Market radicalism

In the wake of the financial crisis which led the global economy to the brink of the abyss, tenants of capitalism and economic liberalism have struggled to respond to criticism. Proponents of market fundamentalism inspired by ideas of friedman, Hayek and Stigler were more concerned about defending the liberal order rather than addressing market failures. By contrast, many critics who blame today's economic inequality, stagnation and political instability on the free market think  that economic liberalism has run its course because  of its inability to respond to current problems of the society. 

In their book “Radical Markets. Uprooting Capitalism and Democracy for a Just Society”,    Posner and  Weyl (2018) offer a different perspective on markets. They propose some revolutionary ideas on how to use markets to bring about fairness and prosperity for all. Radical Markets turns this thinking—and most of all conventional thinking about markets, both for and against—on its head. The book reveals bold ideas to organize markets for the good of everyone. It shows how  genuinely open, free, and competitive markets can reawaken the dormant nineteenth-century spirit of liberal reformism and lead to greater equality, prosperity, and cooperation.

Eric Posner and Glen Weyl demonstrate why private property is inherently monopolistic, and how we would all be better off if private ownership were converted into a public auction for public benefit. Their solution is a new wealth tax - every individual would put a value on each item (s)he owned and would be taxed on total declared wealth. The tax would enable property to be put to its most profitable use, while raising revenue, perhaps to fund a universal basic income. because rich people own the most, it would be drastically redistributive. Most important, people would see property as rented from society, rather than conferring exclusive ownership. Radical collectivism would replace property ownership in democracy. 

They also show how the principle of one person, one vote inhibits democracy, suggesting instead an ingenious way for voters to effectively influence the issues that matter most to them. They argue that every citizen of a host country should benefit from immigration—not just migrants and their capitalist employers. They propose leveraging antitrust laws to liberate markets from the grip of institutional investors and creating a data labor movement to force digital monopolies to compensate people for their electronic data.” 

The authors say their book is intended to provide fresh ideas for a renewed liberalism. But their intrinsic philsophy is utilitaianism -  pursuing the common good maximises happiness. One criticsim would be that they feel relatively unconcerned with individual and social rights. At the end of the book they suggest that the logical extension of their property tax would be to apply it to human capital ie, to require citizens to declare a wage at which they would work, tax them on the basis of that number and force them to accept any job offers. In another chapter, they argue that every citizen should be given a chance to sell a visa directly to an immigrant, whom they would house and help find work. The economic gains to all would offset the social costs of inequality and power imabalnce this would produce. On voting, they calculate that their proposed electoral reforms could boost GDP by 20% (!) as if that, rather than a fair allocation of power is what really matters in electoral systems.

'Radical markets' is ceratinly refreshing in its willingness to question conventional wisdom.  But the proposals would do little to respond to the fundamental criticism that capitalism has neglected human needs beyond economic progress and that market principles would undermine institutions such as property rights and elections that confer dignity on individuals. Posner and Weil may be viewed in the way radicals ar often perceived, as somewhat eccentric. Still, liberals must find some convincing antidote to populism and nationalism. 

When Keynes imagined capitalism in 2030

In his famous essay ' Economic possibilities for our grand-children' , Keynes projected himself a century later to imagine the society of the future. In reading it, growth would have supplanted misery. We would live in a society of abundance in which we would work few hours: " It will be time for the humanity to learn how to devote its energy to other ends than economic ones".

This text has been analysed in many ways and at length but its interest in our view resides in the rupture with capitalism that Keynes foresees. It unveils a 'radical'  vision of society than in most Keynes' writings.

Since the end of the 20s, Keynes predicted that the economic activity would be four to eight times higher after a century. Yet, today, in constant terms, the outpur of developed nations is already more than four times higher than it was in 1930. This prediction is remarkable as it was made in  troubled times with the crisis of 1929 and statistics at that time were relatively scarce. To measure the audacity, we should think about the difficulties that a contemporary economist would face today in predicting the level of development in a hundred years!

However, Keynes imagined a society of abundance, which contrasts with one of the basic principles of capitalism, the  scarcity of resources. He focuses on absolute needs (nutrition, housing, etc;) rather than relative needs (the desire to acquire a higher status), but this is rather consistent with his analysis. In an abundant society, these needs do not have any reason to exist since once materiual needs would be fully satisfied, we would be free to be human and to develop an authentic way of living.

