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Why Capitalism Fails

The man who saw the meltdown coming had another troubling insight: it will happen again

 by the Boston Globe

Since the global financial system started unraveling in dramatic
fashion two years ago, distinguished economists have suffered a crisis
of their own. Ivy League professors who had trumpeted the dawn of a new
era of stability have scrambled to explain how, exactly, the worst
financial crisis since the Great Depression had ambushed their entire
profession.

Amid the hand-wringing and the self-flagellation, a few more
cerebral commentators started to speak about the arrival of a "Minsky
moment," and a growing number of insiders began to warn of a coming
"Minsky meltdown."

"Minsky" was shorthand for Hyman Minsky, a hitherto obscure
macroeconomist who died over a decade ago. Many economists had never
heard of him when the crisis struck, and he remains a shadowy figure in
the profession. But lately he has begun emerging as perhaps the most
prescient big-picture thinker about what, exactly, we are going
through. A contrarian amid the conformity of postwar America, an expert
in the then-unfashionable subfields of finance and crisis, Minsky was
one economist who saw what was coming. He predicted, decades ago,
almost exactly the kind of meltdown that recently hammered the global
economy.

In recent months Minsky's star has only risen. Nobel Prize-winning
economists talk about incorporating his insights, and copies of his
books are back in print and selling well. He's gone from being a nearly
forgotten figure to a key player in the debate over how to fix the
financial system.

But if Minsky was as right as he seems to have been, the news is not
exactly encouraging. 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's vision might have been dark, but he was not a fatalist; he
believed it was possible to craft policies that could blunt the
collateral damage caused by financial crises. But with a growing number
of economists eager to declare the recession over, and the crisis
itself apparently behind us, these policies may prove as discomforting
as the theories that prompted them in the first place. Indeed, as
economists re-embrace Minsky's prophetic insights, it is far from clear
that they're ready to reckon with the full implications of what he saw.

In an ideal world, a profession dedicated to the study of capitalism
would be as freewheeling and innovative as its ostensible subject. But
economics has often been subject to powerful orthodoxies, and never
more so than when Minsky arrived on the scene.

That orthodoxy, born in the years after World War II, was known as
the neoclassical synthesis. The older belief in a self-regulating,
self-stabilizing free market had selectively absorbed a few insights
from John Maynard Keynes, the great economist of the 1930s who wrote
extensively of the ways that capitalism might fail to maintain full
employment. Most economists still believed that free-market capitalism
was a fundamentally stable basis for an economy, though thanks to
Keynes, some now acknowledged that government might under certain
circumstances play a role in keeping the economy - and employment - on
an even keel.

Economists like Paul Samuelson became the public face of the new
establishment; he and others at a handful of top universities became
deeply influential in Washington. In theory, Minsky could have been an
academic star in this new establishment: Like Samuelson, he earned his
doctorate in economics at Harvard University, where he studied with
legendary Austrian economist Joseph Schumpeter, as well as future Nobel
laureate Wassily Leontief.

But Minsky was cut from different cloth than many of the other big
names. The descendent of immigrants from Minsk, in modern-day Belarus,
Minsky was a red-diaper baby, the son of Menshevik socialists. While
most economists spent the 1950s and 1960s toiling over mathematical
models, Minsky pursued research on poverty, hardly the hottest subfield
of economics. With long, wild, white hair, Minsky was closer to the
counterculture than to mainstream economics. He was, recalls the
economist L. Randall Wray, a former student, a "character."

So while his colleagues from graduate school went on to win Nobel
prizes and rise to the top of academia, Minsky languished. He drifted
from Brown to Berkeley and eventually to Washington University. Indeed,
many economists weren't even aware of his work. One assessment of
Minsky published in 1997 simply noted that his "work has not had a
major influence in the macroeconomic discussions of the last thirty
years."

Yet he was busy. In addition to poverty, Minsky began to delve into
the field of finance, which despite its seeming importance had no place
in the theories formulated by Samuelson and others. He also began to
ask a simple, if disturbing question: "Can ‘it' happen again?" - where
"it" was, like Harry Potter's nemesis Voldemort, the thing that could
not be named: the Great Depression.

In his writings, Minsky looked to his intellectual hero, Keynes,
arguably the greatest economist of the 20th century. But where most
economists drew a single, simplistic lesson from Keynes - that
government could step in and micromanage the economy, smooth out the
business cycle, and keep things on an even keel - Minsky had no
interest in what he and a handful of other dissident economists came to
call "bastard Keynesianism."

Instead, Minsky drew his own, far darker, lessons from Keynes's
landmark writings, which dealt not only with the problem of
unemployment, but with money and banking. Although Keynes had never
stated this explicitly, Minsky argued that Keynes's collective work
amounted to a powerful argument that capitalism was by its very nature
unstable and prone to collapse. Far from trending toward some magical
state of equilibrium, capitalism would inevitably do the opposite. It
would lurch over a cliff.

