Minsky was Wrong, and So are Today’s Acolytes

Besides Keynes himself, no other posthumous economists’ legacy has been boosted quite as much as the late Hyman Minsky’s by the financial crisis. Minsky’s famous insight, captured in his Financial Instability Hypothesis, was that capitalist economies inherently tend toward instability due to debt accumulation and exuberance in the face of increasing returns. Minsky theorized that debt accumulation happens in phases, starting with responsible debt financing, and ending with Ponzi-type financing. At some point during the advanced stage of debt accumulation, market participants become salient of the house of cards and this realization produces a “Minsky moment“, as margins are called, and panic selling produces a systemic crisis.

On the face of it, this sounds like a reasonable causal explanation of the events of the late-90’s and early aughts, leading up and through the recession that began in 2007, and then the subsequent “Minsky moment” in 2008. It is certainly true that consumer and institutional debt skyrocketed during this period:

However, the story is still wrong. As you can see from the chart above, leverage ratios are not at all correlated with business cycles. Minsky’s wasn’t an aggregate theory — as he and others seem to believe — but a theory of sectoral balances. This theory certainly has a lot of appeal in explaining the run up in prices in certain sectors of the economy, such as commercial real estate (90’s), tech sector (early aughts, and residential real estate (late aughts)…but a theory of the business cycle it is not. But explaining sectoral balances isn’t interesting.

Cue the clever acolytes of Minsky, as they have seemingly caught onto this failure and have reformulated Minsky for the new era. The new story is that the cumulative debts, accumulated over the course of several business cycles in which the government sees fit to maintain the preceding capital structure, creates a Misky-an “super cycle” in which the now-taped-and-spackled house of cards collapses under its own weight. You can be forgiven for noting the Austrian flavor.

Here is Matthew Klein, at The Economist, advocating this theory:

MANY agree that central banks need to rethink their objectives and tools in light of the crisis. Few, however, agree on what those new objectives should be or what the available tools actually are. (Those interested in some of the latest research should read this.) While some ideas have more merit than others, I am sceptical that any central bank is capable of fulfilling its objectives over any meaningful length of time because, as the late Hyman Minsky explained, lower observed macroeconomic volatility in the short term encourages greater financial risk-taking. Thus, the longer the perceived good times last, the more fragile the economy becomes. (An earlier post explains how this works in the narrower context of bank risk models.) This has few immediate implications, but reformers should be profoundly sceptical that they have found the fool-proof rule for optimal central banking.

While it is intuitively attractive to think this way, it still cannot save Minsky-ism. After all, boring parties are boring, until someone does something crazy, then they’re fun. In this story, macro stability is the same way. It’s boring to park your assets in an index fund and reap the yield. It’s boring to take out an 80:20 30-year and live in your modest house. So in come the super-bankers to magnify your yield by 9000 and put your ass in a mcmansion!

But the sub-prime fiasco was rather public by the end of 2007, and employment in housing construction was depressed. But the economy didn’t crash then. We were facing a mild recession probably for 10 months starting in 2008…but then financial contagion started spreading beyond the sub-prime mortgage market. What changed?

The Fed, in its tepid response to the developing crisis (and focus on booming energy prices) failed to restore nominal spending after the initial shock. The Fed failed right up to the point of the “Minsky moment” in 2008, maintaining interest rates a 2% in the days before Lehman failed! Our tepid labor market recoveries from the past three recessions have featured the same sort of undershoots (though they aren’t as dramatic).

However, there is one aspect of the financial industry that merits scrutiny, and that is the lack of diversity. As we know from nature, a lack of diversity in any given ecosystem breeds instability, and ultimately catastrophic failure. Think a forest full of evergreens. There is a man-made forest by my parents’ house that is nearly all evergreen trees. It has been in secular decline my entire life due to disease. That is because it is not a robust ecosystem.

Cities founded around a single industry fail catastrophically when global economic conditions change (of course I’m going to say Detroit).

Finance exhibits the same kind of behavior. When new financial instruments, tricks, or regulatory arbitrage is found to create a miniscule amount of outsized profit or minimize perceived risk, it induces a rapid herd behavior in porfolio rebalancing toward that particular thing. This reduces the diversity of financial instruments, and creates a situation where the entire ecosystem is prone to collapse. That is a very Minsky-ite story, of course, told from a complex systems perspective…but it is not a macro story, and it is not conditional upon macro stability. This is the too brittle to sustain (TB2S) theory.

**As you will notice, I left a note to myself to insert a chart. That’s because I don’t have access to the chart right now. But I will post it when I do!

P.S. Dispite finding Klein’s theory lacking, I want to wish Klein the best of luck at Bloomberg View!

Related: Vaidas Urba sends me to his excellent post on NGDP volatility.


One thought on “Minsky was Wrong, and So are Today’s Acolytes

  1. Most of the people you call “Minksy-ites” clearly have no clue as to what Minsky was saying.

    Minsky was primarily concerned with explaining the Great Depression, not as an event caused by some external shock, but as one of the possible states of capitalist economies. The question he was trying to answer was, “Can ‘IT’ Happen Again?” His answer was yes, due to increased leveraging over a long period of time, a process *endogenous* to capitalism. Minsky was not trying to explain business cycles (except, possibly, as they are related to asset price bubbles), ergo there are no Minsky “Super-cycles” – the Super-Cycle IS what Minsky was explaining/describing.

    Your idea that the Fed ‘failed to restore nominal spending’ is likewise absurd. At best, the Fed would have just sustained the bubble for longer. In all likelihood, since (as we now know) everyone on the inside knew everything was about to go bust, the Fed probably would have just pumped liquidity into the banks balance sheets, and it would have gone nowhere, since it would have been in each individual bank’s interest to hold on to the excess reserves in order to absorb losses on the assets side due to defaults.

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