Tag Archives: Hyman P. Minsky

Brad DeLong: We’re All Minskians Now!

By L. Randall Wray
(Cross-posted from Great Leap Forward)

Earlier this week I noted, tongue-firmly-in-cheek, that we’re all MMTers now, following Paul McCulley’s recommendation that we just declare victory. And be nice about it.

Well here is a strange post from Brad DeLong: He proclaims that essentially anyone who is anyone is a Minskian. And apparently always was. That is why mainstream economists like “Paul Krugman, Paul Romer, Gary Gorton, Carmen Reinhart, Ken Rogoff, Raghuram Rajan, Larry Summers, Barry Eichengreen, Olivier Blanchard, and their peers” ought to be trusted. Continue reading

Pressures on the Paradigm: The Fall of the New Monetary Consensus

By L. Randall Wray

The following is a paper given at the ASSA conference in Denver this past week for a panel organized by James Galbraith, titled Pressures on the Paradigm, sponsored by Economists for Peace & Security.

The Queen famously asked her economists why none had seen the global crisis coming. Obviously the answer is complex, but it must include the evolution of economic theory over the postwar period—from the “Age of Keynes”, through the Friedmanian era and the return of virulent Neoclassical economics, and finally on to the New Monetary Consensus with a New anti-Keynesian version of fine-tuning by an unaccountable (“independent”) central bank

We cannot leave out the parallel developments in finance theory—with its efficient markets hypothesis—and the subsequent deregulation and de-supervision that led to the financialization of everything.

But to make a long story short: if your theory says that a global collapse is impossible, you won’t see one coming. In truth, as Jamie has argued in his great book, the Predator State, no one outside Chicago and other institutes of the higher learning ever took the free market mantra seriously—outside the ivory towers it was nothing but a slogan, a justification for enrichment of the powerful few.

Like Jamie, I believe orthodox macroeconomics is finished—although not all the zombie practitioners of that dismal religion recognize they are dead. After the crisis hit, Jamie, Duncan Foley and I were invited to appear on panels at the University of Chicago along with a dozen or so of the Chicago boys.

Not surprisingly, none of them was budging from his dogma of free and efficient markets: the crisis was caused by too much government interference; the solution is more deregulation. Three years into this crisis those who never saw it coming proclaim signs of recovery everywhere they look.

And, still, it is only academia that is clueless. Everyone in financial markets saw it coming—indeed, they planned on it and worked fastidiously to create it. They would profit on the way up, and then profit more in the collapse whilst collecting on their credit default swap bets and stealing all the homes.

It is Bush’s ownership society and the goal all along was to transfer all ownership to the top through the creation of serial bubbles—what Michael Hudson calls Bubbleonia. The biggest land grab since the enclosure movement.

So, no, there is no recovery. The banks are more massively insolvent than they were 2 years ago. They are cooking their books so they can pay executive bonuses and reward the traders and the foreclosers who are successfully transferring all wealth to the elite.

But Jamie asked me to address the state of theory—not the economy.

I want to focus on one particular Zombie that needs a stake through its heart or a bullet through its head: the New Monetary Consensus. This is an updated New Keynesian version of the old Bastard ISLM model.

The idea is that inflation slows growth so it must be diligently fought. The Fed will keep inflation expectations low, inflation will be low, and growth will be robust.

Every link in that sentence is a delicious illusion.

The Fed supposedly manages expectations by convincing markets that it controls inflation, and so long as it controls expectations it can control inflation.

But if it cannot control expectations it cannot manage inflation and all bets are off. What a flimsy reed upon which to hang public policy!

And in any case, why should low inflation generate robust growth? Because—well, because the Fed says it will, contrary to all evidence.

Out in the real world, expectations alone cannot govern any economic phenomena: inflation expectations will determine actual inflation only if those with ability to influence prices act on those expectations. And inflation below the high double digits has never proven to be a barrier to economic growth.

Let us take the current experience as an example. We have moved on to QE2, an application of the NMC.

Helicopter Ben is supposedly injecting trillions of dollars of money into the economy to create expectations of inflation—to counter the deflationary real world forces. And many wingnuts actually ARE expecting inflation—running around like Chicken-Littles, buying gold and screaming about hyperinflation and collapse of the dollar. And, yet, no inflation. Why?

Because those who might have pricing power—corporations and organized labor—cannot create inflation. Workers cannot increase their wages given massive global unemployment, and firms cannot increase prices in the face of competitive pressures. So no matter how strong is the will to believe, it has no purchase against the facts.

The wingnuts will be proven wrong. The Fed cannot create inflation. It is within the power of the central bank to lower the price of reserves—the overnight rate–as close to zero as it wants. It can also lower longer term rates on assets it is willing to buy, but there is a nonzero practical limit to that based on what Keynes called the square rule.

Quantitative easing supposedly pumps money into the economy to generate spending in order to create expectations of inflation. But all it really amounts to is substituting reserves for treasuries on bank balance sheets—lowering their interest earnings. QE won’t work because:

• (1) additional bank reserves do not enable or encourage greater bank lending;

• (2) the interest rate effects are small at best, and are swamped by private sector attempts to deleverage;

– The best estimate based on NYFed work: 18 basis points

• (3) purchases of Treasuries are simply an asset swap that reduce the maturity of private sector assets, but do not raise private sector incomes; and

• (4) given the reduced maturity of private sector portfolios, reduced interest income could actually be deflationary.

