I’ve just taken an unplanned 5 month break from the blog! There was no logic to this, it wasn’t a good place to stop, and now I just need to pick up from where I left off. This section has been looking at some of the main trends in financial markets in this century, drawing in particular on the empirical work of Zoltan Pozsar on the concentration of wealth in institutional cash pools, and also at Quantitative Easing and the manipulation of stock prices by companies through share buybacks. All this leads to the conclusion that financial markets are not at all “efficient”, as economists claim, but in reality are highly dysfunctional and unstable.
Over the last two posts I examined a fundamental characteristic of these markets – that they are based around participants predictions of future economic performance, and hence the uncertainty that businesses face about the future. In the last post I explained the difference between uncertainty (when you just don’t know what will happen) and risk (when you can mathematically calculate the actual probability of an event). And this is where we start this week…
… Because Hyman Minsky understood this difference. He built up his understanding of the economy from the recognition that while entrepreneurs might be making informed and even insightful judgements about future markets, demand, and profitability of products, ultimately such judgements are simply their best guesses.
Judgements about future profits are of course informed by the current condition of the economy and observable trends. When the economy is growing and there is a general mood of positivity, this is liable to make entrepreneurs feel more confident. And if entrepreneurs are investing, the flow of money around the economy caused by this expenditure will itself stimulate the economy, making that confidence a self-fulfilling prophecy.
But over time, some judgements by entrepreneurs will prove to have been over-optimistic. Some businesses will fail. The effect here is not just the loss of income of those employed in the business and the subsequent fall in demand in the economy, nor is it even the impact on the confidence of other entrepreneurs when they see businesses failing, but the impact on financial markets. When a business fails its creditors lose money, and this will impact their attitude to risk with respect to their other debtors.
Minsky recognised that periods of economic growth will lead to over-optimistic predictions about future profitability. When these predictions fail to come to true, the economy will falter, and financial assets will not provide the expected returns. This will have real impacts in slowing down the flow of wealth in the economy, but in addition will stimulate a more pessimistic view of the future leading to a slow down in investment.
This is Minsky’s now-famous “financial instability hypothesis”. Financial markets are inherently unstable, as they are driven by the predictions human beings make about the future, predictions that are clearly not going to be perfect in the vast majority of cases, and will on occasions certainly be catastrophically wrong. Over-optimism will push the market up, and when the inevitable downturn comes, markets will react with excessive pessimism causing them to freeze.
Minsky also understood that credit is essential to business activity (a foundational concept of this blog, explained in an early post), and that hence finance is at the heart of the capitalist system. Mainstream economic theory, on the other hand, tends to ignore financial markets (the standard models of national economies used before the last crash did not include finance at all).
Minsky identified 3 types of finance. The first he called “hedge financing”: the firm borrows to fund investment expenditure, and repays the debt out of the increased profits. This is how the layperson might assume financial markets work (hopefully you realise this is not the case if you have been following the blog). The second is “speculative financing”: firms anticipate using their earnings to pay the interest, but rely on being able to take out further debt when the principal becomes due (known as “rolling-over” the debt). The most unstable form of finance he called “ponzi financing”: the borrower does not even have the cashflow to repay the interest, they are solely relying on the value of the asset rising to be able to meet their liabilities.
You can easily see how in booming markets those trading will come to expect that asset prices will continue to rise, and will confidently depend on these rises to fund their borrowing (ponzi financing). When the inevitable crash comes, they are left either bankrupt or needing to renegotiate the terms of their debt. In either case, the real impact is the knock on effect through the economy as lenders are not repaid, and so have less to lend on and less confidence to lend.
But even speculative financing can have dramatic impacts when the downturn hits. If lenders are no longer confident to lend, they won’t roll-over the debts. This is exactly what happened in the last crash, as described here and here.
This is a gross over-simplification of Minsky’s theory. I cannot possibly do it justice in a short blog post, and I don’t want to give the impression that I have. But I feel this is adequate as a broad-brush summary, and, of course, it is also a broad-brush summary of the great financial crisis of 2007/08.
Because Minsky was right.
The precision with which Minsky’s work describes exactly our current economy leaves me awestruck. It is no coincidence that two of the most insightful economists of the present day (Perry Mehrling and Steve Keen) are both heavily influenced by Minsky.
And yet he was derided and ignored by the economics profession in his own lifetime. An article in The Economist in 2016 acknowledges that up until 2007 Minsky had only been mentioned once in its pages, but since the crash was mentioned 30 times. The phrase “Minsky moment” (first coined by Paul McCulley to describe the Russian crash in 1998) has now become part of economics jargon. Yet at the time of the crash some of his books were out of print!
Minsky gives us a framework to understand the impact of uncertainty (rather than risk, as described in the previous post) on financial markets, a framework that perfectly describes the behaviour of the economy since his death.
It should, therefore, be a good guide to understanding how to reform financial markets if we want to create an economy that provides enough for everyone. The model shows us that unregulated free markets will inevitably become unstable, and that asset prices will diverge wildly from their fundamental value, a constant theme of this blog. This is exactly what has happened in current markets, as shown by the empirical work of Pozsar, in particular in his paper with di Iasio, described here.
But as I discussed 2 posts ago, when discussion reaches such conclusions many people will howl in protest that governments cannot make all these decisions – one institution cannot manage all this complexity. But we do not face such a simple dichotomy. Minsky was not advocating for command economies – he believed in free enterprise – but finance needs to be managed and coordinated. There is a role for government in this process.
So what should this role be? What would Minsky do? To quote Mehrling:
“…Minsky took the lesson that capitalism could be stable if, first, large-scale capital investment were owned and financed publicly rather than privately and, second, smaller scale private business were financed with equity rather than debt.”
Ultimately, there is no simple answer to the question of how to do this, and to think there would be is fatuous. We need to learn as a society how official bodies can effectively manage and coordinate markets. At present, we are assuming they have no role, and are not learning anything. We need to stop putting things in simplistic boxes – public ownership vs private enterprise. Next week I am going to look more carefully at what “public ownership” might mean, to give you a new perspective on what public ownership of large-scale investment could look like.