This page has been archived and commenting is disabled.
The Unforgettable Lessons of Hyman Minsky
In early September, economist Paul Krugman of The New York Times and Princeton University published a relatively scathing critique of the current state of macroeconomics in America that asked the very simple question: how did so many economists miss the economic and financial tsunami that has still yet to pass. I assume many people have already read the article, so I won’t spend too much time on it. Briefly, after going through a lengthy discussion of the history of modern economics and a detailed account of the events that led up to the current crisis, Krugman argues the following:
Economics, as a field, got in trouble because economists were seduced by the vision of a perfect, frictionless market system. If the profession is to redeem itself, it will have to reconcile itself to a less alluring vision — that of a market economy that has many virtues but that is also shot through with flaws and frictions.
For a value investor like me, the above is nothing more than a statement of the obvious. Humans are irrational creatures. They oscillate between fear and greed with remarkable speed and agility. They buy when they should be selling and run for the exits as a herd when they should be searching for value. Thus, any market that involves humans is going to embody the traits of its constituents. While market rationality and efficiency may influence the asset values over the long run, in the short run anomalies and dislocations can persist long enough for investors who dig for inconsistencies to profit.
While I do appreciate that Krugman subscribes to the view of markets espoused by the proponents of behavioral finance, something about his analysis of what went wrong and where macroeconomics should go from here bothered me a bit. Take a look at the following passages and see if you can anticipate what I thought was missing:
[M]acroeconomics has divided into two great factions: “saltwater” economists (mainly in coastal U.S. universities), who have a more or less Keynesian vision of what recessions are all about; and “freshwater” economists (mainly at inland schools), who consider that vision nonsense.
Freshwater economists are, essentially, neoclassical purists. They believe that all worthwhile economic analysis starts from the premise that people are rational and markets work, a premise violated by the story of the baby-sitting co-op. As they see it, a general lack of sufficient demand isn’t possible, because prices always move to match supply with demand…Where the freshwater economists were purists, saltwater economists were pragmatists. While economists like N. Gregory Mankiw at Harvard, Olivier Blanchard at M.I.T. and David Romer at the University of California, Berkeley, acknowledged that it was hard to reconcile a Keynesian demand-side view of recessions with neoclassical theory, they found the evidence that recessions are, in fact, demand-driven too compelling to reject. So they were willing to deviate from the assumption of perfect markets or perfect rationality, or both, adding enough imperfections to accommodate a more or less Keynesian view of recessions. And in the saltwater view, active policy to fight recessions remained desirable…
Seems like a pretty good description of the rift between the saltwater and freshwater economists. So, what did he leave out? Well, aside from a brief discussion of the views of Joseph Schumpeter during the 1930s and a passing comment on financial instability, his entire analysis ignores the views of the Austrian School of Economics. Unlike John Maynard Keynes (of whom Krugman is a disciple), men like Schumpeter believed that recessions and depressions were necessary evils and were advocates of creative destruction. This tough love mentality understandably did not gain anywhere near as much traction in the 1930s as did the writings of Keynes Accordingly, it is not a surprise that Krugman sees Keynes’ work was so profound that he believes that Keynesian economics is best suited to understand and deal with current recessions:
So here’s what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit — and this will be very hard for the people who giggled and whispered over Keynes — that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they’ll have to do their best to incorporate the realities of finance into macroeconomics.
As stated above, I agree with numbers one and three emphatically. It is number two that I am not so sure about. It is true that Krugman’s interpretation of a Keynesian solution is going to be the most effective? It seems to me that there is an additional framework that at very minimum could supplement Keynes’ lessons. This is a good time to remind everyone that I am not an economist and as such I am not particularly well versed in the nuances of what camp or subcategory people belong in. However, I certainly don’t view economics as black or white, winner take all field. Economics is not physics. My guess is that no one is going to come along and knock Sir Isaac Newton of off his ledge. But, the understanding of markets and human behavior is an evolving process and even people with completely disparate views can have profound insights that add to the current theories. So, from my perspective as an outsider, I couldn’t possibly care less what a person calls himself or herself as long as the ideas and methodology are sound, compelling, and based on actual human nature (rather than relying solely on complex and somewhat dissonant models).
This is where Hyman Minsky comes into the picture. Minsky was influenced by both Schumpeter and Keynes and his views reflect those of both men. (This is potentially why Krugman doesn’t mention Minsky in his article. My guess is that based on some of the remedies Minsky articulated to fight recessions that mirrored those of Keynes, Krugman considers him sort of a fringe Neo-Keynesian.) While Minsky did not make it to see this wonderful economic mess we have created, his warnings about the potential ills of financial markets are as timeless as any other economist’s teachings. Luckily for those of us whose only objective is to understand what the US is facing, (and don’t care about the somewhat petty infighting between economists who clearly let this country down) there was a beautiful piece on Boston.com that provided a comprehensive discussion of what Minsky was all about (Hat tip to Miguel Barbosa, founder of the wonderful and irreplaceable Simoleon Sense):
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 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.