But we knew all that—Japan has been doing QE for 20 years, trying to create expectations of inflation in the face of deflationary headwinds, thus, it is interesting to compare Japanese and US experience (so far) by looking at a series of three graphs.

As they say, history doesn’t repeat itself but in this case it rhymes nicely. Only insanity would lead us to follow Japan’s path while expecting different results.

Let me finish my critique of the NMC with an observation of a Galbraith—John Kenneth this time:

To limit unemployment and recession in the US and the risk of inflation, the remedial entity is the Fed… For many years (with more to come) this has been under the direction from Washington of a greatly respected chairman… The institution and its leader are the ordained answer to both boom and inflation and recession or depression… Quiet measures enforced by the Fed are thought to be the best approved, best accepted of economic actions. They are also manifestly ineffective. They do not accomplish what they are presumed to accomplish. Recession and unemployment or boom and inflation continue. Here is our most cherished and, on examination, most evident form of fraud.

Even if the early postwar “Keynesian” economics had little to do with Keynes at least it had some connection to the real world. What passed for macroeconomics on the precipice of the global collapse had nothing to do with reality—it is as relevant to our economy as flat earth theory is to natural science.

In short, expecting the Queen’s economists to foresee the crisis would be like putting flat- earthers in charge of navigation for NASA and expecting them to accurately predict points of re-entry and landing of the space shuttle. Of course, the economic advisors to Presidents Bush and Obama could do no better.

Referring to the work of the best known economists over the past thirty years, Lord Robert Skidelsky argues “Rarely in history can such powerful minds have devoted themselves to such strange ideas.” Not only were they strange, but the ideas of the Larry Summers’, Bob Rubins, Mankiws, Marty Feldsteins, Bernankes and John Taylors of the world were, predictably, dangerous.

But one economist got it right, and did see it coming. And that is Hyman Minsky. His theory said it can happen again: market forces are destabilizing.

The economy emerged from WWII with a robust financial system—hardly any private debt and lots of safe and liquid government debt. Various New Deal and postwar reforms also made the economy stable: a safety net that stabilized consumption; strict financial regulation; minimum wage laws and support of unions; low cost mortgages and student loans, and so on. And memories of the Great Depression discouraged risky behavior.

Gradually all that changed—memories faded, self-regulation replaced financial regulations, unions lost power and government support, globalization brought low-wage competition, and the safety net was shredded. Further, profit-seeking firms and financial institutions took on greater risks with ever more precarious finance. Thus, fragility grew on trend. This made “it” possible again.

While most who invoke Minsky focus on the crash, he believed that the main instability is a tendency toward explosive euphoria. High aggregate demand and profits associated with high employment raise expectations and encourage increasingly risky ventures based on commitments of future revenues that will not be realized.

A snowball of defaults then leads to a debt deflation and high unemployment unless there are “circuit breakers” that intervene to stop the market forces. The main circuit breakers, are the Big Bank (central bank as lender of last resort) and Big Government (countercyclical budget deficits).

And, boy-oh-boy have we got a Big Bank and a Big Government! Together, the Benny and Timmy tag team have spent, lent, or guaranteed $25 trillion in the name of Uncle Sam. And that still is not enough. “It” is still happening.

The problem is that most of this was done by the Big Bank Fed, aimed at helping financial institutions—trying to prop up their worthless assets. In short, it was based on the theory that we need Money Manager capitalism and that the only hope is to generate another bubble.

It won’t work. Financialization is the problem, not a sustainable economic strategy. We need to turn instead to an updated Keynesian-Minskian New Deal based on jobs, growing wages, consumption—especially public consumption, constrained and downsized finance, and greater equality. Monetary policy also has to be downsized, while fiscal policy has to play a bigger role. Not fine-tuning but a positive and permanent presence to counter and guide and supplement the private purpose.

More importantly we’ve got to formulate theory applicable to the world in which we actually live—not one in which imaginary representative agents allocate resources along an optimal consumption path.

To that end, we stand on the shoulders of the giants like Minsky in the heterodox tradition.

A Plea to the President: Tear Up That Speech

By Stephanie Kelton

My colleague and fellow blogger, Randy Wray, has just argued that President Obama should scrap the speech he’s planning to deliver tonight and surprise the American people with something entirely different. I couldn’t agree more. And while I agree that job creation must be JOB ONE in the months (and years) ahead, I would encourage the President to make massive tax relief the cornerstone of tonight’s speech.
Specifically, the President should call on Congress to support a full and immediate payroll tax holiday. Right now, the government takes away about 15% of our incomes in the form of payroll taxes. With a full payroll tax holiday, a married couple earning $60,000 a year would see their take-home pay increase by about $750 each month. In the aggregate, this will help millions of Americans pay their mortgages, student loans, credit card bills, and so on, while at the same time reducing business expenses (remember that employers contribute to the payroll tax too). All told, a full payroll tax holiday would allow Americans to keep about $1 trillion this year.
So stand before us, Mr. President, and tell us that you want to stop taking this income away from us until we, as a nation, have clawed back every job that has been lost since the start of the recession. Tell us that you intend to take bold steps to protect jobs, keep families intact and provide relief for millions of American businesses. Tell us that you have done all you intend to do to help the banks and the automakers and that you will not accept a jobless recovery — that an increase in economic activity is meaningless without rising employment in good jobs.
And, most importantly, tell us that you refuse to adopt a timeline for cutting the deficit. Tell us that you will not take one dime of payroll taxes away from us until your Administration can declare “Mission Accomplished” on the job front.
Finally, tell the American people that anyone who opposes a payroll tax holiday wants to keep taking hundreds, perhaps thousands, of dollars from them every month. Then watch what happens in 2012.

