THE FINANCIAL INSTABILITY HYPOTHESIS AS AN INSTITUTIONALIST/EVOLUTIONARY THEORY. Levy Institute Minsky Summer School, June 19-26, 2010

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1 THE FINANCIAL INSTABILITY HYPOTHESIS AS AN INSTITUTIONALIST/EVOLUTIONARY THEORY Levy Institute Minsky Summer School, June 19-26, 2010 John F. Henry Department of Economics University of Missouri-Kansas City The first question that should be posed is whether Minsky considered himself an institutionalist. The short answer is a decided yes. He once declared that he was a post-keynesian institutionalist in that (he) rejects the conventional separation of real and monetary sectors in favor of an integrated view of money, finance and capitalist accumulation, and that the nature and evolution of institutional arrangements are crucial determinants of economic behavior (Whalen 2008, 251). He published a number of articles in the Journal of Economic Issues, the major institutionalist journal in the U.S., and was awarded the Veblen-Commons Award by the Association for Evolutionary Economics in The long answer is a bit more problematic. In his early career, he described his program as analytical institutionalism, conjoining the approaches of Joseph Schumpeter and Henry Simons (Wray 2007, 2). More typically, he described himself as a financial Keynesian and thought there was a way to reconcile his post-keynesian institutionalism with the neoclassical mainstream (Whalen 2008, 251). More importantly, the answer depends what is meant by the term institutionalist or evolutionary. Noting that the term evolutionary has a checkered career progressive, conservative, and radical theorists have all claimed the mantle of evolutionary thinkers I turn to an attempt to understand what is meant by institutionalism. A fundamental issue in determining whether the FIH is an institutionalist theory is that institutionalists themselves are not in agreement as to what the term means. The term (institution) has a long history of usage in the social sciences. However there is no unanimity in the definition of this concept (Hodgson 2006, 1). As Bill Dugger once commented, institutionalists are notoriously independent cusses, so getting them all within the perimeters of a manageable definition is not easy it is a bit like herding stray cats (Dugger 1996, 31). (See Neal (1987) for a rather fulsome discussion of the different way institutions are viewed by institutionalists!) If one begins with Veblen, usually considered the father of institutionalism, we find that he defined an institution as the settled habits of thought common to the generality of man (1909, 626). That is, an institution is not a structure or organization or system as such, but refers to a common understanding or perception of the way things work. Whether this perception is valid in the sense that it conforms to reality is not the central point of Veblen s position. Rather, an institution is the understanding of the world around us that we hold based not on examination, on scrutiny, but simply because we have imbibed a view of supposed reality that conforms to 1

2 normality. We conform to some societal norm that is reflexive rather than critically thoughtful. Thus, for example, the U.S. political system is democratic; a market-driven economy is natural; the war machine of Germany, England, the United States add the country of your choice is designed to safeguard their respective populations from some outside threat. If such perceptions are successfully institutionalized, we don t subject these claims to critical evaluation. As they are normal perceptions, we don t even consider such evaluation: this is just the way things are. In a recent article, Geoffrey Hodgson offers a straightforward definition that does seem to capture a more conventional understanding of institutions, though not fundamentally different from that of Veblen: we may define institutions as systems of established and prevalent social rules that structure social interactions. Language, money, law, systems of weights and measures, table manners, and firms are thus all institutions (2006, 2; emphasis in original). By the above standard, the Financial Instability Hypothesis is not an institution as it is not a social rule that governs social interactions. Nor is it a settled habit of thought common to the generality of man. This does not speak to its validity (as in above), but merely indicates that this theoretical construct carries little or no weight in directing our behavior. If it did, the world would be a different place. But the central issue before us is to what extent the FIH represents an institutionalist approach to the examination of modern money and the ramifications of a monetary production economy. In this regard, Minsky s hypothesis is most definitely of an institutionalist nature. Indeed, in a most perceptive article, Dudley Dillard surveyed the main contributors to what should be an institutionalist tradition to the understanding of money, beginning with the seminal work of Marx and concluding with the Financial Instability Hypothesis of Minsky (Dillard 1987). The first point is that the FIH is specific only to an economy that displays certain institutional features production is for profit and a need for long-term financing of long-lived capital assets. The FIH would not be operable in a feudal or socialist society, nor would it be applicable to a capitalist economy in its very early stages of development. Hence, it is a set of institutional characteristics of modern capitalism which serve as the framework within which the FIH becomes understandable. Given the nature of long-term financing coupled to expected returns on capital investment that may not realize themselves for many years, the outlook for financial positions evolve from hedge to speculative to ponzi as expectations become increasingly optimistic. As expectations become disappointed and/or financial relations become disturbed, the economy experiences increased instability. But this instability is the result of seeming stability in the earlier stages of the financial circuit and is generated by the institutional arrangements of capitalism and the associated change in behavior on the part of both lenders and borrowers. In the hedge state, when returns are sufficient to cover both interest and principle, the outlook is bright on both sides of the various credit arrangements. This encourages more lending, more investment, more economic activity, where the maintenance of good financial order depends on the continued receipt of sufficient returns. Hedge becomes speculative when those returns begin to fall and only interest payments can be made, though loans are still transacted. Eventually, the ponzi stage develops and the growing instability that was somewhat masked by the ability of 2

