Alessandro Vercelli Department of Economic Policy, Finance and Development (DEPFID)

1. Lecture 4bisA Perspective on Minsky Moments: a Revisitation of the Core of The Financial Instability Hypothesis Alessandro Vercelli Department of Economic Policy, Finance and Development (DEPFID) University of Siena

2. Presentation based on: Vercelli, A., 2009a, A Perspective on Minsky Moments: The Core of the Financial Instability Hypothesis in Light of the Subprime Crisis, Levy Working Paper, n. 579, The Levy Economics Institute of Bard College, Annandale-on-Hudson, NY, forthcoming in the Journal of Political Economy. Vercelli, A., 2009b, Minsky Moments, Russell Chickens, and Gray Swans: The Methodological Puzzles of the Financial Instability Analysis, Levy Working Paper n. 582, The Levy Economics Institute of Bard College, Annandale-on-Hudson, NY; in Tavasci, D. and J. Toporowski, eds., 2010, Minsky Crisis and Development, Palgrave Macmillan, Basingstoke and New York. Reflexions on the FIH in the light of the subprime crisis→ restatement 1) analytic and policy issues Twin papers{ 2) methodological aspects

3. Purposes of the presentation - In the first part I will provide a definition Minsky moment based on a simple model of financial fluctuations that restates the core of the Financial Instability Hypothesis in light of the subprime crisis - In the second part I use this model to interpret the subprime crisis - In the third part I draw a few policy implications from the above analysis

4. The euphemisms of mass media • According to Anglo-Saxon mass media: -- Subprime (mortgages) crisis: ongoing financial crisis started in the summer 2007 → Minsky moment: generalized liquidity problem → Minsky meltdown: generalized insolvency problem • Minimalist narration meant to play down the gravity of the problems by reducing: -the general to the particular: not only US subprime bubble: fuse → dynamite? -the global to the local: bubble and policies at the country level → global contagion moment: almost two years and not yet over! -the persistent to the ephemeral { meltdown: not yet extinguished

5. Minsky moments Since the beginning of the ongoing financial crisis → revival of interest in Minsky’s work by academics, practitioners and mass media Surprising: his “financial instability hypothesis” had been harshly rejected by classical camp (monetarism, NCEcs) mainstream economists { Keynesian camp (neoclassical synthesis, NKEcs) insulted: demagogue, lugubrious, obscure, vague, and so on no teaching on Minsky, difficult to publish on Minsky, and so on

6. Minsky moments Minsky moments:exceptional circumstances of severe financial crisis Expression coined in 1998 in occasion of the Russian debt crisis by Paul McCulley manager of bond funds PIMCO, investment co that runs the largest bond Fund → fashionable catch phrase during the subprime crisis, adopted by • top-level practitioners and analysts (such as Magnus, senior economic adviser at UBS Investment Bank: articles on the FT), • leading financial journalists (such as Martin Wolf. Financial Times; Lahart, Wall Street Journal; Cassidy, The New Yorker) • academic economists (such as Whalen, 2008; Wray, 2008; Davidson 2008, Bellofiore and Halevi, 2009) The fad has declined in mass media after the recent policy reversal: however, we could say that this is the Minsky moment of public finance

7. Definitions of Minsky moments • as a point of time (consistently with the usual meaning of “moment”): Magnus (2007, FT): “the point where credit supply starts to dry up”, Wolf (2008, FT): “the point at which a financial mania turns into panic” • as a process (short-lived relatively to the periods of financial tranquillity): McCulley (2001, pimco.com): “a self-feeding process of debt-deflation” Lahart (2007, WSJ): “when over-indebted investors are forced to sell even their solid investments” Magnus (2007, FT): “when lenders become increasingly cautious”, Whalen (2008): “credit crunch or Minsky moment”, Davidson (2008): “when the Ponzi pyramid financial scheme collapses” different aspects of a Minsky process consistent{ Minsky moment as starting point of a Minsky process

8. Minsky moment and Minsky process Minsky moment To avoid confusion we prefer to distinguish { Minsky process → Minsky process as a well-defined phase of a financial cycle → we need a model of the financial cycle to analyze this phase only the “core”: the strict financial part I suggest one based on the FIH { updated and somewhat developed I intend to argue that the moment of Minsky should not be confined to Minsky moments

