By Frank Shostak*
The instability of the financial markets brought back the ideas of the post-Keynesian economist of the school of economics (PK) Hyman Minsky. Minsky argued that the capitalist economy is inherently unstable, culminating in severe economic crisis, with the accumulation of debt being the key mechanism pushing the economy into crisis.
During “good” times, according to Minsky, companies in profitable sectors of the economy are well rewarded for increasing their debt levels. The more you borrow, the more profit you seem to make. Rising profits attract other entrepreneurs to join them and encourage them to increase their level of debt.
As the economy is doing well and the financial health of borrowers is showing visible improvement, this makes lenders more willing to lend. Over time, however, the rate of debt accumulation begins to increase much faster than the borrower’s ability to repay and service the debt. At this point, the foundations for an economic collapse are set in motion.
Minsky distinguishes three types of borrowers. The first type, it labels hedge borrowers who can meet all debt payments from cash flow. The second type is that of speculative borrowers who can only meet interest payments, but must constantly roll over their debt in order to be able to repay their initial loans.
The third group of borrowers that Minsky refers to as Ponzi borrowers who cannot repay either the interest or the original loan. These borrowers rely on the appreciation in the value of their assets to refinance their debt.
This framework includes what Minsky calls the Financial Instability Hypothesis (FIH). According to the FIH, the financial structure of a capitalist economy becomes increasingly fragile in times of prosperity. The longer the prosperity, the more fragile the system becomes. According to Minsky:
In particular, over an extended period of good times, capitalist economies tend to move from a financial structure dominated by speculative finance units to one in which units engaged in speculative and Ponzi finance carry significant weight. .
Another aspect of FIH is that during good times, banks and other intermediaries, through sophisticated innovations, attempt to induce investors to buy debt. Minsky called them “debt dealers.” The hunt for profits causes investors in the financial markets to put their money into various investments with little substance.
However, once economic conditions change the true state of borrowers, a crisis begins. Lenders reduce their supply of funds and borrowers are pushed into bankruptcy because they cannot renew their loan to pay their debts – a financial crisis emerges.
According to Minsky, over time, borrowers and lenders tend to become reckless, leading to financial crisis. However, why should this be so?
Does credit expansion lead to instability?
Note that lent savings are the key to economic expansion, as they finance the production of tools and machines, which then enables the expansion of final goods. This increase, in turn, allows for a further increase in savings which can then support the building up of a more sophisticated structure of production.
The introduction of money does not change the situation. Through money, individuals can channel savings, allowing the process of wealth generation to expand. Whenever an individual lends money, the borrower through the money can obtain final consumer goods that will sustain him while he is engaged in the production of various goods and services.
Credit expansion due to increased savings is good for the economy. This credit, entirely backed by savings, is the agent of economic growth. Note that fully secured credit expansion does not result in natural tendencies, as Minsky suggests, for good times to be a precursor to bad times. Contrary to Minsky, the accumulation of capital makes the economy more robust and less vulnerable.
Unsecured credit and economic instability
However, problems arise when the savings are not enough to finance the loans. The borrower who holds the money empties, so to speak, the exchange for final consumer goods, drawing from the pool of savings without any further savings having taken place, all other things being equal. The true producers of wealth who have contributed to the pool of final consumer goods – the savings pool – will find that the money in their possession will provide them with a smaller number of final goods.
The reason is that the borrowers have consumed part of the final goods. There is a diversion of wealth (final consumer goods) from wealth-generating activities to holders of money, who have emerged “out of nothing”.”
As the pace of unsecured credit increases relative to the supply of savings, less becomes available to true wealth generators. Therefore, with less savings, less wealth can now be generated. In the extreme case, if everyone were content to consume without contributing to the savings pool, there would ultimately be nothing left to consume.
Free market economy and unsecured credit expansion
In a free market economy, intermediaries such as banks will find it difficult to extend unsecured credit, as banks are likely to have difficulty honoring their checks due to unsecured lending by savings. The threat of bankruptcy would likely deter banks from continuing to expand unsecured credit.
Therefore, there is no inherent tendency in the capitalist economy to generate unsecured credit that will destabilize the economy. In the modern capitalist economy, what allows banks to engage in the reckless expansion of credit that makes the capitalist system unstable is the existence of the central bank.
By using monetary expansion policies, the central bank allows banks to expand unsecured credit. So, if Bank A is $50 short, it can sell some of its assets to the central bank for cash, thus preventing Bank A from being “caught”. Bank A can also secure the $50 by borrowing it from the central bank. Where does the central bank get the money? He generates it from “thin air”.
The modern banking system can be considered as a huge monopoly bank guided and coordinated by the central bank. Banks in this framework can be considered as branches of the central bank. By means of monetary injections, the central bank ensures that the banking system is “sufficiently liquid” so that the banks do not put each other out of business.
While Minsky’s framework describes current financial market volatility, it does not provide a satisfactory explanation based on previously established and identified phenomena. Therefore, Minsky describes but does not explain. He arbitrarily blames the instability on the capitalist economy without establishing any verification for this assertion.
Unlike Minsky, we conclude that there is nothing wrong with capitalism. To avoid the threat of boom and bust cycles, the loopholes responsible for creating money out of “thin air” must be closed.
It is not, argue Minsky and post-Keynesians. On the contrary, they argue that any attempt to return to a true laissez-faire free market economy is a prescription for economic disaster.
This answer is not surprising, since Minsky accepted in advance that capitalism is unstable and therefore never questioned its premise. For Minsky, the only way to fix supposedly unstable capitalism is through greater doses of government and central bank interference in the economy.
Contrary to post-Keynesians and Minsky, the existence of the central bank makes the current capitalist framework unstable. Moreover, it is not credit expansion as such that leads to instability, but credit expansion “out of thin air”.
It is through unsecured credit that savings are diverted from productive to unproductive activities, which then weakens the process of wealth expansion. The instability identified by Minsky has nothing to do with capitalism but rather with the central bank preventing the efficient functioning of capitalism.
*About the author: Frank Shostak’s consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact email.
Source: This article was published by the MISES Institute