3 business enterprises to cover at least interest payments now becomes open and the entire financial apparatus is thrown into discord. Minsky saw the economy evolving through various stages of development, becoming increasingly complex and taking on different institutional features. Capitalism is an evolving and dynamic system that has come in many forms and even now different forms coexist. Commercial capitalism gives way to industrial capitalism and wild cat financing gives way to financial capitalism gives way to paternalistic, managerial, and welfare state capitalism gives way in the current period to money market capitalism (Minsky 1996, 362). With the enormous debt deflation of the 1930 s, institutional changes were put into place in an attempt to avoid such a recurrence. Specifically, floors and ceilings were developed in order to contain the cyclical nature of the economy. The two major institutional changes were those of big government that could run budget surpluses and deficits to try to counter the cycle by constraining or stimulating demand, and an activist central bank that could institute a floor on asset prices. However, such institutional adjustments cannot eliminate instability as instability is a necessary feature of an economic organization based on long-term financing of long-lived assets. Indeed, such intervention promotes financial instability. The downturn of a business cycle, though potentially disastrous as in the 1930 s, does serve a cleansing function. As asset prices collapse, debts and assets are wiped off the books a wiping the slate clean process, so to speak. Balance sheets are simplified. But with floors and ceilings in place, increasingly fragile positions can be taken with seemingly less risk of the cleansing of balance sheet. Hence, (t)o contain the evils that market systems can inflict, capitalist economies developed sets of institutions and authorities, which can be characterized as the equivalent of circuit breakers. These institutions in effect stop the economic processes that breed the incoherence, and restart the economy with new initial conditions and perhaps with new reaction coefficients. (T)he aptness of institutions and interventions will largely determine the extent to which the path of the economy through time is tranquil or turbulent: progressive, stagnant, or deteriorating (Delli Gatti, Gallegati, and Minsky 1994, 3, 4). However, as new institutional arrangements are put into place, the economy changes and its principal players capitalists and their agents in both the industrial and financial sectors modify behaviors. The seeming stability gives way to instability, requiring new institutional arrangements to constrain instability, and so on. A constant process of change in the capitalist order what some, including Minsky, term evolution requires constant modification of institutions to prevent the system from tearing itself apart. Hence, capitalism itself undergoes a more or less constant modification in its form 57 varieties and the capitalisms in the 21 st century are likely to be quite different from the models we are familiar with (Minsky 1993b, 7). In particular, Minsky argued that central banks, in particular the Fed, were to guide the evolution of financial institutions by favoring stability enhancing and discourag(ing) instabilityaugmenting institutions. (Minsky 2008 [1986], 349). That is, he proposed a much more activist, interventionist central bank that did not merely react to financial crises, but served to direct the financial sector toward more sound behavior and practices in the interests of the larger economy. The Fed, as an institution itself was to become the dominant organization in 3

4 constructing the institutional arrangements that would then set the framework within which financial structures would conduct their affairs. Thus, any evolutionary developments would not be the result of mere profit-seeking adjustments in the financial sector that could, and probably would lead to harmful outcomes for the economy as a whole, but would be an outcome of considered public policy with specific social objectives in mind designed to counter or constrain mere self-interested profit-seeking. Beyond this general proposition, Minsky proposed significant modifications in the financial system in general: encouragement of medium-sized banks, segmentation of banking activities, and, probably above all, the creation of community development banks that would serve local communities, financing new business ventures, provide mortgage loans to the local citizenry (which would have the additional benefit of providing greater oversight of such loans as such banks would have greater familiarity with customers), and promote local economic development, thus employment. That is, Minsky proposed a set of new institutions and institutional changes that, in his opinion, would facilitate a healthier economy. Institutions matter in both explaining the basis of the FIH, but also in constraining its process. The last point I wish to raise in this presentation is Minsky s support for an Employer of Last Resort program. In Stabilizing an Unstable Economy, and elsewhere, Hyman Minsky laid out what he considered to be an essential program for big government: the assumption of the responsibility to provide employment for all who wanted a job at a wage level consistent with a decent standard of living a living wage as many term it. A capitalist economy will not automatically generate full employment, and most likely will produce substantial unemployment, given that employment decisions are based on expectations of private profit, not considerations of the welfare of workers. Moreover, there is no guarantee that wages paid will be sufficient to provide a reasonably comfortable existence at least for all. As workers do not control employment decisions and, in the absence of sufficient union power cannot guarantee an income sufficient to meet an adequate level of social subsistence, Minsky called on government to assume the task of providing these guarantees. (See Wray 2007 for a discussion of the specifics of the ELR.) Again, an ELR program represents a considered institutional arrangement that is designed to not only compensate for the inadequacies of capitalism in meeting the needs of the larger population, but also to create an economic and social environment that would actually complement this economic order in providing a well-trained, disciplined work-force that has, at the same time, sufficient income for consumption to bolster aggregate spending. Let me end with a brief commentary on the term evolution. There is no common agreement as to what evolution means, nor how an evolutionary process works, particularly in the social world. While some evolutionary thinkers are clearly of a progressive nature in that they foresaw the possibility of a better world and Lewis Henry Morgan, Karl Marx, and Thorstein Veblen come readily to mind others, such as Herbert Spencer, portrayed evolution in terms that merely justified capitalist organization as natural, best suited to some underlying human psychology, and as the end of history. Hyman Minsky confined his theoretical argument to capitalism only, seeing this form of economy developing in various stages leading to, in the current period, money managed capitalism. This development, as in the past, was the result of changes in the structure of the economy, changes in the rules that govern economic activity and relations, and in changes in the behavior of particularly financial capitalists and their agents in their pursuit of profits. 4