9. Minsky moments and subprime crisis All the authors of our sample of definitions, but one (Davidson, 2008) agree that the subprime crisis may be defined as a Minsky moment On the basis of an extremely restrictive definition (see above) applied to a very narrow set of agents (US subprime borrowers) Davidson denies that the subprime crisis may be defined as a Minsky moment, since “ most subprime borrowers who have little or no equity in their homes would have no possibility of obtaining a second (or even a third) mortgage” so engaging in a Ponzi finance transaction” (Davidson, 2008, p.674) No reason for this restrictive definition and application: we would break the bridge with Minsky’s insights without obtaining any advantage

10. Minsky meltdown Minsky meltdown: terminology borrowed by nuclear reactor engineering: extremelyrare event involving high risks (“Once in a century”: Greenspan) Definitions: -McCulley, quoted in Lahart, WSJ, 2007: ”a spreading decline in asset values capable of producing a recession” -G. Magnus, FT, 14.10.2008: ”the point where financial instability has become so acute that only an exceptional, immediate and global government attack on the causes of instability is likely to avert a systemic banking failure in which non-financial companies could rapidly fail too” -Whalen, 2008: “without intervention in the form of collective action, usually by the central bank, the Minsky moment can engender a meltdown, involving asset values that plummet from forced selling and credit that dries up to the point where investment and output fall and unemployment rises sharply” Minsky moment Difference between {is a matter of degree Minsky meltdown Minsky meltdown: when the Minsky process is so intense to trigger a recession

11. Why Minsky now? • Instrumental use: to justify policies in blatant contradiction with orthodoxy • Protective belt around orthodoxy: distinction between rule and exceptions exceptions have a very low probability (Greenspan: “once in a century”) In this view{ “exceptions confirm the rule” orthodox theory for the rule Thus {Keynes:theory of depression heterodox theory for the exceptions { Minsky: theory of financial crises

12. Why Minsky now in Wall Street ? in this view mainstream theory and policy still valid with the only exception of Minsky moments (that may lead to a Minsky meltdown) Analogously, Keynes’s theory has been often defined as the theory of [great] depressions (a few physicists –e.g. Oppenheimer- maintained that the laws of physics are “suspended” near black holes although they work well for the rest of universe)

13. Instrumental use of Minsky Reference to Minsky moments and Minsky meltdown as the only possible theoretical endorsement for a policy in blatant contradiction with previously held neoliberal doctrines For example, after illustration of emergency bail-out plans in the USA, the UK, and EU, G. Magnus (FT, 14.10.2008) : “This comprehensive assault on financial instability is the only solution that Minsky himself would have approved” However, Minsky would not have approved the policies implemented before and during the ongoing (and preceding) financial crises: destabilizing stabilizations in order to “stabilize an unstable economy” we need structural interventions that prevent the crises and thwart them before the first symptoms emerge

14. Mainstream regularism Mainstream economics is based on a principle of regularity → the most influential version is that of Lucas : economics as a science has to be based and applied only to economic regularities (stationary stochastic processes) (Lucas, 1976, 1981) → this justifies in this view equilibrium, stability, substantive rationality, RE, stationarity, weak uncertainty, and so on

15. Why regularism is flawed • Open world → structural change → non-stationarity • The “exception” may be the most important “moment” (Russell) ”The man who has fed the chicken every day at last wrings its neck instead, showing that more refined views as to the uniformity of nature would have been useful to the chicken” (The Problems of Philosophy, 1912, chap IV, On induction) → a more refined view has to encompass the relevant exceptions • The analogy of the “black swan” (Taleb) is misleading: the crisis is a recurrentexception not independent of the rule → the crisis is rather a “grey swan” periodically reappearing (young swans are grey!: color determined by the life cycle)

19. Lucas’s economic regularities Lucas admits that economic phenomena may be sometime irregular however, they cannot be analyzed by economic science → the most important example is the Great Depression: he claims that the more distant in the past it gets the smaller becomes its statistical weight in long-term regularities therefore, in this view, we are justified to ignore this and other exceptions The success of this approach has contributed to the financial crisis by justifying a declining perception of risk

20. A broader perspective We cannot understand and deal properly with a financial crisis if we exclude the relevance of exceptions (disequilibrium, instability, etc) → we need a more general vision: both regular and irregular phenomena Keynes We have to draw inspiration from authors such as { Minsky not because they are theorists of the exceptions but because: accounts also for the exceptions their broader perspective{ clarifies the relation between rule and exceptions in an open world we have to continuously update and develop their theories

