The Limits of Minskys Financial Instability Hypothesis as an Explanation of the Crisis

7/27/2019 The Limits of Minskys Financial Instability Hypothesis as an Explanation of the Crisis

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http://monthlyreview.org/2010/04/01/the-limits-of-minskys-financial-instability-hypothesis-as-an-explanation-of-the-crisis

Thomas I. Palley mo re on Econom ics , Global Econo mic Crisis

The Limits of Minskys Financial Instability Hypothesis as an

Explanation of the Crisis :: Monthly Review

Thomas I. Palley ([email protected]) is an economist living in Washingto n, D.C. He has f ormerly

worked as ass istant directo r of public policy at the AFL-CIO and as chief economist o f the U.S.-China

Security Review Commission. He is t he autho r o fPlenty of Nothing: The Downsizing of the American Dream

and the Case for Structural Keynesianism (2000).

Thomas I. Palley sent John Bellamy Foster the f ollowing article in October 2009 f or publication inMonthly

Review, accompanied by this no te: Im hoping it might pro voke so me discussion and also generate so me

dialogue and consensus between Marxists (like yourself ) and st ructural Keynesians (like myself ). Palleys

piece addressed (along with much else) the article Mono poly-Finance Capital and the Paradox o f

Accumulation by John Bellamy Foster and Robert W. McChesney in the October 2009 issue o fMonthly

Review. In the same spirit of promot ing dialogue between Marxists and Keynesians on the present crisis,

we agreed to publish his contribution, to gether witha response by Fos ter and McChesney, in this issue of

MR.

The Edito rs

Minskys Moment

Aside f rom Keynes , no economist seems t o have benef itted so much f rom the f inancial crisis of 2007-08

as the late Hyman Minsky. The collapse of the sub-prime market in August 2007 has been widely labeled a

Minsky moment, and many view the subsequent implosion o f the f inancial system and deep recess ion as

conf irming Minskys f inancial instability hypothesis regarding economic crisis in capitalist economies.1

For instance, in August 2007, short ly af ter the sub-prime market collapsed, theWall Street Journaldevoted

a f ront -page story to Minsky. In November 2007, Charles Calomiris, a leading conservat ive f inancial

economist asso ciated with the American Enterprise Inst itute, wrote an article for theVoxEUblog of the

mainstream Center f or Economic Policy Research, claiming a Minsky moment had no t yet arrived. Though

Calomiris disputed the nature of the moment, Minsky and his heterodox ideas were the f ocal point o f the

analysis. In September 2008, Martin Wolf of theFinancial Times openly endorsed Minsky: What Went

Wrong? The Short Answer: Minsky Was Right. And in May 2009, Paul Krugman posted a blog titled The

Night T hey Reread Minsky, which was also the t itle of his third Lionel Robbins lecture at the London Schoo l

of Economics.2

Does Minskys Theory Really Explain the Crisis?

Recognition o f Minskys intellectual contribution is welcome and deserved. Minsky was a deeply insightf ul

theo rist about the proclivity of capitalist economies to experience f inancially driven booms and busts , and

the crisis has conf irmed many of his insights. That said, the current article argues that his theo ry only

provides a partial and incomplete account o f the current crisis.

In making the argument, I will fo cus on competing explanations o f the crisis by progressive econo mists . On

one side, Levy Institute economists Jan Kregel, Charles Whalen, and L. Randall Wray have argued the

economic crisis is in the spirit of a classic Minsky crisis, being a purely f inancial crisis that is f ully explainedby Minskys f inancial instability hypothesis.3 On the other side are the new Marxist view of Foster and

McChesney, the social structure of accumulation (SSA) view of Kotz , and the st ructural Keynesian view of

Palley.4 These latter views interpret the crisis f undamentally dif f erently, tracing its ultimate roots back to

developments within the real economy.
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The new Marxist, SSA, and structural Keynesian views trace the roo ts o f the crisis back to the adoption of

the neo liberal growth model in the late 1970s and early 1980s when the pos t- Second World War Treaty o f

Detroit growth model was abandoned.5 The essence of the argument is that the post -1980 neoliberal

growth model relied on rising debt and asset price inf lation to f ill the ho le in aggregate demand created by

wage stagnation and widened income inequality. Minskys f inancial instability hypothesis explains ho w

f inancial markets f illed this ho le and filled it f or f ar longer than might reaso nably have been expected.

Viewed f rom this perspective, the mechanisms identif ied in Minskys f inancial instability hypothesis are

critical to understanding the neoliberal era, but they are part of a broader narrative. The neoliberal model

was always unsustainable and would have ground to a halt o f its o wn accord. The role of Minskys f inancial

instability hypothes is is to explain why the neoliberal model kept going far longer than anticipated.

By giving f ree rein to the Minsky mechanisms o f f inancial innovat ion, f inancial deregulation, regulatory

escape, and increased appet ite f or f inancial risk, policymakers (like f ormer Federal Reserve Chairman Alan

Greenspan) extended the life o f the neo liberal model. The st ing in the tail was that this made the crisis

deeper and more abrupt when f inancial markets eventually reached their limits. Witho ut f inancial innovat ion

and f inancial deregulation t he neoliberal model would have got stuck in stagnation a decade earlier, but it

would have been stagnation without the pyrotechnics o f f inancial crisis.

