by From Lars Syll American economist Hyman Minsky described capitalism as a “two price” system. On one side are asset prices—both financial, like government or corporate bonds, and physical like residential or commercial property. On the other, there are consumer prices—goods and services that determine current output and consumer price inflation. In the contemporary global economy, asset prices are much more sensitive to interest rate adjustments than consumer prices. The present value of assets is determined by expected flows of future returns, which are in turn estimated using today’s interest rates: a five-year bond that pays a fixed 2 percent rate of interest would sell at a lower price than it was purchased for following interest rate hikes. In this way, the prices of fixed income
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from Lars Syll
American economist Hyman Minsky described capitalism as a “two price” system. On one side are asset prices—both financial, like government or corporate bonds, and physical like residential or commercial property. On the other, there are consumer prices—goods and services that determine current output and consumer price inflation.
In the contemporary global economy, asset prices are much more sensitive to interest rate adjustments than consumer prices. The present value of assets is determined by expected flows of future returns, which are in turn estimated using today’s interest rates: a five-year bond that pays a fixed 2 percent rate of interest would sell at a lower price than it was purchased for following interest rate hikes. In this way, the prices of fixed income assets and market interest rates are inversely related: tighter monetary policy necessarily results in lower asset values …
The recent turmoil in financial markets has shown that the main tool central banks use to try to achieve price stability can destabilize the financial system. Monetary policy makers need to recognize that capitalist economies have two price systems which need different medicines. To marry modern-day price and financial stability requires greater coordination between fiscal, monetary, and wider industrial policy. Some examples of this could be seen in the response to the Covid-19 pandemic, where policies created fiscal space for massive investment in health care and the maintenance of jobs, and liquidity to support particular sectors. This more imaginative policymaking now needs to be scaled up to meet the multiple crises facing today’s world.
As all students of economics know, time is limited. Given that, there have to be better ways to optimize its utilization than spending hours and hours working through or constructing irrelevant economic models. I rather recommend my students allocate some time to study great forerunners like Keynes and Minsky, helping them to construct better and more relevant economic models — models that really help us to explain and understand reality.
It is actually remarkable that representatives of the mainstream economic theory seem to not want to learn from history and are now again helpless in the face of today’s bloodbath on stock markets around the world. Especially the experiences of the Great Depression during the interwar period should otherwise be instructive.
The fact that the mainstream economic theory was helpless when it broke out in the late 1920s was perhaps not so surprising when you look at how the established theory of the time looked. The central assumption was that supply created its own demand. If investments were too large relative to demand, interest rates were raised and people demanded loan funds less and saved more. Interest rates were seen as a sensitive instrument with which one could achieve equilibrium between investment and savings.
As the development of the 1920s would show, production in a modern economy cannot be regarded as given. When prices began to fall, employment and production also fell. The orthodox economists interpreted this as a result of wages being sluggish. If only wage flexibility could be increased, unemployment would disappear and production would increase. Based on a purely microeconomic analysis of individuals’ rational choice behaviour, it was concluded that involuntary unemployment was not possible if wages fell fast enough.
When the depression hit the industrial world of the 1930s, the orthodox theory proved to be of little help in getting out of the situation. John Maynard Keynes saw the need to develop a new theory that broke with established truth. In The General Theory of Employment, Interest and Money (1936), he presented his alternative.
Keynes’ attack on the orthodox theory primarily focused on its monetary theoretical foundation. According to Keynes, people kept liquid funds both because they had a motive to keep a certain payment readiness and because they could partly have a motive to speculate. If the interest rate was at a low level and was expected to rise in the future, there were usually good economic reasons to have high liquidity preference and “save in the mattress.”