Every time I read those passages something about them resonate with me even more. Not only do they aptly (and maybe even perfectly) describe the mechanism behind the fantastic debt bubble that so unceremoniously popped, but they also offer a valid assessment of the human component of financial instability. Simply, people got euphoric and then became complacent with success. Obviously there are those of us who are never satisfied and always strive to do more. But the majority of people are what Nassim Taleb would describe as Thanksgiving turkeys. Every day that something bad does not happen, even in the face of overwhelming evidence of emerging risk, confirms that there is no imminent danger. Or, just like the turkey that trusts the farmer who keeps him warm and well fed a little more each sequential day until that fateful moment, people believe that the absence of a calamitous event means that such a happening is less likely. Not Minsky though. He saw a black swan coming.
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.
Obviously Minsky was not alone. There were many others sounding an alarm for a number of years and who were summarily ignored. But instead of kicking ourselves for not heeding his advice, maybe we can glean some guidance from him on how to extricate ourselves from the current quagmire and to avoid future blowups:
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.
You can clearly see the influence of Keynes in those proposed solutions. Curiously enough, these policies are almost identical to those that the executive branch and the Fed have put into action. In many ways, this is also similar to what Krugman continues to advocate, at least when it comes to fiscal stimulus. Will it work? Your guess is as good as mine. Although, I have a sinking suspicion that piling on more debt to try to get us out of an over-leveraged conundrum may not be the best strategy in the long run. Having said that, it gives me a modicum of hope that a man like Minsky, who understood the fragility of markets and the vicissitudes of human nature, believed that a Keynesian reaction to a financial crisis was the best path to recovery. Let us all pray that his prescience when it came to instability extends to the dynamic of returning to prosperity.
- advertisements -
actually we still have a great deal more than 10% of our manufacturing left, and plenty of excess capacity. plus we still grow and process a substantial surplus of food.
In my opinion, it is not that economists missed the troubles ahead. In fact, I had heard several of them talking about the issues with real estate and warning of the bubble.
The issue I believe was that nobody was actually paying attention to them when they were raising red flags. Everyone was consumed with their own jobs and could not do much to protect an entire system.
It is the regulators who should have paid attention to them, but nobody apparently did.
time123
To understand what the US is facing. I think we all know deep down inside what the US is facing. The values that made America great---thrift, hard work, innovation and honor were discarded en masse, and replaced by greed, envy, selfishness and indifference. Whether instability is inherent in Capitalism is debatable. The Chinese seem to be very stable as we once were, back when we were a creditor Nation. Yes, our economists have let us down, and our politicians more so. When we chose to become an "Information Based economy", thus outsourcing manufacturing of 90% of what we consume, the die was cast. When we decided that trade imbalances and unbridled National/personal debt was accceptable, we were sowing the seeds of our own economic destruction. No one can predict the future with certainty, but common sense should provide us with a clue.
Schumpeter is not the Austrian economist to consider when examining business cycles.
If you want to understand business cycles from the Austrian perspective read CHAPTER 5 BANK CREDIT EXPANSION AND ITS EFFECTS ON THE ECONOMIC SYSTEM in this book http://mises.org/books/desoto.pdf
Inoculated Investor, hey, I thought this was a great post. President Obama just visited Florida a couple days ago to show off a brand new solar-energy electrical-generating facility. That's what we need. Put the money into rebuilding and modernizing our infrastructure.
When economics takes its rightful place under psychology, rather than physics or engineering, all will be better. Jane Goodall is a better guide to actual human behavior than any of these clowns. IMHO, of course.
Good point! We aren't that far removed from our animal spirits. Take care of number one and prey on the vulnerable. The problem is the US has a big freaking club.
As long as individual countries control their own currencies, they have the power to influence events. Interesting the discussion about a one world currency. Implementation of a one world currency means that no country will be able to control its own events, many will be hung out to dry because they are under control of a small entity controlling world currencies. Each nation is powerless to find a way out of its crisis. See Iceland. What a monstrous and fool-hardy idea, except of course for the banking Oligarchy.
The theories of Keynes,Schumpeter,Mises, M.Friedman, Minksy,like religions, all hold some elements of truth. The trick is to know the single thread that runs through all of them!
Every fragment of modern economics is fundamentally designed in its core to destroy and undermine man's reason; to cannibalise his ability to formulate his conclusions with the observations of his own senses. This economics is the brand of sheer unadulterated lunacy; the brand of a reprobate mind. In former times man was relentlessly bludgeoned into conformity to declare the earth as a flat linear specie when all along his cognition and volition were both screaming at him with no less ferocity to take hold of the reins, ride down on the stirrup and demand whoa.
Are you Ayn Rand writing from beyond the grave? Not to be overly effusive, but I Love your comments!
The first rule of being an Economist in the U.S. is you work for the Fed, or strive to work for the Fed.
Consequently, you slavishly support the whims of the political party of your choosing by rubber-stamping the economic ideas of the party elite and the Fed.
Non-conforming communication is not welcome. Ever.
I quit reading after that.
