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MONEY
WHAT IT IS
HOW IT WORKS
The late Hyman Minsky (1919–1996) was a leading authority on monetary theory and financial institutions. For much of Minsky’s career, mainstream economics paid little attention to the role of the financial system in macroeconomic theory. But in recent years, there has been an outpouring of new research, both theoretical and empirical, much of which validates his remarkable insights. Following is a digest of a paper* by Papadimitriou and Wray, that briefly outlines Minsky’s views on modern capitalist systems. Capitalism's Many Stages Capitalism is constantly evolving. We can identify several distinct stages in its evolution going back to the early 1600s. Today, capitalism is quite different from what it was just 30 years ago, and it may now be in the process of evolving into a new stage through globalization. The one constant throughout is the profit-seeking motive in money terms that leads to continual innovation, especially in finance. Firms spend money to earn more money. Financial institutions play a critical but delicate role, since they are themselves profit-seeking enterprises. They not only supply the funds, but may have a direct stake in the potential profits of the enterprise. Banks increase the money supply whenever they share the belief of the borrower that positions in assets or financed activity will generate sufficient cash flows. Money is thus created as a result of normal economic processes. The Key Role of Firms A modern economy is ultimately dependent on the viability of its firms, all of which are owned by the household sector, and which provide the main source of household income as wages. The focus should therefore be on firms, not households, and on investment and its finance, not on consumption and saving out of household income flows. This is in sharp contrast to the exposition found in textbooks, which begins with households and their consumption versus saving decision, with thrift determining investment and therefore growth. Two Price Model Minsky’s analysis involves two sets of prices. One set consists of the prices of current output -- consumption, investment, government, and export goods and services. The other set is the prices of assets-- capital assets used by firms in production and financial instruments that firms issue to gain control of fixed and working capital. The second set of prices is critical in determining how much investment will be undertaken. The two sets of prices reflect what happens in two different sets of markets, and thus will vary independently. This is in marked contrast to the single price system of the consumption versus investment model typically used in textbooks. Spending on investment depends on the demand price of capital assets (what firms are willing to pay) relative to supply prices (what suppliers require to produce them). For capital assets to be produced and thus generate profits, demand prices must exceed supply prices by enough to cover the risks. The resulting investment will then validate previous investment. Investment today determines whether investment yesterday was a good idea. But investment today depends on expectations about the future regarding demand and supply prices of investment goods. Whether there will be aggregate profits to distribute depends on aggregate capitalist spending. The Role of Profits Capitalism involves the acquisition of expensive assets that usually necessitate financing of positions in those assets. A firm must have sufficient market power to assure lenders that it will earn enough to service its financial liabilities. Thus a goal of every firm is to gain market power in order to control its markup. The ability to set price is critical in determining who gets credit. At the micro level, each firm must be able to obtain a markup over labor costs. However at the macro level there won’t be any profit unless there is spending in excess of aggregate wages in the consumption sector. Aggregate profit of firms is equal to the sum of investment plus consumption out of profits, plus the government’s deficit, plus the trade surplus, less saving out of wages. In the simple case with no government deficit, no trade imbalance, and no saving out of wages, capitalist profit equals investment plus capitalist consumption. As long as the price is set high enough that workers cannot buy all the output, capitalists can get the rest so long as they spend. The amount of surplus available at the aggregate level depends on the aggregate markup. It is aggregate spending on investment that generates the profit, and validates the accumulated capital. Neither thriftiness nor technology has anything to do with capital accumulation. Financial Positions of a Firm Minsky defines three financial positions of increasing fragility:
Business Cycles Business cycles are endogenously generated, and are not due to shocks. In large part they are due to the interplay between the two price systems and the way the financial system naturally evolves toward fragility. Exogenous effects can precipitate a crisis, but only when the system has already evolved to a fragile position. Conventional wisdom argues that the economy is naturally stable, with the invisible hand guiding the economy to equilibrium. Rather than treating institutions as contributing to stability, orthodoxy views them as barriers to achieving equilibrium. Minsky argues that institutions and interventions thwart the inherent instability of financial capitalism by interrupting the endogenous process and restarting the economy under more favorable conditions. System Instability As Minsky observed, capitalism is inherently unstable. As each crisis is successfully contained, it encourages greater speculation and risk taking in borrowing and lending. Financial innovation makes it easier to finance various schemes. To a large extent, borrowers and lenders operate on the basis of trial and error. If a behavior is rewarded, it will be repeated. Thus stable periods naturally lead to optimism, to booms, and to increasing fragility. A financial crisis can lead to asset price deflation and repudiation of debt. A debt deflation, once started, is very difficult to stop. It may not end until balance sheets are largely purged of bad debts, at great loss in financial wealth to the creditors as well as the economy at large. Big Government and Big Bank Before World War II, government spending was no more than 3% of GNP. Whenever the economy faltered, there was little countercyclical deficit spending to offset the loss in private spending. The era was marked by several depressions. Government has since grown to more than 20% of GNP. Its spending effectively sets ceilings and floors on prices of current output, helping to constrain the natural tendency of aggregate demand toward boom and bust cycles. It is notable that there has been no depression in the Big Government era. Government deficits may not be sufficient to prevent a
debt deflation.
If one occurs on a large enough scale, asset prices can become so
depressed
that revenue from sales of assets does not permit servicing of
debt.
Defaults can spread and bring down more creditors. Minsky argues
that the prevention of such a financial crisis is the primary purpose
of
the central bank and not, as orthodoxy assumes, control of the money
supply
or inflation. To reduce the moral hazard effects, any lender of
last
resort activity must be accompanied by Big Bank supervision of balance
sheets. |
