Levy Economics Institute of Bard College Levy Economics Institute of Bard College Policy Note 2018 / 1 DOES THE UNITED STATES FACE ANOTHER MINSKY MOMENT? l. randall wray Outgoing governor of the People’s Bank of China, Zhou Xiaochuan, recently sounded an alarm about the fragility of China’s financial sector, referring to the possibility of a “Minsky moment.” Paul McCulley coined the term and applied it first to the serial bursting of the Asian Tiger and Russian bubbles in the late 1990s, and later to our own real estate crash in 2007 that reverberated around the world as the global financial crisis (GFC). We are still mopping up after the excesses in the markets for mortgage-backed securities, collateralized debt obligations (squared and cubed), and credit default swaps. Governor Zhou’s public warning was unusual and garnered the attention he presumably intended. With the 19th Communist Party Congress in full swing in Beijing, there is little doubt that recent rapid growth of Chinese debt (which increased from 162 percent to 260 percent of GDP between 2008 and 2016) was a topic of discussion, if not deep concern. Western commentators have weighed in on both sides of the debate about the likelihood of China’s debt bubble heading for a crash. And yet there has been little discussion of the far more probable visitation of another Minsky moment on America. In this policy note, I make the case that it is beginning to look a lot like déjà vu in the United States. Senior Scholar l. randall wray is a professor of economics at Bard College. The Levy Economics Institute is publishing this research with the conviction that it is a constructive and positive contribution to the discussion on relevant policy issues. Neither the Institute’s Board of Governors nor its advisers necessarily endorse any proposal made by the author. Copyright © 2018 Levy Economics Institute of Bard College ISSN 2166-028X Who Was Minsky and Why Should We Care?1 We did not do that this time, and our financial system Hyman P. Minsky was an economist who studied at Harvard remains far bigger (relative to the size of the economy) and far under both Alvin Hansen (secular stagnation) and Joseph more dangerous than it was on the eve of the Great Depression. Schumpeter (innovation and creative destruction). Beginning Indeed, it is arguably worse than it was on the eve of our last in the late 1950s, he developed a theory of the natural evolu- Minsky moment in 2007. Our “too-big-to-fail” institutions tion of the financial structure from robust and safe to fragile actually have bigger market shares than they had before the and crisis prone. He presciently predicted that the early postwar GFC. And nothing significant has been done about the finan- period would be relatively stable (unlike his more pessimistic cial institutions operating in the shadows. As Eugene Ludwig mentors), but insisted that “stability is destabilizing” because it (2016), former Comptroller of the Currency, argued: “While would encourage ever-more risky behavior. reforms adopted since the financial crisis have placed stiff rules Just as he predicted, America’s postwar economy avoided around the regulated financial sector, we’ve seen essentially a financial crisis for the first two decades, until the municipal none for the non-regulated or shadow financial sector. That bond crisis of 1966 required a quick policy response to contain means that many, if not all, of the practices that led to the last the fallout—a process that was repeated every few years over the financial crisis can be practiced almost without restraint in the next two decades as crises came more frequently and with greater shadow system.” 3 punch. In 1982, Minsky published a book titled Can “It” Happen Again?—and by “It” he meant another Great Depression in con- junction with a nearly complete collapse of the financial system. How Bad Is It? At that time, he answered “no.” While the financial system had In the run-up to the Great Depression, total US debt to GDP become more fragile, he was convinced that policymakers had reached nearly 300 percent. After the crash in the early 1930s, sufficient determination and competence to rescue it. it fell to well under 200 percent over the following decade. However, he began to change his mind in the 1990s. Some of the decline was due to bankruptcy, some was due to Finance had ballooned relative to the size of the economy, with debt repayment, and much of it was due to growth of GDP as the great hegemonic financial institutions considered “too big the economy recovered. Importantly, note that nongovernment to fail.” Top management of the biggest banks took advantage debt fell to about 50 percent of GDP, while government debt of the “Greenspan put”2 to ramp up risk, permitted by inno- expanded to 