And, Geoff, this was one of the earliest ones reviving chartalism, at Levy:
While this is a short and simple version at CFEPS:The Neo-Chartalist Approach to Money :
By Geoffrey Schneider, Professor of Economics, Bucknell University
“When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”
¯ John Maynard Keynes, The General Theory of Employment, Interest and Money
In modern capitalism, finance has become a major force affecting the entire global economy. Thus, any analysis that ignores the role of finance is bound to be fundamentally flawed. In mainstream economics, it is typical to ignore the financial sector, assuming that it simply links borrowers with lenders, without impacting the rest of the economy. Mainstream economists typically assume markets are stable, assets are always priced correctly (the efficient market hypothesis), investors rationally balance risks and rewards (capital asset pricing model) and any deviations from this situation are small or temporary. That approach is untenable given the recent financial crisis.
One of the most useful analyses of the role of finance in modern capitalism comes from Hyman Minsky in the form of his Financial Instability Hypothesis. Building on the foundation of the Keynesian business cycle, Minsky adds the role of psychology in financial investments to help us understand why financial markets are prone to recurring crises, and why stability breeds excess which is, in turn, destabilizing.
One of Minsky’s major insights is that in financial markets “stability is destabilizing” (Wray 2016, 15). Rather than tending towards a stable equilibrium, stability breeds excessive risk taking. As investors gain confidence that the good times will never end, as they did in the booms of the 1990s and early 2000s, they engage in increasingly risky investments. The spectacular booms in financial markets are followed by equally spectacular busts. In the modern economy, the financial sector tends to exacerbate the trends in the goods and services sector, amplifying the business cycle. To understand exactly how this takes place, we need to understand the Minsky Cycle.
As Keynes noted, in the typical business cycle, after 1-2 years in a recession followed by another 2-3 years of slow growth, new business opportunities start to arise. Firms identify new products that could be sold, new markets they can exploit, new technologies that can reduce costs, and so on. Meanwhile, consumer confidence starts to improve. Thus, after several years in which very little investment takes place, firms begin to invest again, expanding purchases of plants and equipment and increasing their productive capacity. This causes incomes to increase and unemployment to fall, starting the economic expansion.
What Minsky adds to this story is the role of financial institutions in the boom. The increase in business investment must be financed somehow. In order to finance billions of dollars in new investments, firms borrow from banks.
The investments early in a boom are usually fairly safe. Businesses invest in sound opportunities with a high expected return. They are confident that the increases in revenues from their investments can easily pay off the interest and the principal that they borrowed from banks.
Minsky calls this safest stage of the cycle “hedge finance.” Investments are “hedged” in that they are very safe and unlikely to experience financial losses. (This has nothing to do with hedge funds, which are often very risky.) Expected revenues from investments should easily cover payments on interest and the principal. Both businesses and banks are in a stable situation. But, as noted above, stability breeds instability (success leads to excess which leads to a crash).
As the boom gathers speed, business confidence improves, and this has a major consequence: firms are now willing to take on much more risk. Once all of the best investment opportunities are taken, firms must increasingly look for higher risk investments. High levels of confidence encourage businesses to borrow even more money to finance these higher risk investments. In the process, they take on even more debt, committing larger and larger portions of their expected revenues to debt service.
This phase of the Minksy cycle is termed the “speculative” phase. As businesses borrow more and more money for riskier and riskier investments, the expected revenue from the investments will reach a point where it covers the interest payments but not the principal. Thus, the only way businesses can pay off their debt is if the investment ends up being successful and revenues increase. But, until they experience a revenue increase, businesses will have to keep refinancing their loans whenever they come due (they will have made the interest payments on the loan, but they will not have paid any principal). This phase of the cycle is called “speculative finance” because businesses are speculating that their investments will eventually result in an increase in revenues sufficient to pay off their debts.
Meanwhile banks, assuming that the boom will continue and that businesses will have no problem paying off their debts, are quite comfortable making riskier loans that require less collateral. Normally, a bank would not loan to a business without significant collateral, but when confidence is high, banks tend to relax their rules regarding collateral. And, normally banks would require borrowers to pay off the interest and some of the principal of the loan. This too is relaxed when confidence is high.
Banks, flush with cash because of the boom (savings and business profits are pouring into bank accounts), also start to create new financial products and to work to circumvent rules and regulations in order to take advantage of new opportunities. Hence, we get bank speculation to go along with the business speculation already underway.
Meanwhile, as the economy booms the government tends to take in larger amounts of tax revenues and reduces spending on unemployment and social programs while the central bank (Federal Reserve) raises interest rates, which tends to slow the economy somewhat and increase the risk of default on speculative investments. The good times also prompt calls for deregulation since all is well in financial markets. This combination of deregulation, fiscal and monetary tightening, and riskier investment opportunities moves the economy from a stable structure to a fragile financial situation (Wray 2016, 15).
As the bubble reaches a fever pitch and confidence improves even more, businesses increase investment further in the most risky ventures and take on debt they cannot afford, relying on the hope that the investments will be successful. They take on so much debt that they cannot make the principal or the interest payments, which means that they must borrow more and more money just to make the interest payments on their debts. Their debts continue to mount until the hoped-for increase in revenue from the investment happens.
