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Why stability can be destabilising

Ishan Bakshi 

An Introduction to the Work of a Maverick Economist

L. Randall Wray

Princeton University Press
268 pages; Rs 2,044

Beyond economists working on abstruse models in ivory towers, few had heard of, let alone read, Hyman Minsky before the global financial crisis of 2008.

Minsky died in 1996, but the financial crisis brought this relatively obscure economist to the centre-stage of economic discourse. To many economists, including Nobel Laureate Paul Krugman and Janet Yellen, US Federal Reserve (Fed) Chairman, Minsky offered the most plausible explanation for why the crisis occurred and, more importantly, why mainstream economists missed it. As his new-found followers put it, Minsky had predicted the crisis with a remarkable degree of precision.

Minsky, an economist at Washington University and later at the Levy Economics Institute, wrote on a range of issues spanning financial instability to employment, inequality and poverty. But his writing style was "notoriously opaque" with even economists finding it difficult to comprehend his work.

In a new book titled Why Minsky Matters: An Introduction to the Work of a Maverick Economist, L. Randall Wray, Professor at the University of Missouri and a former colleague and student of Minsky, brings together the maverick economist's work in a more accessible form.

At the core of Minsky's alternate view is the belief that "stability is destabilising". Neo-classical economists believe that even in the event of shocks to the system, market forces will operate to move the economy back to equilibrium. But Minsky disagreed with conventional economic wisdom that market forces are fundamentally stabilising. He discarded Adam Smith's notion of the invisible hand guiding the market economy. In his view, "the internal dynamics of the modern economy are not equilibrium seeking". That's radical stuff, by any standard.

Minsky argued that during periods of tranquillity, market participants change their behaviour. They believe that the good times will last and, thus, begin to take on even riskier bets. Moreover, "a stable economy makes it more difficult to find profitable business opportunities." This encourages risk-taking. Economic stability also promotes financial deregulation on the grounds that the system is more stable. These policies encourage even more risk-taking. In doing so, the seeds of the next crisis are sown. A case in point: Alan Greenspan's "Great Moderation", during which market participants took on more risks and discounted the likelihood of Nassim Taleb's Black Swan events. In some sense, Minsky's analysis, rooted in the behaviour of market participants, draws on psychology rather than economics.

On the issue of the authority's response to the crisis, Mr Wray contends that Minsky would have broadly agreed with the actions of the Fed and US government. In his view, Minsky would have advocated greater fiscal spending and agreed with the Fed's decision to provide liquidity on such a large scale, though on the latter, he would have raised objections about the manner in which it was implemented.

Mr Wray says Minsky would have criticised the Fed's decision to auction funds rather than forcing borrowers to the discount window. Minsky had advocated lending over the discount window as opposed to "open market operations with reserves provided through Fed purchase of assets." The rationale for this was that by exercising this option, the Fed would have had a chance to look at the of institutions borrowing at the discount window. This would have made them better appreciate the scale of the damage that perhaps would have forced them to lend across the entire financial system, something Minsky had advocated.

In the Fed's defence, though, if it had opted for using the discount window, markets may have interpreted it as a signal that borrowers were in deep trouble. This may have worsened the crisis. Thus, other than an odd tinkering here and there, his proposals on the authorities' response to the crisis aren't that different.

On the critical issue of how to promote prudent banking, Minsky's recommendations are anything but radical. He calls for improving underwriting, increasing capital requirements and examining banks at the discount window.

Of the three, the easiest is for the Fed to examine banks at the discount window. Increasing capital requirements, perhaps higher than the Basel III norms, might prove effective but is likely to be fiercely resisted by the banking industry. Improving underwriting standards makes sense. But this needs to be supplemented by exposing the underwriter to long-term risks. Unless it becomes mandatory for underwriters to keep a large enough portion of the original loan on their books, improved underwriting standards by themselves may not amount to much.

Given that Minsky's understanding is in large part grounded in human behaviour, it is a little odd that his solutions don't address the critical issue of incentives that encourage risk-taking behaviour in the first place. Precious little has been said on the issue of the skewed incentives structure of those working in financial markets. While raising capital requirements, strengthening underwriting norms are likely to help; if the rewards are high enough financial institutions are adept at figuring out loopholes in the regulatory architecture to game the system. Thus, the importance of fixing the incentive structure to influence behaviour can hardly be exaggerated.