5 Now, the ostensible purpose of financial activity is to fund those forms of spending that allow long-term economic development. In the modern period, as Minsky observed, a certain cleavage between finance and industry the real economy had occurred. This is, fundamentally, the same cleavage seen by Marx in Volume 3 of Capital and Veblen in his Theory of Business Enterprise. Nor did this escape the attention of Keynes. The consequences for larger society are significant and, potentially at least, extremely dangerous. Capitalism, to succeed, requires oversight, and this understanding goes back all the way to Adam Smith. Left to its own internal workings, capitalism is self-destructive: self-interested behavior is anti-social, and capitalism certainly promotes, indeed requires this behavior. Minsky s fear was that the modern epoch was increasingly characterized by an unfettered capitalism operating without effective oversight in which finance has taken on a life of its own, and, thus, becoming increasingly discordant, unruly, and dangerous. I close with the following quotation taken from Minsky s Schumpeter and Finance of In the present stage of development the financiers are not acting as the ephors (the overseers of Sparta; JFH) of the economy, editing the financing that takes place so that the capital development of the economy is promoted. Today s managers of money are but little concerned with the development of the capital assets of an economy. Today s narrowly-focused financiers do not conform to Schumpeter s vision of bankers as the ephors of capitalism who assure that finance serves progress. Today s financial structure is more akin to Keynes characterization of the financial arrangements of advanced capitalism as a casino. The Schumpeter-Keynes vision of the economy as evolving under the stimulus of perceived profit possibilities remains valid. However, we must recognize that evolution is not necessarily a progressive process: the financial evolution of the past decade may well have been retrograde (Minsky 1993a, 113). 5

6 References: Delli Gatti, Domenico, Gallegati, Mauro, and Minsky, Hyman Financial Institutions, Economic Policy, and the Dynamic Behavior of the Economy. Working Paper #155. The Jerome Levy Economics Institute of Bard College. Annandale-on-Hudson. Dillard, Dudley Money as an Institution of Capitalism. Journal of Economic Issues , Dugger, William. (1996), Redefining economics: from market allocation to social Provisioning. In Charles J. Whalen (ed.), Political Economy for the 21st Century: Contemporary Views on the Trend of Economics, Armonk, New York: M.E. Sharpe, pp Hodgson, Geoffrey What are Institutions? Journal of Economic Issues, Minsky, Hyman. 1993a. Schumpeter and Finance. In Market and Institutions in Economic Development: Essays in Honor of Sylos Labini. Salvatore Biasco, Alessandro Roncaglia, and Michele Salvati, eds. New York: St. Martin s Press b. Finance and Stability: The Limits of Capitalism. Working Paper #93. The Jerome Levy Economics Institute of Bard College. Annandale-on-Hudson Uncertainty and the Institutional Structure of Capitalist Economies: Remarks upon Receiving the Veblen-Commons Award. Journal of Economic Issues. Vol. 30, No. 2. June [1986]. Stabilizing an Unstable Economy. New York: McGraw Hill. Neal, Walter Institutions. Journal of Economic Issues, Veblen, Thorstein The Limitations of Marginal Utility. Journal of Political Economy, Whalen, Charles A Minsky Moment: Reflections on Hyman P. Minsky ( ). Journal of Economic Issues Wray, L. Randall Minsky s Approach to Employment Policy and Poverty: Employer of Last Resort and the War on Poverty. Working Paper No. 515, The Jerome Levy Economics Institute of Bard College. Annandale-on-Hudson. 6