Krugman Gets it Wrong

By L. Randall Wray

In his column in yesterday’s NYT, Professor Paul Krugman rose to the defense of Paul Samuelson. He argued that Michael Hudson’s piece, originally published in 1970, not only misunderstood Samuelson’s theories but also wrongly asserted that he was not deserving of a Nobel. Krugman’s main argument was that Samuelson’s version of “Keynesian” economics offered a solution to depressions that pre-existing “institutionalist” theory did not have:
Faced with the Depression, institutional economics turned out to have very little to offer, except to say that it was a complex phenomenon with deep historical roots, and surely there was no easy answer. Meanwhile, model-oriented economists turned quickly to Keynes — who was very much a builder of little models. And what they said was, “This is a failure of effective demand. You can cure it by pushing this button.” The fiscal expansion of World War II, although not intended as a Keynesian policy, proved them right. So Samuelson-type economics didn’t win because of its power to cloud men’s     minds. It won because in the greatest economic crisis in history, it had something useful to say.

This claim is bizarre, to say the least. First, Roosevelt’s New Deal was in place before Keynes published his General Theory, and it was mostly formulated by the American institutional economists that Krugman claims to have been clueless. (There certainly were clueless economists—those following the neoclassical approach, traced to English “political economy”.)

Second, it was Alvin Hansen, not Paul Samuelson, who brought Keynesian ideas to America. And Hansen retained the more radical ideas (such as the tendency to stagnation) that Samuelson dropped. Further, Hansen was—surprise, surprise—working within the institutionalist tradition (as documented by in a book by Perry Mehrling).

Third, many other institutionalists also adopted Keynesian ideas in their work—before Samuelson’s simplistic mathematization swamped the discipline. For example, Dudley Dillard—a well-known institutionalist—wrote the first accessible interpretation of Keynes in 1948; Kenneth Boulding’s 1950 Reconstruction of Economics served as the basis for four editions of his Principles book—on which a generation of American economists was trained (again, before Samuelson’s text took over). It is in almost every respect superior to Samuelson’s text. I encourage Professor Krugman to take a look.

Fourth, Hyman Minsky (who first trained with institutionalists at the University of Chicago—before it became a bastion of monetarist thought) took Samuelson’s overly simplistic multiplier-accelerator approach and extended it with institutional ceilings and floors. He quickly grew tired of the constraints placed on theory by Samuelsonian mathematics and moved on to develop his Financial Instability Hypothesis (which Krugman has admitted he finds interesting, even if he does not fully comprehend it). I ask you, how many analysts have turned to Samuelson’s work to try to understand the current crisis—versus the number of times Minsky’s work has been invoked?

And fifth, Samuelson’s “button” approach to dealing with the business cycle has been thoroughly discredited since the late 1960s—when he announced that we would never have another recession. In truth, as Minsky argued, it is not possible to “fine-tune” the economy because “stability is destabilizing”. The simplistic “Keynesian” approach propagated by the likes of Samuelson leaves out the behavioral and institutional analysis that is necessary to deal with instability and crisis.

Sixth, as has been long recognized, Samuelson purposely threw Keynes out of his analysis as he developed the “Neoclassical Synthesis”. The name dropping was intentional—Keynes was too radical for the cold warrior Samuelson. At best, what Samuelson presented was a highly bastardized version of Keynes—as Joan Robinson termed it, a Bastard Keynesian approach (we know the mother was neoclassical economics but we do not know who the father was).

Finally, and most telling of all, whose work is universally acknowledged as the most insightful analysis of the Great Depression? Might it be John Kenneth Galbraith’s The Great Crash? I have never heard anyone refer to any work of Samuelson in that context.

So Professor Krugman has got it wrong.

Let’s Create a Real Job Czar for the Jobless

By L. Randal Wray [via CFEPS]

For an example of what can be done, we can look to the recent experience of Argentina. As everyone knows, Argentina had been the darling of the Washington Consensus and of the IMF structural adjustment approach. It opened its economy, freed its markets, privatized government operations, downsized government, adopted fiscal and monetary austerity, and—importantly—adopted a currency board based on the dollar. It did everything “right”, but the IMF/Washington Consensus approach was fundamentally flawed and put Argentina into an inherently unsustainable situation. When world financial markets began to doubt the nation’s ability to maintain the currency board arrangement, there was a run on the domestic currency. The IMF/Washington Consensus recommended more austerity—which caused unemployment and poverty to explode. Social unrest eventually led to rioting in the streets. Argentina wisely abandoned the dollar, floated the currency, defaulted on some of the debt, and rejected the IMF/Washington Consensus.

