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Home , Hyman Minsky, Minsky moment

BSc Thesis Student: Arvid Aagaard Jensen Supervisor: Peter Erling Nielsen University of Copenhagen, Spring 2013

THE - Comparing Minsky to mainstream explanations of the -

Arvid Aagaard Jensen

BSc Thesis

Supervisor: Peter Erling Nielsen Institute of

University of Copenhagen

Spring 2013

1 BSc Thesis Student: Arvid Aagaard Jensen Supervisor: Peter Erling Nielsen University of Copenhagen, Spring 2013

RESUMÈ The purpose of the thesis is to investigate the prevalent mainstream explanations for the financial crisis and how the work of the late (1919-1996) might contribute with new angles from a contemporary point of view. In this regard, the report contains an analysis of how the and Gauti Eggertsson make use of Minsky in the they offer in their 2012 paper , and the and the policy recommendations their findings entail. The basic question that the thesis poses is: how did the financial crisis of 2008 come to pass? With reference to a wide array of economists and institutional reports the prevalent mainstream explanations are summarized in 10 points. 1. boom due to low rates. 2. had been too lax. 3. Housing policies had set wrong incentives 4. Rating agencies had misled . 5. Banking sector had failed in its risk setting. 6. Borrowers had taken on too much debt. 7. Widespread use of complex and obscure financial instruments. 8. Increased interconnectedness among financial markets, nationally and internationally. 9. High degree of leverage of financial institutions. 10. Central role of the sector. The key finding of the thesis in this regard, is that these explanations are exogenous in nature and offer only diminutive systemic reasons for the crisis. As a contrast to this, the Financial Instability Hypothesis of Hyman Minsky offers an endogenous explanation rooted in the irrationality of financial players. He asserts that the recurring phenomenon of financial breakdowns in the western arise from a cyclical market failure propelled by incitements inherent in the very institutions of the financial sector. Minsky emphasizes the role of debt creation in the financial sector, due to financial innovation and its impact on . In it its final part, the thesis analyses how Paul Krugman and Gauti Eggertsson attempt to integrate Minsky’s more general findings concerning sudden deleveraging in the financial sector in relation to the relevant problem of liquidity traps. This is done by altering the well known New Keynesian model framework, focusing particularly on how debt allocation in the financial sector influences aggregate demand and plays a key role in creating financial crises. Their findings sheds light on the seemingly unorthodox macroeconomic mechanisms, as well as the paradoxes of thrift, toil and flexibility, which follows after an exogenously imposed sudden deleveraging. The policy recommendations that are offered focuses on the need to revive debt financed government expenditure as a tool to alleviate a depressed pressed up against the zero lower bound of a liquidity trap.

2 BSc Thesis Student: Arvid Aagaard Jensen Supervisor: Peter Erling Nielsen University of Copenhagen, Spring 2013

THE MINSKY MOMENT

- Comparing Minsky to mainstream explanations of the financial crisis -

INTRODUCTION How did the financial crisis of 2008 come to pass? The prevalent explanations assign the causes of the crisis primarily to exogenous factors such bad and of the financial markets during the 90’s. However, the aftermath of the financial crisis has brought to light an explanation that pin points the causes in the endogenous workings of the financial institutions as such. In his work, the Hyman Minsky (1919 – 1996)1 outlined his Financial Instability Hypothesis, in which he asserted that the recurring phenomenon of financial breakdowns in the western economies arise from a cyclical market failure propelled by incitements inherent in the very institutions of the financial sector. As most Post-Keynesian theory, Minsky’s work has to a large degree remained marginalized and unknown to most economists. Recently this has changed however, as highly profiled economists have sought to introduce Minsky’s ideas in a conventional framework. This reformist approach we find in the recent work of Paul Krugman and Gauti Eggertsson where they attempt to integrate Minsky’s key insights on debt in a well known New Keynesian model, focusing particularly on how debt allocation in the financial sector influences aggregate demand and plays a key role in creating financial crises. The main aim of this paper is to investigate the prevalent mainstream explanations for the financial crisis and investigate why Minsky’s work might contribute with new angles. Furthermore, the report will analyze how Krugman and Eggertsson make use of him in their economic modeling and the policy recommendations this entails.

LITTERATURE In portraying the mainstream explanations of the crisis I have examined various works of esteemed mainstream economists such as , and Alan Greenspan as well as official commission reports such as the Financial Inquiry Report headed by Phil Angelides on behalf of president Obama and the report, Wall Street and The Financial Collapse, worked out by Carl Levin on behalf of the Senate Committee on Homeland Security and Governmental Affairs. I have also surveyed other important documents such as the Basel Accords in my evaluation of the role of credit regulation in creating the crisis.

1 Minsky taught at from 1949 to 1958. From 1957 to 1965 he was Associate Professor of Economics at the University of California, Berkeley. In 1965 he became Professor of Economics, University of Washington in St Louis and retired from there in 1990. Until 3 BSc Thesis Student: Arvid Aagaard Jensen Supervisor: Peter Erling Nielsen University of Copenhagen, Spring 2013

Minsky was extremely productive as a scholar and authored hundreds of articles and books throughout his career. In picking out my sources I have strived to use the works in which he spells out his main theory, the Financial Instability Hypothesis and have narrowed it in to three works. His first rigorous attempt was made in his book , from 1975, which despite the title is not a biography, but rather an outline of his aforementioned hypothesis. His paper Can “It” Happen Again? A Reprise, from 1982, is also of interest since he muses on the possibility of the happening again, and is by many considered as indicative to his correct anticipation of the crisis we’re in today. Lastly I have chosen his paper Stabilizing an Unstable Economy from 1986, in which he delivers the controversial theory that the stabilizing mechanisms used by monetarist policy actually paves the way for more cataclysmic financial crises. As a theorist Minsky was intellectually indebted to the works of John Maynard Keynes, and and I have chosen to include, their relevant works here as well. A particularly vital contribution is Irving Fishers Paper The Debt- Deflation Theory of Great Depressions, from 1933, which is of special importance with regards to Krugman’s and Eggertsson’s model in their paper Debt, Deleveraging and the Liquidity Trap published in the Oxford Journal The Quarterly Journal of Economics in 2012.