Actually, I find Minsky's "lessons" to be perfectly forgettable. YMMV.
Couple of questions
What is the effect of massive media advertising pushing us to buy consumer stuff?
What is the effect of massive media advertising promoting financial services?
How different is it now that folks can sell stocks or withdraw savings in seconds, not days, making panics so much more international and quick?
Why are we so much more likely to create massive future liabilities, such as medicare and SS? Why are these debts not more important in the grand scheme?
Isn't it the case that the recession process is potentially ruinous, such as Zimbabwe? How do we avoid such problems for ourselves? Is the Obama administration an example of such a Zimbabwe or Argentina administration?
I used to hope this website was above spewing postkeynsian drivel. Its bad enough with the king of mainstream, "pop economics" blogs like Barry Ritholtz's big picture pump Minsky and that Boston.com article, but ZH.
This old and well recycled web article from Boston.com "Why Capitalism Fails" ...still gets my blood bloiing whenever I see it (and I see it a lot)
“Instability,” he wrote, “is an inherent and inescapable flaw of capitalism.” Get real Minsky - can we have a little bit of intellectual honesty instead of the sham attempt to defend keynsian economics. Central banking and the ponzi fiannce it enables are not exogenous to capitalism, and playing little word ditties about when the FED injects money (before v. after banks create money) to lay causation at the feet of the private sector and exculpate G engineering is simpleminded at best and insulting to any rational and informed mind.
Only through a sophist's crazy tale could be sown the idea that the FED is not the cause, but rather the solution, to the current predicament.
Minsky = intellectually dishonest turdball.
Couldn't agree more..
Minsky is just another iteration of the tired statist dogma that has passed as economics for the past century.
Obvioulsy capitalism seems inherently flawed when you skip over the fact that the Fed entices the ponzi borrowers to the table.
The inherent failure is in central banking, fiat money, fracational reserve banking, et al. Oh and in Keynes, Krugman and Minsky's brains.
Like everything else, I'm sure these roadmaps are "all else equal." Meaning, there is ultimately a universal "speed limit" or, in this case, a debt limit that makes stimulus impossible to implement. (the constraints of finance).
Also, something should be mentioned... that while Minsky and Krugman can acknowledge a collective euphoria among both consumers and economists which ultimately leads to a "Minksy moment," they fail to realize that their proposed solutions are also rooted in the euphoria. (and are naively optimistic).
They fail to apply what really has happened. The Ponzi consumers (TBTF) are merely vehicles used to corral profits into the hands of a few of their principal actors... In other words, while the Ponzi Consumers may come crashing down in the Minsky Moment, the profits from the Ponzi vehicle have already been offloaded, seeing the wall ahead long ago (or, in this case, building the wall themselves). And, whatever future there may be, the Ponzi Profiteers have adequately positioned themselves, again, because they have unique foresight as the principal actors causing the Moment.
As in any Ponzi scheme, there must necessarily be a higher power that brings Mr. Ponzi to justice. If the Ponzi actor and the higher power are one and the same, we have no method of restitution, short of a politically nihilistic holocaust.
You can clearly see the influence of Keynes in those proposed solutions.
To the author, you seem to suggest the 2 paragraphs above the sentence I quoted above are Minsky's proposed solutions. The Boston.com article says that Minsky did not agree with the second Keynes idea (high skilled union jobs for things like high speed rail) as you seem to imply. The next paragraph in the Boston.com article after the last one you cite said that he had a pretty radical of making the government the employer of last resort for everybody who was willing to work for a minimum wage at jobs that added some value to society. The article then goes on to say that unlike most economists, Minsky didn't believe in pat answers or neat solutions.
Nonsense. Freshwater economists' underlying theory is that there is irrational behavior in the markets. The distinction is that they believe that markets are rational -- that the market naturally corrects irrational behavior on its own -- without .Gov
Good post.
Also, a lot of the behavior deemed "irrational" is behavior that only occurs because of some type of state interference or distortion in the market.
When someone takes an unreasonable risk because he knows the government WILL bail him out, it is not a "market failure".
(and actually is quite rational behavior)
not only is keynes a fool and not an economist but a religious charlatan, this whole article posesses the same rickety poppycock that the pied piper of hamlin whistled....
given the shallowness of the article i will not comment on it except to puke and go on along my way...
I don't think ANYTHING written by Paul Krugman is worthy of even reading, much less any kind of analysis or debate. The guy is a complete fool.
Considering he's criticised rent control, minimum wages, farm subsidies, and some Euro labour regulation, yet identifies as he does with the Dems, I'd say he's more an incomplete fool. :-) When he evolves to one-party puppet...then it'll be complete.
I hate to quibble about anything so forcefully and clearly written, but there is a small inaccuracy here -- you have one letter wrong.
It should be "Tool".
The analogy fails for the US, instead of conservative, speculative and Ponzi investors, the US has Ponzi consumers who now have the lender of last resort, the US Treasury, lending to maintain a modest decrease in consumption.
What is the absolute reduction in consumption required to reach equilibrium in the US?