100 percent of GDP—mostly due to war spending. vation as well as deregulation. Before he died in 1996, Minsky Over the early postwar boom, the government debt ratio began to wonder if our policymakers still had the determination declined steadily, not because bonds were repaid (they were and competence that would be required. Just over a decade later, not!) but because GDP grew. But after the sharp drop in the those policymakers were tested. They were bent, but they were 1930s and 1940s, the private sector debt ratio began to grow on not broken. “It” did not—quite—happen again. trend, slowly in the 1960s, but more rapidly over time, and with There was one important lesson learned in the 1930s an accelerating rate after the mid-1990s. This was true of both that was not applied in response to the GFC. When President corporate debt as well as household debt. This helped to boost Roosevelt took office, he immediately invoked a “bank holiday” the total debt ratio to an even higher peak on the eve of the that shut down all the banks. He put Jesse Jones, who proved to GFC—to 500 percent of GDP (see Figure 1). be a harsh taskmaster, in charge of reopening them. If he did not However, the truly remarkable feature of the later postwar believe a bank could recover, he shut it down (Jones 1951). If it period was the growth of debt in the financial sector itself. We needed help, he “nationalized” it by putting it under partial gov- could call this financialization, financial sector leveraging, or ernment ownership to better control it. He insisted on receiving financial layering of debt-on-debt. This grew to 137 percent of resignation letters from top management, to keep in his drawer GDP by the time of the GFC—more than household debt (100 should he ever need to get rid of recalcitrant managers. The percent), nonfinancial corporate debt (90 percent), or govern- entire financial system was downsized, regulated, supervised, ment debt (80 percent). and domesticated. What is financialization? Financial institutions issuing liabilities to other financial institutions in order to leverage up Policy Note, 2018/1 2 Figure 1 Ratio of Total Liabilities to GDP nonfinancial, noncorporate businesses and farms accounted for another $1.75 of debt to service per dollar of income.) 5 Financial institutions’ leveraging of debts-on-debts added 4.5 4 another $1.37 of debt to service—in the form of extra interest, 3.5 fees, and penalties—for every dollar of income. This debt ser- 3 vice must come from the income-generating part of the econ- 2.5 2 omy, reducing net income that can be used to purchase output 1.5 of final goods and services. Ultimately, that indebtedness within 1 the financial sector gets serviced by the equivalent of a tax lev- 0.5 0 ied on the debts of the household and business sectors. 1 While financial sector indebtedness was occasionally 201 1916 1921 1926 1931 1936 1941 1946 1951 1956 1961 1966 1971 1976 1981 1986 1991 1996 2001 2006 2016 State and Local noticed before the GFC, it was generally dismissed as unim- Federal portant. Surely all this debt within the financial sector nets to Government-Sponsored Enterprise (GSE) Private Finance zero? Bank of America owes Citibank, which owes JPMorgan, Nonfinancial Corporate which owes Bank of America—it is internal to the financial sec- Nonfinancial Noncorporate Households and Nonprofit tor. So long as all the banks keep paying each other, it is just a Note: The government sector excludes all financial activities of the government nice virtuous circle, or so it was assumed. (retirement funds, Ginnie Mae, etc.). The GSE sector includes government- However, this is where the GFC began: the big financial sponsored enterprises and agency- and GSE-backed mortgage pools (includes, among others, Ginnie Mae and Federal Housing Administration pools). institutions were relying on short-term, often overnight, liabili- “Financial” excludes the GSE sector and monetary authorities (which are both ties such as commercial paper that had to be rolled over each part of the financial sector in the Flow of Funds accounts). Before 1945, liabilities for financial institutions are computed from Census Bureau data by morning in order to finance their positions in assets. Suddenly, taking all the liabilities (excluding equity) of commercial banks, credit unions, the purchasers of such debt (for example, money market mutu- savings institutions, life insurance stock companies, and property and life insurance companies, and by removing private bank notes, all deposits, and life al funds) decided they would rather have cash than continue to insurance reserves. From 1945, the total liabilities of the financial sector excludes net interbank liabilities of commercial banks, liabilities of monetary authorities, buy bank debt.