MAINSTREAM EXPLANATIONS FOR THE FINANCIAL CRISIS Before probing into the key facets of Hyman Minsky’s Financial Instability Hypothesis, and what it may contribute to macro economic modeling, it is prudent to first investigate what prevalent explanations are given as to the cause of the 2008-9 financial crisis. A suitable starting point for locating the mainstream view might be the “authoritative study”2 This Time is Different, by Carmen Reinhart and Kenneth Rogoff, which asserts that the trouble started with the deregulation of the financial sector.3 The period of in the 70’s was the definitive end of Keynesianism, and through the influence of and others, the reliance on “big government” was replaced by renewed belief in Adam Smiths harmony of interest reflected in free markets. In this regard, a note worthy contribution was the Efficient Market Hypothesis by Eugene Fama, asserting that financial markets are “informationally efficient”.4 On a political level, Ronald Reagan and Margaret Thatcher supported the laissez faire ideas throughout the 80’s, evidenced by such

2 Claessens, Stijn and Kose, M. Ayhan. Financial Crises: Explanations, Types and Implications. IMF working paper 2013. P. 3 3 Reinhart, Carmen M. and Rogoff, Kenneth S. This Time is Different. Princeton Univeristy Press 2009. P. 199 4 Fama, Eugene F. Efficient Capital Markets: A Review of Theory and Empirical Work. Journal of Finance, vol. 25, issue 2, 383-417, May 1970. 4 BSc Thesis Student: Arvid Aagaard Jensen Supervisor: Peter Erling Nielsen University of Copenhagen, Spring 2013 deregulation policies as Regan’s Garn-St. Germain Depository Institutions Act of 1982.5 The collapse of the Soviet Union in 1991 was successfully used by some as definitive proof of the superiority of free market capitalism most amply stated by the influential American political economist, Francis Fukuyama, when he declared “the end of history”. 6 Liberalism was the name of the game, evidenced by the dramatic privatization policies imposed on the former communist bloc. The advent of ‘western triumphalism’ in economic matters, gave political momentum for continuing the trend of financial deregulation from the 1980’s. Through the 1990’s many of the regulative structures put in place during the 1930’s, were rolled back under the auspice of Bill Clinton, and the incumbent Fed Chair Alan Greenspan and the financial sector in the US, and in many parts of the world, consolidated in a few giant, too-big-to-fail companies. However, events such as the crash of LTCM and the collapse of the IT bubble eventually hampered the enthusiasm of the “new economy” and hinted at the systemic risk associated with a fully globalized, intertwined and deregulated financial system.7 It was in this globalized setting that the financial crisis of 2007/8, would finally unfold. It is commonly agreed upon, that two specific exogenous shocks created the circumstances for the crisis. The first was a substantial boom in the housing market, fueled partly by low interest rates set unprecedentedly low by the in the follow up of the 2001 and was kept there, due to persistent low , until 2004. The second shock was the vast increase in securitization8 of sub prime borrowers on the US housing market. Industry experts have estimated that a variant called the "option adjustable rate mortgage" (option ARM), which offered a low "teaser" rate and later resets so that minimum payments skyrocket, accounted for about 0.5% of all U.S. mortgages written in 2003, but close to thirteen percent (and up to fifty-one percent in some U.S. communities) in 2006.9 The securitizarion process created a market for mortgage-backed securities (MBS’s), which was enhanced by major financial institutions such as Citigroup, Lehman Brothers and Morgan Stanley, who apart from acquiring subprime lenders, provided lines of credit, and purchase guarantees. All in all, it is perceived that these events fueled an unsustainable demand in the housing market, with a doubling of US housing prices in the period 1995-2006, resulting in a burst ripe bubble. In the period 2006-2009 housing prices fell 30% which according to

5 Sherman, Matthew. A Short History of Financial Deregulation in the . Center for Economic and Policy Research 2009. P.1 6 This feeling of western superiority was most readily observed in the influential book from 1992, The End of History and the Last Man, by Francis Fukuyama. 7 Rogoff (2009) p. 279 8 Simply put, securitization is the bundling of of various qualities, such as student loans, car and not least mortgages with the aim of selling the bundle shares to investors. 9 Whalen: 2011. P. 157 5 BSc Thesis Student: Arvid Aagaard Jensen Supervisor: Peter Erling Nielsen University of Copenhagen, Spring 2013 standard economic theory shouldn’t have posed a problem as supply and demand should have just settle in a appropriate equilibrium. The price deterioration had two effects that led to a substantial fall in aggregate demand. The first effect was that many homeowners were suddenly in a position where they owed more to the than their homes were worth and thus unable to their loans. As tried to limit their losses this naturally led to a massive increase in mortgage defaults and home foreclosures that flooded the housing market and exacerbated the decline in prices. As might be predicted by appropriate use of the ‘q-theory of ’ on the housing market, the price decline of residential property relative to the construction of a new home led to a decline in housing construction and related industries adding to the negative shock to aggregate demand.10 The second effect was that many financial institutions, in expectation of a continuously rising housing market, had invested heavily in high risk mortgage-backed securities and thus suffered massive losses when the subprime bubble burst. Due to these losses many institutions didn’t have funds to loan out, and the institutions that did were faced with uncertainty as to the risk exposure of other agents in the market. Suddenly the financial system was unable to allocate resources in a market efficient manner leaving even creditworthy agents without finance for sound - the was a reality. The fear in the markets also led to the withdrawal of funds from the banks, which put a strain on liquidity. One noteworthy example of this was the investment bank Lehman brothers who after a massive exodus of clients, asset devaluation and plunging stocks filed for bankruptcy – the largest in US history. The FED didn’t intervene as lender-of-last resort, which by some critics has been raised as the primary reason for the ensuing volatility in the financial markets. Market volatility was only eased when many governments around the world intervened with bank-bailouts. This has led many economists to characterize the crisis as a widespread liquidity run.11

