A Minskian View of the Causes of the Current Crisis

by L. Randall Wray

In recent weeks, the explanation for the financial and economic crisis that has gripped the world economy has shifted sharply from deregulation and lack of governmental oversight of financial institutions to fraud and criminal activity. In truth, the US Federal Bureau of Investigation began to warn of an “epidemic” of mortgage fraud back in 2004, and my colleague Bill Black has been pointing to the role played by fraud since the crisis began. (See our recent two part series on Foreclosure Fraud here and here.) To be sure, there was ample fraud in the “pump-and-dump” schemes during the dot-com bubble at the end of the 1990s, which was closely followed by the commodities market speculative boom and bust. (See my article on the commodities market bubble. ) And before those episodes we had in quick succession the developing country debt crisis of the early 1980s, the US Saving and Loan fiasco of mid 1980s (with bank crises in many other nations), the Japanese meltdown and the Asian crisis, the Mexican peso crisis, Long Term Capital Management and Russian default, and the Enron affair.

Seemingly, the crises have become more frequent and increasingly severe until almost the whole world was infected. It is obvious that there must be some link among these crises and that while fraud played a role in most or even all of them, it is not sufficient to lay blame on “bad apples”, bad policy, insufficient foresight, and outright stupidity. We must find a more comprehensive explanation.

When the crisis began in the US in 2007, many commentators called it a “Minsky moment” or even “Minsky crisis”, after the late economist Hyman Minsky who had developed what he called a “financial instability hypothesis” over the years after 1960 and to his death in 1996. Minsky was my PhD dissertation advisor and I had already used his approach to analyze the Saving and Loan crisis. Unlike the typical explanation that invokes Minsky’s theories, I recognized that Minsky did not simply provide a “euphoric bubble” approach. Rather he argued that the transformation of the economy and especially its financial system from “robust” toward “fragility” took place over a very long span of time, indeed, over the entire postwar period. The increasingly frequent and severe crises, as well as the growth of fraud as practically normal business practice were a consequence of that transformation. Hence, we should not call this a Minsky moment or crisis but rather a Minsky half-century.

Much of the world emerged from the Great Depression and World War II with a combination of institutions, regulations, financial practices, and memories that together encouraged relatively rapid economic growth, high employment, growing incomes, and growing confidence in our future. Private debt was low (mostly wiped out in the bankruptcies of the 1930s), government debt was high (war finance), and the financial system had been “simplified” (in Minsky’s terminology). Big Corporations mostly used retained profits to finance expenditures; Big Unions kept wages growing so that workers could spend out of income rather than relying on debt; Big Government had filled portfolios of banks and savers with safe government bonds. Finance was kept small, constrained, and relatively irrelevant. Besides, memories of the Great Depression discouraged lending as well as borrowing. Strict regulation—especially in the US—kept risky financial practices segregated outside commercial banking.

Over time a complex combination of factors changed all that—memories faded, regulations were relaxed or financial institutions defeated them with innovations (including new types of instruments and institutions that took market share away from highly regulated banks). Private debt grew. Risky practices emerged. Financial crises resumed. However, the crises were contained by swift intervention of Big Government and the Big Bank (central bank)—that bailed-out institutions and prevented recessions from becoming sufficiently severe to eliminate the risky behavior. Relatively robust growth combined with stronger labor led to growth of pension funds and other private saving—money that needed to be invested to get high returns to support a private retirement system. Clever managers of that money developed increasingly esoteric and complex ways to make—and to lose—money.

The age of what Minsky called “money manager capitalism” had arrived—a form that put finance first. And, importantly, this new capitalism took a global form—a new globalization of finance developed. Again for complex reasons, the interests of money managers did not coincide with those of Big Corporations and Big Unions—the “leveraged buy-out” was used to strip firms of assets, load them with debt, and bust their unions. Wages stopped growing; consumers relied on debt to maintain living standards. Globalized finance also helped to globalize production—with low wage workers in developing nations helping to depress incomes in developed nations. Thus, “financialization” of the economies concurrently meant both “globalization” as well as rising inequality.

The weight of finance moved away from institutions—that were guided by a culture of developing relations with customers—toward “markets” (the “originate to distribute” model of securitizing pools of mortgages is a good example). This virtually eliminated underwriting (assessing credit worthiness of customers) and also favored the “short view” (immediate profits) of traders (you are only as good as your last trade) over the long view of financial institutions that hold loans. In addition, the philosophy of “maximization of total shareholder returns” as well as the transition away from partnerships in investment banking toward public holdings promoted pump and dump schemes to increase the value of stock options that rewarded CEOs and traders. A “trader mentality” triumphed, that encouraged practices based on the “zero sum” approach: in every trade there is a winner and a loser. As practiced, the bank would be the winner and the customer would be duped.

This transformation helps to explain why fraud became rampant as normal business practice. Competition among traders and top management to beat average returns led to ever lower underwriting standards to increase the volume of trades—with fees booked on each one—and with strong incentives to “cook the books” (record false accounting profits). Once accounting fraud is underway, there is a strong incentive to engage in ever more audacious fraud to cover the previous crimes. In the end, the US financial system (and perhaps many others) became nothing but a massive criminal conspiracy to defraud borrowers (through such instruments as “liar’s loans”, NINJAS—no income, no job, no assets, no problem!—and “no doc” loans) as well as investors in securitized products (mortgage backed securities, collateralized debt obligations that were securities of the worst MBSs, and on to CDOs squared and cubed). All of this led to layering and leveraging of debt on debt and debt on income. At the peak, US indebtedness was five times national income—meaning each dollar of income was pre-committed to service five dollars of debt! This was, of course, impossible. The pyramid of debt collapsed like a house of cards.

