In the two decades since his death, Hyman Minsky’s stature has grown enormously. He foresaw the great financial crisis of 2007-2009, and economists routinely refer to “Minsky moments” as the tipping point when seemingly stable financial markets collapse with catastrophic consequences. It’s instructive to speculate on how Minsky would view our post-crisis economic recovery, and a new book allows us to do just that.
Although Minsky emerged from the liberal political tradition, he was deeply respected by capitalists and right-leaning economists. Minsky, who lived from 1919 until 1996, promulgated the “financial instability hypothesis” that shows how, paradoxically, the root cause of instability is stability. He synthesized ideas from many walks of economic life: the Chicago School’s love of data and methodology; a careful study of money, banking and the financial system; and the development of policies for alleviating poverty.[1] Almost every topic on which he wrote is relevant to today’s challenges.
In Why Minsky Matters, his student and acolyte, L. Randall Wray -- a professor of economics at the University of Missouri–Kansas City and senior scholar at the Levy Economics Institute of Bard College, where Minsky did much of his work -- provides readers with an indispensable guide to Minsky’s thought.[2] Commendably, Why Minsky Matters is written for the educated amateur. It is not a technical economics book. Wray’s language is crisp and lucid. Almost everyone with a strong interest in investing, the financial system or economic policy will both benefit from reading it and enjoy the experience.
Minsky was brilliant and farseeing, and his insights cut across the political and tribal boundaries that characterize modern economics; most of them are well outside the box that liberal thought now occupies. We would do well to study, and in some cases implement, Minsky’s recommendations for a more stable and fairer financial system. But policies based on a superficial understanding of his work can lead to economic paralysis, a topic to which I’ll return.
The financial instability hypothesis
Minsky is best known for his financial instability hypothesis. He says that the root cause of financial instability is stability. What does this mean? Investors, accustomed to stability and good times, start to take greater risks as lesser ones begin to produce disappointing returns. They find it hard to believe that, in such a benign environment, these greater risks might not pay off – despite financial theory that tells them greater return must be accompanied by greater uncertainty.
And for a while, they are right. The reward from increased risk-taking spurs investors on to even riskier behavior. Profits abound, stock prices rise, credit spreads shrink… until the “Minsky moment” when, catalyzed by an unforeseen bad event, the whole process begins to reverse, at first “gradually and then suddenly” (as Hemingway’s character Mike Campbell said when asked how he went bankrupt).[3]
Sound familiar? If the global financial crisis of 2008 had a prophet, it was Minsky, who formulated the instability hypothesis as early as 1960, in the middle of the postwar boom when it seemed as though the curse of the Great Depression and its precursors had been lifted forever.[4]
The instability hypothesis is so self-evidently correct that I am surprised it isn’t part of the ancient lore of finance. I suspect that a careful study of the history of ideas in finance would turn up examples of the hypothesis in literature much older than Minsky’s.
Not everything Minsky said or did was brilliant. He famously grouped financing schemes into three categories, “hedge” (where the cash flow from a project is sufficient to pay down principal as well as cover interest), “speculative” (cash flow sufficient to pay interest but not principal), and “Ponzi” (cash flow so meager that the debtor needs to borrow just to cover interest).
But this triage – hedge better than speculative better than Ponzi – has no real content. While the accounting split between principal and interest is clear, the economic split is essentially arbitrary; how do we inflate the principal? By the CPI? By the rate of appreciation or depreciation of the asset being financed? Not at all? Moreover, while a true Ponzi scheme involves no investment at all, with the operator paying old “investors” with the funds raised from new ones, what Minsky calls Ponzi financing is just a negative-cash-flow deal, which real estate investors undertake as a standard practice during periods of inflation, usually with profitable results.
Insights into money and banking
Minsky had an idiosyncratic view of what banks do. (You’d think that this would be one of the basics on which all economists agree, but it isn’t.) Most people, including most bankers and economics professors, think that banks accept deposits and then lend out the money that has been deposited. Minsky turned this concept on its head, claiming, “[A] bank first lends or invests and then ‘finds’ the cash to cover whatever cash drains arise.” He also said that banks create money through book entries, whereas most economists believe that only central banks can create money.
As Wray boasts, Minsky’s view of banks “has the advantage of being correct.” What can we learn from it?
If banks acquire assets and pay for them by issuing liabilities, then they are just like any other business unit and can be understood that way: “We can analyze any economic unit (firm, household, or government) as if it were a bank that issues liabilities and takes positions in assets,” Wray writes. And Minsky persistently advised his students to “discipline your analysis with balance sheets.”