Figure 1. Overview of the Housing Crisis

10 Sørensen, Peter B. and Whitta-Jacobsen, Hans J. Introducing Advanced : Growth and Business Cycles. McGraw-Hill 2010. P. 408 11 Gorton, G. Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007. Paper prepared for the Federal Reserve Bank of Atlanta’s 2009 Financial Markets Conference: Financial Innovation and Crisis, May 11-13. 2009 6 BSc Thesis Student: Arvid Aagaard Jensen Supervisor: Peter Erling Nielsen University of Copenhagen, Spring 2013

What might have unfolded as a merely a US phenomenon, spread across the globe through the mortgage backed securities market and created a massive risk exposure that jeopardized the solvency of banks and insurance companies worldwide who had invested heavily in these high risk toxic assets. Ironically, the strategy of reduced risk from diversified asset allocation ended up plunging the global financial system into a crisis of a magnitude not seen since the thirties. The near term macroeconomic outcome of the above-listed events was a sharp decline in GDP and employment caused by a downward shift in aggregate demand. Almost all countries with “twin booms” in the housing and credit market ended up in either a crisis or considerable drop in GDP growth rate compared with the 2003-07 period.12 Between the fourth quarter of 2007 and the second quarter of 2009 US GDP fell 4 percent and rose from 4.4 percent to 10.1 percent. The crisis and the ensuing downturn gave rise to increased interest in the role debt and leverage plays in the economy both in the government sector, illustrated by the novel term ‘sovereign debt’ crisis, but primarily in the private sector, where indebtedness as percentage of GDP has risen to unprecedented levels. The reason for this has partly been the possibility for financial players to leverage their investments quite substantially such as Lehman Brothers who according to their 2007 financial statements had an accounting

12 Dell’Ariccia, G., D. Igan, and L. Laeven, 2012, “Credit Booms and Lending Standards: Evidence from the U.S. Subprime Mortgage Market,” Journal of , Credit and Banking, Vol. 44, pages 367-84. 7 BSc Thesis Student: Arvid Aagaard Jensen Supervisor: Peter Erling Nielsen University of Copenhagen, Spring 2013 leverage of 30.7 times. 13 The bankruptcy examiner of Lehman Brothers, Anton Valukas determined that the accounting leverage was even higher.14 Although Basel I and II, had tried to confront the issue, the industry was reluctant to implement the standards, which is not so controversial considering the fact that it is difficult to institute a legal obligation to do so. The build up of debt was also caused by the formation of a parallel credit market prior to the crisis. The Financial Inquiry Report headed by Phil Angelides highlights the particular factor of financial innovation as plausible cause: “The origin of the recent global crisis can be traced in large part to the following financial-sector innovations: unconventional mortgages, securitization, the rise of funds, and the globalization of finance.”15 Financial innovation led to a massive credit expansion before the crisis provided by institutions as hedge funds and other non-bank intermediaries in the , which at the peak of the financial crisis was larger than the traditional banking system as the left hand side of figure 2. illustrates. The more recent Basel III accords were developed in response to the deficiencies revealed by the 2008 crisis, and are scheduled to be implemented from 2013 to 2015. Herein banks are required to hold 4.5 percent of common equity – a 2 percentage point increase from Basel II – and 6 percent of Tier 1, i.e. core capital – a 2 percentage point increase from Basel II. Furthermore, stringent limitations are put on innovative instruments used to generate Tier 1 capital.16

Figure 2. Credit expansion and Dept in the US

13 Lehman Brothers Holdings Inc Annual Report for year ended November 30, 2007. 14 Report of Anton R. Valukas, Examiner, to the United States Bankruptcy Court, Southern District of New York, Chapter 11 Case No. 08- 13555 (JMP) 15 Whalen (2011): P. 157 16 Basel Committee on Banking Supervision. Enhancements to the Basel II Framework. Basel: Bank for International Settlements, 2009.; Basel Committee on Banking Supervision. An assessment of the long-term economic impact of stronger capital and liquidity requirements. Bank for International Settlements, Basel 2010.; Basel Committee on Banking Supervision. Basel III: A global regu- latory framework for more resilient banks and banking systems. Bank for International Settlements, Basel 2011. 8 BSc Thesis Student: Arvid Aagaard Jensen Supervisor: Peter Erling Nielsen University of Copenhagen, Spring 2013

So, who should be blamed for this calamity? In 2005, a report issued by the Basel Committee on Banking Supervisions Joint Forum posed the question whether financial institutions fully appreciated the risks associated MBS’s and related securities, and concluded that the credit risk was “Quite modest”.17 This has led the authors of the FDIC to conclude, that “Regulators failed to rein in risky home mortgage lending. In particular, the Federal Reserve failed to meet its statutory obligation to establish and maintain prudent mortgage lending standards and to protect against .”18 In regard to this, some have accused economists and policy makers for uncritically accepting such theories as the Efficient Market Hypothesis, since the crisis showed that “the credit rating agencies abysmally failed in their central mission to provide quality ratings on securities for the benefit of investors.”19 In the aftermath of the crisis many economists have tried to give a satisfactory explanation of its causes. An explanation common to most is the one given Harvard professor and president of the National Bureau of Economic Research, Martin Feldstein, who lists 6 reasons for the meltdown: 1. Credit boom due to low interest rates. 2. financial regulation had been too lax. 3. The housing policies had set wrong incentives 4. Rating agencies had misled investors. 5. The banking sector had failed in its risk setting. 6. Borrowers had taken on too much debt. In addition to this, Stijn Claessens, Chief of the Financial Studies Division in the IMF Research Department, considers the following factors to be commonly accepted: 7. The widespread use of complex and opaque financial instruments. 8. Increased interconnectedness among financial markets, nationally and internationally, with the U.S. at the core. 9. High degree of leverage of financial institutions. 10. Central role of the household sector.20 Although different weights are assigned to the impact of the factors most theories developed over the years recognize the importance of booms in assets and credit markets, and credit growth as “the most important, but still imperfect predictor.”21 As any prudent scientist should be, when confronted with the complexities of economic systems, most distinguished economic researchers are reluctant to name a final causal factor even with the benefit of hindsight. A great many even deem financial crises unpredictable in nature. Most, however, are inclined to narrow it down to the 10 factors listed by Feldstein and Stijn, although assigning different weights. This has implications for how the crisis is categorized and consequently for which policy recommendations are given. Nevertheless, all mainstream economists, by default, agree that the crisis might be explained