This process of f inancial innovation and deregulation expanded the economic power and presence o f the

f inancial sector and has been termed f inancializat ion.6 Financialization is the concept that marries

Minskys ideas about f inancial instability with new Marxist and s tructural Keynesian ideas abo ut demand

sho rtage arising f rom the impact o f neoliberal econo mic policy on wages and income inequality.

The interpretation placed on the crisis matters enormously fo r policy prescriptions in response to the

crisis. If the crisis were a pure Minsky crisis, all that would be needed would be f inancial reregulation aimed

at put ting speculation and excessive risk-taking back in the box. Ironically, this is the approach being

recommended by Treasury Secretary Geithner and President Obamas chief economic counselor, Larry

Summers. Their view is t hat f inancial excess was the o nly problem, and normal growth will return o nce that

problem is remedied.7

The new Marxist -SSA-s tructural-Keynesian f inancialization interpretation of the crisis is f ar more

pessimistic. Financial regulation is needed to ensure econo mic stability, but it does not address the ultimate

causes o f the crisis, no r will it restore growth with f ull employment. Indeed, paradoxically, f inancial

reregulation could even slow growth because easy access to credit is a major engine of the neo liberal

growth model. Taking away that engine while leaving the model unchanged, therefore promises even slower

growth.

Minskys Financial Instability Hypothesis

Minskys f inancial instability hypothesis maintains that capitalist f inancial systems have an inbuilt proclivity

to f inancial instability. That pro clivity can be summarized in the aphorism Success breeds success breeds

f ailureor bett er st ill, Success breeds excess breeds f ailure.

Minskys f ramework is o ne of evolutionary instability and it can be thought o f as rest ing on two dif f erent

cyclical processes. The f irst cycle can be labeled the basic Minsky cycle, while the second can be labeled

the super-Minsky cycle.

The basic Minsky cycle concerns the evolution of patterns of f inancing arrangements, and it captures the

phenomenon o f emerging f inancial fragility in business and househo ld balance sheets. The cycle begins

with hedge finance when borro wers expected revenues are suf f icient to repay interest and loan principal.It t hen passes o n to speculative f inance when revenues o nly cover interes t. Finally, the cycle ends with

Ponzi f inance when revenues are insuf f icient to cover interest payments and borro wers are relying on

capital gains to meet their obligations.
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The basic Minsky cycle of f ers a psychologically based theory o f the business cycle. Agents become

progressively more o ptimist ic, which manifests in increasingly optimist ic valuations o f assets and

associated revenue streams and willingness to take on increasing risk in belief that the good times are here

f orever. This o ptimistic psychology af f licts bo th borrowers and lenders and not just one side of the market.

That is critical because it means market discipline becomes progressively removed.

This process of rising optimism is evident in the way business cycle expansions tend to generate talk

about the death of the business cycle. In the 1990s there was talk of the new econo my that was

supposed to have killed the business cycle by inaugurating a period of permanently accelerated product ivitygrowth. In the 2000s there was talk of the Great Moderat ion that claimed central banks had tamed the

business cycle through improved monetary policy based on improved theoret ical understanding of the

economy. This talk is not incidental but instead const itutes evidence of the basic Minsky cycle at work.

Moreover, it af f licts all, including regulators and po licymakers. For instance, Federal Reserve Chairman Ben

Bernanke himself indicated in 2004 that he was a believer in the Great Moderat ion hypothesis.8

The basic Minsky cycle is present in every business cycle. It is complemented by the super-Minsky cycle that

works over a period o f several business cycles. This super-cycle is a process that t ransforms business

institutions, decision-making conventions, and the st ructures o f market governance, including regulation.

These st ructures are critical to ensuring the stability of capitalist economies, and Minsky called them

thwarting institutions.9

The process of erosion and transf ormation takes several basic cycles, making the super-cycle a long

phase cycle relative to the basic cycle. Both o perate simultaneously so that the process o f institutional

eros ion and transf ormation cont inues during each basic cycle. However, the economy only undergoes a

f ull-blown f inancial crisis that t hreatens its survivability when the super-Minsky cycle has had time to erode

the economys thwarting institutions. In between these crises the economy experiences more limited

f inancial boo m-bust cycles. Once the econo my has a full-scale crisis, it enters a period o f renewal of

thwarting institut ionsa period of creating new regulations such as the current moment.

Analytically, the super-Minsky cycle can be thought of as allowing more and more f inancial risk into thesystem. The cycle involves twin developments of regulatory relaxation and increased risk taking. These

developments increase both the supply of and demand f or risk.

The process of regulatory relaxation has three dimensions . One dimension is regulato ry capture whereby

the inst itut ions des igned to regulate and reduce excessive risk-taking are captured and weakened. That

process has clearly been evident in the past twenty- f ive years, when Wall Street stepped up its lobbying

ef f ort s and established a revolving door with regulatory agencies such as the Federal Reserve, the

Securities and Exchange Commission, and the Treasury Department.

