Tuesday, September 9, 2014

The limits of limits

It's four years old, but I am fascinated by Thomas Palley's The Limits of Minsky’s Financial Instability Hypothesis as an Explanation of the Crisis. Minsky makes a good point, Palley says, but "his theory only provides a partial and incomplete account of the current crisis."

I'm still reading, but according to Palley, Tim Geithner and Larry Summers -- the Treasury Secretary and the President's chief economic counselor when the piece was written -- Geithner and Summers' view, Palley says, was that "financial excess was the only problem, and normal growth will return once that problem is remedied." Palley disagrees, and pushes the "roots of the crisis" back to the late 1970s, early '80s:

By giving free rein to the Minsky mechanisms of financial innovation, financial deregulation, regulatory escape, and increased appetite for financial risk, policymakers (like former Federal Reserve Chairman Alan Greenspan) extended the life of the neoliberal model. The sting in the tail was that this made the crisis deeper and more abrupt when financial markets eventually reached their limits. Without financial innovation and financial deregulation the neoliberal model would have got stuck in stagnation a decade earlier, but it would have been stagnation without the pyrotechnics of financial crisis.

When Palley goes back in time to the root of the crisis, he finds people doing what Minsky said they'd be doing. So I haven't figured out why Palley says Minsky's theory provides only a partial explanation. But like I said, I'm still reading.

"The sting in the tail", Palley says, was that the long duration of the policy made the crisis worse "when financial markets eventually reached their limits." Sure: Preventing small forest fires makes the big ones bigger. But I have trouble with the words "reaching the limits".

Palley doesn't say it, but to me the word "limits" implies we might somehow be able to calculate those limits, and that way avoid a crisis the next time. This brings to mind a calculation by Richard Vague, recently referenced by Steve Keen:

This recovery is starting from an unprecedented level of private debt: whereas the last post-recession recovery in America began from a debt level of 115 per cent of GDP, this one is commencing from 155 per cent (see Figure 2). If it only reaches the level of the previous peak (177 per cent) in the next five years, it will have fulfilled Richard Vague’s empirical rule of thumb for the cause of an economic crisis (a private debt to GDP ratio above 150 per cent, and an 18 per cent increase in that ratio over 5 or less years).

I think it conveys the wrong idea to say a crisis occurs when markets reach their limits. It implies there is a number, 18 or 5 or maybe 42, a magic number that when you reach it all hell breaks loose.

I didn't read Minsky, so maybe I have this wrong. (If you think I'm wrong, quote Minsky to me. Don't quote somebody else.) But here's what I'm pretty sure Minsky said: Financial instability increases.

Until what Thomas Palley calls Minsky's "thwarting institutions" are restored, instability increases. As instability increases, the economy becomes increasingly more fragile. Eventually, the weight of a feather is enough to bring it down. An analogy that comes to mind: a bicycle going slower and slower, wobbling and righting itself once, wobbling again, then falling over in a sudden crash.

If the bicycle kept going fast enough, it might have stayed upright. If the economy didn't grow increasingly fragile, it might have withstood the shock that brought it down. It's not like there's a limit-line on the pavement and the bicycle will fall when it reaches the limit.

I think a shock that would scarcely be noticed in a strong economy is enough to topple a weak one. You don't calculate the "limits" at which an economy comes crashing down. You figure out what's making the economy weak, and you calculate how best to strengthen it.


jim said...

Art maybe you should take your own advice and read Minsky rather than looking at what others say he meant to say.

Minsky died 13 years before the financial meltdown so that might account for why he didn't address every little detail. Minsky often stated that the fundamental overarching difference between the US before WW2 and after is the pre-war history of the country was punctuated by regularly recurring depressions and there have been none since. I think he would say that record still holds. According to Minsky, it is that failure to remember what a depression is really like that is the root cause of the modern risk taking that leads to financial fragility.

"In a world of businessmen and financial intermediaries who
aggressively seek profit, innovators will always outpace regulators; the authorities cannot prevent changes in the structure of portfolios from occurring...."-Hyman Minsky, 1986

There is a lot more financial reward in the private sector than in the regulatory bureaucracy. Private actors in the financial sector are just a lot more motivated to stay on top of technology changes than the bureaucrats. That is not due to bad policy - that's just the way the world works.

Oilfield Trash said...


I do not know if you want to wade in on Minsky, but below is a link from Keen and at the bottom is a link to a lecture he gives.

But Jim is right there are a lot of things to unpack with Minsky.


The Arthurian said...

I think a shock that would scarcely be noticed in a strong economy is enough to topple a weak one. You don't calculate the "limits" at which an economy comes crashing down. You figure out what's making the economy weak, and you calculate how best to strengthen it.

Jazzbumpa said...

just a thought on your bicycle limit analogy, which I like a lot.

The limit doesn't imply a specific number, but rather a condition of lost momentum. Level vs hilly terrain, and wind gusts will make a difference in where the bike tumbles, not just initial speed.


Jazzbumpa said...
This comment has been removed by the author.
jim said...

Minsky wrote:

"If economic theory is to be relevant, then an economic theory
which fully incorporates financial factors is needed. Such a theory should not hold that financial factors are "exogenous shocks" to the economy or explain whatever malfunctioning of the economy that takes place is the result of the incompetence of central bankers."

The Arthurian said...

Good quote.

jeff said...

Regarding Minsky's financial instability hypothesis of the housing crisis he would say
1. people see that housing price rise and view as a good investment
2. as they get confidence, they then start to borrow and cover the expenses through "rent"
3. seeing housing as sure thing, they ignore covering interest costs with rent and pay off "interest" through house price appreciation (flipping homes)
4. This he would define as a "ponzi" and eventually it will collapse as you can't sustain borrowing costs soley on asset appreication

[The same model applies to nasdaq that was partially financed on margin debt].

There was more going on here with the governments supporting housing growth and creditor giving easy borrowing terms. But I like the theory, basically buyers, creditors and government get more "comfortable" with it as sure thing and extend more and more leverage which at "some" point breaks down.

jim said...

Jeff wrote:

"There was more going on here with the governments supporting housing growth and creditor giving easy borrowing terms."

This is the propaganda story that Wall Street wants you to believe. The story is pure fiction.

In order to support housing growth you need to support sales to first time home buyers. The evidence shows that sales to first time buyers fell during the bubble years. Market share for first time buyers fell to record lows. Any govt policy promoting home ownership growth was extraordinarily ineffectual during the bubble years. Home ownership rate growth did exist before the bubble, but started to slow down as the bubble formed, reached a peak in 2004 and has declined since. The bubble was all about taking away home ownership not expanding it. 70% of the subprime loans that fueled the bubble and then ended in default were refinance loans. Very few were given to first time buyers

The mortgages that were fueling extra spending the most were the sub-prime mortgages. The chief feature of these loans was the extraordinarily high interest rates and fees, which is not what I would call "easy borrowing terms"