What appears incongruent is that a  liberal economist conceives capitalism as a provisional phase of the development of mankind, where liberals think of it as the definitive and unsurmountable form of the economic order. But it is also the antagonism between true human values and the values of capitalism such as the love of money " which will be recognised for what it is, a somewhat disgusting morbidity".. In his vision, capitalism constitutes a sort of dark age during which men are constrained by the scarcity of resources. True values will only prevail when we will get out from an economy centered on work and subsistance. Keynes imagines a society where the 'old Adam' (our deep nature) would still feel the need to work three hours a day.

What makes this text debatable is the questioning of the logic of capitalism, which consists in producing continuingly more goods and serices. For Keynes, capitalism is conceivable only if we can break up with it to build a society of sobriety. Today, we face a similar  economic problem on a much larger scale because the 'productivist' model has reached its limits, due to the limitation of resources and the ecological equilibrium. This again contrasts with Keynes' traditional view on growth and innovation as palliatives to resolve our economic problems.

From an ethical perspective, he opposed the 'Benthamian' tradition which assimilates the good to the useful. Instead, 'once out of the tunnel of economic necessity (...) we shall prefer the good' as opposed to 'avarice' and 'usury'. But his conception of the good is of a different nature and identifies with 'delightful people' and  ' direct enjoyment in things',  which presumably owes to George Edward Moore, a philosophy professor at Cambridge and his 'Principia Ethica".

Interestingly, Keynes concluded that we should "not overestimate the importance of the economic problem, or sacrifice to its supposed necessities other matters of greater and more permanent significance. It should be a matter of specialists - like dentistry. If economists could manage to get themselves though of as humble, competent people on a level with dentists, that would be splendid"  .


His conception of the economy is not about entrepreneurship and innovation and he identified capitalism not with the spirit of enterprise but the desire of money. In his 'General Theory', consumption plays a central role, and saving a secondary role. His rejection of accumulation of money is at the heart of his economic doctrine. His vision of capitalism is not about finance and he imagines without any hesitation 'the euthanasia of rentiers' due to the necessary fall of the rate of interest. For Keynes, the two vices of the economic world are unemployment and inequality of wealth and income. In this sense, his liberal ideas are inseparable from social justice and the search for a better world.

 

Keynes and the Universal Basic Income

One of the most famous Keynes' predictions is that people could afford to work less hours   and have more spare time for leisure. His Essay 'Economic Possibilities for our grand-children" was written before the Great Depression and published in 1930. But his point seems to be misinterpreted bymainstream economists. His prediction was that, in the long term, say a hundred years, living standards in 'progressive countries' would be between four and eight times as high. The main arugment is that the society would be more productive with technological progress and resulting increased productivity. Hence  "mankind would  have resolved its economic problem".   

A book published  eight years ago by some of the world's leading economists explores the reasons Keynes was mistaken about a new era of leisure. One argument is Keynes' forgetfulness about distribution.  The trend in recent years, though, has been towards more income inequality, between and within groups. The gap between the top 1% of earners and the rest has widened, but so has the gap   among all other sub-groups of society. The rich  spend more as they get richer, which leads to others wanting to spend more as well. Not all of them can afford to maintain the spending habits of those better-off  , and as a result they borrow. The result, contrary to what Keynes may have imagined, has been a collapse in savings ratios in the US and Britain, and a rise in debt levels and bankruptcies. The other main argument is about working hours. There is no country that conforms to Keynes's ideal of a 15-hour working week. However, France has introduced the 35 hour week that right wing governments wanted to scrap and ask people to work longer. Recently, Sweden has voted for a six hour working day for all workers.  The question is why with sustained technological progress, people still work longhours,  in the US 30% more than in Europe.

Over the last 50 years, living standards in developed western economies have seen rapid growth; by 2030 it is likely that they will have risen at least eightfold if there is a strong recovery from the financial crisis.  But rising living standards have not seen people deciding to satisfy their material needs.  People with low wages have no choice but to work long hours. In his essay in 'Revisiting Keynes" , Richard Freeman notes that more Americans than Europeans say that they want to increase hours worked than to decrease at given wage rates, and that's probably a function of a lower minimum wage and stagnant real incomes for all but the highest earners. Furthermore, widening gap in earnings may create an incentive to work longer hours. 