A second dimens ion is regulatory relapse. Regulators are human and part of society, and, like investors,

they are subject to memory loss and reinterpretation o f history. Consequently, they too f orget t he lessons

of the past and buy into rhetoric regarding the death o f the business cycle. The result is willingness t o

weaken regulation on grounds t hat things are changed and regulation is no longer needed. These actions

are support ed by ideological developments that justif y such actions. That is where econo mists have been

influential through their theories about the Great Moderation and the viability o f self -regulation.

A third dimensio n is regulatory escape whereby t he supply o f risk is increased thro ugh f inancial innovat ion

that escapes the regulato ry net because the new f inancial products and practices were not conceived of

when existing regulation was written.

The processes o f regulatory capture, regulatory relaxation, and regulatory escape are accompanied by

increased risk-taking by borro wers. First , f inancial innovation provides new products that allow borrowers

to take on more debt. One example of this is ho me equity loans; another is mortgages t hat are st ructured

with initial low interest rat es that later jump to a higher rate.
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Second, market part icipants are also subject to gradual memory loss that increases their willingness to t ake

on risk. Thus, the passage o f time contributes t o the forgett ing of earlier f inancial crises, which f os ters

new willingness to take on risk, the 1930s generation was cautious about buying stock, but baby boomers

became keen stock investors.

Changing taste f or r isk is also evident in cultural developments. An example of this is the development of

the greed is good culture epitomized by the f ictional character Gordon Gecko in the movieWall Street.

Another example is t he emergence o f investing as a f orm of entertainment, ref lected in pheno mena such

as day trading; the emergence of TV personalities like Jim Cramer; and changed att itudes toward homeownership that become interpreted as an investment opportunity as much as a place to live.

Import antly, changed attitudes to risk and memory loss also af f ect both sides of the market (i.e., borrowers

and lenders) so that market discipline becomes an inef f ective protection against excessive risk-t aking.

Borrowers and lenders go into the crisis arm in arm.

The theo retical f ramework behind the f inancial instability hypothesis is elegant and appealing. It

incorporates institutions, evolutionary dynamics, and the f orces o f self -interest and human f allibility.

Empirically, it appears to comport well with developments over the past thirty years. During this period there

were three business cycles (1981-1990, 1991-2001, and 2002-2009). Each of tho se cycles was marked by a

basic cycle in which borro wers and lenders to ok on increasingly more f inancial risk. Additionally, the period

as a who le was marked by a super-cycle involving f inancial innovat ion, f inancial deregulation, regulato ry

capture, and changed investo r att itudes to risk.

For Minsky proponents, like Kregel, Whalen, and Wray, the f inancial instability hypothesis appears to give a

f ull and complete account o f the crisis.10 Over the past twenty-f ive years, there was a massive increase in

borro wing and risk-taking that increased f inancial fragility at bo th the individual and systemic level. The

operation o f the Minsky super-cycle gradually eroded the thwarting institut ions t hat pro tected the system,

and that ero sion allowed a hous ing bubble that engulfed the banking system in a full-blown Ponz i scheme

and also spawned related reckless risk- taking on Wall Street . This st ructure crashed when house prices

peaked in mid-2006 and the subprime mortgage market imploded in 2007.

New Marxist, SSA, and Structural Keynesian Interpretations of the Crisis

A Minskyian interpretat ion o f the crisis leads to an exclus ive f ocus on f inancial market s. In contrast, new

Marxist (Foster and McChesney), SSA (Kotz ), and s tructural Keynesian (Palley) interpretat ions believe the

crisis has deeper roots located in the real economy.11

Foster and McChesney adopt a Baran-Sweezy mono poly capital mode of analysis to explain the crisis,

arguing the crisis represents a return of the histo rical tendency to stagnation within capitalist economies.12

Kotz adopts an SSA mode o f analysis that has s tro ng similarities with the Foster-McChesney approach.

For both, the crisis represents a surf acing of the contradictions within the neoliberal regime of growth andcapital accumulation caused by three decades o f wage stagnation and widening income inequality. Finance

is visibly present in the crisis because the expansion of f inance played a critical role supporting demand

growth and countering stagnationist tendencies within the neoliberal model.

The structural Keynesian argument developed by Palley has many similarities to the new Marxist and SSA

approaches, particularly regarding the signif icance of the shif t to neo liberalism in the late 1970s and early

1980s. The Keynesian dimension is the explicit f ocus on aggregate demand, which is t he f unnel by which

the st ructural changes asso ciated with neoliberalism af f ect the economy.

Parenthet ically, what distinguishes s tructural Keynesianism f rom the o ld Keynesianism of economists like

James Tobin and Paul Davidson is the inclusion o f class conf lict ef f ects. Old Keynesians are also

interested in financial instability and problems o f demand shortage but t heir analysis ignores income

distribution ef f ects o n aggregate demand arising f rom class conf lict.


