Hyman Minsky and the theory of money
Hyman Minsky stands apart from all other economists in the attention he paid to and the understanding he brought to bear upon both financial crises and the role of financial institutions in causing them.
A quarter century after the publication of Minsky's magnum opus Stabilizing an unstable economy what strikes one on reading it is both the clarity of his conception and the fact that so little of it has penetrated mainstream economics.
In what follows I quote a few sentences from the book. Even torn out of context they underline the difference between Minsky and other economists. Some of the statements may seem trite, especially the point about the creation and destruction of money through bank lending, and the reader may wonder why it is being cited here and why Minsky returns to it repeatedly at various points in his book. The reason is that though on first look it seems obvious even to an undergraduate it is precisely the fact that it does not enter into current models of money that is responsible for our failure to understand financial crises.
"Standard economic theory not only does not lead to an explanation of instability as a system attribute, it really does not recognize that endogenous instability is a problem that a satisfactory theory must explain."
"Unless we understand what it is that leads to economic and financial instability, we cannot prescribe -- make policy -- to modify or eliminate it. Identifying a phenomenon is not enough; we need a theory that makes instability a normal result in our economy and gives us handles to control it."
"During the 1970s American economists engaged in what might have been taken to be a serious controversy between Keynesians and monetarists. The participants and the press made it appear that a deep debate was taking place. In truth, the differences were minor -- as the competing camps used the same economic theory."
" … money is created in the process of financing investment and positions in capital assets. An increase in the quantity of money first finances either an increase in the demand for investment output or an increase in the demand for items in the stock of capital or financial assets. … On the other hand, the money supply decreases as bank loans are reduced."
Minsky quotes Milton Friedman
"Despite the importance of enterprises and money in our actual economy, and despite the numerous and complex problems they raise, the central characteristic of the market technique of achieving coordination is fully displayed in the simple exchange economy that contains neither enterprises nor money"
to underline how primitive Friedman's theory of money really is.
"Money is created as bankers go about their business of arranging for the financing of trade, investment, and positions in capital assets. An increase in the quantity of money through bank lending to business transforms a desire for investment or capital assets into an effective demand; the creation of money is part of the mechanism by which a surplus is forced and allocated to the production of particular investment outputs."
"Money is unique in that it is created in the act of financing by a bank and is destroyed as the commitments on debt instruments owned by banks are fulfilled. Because money is created and destroyed in the normal course of business, the amount outstanding is responsive to the demand for financing."
At least as important as what Minsky said is what he did not say. For him money is created and destroyed only through bank lending. Not once does he refer to "cash balances", which is the staple model of money used by Keynes, monetarists and the Austrian school.
Every one of these is a penetrating insight. And yet the fact remains that Minsky is no more than an outsider in mainstream economics. There have been more than half a dozen financial crises since his book was published. But until recently few economists have bothered to use his analysis to understand and prevent financial crises. He is regarded as someone with interesting and useful opinions but his ideas continue to be seen as interesting opinions, not proven propositions.
It would be flattering to Minsky to say that his was the typical fate of someone who was far ahead of his time. But I think the real fault lay with Minsky himself. He always believed that he was doing not much more than deepening Keynes's original ideas in which uncertainty played a key role and which had been misrepresented by the neat mathematical models built by Keynesians. He failed to see that a) his own ideas represented a complete rupture with Keynes, b) that Keynes's model of money was as primitive as Friedman's because it was basically identical, and c) that Keynes was wholly wrong in his views about money. Since he did not see all this, after his radical exposition on the workings of modern finance, he would inevitably return to the Keynesian focus on aggregate demand.
I have shown elsewhere (Paul Krugman and the Liquidity Trap) that Keynes's theory of the speculative mode of liquidity preference unknowingly assumes a world in which there are no banks and in which currency is the only form of money. Once banks are introduced into the system, the thesis of liquidity preference collapses and it becomes clear (both logically and empirically) that the principal problem in recessions is not that people hoard cash but that banks do not lend money. When this is recognised the whole problem of recessions gets turned on its head; it is no longer a question of aggregate demand but of aggregate supply, no longer a drop in consumer spending that is the cause but a drop in income generation because output is cut for lack of finance.
For Keynes the uncertainty in modern economic systems lay in the fickleness of investors and the hesitation of consumers to spend. In short, he saw uncertainty everywhere except where it actually lay: in the availability of finance.
In many ways it is strange that Minsky did not recognise that he was striking along a path completely at variance with Keynes. For instance, Minsky was clear that the role of the central bank as a lender of last resort was paramount in preventing recessions. Keynes, on the other hand, always lays stress on government spending, and never realised that the key to preventing recessions was bank rescues. Nowhere in the General Theory are bank rescues given any importance.
Once it is recognised that the principal problem in recessions is bank lending, entire periods of economic history can be seen from a new perspective. The two decades after World War II are even today regarded as the heyday of Keynesianism, when fine tinkering with demand kept the economy chugging along at a steady pace. In reality the reason was simply that there were no banking crises. And the reason there were no banking crises was that safe government debt issued during the war constituted a huge proportion of banks' assets. Once this began to run down, banking crises began to rear their head. What is surprising is that Minsky saw all this clearly and yet he did not take the next logical step and reject Keynes.
Minsky understood that the correct model of the economy would have three principal attributes: a) money is created as banks lend money and is destroyed as loans are liquidated b) money is endogenous to the system and c) the system must be capable of being in equilibrium even when operating at levels far below full capacity.
I do not know if he would have been surprised to find that the model of money he sought after all his life looked as in the figure below.
But I am sure he would have been filled with delight at the stark simplicity of the model and the fact that it is derived using the plain application of logic and without complicated mathematics.
Oddly, for one who focused so much on money and the financial system, Minsky seems never to have given much thought to the derivation of an accurate monetary aggregate. But I am sure that he would have been pleased that the model of the economy that incorporates his features yields a monetary aggregate that tracks the economy with frightening accuracy. The figure below shows Corrected Money Supply for the period 2001 to 2011 in billion dollars. It shows the rise in money supply upto 2006 at which point it begins to fall, mirroring the drop in housing loans and the drop in housing starts. It falls sharply during the recession and rises after it to dangerous proportions once again.
The complete elaboration can be read at The Riddle of Money, Finally Solved
Finally, I would not be surprised if the model I have outlined takes years to be accepted. It is comforting to remember that for two decades and more, Minsky's was a voice in the wilderness.
26 April 2011