The rioting stopped when the government implemented a job creation program designed to provide a social safety net for poor households with children. The program evolved through several stages, with the final phase beginning in April 2002 with the implementation of the Jefes de Hogar (Heads of Household) program that provides a payment of 150 pesos per month to a head of household for a minimum of 4 hours of work daily. Participants work in community services and small construction or maintenance activities, or are directed to training programs (including finishing basic education). The household must contain children under age 18, persons with handicaps, or a pregnant woman. Households are generally limited to one participant in the Jefes program.

The program’s total spending is currently equal to about 1% of GDP, with nearly 2 million participants (about 1.7 million in Jefes and 300,000 in PEL). This is out of a population of only 37 million, or more than 5% of the population. However, it should be noted that the US spends 1% of GDP on social assistance, while France and the UK spend 3-4% of GDP on such programs. Given a national poverty rate above 50%, and with 9.6 million indigents and a child poverty rate approaching 75%, Argentina’s spending is small relative to needs.

According to the World Bank’s reviews, the program has been highly successful in achieving a number of goals. First, program spending is well-targeted to the intended population—poor households with children. Second, the program has provided needed services and small infrastructure projects in poor communities, with most projects successfully completed and operating. Third, the program has increased income of poor households. While there have been some problems associated with implementation and supervision of the program cases involving mismanagement or corruption appear to have been relatively rare. Still, there are reports of favoritism, and home country researchers have made serious critiques of program design. However, surveys show that program participants are overwhelmingly happy with the program.

On November 3, 2003, the Mayor of Istanbul, Turkey, announced his intention to create a similar program to fight the growing unemployment problem in that city. Unemployment imposes severe costs on society—both economic costs in terms of foregone output, but also intolerable social costs in terms of rising crime and disintegrating families and communities. The Mayor recognized that no other social program brings so many benefits as those that accompany a job creation program. It will be interesting to follow the developments in Turkey as a “heads of household” job creation program is implemented.

Any sovereign nation that issues its own floating rate currency can “afford” full employment. (Indeed, one might rightly question whether nations can truly “afford” unemployment.) This is because such a government spends by crediting bank accounts, and taxes by debiting them. There can be no question about the solvency of such a nation—even if a deficit results. Japan’s sovereign deficit reaches 8% of GDP; Turkey’s sovereign deficit exceeds 25% of GDP. But so long as these nations maintain floating exchange rates, they can always spend and “service” debt by crediting bank accounts. Hence, if there are unemployed resources, including labor, the sovereign government can put them to work.

The big fear, of course, is that full employment will necessarily generate inflation. If full employment is achieved by “pump priming”, that is, by trying to raise aggregate demand through tax cuts or general government spending, it can in some circumstances generate inflation. However, if full employment is generated through a job creation program designed like Argentina’s Jefes program, it cannot be inflationary. This is because such a program sets a fixed basic wage and then hires all who are ready and willing to work at that wage. This operates like a commodities buffer stock program that sets a floor price—it prevents prices from falling through the floor, but does not push up prices. If the private sector expands, workers are hired out of the labor “buffer stock”; when the private sector down-sizes, workers flow into the “buffer stock”. Hence, the Jefes-type program also provides a strong counter-cyclical stabilizing force. It should be noted that government spending on the program will also be strongly counter-cyclical.

A real Job Czar would be put in charge of a job creation program that would achieve full employment without generating inflationary pressures. Once full employment is achieved, then the pressures to use protectionist measures to fight imports will be diminished. Further, the wage-and-price stabilizing features of a buffer stock approach would reduce reliance on fiscal and monetary austerity to fight inflation.

Keynes’s Relevance and Krugman’s Economics

By Felipe C. Rezende

It is true that Krugman considered himself a saltwater economist. But he is closer to Post Keynesian economics than he imagined. In his post “The greatness of Keynes …” he wrote: “The key to Keynes’s contribution was his realization that liquidity preference — the desire of individuals to hold liquid monetary assets — can lead to situations in which effective demand isn’t enough to employ all the economy’s resources.”

That is precisely what Post Keynesian economists have been arguing since Keynes’s revolution. Given uncertainty in the Knightian sense, it is the existence of money and the organization of production around money that cause unemployment of labor and productive resources. This is so because money is special in a capitalist economy, it affects economic decisions both in the short-run and in the long-run. According to Keynes (1936), money has special properties such as almost zero elasticity of production, almost zero elasticity of substitution and low carrying costs. See Krugman’s introduction to the new edition of Keynes’s General Theory, Wray (2007) and Davidson (2006) for further details.