17 Basel Committee on Banking Supervision: Joint Forum. Credit Risk Transfer. Bank for International Settlements, March 2005, pp. 3–4, 6– 7, 5–10; Angelides, Phil. The Financial Crisis Inquiry Report. Official government edition 2011. P. 206 18 Ibid. p. 101 19 Angelides, Phil. The Financial Crisis Inquiry Report. Official government edition 2011. P. 212 20 Stijn (2013) p. 22 21 Ibid. p. 33 9 BSc Thesis Student: Arvid Aagaard Jensen Supervisor: Peter Erling Nielsen University of Copenhagen, Spring 2013 by exogenous factors such as bad monetary policy and reprehensible risk management in the financial sector. Generally you find two types of explanations of the financial crisis: 1. Financial crises are caused by exogenous shocks. Followers of this interpretation normally base their models on the hypothesis of and homogeneity of the economic actors. 2. Financial crises are caused by endogenous mechanisms. Followers of this type of explanation often outline the institutionalized role of mass psychology and herd behavior of economic actors. It seems reasonable to conclude that the mainstream view that has just been accounted for is firmly placed in the first category. Now let us turn to an explanation of the second type. Enter Hyman Minsky.

MINSKY’S FINANCIAL INSTABILITY HYPOTHESIS Despite the withstanding consensus, some economists put primary emphasis on endogenous instead of exogenous factors when explaining not only the most recent financial calamity, but also preceding ones. One proponent of this is the late Hyman Minsky, whose theory has attracted unprecedented attention after economists and news outlets called the eruption of the crisis a ‘Minsky moment’.22 According to Minsky, “(i)nstability is an observed characteristic of our economy. For a theory to be useful as a guide to policy for the control of instability, the theory must show how instability is generated.”23 Explained through his Financial Instability Hypothesis (FIH), laid out in his magnum opus John Maynard Keynes from 197524, he claimed that financial crises are debt driven, cyclical phenomena, promulgated by endogenous factors inherent in the institutions of the post-war, western-type financial system. To explain the Financial Instability Hypothesis (FIH), Minsky takes point of departure in thriving economy without the intervention of a or ‘big government’. It is assumed that the economy has recently been through a systemic financial crisis with many unsuccessful investments leaving many firms unable to finance borrowings and forcing banks to discard bad . Thus, firms and banks are very risk aversive in their portfolio and loan management respectively, favoring lower bound estimates of future cash flows and very

22 The phrase was coined by Paul Allen McCulley (1957-), an American economist and former managing director at the investment firm PIMCO, that manages assets worth of 2 trillion dollars. He is regularly used as a financial expert by CNBC and Bloomberg Television. He also introduced the term Shadow Banking System, used by among others the FCIC. On August 22nd, 2007, the Guardian leader had the headline: In praise of ... Hyman Minsky. 23 Minsky(1982): p.6 24 Minsky, H. P. John Maynard Keynes, Columbia University Press 1975. 10 BSc Thesis Student: Arvid Aagaard Jensen Supervisor: Peter Erling Nielsen University of Copenhagen, Spring 2013 high risk premiums. As time passes, the milieu of a growing economy and risk aversive financing renders most investment projects successful and leaves firms and banks with the view that increased financial leveraging pays off. The expectation of future encourages firms and banks to lessen their risk averseness using more optimistic estimates of future cash flows and lower risk premium. The result is growing levels of investments and exponentially rising asset prices. The economic boom raises also raises the demand for funds to finance in assets, and since investors and bankers alike share the optimism of the ‘new economy’, the demand is met. The debt to equity ratio increases, liquidity decreases and credit provision accelerates, demarcating a phase shift into what Minsky calls the ‘euphoric economy’25, where creditors and debtors have steadfast expectations of continued upward appraisal of asset prices and accept liabilities that in a more risk conscious environment would have been rejected.26 Simultaneously, the increased debt to equity ratio makes firms more vulnerable to increasing interest rates. Even when ignoring the likely intervention from monetary authorities or an active state to regulate the boom, the general decrease in liquidity and the rise in interest paid on highly liquid induce a market driven increase in the . The economy experiences a decline in the demand elasticity with respect to credit, since the projected pay offs from speculative investments are prone to exceed interest rates by a large margin. Thus, the increased credit costs has a negligent impact on mitigating the boom. The ‘euphoric economy’ also sets the stage for an agent which plays a crucial role in Minsky’s theory, namely the ‘Ponzi financier’. 27 This category of investors makes a business of taking on massive debt, through leverage, to speculate in the rising market, and although the servicing cost for Ponzi debtors surpass the cash flows from the firms they own, the capital appreciation of their assets easily cover the costs of servicing their loans. The rise of investors has two implications on the market. Firstly, they push up the market interest rate and secondly, but not less significantly, their heavily leveraged positions increase the fragility of the system should a reversal in asset growth occur. Viewing the 2008 financial crisis from this standpoint the monetary policy of low interest rates after 9/11, actually increased instability further. In due time the twin effects of rising interest rates and an increased debt to equity ratio, has an impact on a wide range of business undertakings. The reduced interest rate cover transforms conservatively funded business ventures into speculative ones and