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As with the new Marxist and SSA accounts, f inance plays a crit ical ro le in the s tructural Keynesian acco unt

by maintaining demand via debt and asset price inf lation in place of wage growth. However, there are two

additional f eatures to the s tructural Keynesian account.

One is its identif ication o f and emphasis on t he f unctional signif icance of f inancial innovation and

deregulation in fueling demand growth. This provides the channel for incorpo rating Minskys f inancial

instability hypothesis into a broader synthetic explanation o f the crisis.

The second is its identif ication o f the t rade def icit and the f lawed U.S. model of global economicengagement in causing the crisis. This role concerns no t only wage squeeze ef f ects, but also the ef f ects

of draining demand out o f the U.S. economy. The f lawed model of U.S. global econo mic engagement

created a triple hemorrhage of leakage of spending on imports , of f shoring of jobs, and of f shoring of new

investment. This tr iple hemorrhage accelerated the s tagnat ionist proclivities inherent in the neoliberal

growth model, thereby helping to bring on the crisis.

Neoliberalism and the Root s o f the Crisis

A cent ral f eature co mmon to new Marxist, SSA, and structural Keynesian analyses concerns the adopt ion

of the neoliberal growth model around 1980. That shif t initiated a thirty-year period o f wage stagnation and

widened income inequality, and both narratives trace the roo ts of the crisis back to this change ofeconomic paradigm.

Pre-1980, economic policy was committed to f ull employment and wages grew with productivitythe so-

called Treaty of Detro it model. This conf iguration created a virtuo us circle of growth. Wage growth tied to

product ivity meant robust aggregate demand that contributed t o f ull employment. Full employment pro vided

an incentive to invest, which in turn raised pro ductivity, support ing higher wages.

Post -1980, econo mic policy retreated f rom commitment to f ull-employment and helped sever the link

between productivity gro wth and wages. In place, policymakers established a new neo liberal growth model

that was f ueled by borro wing and asset price inf lation, which became the engines of aggregate demand

growth in place of wage growth.

The results of the neo liberal model, now well documented, were widening income inequality and detachment

of worker wages f rom productivity growth.13 The severing of the wage-productivity link was brought about

by subst ituting concern with inflat ion in place of f ull employment; att acking unions, labor market

protections , and the minimum wage; and placing U.S. workers in international competition via globalizat ion.

Economic policy played a critical ro le in generating these o utcomes, with po licy weakening the position of

workers and s trengthening the pos ition o f corporations. These new policies can be described in terms of a

pen that f enced workers in. The four sides of the pen are globalizat ion, labor market f lexibility, small

government, and abandoning f ull employment.

Globalization promotes the internationalization o f production that puts workers in international

competition. Attacks on the legitimacy of government push privatizat ion, deregulation, and a tax cut agenda

that worsens income inequality and squeezes government spending and public investment. The labor

market f lexibility agenda attacks unions and labor market supports such as the minimum wage,

unemployment benef its, employment protections , and employee rights . The adoption of inf lation target ing

places concern with inf lation ahead of f ull employment, and it also turns o ver to f inancial interests the

management of central banks and monetary policy.14

Finally, the Washingto n Consensus development po licy pushed by the World Bank and IMF spreads the

neoliberal agenda globally, thereby multiplying its impact by having all count ries adopt it. That imposed awage squeeze in all countries and also multiplied the force of wage competition and deregulation across

countries.

How Minsky Fits into the New Marxist-SSA-Structural Keynesian Accounts


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There is another critical element to the neo liberal model that was initially entirely over-looked by SSA

theo rists . That element is debt and financial boo m.15 In contrast to SSA theorists, new Marxists recognized

the significance o f debt but they failed to recognize the ability of the f inancial system to keep expanding

the supply of credit, which is why they were perplexed by neo liberalisms longevity. This is where Minskys

thinking becomes so import ant, as it explains the ability to expand credit. It also adds f inancial instability

into the brew of stagnation.

Debt provides consumers with a means o f maintaining consumption despite st agnant wages and widened

income inequality, while f inancial boo m provides consumers and f irms with collateral to support f urtherdebt-f inanced spending. These critical roles of debt and f inancial boom in turn provide the avenue f or

embedding Minskys f inancial instability hypothesis within the new Marxist, SSA, and st ructural Keynesian

narratives.

The neoliberal growth model has a logic that begins with redirecting income from workers to upper- income

management and prof its. Workers then maintain consumption despite st agnant wage income by borrowing,

while the nonf inancial corpo rate sector promotes f inancial boo m via stock buy-backs and leveraged

buyouts. Not o nly does that raise stock prices; it also transf ers f unds to households. These practices

explain rising household and corporate indebtedness, measured respectively as debt-to-income and debt-

to -equity ratios, and increased indebtedness explains the shift of prof its toward the f inancial secto r.

Borrowing is f acilitated and expanded by f inancial innovat ion and f inancial deregulation, which become

essential to keeping the system going. Thus, not only does neo liberalism ideologically support f inancial

deregulation; it also needs it, f unctionally. Together, financial innovation and deregulation ensure a steady

f low of new products that allow increased leverage and widen the range of assets that can be

collateralized. Such products include home equity loans, exotic mort gages such as zero- downs, and the

shif t to 401(k) pension plans that can be borrowed against.

