As the most severe financial crisis since the 1930s Depression has unfolded over the past eighteen months, the ideas of the late economist Hyman Minsky have suddenly come into fashion. In the summer of 2007, the Wall Street Journal ran a front-page article describing the emerging crisis as the financial market’s “Minsky moment.” His ideas have since been featured in the Financial Times, BusinessWeek and The New Yorker, among many other outlets. Minsky, who spent most of his academic career at Washington University in St. Louis and remained professionally active until his death, in 1996, deserves the recognition. He was his generation’s most insightful analyst of financial markets and the causes of financial crises.
Even so, most mainstream economists have shunned his work because it emerged out of a dissident left Keynesian tradition known in economists’ circles as post-Keynesianism. Minsky’s writings, and the post-Keynesian tradition more generally, are highly critical of free-market capitalism and its defenders in the economics profession–among them Milton Friedman and other Nobel Prize-winning economists who for a generation have claimed to “prove,” usually through elaborate mathematical models, that unregulated markets are inherently rational, stable and fair. For Friedmanites, regulations are harmful most of the time.
Minsky, by contrast, explained throughout his voluminous writings that unregulated markets will always produce instability and crises. He alternately termed his approach “the financial instability hypothesis” and “the Wall Street paradigm.”
For Minsky, the key to understanding financial instability is to trace the shifts that occur in investors’ psychology as the economy moves out of a period of crisis and recession (or depression) and into a phase of rising profits and growth. Coming out of a crisis, investors will tend to be cautious, since many of them will have been clobbered during the just-ended recession. For example, they will hold large cash reserves as a cushion to protect against future crises.
But as the economy emerges from its slump and profits rise, investors’ expectations become increasingly positive. They become eager to pursue risky ideas such as securitized subprime mortgage loans. They also become more willing to let their cash reserves dwindle, since idle cash earns no profits, while purchasing speculative vehicles like subprime mortgage securities that can produce returns of 10 percent or higher.
But these moves also mean that investors are weakening their defenses against the next downturn. This is why, in Minsky’s view, economic upswings, proceeding without regulations, inevitably encourage speculative excesses in which financial bubbles emerge. Minsky explained that in an unregulated environment, the only way to stop bubbles is to let them burst. Financial markets then fall into a crisis, and a recession or depression ensues.
Here we reach one of Minsky’s crucial insights–that financial crises and recessions actually serve a purpose in the operations of a free-market economy, even while they wreak havoc with people’s lives, including those of tens of millions of innocents who never invest a dime on Wall Street. Minsky’s point is that without crises, a free-market economy has no way of discouraging investors’ natural proclivities toward ever greater risks in pursuit of ever higher profits.
However, in the wake of the calamitous Great Depression, Keynesian economists tried to design measures that could supplant financial crises as the system’s “natural” regulator. This was the context in which the post-World War II system of big-government capitalism was created. The package included two basic elements: regulations designed to limit speculation and channel financial resources into socially useful investments, such as single-family housing; and government bailout operations to prevent 1930s-style depressions when crises broke out anyway.
Minsky argues that the system of regulations and the bailout operations were largely successful. That is why from the end of World War II to the mid-1970s, markets here and abroad were much more stable than in any previous historical period. But even during the New Deal years, financial market titans were fighting vehemently to eliminate, or at least defang, the regulations. By the 1970s, almost all politicians–Democrats and Republicans alike–had become compliant. The regulations were initially weakened, then abolished altogether, under the strong guidance of, among others, Federal Reserve chair Alan Greenspan, Republican Senator Phil Gramm and Clinton Treasury Secretary Robert Rubin.
For Minsky, the consequences were predictable. Consider the scorecard over the twenty years before the current disaster: a stock market crash in 1987; the savings-and-loan crisis and bailout in 1989-90; the “emerging markets” crisis of 1997-98–which brought down, among others, Long-Term Capital Management, the super-hedge fund led by two Nobel laureates specializing in finance–and the bursting of the dot-com market bubble in 2001. Each of these crises could easily have produced a 1930s-style collapse in the absence of full-scale government bailout operations.
Here we come to another of Minsky’s major insights–that in the absence of a complementary regulatory system, the effectiveness of bailouts will diminish over time. This is because bailouts, just like financial crises, are double-edged. They prevent depressions, but they also limit the costs to speculators of their financial excesses. As soon as the next economic expansion begins gathering strength, speculators will therefore pursue profit opportunities more or less as they had during the previous cycle. This is the pattern that has brought us to our current situation–a massive global crisis, being countered by an equally massive bailout of thus far limited effectiveness.
Minsky’s Wall Street paradigm did not address all the afflictions of free-market capitalism. In particular, his model neglects the problems that arise from the vast disparities of income, wealth and power that are just as endemic to free-market capitalism as are its tendencies toward financial instability, even though he fully recognized that these problems exist.
Yet Minsky’s approach still provides the most powerful lens for understanding the roots of financial instability and developing an effective regulatory system.
Minsky understood that his advocacy of comprehensive financial regulations made no sense whatsoever within the prevailing professional orthodoxy of free-market cheerleading. In his 1986 magnum opus, Stabilizing an Unstable Economy, he concluded that “the policy failures since the mid-1960s are related to the banality of orthodox economic analysis…. Only an economics that is critical of capitalism can be a guide to successful policy for capitalism.”