans_Run's picture

I believe I am too but I think that is because I have been taking things into my own hands a little too much while attempting to calm my nerves from these market moves.

Thu, 11/04/2010 - 13:23 | Link to Comment AR
AR's picture

Thank you Professor for your opinions and ideas, they are well taken. As self professed "old timers" in this business, survivors, and successful, two lines copied below caught our eye:

The firstWhere it will all end is unknown but a complete collapse of the financial system is not out of the question.

The secondHow this will all turn-out I do not know, but another crash and even deeper downturn seems likely.

We sincerely agree with your well-read, and experienced point of view in this regard.  Funny closing thought, as a kid, our father taught us to always listen carefully to what a man had to say when he left under the doorstep of your house...for it is then, that one often shares his most profound ideas. The closing thoughts of your last couple of paragraphs caught our attention (repeated shown above). Good luck to you.

 

Thu, 11/04/2010 - 13:27 | Link to Comment michael.suede
michael.suede's picture

He's inverting cause and effect.

I don't find his explanations attractive at all.

In fact, he doesn't even really offer explanations. 

The ROOT CAUSE of WHY the financial industry was able to get away with the fraud can be pinned solely on the cartelization of banking in the form of the Federal Reserve system and the fact that Federal Reserve Notes were forced upon the public as legal tender.

This allowed the Fed to inflate and manipulate rates, which ultimately lead to the cheap money which enabled the fraud to begin with.

In a free market, when fraud is discovered it is punished swiftly and immediately.  It can not continue once the market determines a particular financial institution is acting in a fraudulent manner.  Only through the coercive intervention of the State in the form of imposed monies and cartels can it continue unabated.

The CAUSE of the .dot com bubble was indeed fraud, but it was the fraud of State created artificial interest rates and monopoly money that enabled the whole thing in the first place.

 

 

Thu, 11/04/2010 - 13:36 | Link to Comment Something Wicke...
Something Wicked This Way Comes's picture

Totally agree. I talk about the political end quite a bit. Kinda glad Tyler doesn't.

Fuckers. http://thecivillibertarian.blogspot.com/

Thu, 11/04/2010 - 14:00 | Link to Comment Baron Robber
Baron Robber's picture

You are incorrect. The fed is not the state, it is a private institution, a criminal cabal really. but it is not the state. Eliminate the  fed and you eliminate half the problem, break up the criminal oligopoly for the second half.

Thu, 11/04/2010 - 14:57 | Link to Comment tip e. canoe
tip e. canoe's picture

respectfully disagree sir baron, the FED is the essence of corporatism as defined by Il Duce - the merging of the state and corporate interests.

Thu, 11/04/2010 - 15:22 | Link to Comment Common_Cents22
Common_Cents22's picture

The FED might as well be the state.  It is so intertwined and powerfully influential.  

Thu, 11/04/2010 - 16:00 | Link to Comment Bearster
Bearster's picture

+3 in 1990 dollars

+3,000,000,000 in Bernanke Money

Thu, 11/04/2010 - 13:28 | Link to Comment gwar5
gwar5's picture

A little timely austerity would have been nice, but now it's too late for poor ol' Danny Bailey and, I agree with the professor, more pain ahead on the road to serfdom.

Thu, 11/04/2010 - 13:33 | Link to Comment gwar5
gwar5's picture

A little timely austerity would have been nice, but now it's too late for poor ol' Danny Bailey and, I agree with the professor, more pain ahead on the road to serfdom.

Thu, 11/04/2010 - 13:36 | Link to Comment spartan117
spartan117's picture

Ok, don't bail out the banks.  Let's see depositors try and withdraw their savings from all the failed banks in this country.  Forget your Minsky melt-up.  We'll have Mad Max Melt Down instead.  Pick your poison.

Thu, 11/04/2010 - 14:01 | Link to Comment Baron Robber
Baron Robber's picture

hopefully you will be downsized from JPM soon.

Thu, 11/04/2010 - 14:47 | Link to Comment Lucius Corneliu...
Lucius Cornelius Sulla's picture

My guess is that you will see a secessionist movement as part of the end game.  States will basically just say F-off to the USG once their is nothing left.  Empires usually end that way.  Chunks just start falling away, starting at the periphery.