House price inf lation plays an especially important ro le since higher home values provide collateral that can

be borro wed against . That makes f inancial innovations and deregulation that increases the availability of

hous ing finance especially import ant, because increased supply of hous ing finance increases house prices.It also explains why house price inf lation correlates so s tro ngly with economic expansion in the neoliberal

era.16

However, this dynamic remains intrinsically unsustainable, as it relies o n rising debt and ho use prices at the

same time that o rdinary household income is being squeezed. Once households are unable to borrow

f urther, owing to hitting borrowing limits o r owing to an end to house price inf lation, the system quickly

stops. That is what happened with the collapse o f the housing bubble that provided households with the

equivalent o f a personal ATM and also spurred a construction boom.

Minskys f inancial instability hypothesis is a critical part of the narrat ive because it explains why the

neoliberal growth model was able to avoid stagnation f or so long. The processes o f f inancial innovation,

deregulation, regulatory escape, and increased appetite f or risk enabled the f inancial system to raise debt

ceilings and expand the provision o f credit.

That had two critical ef f ects. First, it extended the lifespan of the neoliberal model enabling it to maintain a

patina of prosperity. Second, since these processes increased indebtedness and leverage, the crisis was

f ar more severe when it f inally occurred. Absent twenty-f ive years of debt-f ueled growth and debt- f inanced

asset price inf lation, the neoliberal model would have succumbed to creeping stagnation. Instead, the

processes identif ied in Minskys f inancial instability hypothesis staved o f f stagnation, but when these

f inancial processes f inally exhausted themselves, the result was a f inancial crash o f historic proport ions.

That explains why the current stagnation (which many mainstream economists now appear to be signing onto ) was initiated with a major f inancial crisis.17


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Such reasoning renders Minskys f inancial instability hypothesis f ully consist ent with the new Marxist-SSA-

st ructural Keynesian perspective on the crisis. Indeed, the histo rical record cannot be explained without it.

However, the grave danger is that the crisis will be interpreted as a purely f inancial crisis and its neoliberal

roo ts overlooked. Avoiding that pitf all requires recognizing that t he crisis o nly to ok the f orm of a f inancial

crisis because f inancial excess was used to keep at bay neoliberalisms tendency to stagnation.

Flawed U.S. Global Economic Engagement and the Crisis

A second f eature dist inct to the s tructural Keynesian narrat ive concerns the f lawed U.S. model of globalengagement. Bot h the new Marxist and structural Keynesian accounts o f the crisis at tribute a ro le to

globalization thro ugh its impact o n squeezing wages. However, ref lecting its Keynesian dimension, the

st ructural Keynesian account gives an additional important role to the t rade def icit and of f shoring through

their impact o n aggregate demand.

According to the s tructural Keynesian narrative, the neoliberal gro wth model might have go ne o n quite a

while longer were it not f or f lawed U.S. international economic policy.18 That po licy accelerated the

undermining of the real economy by further undermining income and employment necessary to support

borrowing and asset price inf lation.

During the 1990s the Clinton administration cemented a new corpo rate model of globalization with NAFTA(1994), establishment o f the WTO (1996), adoption of a st rong do llar policy af ter the East Asian f inancial

crisis (1997), and granting China permanent no rmal trading relations (2000). These measures delivered the

model of globalization for which corpo rations and their Washingto n think-tank allies had lobbied. The irony

is that , when they got what they wanted, the result was to undermine the neo liberal model at warp speed.

This is because the new globalizat ion model created a t riple hemorrhage. The f irst hemorrhage was

leakage of spending on import s. Spending therefore drained out o f the econo my, creating incomes

of f shore rather than in the United States, but borro wing kept adding to debt burdens.

The second hemorrhage was leakage of jobs out of the U.S. economy. This leakage was driven by the

process o f of f shoring, made poss ible by the new model of globalization. This job loss directly undermined

household incomes. Moreover, even when jobs did not move of f shore, the threat o f of f shoring was used

to suppress wages, and that lowered income and undermined the ability to bo rrow.19

The third hemorrhage concerns new investment. Not only were existing plants closed and of f sho red, but

new investment was also diverted of f sho re. That imposed double damage since the United States lost

both the jobs that would have come with building new plants and the jobs that would have been created to

operate those plants.

This triple hemorrhage was the inevitable result of the corpo rate model of globalization, whose go al was

never to create a global market in which corporat ions could sell U.S. products. Instead, the goal was tocreate a global production zone in which corporations could produce and export to the United States. Given

this goal, it was inevitable the United States would suff er persistent growing trade def icits, of f shoring of

employment, and diversion of investment.

The new model also explains why corporations supported the strong dollar policy since it lowered the cost

of goods imported into the United States. That raised corporate prof it margins s ince companies cont inued

charging dollar prices o n Main Street while import ing inputs and products paid for with under-valued f oreign

currency.