25 Minsky 1982, pp. 120-124 26 Minsky 1982, p. 123 27 Minsky 1982, pp. 70, 115 11 BSc Thesis Student: Arvid Aagaard Jensen Supervisor: Peter Erling Nielsen University of Copenhagen, Spring 2013 speculative undertakings into ‘Ponzi’. Businesses in the latter category will at some point be forced to sell assets to service their debt, which punctures the exponential growth in assets prices, leading to dramatic consequences for the market. The Ponzi agents suddenly find themselves in a situation with asset holdings that may no longer be traded with a profit, and debt obligations that can’t be serviced by the cash flow of their businesses, leaving them with no choice than to sell off and thus further accelerate the price fall. Furthermore, the banks that financed the asset purchases, realize that their customers can’t pay their debts, which leads them to hike up the interest rate. Amidst doubt of ‘marked-to-market’ asset values liquidity becomes highly sought. In an attempt to sell illiquid assets in return for liquidity the market is flooded with assets and the euphoria of the boom gives way for the panic of the bust. In the aftermath of the boom, the underlying problem facing the economy is the disparity between debts incurred to finance investment, and the cash flows these investments generate. The cash flows are highly dependent on the level of investment and on the inflation rate. Since the investment level has plunged, asset price deflation or current price inflation stand out as the only two forces that may restore the harmony between asset prices and cash flows. The choice between the paths of ‘asset price deflation’ or ‘current price inflation’, were important for Minsky’s controversial view of the role of inflation, which he outlined in his analysis of the stagflation era of the 1970’s. In this regard he argues, that if the inflation rate is high or the debt level is relatively low at the beginning of the crisis, then rising cash flows may in short notice repay the loans taken on during the boom. The economy may then come out of the crisis with hampered growth and high inflation, but also with minimal amount of bankruptcies and a sustained fall in liquidity. So although this option invokes stagflation, it is a self-correcting mechanism and a prolonged downturn is prevented. However, even though a severe, depression-like, disaster has not unfolded due to the above mentioned self-correcting mechanisms, the circumstance for the cycle to repeat itself is soon established anew and, in due time one might expect a decrease in the once again. As each new cycle begins before the accumulated debt in the previous on has been repaid, there appears a trend towards increasingly higher debt to equity ratios in each consecutive cycle, thus increases the instability of the financial system over time. If alternatively, the rate of inflation are low and the debt levels are very high in the beginning of the crisis, then cash flows will not be able to sustain the prevailing debt structures. Affected firms, those with interest costs in excess of their cash flows, are left with three options. They might sell of assets, cut their margins to increase their cash flows or file in bankruptcy. Unlike the inflationary course, these actions are prone to further depress the

12 BSc Thesis Student: Arvid Aagaard Jensen Supervisor: Peter Erling Nielsen University of Copenhagen, Spring 2013 current and thus to some degree worsen the original disparities. So the path of ‘asset price deflation’ is self reinforcing, rather than self-correcting, and is how Minsky explains a depression. The above rendition of Minsky’s Financial Instability Hypothesis, excludes the intervention of an active government. His view on government may be portrayed by the following quote: “An economy in which a government spends to assure capital formation rather than support consumption is capable of achieving a closer approximation to tranquil progress than is possible with our present policies. Thus while big government virtually ensures that a great depression cannot happen again, the resumption of tranquil progress depends on restructuring government so that it enhances resource development. “28 Introducing an active state in the economic scenario might alter the story in several ways, since it might intervene with expansionary fiscal policies and ameliorate the collapse in cash flows through automatic stabilizers as well as Reserve Bank interventions. In this regard he challenges the stabilizing effects of a policy of lender-of-last-resort, if not followed up by structural changes. Policy must adapt as the economy is transformed and the inherent behavior of financial players must be continuously regulated, matching the ceaseless financial innovation. Thus “successful” efforts by governments and central banks on keeping financial institutions afloat in the short run will actually deepen the inevitable future collapse. In his from article from 1982, Can “it” happen again, Minsky sums up the thought- provoking conclusion that “Stability…is destabilizing”29.

THE ISSUE OF DEBT REVISITED: MINSKY AND MAINSTREAM MODELING In retrospect, Minsky’s FIH was meant to challenge the hailed Efficient Market Hypothesis (EMH) of the 1970’s. As a consequence of the recent crisis EMH was left in such shambles that even one of the most revered supporters of unregulated markets, Alan Greenspan, testified to the US Senate that “(t)hose of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief,”.30 Like Greenspan an overwhelming majority of economists were taken by surprise and duly noted the dire analogies to the 1930’s raising the headline question posed by

28 Minsky(1982): p. 13 29 Minsky, Hyman P. Ph.D. Can "It" Happen Again? A Reprise. Hyman P. Minsky Archive, http://digitalcommons.bard.edu/hm_archive/155. Paper 155, 1982. 30 http://www.nytimes.com/2008/10/24/business/economy/24panel.html?_r=0 13 BSc Thesis Student: Arvid Aagaard Jensen Supervisor: Peter Erling Nielsen University of Copenhagen, Spring 2013

Minsky, can “it” happen again?31 In 2008, when asked a similar question, I.M.F. chief economist, Olivier Blanchard32, wholly disregarded the idea claiming that economists had learned their lesson, and wouldn’t repeat mistakes of the past. To which Gregory Mankiw rhetorically countered “but have we learned enough?”33 Studies of the 1930’s have shown that competing forecasting services at Harvard and Yale were caught completely by surprise as to the gravity and longevity of the Great Depression.34 And similarly, contradicting Blanchard’s claim, the progression in the tools and the data available to modern economists, still left most oblivious of the impending crisis. In the aftermath Paul Krugman bluntly stated that the economist profession had “failed” and called for a thorough reassessment of integral parts of macroeconomics analysis. Together with the Icelandic economist, Gauti Eggertsson, Krugman modeled theories by Irving Fisher, Hyman Minsky and Richard Koo in their recently published Debt, Deleveraging, and the Liquidity Trap. They claim that although the issue of debt is a key factor in major economic downturns and although at the heart of the present “” it is commonly disregarded in mainstream economic modeling giving rise to severe blind angels when analyzing monetary and fiscal policy35. In the paper they introduce a New Keynesian model of aggregate demand is affected when various agents with an overhang of debt is forced into deleveraging and argue that their findings may explain economic difficulties historically as well as presently. Along with many others, KE argues that the rapid increase in gross household debt in a number of countries, paved the way for the 2008 crisis and that it furthermore hinders a recovery. In their view, critics use debt as an unjustified argument against expansionary , asserting that you cannot cure a problem caused by debt, by even more debt36. See Table 1.

