Tag Archives: Credit crunch

Financial Instability

By L. Randall Wray [via CFEPS]

Economists have long been concerned with the economic fluctuations that occur more-or-less regularly in all capitalist economies. (Sherman 1991; Wolfson 1994) To be sure, there are different kinds of economic fluctuations—ranging from the Kitchin cycle (tied to inventory swings and lasting on average 39 months) to the Juglar cycle (lasting about seven or eight years and linked to investment in plant and equipment) to the Kuznets cycle of twenty years (associated with demographic changes) and finally to the Kondratieff long wave cycles attributed to major innovations (electrification, the automobile). (Kindleberger 1989) Financial factors might play only a small role in some of these fluctuations. Generally, economists studying financial instability have tended to focus on periodic financial crises that frequently coincide with the peak of the common business cycle, although financial crises (especially in recent years) can occur at other times during the cycle. Furthermore, an economy might be financially unstable but manage to avoid a financial crisis. It is best to think of financial instability as a tendency rather than as a specific event, although the typical financial crisis might be the result of unstable financial processes generated over the course of a business cycle expansion. In this essay, we will be concerned primarily with economic instability that has at its roots a financial cause, with less interest in either economic fluctuation that is largely independent of finance or in isolated financial crises that do not spill over to the economy as a whole.

A variety of explanations of the causes of financial instability have been offered. One possible cause could be a speculative “mania” in which a large number of investors develop unrealistic expectations of profits to be made, borrowing heavily to finance purchases of assets and driving their prices to absurd levels. Eventually, the mania ends, prices collapse, and bankruptcies follow. (Kindleberger 1989) The tulip mania of 1634, the South Sea bubble in 1719, or the Dot-com boom of the late 1990s might be cited as examples of speculative manias. Speculative booms often develop, and are fueled by, fraudulent schemes. Recent examples of financial crises in which fraud played a large role include the collapse of the Albanian national pension system (1990s) as well as the American Savings and Loan fiasco (1980s). (Mayer 1990) Other explanations have tended to focus on a sudden interruption of the supply of money or credit that prevents borrowing and forces spending to decline, precipitating a cyclical downturn. The modern monetarist approach attributes financial instability and crises to policy errors by central banks. According to monetarist doctrine, when the central bank supplies too many reserves, the money supply expands too quickly, fueling a spending boom. If the central bank then over-reacts to the inflation this is believed to generate, it reduces the money supply and causes spending to collapse. (Friedman 1982) Others advance a “credit crunch” thesis according to which lenders (mostly banks) suddenly reduce the supply of loans to borrowers—either because the lenders reach some sort of institutional constraint or because the central bank adopts restrictive monetary policy (as in the monetarist story). (Wojnilower 1980; Wolfson 1994) Finally, one could add exchange rate instability and foreign indebtedness as a precipitating cause of economic instability, especially in developing nations since the breakup of the Bretton Woods system. (Huerta 1998)

Other analyses have identified processes inherent to the operation of capitalist economies. (Magdoff and Sweezy 1987) In other words, rather than looking to fundamentally irrational manias or to “exogenous shocks” emanating from monetary authorities, these approaches attribute causation to internal or endogenous factors. Karl Marx had claimed that the “anarchy of production” that is an inevitable characteristic of an unplanned economy in which decisions are made by numerous individuals in pursuit of profit is subject to “disproportionalities” of production such that some of the produced goods cannot be sold at a price high enough to realize expected profits. Key to his explanation was the recognition that production always begins with money, some of which is borrowed, used to purchase labor and the instruments of production in order to produce commodities for sale. If, however, some of the commodities cannot be sold at a sufficiently high price, loans cannot be repaid and bankruptcies occur. Creditors then may also be forced into bankruptcy when their debtors default because the creditors, themselves, will have outstanding debts they cannot service. In this way, a snowball of defaults spreads throughout the economy generating a panic as holders of financial assets begin to worry about the soundness of their investments. Rather than waiting for debtors to default, holders of financial assets attempt to “liquidate” (sell) assets to obtain cash and other safer assets. This high demand for “liquidity” (cash and marketable assets expected to hold nominal value) causes prices of all less liquid assets to collapse, and at the same time generates reluctance to spend as all try to hoard money. Thus, the financial crisis occurs in conjunction with a collapse of aggregate demand. (Sherman 1991; Marx 1990, 1991, 1992)