Finally, the f lawed U.S. model o f global economic engagement also helps explain the global nature o f the

crisis. Thus, developing count ries embraced the U.S. model o f global econo mic engagement s ince it allowedthem to pursue export - led growth policies. The U.S. model of globalization encouraged investment and

transf er of manufacturing know-how to developing count ries. Furthermore, the U.S. policy of a stro ng

dollar f it with developing count ries that wanted undervalued currencies in order to maintain competitive

advantage.


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The net result was that developing countries enjoyed ten years o f f ast export -led growth during which they

ran large trade surpluses, built up large foreign exchange holdings, and received large inf lows o f f oreign

direct investment. However, the new system f orced the global economy eff ectively to f ly on one engine,

with its f ate tied to t he U.S. economy and the U.S. consumer, in part icular. When the U.S. economy crashed

with the burst ing of the house price bubble, it pulled down the global economy too. Far f rom creating a

decoupled global econo my, as claimed by many economists , the system was s ignif icantly linked, and

exhibited a concertina ef f ect whereby other economies came crashing in behind.

Conclusion: Why Interpretation Matt ers

The f inancial crisis and Great Recess ion that began in 2007 have been widely interpreted as a Minsky crisis.

I have argued that such an interpretation is misleading. The processes identif ied in Minskys f inancial

instability hypothes is played a critical role in the crisis, but that ro le was part o f a larger economic drama

involving the neoliberal growth model that was implemented aro und 1980.

The neoliberal growth model inaugurated an era o f wage stagnation and widened income inequality. In place

of wage growth to spur demand growth, it relied on borrowing and asset price inf lation. That arrangement

was always unsustainable, but the combination of f inancial innovation, f inancial deregulation, regulato ry

escape, and increased appetite f or f inancial risk warded o f f the models stagnationist tendencies f ar longerthan expected. Bubbles and debt ceilings are hard to predict, which is why critics o f the model were early in

their predictions of its demise.20

These delay mechanisms represent t he point at which Minskys f inancial instability hypothesis enters the

narrative. However, keeping the model go ing via rising indebtedness and asset price bubbles meant t hat the

crash was f ar larger and to ok the shape of an abrupt f inancial crisis when the process eventually ran out

of steam.

At this juncture, the int erpretat ion o f the f inancial crisis and Great Recessio n has enormous signif icance

f or economic policy. If the crisis is interpreted as a purely f inancial crisis, in the narrow spirit of Minskys

f inancial instability hypothesis, the policy implication is to f ix the f inancial system thro ugh reformsaddressing excess leverage, excess risk-t aking, inadequate capital requirements, and badly designed

incentive pay arrangements f or bankers and f inanciers. However, there is no need for reform of the real

economy because the real economy is no t t he source of the problem.

Such an interpretat ion generates policy recommendations similar to tho se o f Larry Summers and Treasury

Secretary Geithner. That is also the view of Simon Johnson, a former IMF chief economist , who has also

f ocused on the po litical power of the Wall Street lobby and the problem of regulatory capture.21 Ironically,

this places Minsky, who was always a hetero dox thinker, in the most ort hodo x policy company.

If , instead, the crisis is interpreted through a new Marxist-SSA-st ructural Keynesian lens, the po licy

implications are deeper and more challenging. Financial secto r ref orm remains to deal with the problems o f

destabilizing speculation, po litical capture, excessive pay, and misallocation of resources. However,

f inancial secto r reform will not address the root problem, which is the neoliberal growth model.

Resto ring stable shared prosperity requires replacing the neo liberal growth model with a new model that

restores the link between wage and productivity growth. That will require adoption of a new labor market

agenda, refashioning globalizat ion, reversing the imbalance between market and government, and resto ring

the goal of f ull employment.

Financial sector ref orm, without ref orm of the neo liberal growth model, will leave the econo my stuck in an

era of stagnation. That is because s tagnation is t he logical next step of the neoliberal model, given current

conditions. Indeed, f inancial secto r ref orm alone may worsen stagnation, since f inancial excess was a

major driver of the neo liberal model, and that driver would be removed.


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Reflection upon the crisis also helps understand some of the splits that af f licted progressive economics in

1970s and 80s. Minskys f inancial instability hypothes is represents capitalist crisis as a purely f inancial

phenomenon driven by proclivity to speculation and excessive optimism on the part of borrowers and

lenders. This contrasts with the ortho dox Marxist pos ition that interprets s tagnation as a real phenomenon

driven by the f alling rate of prof it due to rising capital intensity.

It also contrasts with t he early SSA position that f ocused initially on the problem of f ull employment pro f it

squeeze and then on the problem of neoliberal wage-squeeze and ef f ort exploitation.22 Like orthodo x

Marxism, early SSA theory also interpreted s tagnat ion as a purely real phenomenon, being due to lack ofaggregate demand caused by worsened income distribut ion. Consequently, there was a f undamental

intellectual ant ipathy between Minskys purely f inancial interpretation o f crisis and SSAs initial purely real

economy interpretation.