In other words, as Wray suggests, “Every economic unit…has a balance sheet and if we begin with assets, liabilities, and net worth of each, we have a better chance of getting the analysis correct.” Many finance professors recommend this approach, which is typically shunned by non-finance economists, journalists and amateurs trying to understand the economic environment. Fortunately, investment professionals are usually comfortable with balance sheets, even if they spend too little time actually studying them.
Banks, Minsky argues, create money in the same sense that anyone can create money. If you write “IOU” on a piece of paper, that’s an attempt at creating money; the trick is in getting it accepted. IOUs of the Treasury and Fed are universally accepted. Money-market fund (MMF) shares also trade as money, but have less “moneyness” than currency; the MMF “buck” has occasionally been broken.[5] A bank’s book entries increasing someone’s available balance (when they take out a loan) are likewise money. And, while most people’s IOUs are not likely to be acceptable as money, an IOU from Bill Gates would be.
This view of money is profoundly Chicagoan, and is the correct way to understand money creation. Minsky’s insights in this regard are particularly valuable because they explain the actions and risks of non-bank banks, including not only money market funds but also hedge funds and broker-dealers.[6] If one applies the balance-sheet principle (understand the balance sheet and everything becomes much clearer), non-bank banks can be understood like any other business: they acquire assets that they expect to be profitable, they finance these acquisitions by issuing liabilities and they create money in the process.
During the global financial crisis, non-bank (“shadow”) banks put the financial system at risk because the money they created was less acceptable as settlement for debts than Treasury- and Fed-created money but was treated as if it were just as good. When the lessened acceptability of money issued by non-bank banks became obvious, the financial system nearly collapsed and would have collapsed if not for the government’s emergency injection of liquidity. We can thank Minsky for the clarity with which this process can now be understood and perhaps prevented in the future.
The alleviation of poverty
Minsky would have loved to participate in today’s debate on inequality although, unlike some on the left, he was intensely focused on poverty and only indirectly concerned with inequality. He “opposed Aid to Families with Dependent Children…as well as the Food Stamp program. Instead, he advocated removing barriers to work.” He favored programs that would foster “labor force attachment.” Wray recalls, “To me, he sounded a bit like then-President Reagan, who argued for work, not handouts.”
What does this mean? Was Minsky a crypto-libertarian, believing that removing barriers to work, such as minimum wages and labor regulations, would achieve a social optimum? No. An admirer of Franklin Roosevelt’s Works Progress Administration and kindred programs, Minsky thought that persistent unemployment could only be remedied by having the government itself hire people whom private enterprise would not rationally hire, and that marketable skills and a work ethic could be built that way. He particularly favored government jobs programs for low-skilled African Americans.
There is something to be said for such direct government involvement in the labor market. The present system of intricate regulation and expensive mandates has fostered a seemingly permanent high level of unemployment when one counts discouraged and part-time workers; the labor participation rate has been plunging. The so-called War on Poverty, which Minsky disdained as a “conservative” response to the allegation that capitalism generates “poverty in the midst of plenty,” produced a distinctively un-conservative result: a large population dependent on government.
In contrast, Roosevelt’s programs – while not immediately successful in ending the Great Depression – ushered in a generation of low unemployment and high labor-force participation that many Americans now look upon with nostalgia. Policymakers of any political stripe should consider the possibility that Minsky’s cures for poverty are better than the complex and ineffective ones we now have.[7]
The global financial crisis and “money manager capitalism”
Minsky’s work first became popular outside the academy when the PIMCO executive Paul McCulley, who had a wide audience among sophisticated investors, told his readers that Minsky had warned of a crisis unfolding (he did not say when) along the lines of the giant bank run and margin call that took place in 2007-2009.[8] The possibility, or perhaps inevitability, of such a “Minsky moment” – McCulley’s term, not Minsky’s – was Minsky’s most visible contribution.
I’ve already noted the explanatory power of the financial instability hypothesis for the various bubbles and crashes of the late 1990s and early 2000s, culminating in the 2007-2009 meltdown. But there is more to the story. Minsky noted that “growing instability would be encouraged if financial crisis were resolved by swift government intervention.”[9]
In other words, Minsky explicitly recognized the moral hazard involved in the government assisting failing businesses and financial institutions; he did not favor phony stabilization through escalating bailouts. There is no way to know what Minsky, who died in 1996, would have wanted to do to resolve the global financial crisis, but Wray hazards a series of guesses, mostly focusing on ways of averting financial-institution insolvencies. He speculates,
One thing we can be sure of is that Minsky would not have advocated trying to “reboot” money manager capitalism by bailing out the biggest banks and the practices that had brought on the [crisis].
And, as Minsky might have forecast, after a relatively short time we now observe a repeat of some of the same conditions that preceded the crisis – rising real estate prices, high multiples for stocks and too-big-to-fail banks.
