On the eve of the global financial crisis, economists were busy celebrating. Inflation and unemployment were falling, and boom and bust seemed to be a thing of the past. Having arrived at what they thought was the “correct” model of the economy, economic experts believed that they had the knowledge and tools necessary to keep the economy on an even keel. From now on, policymaking was supposed to be simple. Robert Lucas, the president of the American Economic Association and a Nobel laureate, even went so far as to announce that the “central problem of depression-prevention had been solved”. The Great Depression would, apparently, never happen again.
No one, therefore, was more shocked by the events of 2008 than economists themselves – so much so that, as L. Randall Wray notes at the start of his brilliant new book, the Queen of England felt compelled to ask of economists, “Why did nobody see it coming?”
Their answer, while it was long in the making and attracted many reputable signatories, dodged the truth: that not enough economists had read the works of Hyman P. Minsky (1919-96). Thanks to this crystal-clear summary of Minsky’s life’s work, written by a former student and colleague, and without all the usual economic jargon and equations, there is now no excuse.
As Wray so astutely notes, for too long economists had presumed that we could take the benefits of free markets without also accepting the associated costs. While the economic party was in full swing, they were blind to the problems building up beneath the surface. This was particularly true of finance, an area Minsky knew from the inside.
The benefits of finance are, of course, difficult to deny, in allowing businesses to access funds that permit the economy to develop and grow. However, while finance helps us to travel ever upwards, it also creates instability along the way, and it is his “financial instability hypothesis” for which Minsky is best known.
As Wray is at pains to emphasise, this inherent instability had simply been ignored by the economic mainstream before 2008. In fact, we could take this even further. Not only did they ignore it, both then and today, but they also wrongly assumed that the financial system was becoming ever more stable, bolstered by the fact that in 2002, Alan Greenspan, then chairman of the US Federal Reserve, was given an honorary knighthood for his “contribution to global economic stability”.
As 2008 so clearly showed, we simply cannot have our cake and eat it. Financial crises are not just events that happened a long time ago in history – or far, far away in distant and much poorer lands. They are hard-wired into the capitalist system. Minsky was one of the valiant few who tried to draw attention to this fact, and one of the few to predict the global financial crisis decades before it actually hit. Unfortunately, his warnings fell on deaf ears. Like many a great artist, his popularity soared only after his death and only once the crisis hit – in what came to be known as a “Minsky moment”.
Having experienced the pain of a new Great Depression, the very least we should expect is that economists try to learn from it. Unfortunately, still too few of them understand the importance of what Minsky had to say – and that, according to Wray, includes notable left-leaning economists (unlike the author, I’m naming no names). While Minsky is now quite well known, his contributions are still widely ignored or misunderstood. This makes Wray’s book a godsend.
To truly understand Minsky, we have to go back to the work of John Maynard Keynes and, in particular, his belief that economic instability is inescapable. According to Keynes, instability follows from one simple fact: the future is completely unpredictable – we never quite know what will happen. The “unknowability” of the future makes investing very difficult. When making investment decisions – whether it be a firm deciding whether to expand, you or me deciding whether to invest in buy-to-let properties, or each of us deciding what to do with our pension pot – it is necessary for us to make predictions about the future, whether that be to estimate how much house prices are likely to rise, whether stocks will do better than bonds, or how much demand the firm expects to have for the products it produces. However, because the future is unknowable it is impossible to answer these questions with any degree of certainty. If we cannot predict the future, we cannot, for example, calculate the “true” value of a stock or a house. As a result, the market has no anchor – instead, asset prices will blow with the wind.
Facing an uncertain future, Keynes argued that it is very difficult to imagine that people will behave “rationally” in the way that most economists like to assume. If you don’t know what will happen, perhaps the best you can do is to look at what everyone else is doing and follow the crowd. We jump on bandwagons, fearful of missing out on something, overconfident one moment and then overcome by panic the next. These waves of optimism and pessimism then translate into severe fluctuations in investment activity, destabilising the economy.
Minsky took Keynes’ important insight one major step forward, and showing how he did so is a particular strength of Wray’s book. Minsky argued that if financial markets provide the potential to borrow, allowing people to take on debt to fund their investments, they will serve to push prices further upwards in a boom, and create greater downfalls in a bust, making investment in the economy even more unstable.
Given that banks are responsible for the vast majority of loans made in the modern economy, the activity of banks (and other such institutions) was at the centre of Minsky’s work. He reasoned that the amount of lending (and so investment) in the economy will depend on how willing banks are to speculate on the future. After a downturn, banks can often be cautious in making loans, lending only to those they judge to be low-risk. However, in competition with other banks to make profits, once they run out of low-risk customers, banks gradually start to devise new financial products (new ways of creating credit) that allow them to lend to higher-risk customers, via sub-prime mortgages, for example. Banks become increasingly leveraged, but this is masked by the fact that the increased availability of loans pushes up asset prices.
Unfortunately, a boom can never go on for ever. Eventually, news of some form or another unsettles the status quo. With the news comes a contraction of credit and the “calling in” of loans. The upward spiral now goes into reverse: lower credit means fewer buyers of assets, with which asset prices plunge, leading to credit restriction, further asset price falls and so on. People soon find that they are much more indebted and leveraged than they had anticipated when the economy was booming. Defaults increase, and the banks start to experience severe financial difficulty.
It is in the good times, as Wray so clearly elucidates, that the seeds are sown for the bad times to come. Instability is near impossible to avoid. If we want the benefits of an ever more prosperous economy, the trick is therefore to recognise and then to do all that we can to try to limit this instability. Precisely what we can do is at the centre of Minsky’s work. By making his insights accessible to a general audience for the first time, Wray’s book has the potential to transform the future of economic policymaking and, with it, to create a better life for future generations. Let’s hope that this happens sooner rather than later. Until then, the world economy should remain on high alert.