Keynes's  failure might be  to recognise that distribution matters. The economic problem will not be solved while a quarter of the world lives in abject poverty, nor while a good slice of those living in developed countries are not sharing in economic prosperity or feel they need to spend longer and longer on the workplace.

Keynes' view might be ethnocentric but his argument referred to progressive societies such as France or Sweden. It had to be put in context, bearing in mind the accumulation of capital and the wide variety of goods that technological progress offers. What he had in mind is the ' good society' that Galbraith attempted to lay out twenty years ago.

 In our unequal societies,  a greater degree of income equality would indeed help to improve the welfare of low earners. The new frontier is the introduction of a universal basic income (UBI)whatever the form it takes. Y. Varoufakis made convincingly this point :  "A universal basic income allows for new understandings of liberty and equality that bridge hitherto irreconcilable political blocs, while stabilizing society and reinvigorating the notion of shared prosperity in the face of otherwise destabilizing technological innovation". His proposal is to fund UBI not with taxation but from returns on capital, i.e.. profits. This could be an important step up towards a more equal society.

We need a visionary hope

        One of the most famous quotes in economic theory to be read and re-read ...

           
          John Maynard Keynes (1936): The General Theory of Employment, Interest and Money:

…Have they insufficient roots in the motives which govern the evolution of political society? Are the interests which they will thwart stronger and more obvious than those which they will serve?

I do not attempt an answer in this place…. But if the ideas are correct… it would be a mistake, I predict, to dispute their potency over a period of time…. The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas….

There are not many who are influenced by new theories after they are twenty-five or thirty years of age, so that the ideas which civil servants and politicians and even agitators apply to current events are not likely to be the newest. But, soon or late, it is ideas, not vested interests, which are dangerous for good or evil.

Tribute to Albert Hirschman

Nowadays, there is a shortage of great thinkers with a sort of vision embracing different disciplines and areas of research. Albert Hirschman was perhaps one of the last great thinkers of the twentieth century. He was also a free thinker in the sense that he has never been tied up to any ideology. for over half a century, he was a living conscience for an entire generation of social scientists. Trespassing is perhaps the word which best characterizes his lifetime work.

He was an influential economist who wrote several books and articles on political economy.  His first major contribution was in the area of development economics where he emphasized the need for unbalanced growth. Like in F. Perroux's growth pole theory, he thought that industries with strong linkages with other industries should be encouraged. 

His later work was in political economy and there he advanced two simple but intellectually powerful ideas. The first describes the three basic possible responses to decline in firms : exit, voice and loyalty. The second describes the basic arguments made by conservatives: perversity, futility and jeopardy, in The Rhetoric of Reaction. 

But there is an intrinsic unity in all his work which is conducive to a deep reflection on the problem of development. He wrote: “ In dealing with the multiple and complex problems of development we have learnt that we must fashion generalizations at all kinds of ranges and be deaf, like Ulysses, to the seductive chant of the unique paradigm ”.

As the Economist pointed out, "Hirschman's exit will not silence his voice".

Finance and the good society

Robert Shiller of Yale University talks  about his book, ‘Finance and the Good Society’, in which he argues that even after the crisis, rather than condemning finance, we need to reclaim it for the common good. He discusses financial innovation, personal morality, the importance of education, and the contribution that finance can make to our lives. The interview was recorded in Bristol in May 2012.


Finance and the good society | vox

Tribute to Gérard de Bernis

My beloved master, Professor emeritus Gérard Destanne de Bernis, passed away on Christmas Eve. He was an exceptional man in many respects, by his monumental work, his political engagement in ideas he believed in and his intellectual honesty. His writings and lectures were a testimony of his brilliance.