Table 1. Household gross debt as % of personal income

Source: McKinsey Global Institute (2010)

31 Minsky (1982): p.5 32 Blanchard has held this position since 2008, and is one of the most cited economists in the world, according to Research Papers in Economics. 33 http://www.nytimes.com/2008/10/26/business/26view.html?_r=0 34 Dominguez, Kathrin M. ; Fair, Ray C.; Shapiro, Matthew. Forecasting the Depression: Harvad Versus Yale. The American Economic Review, Vol. 78, No. 4, pp. 595-612, September 1988. 35 Krugman, P. and G. B. Eggertsson (2010). Debt, Deleveraging, and the Liquidity Trap: A Fisher-Minsky-Koo approach. New York, Federal Reserve Bank of New York & Princeton University 2010. 36 Krugman(2012): p.1 14 BSc Thesis Student: Arvid Aagaard Jensen Supervisor: Peter Erling Nielsen University of Copenhagen, Spring 2013

A similar academic interest in the role of debt arose in the 1930’s, where the notable economist Irving Fisher in his paper The Debt-Deflation Theory of Great Depressions, from 1933, set forth the argument that the cause of the Great Depression was rooted in the vicious circle of debt-deflation. Fisher describe this as a dynamic process in which declining commodity and asset prices, puts pressure on nominal debt holders forcing them to distress sales of assets leading to even more deflation and falling aggregate demand, along with adverse effects on the financial markets. 37 It is worth of note, that what Fisher here described was an endogenous explanation for the crisis, which was just as controversial at the time as it is now. In his treatment of the subject Ben Bernanke elaborates on how Fisher idea was received by the economic profession: "Fisher's Idea was less influential in academic circles though, because of the counterargument that debt-deflation represented no more than a redistribution from one group (debtors) to another (creditors). Absent implausibly large differences in marginal spending propensities among the groups, it was suggested, pure redistributions should have no signifiant macro-economic effects"38 As Bernanke outlines the prime reason for dismissing the theory was that debt has no macro- economic effects, and that debt merely involves a transfer of spending power from saver to borrower. Thus, deflation simply increases the amount transferred in debt servicing and repayment from the borrower to the saver and therefore has no impact on aggregate demand unless savers and borrowers have very different spending propensities Naturally, Eggertson and Krugman (KE) are well aquainted with the Bernanke’s mainstream idea of seeing debt merely as a transfer of spending power. But argues that the view is ill considered. “It assumes, implicitly, that debt is debt -- that it doesn't matter who owes the money. Yet that can't be right; if it were, debt wouldn't be a problem in the first place… It follows that the level of debt matters only if the distribution of that debt matters, if highly indebted players face different constraints from players with low debt. And this means that all debt isn't created equal -- which is why borrowing by some actors now can help cure problems created by excess borrowing by other actors in the past.”39

37 Fisher, Irving. "The Debt-Deflation Theory of Great Depressions." (1933). Martino Publishing 2011. 38 Bernanke, B. S. Essays on the Great Depression. Princeton University Press 2000. P. 24 39 Krugman, P. and G. B. Eggertsson (2010). Debt, Deleveraging, and the Liquidity Trap: A Fisher-Minsky-Koo approach. New York, Federal Reserve Bank of New York & Princeton University 2010. p. 3 15 BSc Thesis Student: Arvid Aagaard Jensen Supervisor: Peter Erling Nielsen University of Copenhagen, Spring 2013

How more debt may solve a problem arising from debt is the main issue when considering KE’s mode.

THE MODEL In the following exposition, I will focus on the main insights the model reveals in relation to the current policy debate. A more elaborate walkthrough of the model may be found in appendix A to which I will continuously refer. It needs mentioning that one of the contentions among scholars with regard to Minsky, is how to interpret him justly. Being a post-keynesian, Minsky himself stated that his theories could not be modeled from a neoclassical perspective based on long run equilibrium models and representative agents, which “abstract from time” and doesn’t “make great depressions one of the possible states in which our type of capitalist economy can find itself.”.40 However, Paul Krugman is quite clear on the matter when he writes: “my basic reaction to discussions about What Minsky Really Meant — and, similarly, to discussions about What Keynes Really Meant — is, I Don’t Care. I mean, intellectual history is a fine endeavor. But for working economists the reason to read old books is for insight, not authority”.41 Despite their reservations, KE follow Minsky’s lead and start of by explaining that the “central idea of debt-centered accounts of economic instability…is that views about safe levels of leverage are subject to change over time.”42 Furthermore they echo Minsky when they explain how a stable period of growth and rising asset prices reassures banks and firms that “(e)xisting debts are easily validated and units that were heavily in debt prospered: it pays to lever”.43 However, “at some point this attitude is likely to change, perhaps abruptly – an event known variously as the Wile E. Coyote moment or the Minksy moment.”44 In relation to the 2008 crisis this was the point in time when it became clear that MBS’s were overvalued and that the collateral in the financial sector was insufficient. The model follows a basic textbook New Keynesian framework, with monopolistic and infinite-lived optimizing consumers and is based on Michael Woodfords ‘cashless economy’45, although prices are naturally given in money units. There is time-dependent pricing, meaning that some fraction of firms can set prices at will and