As Wray (2007) put it:

In my view, the central proposition of the General Theory can be simply stated as follows: Entrepreneurs produce what they expect to sell, and there is no reason to presume that the sum of these production decisions is consistent with the full-employment level of output, either in the short run or in the long run. Moreover, this proposition holds regardless of market structure—even where competition is perfect and wages are flexible. It holds even if expectations are always fulfilled, and in a stable economic environment. In other words, Keynes did not rely on sticky wages, monopoly power, disappointed expectations, or economic instability to explain unemployment. While each of these conditions could certainly make matters worse, he wanted to explain the possibility of equilibrium with unemployment. (Wray 2007:3)

Krugman also refuted the New Keynesian claim that involuntary unemployment exists due to price and wage stickiness. According to Krugman, “there’s no reason to think that lower wages for all workers — as opposed to lower wages for a particular group of workers — would lead to higher employment.” Keynes explained why flexible wages do not assure full employment and, as Krugman noted, Keynes wrote a whole chapter entitled “changes in money wages” to explain that the cause of unemployment is not due to wages and prices rigidities as New Keynesians wrongly claim. (See for instance here, here, and here)

Wray also pointed out that

“Keynes had addressed stability issues when he argued that if wages were flexible,then market forces set off by unemployment would move the economy further from full employment due to effects on aggregate demand, profits, and expectations. This is why he argued that one condition for stability is a degree of wage stickiness in terms of money. (Incredibly, this argument has been misinterpreted to mean that sticky wages cause unemployment—a point almost directly opposite to Keynes’s conclusion.)” (Wray, 2007:6)

In fact, Krugman observed that flexible wages and prices can make things worse rather than better even if one includes real balance effects. Wage and price flexibility are destabilizing forces which also trigger a Fisher-type debt deflation process.

On Say’s Law, Krugman argued (here and here) that

“If there was one essential element in the work of John Maynard Keynes, it was the demolition of Say’s Law — the assertion that supply necessarily creates demand. Keynes showed that the fact that spending equals income, or equivalently that saving equals investment, does not imply that there’s always enough spending to fully employ the economy’s resources, that there’s always enough investment to make use of the saving the economy would have had it it were at full employment.”

“The understanding that Say’s Law doesn’t work in the short run — that a fall in consumption doesn’t automatically translate into a rise in investment, but can lead to a fall in output and employment instead — is the central insight of Keynes’s General Theory.”

On the Loanable funds model of the interest rate he pointed out (here and here) that:

“One of the key insights in Keynes’s General Theory — actually, THE key insight— was that the loanable funds theory of the interest rate was incomplete. Loanable funds says that the interest rate is determined by the supply of and demand for saving; Keynes pointed out that the supply of saving is endogenous, depending on the level of output. He even illustrated the point with a remarkably ugly diagram.”

Krugman also argued that “saving and investment depend on the level of GDP. Suppose GDP rises; some of this increase in income will be saved, pushing the savings schedule to the right. There may also be a rise in investment demand, but ordinarily we’d expect the savings rise to be larger, so that the interest rate falls”

It means that as income expands, for instance due to government spending, there is a downward pressure on the interest rate. This is the crowding in effect. As he noted government spending “does NOT crowd out private spending”

He then pointed out that what is moving interest rates “it is not deficits. It’s the economy.”

He also has been using a framework that Post Keynesian economists have been using for a long time. See for instance here, here, here, and here. Check also Krugman’s posts here and here.

Krugman, clearly following Minsky (1986), concluded that “government deficits, mainly the result of automatic stabilizers rather than discretionary policy, are the only thing that has saved us from a second Great Depression.” This is precisely the point that Minsky made in the first chapters of his book “Stabilizing an Unstable Economy”.

The above statements are precisely what Post Keynesian Economists have been arguing for years. They completely refute the basis of the mainstream economics which guide policy both in the U.S. and in the rest of the world. However, there is definitely a convergence of economic thought between Paul Krugman’s economics, Post Keynesian economists and the specialized media (see here and here). Keynes’s and Minsky‘s economics provide the basis for the next generation of economic models.

As Greenspan admitted before the members of the Congressional committee :”I found a flaw in the model that I perceive is the critical functioning structure that defines how the world works. That’s precisely the reason I was shocked….I still do not fully understand why it happened, and obviously to the extent that I figure it happened and why, I shall change my views”.

Shall they?

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.

Another Great Depression?

By Felipe Rezende

In a previous post, I explained that automatic stabilizers- i.e. the fact that the federal government’s budget moves counter-cyclically and in an automatic fashion – imparts a great stabilizing force to aggregate demand.
However, the picture below shows that, during the Great Depression the government sector was too small relatively to the rest of the economy.

Source: Tymoigne, 2008: 12

The implementation of New Deal policies created automatic stabilizers which work by putting a floor under aggregate demand, preventing a deflationary spiral, but they also put ceilings in place, as rapid economic growth translates into rising tax revenues which destroy income and temper the expansion.
Nowadays, the size of the government and the impact of large automatic stabilizers explain why we can have a deep recession but another Great Depression is unlikely.
But how do automatic stabilizers work? What happens over the cycle? Hyman Minsky sheds light on these issues.

Minsky’s financial instability hypothesis can be described as follows. Let us consider that the whole U.S. economy is in a hedge position, i.e. that cash inflows are greater than outflows for every period, so that debt/payment commitments can be fulfilled while safety margin are kept at some positive level, for instance 20%. As firms and households become more optimistic about future earnings, and as their expectations get validated by economy growth, they change their behavior and reduce their margins of safety, let’s say now to 10%.