Some of the elements of Marx’s analysis were adopted by Irving Fisher in his “debt deflation” theory of the Great Depression, as well as by John Maynard Keynes in his General Theory. While Fisher devised a theory of special conditions in which markets would not be equilibrating, in Keynes’s theory these were general conditions operating in monetary economies. Briefly, Fisher attributed the severity of the Great Depression to the collapse of asset prices and the ensuing financial crisis that resulted from an avalanche of defaults. (Fisher 1933; also Galbraith 1972) Adopting Marx’s notion that capitalist production begins with money on the expectation of ending with more money later, Keynes developed a general theory of the determination of equilibrium output and employment that explicitly incorporated expectations. (Keynes 1964) He concluded there are no automatic, self-righting forces operating in capitalist economies that would move them toward full employment of resources. Indeed, he described destabilizing “whirlwinds” of optimism and pessimism, in striking contrast to the Smithian notion of an “invisible hand” that would guide markets toward stable equilibrium. Also, like Marx, Keynes identified what he called the “fetish” for liquidity as a primary destabilizing force that erects barriers to the achievement of full employment. Most relevantly, rising liquidity preference lowers the demand for capital assets, which leads to lower production of investment goods and thus falling income and employment through the multiplier effect.

Hyman Minsky, arguably the foremost twentieth century theorist on the topic of financial instability, extended Keynes’s analysis with two primary contributions. (Minsky 1975, 1986) First, Minsky developed what he labeled “a financial theory of investment and an investment theory of the cycle”, attempting to join the approaches of those who emphasized financial factors and those who emphasized real factors as causes of the cycle by noting that the two are joined in a firm’s balance sheet. (Papadimitriou and Wray 1998) As in Keynes’s approach, fluctuations of investment drive the business cycle. However, Minsky explicitly examined investment finance in a modern capitalist economy, arguing that each economic unit takes positions in assets (including, but not restricted to, real physical assets) that are expected to generate income flows by issuing liabilities that commit the unit to debt service payment flows. Because the future income flows cannot be known with certainty (while the schedule of debt payments is more-or-less known), each economic unit operates with margins of safety, collateral, net worth, and a portfolio of safe, liquid assets to be drawn upon if the future should turn out to be worse than expected. The margins of safety, in turn, are established by custom, experience, and rough rules of thumb. If things go at least as well as expected, these margins of safety will prove in retrospect to have been larger than what was required, leading to revisions of operating rules. Thus, a “run of good times” in which income flows are more than ample to meet contracted payment commitments will lead to reductions of margins of safety. Minsky developed a classification scheme for balance sheet positions that adopted increasingly smaller margins of safety: hedge (expected income flows sufficient to meet principal and interest payments), speculative (near-term expected income flows only sufficient to pay interest), and Ponzi (expected income flows not even sufficient to pay interest, hence, funds would have to be borrowed merely to pay interest).

This leads directly to Minsky’s second contribution, the financial instability hypothesis. Over time, the economy naturally evolves from one with a “robust” financial structure in which hedge positions dominate, toward a “fragile” financial structure dominated by speculative and even Ponzi positions. This transition occurs over the course of an expansion as increasingly risky positions are validated by the booming economy that renders the built-in margins of error superfluous—encouraging adoption of riskier positions. Eventually, either financing costs rise or income comes in below expectations, leading to defaults on payment commitments. As in the Marx-Fisher analyses, bankruptcies snowball through the economy. This reduces spending and raises planned margins of safety. The recession proceeds until balance sheets are “simplified” through defaults and conservative financial practices that reduce debt leverage ratios.