The new Marxist interpretation, as exemplif ied by Magdof f and Sweezy, sits in between, recognizing the

role of real econo my forces and also giving a role to debt as a means of sustaining the cycle. However, it

f ails to incorporate the mechanisms of Minskys f inancial instability hypothesis.23

Structural Keynesianism of f ers a synthesis of these po ints o f view. First, it shares the generic Marxist

point of view that there is an underlying real economy problem regarding wage squeeze and deterioration

of income distribution, which ultimately gives rise to a Keynesian aggregate demand problem. This is where

the great Polish economist Michal Kalecki is so import ant, as his f ramework provides the bridge between

Keynesian and new Marxist logic.

Second, s tructural Keynesianism recognizes that f inance played a critical role in sustaining the neo liberal

regime by f ueling asset price inf lation and bo rrowing, which f illed the demand gap created by the wage

squeeze. That recognition opens the way f or incorpo rating Minskys f inancial instability hypothesis, with

f inancial excess being the way that neoliberalism staved of f its s tagnat ionist tendency. This in turn explains

why the crisis t oo k the f orm of a f inancial crisis when it eventually arrived. However, the reality is that

f inancial excess was always a patch on the underlying real econo mic cont radiction.

The above analysis shows t hat the new Marxist, SSA, and structural Keynesian accounts o f the crisis

share many similarities. Mos t important ly these accounts all identify the need to reverse neoliberalism and

resto re the link between wages and productivity growth. That raises questions as to what are the

f undamental diff erences, if any.

Orthodox Marxists believe that the crisis results f rom a falling rate o f prof it due to a rising organic

composition of capital. New Marxists and SSA theorists adopt an under-consumptionist position in which

the econo my becomes constrained by lack of demand, owing to excessive wage squeeze. If the pro f it rate

f alls, it is due to Keynesian lack of demand, which prevents the economy f rom operat ing at an adequate

level of activity. New Marxists and SSA theo rists were previous ly separated by the new Marxist

incorporation o f f inancial facto rs, but SSA theorists have now accepted the importance of such factors.

Neo-Keynesians, who dominated the economics prof ess ion until the late 1970s, dismissed problems of

under-consumption and wage squeeze because of their belief in the marginal product ivity theo ry of income

distribut ion. Instead, they located capitalisms problems in the volatility of investment spending due to

unstable entrepreneurial animal spirits and f undamental uncertainty. They also believed that f ull employment

could be maintained by activist monetary and f iscal policy.

Structural Keynesians retain the neo-Keynesian emphasis on the centrality of aggregate demand in

determining the course of capitalist economies, but t hey reject the neo-Keynesian theory o f income

distribution and recognize the po ssibility of wage squeeze and underconsumptionist stagnation. That also

means that activist monetary and f iscal policy is not suf f icient to ensure growth with f ull employment.


10/11

Putting the pieces together, orthodo x Marxists are f undamentally divided f rom new Marxists and SSA

theo rists at the theoretical level. Neo-Keynesians and st ructural Keynesians are also divided f undamentally.

However, once f inancial fo rces are incorporated (including Minskys f inancial instability hypothesis), new

Marxists, SSA theorists , and structural Keynesians appear to share a broadly similar theo retical f ramework.

If there is a dif f erence, it may well be a dif f erence of degree of optimism. Structural Keynesians believe it

possible to des ign appropriate institutions that, combined with t raditional Keynesian demand management,

can escape capitalisms st agnationist tendencies and deliver full employment and shared pro sperity. New

Marxists and SSA theo rists are more pessimist ic about the capitalist process, the ability to escape

stagnation, and the so cial poss ibilities of markets. Consequently, their inst itut ional design would have a

larger public sector and more nationalizat ion, especially regarding the f inancial sector.

Notes

1. Ferri, Piero and Hyman P. Minsky, Market Processes and Thwart ing Systems,Strucural Change

and Economic Dynamics 3 (1992), 79-91; Hyman P. Minsky, The Financial Instability Hypot hesis ,

Working Paper no. 74, Levy Economics Inst itut e of Bard College, http://levy.org.

2. Justin Lahart, In Time o f Tumult, Obscure Economist Gains Currency,Wall Street Journal, August

18, 2008; Charles W. Calomiris, No t (Yet) a Minsky Moment, VoxEU, November 23, 2007,

http://voxeu.org; Martin Wolf , The End of Lightly Regulated Finance Has Come Closer, FT.com,September 16, 2008; Paul Krugman, The Night T hey Read Minsky, http://krugman.blogs.nytimes.com,

May 17, 2009.

3. Jan Kregal, The Natural Instability o f Financial Markets, Levy Econo mics Inst itute o f Bard College,

Working Paper no. 523 (December 2007), http://levy.org, Minskys Cushions of Safety, Levy

Economics Institut e, Public Policy Brief no. 93 (January 2008), ht tp://levy.org, and Changes in the U.S.

