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.