Central to Minsky’s exposition is his recognition that development of the “big bank” (central bank) and the “big government” (government spending large relative to GDP) helps to moderate cyclical fluctuation. The central bank helps to attenuate defaults and bankruptcies by acting as a lender of last resort; countercyclical budget deficits and surpluses help to stabilize income flows. The problem, according to Minsky, is that successful stabilization through the big bank and the big government creates moral hazard problems because economic units will build into their expectations the supposition that intervention will prevent “it” (another great depression) from happening again. Thus, risk-taking is rewarded and systemic fragility grows through time, increasing the frequency and severity of financial crises even as depression is avoided. While there may be no ultimate solution, Minsky believed that informed and evolving regulation and supervision of financial markets is a necessary complement to big bank and big government intervention. Like Keynes, Minsky dismissed the belief that reliance upon an invisible hand would eliminate financial instability, indeed, he was convinced that an unregulated, small government capitalist economy would be prone to great depressions and the sort of debt deflation process analyzed by Irving Fisher.



Fisher, I. (1933), ‘The Debt-Deflation Theory of Great Depressions’, Econometrica, 1, October: pp. 337-57.

Friedman, M. (1982), Capitalism and Freedom, Chicago and London: The University of Chicago Press.

Galbraith, J. (1972), The Great Crash, Boston: Houghton-Mifflin.

Keynes, J. (1964), The General Theory of Employment, Interest, and Money, New York and London: Harcourt Brace Jovanovich.

Kindleberger, C. (1989) Manias, Panics, and Crashes: A history of financial crises, New York: Basic Books, Inc.

Huerta, A. (1998), La Globalizacion, Causa de la Crisis Asiatica Y Mexicana, Mexico: Editorial Diana.

Magdoff, H. and P. Sweezy. (1987) Stagnation and the Financial Explosion, New york: Monthly Review Press.

Marx, K. (1990), Capital: Volume 1, London: Penguin Classics.

—–. (1991), Capital: Volume 3, London: Penguin Classics.

—–. (1992), Capital: Volume 2, London: Penguin Classics.

Mayer, M. (1990), The Greatest-Ever Bank Robbery: the collapse of the savings and loan industry, New York: Charles Scribner’s Sons.

Minsky, H. (1975), John Maynard Keynes, New York: Columbia University Press.

—–. (1986), Stabilizing an Unstable Economy, New Haven and London; Yale University Press.

Papadimitriou, D. and L.R. Wray (1998), ‘The Economic Contributions of Hyman Minsky: varieties of capitalism and institutional reform‘, Review of Political Economy 10, No. 2, pp. 199-225.

Sherman, H. (1991), The Business Cycle: Growth and crisis under capitalism, Princeton, New Jersey: Princeton University Press.

Wojnilower, A. (1980), ‘The Central Role of Credit Crunches in Recent Financial History’, Brookings Papers on #Economic Activity, No. 2: 277-326.

Wolfson, M. (1994), Financial Crises: Understanding the postwar U.S. experience, Armonk, New York and London: M.E. Sharpe.

Financial Engineers and The Brave New World

And some people say that no one saw this crisis coming. Bright people almost 10 years ago foresaw and understood the risks and consequences of private sector indebtedness and its relation to government surpluses.

by Warren Mosler and Eileen Debold

Just as the Corps of Engineers sustains the army’s fighting ability, our financial engineers have been sustaining the US post-Cold War economic expansion. Financial engineering has effectively supported an expansion that could have long ago succumbed to the ‘financial gravity’ economists call ‘fiscal drag.’ For even with lower US tax rates, the surge in economic growth has generated federal tax revenues in excess of federal spending. This has led to both record high budget surpluses and the record low consumer savings that is, for all practical purposes, the other side of the same coin. As the accounting identity states, a government surplus is necessarily equal to the non-government deficit. The domestic consumer is the largest component of ‘non-government’ trailed by domestic corporations, and non- resident (foreign) corporations, governments, and individuals.