40 Minsky (1982): p. 5 41 New York Times Blog, March 27, 2012. Minsky and Methodology (Wonkish). http://krugman.blogs.nytimes.com/2012/03/27/minksy-and- methodology-wonkish/ 42 Krugman (2012): p.7 43 Minsky 1982, p. 65 44 Krugman (2012): p.7 45 Woodford, Michael. Interest and Prices: Foundations of a Theory of Monetary Policy. Princeton University, 2003. 16 BSc Thesis Student: Arvid Aagaard Jensen Supervisor: Peter Erling Nielsen University of Copenhagen, Spring 2013 others must set prices one period ahead. The nominal interest rate is determined using the Taylor rule. It differs from conventional New Keynesian models in three ways. Firstly, consumers have different time preferences and are divided into ‘patient’ and ‘impatient’. ‘Patient’ consumers are prone to lend, ‘impatient’ are prone to borrow, which in the mathematical construction is done by giving the two types different discount factors. Secondly, there is an exogenously given debt limit, set in real terms, for both consumer types and it is assumed that maximized consumption of the impatient consumer is achieved when he borrows to the limit. Thirdly, KE incorporates “Fisherian” by denominating debt in nominal terms. First they model the ‘Minsky moment’ in a price flexible economy, by an the exogenously imposed fall in the debt constraints of their two representative agents from Dhigh to Dlow. This causes a deleveraging shock since the borrower has to reduce consumption. To make up for the lower consumption, the real interest rate has to be lowered temporarily so the saver will spend more, to uphold the consumption Euler condition.46 Furthermore, it is shown that if the debt overhang is large enough the real interest rate must go negative causing a liquidity trap, which is “an observation that goes to the heart of the economic problems we currently face.”47 Under more realistic conditions a liquidity trap refers to a situation in which central bank efforts to expand the fails to lower the interest rate and kindle economic growth. It is caused when people stockpile cash because they expect an unfavorable economic event such as the fear of asset-price deflation in the advent of the 2008 crisis. Figure 3 visualizes a liquidity trap in an IS-LM diagram. Here a monetary expansion from LM to LM’ has no effects on the interest rate or output. Contrary to this, fiscal expansion may in this scenario be especially efficient to induce higher output, since there is no change in interest rates and thus no crowding out. This is shown by the outward move of the IS curve.

Figure 3. A Liquidity Trap

46 Appendix A: Equations 10-20. 47 Ibid. 17 BSc Thesis Student: Arvid Aagaard Jensen Supervisor: Peter Erling Nielsen University of Copenhagen, Spring 2013

When introducing debt in nominal terms, but keeping the debt limit given in real terms, KE show that if the shock pushes the natural rate of interest below zero, it necessitates a drop in the price level.48 As the price level falls, the natural rate of interest becomes even more negative leading to a further price drop, repeating in a consecutive cycle. This is Irving Fisher’s debt deflation, where the natural rate of interest is now endogenously given.

In the final part of the paper KE introduces production to their model. Ct now refers to a continuum of goods giving producers of each good market power with elasticity of demand given by �. Agents face the same budget constraints as before, but instead of an endowment they receive income through wage Wt for each hour worked. Furthermore, there is a continuum of monopolistically competitive firms of measure one; each producing one type of the varieties the consumers like and with a production function linear in labor. 1 − � keep their prices fixed for a certain planning period and � change their prices continuously. Firms are committed to sell all that is demanded at the price they set and thus have to hire labor to meet this demand. Since production is endogenous, agents must not only optimize consumption but also how much they work. After deriving all the equilibrium conditions KE make a linear approximation around the steady state. Since production is endogenous and some prices are rigid a “New Classical ” - or AS curve - is established49. They also develop an IS curve50 which they combine with the assumed Taylor rule51 to obtain an AD curve. Assuming that the shock is large enough for the zero bound to be binding, it is shown that the larger the shock the larger is the fall in output and the price level.52 When graphing the model in a familiar supply and demand framework, we see that short-run curve is upwards sloping. Following a deleveraging shock, which invokes the zero lower bound, the aggregate demand curve is also upwards sloping or as KE puts it “back ward bending”.53 See figure 3. The reason for the downward sloping AD curve is that a lower price level increases the of debt giving borrowers no choice but reducing consumption. Since the interest rate is stuck at zero, savers are not inclined to consume more. This has important macroeconomic implications.

48 Appendix A: E27 49 Appendix A: E34 50 Appendix A: E43 51 Appendix A: E35 52 Krugman (2012): p. 18; Appendix A: E46 and E47 53 Krugman (2012): p. 18 18 BSc Thesis Student: Arvid Aagaard Jensen Supervisor: Peter Erling Nielsen University of Copenhagen, Spring 2013

Figure 4. AS and AD Figure 5. Paradox of toil Figure 6. Paradox of flexibility

One implication is a vestige from traditional ; namely the ‘’.54 If everyone tries to save while the interest rates are pressed against the zero lower bound, aggregate demand will fall, which eventually leads to lower investment and, in accordance with the accounting identity, lower . A second paradox is Eggertssons ‘paradox of toil’55 as displayed in figure 5. If the aggregate supply shifts out for due to a higher willingness to work for example, the effect would normally lead to higher actual output. However, in the present scenario it would lead to a fall in prices, which due to the Fisher effect is contractionary as shown by the back ward bending AD curve. Thus, a higher willingness to work paradoxically leads to less work being done. A third paradox arises, which KE call the ‘paradox of flexibility’.56 They explain it by taking point of departure in the common conception that price and wage flexibility are prone to mitigate the losses from negative demand shocks. As Milton Friedman and Anna Schwarz have argued in connection to the Great Depression, the significant pool of unemployed workers would have led to a fall in wages and prices restoring equilibrium in the labor market, if the government had just kept the money supply from falling. Friedman thus criticized the New Deal Policies for inhibiting wage and price flexibility which blocked a natural economic recovery.57 KE’s model argues against this. If we introduce more price flexibility, illustrated by a steeper aggregate supply curve in figure 6 we may graph the shock as a leftward shift from AD1 to AD2 and see the effects with ‘sticky’ prices given by ASsticky and compare with the more price/wage responsive ASflexible. As the figure indicates, the fall in output is larger when prices are flexible than when they are sticky. This is because falling prices raises the real value of debt and reduces the borrowers spending in accordance with the Fisher effect.

