Bill Totten's Weblog

Sunday, April 19, 2009

Minsky's moment

A new appraisal of an economist's theories challenges the blind faith in free markets

by Buttonwood (April 02 2009)

STABLE economies sow the seeds of their own destruction. That sounds like Karl Marx but it is the basic insight of Hyman Minsky, an economist of the mid-20th century whose reputation is being revived. Minsky argued that the financial system played a big role in exaggerating the economic cycle, one that was understated by conventional theory.

Investors, banks, companies and consumers all tend to be guilty of the sin of extrapolation; they assume the future will be like the recent past. After several years of steadily growing output and low inflation, people develop a misguided confidence that such benign conditions will continue. They are thus happy to borrow, and lend, more. As they do, the riskiness of the system steadily increases.

Minsky divided the process into three phases. In the first, investors take on little enough debt that they have no trouble meeting their capital and interest payments. In the second, they stretch their finances so they can only afford the interest. In the third, or Ponzi, phase they take on debt levels that require rising prices to be safely financed; the homebuyers who took on 125% mortgages at the peak of the property boom were a classic example.

When markets reach this fantasy land, a small change in the fundamentals or in investor attitudes can be enough to cause the system to unravel. Once prices start to drop, borrowers start to default on their loans, or seek to sell their assets, causing prices to fall further.

The cost of capitalism, to use the title of a new book {1} that draws heavily on Minsky's work, is first, that financial bubbles are created and second, that governments are forced to rescue the sector when those bubbles pop. Those who believe blindly in free markets are thus mistaken, in the view of Bob Barbera, a Wall Street economist and the book's author.

Government action is inevitable. In conventional industries, the demise of companies leads to "creative destruction" with capital being reallocated to more productive areas. But in banking and finance, a crisis leads to "deflationary destruction" as capital is eliminated. Businesses, investors and consumers lose confidence; borrowers are unable to repay their lenders, who suffer as well.

But by stepping in to rescue markets when they wobble, central bankers create asymmetric risk. Hence Mr Barbera rejects the idea, popular in the era of Alan Greenspan, that central banks should do nothing to burst asset bubbles.

Instead, he suggests that central banks should build the level of corporate-bond spreads into their models. When spreads are low, risk appetites are high, as they were in 2005-06. That should lead central banks to tighten monetary policy. When spreads are high, they should ease.

Whether that would have stopped the housing bubble is open to question. The Federal Reserve did indeed raise rates in 2005-06, albeit in a steady and unthreatening manner. Nevertheless, the current crisis suggests that monetary and fiscal policy cannot be driven exclusively by economic fundamentals such as inflation and unemployment. When interest rates are low, consumers and businesses do not just borrow money; they borrow money to buy assets, setting up a feedback loop that can eventually lead to a bubble. When such a bubble is inflating, government revenues (in the form of taxes on capital gains, bonuses, corporate profits and property sales) tend to be strong. As governments are now discovering, such revenues collapse very quickly when the bubble bursts.

But it is easy to get carried away during a boom; the strength of financial markets tends to be seen as a signal that the economy is soundly based. Those who work in the financial system are assumed to be the best and the brightest. Even the government seems to be in their thrall.

In a recent article, Simon Johnson, a former chief economist of the IMF, points out the parallels between emerging markets, where governments are dominated by the economic elite, and America, where officials glide easily between Wall Street and the Treasury. What is good for Goldman Sachs might turn out to be good for America, but it might be best if the government could make an independent judgment. If we accept Minsky's idea that financial markets are not always right, then we might be willing occasionally to act against Wall Street's interests, however loudly bankers would complain.

Note {1} The Cost of Capitalism: Understanding Market Mayhem and Stabilising Our Economic Future, by Robert Barbera. Published by McGraw-Hill.

Buttonwood now writes a blog, which is open for comment at

Copyright (c) 2009 The Economist Newspaper and The Economist Group. All rights reserved.


G20: Bin Laden's lament

If I were Osama bin Laden, I'd be thinking 'If only I'd known that capitalism would fall down of its own accord!'

by William Leith (April 03 2009)

As the world casts its eyes to London, where people have gathered to talk about the collapse of capitalism, it struck me that Osama bin Laden must be watching, wherever he is. At first, I imagined him sitting there, feeling rather smug. But the more I thought about it, the more I realised that this probably isn't how he feels at all. In fact, if I were bin Laden, I'd be gutted.

If I were bin Laden, I'd be thinking: damn! I've blown it. I'd be thinking that I did exactly the wrong thing. My thoughts would be: I wanted to smash capitalism, so I became a man of violence. I gambled, and I lost. If only I'd known that capitalism would fall down of its own accord! If only I'd actually believed that capitalism was flawed, I could have invested my time as the leader of a prospective Islamic caliphate much more wisely. As it is, I'm the most unpopular person in the world.

And for what?

The more you think about it, the worse it gets for bin Laden. He, above all people, was supposed to understand that capitalism didn't work. But what he did - hurling death and destruction at it - was, in reality, actually a sort of endorsement of capitalism. Bin Laden was showing the world how powerful he believed capitalism to be. He threw everything away, every scrap of credibility that he might be a decent human being, in an effort to land a blow on his enemy. And it turned out that the enemy's only real threat was itself. Capitalism, as it turns out, has made suckers of us all; bin Laden must feel like the biggest sucker of all.

All those years of dreary, not to say nasty, work! All that careful planning, arranging for pilots to be trained, the secret bank accounts, the bribed officials, the dodgy passports, the scanning of bus and train timetables, the endless talk of X-ray technology, all those hours spent with people coming to him with an idea for a shoe bomb, or a toothpaste bomb, or a deodorant bomb.

Well, he'll be thinking, I needn't have bothered. He must be seething. He'll be thinking: I could have been Gandhi! I could have chosen the route of non-violent protest - and then, when capitalism fell, I would have been home free. I could have said, "Yes, I told you so, it was always flawed. It was just a matter of time."

He'll be thinking: "I could have said, 'You only need to study the Austrian business cycle, as discussed in the works of economists such as Ludwig von Mises, to see that capitalism is flawed. Once lending gets out of hand, bad investments must follow, asset prices must fall, and the whole system will crash. In fact, it's all there in the work of the economist Hyman P Minsky. You can get it on the internet. Just a couple of clicks - that's all it takes. Capitalism is always about boom and bust, and the bigger the boom, the bigger the bust.'"

He'll be thinking: "Damn!"

He'll be thinking: "I so blew it".

He'll be thinking: "I could have been Gandhi. Could have been admired and respected, instead of universally loathed. Could have been a beacon for peaceful protest. Could have been picking up the phone, right now. Could have been saying: 'Sir Ben Kingsley? Yes - I'd be honoured'." (c) Guardian News and Media Limited 2009

Bill Totten


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