Going beyond financial instability hypothesis

Going beyond financial instability hypothesis

As the curtain comes down on the tumultuous year that was 2009, most people will be heaving a sigh of relief that the direst predictions about the crisis have not come true.

The much-derided green shoots of recovery have turned into saplings. The central bankers of the world, many of whom have been accused of causing the crisis in the first place, seem to have pulled off a recovery. The grim warnings of a second Great Depression have been belied, and even the prospect of a Japan-style deflation for the West no longer rings true.

As for the rumblings of an imminent end to the Anglo-Saxon brand of financial capitalism, these are now dismissed out of hand. The party line now is: it was a financial crisis, pure and simple. The underlying real economy is perfectly safe and sound—it was those dastardly bankers who are the villains.

Those on the right say that all that is required is to tighten the regulatory structures, tweak the financial incentives for bankers a bit, and voila, we can all start playing the game again. Those on the left fret and fume against the bankers and say that Wall Street must once again be made subservient to Main Street.

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There is no doubt, though, that the crisis has led to a search for what went wrong and part of that process has been the rediscovery of unorthodox economists. Foremost among them is Hyman Minsky, whose financial instability hypothesis is probably required reading now for all bankers and economists. Minsky has been resurrected, dressed in appropriately respectable clothes and appropriated by the establishment.

Of course, not all parts of the Minsky canon deserve equal respect. His call for a socialization of investment has been completely ignored, but his instability thesis has been eagerly adopted by the mainstream.

What exactly does this financial instability hypothesis tell us? Simply, Minsky says that good times lead to bad. That’s because when times are good, people become overconfident, start to speculate, and borrow to support the speculation. Borrowers as well as lenders take on more risk in the belief that the good times will last forever. The bubble then bursts, debts are called in, speculators are unable to pay up, leading to unwinding of debt across the board, asset prices crash and the economy grinds to a halt.

The momentum is reinforced by a supercycle of deregulation and changing attitudes to risk-taking. In the early stages of the supercycle, the institutions and regulations will act against the excesses of the cycle. But as business continues to progress more or less smoothly, complacence creeps in, regulations are dismantled and people start believing that this time it’s different. Remember all the talk of the Great Moderation, the belief that the world economy had reached a blissful state of high and sustainable growth with little inflation just before the bust?

Note that Minsky’s theory has two facets: It’s a theory based on psychology and it has as its centre the financial system. It follows, therefore, that putting some “sand in the wheels of finance" by tightening regulations, or by having a tax on speculative transactions, should be enough to cool the cycle. Hence the demand that central bankers should step in early to prick asset bubbles.

But not everybody is convinced. Thomas Palley, an economist with the New America Foundation in Washington, DC, says the crisis was not a financial crisis alone, but was the result of deep underlying problems in the real economy. In a paper titled The Limits of Minsky’s Financial Instability Hypothesis as an Explanation of the Crisis, Palley says that while financial reform is certainly needed to address the problems of excessive speculation, the root cause of the crisis is the neo-liberal growth model.

This model is essentially political. Its aim was to curb the power of the working class in the West and restore conditions for rapid capital accumulation. To do that, it delegitimized trade unions, shifted production to cheaper locations, pitting workers in competition with each other. The upshot: stagnant real wages for workers in the US and a rising share of profits in gross domestic product.

Writes Palley: “These new policies can be described in terms of a pen that fenced workers in. The four sides of the pen are globalization, labour market flexibility, small government and abandoning full employment."

But how did the model ensure growth? It used two mechanisms: increased borrowing by households and rising asset prices. Palley points out, echoing Minsky, that financial innovation and deregulation help to expand and increase borrowing and allow a steady flow of new financial products that increase leverage and widen the range of assets that can be collateralized.

In short, Palley’s point is that the neo-liberal model works only because of the financialization of the economy and Minsky’s instability thesis is therefore part and parcel of an underlying problem in the real economy. If you merely try to clip the wings of the financial system, growth under the neo-liberal system will falter.

As economist Andy Xie has argued, “While there are many theories why monetary policy works, the dirty little secret is that it works by inflating asset markets... In other words, monetary policy works by creating asset bubbles."

Minsky said: “Whereas all capitalisms are flawed, not all capitalisms are equally flawed." Will we have a less flawed, more stable capitalism? At the moment, that seems very doubtful. Watch out for the next bubble.

Manas Chakravarty takes a weekly look at trends and issues in the financial markets. Your comments are welcome at capitalaccount@livemint.com