Thursday, October 29, 2009

The Unforgettable Lessons of Hyman Minsky

In early September, economist Paul Krugman of The New York Times and Princeton University published a relatively scathing critique of the current state of macroeconomics in America that asked the very simple question: how did so many economists miss the economic and financial tsunami that has still yet to pass. I assume many people have already read the article, so I won’t spend too much time on it. Briefly, after going through a lengthy discussion of the history of modern economics and a detailed account of the events that led up to the current crisis, Krugman argues the following:

Economics, as a field, got in trouble because economists were seduced by the vision of a perfect, frictionless market system. If the profession is to redeem itself, it will have to reconcile itself to a less alluring vision — that of a market economy that has many virtues but that is also shot through with flaws and frictions.

For a value investor like me, the above is nothing more than a statement of the obvious. Humans are irrational creatures. They oscillate between fear and greed with remarkable speed and agility. They buy when they should be selling and run for the exits as a herd when they should be searching for value. Thus, any market that involves humans is going to embody the traits of its constituents. While market rationality and efficiency may influence the asset values over the long run, in the short run anomalies and dislocations can persist long enough for investors who dig for inconsistencies to profit.

While I do appreciate that Krugman subscribes to the view of markets espoused by the proponents of behavioral finance, something about his analysis of what went wrong and where macroeconomics should go from here bothered me a bit. Take a look at the following passages and see if you can anticipate what I thought was missing:

[M]acroeconomics has divided into two great factions: “saltwater” economists (mainly in coastal U.S. universities), who have a more or less Keynesian vision of what recessions are all about; and “freshwater” economists (mainly at inland schools), who consider that vision nonsense.

Freshwater economists are, essentially, neoclassical purists. They believe that all worthwhile economic analysis starts from the premise that people are rational and markets work, a premise violated by the story of the baby-sitting co-op. As they see it, a general lack of sufficient demand isn’t possible, because prices always move to match supply with demand…Where the freshwater economists were purists, saltwater economists were pragmatists. While economists like N. Gregory Mankiw at Harvard, Olivier Blanchard at M.I.T. and David Romer at the University of California, Berkeley, acknowledged that it was hard to reconcile a Keynesian demand-side view of recessions with neoclassical theory, they found the evidence that recessions are, in fact, demand-driven too compelling to reject. So they were willing to deviate from the assumption of perfect markets or perfect rationality, or both, adding enough imperfections to accommodate a more or less Keynesian view of recessions. And in the saltwater view, active policy to fight recessions remained desirable…

Seems like a pretty good description of the rift between the saltwater and freshwater economists. So, what did he leave out? Well, aside from a brief discussion of the views of Joseph Schumpeter during the 1930s and a passing comment on financial instability, his entire analysis ignores the views of the Austrian School of Economics. Unlike John Maynard Keynes (of whom Krugman is a disciple), men like Schumpeter believed that recessions and depressions were necessary evils and were advocates of creative destruction. This tough love mentality understandably did not gain anywhere near as much traction in the 1930s as did the writings of Keynes Accordingly, it is not a surprise that Krugman sees Keynes’ work was so profound that he believes that Keynesian economics is best suited to understand and deal with current recessions:

So here’s what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit — and this will be very hard for the people who giggled and whispered over Keynes — that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they’ll have to do their best to incorporate the realities of finance into macroeconomics.

As stated above, I agree with numbers one and three emphatically. It is number two that I am not so sure about. It is true that Krugman’s interpretation of a Keynesian solution is going to be the most effective? It seems to me that there is an additional framework that at very minimum could supplement Keynes’ lessons. This is a good time to remind everyone that I am not an economist and as such I am not particularly well versed in the nuances of what camp or subcategory people belong in. However, I certainly don’t view economics as black or white, winner take all field. Economics is not physics. My guess is that no one is going to come along and knock Sir Isaac Newton of off his ledge. But, the understanding of markets and human behavior is an evolving process and even people with completely disparate views can have profound insights that add to the current theories. So, from my perspective as an outsider, I couldn’t possibly care less what a person calls himself or herself as long as the ideas and methodology are sound, compelling, and based on actual human nature (rather than relying solely on complex and somewhat dissonant models).

This is where Hyman Minsky comes into the picture. Minsky was influenced by both Schumpeter and Keynes and his views reflect those of both men. (This is potentially why Krugman doesn’t mention Minsky in his article. My guess is that based on some of the remedies Minsky articulated to fight recessions that mirrored those of Keynes, Krugman considers him sort of a fringe Neo-Keynesian.) While Minsky did not make it to see this wonderful economic mess we have created, his warnings about the potential ills of financial markets are as timeless as any other economist’s teachings. Luckily for those of us whose only objective is to understand what the US is facing, (and don’t care about the somewhat petty infighting between economists who clearly let this country down) there was a beautiful piece on that provided a comprehensive discussion of what Minsky was all about (Hat tip to Miguel Barbosa, founder of the wonderful and irreplaceable Simoleon Sense):

He believed in capitalism, but also believed it had almost a genetic weakness. Modern finance, he argued, was far from the stabilizing force that mainstream economics portrayed: rather, it was a system that created the illusion of stability while simultaneously creating the conditions for an inevitable and dramatic collapse.