21. The parable of Russel’s chicken «In the animals farm (where each animal speaks and reasons as an Homo economicus) there was a flock of rational chickens (rational in the sense of Lucas) that were happy to run to the farmer every morning to be fed Only one eccentric chicken noticed that older chickens had periodically disappeared and expressed the fear that the benevolent farmer was fatting them to bring them to the slaughterhouse The other chickens didn’t take him seriously: they claimed that he was a lugubrious troublemaker and that if some chickens had disappeared this depended on the fox; however the farmer had already promised to raise and strengthen the fence That night the eccentric chicken escaped from the farm before a stronger fence would prevent it and saved himself: the following morning all the other chickens were put on a lorry and brought to the slaughterhouse»

22. The parable of Russel’s chickens Moral: the rational chickens behaved according to a “science” based on empirical regularities (the farmer fed them all the mornings): their science was apparently wrong only in a particular morning but that moment was the most important one Bertrand Russel: ”The man who has fed the chicken every day at last wrings its neck instead, showing that more refined views as to the uniformity of nature would have been useful to the chicken” (The Problems of Philosophy, 1912, chap IV, On induction) The eccentric chicken saved himself because he had a more general point of view than the “rational” chickens: the trouble is that in a globalized world we cannot escape beyond the fence → we need a more general vision but we have also to change the world

23. Minsky’s implicit theorizing Victim of many unjustified criticisms; one to be taken seriously is: Implicit theorizing : axioms are not made explicit, arguments are not fully rigorous, models are insufficiently formalized (in particular by Tobin; after Leontiev against Keynes) This is the hallmark of original theories (in all scientific disciplines) theorizing is made explicit only through the work of generations of followers e.g. standard economic theory has been developed/refined by generations of scholars → if the Minsky’s view of financial fluctuations is more general and realistic and may save us from Minsky’s moments and financial meltdowns we should invest in its development/refinement what follows aims to go in this direction

24. The core of FIH: a restatement Minsky starts his numerous versions of the FIH from a classification of economic units from the point of view of their financial conditions hedge Financial units { speculative non-hedge { Ponzi

25. Distinction hedge/non hedge mt = yt - et current excess (or net) financial inflows mt* = sum of discounted expected net inflows: net worth of the unit mtindex of liquidity mt* index of solvency mt> 0 for every tmt< 0 for some (not all) t hedge { non-hedge { mt* > 0 mt* > 0

26. Distinction speculative/Ponzi:two basic criteria a) Different time profile of net inflows: mt< 0 for: t < s <n (s small), mt > 0 for: s < t ≤ n speculative { mt* > 0 mt< 0 for: t<n-1, mt >> 0 for: t = n Ponzi { mt* > 0 b) different gravity and urgency of liquidity problems: -speculative can repay maturing interests but not principal in all t -Ponzi cannot repay even the maturing interest in all t

27. Constructive criticism The use of this taxonomy by Minsky is full of illuminating qualitative details (accounting, institutional, historical details, and so on) However, the way in which he formalized it is wanting: obstacle to a further development of the FIH in applied research hedge qualitative taxonomy{ speculative Ponzi unfit for quantitative analysis { qualitative attributes ambiguous such as E deficit small and E surplus >>

28. A further category: distressed units We should consider a further category of financial units: units in financial distress Distressed unitsvirtually insolvent: net worth negative In the past two years many banks and financial institutions had to be classified in this way, and –to some extent- this is always true in financial crises: particularly important object of analysis Minsky did not consider them in a systematic way, probably because they are by definition virtually insolvent and then unsustainable units however this does not mean actual insolvency → they may be bailed out by the state, by other units, or by means of a radical restructuring even according to Minsky the net worth of a Ponzi unit is negative for “any honest computation of present value” (Minsky 1977 c)

29. A suggested classification of financial units Each financial unit is characterized by a pair of values: kt and kt* that define its liquidity and solvency situation at time t: continuum of values in a 2-dimensional space -allow a representation in a Cartesian diagram in order to { -while keeping in touch with their intuitive meaning I restate the two indexes as ratios: liquidity ratio: excess (or net) financial outflows kit = eit / yit solvency ratio: net worth of the unit i

