Minsky’s most famous aphorism — “Stability – or tranquility – in a world with a cyclical past and capitalist financial institutions is destabilising” (Minsky, 1982, p. 101) — sums up the crux of his understanding of the transformation undergone by the American economy over the post war period. The bulk of Minsky’s work was produced throughout the 1970s and 1980s, at a time when mainstream economics’ understanding of the business cycle emphasised endogenous stability and exogenous shocks. Contrastingly, Minsky’s basic thesis was concerned with capitalist financial systems’ natural predilection for instability and the ever-present risk of the recurrence of a major financial crisis. The endogenous dynamics of any capitalist economy, set out in Minsky’s interpretation of the business cycle, are explosive and inherently disequilibrating. In order to contain the inevitable instability, action is required by institutional ceilings and floors, or so-called “thwarting systems,” which Ferri and Minsky defined as institutions able to “constrain the outcomes of capitalist market processes to viable or acceptable outcomes” (1991).
This chapter will begin by providing a short overview of the FIH and the Minskyan business cycle. The second part of the chapter will examine Minsky’s understanding of the aforementioned institutional ceilings and floors, and the role he ascribed to Big Government and the lender of last resort in containing financial instability.
The FIH and the Minskyan Business Cycle
Writing his landmark The Financial Instability Hypothesis: An Interpretation of Keynes and an Alternative to “Standard” Theory in 1977, Minsky surveyed the American economy’s postwar journey, of which the first twenty years had been characterised by financial tranquility. Contrastingly, the decade since 1966 signalled a return to the financial instability which had plagued the economy before World War II: the 1966 credit crunch; the 1970 failure of the Penn-Central Railroad, which instigated a run on the commercial paper market; and, finally, the recession of 1974-5, resulting from the speculative activities of large banks, such as the failed Franklin National Bank of New York. In light of such episodes, Minsky perceived the tranquility of the first two postwar decades as anomalous; instead, he argued that “since the middle sixties the historic crisis-prone behaviour of an economy with capitalist financial institutions has reasserted itself” (Minsky, 1977, p. 63). Minsky identifies an important distinction between the financial episodes of the pre- and post-war periods: unlike before, between 1966 and 1977, the combination of a much bigger US government sector plus Federal Reserve action made the containment of financial turmoil possible.
The wider context of the new wave of instability is a Keynesian “paper world” characterised by money today exchanged for money in the future, and commitments to pay cash in the future exchanged for cash today. Such a world is conditioned by the cash flows — the gross profits after out-of-pocket costs and taxes — resulting from the income-generating process of economic units such as businesses, households, and governmental bodies (Minsky, 1977, p. 63). Upon establishing the nature of the capitalist financial world, Minsky borrows heavily from Keynes’ investment theory, describing gross profits as preponderantly determined by investment. In doing so, he arrives at this neat conclusion: “The behaviour of our economy depends upon the pace of investment” (Minsky, 1977, p. 65). To unpack this: gross profits are determined by investment; in turn, they determine the valuation of capital assets and the ability to fulfil contractual commitments. Additionally, current investment and financing possibilities critically depend upon valuation and, respectively, the ability to fulfil commitments. Therefore, it follows that expectations of future investment — and whether it will proffer sufficient cash flows to cover the repayment or refinancing of debts issued today — will be crucial in determining the ability to debt finance new investment. Moreover, investment simultaneously determines aggregate demand and the viability of debt structures (Minsky, 1977, p. 65). The combination of the impact of investment and expectations of future investment plus the what Minsky correctly identifies as the highly subjective nature of such expectations makes any economy with private debt highly vulnerable to the ebb and flow of the pace of investment. The importance of expectations is made evident by economic behaviour at times when the economy is doing well: during good times, financiers and businessmen’s perceptions of acceptable debt amounts and structures change; debt financing is viewed more favourably and thereby increases exponentially. In turn, this increase increases both valuation of capital assets and investment. This process effectively gives rise to a boom economy. However, it is inconsistent with stable growth. The crux of Minsky’s opinion here is that “the fundamental instability of a capitalist economy is upward” (Minsky, 1977, p. 66). In other words, the fundamental destabilising factor of a capitalist economy is its tendency to convert a good economic period into a speculative investment boom.