While Minsky enthusiastically supported big government as a general force for good, his awareness of moral hazard made him cautious when it came to bailouts. Thus, it is not clear that Minsky would have wanted a stronger government response to the financial crisis, only a cleverer and more nuanced one.
Is growth in assets under management a hazard?
But there’s a side of Minsky’s critique of modern finance that I find wrongheaded. Wray writes,
[T]he ugly side of money manager capitalism…was…the growth of financial assets under management. [These are]… equal to the financial liabilities of somebody…. At the Levy Institute, we believed that the private sector debt load would become too great, causing borrowing and spending to fall. Then the economy would slip into recession… forc[ing] defaults on some of the debt. [T]hat would set off a severe financial crisis… By 2007, the U.S. ratio of total debt to GDP reached…500%, or five dollars of debt to service using each dollar of income.
Well, sure. Debt defaults did precipitate the 2008 crash. But Wray’s statement, presumably reflecting Minsky’s view, is way too broad; growth in assets managed by investment management firms should generally be considered good for three reasons. One, much of the growth represents an increase in individual savings, which is desperately needed if people are going to be able to retire in comfort. Two, some of the growth comes from an increase in “financialization” or public trading of formerly private or government holdings; such an increase in liquidity is generally desirable. Three, much of the growth in assets under management reflects increases in equity prices, which – at least to some extent – reflect increases in underlying real economic values.
How did Minsky get this wrong? He focuses on the fact that any asset is someone else’s liability, but that statement has economic meaning primarily for debt assets. Equity assets are indeed offset by a liability, but that liability is “owner’s equity” representing an obligation from the equity issuer (corporation) to its shareholders. This obligation is not debt and does not have to be serviced.[10]
Thus, if assets under management increase either because new equities have been issued or because equity prices have risen, there has not been a corresponding increase in liabilities other than owner’s equity.
Considering that Minsky devoted special attention to balance sheets and the importance of understanding accounting identities, this oversight is disappointing. And, while we should be careful of excessive levels of debt for exactly the reasons Minsky described, we do not need to be as wary of “financialization” as he was.[11] As noted earlier, financialization is just a rise in the proportion of real economic assets that are represented by liquid financial instruments, rather than by illiquid private holdings or government holdings. All other things equal, more liquidity is good.
To sum up, an increase in assets under management and, particularly, in the market capitalization of publicly traded equities represents one of the successes of the financial system, not one of its shortcomings.
Should Minsky’s recommendations be implemented?
The last chapters of Wray’s book set forth his recommendations for stabilizing the economic system. Minsky regarded capitalism as suffering from not just the two flaws usually identified by its critics – “chronic unemployment and excessive inequality” – but also inherent instability, as manifested by his financial instability hypothesis. Minsky’s proposals for stabilizing the economy were not particularly radical, but policymakers should be wary of them anyway. Thinkers with many good small ideas often also contemplate big ones – and therein lies trouble because big changes for the better are almost always accompanied by unforeseen or unintended consequences, most of them for the worse. Minsky, with his proposals to stabilize the whole economy, is no exception to this rule of human nature.
To limit instability, Minsky argued that “ceilings and floors” should be imposed on various types of economic activity. He then wisely cautioned that these could be self-defeating:
However, to the extent that the constraints successfully achieve some semblance of stability, that will change behavior in such a manner that the ceiling will be breached in an unsustainable speculative euphoria. If the inevitable crash is cushioned by the institutional floors, the risky behavior that caused the boom will be rewarded. Another boom will build, and its crash will again test the safety net. Over time, the crises become increasingly frequent and severe until finally “it” (a great depression with a debt deflation) becomes possible.[12]
This last risk can, of course, only be mitigated by more ceilings and floors – there being few other tools at the regulating authority’s disposal. If this discussion seems lofty and general, it is; Minsky often spoke in such generalities, although his scholarly work is more detailed and specific.
Taking account of the cost of stability
We should, of course, welcome additional stability if it comes at little or no cost, but that is not the situation at hand. We know that Minsky understood the cost of instability, but did he have a full appreciation of the cost of stability? The French economist Frédéric Bastiat, more than a century before Minsky, wrote eloquently about “what can be seen and what cannot be seen”: while the benefits of a policy are often obvious, the costs are more typically invisible, and those paying the cost may be unwilling to do so or unaware that they are doing so. This may be the case with the intentional moderation of financial and economic instability.
What good does instability do? Let’s start by examining stability. If a factory is built, it’s because its builder believes the output is needed every year for decades, not just next year. Otherwise the bank would not lend, the equity holders would not invest and the entrepreneur would not build. So the long-term discipline imposed by markets is the underlying source of stability.