It is our financial engineers who have empowered American consumers with innovative forms of credit, enabling them to sustain spending far in excess of income even as their net nominal wealth (savings) declines. Financial engineering has also empowered private-sector firms to increase their debt as they finance the increased investment and production. And, with technology increasing productivity as unemployment has fallen, prices have remained acceptably stable.

Financial engineering begins deep inside the major commercial and investment banks with ‘credit scoring.’ This is typically a sophisticated analytical process whereby a loan application is thoroughly analyzed and assigned a number representing its credit quality. The process has a high degree of precision, as evidenced by low delinquencies and defaults even as credit has expanded at a torrid pace. Asset securitization, the realm of another highly specialized corps of financial engineers, then allows non-traditional investors to be part of the demand for this lending-based product. Loans are pooled together, with the resulting cash flows sliced and diced to meet the specific needs of a multitude of different investors. Additionally, the financial engineers structure securities with a careful eye to the credit criteria of the major credit rating services most investors have come to rely on. The resulting structures range from lower yielding unleveraged AAA rated senior securities to high yielding, high risk, ‘leveraged leverage’ mezzanine securities of pools of mezzanine securities.

Private sector debt growth can only exceed income growth for a limited time, even if the debt growth is also driving asset prices higher. At some point the supply of credit wanes. But not for lack of available funds (since loans create deposits), but when even our elite cadre of financial engineers exhaust the supply of creditworthy borrowers who are willing to spend. When that happens asset prices go sideways, consumer spending and retail sales soften, jobless claims trend higher, leading indicators turn south, and car sales and housing slump. There is a scramble to sell assets and not spend income in a futile attempt to replace the nominal wealth being drained by the surplus. Consequently, as unemployment bottoms and begins to increase, personal and corporate income decelerate, and government revenues soon fall short of expenditures as the economy slips into recession. The financial engineers then shift their focus to the repackaging of defaulted receivables.

Both Presidential candidates have voiced their support for maintaining the surplus to pay down the debt, overlooking the iron link between declining savings and budget surpluses. For as long as the government continues to tax more than it spends, nominal $US savings (the combined holdings of residents and non-residents) will be drained, keeping us dependent on financial engineering to sustain spending and growth in the global economy.

Mr. Mosler is the chairman of A.V.M. L.P. and director of economic analysis, III Advisors Ltd. Ms. Debold is vice president, Global Risk Management Services, The Bank of New York.


Another interesting piece, an interview of Professor L. Randall Wray, almost 9 years old saw the current crisis coming.

Q:Based on the current economic scenario, and taking into account the recent interest rates increases, how probable is the hypothesis of a “soft-landing” for the American economy?

LRW: It is highly improbable that an economic slowdown could stop at a “soft-landing”, given economic conditions that exist today. The U.S. expansion of the past half dozen years has been driven to an unprecedented extent by private sector borrowing. Indeed, the private sector has been spending more than its income in recent years, with its deficit reaching 5.5% of GDP in 1999. In order for the economy to continue to grow, this gap between income and spending must continue to grow. My colleague at the Jerome Levy Economics Institute, Wynne Godley, has projected that the private sector’s deficit would have to climb to well over 8% of GDP by 2005 in order to keep economic growth just above 2.5%. Even that is below the current rate of growth (about 4%). A smaller private sector deficit would mean even lower growth. There are two problems with this scenario. First, our private sector has never run deficits in the past as large as those experienced in this current expansion. In the past, private sector deficits reached a maximum of about 1% of GDP and then quickly reversed toward surplus as households and firms cut back spending to bring it below income. Not only are current deficits already five times higher than anything achieved in the past, they have already lasted two or three times longer than any previous deficits. Even more importantly, the private sector has had to borrow in order to finance its deficit spending, which increases its indebtedness. Private sector debt is already at a record level relative to disposable income. As interest rates rise, this increases what are known as debt service burdens—the percent of disposable income that must go to pay interest (and to repay principal) on debt. In combination with an economic slowdown, which reduces the growth of disposable income, many firms and households will find it impossible to meet their payment commitments. Defaults and bankruptcies are already on the rise, and things will only get worse. Thus, I believe there is a real danger that an economic slowdown could degenerate into a deep recession—or even worse.