Where are we now? Many governments reacted with fiscal stimulus packages as well as bail-outs of financial systems. While many have proclaimed that the worst is behind, by all objective measures, nearing the end of 2010 the financial system is probably in worse shape than it was at the end of 2007 when it collapsed. Debt ratios have not come down appreciably. Defaults and delinquencies are up by huge amounts. In the US foreclosures have come to a virtual standstill as it has been recognized that many or perhaps most foreclosures that have taken place were almost certainly illegal. Holders of securitized products like MBSs and CDOs have begun to sue banks for fraud, demanding they take them back. While banks have reported strong earnings, almost all of these have been in trading activity or have resulted from reducing loss reserves (ironically, as defaults rise). In other words, none of the normal bank activity is generating revenue—all profits are accounting profits where it is easy to “cook the books”. Where it will all end is unknown but a complete collapse of the financial system is not out of the question.

This time around, it is not clear that governments will save the banks–having been burned last time around, voters are not sympathetic. Especially in the US the feeling is that Main Street’s needs have been ignored while Wall Street has been favored. And in most nations, government has adopted austerity policies to reduce spending and where possible to raise taxes. In some countries this appears to be necessary—such as the so-called “PIIGS” (Portugal, Ireland, Italy, Greece, Spain) that are heavily indebted with hands tied due to constraints imposed by the currency union. In others, such as the UK and the US it is mostly political—a reaction against the bail-outs of financial institutions. How this will all turn-out I do not know, but another crash and even deeper downturn seems likely.

L. Randall Wray is a Professor of Economics at the University of Missouri-Kansas City and Research Director with the Center for Full Employment and Price Stability as well as a Senior Research Scholar at The Levy Economics Institute and author of Understanding Modern Money.

Professor Wray also blogs at New Economic Perspectives, and at New Deal 2.0.

A version of this article first appeared on Benzinga

  1. Sam Costanzo says

    OK Wray, make up your mind.Which was it, debt at 5 times national income, or a vast criminal enterprise? We know where your emotions are, but now give us a RATIONAL analysis with concrete evidence and facts not fanciful conjecture.

  2. Scott Fullwiler says

    It was both, Sam. And your suggestions that Randy doesn’t have the evidence–his office is a few doors down from Bill Black’s–and is operating on emotion is simply ridiculous, if not insulting.

  3. Alan Avans says

    Sam, I’ll be nice and forbearing and not call you an idiot.

  4. Scott Fullwiler says

    Give me a break, Tschaeff. Randy, Bill B, Jan, Eric T have been publishing the evidence for 2 years now. We certainly know where Sam’s emotions are, though.

  5. Tschäff Reisberg says

    Sure, but even on TV shows they say, “Previously on Desperate Housewives, Brie walked in on her son… and her new love interest from AA..” So when Wray says banks are insolvent.. we might have good reason to believe him, but if you’ve missed a few episodes you’re just going on his word alone.

  6. Scott Fullwiler says

    Then go back and see the episodes you missed before you start claiming someone is just being emotional rather than giving rational analysis.

  7. Tschäff Reisberg says

    I take issue with his jumping to conclusions also, but what harm is it really? If anything he serves as a gauge of how effective we are at getting our message across to someone more reasonable than many.

  8. Tschäff Reisberg says

    play nice boys. Sam wants more evidence that’s a fair request. Lets keep it civil.

  9. DavidLazarusUK says

    I think that this crisis was created and built up by a number of measures. First spark was the UK Big Bang in financial services that lead shortly after to the ending of Glass-Steagall. The ending of capital controls was also important. This enabled banks and then other corporations to expand overseas in a way that did not benefit its host nation. Then with the ability to lower taxable profits through rigged transfer prices it deprived nations of tax revenue. This resulted in governments increasing the tax burden on citizens through indirect taxes for fear of driving away the “wealth creators” if they raised direct taxes. In the thirties there was the threat of communism to stop governments squeezing its workers too much. That is no longer there. As the workers are driven into bankruptcy the protection that businesses have from trouble will evaporate as workers have less and less to lose from violent reactions. This time revolutions will still happen but it will not end well. The Tea Party movement is symptomatic of the views of populations everywhere. Governments are still oblivious to this threat to their existence.

    I fully anticipate another major crisis within a few years. This will probably lead to major defaults of a number of governments, in fact the default of governments could be the cause. I have Ireland and Greece as almost guaranteed to default. Also a number of east european states will also default, causing problems in some of their neighbours. Austria will be impacted by the default of Hungary and other central european nations. Sweden will be hit hard by the default of the baltic states. Longer term this will push for national regulation ending banks overseas investments. This will insulate nations from future overseas problems.

    Capital controls will return in response to QE. Developing nations will be forced to impose capital controls to stop the violent swings in its currency as a result of QE and hot money, and the bubbles that they bring. It will also eliminate the problems of regulation arbitrage. This will enable states to improve regulations without fear of them being held to ransom by the banks.

    Longer term what needs to happen is the separation of investment banking from commercial banks. The restoration of capital controls will restore the opportunities of domestic producers, and remove the advantages of globalisation for multinationals, and their tax dodging. This will improve the opportunities for new businesses and workers and enable governments to reduce their deficits through higher taxes. Higher taxes will give businesses incentives to invest rather than hand the profits over in taxes.

    The US also desperately needs political finance reform. Without this politicians will be too distracted raising funds to actually create decent legislation that benefits their citizens and not the corporations that fund them.

    I agree that there will be another crash and even deeper downturn. Though I think that it will be an extension of the current crisis, that has only been masked by “extend and pretend” on a massive scale through central bank support for the banks. None of which has helped the real economy.

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