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Tuesday, December 22, 2009

Minsky in Plain English

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plagarizing, paraphrasing and semi-quoting

in the chapter on institutional dynamics from Stabilizing an Unstable Economy, 1986, pp 278 and following

Flexibility of finance and its responsiveness to business are needed for a dynamic capitalism. This cannot exist without the banking process. But banking and finance are highly disruptive forces in our economy.

The destabilizing aspects of banking should not be surprising. After all, bankers are specialists in providing short-term financing and the banker sells his services by teaching customers how to use bank facilities. Bankers cannot make a living unless business, government and households borrow. Banks are merchants of debt.

There is currently a game that is played between the authorities and profit-seeking banks. In this game, the authorities -- the central banks -- impose interest rates and reserve regulations and operate in money markets to produce what they consider to be the right amount of money. The banks invent and innovate in order to circumvent the authorities. The authorities may constrain the rate of growth of the reserve base, but the banking and financial structure determines the efficacy of reserves.

This is an unfair game. The entrepreneurs of the banking community have much more at stake than the bureaucrats of the central banks. For forty years, the authorities have been repeatedly "surprised" by changes in the way financial markets operate. Profit-seeking bankers inevitably win. But in winning the game, the banking community destabilizes the economy. The true losers are the newly unemployed and those hurt by inflation.

It is the self-interest of the butcher and the baker that leads to the provision of meat and bread. This is a dictum propounded by Adam Smith. It has evolved into the proposition that the pursuit of self-interest leads to market equilibrium. But it is in the self-interest of bankers to make loans, to spread the use of their services. At the same time it is in the self-interest of investors to use bankers' services as long as the price of capital assets exceeds the supply price of investment goods.

That is, if you can build an asset whose price is higher than the cost of building it, investors will make as many as possible.

Whereas in commodity production the process of supply generates incomes equal to the market value of supply, in financial markets with responsive banking the demand for finance generates the offsetting supply of finance. On top of this, excess supply of finance will push up the price of capital assets relative to the supply price of investment output, and this will increase the demand for investment and therefore finance.

In a world with capitalist finance it is simply not true that the pursuit by each unit of its own self-interest will lead an economy to equilibrium. The self-interest of bankers, levered investors, and investment producers can lead the economy to inflationary expansions and unemployment-creating contractions. Supply and demand analysis -- in which market processes lead to an equilibrium -- does not explain the behavior of a capitalist economy. The financial processes endogenously create destabilizing forces. Financial fragility, which is a prerequisite for financial instability, is fundamentally a result of internal market processes.

Control of these destabilizing forces is attempted through the regime of regulation by the authorities, by chartering restrictions, and by central bank determination of the volume and effectiveness of bank reserves. The dominant economic theory of the moment, however, discredits regulatory arrangements because they are seen to reflect primitive superstitions and ignorance. This current view holds that the authorities are trying to regulate and control phenomena that do not exist in nature -- booms, inflations, crunches, recessions and depressions. These kinds of instability are, it is said, due to the very efforts to contain and offset them.

Institutions such as the Federal Reserve were introduced in an effort to control and contain disorderly conditions in banking and financial markets These institutions have now become slaves to an economic theory that denies the existence of such conditions. This theory holds that the authorities should focus on the money supply and try to achieve a constant rate of growth of this construct. [Minsky is writing in the early 1980s, at the time of the Volcker Monetarist experiment.] The authorities, in fact, accept these blinders, and now ignore the financial relations by which monetary phenomena affect activity.

These money-supply blinders conceal from view the ways in which portfolio transformations occur and how they affect the stability of the economy. The erosion of bank equity bases, the growth of liability management banking, and the greater use of covert liabilities are virtually ignored until financial markets break down. Only then does the Federal Reserve's original reason for being come into play. The Fed, acting as a lender of last resort, pumps reserves into the banking system and refinances banks in order to prevent a breakdown of the financing system.

In this role as lender of last resort, the authorities increase the reserve base of banks and validate the threatened financial usages. Many financial institutions, in addition to those that are in immediate danger of failing, retrench and become conservative to improve their own financial posture. In a capitalist economy with Big Government, automatic and discretionary fiscal stabilizers lead to a large deficit that sustains profits and employment. It is these deficits and the lender-of-last-resort interventions that abort the the downward spiral so common in earlier history.

The lender-of-last-resort actions combine with the huge government deficits to increase the reserve base and holdings of government debt by the banking system. This exercise shores up financing ability for a future business expansion. Because the interventions lead to a quick halt to the downturn, [obviously written before the current situation] financial disturbances ... no longer lead to sustained price decreases. Quite the opposite, the actions taken to prevent a debt deflation and a depression set a groundwork for a burst of expansion followed by inflation.

Expansions breed new financial instruments and new ways of financing activity. Defects of the new ways and the new institutions are typically revealed only when the crunch comes. The authorities intervene to prevent localized weakness from leading to a broad decline in asset values; an intervention usually taking the form of the Federal Reserve accepting new types of instruments into its portfolio or acquiescing in refinancing arrangements for new institutions and markets. By this intervention, since it validates the new ways, the central bank sets the stage for a broader acceptance and use of the new financial instruments in subsequent expansions.

If the disrupting effects of banking are to be constrained, the authorities must drop their blinders and accept the need to guide and control the evolution of financial usages and practices. In a world of businessmen and financial intermediaries who aggressively seek profit, innovators will always win the game with regulators. The authorities cannot prevent changes in the structure of portfolios from occurring. What they can do is keep the asset to equity ratio of banks within bounds by setting equity absorption ratios for various types of assets. If the authorities constrain banks and are aware of the activities of fringe banks and other financial institutions, they are in a better position to attenuate the disruptive expansionary tendencies of our economy.

Bankers supervise borrowers and holders of lines of credit. Once a line of credit is opened, the banker has a continuing concern about the affairs of the borrower and about business and financial developments that can affect the customer's viability. Given his behavior as a lender, a bank as a borrower naturally accepts supervision from its actual or potential lenders. But depositor surveillance has disappeared, a victim of deposit insurance and the merger technique of dealing with distressed banks. Bank examination by the insuring or chartering agency is now a substitute for depositor surveillance. Thus the insuring authority should have power to constrain and control business practices of its policy holders. If the deposits were uninsured, depositors would walk away from banks with low equity ratios and suspect assets. As substitutes for this depositor surveillance, the regulating and insuring authorities must be able to constrain bank asset to equity ratios and asset structures.

Commercial bank reserves mainly result from the ownership of government securities by the Federal Reserve. The government security/open market technique of supplying reserves to the banking system is not the only way reserves can be furnished. Prior to the Great Depression, a major part of reserves that were not based on gold were based on borrowings by banks at the discount window. The resurrection of the discount window as a normal source of bank reserves is a way of tightening Federal Reserve control over commercial banks. If commercial banks normally borrow at the Federal Reserve discount window, they will necessarily accept and be responsive to guidance by the Federal Reserve.

As long as bank reserves are mainly the result of open-market purchases of government securities, the giant banks are virtually immune to Federal Reserve pressures. If normal functioning required banks to borrow at the discount window, then the capital adequacy and asset structure of banks would be under Federal Reserve supervision. This would then diminish the destabilizing influences in our economy that result from too rapid an expansion of bank financing of business and asset holdings.

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