He had a strong influence from F.Perroux, a great French economist, who achieved an original synthesis of Schumpeter and Marx and elaborated a critique of the general equilibrium theory. His main contribution  to economic theory was to introduce the concept of 'regulation' - which was developed by French philosopher Georges Canguilhem- just as   scientific concepts elaborated by physicists and mathematicians to explain dynamic phenomena. In fact, he developed a general theory to explain the dynamic of capitalism and its crises in a historic context. This was a lifetime endeavour: his main writings date from the 70s and the 80s, in particular his impressive text-book on international economics.

His development theories will be largely influenced by Perroux' ideas on the role of power, domination and assymetries as well as structuralist economists (Gunnar Myrdal, Prebisch, Furtado). He introduced the concept of "industrializing industries", close to the idea of 'growth pole' developed by F.Perroux. The idea is that certain industries may drive the entire development of an economy due to stronger linkage effects with other industries as well as growth enhancing effects. From a general perspective, de Bernis will defend a model of 'endogenous' development  open to international trade, but this openness will have to be controlled by the State to protect domestic industries from external domination of foreign capital, at least at their early stage of development. His ideas were put in practice to a large extent in the 60s in Algeria and Tunisia. 

Nevertheless, Prof. de Bernis was not a pure academic. His research work was entirely conceived as being instrumental to the critique of 'mainstream' economic analysis and policy. He was, in that respect, an"organic intellectual" (Gramsci) fully committed to the ideals of justice and  equity though he always acted as a free public thinker.  Many of his students and companions will recall him as a relentless worker for this cause.

He was profoundly inspired by Christian values, which mean in their essence the pursuit of social justice and the liberation of men from any form of exploitation. He was an ethical economist with a strong belief in human action to change the existing order. He had a nature that was worthy of  admiration and profound respect and those who knew him will keep his memory alive.

R.I.P. 

Economists should listen to people

Economics has never been as popular as today. Books, articles, blogs, lectures are spreading and influencing public opinion. People want to understand what is happening to the economy and how it is possible to improve the situation. Yet, economists have lost credibility as they failed to predict the current economic crisis, the biggest since the Great Depression.

It is true that some professional economists such as Paul Krugman have a particular talent to explain economic problems to the general public in an intelligible way. The reason why economics is so sympathetic is that it is regarded as an open, pragmatic discipline. Economics is not more scientific because it is based on extensive use of maths and sophisticated economic models. The problem is not that economics has a scientific purpose but that even sophisticated models can be inadequate for economic forecasts because they were based on wrong assumptions.

R.Schiller, in a recent article wrote : ' sometimes we need to turn off autopilot and think for ourselves, and when a crisis occurs, use our best human intellect". This resembles to what Keynes' set as a method for economic analysis, not because he was unable to put his theory into mathematical language - he was the author of a complex book on probability - but because he wanted precisely to use his intellect to explain what was happening during the Great depression and how we could get out from it.

in his 'Essay on the nature and significance of economic science' (1932), Lord Robbins, a British economist, became famous for his definition of economics: ' a science which studies human behaviour as a relationship between ends and scarce means which have alternative uses'. This definition owes to neoclassical theory more than to unconventional wisdom. Economic thinking has evolved considerably, but it does not mean that economists can provide answers to all issues. Connections with other disciplines have enriched the nature of economics and its significance by considering human beings as actors being able to influence the functioning of markets.

Like Keynes, R.Schiller pledges for full account of human behaviour, which by definition cannot be reduced to mathematical analysis. He acknowledges that the " relatively few professional economists who warned of the current crisis were people, it seems, who not only read the scholarly economics literature, but also brought into play more personal judgment; intuitive comparisons with past historical episodes; conclusions about speculative trading, price bubbles, and the stability of confidence; evaluations of the moral purposes of economic actors; and impressions that moral complacency had set in, lulling watchdogs to sleep".

In economics, like in any other social science, there is no universal truth, but just propositions which need to be validated by historical or empirical evidence. But we should acknowledge that economics is not the 'dismal science' described by Carlyle in his controversy with Malthus. It is, indeed, an ethical and historical science, and therefore is not an exact or purely abstract science. People's economics needs to be further developed, looking at their fundamental needs and aspirations for a better society.