This is called the “Ponzi” phase of the cycle because businesses are borrowing money that they cannot pay back given existing conditions. Their only hope of paying back their loans is if their investments generate substantial new revenues.
This is very similar to a Ponzi scheme, such as that recently perpetrated by Bernie Madoff, where an unscrupulous investment manager takes in money from investors but, rather than investing it, squanders it. His only hope of paying off the original investors is if new investors also entrust him with their money, at which point the Ponzi scheme operator can use the money from the new investors to pay dividends to the original investors. The Ponzi scheme can only continue as long as new investors continue to give new money to the Ponzi investment manager so he can continue to pay off his other investors. Once new investments dry up the whole scheme will collapse.
Similarly, in the Ponzi phase of the business cycle, businesses are borrowing money that they cannot possibly pay back unless their risky investment is actually successful in generating new revenues. While they wait for the hoped-for increase in revenues, they must continue to receive financing from banks to cover their principal and interest payments. There is an inherent instability in such a situation.
Businesses in this phase of the cycle will not default as long as banks continue to loan them increasing amounts of money. However, once the economy becomes this fragile numerous factors can derail the boom. Multiple defaults can occur if (1) revenue flows from investments turn out to be lower than expected, (2) interest rates increase, (3) banks get scared and curtail lending, or, (4) a prominent firm or bank defaults on payments and scares investors or lenders.
Once businesses, investors or banks are spooked, we have reached the “Minsky Moment,” and the financial bubble collapses rapidly. As everyone tries to unload risky assets, their prices plummet, and bankruptcies and defaults ensue. The risky investments collapse. Firms lay off workers and income and employment fall, reducing consumer spending and making the situation even more dire. The economy spirals into recession, and only a significant injection of money into financial markets by the national bank (Fed) and a large increase in government spending by the government can stop the crash.
There is also a trend in financial markets where the likelihood of a severe financial crash increases over a period of several decades. If the regular recessions and crashes are mild, there will be increasing calls for deregulation over time. For example, financial markets were deregulated substantially in the 1990s and early 2000s after two decades of relatively stable growth. The more financial markets are deregulated, the more risky the behavior can be. This will tend to increase the severity of the crash as deregulation proceeds, resulting in a major crash such as the Great Depression of the 1930s or the Great Recession of 2007-2009. Of course, in the wake of a major crash, calls for new regulations emerge and safeguards are put into place. This stabilizes the system and reduces the severity of the next several recessions. That is, until the lessons have been forgotten and renewed calls for deregulation are heeded, setting up the next major crash.
As numerous publications and economists from both mainstream and heterodox perspectives have noted, Minsky’s Financial Instability Hypothesis is very important in understanding the modern business cycle. Minsky left us with a number of key ideas that we can use to anticipate and possible to avoid future crises:
· Stability is destabilizing: Stability encourages excessive risk taking which leads to fragility and crisis.
· Over the long term (several decades), stability is destabilizing partly because it encourages deregulation of financial markets, which sets the stage for a larger speculative boom and much deeper bust.
· Over the typical 10-year business cycle, stability is destabilizing because of the manner in which improvements in confidence encourage businesses and banks to engage in increasingly risky behavior.
· In the first “stable” or “hedge” phase of the business cycle, firms make sound investments and banks make sound loans which should be successful and that have a low probability of default.
· In the second “risky” or “speculative” phase, as the economy grows and confidence improves firms take on more debt and make increasingly risky investments while banks create new, riskier financial securities. The probability of defaults increases.
· In the third “Ponzi” phase, rapid growth and appreciating asset values cause the boom to reach a fever pitch as firms and banks make even riskier investments, and the probability of defaults becomes very high.
· At some point, when it becomes clear that the risky investments will not generate the necessary returns, the economy reaches a “Minsky Moment,” panic selling ensues, and the market crashes. The financial market crash causes reduced investment and consumer spending, unemployment increases, and the economy falls into a recession.
If we take Minsky’s analysis to heart, then financial markets, and markets in general, must always be regulated to prevent Ponzi-like behaviors. Only then can we avoid the worst excesses of financial markets.
Wray, L. Randall. Why Minsky Matters. Princeton, New Jersey: Princeton University Press, 2016.
 The author would like to thank Janet Knoedler and Erdogan Bakir for their feedback on this section. Any errors are, of course, my own.
 Collateral is security that is provided for repayment of a loan, which is forfeited in the event of a default. For example, a business financing an expansion of their operations would have to put up as collateral their existing business assets in order to secure bank financing. That way, if the investment fails and the firm cannot pay the bank, the bank can seize the assets of the business as compensation.
 When financial markets have seemingly exhausted the less risky investments, they will clamor for deregulation to be able to invent new instruments, as Savings and Loan Banks did in the 1980s (leading to the Savings and Loan Crisis of the late 1980s), or as investment banks did in the late 1990s and early 2000s (leading to the Financial Crisis of 2007-2009).
 Higher interest rates mean that firms have to borrow even more money to keep financing their risky investments and the return from the investments has to been even higher in order to stave off losses.