As the economy booms, and future earnings turn out to be more than expected, firms and households revise their expectations upwards, they begin to believe they were too pessimistic in the past and, therefore, reduce their cushions of safety, and start to take on more and more riskier projects. They have voluntarily moved into a position Minsky called speculative. A speculative position is one in which cash inflows are enough to meet interest payments, i.e. as they cannot repay the principal they need to refinance the outstanding debt. Borrowers start to discount risk and lenders, now more optimistic about prospective future earnings and profits, increase their willingness to lend.

It is now important to introduce how the level of investment is determined according to Minsky’s framework. Firms invest if the demand price of capital exceeds the supply price of current output. “The quantity of investment goods purchased (OId) is determined where PId = PIs” (Tymoigne and Wray 2008, p.9)

The demand price, Pk, is the price that firms are willing to pay for the capital asset. The demand price depends upon the cash flows that ownership is expected to yield and the liquidity of the asset. The curve is horizontal up to the point where firms only commit their internal funds. However, once firms rely on external financing then the subjective borrower’s risk comes into play. This risk is incurred by firms as they may not be able to service their debt. Thus, the price that firms are willing to pay for capital assets decline as the amount they have to borrow to finance it increases.

The supply price, Pi, is the price that firms actually have to pay for the capital good. Firms can use their internal funds up to Oif , and only up to this point, the supply price equals costs + markup. When firms have to borrow to buy capital goods, the supply price of investment is raised by the interest payments on the loan. The curve slopes up after the point Oif because of the lender’s risk. The lender’s risk is the risk the firm will not repay the loan. The more the individual firm borrows, the greater the lender’s risk associated and the higher the interest rate charged on the loan.

When lenders and borrowers become more optimistic about future earnings and profits, they start to discount risks. Firms take on riskier projects and financial institutions riskier loans. Thus, the belief is now that future income will be enough to cover debt commitments. They are in a speculative position.

If there is a change in the economic environment firms’ financial positions may be adversely impacted. Let’s consider the following situation where the economy accelerates and inflation becomes a concern to the monetary authority. The turning point would happen when the Fed decides to increase the overnight interest rate. If the interest rate specified on contracts is allowed to fluctuate, firms incur in higher financial costs to service the loan. At the new circumstance, firms can either abandon the project, as it is no longer profitable at higher interest rates, or they can borrow, from willing financial institutions, the funds they need to meet the interest payments on the previous loans. In other words, if interest rates are increased to such a point where firms’ income inflows are no longer sufficient to meet the firms’ outflows, they have involuntarily moved into a new financial position that Minksy called Ponzi. In a Ponzi scheme, firms have to capitalize interest. If financial institutions become worried about the future performance of the economy as a whole or the firm in particular, and decide to no longer extend those Ponzi loans, then firms are no longer capable of meeting their financial commitments and may default on their loans. This situation can be compounded as firms decide to sell their assets at fire sale prices in order to meet their obligations, setting in a Fisher-type debt deflation process which triggers a domino effect on the economy.

Another situation we could consider as a turning point is one in which firms’ expectations about future earnings/profits is not fulfilled. In such an environment, firms will revise their expectations downwards and cut investment. As we know, this will have a multiplier effect in the economy. As income is reduced, so is consumption. Firms cut back production and investment, which depresses incomes further. The economic activity spirals down squeezing incomes even more. As firms’ income inflows were significantly reduced, firms may get to a point where they can no longer meet their liability commitments. Once again, a debt-deflation process may be set in place by the new economic environment when firms decide to sell their assets at fire sale prices trying to meet their obligations.

Now, we may ask ourselves: what is the role of automatic stabilizers in this process?
The answer becomes even clearer. With big government automatic stabilizers are large enough to offset the swings in private spending. As explained in a previous post, when the economy goes into recession, unemployment rises which means that income transfers such as unemployment compensation and welfare are automatically increased.

According to Minsky, there are 3 major effects derived from automatic stabilizers: the income and employment effect, the cash flow effect, and the portfolio effect. Let me briefly explain each one:

The income effect is the traditional Keynesian multiplier. As the economy slows down, the government deficit increases as there is an automatic increase in spending and a reduction of the amount of taxes collected. As noted in previous posts (here and here), a sovereign government spends by crediting bank accounts which means that the banking system, all else equal, now has excess reserves (ERs). The ERs put a downward pressure on the fed funds rate. If the Fed is to hit its overnight nominal interest rate target, it has to intervene and conduct open market sales (OMS) to drain the ERs. As the Fed provides an interest bearing alternative – such as government securities – this is adds to the private sector’s income.
Therefore, transfer payments and interest payments automatically increase when the economy is moving into a recession.

The other one is the cash flow effect. The idea is that government deficits maintain the flow of profits. Following Kalecki (1972) and national accounting identities, in the simplest version, aggregate profits equal investment plus the government’s deficit, Π = Invest. + Gov. Deficit. In the expanded model, gross profits, after corporate tax, equals investment plus government fiscal deficit plus consumption out of profits plus net exports less saving out of wages, i.e. Π = Invest. + Gov. Deficit + CC + NX– SW. This means that government deficits add to profits (private wealth). The flow of profits prevents the collapse of expectations and the deterioration of private sector’s balance sheet.

