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Saturday, December 26, 2009

Review: Stabilizing an Unstable Economy

The recent financial crisis has been called a Minsky moment by many economists I respect. Minsky's 1984 work, Stabilizing an Unstable Economy was out of print for many years, and certainly not available at my local library, so I bought the Kindle edition and decided to read it over my vacation.

What the book encompasses is a re-engineering of existing orthodox economic theory. Fundamentally, Minsky believes that the lessons of John Maynard Keynes has been misunderstood and unincorporated into modern economic theory, which holds that a free market, capitalist economy is self-stabilizing at an equilibrium that approximates full employment. The typical argument then, is that government intervention is self-defeating and does not accomplish much.

The book covers several topics, the most important of which is an exposition of what Minsky considers the basic instability of our capitalist economy. He fundamentally divides financing schemes for projects into 3 types: hedge finance, where debts are paid for out of ongoing operations, speculative finance, where debts are paid for by a series of continual refinancing activities in the hopes that ongoing operations will eventually exceed the costs of refinancing, and finally ponzi finance, where even the interest on debt is paid for by a series of increasingly large refinancing activities, in the hopes of a future payoff. An economy consisting entirely of hedge projects is very stable, while an economy filled with speculative and ponzi projects runs the risk of a financial collapse. The post-war economy from 1946 to 1966 looked very much like the former, while the economy post 1966 looked very much like the latter.

How then, does our current economy not collapse into a depression despite having had several financial collapses? The answer, Minsky answers is Big Government, which is capable of running a deficit as well as organizing bailouts of bad financial bets when they reach a collapse. However, Minsky argues that this leads inexorably to the increasing instability of the economy, since each bail out legitimizes and validates the dodgy financial instruments that caused the financial collapse in the first place.

Acceptable financing techniques are not technologically constrained; they depend upon the subjective preferences and views of bankers and businessmen about prospects. With the financial structure that ruled in the 1950s, it was correct for businessmen and bankers to increase short-term indebtedness. However, success breeds a disregard of the possibility of failure; the absence of serious financial difficulties over a substantial period leads to the development of a euphoric economy in which increasing short-term financing of long positions becomes a normal way of life.16 As a previous financial crisis recedes in time, it is quite natural for central bankers, government officials, bankers, businessmen, and even economists to believe that a new era has arrived. Cassandra-like warnings that nothing basic has changed, that there is a financial breaking point that will lead to a deep depression, are naturally ignored in these circumstances. Since the doubters do not have fashionable printouts to prove the validity of their views, it is quite proper for established authority to ignore arguments drawn from unconventional theory, history, and institutional analysis. Nevertheless, in a world of uncertainty, given capital assets with a long gestation period, private ownership, and the sophisticated financial practices of Wall Street, the successful functioning of an economy within an initially robust financial structure will lead to a structure that becomes more fragile as time elapses. Endogenous forces make a situation dominated by hedge finance unstable, and endogenous disequilibrating forces will become greater as the weight of speculative and Ponzi finance increases.
The result of these continual series of bailouts is that inflation has become a persistent and endemic part of the economy, and each bail out has to be increasingly larger, while not solving the fundamental instability of the economy in the form of financial institutions which while under regulation very quickly take control of the regulators, no matter the intentions of the legislation behind such regulation.

Minsky then goes on to describe what he considers to be important measures that could stabilize an economy. These prescriptions seem guaranteed to piss off liberals and conservatives alike, but in the light of his theory seem very sensible. He proposes setting a desired target size for the government such that it is big enough to manage changes in the economy. He further proposes the elimination of welfare, and replacing it with a guaranteed jobs program much like Roosevelt's. Then, financial institutions can be allowed to fail, since a series of Ponzi schemes that fall apart would not automatically spread across the entire economy.

I think a lot of people wouldn't like the typical man on the street to read this book: the existing Economics establishment wouldn't want you to read it because it highlights the failings of conventional economic theory. Conservatives probably wouldn't like the prescription of a Big Government, and Liberals wouldn't like the destruction of transfer payments. Yet the book is relatively accessible: none of the math involves more than simple summation series and algebra, and the writing is relatively clear and lucid, though dense. More importantly, if we realized the major structural problems in the economy that Minsky describes, we can actually have a debate about how to fix the root causes, rather than indulging in one bailout after another which doesn't actually seem to solve any problems, and just sets us up for further economic collapse. Highly recommended at the full price.

One caveat about the Kindle version: It's not very well formatted for the Kindle, as footnotes are inline rather than hyper-linked. This makes the footnotes very jarring to read. Nevertheless, it was worth it to have the book available on vacation.

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