For Keynes, the uncertainty of the future and the incompleteness of knowledge are indispensable conditions for real choice behaviour and the significance of time. And this is also where the decisive importance of money comes in. If we do not know what the future holds, we try in different ways to hedge ourselves and perhaps postpone decisions. If we are unsure about the return on a hypothetical investment, we may choose to keep our funds in liquid form — money — and postpone the investment decision to the future when uncertainty may have decreased. Choosing to hold assets in monetary form is the same as postponing decisions that are perceived as too uncertain today to a hopefully less uncertain future. Instead of making a wrong investment today, we hope to make a profitable investment tomorrow. And in the meantime, we keep our money or earn interest on it in the bank. This creates increased freedom for the individual, but unfortunately also increases economic risks, primarily at the societal level.
Uncertainty has a double impact on investments. Directly, by making the investor less inclined to invest in an uncertain project, and indirectly, by raising interest rates and thereby reducing investments. For Keynes, the cases where uncertainty is high are most interesting because this uncertainty normally reduces investment activity and thereby contributes to the worsening of the employment problem. In such situations, investors often choose to hold their assets in the form of money. Our tendency to hold money functions as a kind of gauge of how much trust we have in our future expectations. The more uncertain we feel, the higher premium we require to part with our money. The interest rate is a measure of how large this premium is. The liquidity preference that individuals usually have fundamentally depends on the uncertainty in future interest rate developments and must be compensated for in some way if we are to abstain from it.
Investment decisions primarily depend on the relationship between the marginal productivity of capital and the interest rate. If the interest rate is higher than the expected future return on invested capital, one refrain from investing. The problem with investments is that they are sensitive to the business world’s expectations and future assessments and that changes in these can very quickly neutralize the effects of any interest rate changes. It is therefore not certain that an expansion of the money supply with subsequent interest rate reduction leads to increased investment. The state must therefore take a more active part in creating a greater effective demand that can create employment and prosperity.
Keynes’ analysis shows forcefully that orthodox economists’ monetary policy is far too blunt an instrument to address the economy’s more fundamental systemic flaws and cyclical problems. What is worse — when the liquidity trap strikes again during a recession, no interest rate cuts help. Even if monetary policy were to result in a lower interest rate, the business world’s pessimistic future expectations could very well neutralize its effects. To emerge from recessions and economic depressions, sharper and more effective instruments are needed. Active fiscal policy is needed if mass unemployment is not to risk leading to a completely uncontrollable development.
If we look at the crisis that the global economy run into in 2008, we see that the overall pattern is the same as in other crises. For some reason, a shift (war, innovation, new rules, etc.) occurs in the economic cycle, which leads to changes in banks’ and companies’ profit opportunities. Demand and prices rise, and more and more parts of the economy are caught up in a kind of euphoria. Speculation becomes rampant, whether it’s about tulip bulbs, real estate, or mortgages. Eventually, someone sells to take out their profits, and a rush for liquidity sets in. It’s time to get off the carousel and convert securities and other assets into cash. A financial emergency arises and spreads. Prices begin to fall, bankruptcies increase, and the crisis accelerates and turns into panic. To prevent the final crash, credit is tightened, and people start calling for a lender who can ultimately guarantee the availability of the demanded cash and restore confidence. If this fails, the crash is a fact.
Perhaps the foremost financial crisis theorist of our time, Hyman Minsky, had as his main idea in his work that crises are endogenous (system-internal) phenomena where stability creates instability and reduced safety margins for financial transactions with too high leverage effects. During the upswing phase of financial bubbles, safety margins decrease, and even the smallest setback can lead to expectations not being met and force companies and investors to revise their plans to be able to meet their cash flow commitments. The result may be that assets have to be sold, contributing to a debt deflation process with increasingly larger real debt burdens and problems solving liquidity problems through asset disposals.
According to Minsky, these were inevitable processes. “Stability creates instability” even without euphoria and excessive optimism. During the upswing phase, banks’ lending practices are confirmed and even validate riskier projects. In accordance with the cascade of information theory, we get a logic where what was initially perceived as risky ends up being experienced as completely risk-free. The banks become more and more confident.
