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THE MINSKY MOMENT - Comparing Minsky to Mainstream Explanations of the Financial Crisis

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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 - Arvid Aagaard Jensen BSc Thesis Supervisor: Peter Erling Nielsen Institute of Economics 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 Hyman Minsky(1919-1996) might contribute with new angles from a contemporary point of view. In this regard, the report contains an analysis of how the economists Paul Krugman and Gauti Eggertsson make use of Minsky in the economic model they offer in their 2012 paper Debt, Deleveraging and the Liquidity Trap 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. Credit boom due to low interest rates. 2. Financial regulation had been too lax. 3. Housing policies had set wrong incentives 4. Rating agencies had misled investors. 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 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. 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 economies 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 aggregate demand. 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 economy 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 monetary policy and deregulation 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 economist 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 deflation 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 Ben Bernanke, Kenneth Rogoff 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 Brown University 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 John Maynard Keynes, 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 Great Depression 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, Joseph Schumpeter and Irving Fisher 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 stagflation in the 70’s was the definitive end of Keynesianism, and through the influence of Milton Friedman 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
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