54 As explained by Keynes, the paradox of thift states that a collective rise in savings during an economic recession will lead to a fall in aggregate demand and thus lower savings. 55 Krugman(2012): p.19 56 Ibid. 57 Friedman, Milton; Schwartz, Anna. A Monetary History of the United States, 1867–1960. Princeton University Press 1963. P. 125 19 BSc Thesis Student: Arvid Aagaard Jensen Supervisor: Peter Erling Nielsen University of Copenhagen, Spring 2013

POLICY IMPLICATIONS In terms of the monetary policy that should be put in place following a deleveraging shock, KE suggest the solution of raising expected inflation since it may allow for a negative natural interest rate even though nominal interest rates are bound at zero. In the context of KE’s model, a rise in expected inflation might be achieved by changing the Taylor rule, such that the central bank has a higher inflation target for a limited amount of time. This however, would only work if the higher target is credible and many might be inclined to expect central bankers to fall back into their normal habit of restricting inflation. The promise of future inflation is therefore time-inconsistent, since the central bank may act in a discretionary manner.58 In terms of fiscal policy KE argues, that their model gives reason to believe that a liquidity trap caused by deleveraging is only temporary. In light of this, they argue that a debt financed government fiscal expansion may indeed solve problems incurred by too much private debt, since it sustains output and employment and allows the private sector to repair its balance sheets. In contrast to this, some economists argue that fiscal expansion is futile due to Ricardian equivalence, which simply mean that consumers will revise their intertemporal budget plan and expect higher taxes in the future thus holding back spending in the present, and fully offset government efforts. With reference to their model, KE argues that Ricardian equivalence does not hold, because borrowers are liquidity constrained and forced to pay down their debts just as Minsky anticipated in his theory. This means that their spending depends on the margin of current income, not expected future income, which makes way for an “old-fashioned Keynesian analysis”59 even when considering rational forward looking consumers. KE also argue that tax cuts and transfer payments are effective, but only to the extent that these fall on the debt-constrained agents. Considering the difficulty in singling these agents out in a tax reform it is more likely that government spending would be more effective after a large deleveraging shock and the ensuing liquidity trap since “deficit-financed government spending can, at least in principle, allow the economy to avoid unemployment and deflation while highly indebted private-sector agents repair their balance sheets.”60 Expansionary fiscal policy not only limits the output loss, but also works against the Fisherian debt deflation, due to rising prices, which limits the shock itself.

58 Sørensen(2010): p. 662 59 Krugman(2012): p. 22 60 Krugman, P. and G. B. Eggertsson (2010). Debt, Deleveraging, and the Liquidity Trap: A Fisher-Minsky-Koo approach. New York, Federal Reserve Bank of New York & Princeton University 2010. p. 3 20 BSc Thesis Student: Arvid Aagaard Jensen Supervisor: Peter Erling Nielsen University of Copenhagen, Spring 2013

CONCLUSION It is a well-established consensus among scholars of history of economic thought, that economic theory progresses neither in a linear nor cyclical manner, but rather as a spiral where old ideas, in an evolved form, fit for a present context, regain preeminence.61 Thus theoretical approaches once deemed obsolete might lay claim to new appraisal as groundbreaking political, cultural or economics events unfold. The recent occurrence of Minsky’s ideas in the avant-garde of mainstream economic theory, following the 2008 crisis, is one such instance. One basic question that this thesis has posed is: how did the financial crisis of 2008 come to pass? With reference to a wide array of economists and institutional reports the prevalent mainstream explanations a summarized in 10 points. 1. Credit boom due to low interest rates. 2. Financial regulation had been too lax. 3. The housing policies had set wrong incentives 4. Rating agencies had misled investors. 5. The banking sector had failed in its risk setting. 6. Borrowers had taken on too much debt. 7. Widespread use of complex and opaque financial instruments. 8. Increased interconnectedness among financial markets, nationally and internationally. 9. High degree of leverage of financial institutions. 10. Central role of the household sector. The key finding of the thesis in this regard, is that these explanations are exogenous in nature and offer only diminutive systemic reasons for the crisis. Minsky’s Financial Instability hypothesis offers a more systemic explanation of the financial structure of the economy and may thus complement the more discrete mainstream explanations. Krugman and Eggersson, who in their paper examine the effects of a change in the debt limit, have certainly reviewed his emphasis on the importance of debt; such as it happened during the crisis. They argue that such a ‘Minsky moment’ causes deleveraging since borrowers are forced to reduce their debt by reducing their consumption which in turn puts downward pressure on the real interest rate, due to the Taylor-rule policy, pressing it up against the zero lower bound of the nominal interest rate, thus hampering monetary policy. KE also show that Fisherian debt-deflation arise since the price level falls; increasing the value of outstanding debt, which leads to further deleveraging and price falls. KE’s findings are of special relevance to the present public debate concerning the so called ‘sovereign debt crisis’. In the paper “Growth in Time of Debt” from 2010 Carmen and Rogoff propose a set of stylized facts with regards to the relationship between

61 Brue, Stanley and Grant, Randy. The History of Economic Thought. Thomson South Western, 2007. P 7 21 BSc Thesis Student: Arvid Aagaard Jensen Supervisor: Peter Erling Nielsen University of Copenhagen, Spring 2013 public debt and GDP growth based on they findings in table 2.62 Their findings have cause many policy makers to heed the heed the view that “traditional debt management issues should be at the forefront of public policy concerns”63, invoking ‘fiscal discipline’ manifested in such measures as 2011 EU reform of the Stability and Growth Pact. Table 2. Real GDP Growth as the Level of Public Debt Varies 20 advanced economies, 1946–2009

Sources: Reinhart, Carmen M. and Rogoff, Kenneth S. Growth in a Time of Debt Appendix Table 1, line 1.

Recently however, a study has brought to light the results in table 2 were incorrectly calculated, and that the correct average annual real GDP growth rate for countries with a public debt-to-GDP ratio over 90 percent is actually 2.2 percent and not -0.1.64 This might renew support for government fiscal stimulus such as KE suggests.

62 Reinhart, Carmen M. and Rogoff, Kenneth S. Growth in a Time of Debt. American Economic Review: Papers & Proceedings 100 (May 2010): p. 573–578 63 Ibid. p. 578 64 Herndon, Thomas; Ash, Michael; Pollin, Robert. Does High Public Debt Consistently Stifle Economic Growth? A Critique of Reinhart and Rogoff. Research Institute, 2013. P. 1 22 BSc Thesis Student: Arvid Aagaard Jensen Supervisor: Peter Erling Nielsen University of Copenhagen, Spring 2013

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Websites:

Levi Institute: http://digitalcommons.bard.edu/hm_archive/index.4.html

New York Times:

- Alan Greenspan quote: http://www.nytimes.com/2008/10/24/business/economy/24panel.html?_r=0

- Krugman Blog: http://krugman.blogs.nytimes.com/2012/03/27/minksy-and- methodology-wonkish/

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