Securitization has meant that traditional credit ratings have been replaced by ratings performed by rating agencies without first-hand knowledge of the borrowers. This is based on a kind of stochastic assessment where, instead of relying on the credit history of each individual borrower, the borrowers are viewed as random realizations of a “representative” borrower with risks that follow a normal distribution curve with a given mean and variation. However, if real borrowers do not exhibit the degree of homogeneity that such a statistical approach is based on, the shortcomings of the model become apparent. When the risk turns out to be “fat-tailed”, the intention to reduce and distribute the risks is turned on its head. The problem is that this is not really evident until the crisis is in full bloom and the “representative” borrower is hanging by a thread. Assets that banks have tried to move off-balance sheets through securitization reappear when the institutions they have created off-balance sheets are forced to seek help to solve acute liquidity problems.
The crisis showed how systematically inadequate credit ratings are in today’s financial system. One of the fundamental reasons is that those who take the risks are no longer responsible for evaluating borrowers’ ability to bear their costs. The instruments that are said by the financial market’s own representatives to be created to distribute risk optimally among different actors cannot fulfil their task when there is no credible mechanism for assessing risks. Not even in capitalism’s flagship, the financial markets, can genuine economic uncertainty be reduced to manageable stochastic risks (stochastic processes are like the ones we have when we flip a coin and we know with certainty that the outcomes are either heads or tails and where randomness means that in repeated coin flips we have an equal chance of getting heads as tails). If securities and other assets are priced based on risks estimated with assumptions that apply to stochastic normal distribution models, these prices can never be better than the model assumptions they are based on. In normal times, they may provide decent approximations, but when bubbles grow and the future definitely does not look like history (in statistical terms, economies are not ergodic systems, where processes remain unchanged over time), the result is spelt crisis.
Crises stem from a financial system that systematically undervalues risks and overvalues creditworthiness. The financial instability that Minsky claimed permeates financial markets cannot be completely eliminated. However, we can ensure the implementation of regulations and institutions that minimize the damage.
Conventional theory struggles to explain financial crises. Often, the explanation is that it results from reckless speculation by irrational “noise traders.” In reality, the cause is that we do not have perfect information about the future, and it is precisely future expectations that drive the financial market. Speculation is about trying to anticipate how these future expectations will manifest themselves in the market. This is difficult to do — market psychology is hard to grasp — and often leads to rapid swings in the market and herd-like behaviour, where expectations of what other speculators expect to play a greater role than economic fundamentals. Crises are fundamentally endogenous, not exogenous (information failures, irrationality, etc.). Financial crises are not anomalies but rather a highly possible and expected part of a genuinely uncertain economic world.
The main lesson that financial crisis theory and historical experience teach us is that recurring financial crises are part of the essence of our economic system. They are not just a series of coincidences and misjudgments. They are a consequence of the deeper underlying and long-term instabilities that characterize the financial system itself and are a source of economic instability and crises.
So, what can we do to minimize the risk of future crises and prevent the economy from completely grinding to a halt? The neoliberal era has reached its end. What is needed now is enlightened action based on a relevant and realistic economic theory of the kind that Keynes and Minsky represent.
The imminent danger is that we won’t get consumption and lending going. Confidence and effective demand must be restored. And I believe we must realize that we cannot both have our cake and eat it too. As long as we have an economy with unregulated financial markets, we will also be subject to periodically recurring crises. That does not mean that we should just sit with our arms crossed and wait for the storm to pass. A Keynesian tax on the financial market, stricter regulations, and increased transparency can actively contribute to reducing the risks of costly financial system crises in the long run. However, if we reflexively refuse to see the extent of the problems, we will once again be powerless when the next crisis looms.
One of the fundamental misconceptions in today’s crisis discussion is that one does not distinguish between debt and debt. Even though at the macro level it is necessary that debts and assets balance each other out, it is not insignificant who has the assets and who has the debts.
In mainstream economics, crisis resolution is often presented as if a monetary policy change — such as a raised interest rate — would be sufficient. But that’s not the case. Tightening would lead to lower wages which in turn would make the real debt burden higher and, in fact, worsen the economic situation.
As a young research stipendiate in the U.S. forty years ago, yours truly had the great pleasure and privilege of having Hyman Minsky as a teacher.
He was a great inspiration at the time.
He still is.