Finally, the portfolio effect is generated by the increase in the sale of government bonds as a consequence of the (mostly automatic) increased government deficit (as I have just explained). These bonds are safe assets and their holdings on private sector’s balance sheets help to keep expectations from collapsing below a certain level.

The Big Bank (the Fed) act as a lender of last resort, it can prevent or minimize the fall in asset prices. In other words, the Fed can always put a floor to asset prices. This can be done in many ways, such as by calling up banks and say that they need to lend to investors who want to buy assets. The Fed can also decide to buy a wide range of private assets to smooth market transactions. If the Fed decides to buy a wide range of assets to provide liquidity to markets it smoothes liquidity concerns of market participants. It can also regulate markets and discourage bad loans such as subprime real state booms in some regions so that banks will not provide those loans. However, ceilings should also be put in place such as supervision and regulation, as has been emphasized by William K. Black.

In the current recession, the forecast is that the personal saving rate will reach something like 10% in 2009 and that it could jump to 14-16% by 2010. To meet the private sector rising saving desire the government should implement another stimulus package (in the context of the Krugman’s cross described here, this would be equivalent to a shift of the government sector balance -GSB- curve to the right) thus preventing a deflationary spiral and further declines of income due to rising private sector saving desire. At the same time, it becomes important to adopt policies that make the curve steeper by enhancing the role of automatic stabilizers. One possibility is an employer of last resort program in which the federal government provides a job to everyone willing and able to work at a given nominal wage. As argued in previous posts(here and here) such program would reduce both unemployment and poverty and minimize declines in the economic activity by enhancing the ceilings and floors of the system.

A note on Automatic Stabilizers

What has so far prevented a deep depression in 2009? The answer, as Paul Krugman explained yesterday, are automatic stabilizers. Indeed, as Hyman Minsky emphasized more than 20 years ago in his book Stabilizing an Unstable Economy (1986), this feature of the federal government’s budget – i.e. the fact that it moves counter-cyclically in an automatic fashion – imparts a great stabilizing force to aggregate demand.

The figure below sheds light on the non-discretionary (i.e. automatic) nature of government deficits. In an economic downturn, tax receipts automatically fall, and government expenditures automatically rise, resulting, automatically, in budget deficits. (net govt saving = right hand scale)

Source: Bureau of Economic Analysis (BEA)

The components of government spending that rise automatically are called ‘transfer payments’, that include unemployment compensation, Medicaid, grants-in-aid to state and local government, etc.
With these forms of payment increasing and tax receipts declining due to falling economic activity, the federal budget moves automatically into deficit.

Source: Bureau of Economic Analysis (BEA)

So far the stimulus package was not what saved the US economy. The budget projections show that 24% of the total cost of the stimulus package will occur in fiscal year 2009 (which means $198 billion) and 47% of it occurring in fiscal year 2010.

“The ARRA is estimated in the budget to cost $825.4 billion over the next 10 years. These costs are split between $600.0 billion in increased outlays and $225.4 billion in reduced receipts. Although the cost of the ARRA is spread over 10 years, the budget projections show 24 percent of the total cost occurring in fiscal year 2009 and 47 percent of the total cost occurring in fiscal year 2010…The budget estimates that receipts will be reduced $77.4 billion in fiscal year 2009 and $152.3 billion in fiscal year 2010 primarily because of the tax provisions of ARRA… The budget estimates that outlays will be increased about $120.2 billion for fiscal year 2009 and $237.8 billion for fiscal year 2010 because of the spending and investment provisions of the ARRA.”

As noted in previous posts (here, here, and here), government deficits, themselves, perform an important stabilizing function, because they allow the private sector to net save. Given that during a recession there is a sharp increase in uncertainty and insecurity, the private sector desires to spend less than its income which translates into a rising personal saving rate. In the current recession, the forecast is that the personal saving rate will reach 10% in 2009 and that jump to 14-16% by 2010. Such large decline in consumption means falling sales, production and further declines in GDP. As noted above, to meet the private sector rising saving desire the government should run bigger deficits to prevent a deflationary spiral.

Source: Jan Hatzius, Goldman Sachs

As Minsky emphasized, the problem, during the Great Depression, was that the government sector was too small relative to the rest of the economy; it couldn’t fill the demand gap and allow the private sector to save as much as it desired. In the absence of large enough automatic stabilizers to offset swings in private spending, GDP contracted to the point where desired net nominal saving equaled actual net nominal saving. Note that in second half of the last century, given the private sector’s desire to have positive net nominal saving, the US government normally ran budget deficits.

As Wray pointed out, “Since WWII we have had the longest depression-free period in the nation’s history. However, we have had nine recessions, each of which was preceded by a reduction of deficits relative to GDP.” This directly results from the impact of large swings in the federal government’s budget.

