Hyman Minsky is a popular guy these days. An economist who studied under Joseph Schumpeter, Minsky has become the dismal scientist of choice in the wake of the Great Recession as the man who told us so.
Robert Barbera in The Cost of Capitalism: Understanding Market Mayhem and Stabilizing our Economic Future identifies a key theme in Minsky's oeuvre by explaining that the "renegade financial economist…insisted that finance was always the key force for mayhem in capitalist economies." Barbera goes on to observe that Minsky advanced two ideas that were central to his view of the economic world:
First, the persistence of benign real economy circumstance invites belief in its permanence. Second, growing confidence invites riskier finance. Minsky combined these two insights and asserted that boom and bust cycles were inescapable in a free market economy—even if central bankers were able to tame big swings for inflation.John Cassidy is no less effusive in profiling Minsky. In last year's How Markets Fail: The Logic of Economic Calamities, Cassidy writes:
From the early 1960s until shortly before his death in 1996, Minsky advanced the view that free market capitalism is inherently unstable, and that the primary source of this instability is the irresponsible actions of bankers, traders, and other financial types. Should the government fail to regulate the financial sector effectively, Minsky warned, it would be subject to periodic blowups, some of which could plunge the entire economy into lengthy recessions.There is much to admire in Minsky's sober-eyed view of business cycles, even if some of it is self-evident. The idea that stability breeds instability, as he preached, is just another way of saying that business cycles persist. At times, these cycles "have have the potential to spin out of control," as Minsky wrote in the early 1990s.
Recognizing the challenge of macroeconomics is one thing; solving the challenge is something else. Surely there are broad principles upon which all (or at least most) students of economic theory can agree, with the first being that an unfettered, totally free and unregulated market system can't dispense economic nirvana at all times under all conditions. To quote Minsky again from the above paper, the various economic seizures throughout history "are evidence supporting the view that the economy does not always conform to the classic precepts of Smith and Walras: they implied that the economy can best be understood by assuming that it is constantly an equilibrium seeking and sustaining system."
Perfection does not exist, in economics, investing or anything else. But what does that imply? For some, the temptation to regulate the markets is the obvious response. Indeed, it is now the cause celebre to argue over the details of how to embrace so-called financial reform. For all the rhetoric and popularity of invoking Minsky of late, success won't be anywhere near as easy as the Monday morning quarterbacking suggests.
For one thing, financial markets are already regulated, and they have been for decades. Yes, there's a furious debate over the details, including when, how and if regulation in recent years has failed and what should be done about it. But it's naïve to expect that some obvious piece of new financial regulation can be enacted and, voilà, Minsky's ghost will rest easy for all of eternity. Washington has been tinkering with regulation for decades and it's not always clear that progress is inevitable. Countless numbers of economists of all stripes have weighed in. The system has leaned toward relatively light regulation to heavy handed regulation to something in between since the government took up the cause in the 1930s. It should be lost on no one that despite the best (and worst) efforts of regulators, the business cycle is not yet tamed.
In the grand scheme of macroeconomics lies the basic conundrum of deciding how to integrate government's hand with the principles of free markets. We've known since at least Bagehot's Lombard Street. A Description of the Money Market, first published in 1873, that the banking system requires a lender of last resort from time to time.
We've also learned that seemingly easy solutions to what are ultimately complex economic paradigms can give temporary relief but perhaps at the cost of delaying the inevitable, and paying through the nose for the procrastination. Liaquat Ahamed's magnificent tome from last year—Lords of Finance: The Bankers Who Broke the World--spells out this pitfall as practiced during the 1920s and early 1930s by way of embracing the gold standard as the all-season answer to the surviving the business cycle. But as Ahamed's book reminds, nothing works all of the time. Every solution in economics has a glitch. Everything fails at times. Should we expect the approaching solutions to the crisis du jour to fare any better?
As we await for an answer, the crowd wants blood. The popular idea that the market has failed is intuitively appealing. But is that really how we should explain price fluctuations? Clearly, investors, business people, government regulators, and the rest of the human species are prone to error. It's not always obvious in advance what distinguishes enlightened decisions from folly. In the end, the market will instill discipline by lowering or raising prices to reflect new information. Still, delusion at times is possible if not inevitable. Bidding up the price of houses and stocks above "fair value" isn't beyond the pale. The trick is defining fair value and estimating when the market will reprice assets to move closer to this idealized state of valuation. Unfortunately, markets don't come with instructions, leaving mere mortals to reverse engineer the laws in real time, and at times with great difficulty.