In other words, the one person who foresaw the crisis also believed that our whole financial system contains the seeds of its own destruction. “Instability,” he wrote, “is an inherent and inescapable flaw of capitalism…”

Minsky called his idea the “Financial Instability Hypothesis.” In the wake of a depression, he noted, financial institutions are extraordinarily conservative, as are businesses. With the borrowers and the lenders who fuel the economy all steering clear of high-risk deals, things go smoothly: loans are almost always paid on time, businesses generally succeed, and everyone does well. That success, however, inevitably encourages borrowers and lenders to take on more risk in the reasonable hope of making more money. As Minsky observed, “Success breeds a disregard of the possibility of failure.”

As people forget that failure is a possibility, a “euphoric economy” eventually develops, fueled by the rise of far riskier borrowers - what he called speculative borrowers, those whose income would cover interest payments but not the principal; and those he called “Ponzi borrowers,” those whose income could cover neither, and could only pay their bills by borrowing still further. As these latter categories grew, the overall economy would shift from a conservative but profitable environment to a much more freewheeling system dominated by players whose survival depended not on sound business plans, but on borrowed money and freely available credit.

Once that kind of economy had developed, any panic could wreck the market. The failure of a single firm, for example, or the revelation of a staggering fraud could trigger fear and a sudden, economy-wide attempt to shed debt. This watershed moment - what was later dubbed the “Minsky moment” - would create an environment deeply inhospitable to all borrowers. The speculators and Ponzi borrowers would collapse first, as they lost access to the credit they needed to survive. Even the more stable players might find themselves unable to pay their debt without selling off assets; their forced sales would send asset prices spiraling downward, and inevitably, the entire rickety financial edifice would start to collapse. Businesses would falter, and the crisis would spill over to the “real” economy that depended on the now-collapsing financial system.

Every time I read those passages something about them resonate with me even more. Not only do they aptly (and maybe even perfectly) describe the mechanism behind the fantastic debt bubble that so unceremoniously popped, but they also offer a valid assessment of the human component of financial instability. Simply, people got euphoric and then became complacent with success. Obviously there are those of us who are never satisfied and always strive to do more. But the majority of people are what Nassim Taleb would describe as Thanksgiving turkeys. Every day that something bad does not happen, even in the face of overwhelming evidence of emerging risk, confirms that there is no imminent danger. Or, just like the turkey that trusts the farmer who keeps him warm and well fed a little more each sequential day until that fateful moment, people believe that the absence of a calamitous event means that such a happening is less likely. Not Minsky though. He saw a black swan coming.

Minsky spent the last years of his life, in the early 1990s, warning of the dangers of securitization and other forms of financial innovation, but few economists listened. Nor did they pay attention to consumers’ and companies’ growing dependence on debt, and the growing use of leverage within the financial system.

By the end of the 20th century, the financial system that Minsky had warned about had materialized, complete with speculative borrowers, Ponzi borrowers, and precious few of the conservative borrowers who were the bedrock of a truly stable economy. Over decades, we really had forgotten the meaning of risk. When storied financial firms started to fall, sending shockwaves through the “real” economy, his predictions started to look a lot like a road map.

Obviously Minsky was not alone. There were many others sounding an alarm for a number of years and who were summarily ignored. But instead of kicking ourselves for not heeding his advice, maybe we can glean some guidance from him on how to extricate ourselves from the current quagmire and to avoid future blowups:

To prevent the Minsky moment from becoming a national calamity, part of his solution (which was shared with other economists) was to have the Federal Reserve - what he liked to call the “Big Bank” - step into the breach and act as a lender of last resort to firms under siege. By throwing lines of liquidity to foundering firms, the Federal Reserve could break the cycle and stabilize the financial system. It failed to do so during the Great Depression, when it stood by and let a banking crisis spiral out of control. This time, under the leadership of Ben Bernanke - like Minsky, a scholar of the Depression - it took a very different approach, becoming a lender of last resort to everything from hedge funds to investment banks to money market funds.

Minsky’s other solution, however, was considerably more radical and less palatable politically. The preferred mainstream tactic for pulling the economy out of a crisis was - and is - based on the Keynesian notion of “priming the pump” by sending money that will employ lots of high-skilled, unionized labor - by building a new high-speed train line, for example.

You can clearly see the influence of Keynes in those proposed solutions. Curiously enough, these policies are almost identical to those that the executive branch and the Fed have put into action. In many ways, this is also similar to what Krugman continues to advocate, at least when it comes to fiscal stimulus. Will it work? Your guess is as good as mine. Although, I have a sinking suspicion that piling on more debt to try to get us out of an over-leveraged conundrum may not be the best strategy in the long run. Having said that, it gives me a modicum of hope that a man like Minsky, who understood the fragility of markets and the vicissitudes of human nature, believed that a Keynesian reaction to a financial crisis was the best path to follow. Let us all pray that his prescience when it came to instability extends to the dynamic of returning to prosperity.

(Picture of Hyman Minsky courtesy of