Financial System and the Subprime Crisis, Levy Economics Institute, Working Paper no. 530 (April

2008), http://levy.org; Charles Whalen, The US Credit Crunch of 2007, Levy Econo mics Institute,

Public Policy Brief no. 92 (2007), htt p://levy.org; L. Randall Wray, Lesso ns f rom the Subprime

Meltdown, Levy Economics Institute, Working Paper 522 (December 2007), http://levy.org, Financial

Markets Meltdo wn, Levy Economics Institute, Public Policy Brief no. 94 (2008), ht tp://levy.org, andMoney Manager Capitalism and the Global Financial Crisis, Levy Economics Institute, Working Paper

no. 578 (September 2009), http://levy.org.

4. John Bellamy Foster and Robert W. McChesney, Monopoly-Finance Capital and the Paradox of

Accumulation, Monthly Review61, no. 5 (October 2009), 1-20; David M. Kotz, The Financial and

Economic Crisis of 2008, Review of Radical Political Economics 41, no. 3 (2009), 305-17; Thomas I.

Palley, Americas Exhausted Growth Paradigm,Chronicle of Higher Education, April 11, 2008; and

Americas Exhausted Paradigm: Macroeconomic Causes o f the Financial Crisis and the Great

Recession, New America Foundation (July 22, 2009), http://newamerica.net.

5.

The treaty of Detroit ref ers to the f ive-year wage cont ract negot iated by the United Auto workersUnion with Detro its big-three automakers in 1950. That cont ract symbolized a new era of wage-

set ting in the U.S. economy led by unions, in which wages were ef f ectively tied to product ivity gro wth.

6. Thomas I. Palley, Financializat ion: What It Is and Why It Matters, in Eckhard Hein, et al., eds.,

Finance-Led Capitalism? (Marburg, Germany: Metropolis-Verlag, 2008), 29-60.

7. Summers: Obama Policies Averted Economic Abyss, New York Times, October 12, 2009.

8. Ben Benanke, The Great Moderation, Remarks at the Meetings of the Eastern Economic

Associat ion, Washington, D.C., February 20, 2004, ht tp://federalreserve.gov.

9. Ferri and Minsky, Market Processes and Thwarting Systems.

10. See citations in endnote 3 above.

11. See citations in endnote 4 above.

12. See Paul A. Baran and Paul M. Sweezy, Monopoly Capital(New York: Monthly Review Press, 1966).

13. Lawrence R. Mishel, Jar Bernstein and Heidi Shielholz,The State of Working America, 2007/2008
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(Armonk, N.Y.: M.E. Sharpe, Inc., 2008).

14. Thomas I. Palley, The Institut ionalization o f Def lationary Policy Bias, in H. Hagerman and A.

Cohen, eds .,Advances in Monetary Theory(Boston: Kluwer Academic Publishers, 1997), 157-73.

15. Samuel Bowles, David M. Gordon, and Tho mas E. Weisskopf ,Beyond the Wasteland(Garden City,

New Jersey: Anchor Press/Doubleday, 1983); David M. Gordon,Fat and Mean (New York: Free Press,

1996).

16. Palley, America.

17. Many leading mainstream econo mists are now predicting an extended period o f stagnation.

Lawrence Summers declared in a speech on the Principles o f Economic Recovery and Renewal to

the National Asso ciation f or Business Econo mics on October 12, 2009: For the f oreseeable future,

lack of demand will be the major const raint on output and employment in the American econo my,

http://whitehouse.gov. Harvard Prof essor and f ormer IMF Chief Econo mist, Ken Rogo f f has written

about the new normal for growth being a notably lower average growth rate than they enjoyed

before the crisis. Rogof f , The New Normal Growth, ht tp://project-syndicate.org. And Paul Krugman

has written, [T]he job market will remain terrible for years to come. Krugman, Mission Not

Accomplished, New York Times, October 2, 2009.

18. Palley, Americas Exhausted Paradigm.

19. Kate Bronf enbrenner and Stephanie Luce,Uneasy Terrain, Report , United States Trade Def icit

Review Commiss ion, Washington, D.C., September 2000, andThe Changing Nature of Corporate

Global Resturcturing, Report, U.S.-China Economic and Security Review Comission, Washington, D.C,

October 2004.

20. See, for instance, Thomas I. Palley, Plenty of Nothing: The Downsizing of the American Dream and

the Case for Structural Keynesianism (Princeton: Princeto n University Press, 1998), chapter 12.

21. Simon Johnson and James Kwak, Its Crunch Time,Washington Post, September 29, 2009; Simon

Johnson, T he Quiet Coup, The Atlantic Monthly, May 2009.

22. See citations in endnote 11.

23. See Paul Sweezy, Crisis Within the Crisis, Monthly Review30, no. 7 (December 1978), 7-10; and

Harry Magdof f and Paul M. Sweezy, Debt and the Business Cycle,Monthly Review30, no. 2 (June

1978), 1-11both reprinted in Harry Magdof f and Paul M. Sweezy,The Deepening Crisis of U.S.

Capitalism (New York: Monthly Review Press, 1981), 70-80, 90-93.
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The Limits of Minskys Financial Instability Hypothesis as an Explanation of the Crisis