Wray also saw it coming (see here), as he put it:

How would Minsky explain the processes that brought us to this point, and what would he think about the prospects for continued Goldilocks growth?

First, I think he would argue that consumers became ready, willing, and able to borrow, probably to a relative degree not seen since the 1920s. Credit cards became much more available; lenders expanded credit to sub-prime borrowers; bad publicity about redlining provided the stick, and the Community Reinvestment Act provided the carrot to expand the supply of loans to lower income homeowners; deregulation of financial institutions enhanced competition. All of these things made it easier for consumers to borrow. Consumers were also more willing to borrow. As Minsky used to say, as memories of the Great Depression fade, people become more willing to commit future income flows to debt service. The last general debt deflation is beyond the experience of almost the whole population. Even the last recession was almost half a generation ago. And it isn’t hard to convince oneself that since we’ve really only had one recession in nearly a generation, downside risks are small. Add on top of that the stock market’s irrational exuberance and the wealth effect, and you can pretty easily explain consumer willingness to borrow.

I would add one more point, which is that until very recently, most Americans had not regained their real 1973 incomes. Even over the course of the Clinton expansion, real wage growth has been very low. Americans are not used to living through a quarter of a century without rising living standards. Of course, the first reaction was to increase the number of earners per family—but even that has allowed only a small increase of real income. Thus, I think it isn’t surprising that consumers ran out and borrowed as soon as they became reasonably confident that the expansion would last.

The result has been consistently high growth of consumer credit…The expansion might not stall out in the coming months, but continued expansion in the face of a trade deficit and budget surplus requires that the private sector’s deficit and thus debt load continue to rise without limit…What would Minsky recommend? So long as private sector spending continues at a robust pace, he would probably recommend that we do nothing today about the budget surplus. He would oppose any policies that would tie the hands of fiscal policy to maintenance of a surplus. Rather, he would push toward recognition that tax cuts and spending increases will be needed as soon as private sector spending falters. That means it is time to begin discussion of the types of tax cuts and spending programs that will be rushed through as the recession begins. For the longer run, he would recommend relaxation of the fiscal stance so that surpluses would be achieved only at high growth rates (in excess of the full employment rate of economic growth). For the shorter run, he would oppose monetary tightening, which would increase debt service ratios and push financial structures into speculative or Ponzi positions. He would support policies aimed at reducing “irrational exuberance” of financial markets; most importantly, increased margin requirements on stock markets would be far more effective and narrowly targeted than are general interest rate hikes that have been the sole instrument of Fed policy to this point. Most importantly, Minsky would try to shift the focus of policy formation away from the belief that monetary policy, alone, can be used to “fine-tune” the economy, and from the belief that fiscal policy should be geared toward running perpetual surpluses—in Minsky’s view, this would be high risk strategy without strong theoretical foundations.

The Financial Instability Hypothesis

Janet Yellen, President of the San Francisco Federal Reserve, pointed out at the 18th annual conference honoring the work of Hyman P. Minsky that:
“… with the financial world in turmoil, Minsky’s work has become required reading. It is getting the recognition it richly deserves.”

Paul Krugman has also been re-reading Hyman Minsky’s most famous book Stabilizing an Unstable Economy.

Central to Minsky’s view of how financial meltdowns occur is his Financial Instability Hypothesis (FIH) — what has come to be known as ‘an investment theory of the business cycle and a financial theory of investment’. But, what is it all about? Quoting from Minsky . . .