Do not forget Keynes' lesson about the euthanasia of the rentier

Classical economists (A.Smith, D.Ricardo, etc.) distinguished between productive and unproductive labour. Some incomes are not earned such as the rent. The rentier economy is that some economic agents, say banks derive their income through speculation rather than from the productive economy. The source of the present crisis is the rentier system that the last financial revolution engineered since the 1980s. Savings have been lent out without increasing production or living standards to finance speculation and debt leveraging. But the big picture is that the debt overhead has soared without corresponding means in the ability to pay this debt.

In the last chapter of the General Theory (Chap.XXIV), Keynes outlined a vision of capitalism in which he figured out the euthanasia of the rentier:

«Now, though this state of affairs would be quite compatible with some measure of individualism, yet it would mean the euthanasia of the rentier, and, consequently, the euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital. Interest today rewards no genuine sacrifice, any more than does the rent of land. The owner of capital can obtain interest because capital is scarce, just as the owner of land can obtain rent because land is scarce. But whilst there may be intrinsic reasons for the scarcity of land, there are no intrinsic reasons for the scarcity of capital. An intrinsic reason for such scarcity, in the sense of a genuine sacrifice which could only be called forth by the offer of a reward in the shape of interest, would not exist, in the long run, except in the event of the individual propensity to consume proving to be of such a character that net saving in conditions of full employment comes to an end before capital has become sufficiently abundant. But even so, it will still be possible for communal saving through the agency of the State to be maintained at a level which will allow the growth of capital up to the point where it ceases to be scarce. I see, therefore, the rentier aspect of capitalism as a transitional phase which will disappear when it has done its work. And with the disappearance of its rentier aspect much else in it besides will suffer a sea-change. It will be, moreover, a great advantage of the order of events which I am advocating,that the euthanasia of the rentier, of the functionless investor, will be nothing sudden, merely a gradual but prolonged continuance of what we have seen recently in Great Britain, and will need no revolution".

However, Keynes does not explain how this process will be accomplished. As Paul Krugman explained in his introduction* to the General Theory,  this rentier aspect was not transitional neither its euthanasia was gradual.

By that, Keynes meant a debt write-down. This is the only ultimate solution. As Adam Smith noted in 1776, no government ever has repaid its foreign debt. Today one can say the same thing about the private sector. Bankruptcy seems to be the indicated way to wipe it out. Governments are postponing this resolution by bailing out creditors – not debtors. This was not the solution suggested by Keynes: he wanted to minimize debt overhead, not bail out the financiers and builders of debt pyramids.

A key feature of the current global crisis is that we have not learnt the lessons from the past crisis. The excessive share of finance in capitalist economies has led to the formation of asset bubbles and therefore to a dramatic increase of inequalities to the advantage of capital holders (rentiers) and to the detriment of the working class. Rentiers continue to experience an increase in the rentier income share in average in the second half of the 20th century in developed countries**. This phenomenon is clearly related with the accumulation of capital and interest rate reduction.

We need a radical change in the finance, insurance and real estate sector – the rentier system -. The recent Obama experience shows how difficult it is.

* http://www.pkarchive.org/economy/GeneralTheoryKeynesIntro.html

** Trends in the Rentier Income Share in OECD Countries, 1960‐2000  by Dorothy Power, Gerald Epstein and Matthew Abrena.

Animal spirits, irrationality and markets

The current crisis brings about a radical shift in economic thinking. There is a hot debate among economists about the reasons why they failed in predicting the crisis. In fact, there is no consensus on the analysis of the causes of the crisis nor on the ways to get out from it. Now, the dominant view among (orthodox) economists is that we are seeing the light from the tunnel.

Economists who believe in the rationality of markets would be more incline to think that the crisis is just a temporary imbalance which has led the economy far from the equilibrium. John Maynard Keynes warned against this simplistic view: “Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.” But all this is not about rationality, it is related to human psychology of economic behaviour.

In their book*, G. Akerlof, who shared the Nobel prize in 2001 for his work on information assymetries and R. Schiller - who predicted the dotcom and real estate bubbles - reassert the necessity of an active government role in economic policymaking by recovering the idea of animal spirits, a term John Maynard Keynes used to describe the gloom and desperation that led to the Great Depression and the changing psychology that accompanied recovery. Keynes's forgotten lesson is not here the theory of government spending; he asserts that the behaviour of economic agents is not inspired by a pure rational model, but is largely driven by irrational and psychological factors. Markets are not regulated by rational and imprescriptible laws; they are largely influenced by passions and interests of human beings. In other words, they can be guided by an economic policy geared to collective interest and full employment.

