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.

What's wrong with this picture?

This picture. The FRED Blog graph we looked at yesterday:

Graph #1: Quantity of Currency in Circulation Relative to GDP

What's wrong with it?

Here, let me ask the question this way: What stands out?

I'll give you a hint:

Graph #2: Same graph as Above, Except it Starts at 1960

There is an anomaly on this graph, a decade that's not like all the others. See it?

Here's another hint:

Graph #3: Same graph as Above, Except it Starts at 1995

You can see in all three graphs above, regardless of whether the general trend is upward or downward, the steps are always tiny. Perhaps the better word is "brief".

The graph is a plot of quarterly values. That means every three months there is a different value. And you can see easily that every three months, the line is just a little bit different than it was before.

Even the seriously large changes of the early 1950s, on Graph #1, occurred during very brief periods of time.

The anomaly is that the brief steps didn't happen in the years leading up to the Global Financial Crisis and the Great Recession of 2009.

The random walk uphill, which began in the mid-1980s, was interrupted by a purposeful walk downhill from 2003 to 2008.

A purposeful walk is an act of policy. The uninterrupted five-year decline visible on these graphs was an act of policy. It can be nothing else.


Actually, I showed you that decline before. It is visible in the growth rate of Base Money. As with the graphs above, the decline occurs during the decade before the Great Recession:

Graph #4, from mine of 14 October 2011.
See also mine of 6 March 2014.

It also occurred during the decade before the Great Depression.


You know, I wasn't gonna beat you over the head with this. I was gonna let it go. But then I bumped into Scott Sumner's Four things I believe. And Sumner's Thing One is this:

1. The Great Recession was caused by tight money at the Fed, and other major central banks. Period. End of Story.

I hate to say it, but he's right. But he didn't show the graphs, so I did.

Period. End of Story.

Let's draw a conclusion

At FRED Blog: How much money is the Fed printing?

To answer that question they look at currency in circulation. Two graphs.

First graph:

Graph #1: Quantity of Money, in Natural Log Values

Before 1960, flat. After 1960, straight-line increase.

The graph uses natural log values to show growth rates. As the FRED post says, "if the slope is the same for two years, the growth rate is the same." A more upward slope is faster growth. A less upward slope is slower growth.

The FRED post says the values are "indeed increasing, but there is no indication that it is accelerating". In other words: The line goes up, yes, but after the early 1960s it doesn't curve up.

Second graph:

Graph #2: Quantity of Money Relative to GDP

Graph #2 shows the same money as Graph #1 but shows it a different way. No "log" numbers. Instead, the graph compares the quantity of money to GDP. On Graph #2 we have downtrend to about 1985, and then uptrend: The currency component of M1 grew more slowly than GDP in the early years, and more quickly than GDP in the late years. I want to say the change occured around 1985.

Leave out the years before 1960 where Graph #1 has the flat trend. Look at the years since 1960, where #1 shows a straight-line uptrend.

From 1960 to 1985 the trend is down on Graph #2. After 1985 the trend is up. And yet, as the FRED Blog says, Graph #1 shows no acceleration.

Graph #1 shows that currency growth did not change. Graph #2 shows that either currency growth or GDP growth did change. We have to put the two facts together in our head: Either currency growth or GDP growth did change, but currency growth did not change. Therefore, GDP growth changed.

Voila.

To confirm, I took a quick look at the numbers.

During the 25 years from 1960 to 1985, currency in circulation increased by a factor of 5.6. During the 25 years from 1985 to 2010, currency in circulation increased by a factor of 5.5. Almost exactly the same. So, a straight line increase it is. As FRED said.

During the first 25 years GDP increased by a factor of 8.0. That's faster than currency growth, so the line on Graph #2 goes down between 1960 and 1985.

During the second 25 years GDP increased by a factor of 3.4. That's slower than currency growth, so the line on Graph #2 goes up between 1985 and 2010.

Currency growth was the same for the two periods, even though the "Great Inflation" is entirely contained in the earlier period. Currency growth was the same, but GDP growth was different. GDP growth was much faster in the early period, and much slower in the second.

The only math you need to know

... a population of actors effecting “random walks” by betting their wealth daily, or more precisely a modest part of their fortune that lies above the poverty level, will eventually see a small group of “very rich” emerge ...

- Julien Alexandre at Paul Jorion's Blog

How it is when times are good

"When times are good" -- When was that?

Oh, in the early 1960s, say, and in the latter 1990s.

Consider the '90s. In The Sixteen-Page Economic History of the World, a paper from 1999, Gregory Clark wrote:

There are surely many surprises ahead for mankind in the centuries to come, but for the most part the economic future is not an alien and exotic land. We already see how the rich live, and their current lifestyle predicts powerfully how we will all eventually live if economic growth continues. Anyone who has visited the British Museum or the Sistine Chapel, for ex­ample, has had a foretaste of the relentless tide of tourism set to be unleashed on the world by another few decades of strong economic growth. Even the high-income demand for unique and individualized travel and dining expe­riences is now catered to on an industrial scale.

Just a little over the top, don't you think? I mean, the nineties were good, but who would have written such a thing during the crappy economy we had after the fall of the Twin Towers? Or after the fall of Lehman? Today, surely, no one would express such expectations.