Against this backdrop, Minsky introduces the keystone of his FIH: his categorisation of hedge, speculative, and Ponzi financial positions. The evolution of financing arrangements from hedge to speculative and then to Ponzi represents Minsky’s take on the business cycle. Hedge finance is the starting point: a financial unit — be it business organisation, household, or government body — is expected to derive sufficient cash flows from its operations in order to cover repayment of its debts. In a speculative position, while the present value of the financial unit’s cash receipts exceeds the value of its payment commitments on debts, its cash flows are not expected to cover the commitments (Minsky, 1977, p. 66). As a result, speculative units are to raise funds through new debts in order to meet their commitments. Minsky recognises that speculative positions are only made viable by the successful functioning of the economy, and that the continual refinancing that their very existence depends upon is conditioned by the normal functioning of financial markets. Finally, there is Ponzi finance, whereby only increasing the amount of debt outstanding ensures the unit meets its cash payments commitments on debt (Minsky, 1977, p. 67). Minsky concludes that the lifespan of Ponzi units is limited. Once revealed to financiers, the weakness of Ponzi units’ financial position affects the willingness of financiers to debt finance such units. The inevitable results of a reluctance to finance are a quickly-spreading decline in profits and inability to sustain high debt ratios, ultimately leading to a contagious panic.
The FIH as summarised above charts the endogenously-driven evolution of unstable financial structures of a capitalist economy. The investment-led nature and speculative behaviour of financial units over a boom period are conducive to panic and, ultimately, crisis. When, as a result of the endogenous processes summarised above, financial crisis becomes a real possibility, the economy can be brought back from the brink by a combination of Federal Reserve intervention and huge, demand- and profit-sustaining government deficits. These institutional ceilings and floors will be addressed in the following section.
Institutional Ceilings and Floors
After developing the FIH in 1977 as a response to the 1966, 1970, and 1974-5 episodes of financial turbulence, Minsky returned to the issue in his 1986 Stabilising an Unstable Economy. This time, he pays specific attention to the two aspects of the American economy identified as central to the prevention of deep depressions in both the 1974-5 recession and the similar 1981-2 episode. First, derived from the work of Kalecki (1971), is the notion of Big Government: the sheer size of the government sector enables to stabilise employment, income, business cash flows, and asset values. Second, and equally important, is the ability and willingness of the Federal Reserve System (together with cooperating public and private bodies) to act as lender of last resort. Examining the 1974-5 recession (whose causes and chronology will be addressed in more detail in the third chapter of this dissertation), Minsky proffers a dual answer to the question of why a major depression did not occur in 1975: firstly, Big Government was able to run huge deficits, which sustained demand as well as business profits and financial commitments, and supplied much-needed safe and liquid assets to portfolios; secondly, the Federal Reserve System intervened promptly in order to execute refinancings (Minsky, 1986, p. 21).
Big Government
Minsky provides an overview of the size of the US of the government and its components, and identifies four aspects of government spending which make the government “big”: government employment and production, government contracts, transfer payments, and interest on government debt. Of these, Minsky isolates transfer payments and the costs of servicing government debt as the key determinants of the cyclical impact of government spending (Minsky, 1986, p. 21). In this context, a huge government deficit is arrived at by way of a fall in national income. In order to support this argument, Minsky analyses sectoral surpluses and deficits accounting tables (Table 1 and 2 below) during and surrounding the 1974-5 recession to arrive at a relationship between determining (business investment and government spending) and determined (disposable personal income, household personal outlay, etc.) variables. In doing so, he finds that the relations of these variables ensure that a fall in income will lead to a simultaneous increase in takings from government entitlement programs and decrease in government tax receipts (Minsky, 1986, p. 36). As Minsky sees it, it is this combination, together with Big Government discretionary spending and tax changes, that gives rise to the massive government deficit required to stabilise the economy in the event of a panic. The deficit is necessarily matched by a move toward surplus in the business and household sectors. Such a move has two effects: firstly, it augments the business sector’s debt-carrying capacity; secondly, the resulting household saving ratio will induce an autonomous rise in consumer spending. In the absence of Big Government deficit, the compromised debt-carrying capacity of households as well as businesses would lead, in Minsky’s opinion, to “an iterative, downward spiral of income and profits [and eventually] to the debt deflations and deep depressions of the past” (Minsky, 1986, pp. 36-7). In other words, the main function of Big Government in containing financial turmoil is its potential of running large automatic deficits, thereby putting a “high floor” under the economy’s downward spiral. This function becomes especially important in Minsky’s “paper world,” which depends upon the validation of corporate and household debt, the process most threatened by financial crises of the type that Minsky is describing.