But nothing is stable forever. Over time, usually a long time but occasionally a very short one, the factory’s output becomes obsolete, unneeded or too expensive relative to alternatives. Should the factory be required to stay in business, consuming either the owner’s capital or public funds? Or should the builder of the factory have been stopped from building it, out of fear that the obsolescence would come sooner rather than later?
Almost all economists would say no to both questions. Yet actions to promote economic stability would tend to keep the factory running when the resources needed to do so – including labor as well as capital – would be better deployed elsewhere. Markets are an effective means of making sure that redeployment happens to the long-run benefit of almost everyone. (Social safety nets are needed to keep the human costs of such difficult long-run adjustments from becoming so large that the adjustments are not undertaken.)
Governments tend to do the opposite because elected officials act to maximize votes. They therefore preserve the status quo for short-run benefit, sacrificing the long-run greater good. We could wish it otherwise, but the evidence is overwhelming that governments make poor long-run capital allocation decisions. And government is the instrument by which Minsky and his followers propose to stabilize, or modulate, market outcomes – understandably so, since government is the only alternative to markets as a source of decision-making authority.
Can we foster creative destruction while protecting the vulnerable?
No matter how good the intentions, then, an artificially stabilized economy cannot easily benefit from what the great Austrian economist Joseph Schumpeter called “creative destruction.” Minsky, a careful student of things as they are, seemed to understand the need to destroy in order to create. For example, Wray writes, “Minsky always argued that one of the good things about great depressions accompanied by deep financial crises is that they ‘cleanse’ the system of debt and risky practices,” although he did not welcome such events because of the human cost.
If that cost can be moderated by protecting the most vulnerable, maybe it is better just to live with the instability that naturally accompanies capitalism. Creative destruction, which gives us our “sunrise” (i.e., emerging technology) industries, is instability. Without the ability of firms in sunset industries to fail, lay off workers and cause investors to lose their shirts, we would not free up the resources that the sunrise firms need in order to grow and thrive. And without the risk-loving and destabilizing behavior of venture capitalists and their clients at endowment funds, foundations and family offices, we would have a lot less new technology.
Long-run economic growth can be visualized as travel up a slope. Taking out the bumps in the road does not necessarily mean that the smoothed ride will be at the same slope. As Minsky acknowledged, the bumps or down periods have a purpose; the fast growth you typically get when you're not in a recession or depression is partly the result of the recession’s cleansing effects. I fear that the stabilized path favored by Minsky and his followers is too gently sloped to ever produce real riches.
Larry Siegel is the Gary P. Brinson Director of Research for the CFA Research Foundation. He is a member of the editorial boards of The Journal of Portfolio Management and The Journal of Investing and serves on the board of directors and program committee of the Q Group.
[1] By the Chicago School, I mean the school of economic thought that flourished at the University of Chicago and at other institutions under its influence from about 1930 onwards; I do not mean the University of Chicago economics department per se. According to Kaufman (2010), the School incorporates “a deep commitment to rigorous scholarship and open academic debate, an uncompromising belief in the usefulness and insight of neoclassical price theory, and a normative position that favors and promotes economic liberalism and free markets.” I differ from Kaufman slightly in placing greater emphasis on a special respect for empiricism and the need for data and theory to work together, and less emphasis on the political aspects (because many Chicago School figures had or have political views that do not fit the mold). Kaufman, Bruce. 2010. “Chicago and the Development of Twentieth-Century Labor Economics,” in Ross B. Emmett, ed., The Elgar Companion to the Chicago School of Economics, Cheltenham, UK: Edward Elgar.
[2] Full disclosure: I am the former director of research in the investment division of the Ford Foundation, which provides the Levy Institute with one of its principal sources of support.
[3] Hemingway, Ernest, The Sun Also Rises (1926).
[5] Breaking the buck is industry jargon for a money-market fund share trading at less than its par value of $1.00. Typically, if the net asset value (NAV) of a money-market fund falls below $1.00, the fund operator puts its own capital into the fund to bring the NAV back up to $1.00.
[6] After the global financial crisis, most broker-dealers were reconstituted as regular banks.
[7] Note that Minsky also “rejected…demand stimulus policies” that have been pursued in the name of Keynesian economics. Minsky was anything but a typical Keynesian.
[8] McCulley’s coinage of the phrase “Minsky moment” was in 1998 and referred to the Russian financial crisis. McCulley and others later applied it to the global financial crisis of 2007-2009.
[10] While some equity issuers “service” the issuance by paying dividends, dividends are voluntary (shareholders of non-dividend-paying stocks can create homemade “dividends” by selling shares).
[11] “Financialization” is a popular term (used by many of Minsky’s Levy Institute colleagues) for what Minsky himself called “money manager capitalism.”
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