In past thirty years, this lesson has been forgotten. Likening the role of government to a parent's duty to create a happy home, the authors write: " The proper role of the parent is to set the limits so that the child does not overindulge her animal spirits . Likewise, they point out that 'no limits were set to the excesses of Wall street. It got wildly drunk...And now the world must face the consequences".

It is thus necessary to rethink the behaviour of economic agents whatever their motives are rational or irrational. Akerlof and Schiller examine some psychological factors which could influence economic behaviour - confidence or mistrust, bad faith, corruption, monetary illusion- and draw conclusions in terms of economic policy inspired by a 'good education'. In overlooking those factors and being confident in the 'invisible hand' of the market, (orthodox) economists made disastrous mistakes in their forecasts. They have developed sophisticated econometric models - for which some of them got the Nobel Prize- which turned out to be impractical.

The fundamental reason for which economists failed in their forecasts is because the market is largely influenced by a complex interaction of economic powers, instincts and passions. If asset prices go up, demand can also go up due to expectations on further increases leading to asset bubbles. As J.K. Galbraith wrote in his foreword to the 1993 edition of 'A Short History of Financial Euphoria', investors “might be reminded of the way not only fools but quite a lot of other people are recurrently separated from their money in a moment of speculative euphoria.” But, other 'innocent'people are separated from their money and their jobs.

In their analysis of the Great Depression, the two authors portray Keynes as a true 'liberal'- but he has inspired, nevertheless, the economic policy of many governments run by socialist parties, like the Jospin government in France. Right wing critics insist, conversely, that through balanced budgets and limited government regulation private markets would create jobs for any worker willing to get paid less than he produced. Keynes thought capitalism as productive system, but unstable and fragile, prey to the 'animal spirits' that lead to speculative mania and panic, which in turn leads to joblessness (quaintly described as 'involuntary unemployment').

In times of recession animal spirits tend to revive. The proper role of government is to temper these excesses through financial regulation- and to stimulate demand using deficit spending. In the wake of the crisis of the 30s, the Us governments showed excessive concern for balanced budgets but they still managed to impose some financial reforms and to stimulate demand. the authors point out, indeed, that fiscal policy was at that time insufficiently bold.

We have to think about the situation of the American economy in the 30s. There was a widespread feeling about the unfairness of the economy leading to labour unrest and the 'spectre of socialism (which the most conservative parts of the US society are still agitating today, for instance in the debate on healthcare reform). A key feature of animal spirits is 'money illusion': the inability to recognize that prices fell by 27 percent led Hoover, then Roosevelt to focus on raising real wages increasing purchasing power rather than stimulating demand to reduce unemployment.

As Keynes pointed out, the fundamental problem was that bankers were too reluctant to loan, because they thought they would lose their money. And some of the more 'radical' measures of the New Deal led capitalists to worry that market system would be replaced by a communist dictatorship, which further depressed their willingness to invest. Since deficit spending was not of enough scale to stimulate demand, economic pessimism tended to set in. Only with the emergency mobilization of World War II did the national economy begin to change.

Our contemporary economic problems cannot be directly compared with the situation of the 30s. However, Akerlof and Schiller end with a positive note: 'Yet we are currently not really in a crisis for capitalism. we must merely recognize that capitalism must live within certain rules". But we must take into account that irrational behaviour has a real effect on demand, necessitating government intervention.

Just a last observation on the general approach of the book. In their analysis, Akerlof and Schiller focus on individual agents, for which we can distinguish between rational and irrational motives. But our modern economies are also characterized by collective agents, firms, trade unions as well as the State. Choices made by these agents might be rational, but different from those of individual agents. The threat of being fired might lead workers to accept a reduction of their wages, but it could also determine a reaction from trade unions to defend the workers' wages, which in turn would cause cost increases for the firm and in macroeconomic terms a stimulation of demand.

From a different perspective, decisions taken on the basis of self interest might be contrary to the general interest if agents's behaviours are largely interdependent. We should rather make a distinction between public and private interests. Collective, rather than individual motives need to be evaluated every time in accordance with the general interest.