Among the various trends du jour in Washington is one of forcing the Federal Reserve to prick "bubbles" in order to sidestep the troubles of the last several years the next time out. But it's not obvious how this should be done in real time, even if the general concept is appealing. Stating a general case for pricking bubbles won't suffice. Details, man, give us details. When? Under what conditions? Perhaps this mandate is warranted, but writing the rules in advance will be torture. And in the end, there's still likely to be mistakes. Pricking too early, or too late. Pricking bubbles that seemed to exist but didn't. And on and on.
Meantime, didn't Minsky tell us that the business cycle is endemic to capitalism? If so, are we simply chasing our own tails by assuming that the business cycle can be tamed to a degree that satisfies the quest for stable growth without the nasty side effects?
Barbera is correct when he identifies a crucial change in the nature of business cycles over the past 30 years. A sharp rise in wages and inflation didn't precede the great cyclical episodes since the early 1990s. That's in contrast to recessions in previous years. "From 1945 to 1985," he writes, "there was no recession caused by the instability of investment prompted by financial speculation—and since 1985 there has been no recession that has not been caused by these factors."
The trouble, Barbera argues, is that central bankers were fighting the proverbial last war in the last two decades, i.e., keeping inflation at bay without paying heed to financial bubbles. "Surging asset prices and increasingly dubious finance define excess in the modern day cycle," he explains.
Maybe so, although one might wonder if that will remain true in the years ahead. Are we doomed to always fight the last war? There's a reason why so many smart economists thought the Great Moderation was durable in the 1990s and early 2000s: It was, at least until it wasn't.
In fact, we're always fighting the last war for the simple reason that the future is uncertain. Despite more than two centuries of central banking, the best and brightest are still trying to figure out how to optimize the management of the economic cycle. The first 8 million books and research papers were only a prelude to the real insight that's surely lying just around the corner.
To be sure, there are some very definite things we should be doing now that we weren't doing before, such as putting a lid on the capacity of financial institutions to sell insurance contracts (i.e., certain derivatives) without an appropriate level of collateral to offset the associated liabilities. In fact, coming up with a laundry list of things we should have done is easy, as it always is after the fact. We've been doing no less since the 1930s. So why isn't there more progress to show for all our efforts at trying to tame of the cycle? And just how much should we try?
One can argue that the Greenspan/Bernanke approach to central banking was all about moderating the business cycle. It seemed to work, until it didn't. How much confidence should we have that tomorrow's solution will bring salvation? The jury's always out on that one, but for our money we're forever skeptical. The same wetware that brings us to each mess is also asked to get us out. The human mind is capable of many things, but finding perfect solutions to the business cycle is hopelessly elusive. That doesn't mean we shouldn’t try. But we must also beware that the apparent answers have consequences too.
The seemingly productive goal of minimizing recessions may have long-run costs. As James Grant outlined in The Trouble With Prosperity: The Loss of Fear, the Rise of Speculation, and the Risk to American Savings, "…the attempted suppression of the business cycle has hurt economies through the industrialized world."
Not everyone agrees, of course. But this is economics and so definitive proof is always lacking, one way or the other. Economics, in other words, is all about juggling risk. Sometimes we do well, sometimes not. On that note, Grant quotes Clement Juglar, father of business cycle theory: "Where economic growth is slow and calm, crises are less noticeable and very short; where it is rapid or feverish, violent and deep depressions upset all business for a time. It is necessary to choose one or the other of those conditions, and the latter, in spite of the risks which accompany it, still appears the more favorable."
There are many poisons to pick, of course. But having tried the others, the free market poison is still the least worst of all the alternatives. Can we improve it? Perhaps, but it's not going to be easy. It's not even clear that well-intentioned efforts at a solution in the coming months and years will be successful, or that the reported solutions won't end up causing more pain. Nonetheless, the great experiment in macroecononmics rolls on! Just be careful if some wide-eyed pundit tells you it'll be different the next time, or that enduring progress is just one more piece of legislation away.
This post has been republished from James Picerno's blog, The Capital Spectator.
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