Automatic stabilizers work by putting a floor under aggregate demand, preventing a deflationary spiral, but they also put ceilings in place, as rapid economic growth translates into rising tax revenues which destroy income and temper the expansion. The impact of large automatic stabilizers explains why we can have a deep recession but not a Great Depression. As Wray noted:

“With one brief exception, the federal government has been in debt every year since 1776. In January 1835, for the first and only time in U.S. history, the public debt was retired, and a budget surplus was maintained for the next two years in order to accumulate what Treasury Secretary Levi Woodbury called “a fund to meet future deficits.” In 1837 the economy collapsed into a deep depression that drove the budget into deficit, and the federal government has been in debt ever since. Since 1776 there have been six periods of substantial budget surpluses and significant reduction of the debt. From 1817 to 1821 the national debt fell by 29 percent; from 1823 to 1836 it was eliminated (Jackson’s efforts); from 1852 to 1857 it fell by 59 percent, from 1867 to 1873 by 27 percent, from 1880 to 1893 by more than 50 percent, and from 1920 to 1930 by about a third. (Thayer 1996) The United States has also experienced six periods of depression. The depressions began in 1819, 1837, 1857, 1873, 1893, and 1929. Every significant reduction of the outstanding debt has been followed by a depression, and every depression has been preceded by significant debt reduction. Further, every budget surplus has been followed, usually sooner rather than later, by renewed deficits. However, correlation—even where perfect—never proves causation. Is there any reason to suspect that government surpluses are harmful?”

Can Better Risk Management Techniques Prevent “It” From Happening Again?

by Eric Tymoigne

The risk-management approach to financial regulation has been around for a long time and it has failed consistently. It has not only failed to promote safer economic decisions and prevent the emergence of crises, but it has also failed to provide a relevant protection against major financial problems. Since at least 1864, with the imposition of capital adequacy ratios on national banks, regulators have tried to establish adequate buffers against expected and unexpected financial losses. Over time, the calculation of those buffers (liquidity, loan provisions, capital equity, etc.) has been refined, and Basel II was supposed to provide the latest improvements in this area. The current crisis has already made Basel II obsolete and many economists have noted the importance of accounting for liquidity issues in addition to loss issues.

Recent reports (e.g., CRMPG, BIS, IMCB, FSF, and the Department of the Treasury) have suggested that risk management can be improved by accounting for systemic risk and liquidity risk, and by making capital adequacy ratios more countercyclical. In addition, improvements were suggested in terms of reinforcing the role of risk officers in the governance of companies and in terms of remuneration methods.

Two of the major drawbacks of these proposals are that, first, like all previous risk-management policies, they do not deal with the core cause of financial instability and, second, they aim at being the least “intrusive,” which gives them only a very indirect impact on the management of financial stability.

Regarding the latter point, the philosophy of the past and current regulatory approaches has been to let individuals take whatever risk they find appropriate given market signals. Regulation is just there to tweak costs and returns in order to give an incentive to make “prudent” decisions as defined by arbitrary ratios of capital and liquidity (as well as by insurance premiums). As a consequence, as long as financial institutions meet the regulatory ratios, they are assumed to be safe and prudently managed, no matter how risky their asset positions and funding methods are. In addition, financial institutions can self-righteously complain further supervisory scrutiny if they meet their capital requirements, which greatly limits the effectiveness of supervision. All this is rather a permissive approach to financial regulation that is highly reluctant to forbid unsustainable financial practices. This is all the more so that economic agents are willing, and are forced by market mechanisms, to use those financial practices to improve their economic situations (unfortunately without consideration for the long-term indirect consequences of their choices).

Regarding the former point, the core cause of systemic financial crisis is the growing use of Ponzi finance over enduring periods of economic expansion. Ponzi finance means that the servicing of a given amount of debts requires the growing use of refinancing operations and/or liquidation of assets at rising prices. Ponzi funding methods are usually associated with crooks like Madoff, but the most devastating Ponzi processes are those that involve legal economic activities that are at the core of the economic growth process. Consumer finance for the past twenty years and the mortgage booms of the past ten years were Ponzi processes that involved honest and creditworthy borrowers who just wanted to improve their standard of living; lenders were more than eager to promote this trend to maintain their profitability and competitiveness, which was seen as a proud achievement of American free enterprise. Thus several Ponzi processes were at play and they all were used “judiciously” to maintain economic growth and business activities.

The problem with the type of Ponzi processes that we have experienced, is that, no matter how sophisticated and well informed financial players are, and no matter how efficient financial markets are, it always fails; and when it does, no buffer, no matter how high it is, can protect against the collapse. Pyramid Ponzi processes cannot be “risk managed.”

To better prevent the emergence of Ponzi processes an emphasis should be put on cash flows (rather than accounting profit) and on how economic entities plan to meet their financial commitments. Rather than asking, “Will you pay on time?” to determine creditworthiness, a more relevant question would be, “How will you pay on time?” And rising collateral price and access to refinancing channels should not be used to determine the expected capacity to repay of a borrower. Collateral liquidation (and so price) would only be used as a defensive means to protect banks against unexpected default, rather than as an offensive means to grow market shares and lending volumes. Ponzi processes should be eliminated or discouraged, no matter how good (or necessary) they appear for the competitiveness and (short-term) improvement of standards of living.

All financial institutions should be regulated, and the restructuring of the financial system should be based on promoting hedge financing of economic activities. By focusing on the financial practices of financial institutions, strong financial stability will be promoted and economic growth will proceed on more solid grounds (albeit probably at a slower pace).