ii. Lender of last resort
In halting financial crises, demand- and profit-sustaining Big Government deficit is complemented by the lender-of-last-resort intervention of the Federal Reserve System, aided by the Federal Deposit Insurance Corporation (FDIC) and cooperating private institutions. Both Big Government and the Federal Reserve act primarily as stabilisers: while Big Government deficit impacts output, employment, benefits, and profits, Federal Reserve intervention affects asset values and financial markets; moreover, while Big Government operates on aggregate demand, sectoral surpluses, and increments of government liabilities in portfolios, the Federal Reserve as lender of last resort is concerned with value of the inherited structure of assets and the refinancing available for portfolios (Minsky, 1986, p. 43). To define the concept of lender of last resort more broadly: in acting as a lender of last resort, an institution guarantees the fulfilment of certain contracts, whatever the market conditions or the situation of the debtor in question (Minsky, 1986, p. 47). In doing so, it reduces the risk of default of the assets it guarantees. As low default risks are readily marketable — liquid, that is — it follows that in extending its lender-of-last-resort protection to more assets (of banks or other financial institutions), the Federal Reserve is effectively increasing the overall liquidity and financing capacity of the economy. In simple terms, the Federal Reserve exchanges its own deposits or notes for customers’ deposits of qualified institutions and markets. This process of refinancing prevents the financial unit in need of financing from resorting to selling out positions in financial and real assets, thereby leading to sharp declines in asset values. The financial unit’s situation is arrived at by way of the speculative financing arrangements discussed in the first section of this chapter. In fact, Minsky believes that the lender of last resort’s very raison d’être “follows from an explosive growth of speculative finance and the way in which speculative finance leads to a crisis-prone situation” (Minsky, 1986, p. 59). While most prudent financial units engaging in speculative activities possess backup financing facilities functioning as mini lenders of last resort, the Federal Reserve System functions as the ultimate contingency financing source in the American economy. In sum, whereas Big Government deficit acts as a “high floor” under a downward spiral, the lender of last resort sets floors under asset prices and ceilings on financing terms (Minsky, 1986, p. 48-9).
To Minsky, the promptness of lender-of-last-resort intervention is of utmost importance. It must step in to assure refinancing before financial units — be they banks, ordinary firms, or even government bodies — are forced to resort to extraordinary measures in order to meet the payment commitments on their debt. Unless it does so, it risks the imminence of a debt deflation. Therefore, the need for lender-of-last-resort intervention typically precedes the fall in national income described in the previous section, and before the need for Big Government deficit stabilisation. As Minsky sees it, if the Federal Reserve System plus other institutions fulfilling the lender-of-last-resort role fail to act, allowing market forces to unfold freely, the effects would be dire. Asset values relative to current output prices, investment, debt-financed consumption, income, employment, and profits would all fall significantly further than they would in the event of timely intervention. Such developments, and the debt deflation they signal, may temporarily overwhelm Big Government’s stabilising capacity (Minsky, 1986, p. 44). However, Minsky is of the firm opinion that Big Government is able to single-handedly bring about economic recovery, even in the absence of lender-of-last-resort assistance. However, failure or delay to act by the lender of last resort will result in considerable lost income and collapsing asset values.