30. Classification of financial units k speculative and Ponzi highly distressed 1 hedge distressed 1 k*

31. Table 1: Relationship between Minsky’s and this paper’s taxonomies:rules of translation

32. The margin of safety The new taxonomy defines the Cartesian space of financial fluctuations The behavior of units depends on their perception of risk→ most units have margins of safety that they do not want to breach to avoid unnecessary risk The most important margin of safety is a solvency margin to avoid bankruptcy The units struggle to stay sufficiently far from the insolvency line at kit = 1 The margin of safety may be thus expressed as a desired margin from 1:1- μ → I can represent the dynamic space of the financial conditions of each financial unit in the following diagram

33. Fig.1: classification of financial units 2 3 kit 5 highly distressed speculative hyper-speculative 1 hedge distressed hyper-hedge 4 6 1 1-μi 1 kit*

34. Financial instability hypothesis: a model We are now in a position to restate the core of the FIH with the aid of a simple model interaction between the liquidity ratio and the solvency ratio (cash-flow approach), ( 1 ) α > 0 ( 2 ) β > 0 This elementary Lotka-Volterra model is based on: Vercelli, A., 2000, Financial Fragility and Cyclical Fluctuations, Structural Change and Economic Dynamics. 1. pp.139-156); Sordi, S., and A. Vercelli, 2006, Financial Fragility and Economic Fluctuations,Journal of Economic Behaviour and Organization, 61 (4), pp. 543-561 Dieci, R, Sordi, S., and A.Vercelli, 2006, Financial fragility and global dynamics, Chaos, Solitons and Fractals, 29(3), pp. 595-610

35. Definition of Minsky moment and Minsky process This Lotka-Volterra model produces clockwise cycles that have properties very similar to those described by Minsky in the FIH kt 2 3 5 A B 1 ω A Minsky moment A-B Minsky process 1 4 6 1-μ 1 k*t

36. The financial feedback and complex behavior The feedback between k and k*, although apparently very simple, may easily lead to complex behavior (regime shifts, bifurcations, chaos): -present/future Self-referential loop { -subject/object -realized/expected Dieci, R., Sordi, S., and A. Vercelli, 2006, Financial fragility and global dynamics, Chaos, Solitons and Fractals, 29(3), pp.595-610 Sordi, S. and A. Vercelli, 2010, Heterogeneous expectations and strong uncertainty in a Minskyian model of financial fluctuations, DEPFID Discussion Papern.7

37. Disequilibrium and instability The model shows persistence of disequilibrium dynamic instability emerges in consequence of the declining perception of risk, the more so the more persistent is the boom → the safety margin 1- μshiftstowards the right, increasing the gap from equilibrium → outwards spiral when the awareness spreads that the margin of safety has been overcome it may be too late:the inertia of the cycle pushes the economy near the solvency barrier → growing financial fragility of financial units financial fragility as the size of the minimum shock that pushes a financial unity beyond the solvency barrier: degree of structural instability that changes endogenously → dispersion → insolvency of a sizable subset of units→ contagion

38. Financial fluctuations: dynamic and structural instability kt P 1 ω ω’ k*t 1-μt 1-μt’ 1

39. Sequence of financial cycles (→long cycle) The degree of instability and fragility reached in the final stage of a financial cycle depends on the characteristics of preceding cycles gravity and length of the last crisis Tends to grow in proportion to { time distance from the last great crisis The average safety margin tends to grow progressively: germs of a successive great crisis: In the last century long financial cycles of about 30 years: trough-to-trough: 1930-1950, 1950-1982, 1982- 2010?

40. Long cycles in finance, USA, 1900-2008 the last one: 1980-2010? US Stock market valuation Source: Martin Wolf FT, 26.11.08 from Robert Shiller et al. CAPE = Cyclically adjusted price-earning ratio Q = cyclically adjusted Tobin Q

41. The neoliberal long cycle We are at the end of a long cycle started at the turn of the 1970s when the CAPE (cyclical adjusted price–earnings ratio) was at a minimum It continued to grow in the 1980s and 1990s culminating in 1999 then it was artificially kept above the long-period average Greenspan put through { monetary policy Bernanke put financialization → neoliberal era { market fundamentalism