This insight bore the stamp of his advisor Joseph Schumpeter, the
noted Austrian economist now famous for documenting capitalism's
ceaseless process of "creative destruction." But Minsky spent more time
thinking about destruction than creation. In doing so, he formulated an
intriguing theory: not only was capitalism prone to collapse, he
argued, it was precisely its periods of economic stability that would
set the stage for monumental crises.

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.

From the 1960s onward, Minsky elaborated on this hypothesis. At the
time he believed that this shift was already underway: postwar
stability, financial innovation, and the receding memory of the Great
Depression were gradually setting the stage for a crisis of epic
proportions. Most of what he had to say fell on deaf ears. The 1960s
were an era of solid growth, and although the economic stagnation of
the 1970s was a blow to mainstream neo-Keynesian economics, it did not
send policymakers scurrying to Minsky. Instead, a new free market
fundamentalism took root: government was the problem, not the solution.

Moreover, the new dogma coincided with a remarkable era of
stability. The period from the late 1980s onward has been dubbed the
"Great Moderation," a time of shallow recessions and great resilience
among most major industrial economies. Things had never been more
stable. The likelihood that "it" could happen again now seemed
laughable.

Yet throughout this period, the financial system - not the economy,
but finance as an industry - was growing by leaps and bounds. 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.

"This wasn't a Minsky moment," explains Randall Wray. "It was a Minsky half-century."

Minsky is now all the rage. A year ago, an influential Financial
Times columnist confided to readers that rereading Minsky's 1986
"masterpiece" - "Stabilizing an Unstable Economy" - "helped clear my
mind on this crisis." Others joined the chorus. Earlier this year, two
economic heavyweights - Paul Krugman and Brad DeLong - both tipped
their hats to him in public forums. Indeed, the Nobel Prize-winning
Krugman titled one of the Robbins lectures at the London School of
Economics "The Night They Re-read Minsky."

Today most economists, it's safe to say, are probably reading Minsky
for the first time, trying to fit his unconventional insights into the
theoretical scaffolding of their profession. If Minsky were alive
today, he would no doubt applaud this belated acknowledgment, even if
it has come at a terrible cost. As he once wryly observed, "There is
nothing wrong with macroeconomics that another depression [won't] cure."

But does Minsky's work offer us any practical help? If capitalism is
inherently self-destructive and unstable - never mind that it produces
inequality and unemployment, as Keynes had observed - now what?

After spending his life warning of the perils of the complacency
that comes with stability - and having it fall on deaf ears - Minsky
was understandably pessimistic about the ability to short-circuit the
tragic cycle of boom and bust. But he did believe that much could be
done to ameliorate the damage.

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.

Minsky, however, argued for a "bubble-up" approach, sending money to
the poor and unskilled first. The government - or what he liked to call
"Big Government" - should become the "employer of last resort," he
said, offering a job to anyone who wanted one at a set minimum wage. It
would be paid to workers who would supply child care, clean streets,
and provide services that would give taxpayers a visible return on
their dollars. In being available to everyone, it would be even more
ambitious than the New Deal, sharply reducing the welfare rolls by
guaranteeing a job for anyone who was able to work. Such a program
would not only help the poor and unskilled, he believed, but would put
a floor beneath everyone else's wages too, preventing salaries of more
skilled workers from falling too precipitously, and sending benefits up
the socioeconomic ladder.

While economists may be acknowledging some of Minsky's points on
financial instability, it's safe to say that even liberal policymakers
are still a long way from thinking about such an expanded role for the
American government. If nothing else, an expensive full-employment
program would veer far too close to socialism for the comfort of
politicians. For his part, Wray thinks that the critics are apt to
misunderstand Minsky. "He saw these ideas as perfectly consistent with
capitalism," says Wray. "They would make capitalism better."

But not perfect. Indeed, if there's anything to be drawn from
Minsky's collected work, it's that perfection, like stability and
equilibrium, are mirages. Minsky did not share his profession's quaint
belief that everything could be reduced to a tidy model, or a pat
theory. His was a kind of existential economics: capitalism, like life
itself, is difficult, even tragic. "There is no simple answer to the
problems of our capitalism," wrote Minsky. "There is no solution that
can be transformed into a catchy phrase and carried on banners."

It's a sentiment that may limit the extent to which Minsky becomes
part of any new orthodoxy. But that's probably how he would have
preferred it, believes liberal economist James Galbraith. "I think he
would resist being domesticated," says Galbraith. "He spent his career
in professional isolation."


© 2021 Boston Globe

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