*George A. Akerlof and Robert J. Shiller, Animal spirits- How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism 230 pp. Princeton University Press. 2009

** J.K.Galbraith, A Short History of Financial Euphoria, - Foreword to 1993 Edition, Viking Press, 1994

The Minsky moment

The Economist (17 July) asks what went wrong and how the crisis is changing economic thinking. It writes: 'Economists need to reach out from their specialised silos: macroeconomists must understand finance, and finance professors need to think harder about the context within which markets work. And everybody needs to work harder on understanding asset bubbles and what happens when they burst. For in the end economists are social scientists, trying to understand the real world. And the financial crisis has changed that world'.

The current crisis has revived the debate among rival economic theories. Monetarism is dead and keynesianism is back. An economist, H.Minsky* has gained influence over a decade or so; although educated at Chicago , Minsky was nonetheless an enemy of the "Chicago School" of economists, who typically believe in the efficiency of markets. Building on Keynes' General Theory, Minsky argued that crises were integral to financial markets.

Minsky claimed that in prosperous times, when corporate cashflow rises beyond what is needed to pay off debt, a speculative bubble develops, and soon thereafter debts exceed what borrowers can pay off from their incoming revenues, which in turn produces a financial crisis. As a result of such speculative bubbles, banks and lenders tighten credit availability, even to companies that can afford loans, and the economy subsequently contracts.

In other words, the longer economic stability lasts, the more risks borrowers will take. His model of the credit system shows that the cause of instability is the accumulation of debt. He distinguishes three types of borrowers (hedge borrowers, speculative borrowers and Ponzi borrowers). While some debtors are perfectly sound, others can only pay off their interest by renewing their loans. The third group of borrowers (that he calls Ponzi) sounds dangerously familiar: they borrow based on the belief that the appreciation of the value of the asset will be sufficient to refinance the debt but could not make sufficient payments on interest or principal with the cash flow from investments.

The 'Minsky moment' - a term coined by an American economist, Paul McCulley** is the point in a credit or business cycle when investors have cash flow problems due to spiraling debt they have incurred in order to finance speculative investments. At this point, a major selloff begins due to the fact that no counterparty can be found to bid at the high asking prices previously quoted, leading to a sudden collapse in asset prices and a sharp drop in financial liquidity.

Minsky's financial instability hypothesis has received revived attention during the 2008 subprime crisis due to the debt accumulation problem. McCulley illustrated the three types of borrowing categories using an analogy from the mortgage market: a hedge borrower would have a traditional mortgage loan and is paying back both the principal and interest; the speculative borrower would have an interest-only loan, meaning they are paying back only the interest and must refinance later to pay back the principal; and the Ponzi borrower would have a negative amortization loan, meaning the payments do not cover the interest amount and the principal is actually increasing. Lenders only provided funds to Ponzi borrowers due to a belief that housing values would continue to increase.

McCulley writes that the forward progression through Minsky's borrowing stages was evident as the credit and housing bubbles built through approximately August 2007. Demand for housing was both a cause and effect of the rapidly-expanding shadow banking system, which helped fund the shift to more lending of the speculative and Ponzi types, through ever-riskier mortgage loans at higher levels of leverage. This helped drive the housing bubble, as the availability of credit encouraged higher housing prices. Since the bubble burst, we are seeing the progression in reverse, as businesses de-leverage, lending standards are raised and the share of borrowers in the three stages model shifts back towards the hedge borrower.

As Henry Kaufman, a Wall street economist and banker writes in the foreword of Minsky's book: 'now it is time to take seriously the insights of Hyman Minsky and build upon his groundbreaking work in order to find ways of putting our financial system on a more solid footing'. This sounds as a serious warning, but this means putting an end to the greed and cupidity of bankers. We badly need ethical rules and regulation to bring radical changes in the financial system.

* Hyman P. Minsky, Stabilizing an Unstable Economy, 2nd edition, Foreword by Henry Kaufman- McGraw Hill 2008

** Paul McCulley, The Shadow Banking System and Hyman Minsky's Economic Journey, PIMCO May 2009