“The theoretical argument of the financial instability hypothesis starts from the characterization of the economy as a capitalist economy with expensive capital assets and a complex, sophisticated financial system… The focus is on an accumulating capitalist economy that moves through real calendar time…”

“The capital development of a capitalist economy is accompanied by exchanges of present money for future money. The present money pays for resources that go into the production of investment output, whereas the future money is the “profits” which will accrue to the capital asset owning firms (as the capital assets are used in production). As a result of the process by which investment is financed, the control over items in the capital stock by producing units is financed by liabilities–these are commitments to pay money at dates specified or as conditions arise. For each economic unit, the liabilities on its balance sheet determine a time series of prior payment commitments, even as the assets generate a time series of conjectured cash receipts…
A part of the financing of the economy can be structured as dated payment commitments in which banks are the central player…”

“Thus, in a capitalist economy the past, the present, and the future are linked not only by capital assets and labor force characteristics but also by financial relations. The key financial relationships link the creation and the ownership of capital assets to the structure of financial relations and changes in this structure…”

“In spite of the greater complexity of financial relations, the key determinant of system behavior remains the level of profits. The financial instability hypothesis incorporates the Kalecki (1965)-Levy (1983) view of profits, in which the structure of aggregate demand determines profits. In the skeletal model, with highly simplified consumption behavior by receivers of profit incomes and wages, in each period aggregate profits equal aggregate investment…”

“In a more complex (though still highly abstract) structure, aggregate profits equal aggregate investment plus the government deficit. Expectations of profits depend upon investment in the future, and realized profits are determined by investment: thus, whether or not liabilities are validated depends upon investment. Investment takes place now because businessmen and their bankers expect investment to take place in the future…”

“The financial instability hypothesis, therefore, is a theory of the impact of debt on system behavior and also incorporates the manner in which debt is validated….”

“The financial instability hypothesis takes banking seriously as a profit-seeking activity. Banks seek profits by financing activity and bankers. Like all entrepreneurs in a capitalist economy, bankers are aware that innovation assures profits. Thus, bankers (using the term generically for all intermediaries in finance), whether they be brokers or dealers, are merchants of debt who strive to innovate in the assets they acquire and the liabilities they market…”

“Three distinct income-debt relations for economic units, which are labeled as hedge, speculative, and Ponzi finance, can be identified.
Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows.
Speculative finance units are units that can meet their payment commitments on “income account” on their liabilities, even as they cannot repay the principle out of income cash flows. Such units need to “roll over” their liabilities: (e.g. issue new debt to meet commitments on maturing debt)
For Ponzi units, the cash flows from operations are not sufficient to fulfill either the repayment of principle or the interest due on outstanding debts by their cash flows from operations. Such units can sell assets or borrow. Borrowing to pay interest or selling assets to pay interest (and even dividends) on common stock lowers the equity of a unit, even as it increases liabilities and the prior commitment of future incomes. A unit that Ponzi finances lowers the margin of safety that it offers the holders of its debts.”
“Over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system.
In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance.”
“Furthermore, if an economy with a sizeable body of speculative financial units is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make position by selling out position. This is likely to lead to a collapse of asset values.”
“The financial instability hypothesis is a model of a capitalist economy which does not rely upon exogenous shocks to generate business cycles of varying severity. The hypothesis holds that business cycles of history are compounded out of (i) the internal dynamics of capitalist economies, and (ii) the system of interventions and regulations that are designed to keep the economy operating within reasonable bounds.”

Source: Excerpts from Hyman Minsky’s 1992 paper linked to above.

Update: A good summary of Minsky’s view can be found here and here.

Big, Bigger, and Too Big

Click here to to read James K. Galbraith’s piece on The Deal Magazine.

The Audacity of Dopes

Click here to read William K. Black’s piece on The Audacity of Dopes.
William K. Black is Associate Professor of Economics and Law, University of Missouri – Kansas City. He held senior regulatory positions during the S&L debacle and is the author of “The Best Way to Rob a Bank is to Own One” (2005)

What Caused the Crisis?

Click here to read James K. Galbraith’s piece on the causes of the crisis.