Thu, 11/04/2010 - 13:36 | Link to Comment Rainman
Rainman's picture

"Once accounting fraud is underway, there is a strong incentive to engage in even more audacious fraud to cover the previous crimes ".

Excellent. Right out of the embezzler's reference manual.

Like Visa, this truth is accepted everywhere.

Thu, 11/04/2010 - 14:32 | Link to Comment Ripped Chunk
Ripped Chunk's picture

The defenition of a Ponzi scheme.

Thu, 11/04/2010 - 13:59 | Link to Comment theXman
theXman's picture

Great article! Incisive analysis.

Thu, 11/04/2010 - 14:24 | Link to Comment Ripped Chunk
Ripped Chunk's picture

Let's get Bill Black a private merc force and go after the fraudsters.

Thu, 11/04/2010 - 14:41 | Link to Comment DB Cooper
DB Cooper's picture

I can't see how pumping stock markets and killing the dollar will lead to borrowing by individuals or corporations.  I think most can see the short term nature of the pump and you might as well trade it - but who wants to commit long-term (thru debt) to this charade.  Enjoy the ride for now but the last one left in the market when it goes off the tracks is in for quite a surprise.  Only question in my mind is when that will be?  I'm usually way too early on my trades which can be costly. 3 months, 6 months, 1 year?  I can't see it being more than that - my guess 6 months.

Thu, 11/04/2010 - 14:56 | Link to Comment RecoveringDebtJunkie
RecoveringDebtJunkie's picture

Arguably, the economy has been going from robust to fragile for more than a century now. Perhaps speculative finance is a natural outgrowth of productive finance, which itself is a natural outgrowth of capitalism.

http://peakcomplexity.blogspot.com/2010/09/complexity-manifesto.html

 

Thu, 11/04/2010 - 15:19 | Link to Comment Lux Fiat
Lux Fiat's picture

Have been reading Minsky's "Stabilizing an Unstable Economy" as snippets of time allow.  While published in 1986 and looking back at the post WWII era up to that point, it could have been been written yesterday. 

"In light of recent experience, when the difficulties encountered by giant corporations and financial institutions are central to the instability that plague 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."  My translation - axe TBTF.

"Effective reforms must be consistent with the processes of the economy and not violate the character of the people.  Without an understanding of the economic process, and without a passionate, even irrational commitment to democratic ideals, an agenda for change, in response to a perceived need for change, can become the instrument of demagogues who play on fears and frustrations and offer panaceas and empty slogans."  Can become?  How about "has become".

Thu, 11/04/2010 - 15:54 | Link to Comment Joe Davola
Joe Davola's picture

I don't disagree with your points, but aren't all slogans empty?

Thu, 11/04/2010 - 17:48 | Link to Comment Lux Fiat
Lux Fiat's picture

Like many a corporate (or personal) mission statement, most are honored in the breach.  However, in rare cases, there are some that are followed, but only the passage of time reveals them.

Thu, 11/04/2010 - 17:52 | Link to Comment AUD
AUD's picture

"The choice of banks' assets is a directing factor in the allocation of capital between long-and short-term uses. A liquid structure tends to give preference to 'labor intensive' industry, as against the one with larger fixed capital requirements per unit of labor, and ceteris paribus, to a commercial enterprise rather than to an industrial one. The preference for providing circulating capital also tends to strengthen the medium-sized business as against the mammoth concern which in turn is favored by an illiquid system."

Melchior Palyi, 1936

Thu, 11/04/2010 - 21:31 | Link to Comment Lux Fiat
Lux Fiat's picture

A lot of timeless observations came out of that period.  Same can probably be said for periods following earlier global calamities.  As the quote from one movie goes, "And some things that should not have been forgotten were [for all practical purposes] lost.

Thu, 11/04/2010 - 18:59 | Link to Comment M.B. Drapier
M.B. Drapier's picture

For anyone who's missed it, L. Randall Wray and William K. Black (yes!) are currently blogging together on HuffPo.

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