Consider the '60s. In the 31 December 1965 issue of Time magazine, we read:

In Washington the men who formulate the nation's economic policies have used Keynesian principles not only to avoid the violent cycles of prewar days but to produce a phenomenal economic growth and to achieve remarkably stable prices.

Just a little over the top, don't you think?


What was it Minsky said? Something like the expectation of good times feeds on itself. Something like that.

But, dammit, that's what we have policy for: to prevent irrational exuberances.

He was easier to ignore when he was just Noah Pinion

Noah Smith:

There are insights that you get from doing economics that you won’t get in a physics lab or from Shakespeare.

The main insight, in my opinion, is that most things in the world have some randomness in them. Economics deals with hideously complex systems where controlled experiments are usually impossible. If you want to isolate one phenomenon, you’re going to have to ignore an awful lot of interesting stuff.

I spent a lot of time -- most of the 1980s and half the '90s I'd guess -- trying to simplify. Trying to prune away the irrelevant. It doesn't come easy. You have to prioritize everything. You have to separate out separate topics and treat them separately. You have to learn to recognize separate issues.

Things are not "hideously complex" when you prune off the irrelevant. Who was it... Who was it that said "The ideas which are here expressed so laboriously are extremely simple and should be obvious." Who was that, anyway?

Keen, Hudson, Bezemer, Werner, Koo, Vague, and others

Recommended reading: At Business Spectator, Time for a Copernican revolution in economics by Steve Keen. Keen writes:

The global financial crisis took the vast majority of the economics profession by surprise... The OECD’s advice in its June 2007 Economic Outlook was typical:

"Indeed, the current economic situation is in many ways better than what we have experienced in years. Against that background, we have stuck to the rebalancing scenario. Our central forecast remains indeed quite benign..."

After being so disastrously wrong, one might expect that this modeling approach would now be subject to serious revision. But while New Keynesian DSGE model-builders are starting to add “financial frictions” to their repertoire of factors that prevent the economy from almost instantly attaining a competitive equilibrium (as in New Classical models), the core paradigm -- of an economy which, left to its own devices, will ultimately reach equilibrium, and in which money and financial institutions generally play non-essential roles -- has not been challenged.

Keen provides an extended analogy to astronomy. He explains:

I believe there are enormous parallels between the Ptolemaic-Copernican transformation of astronomy and the current state of economics.The alternative vision of capitalism -- as fundamentally unstable and monetary -- is as discordant with the Neoclassical vision of equilibrium in a barter economy as Copernicus’s Heliocentric vision was to Ptolemy’s Earth-centric model. It simply isn’t possible for one vision to incorporate the other -- which is why Neoclassical attempts to assimilate Hyman Minsky’s “Financial Instability Hypothesis” have been so lame...

Here Neoclassical economics shares another commonality with Ptolemaic astronomy. Just as it couldn’t explain comets, nor will Neoclassical theory be able to explain if another major financial crisis occurs in the relatively near future -- say the next three to seven years (bear in mind that the gap between the crisis of 2007/8 and the previous serious recession was about 18 years). On the other hand, the alternative private-debt-focused perspective that I share with Michael Hudson, Dirk Bezemer, Richard Werner, Richard Koo, Richard Vague, and many others, will have an explanation.

Well I see I didn't make the list :)

I do like that "vision of capitalism -- as fundamentally unstable and monetary". But I don't so much like the self-satisfying notion that Keen, Hudson, Bezemer, Werner, Koo, Vague, and others "will have an explanation" if "another major financial crisis occurs in the relatively near future".

I don't want an explanation. I want to prevent the problem. See the difference?

Keen provides this graph and text:

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).

Yeah, I read that rule. I don't think you can calculate the future so precisely. So, grain-of-salt there. But this recovery is most assuredly starting with an unprecedented level of private debt, and that can't be good.

I don't see why this doesn't make sense to people: If we need credit for growth, and growth is, you know, maybe five percent each year, then I can easily see that we need an accumulated debt of five or ten percent of GDP. And, if it takes some years to pay off debt then I can see that we might have an accumulated debt equal to 50% or 100% of GDP. But there is no reasonable justification to ever have an accumulated debt of 300% or 350% of GDP or more. There is just no reason for it.

Of course, there is a reason. There is no justification for it. The reason we have such debt is that policy encourages the accumulation of debt, fails to discourage the accumulation of debt, and fails to encourage the accelerated repayment that could reduce debt to a sustainable level, a level that maximizes rather than hinders economic growth.

Oops! I let the cat out of the bag. I gave away the secret. I gave you my plan to prevent the problem.

Sometimes, it just clicks

Fragments from mine of 31 August, showing evolution in my use of a concept:

  •  "The answer (of course) is 'Money!'"
  •  "Maybe I should be calling it accumulated financial capital."
  •  "Government spending is the source of private sector net assets."
  •  "...most of all because net financial assets were available..."

It isn't my phrase, net financial assets. I think the August 31 post contains my first use of that phrase on the blog, apart from just wondering what it might mean. And you can see me struggle over the course of the post to get to the point where I can use the phase.

Commenting on net financial assets (NFA) Auburn Parks said

(just make sure to remember to include the F for financial otherwise you'll get people saying "the Govt doesn't create real wealth" on you)

Oh, of course: financial versus real. Suddenly it clicked. (Financial versus real is what it's all about. I know that.) Thank you, Auburn Parks.

Samuel H. Williamson: The Parable of the Two Workers

Recommended reading.