42. The ongoing financial crisis: insights from Minsky Generally the evolution of facts makes theories obsolete this is not the case of the FIH → the evolution of facts made this approach progressively more important: growing importance of finance: -the ratio between financial and real assets (as measured by the FIR of Goldsmith) grew from < 1 at the beginning of the 1980s to > 3 today -GDP share of FIRE increased to 12% -share of profits about 40% in 2007 non-financial firms this is true also for { households (↑shares, ↑pension funds) theoretical →↑ scope { of the FIH empirical

43. Towards a “pure finance” economy (Wicksell) The model we have discussed before (and the underlying hypotheses) is relevant not only for the financial sector but for the whole economy Let’s represent the economy as a complex network of transactions M-C-M’: the models in real terms look at the economy from the point of view of real commodities keeping implicit the financial flows: (M –) C (– M’) – C’ (– M’’) – C’’ (– M’’’) The models in financial terms look at the same process from the point of view of financial flows keeping implicit the real flows: M (– C) – M’ (– C’) – M’’ (– C’’) – M’’’ From the sovereignty of consumers (real capital) to that of financiers (financial capital)

44. The neoliberal era 1 The neoliberal era starts as a reaction to the Great Stagflation of the 1970s The mainstream view blamed for the economic failures exogenous factors: -Keynesian full-employment policies -inflationary bias of the Bretton Woods era { -“excessive” power of trade unions -oil shocks (1973 and 1979): “excessive power” of OPEC The emerging neoliberal view sought a remedy in the revival of competitive markets: -privatization policy strategy { -deregulation

45. The neoliberal era 2 Monetarist initial phase 1979-1987 (Volker governor of FED) trade unions very restrictive monetary policy→ weakened { OPEC labor markets → deregulation of { international markets The inflationary bias in real markets is overcome: emergence of the great moderation: progressive downward shift and flattening of the Phillips curve: This allows the introduction of a lax monetary policy since 1987 (Greenspan): Greenspan put: floor to the price of financial assets not accompanied by a ceiling

46. The neoliberal era 3 → ↑ liquidity to reduce length of financial crises Consequences { → ↓ prudential margin1- μ → ↑ financial fragility → new inflationary bias in the financial markets → environment conducive to financial bubbles: of the 18 major bank-centered post-war financial crises identified by Kaminsky and Reinhart (1999) 3 are in the late1970s 7 in the 1980s, 8 in the 1990s not global: circumscribed to a particular company (LTCM, 1998), sector (US loan and investment banks), or a country (Italy, 1990, UK 1991, Japan, 1992) however, the immediate and generous bail-outs of big units in distress pave the way to the global crises of the 2000s

47. The neoliberal era 4 The dot.com crisis 2000-2002 was a serious warning that was not understood: Even in this case the put policy managed to abort the crisis quicker than expected, strengthening the faith in the omnipotence of the invisible hand supported by Greenspan’s visible hand Further acceleration of the process of financialization: new boom 2003-2006 The speculators turned from IT immaterial goods to brick-and-mortar goods: → housing bubble (US, UK, Spain, etc.) detonator → subprime crisis { propagation of the implosion

48. The subprime crisis: the detonator housing crisis: initially slow decline of housing prices since late 2006 → Detonator { spike in the price of oil: from $63 in Dec. 2006 to $147 in July 2008 (and other natural resources including food) Most observers expected a soft lending of housing prices without systemic effects However the spike of oil brought about cost inflation → notwithstanding the emerging crisis, the Central banks reacted in the usual way by increasing the discount rate This accelerated the fall of housing prices and mortgage delinquencies: this was the Minsky moment that triggered the Minsky process What has to be explained is why this specific and local financial crisis rapidly became a generalized worldwide crisis notwithstanding a big state and powerful central bank willing to act

49. The subprime crisis: propagation of the implosion The detonator blew out near a great deposit of explosive progressively accumulated in the neoliberal eraIn consequence of deep structural changes FIR of Goldsmith from ~1 (1980) to > 3 -financialization{ FIRE profits > 40% FIRE from 15% to 20% share of GDP -securitization: delegation to the market of the evaluation of expected cash-flows → generalized relief from responsibilities -autonomous shadow FI: investment banks, hedge funds… banking { -dependent shadow FI: SIV, conduits… -shadow{ markets: OTC derivatives, ABS, MBS, CDS… Shadow finance provided in 2007 about half of the total credit in the US

50. Policy implications The approach outlined may guide us to draw private sector to get out of the crisis { public sector policy implications{ to avoid that “it” may happen again