Victoria Bateman is fellow and director of studies in economics, Gonville and Caius College, Cambridge, a regular contributor of economic commentary for CapX and author of Markets and Growth in Early Modern Europe (2012).
Why Minsky Matters: An Introduction to the Work of a Maverick Economist
By L. Randall Wray
Princeton University Press, 288pp, £19.95
ISBN 9780691159126 and 9781400873494 (e-book)
Published 16 December 2015
L. Randall Wray, senior scholar in the Levy Economics Institute, Bard College, New York, lives “in the tiny village of Red Hook in upstate New York, with my wife, Xinhua Liu (a professor of economics at Shaanxi Normal University in China), our new baby, and my older son; my other daughter is in the dorms at Bard. We share our house and four acres with Chubby and Skinny – one of whom is a rather large black and white cat, skinny only in comparison with his brother, who is the black St Bernard of cats.”
He was born “in the small fishing and lumber city of Eureka in far northern California. Except for practice teaching in Mexico City while pursuing my credentials in a teacher education programme in 1974, I never really left California until I entered the PhD programme at Washington University in St Louis when I was nearly 30.
“Northern California was an interesting place to be in the 1960s – the student movement, the hippies, and, most importantly, the anti-war protests. That bred a scepticism of the established views, no doubt. There was also a strong feeling among us that California was unique, and better because of it. Since I’ve lived the last 33 years in St Louis, Denver, Kansas City, Italy and New York, that view now seems quaint.”
As a child, Wray recalls, he was “a bookworm – it was an escape into other worlds. My mom was a voracious reader, too, and later became a writer for trade journals as well as a poet. She had attended only one year of college before meeting my dad (a mechanic who probably never attended high school). I was born the next year and they married a couple of years later. She typed all of my college papers until the age of computers arrived, and continued to read and comment on everything I wrote even as it became increasingly esoteric.
“I attended a one-room elementary school (with no running water and pits for toilets). It was impressed upon me when I was very young that I had to get the highest marks in school so as to earn scholarships for college. I would say I was not enamoured with any of my teachers (nor they with me – my mom later got all our school records released and year after year the teachers would lament that although I seemed bright and my mom had attended one year of college, the family financial situation was not promising). Not until much later, that is, when I had a few good teachers in high school. However, I was very lucky in college – both at the undergraduate and graduate levels – with remarkable professors who provided encouragement as well as serving as role models.”
What sort of undergraduate was he?
“You have to remember that this was at the end of the 1960s,” observes Wray. “I attended an experimental ‘hippie’ school, Callison College at the University of the Pacific: no grades, no traditional classes, few requirements, and lots and lots of freedom and libertine behaviour. It was eye-opening, to say the least. However, after a couple of years of that, one does settle down to hard work. The (extremely) liberal arts education provided an excellent foundation for graduate work. Moreover, I was pursuing teaching credentials in the school of education at the same time, so that provided grounding, as I worked each semester in the public school system in poor neighbourhoods.
“Teaching elementary school (I preferred 4th grade, 9-year-olds) was my dream. It was the most prestigious occupation I knew much about as a kid. As it happened, I came out of college with a glut of teachers in California. After some years of unemployment and casual employment, I got a job in Jimmy Carter’s CETA (Comprehensive Employment and Training Act, which created jobs in the public sector for long-term unemployed) where I learned to ‘spec’ garbage trucks, helped formulate the kerbside recycling programme for Sacramento County, served as liaison to the county’s community advisory board for solid waste management, and did time-and-motion studies of garbage collection. I moved on to Governor Jerry Brown’s California Energy Commission, forecasting energy demand in the agricultural sector. During those stints I began to study economics (for the first time) in night school. So, I thank a New Deal-style job creation programme for my career in economics.”
Wray studied psychology as an undergraduate. Did this make him more inclined to distrust the orthodox economic view of humans as rational agents?
“The economist’s view of human behaviour struck me as ridiculously simplistic – I never bought the assumptions for a minute. (And behavioural economics is only a marginal improvement over neoclassical economics, and a big step backward from Thorstein Veblen or John Maynard Keynes, in my view.) It helped that I had not studied any economics until several years after graduating – age and experience made neoclassical theories seem unrealistic. Fortunately, the economics department at California State University at Sacramento was pluralistic, offering institutionalist, Keynesian and Marxist views in addition to the neoclassical approach. Given my undergraduate education as well as real world experience, I was open to heterodoxy from the beginning.
“To tell the truth, one of the things that appealed to me about economics was that it seemed to be in a stage of development similar to that of psychology – infancy, or perhaps the toddler stage. There is far more unknown than known, opening the opportunity for contributions. While economists (and some psychologists) pretend that they are practicing science, I think Adam Smith had it nailed correctly as ‘moral philosophy’. I thought it would be relatively easy to make a mark in economics – much easier than in the sciences, which are far more advanced. Very few economists ever have to leave their desks to ‘do’ economics, that is, moral philosophy. I think I made the right decision.”
Since Wray's work focuses on ‘a critique of orthodox monetary theory and policy’, would it be appropriate to call him a heterodox economist? If not, why not? (Is it too loaded, or alienating, a term?)
“I suppose it is as good a term as we have. I do not mind being alienating – I have always tried to distance myself from mainstream economics, which I find to be wrong and even sometimes repulsive. Some of that is my 1960s conditioning, of course.”
Wray was a student of Hyman Minsky in his time as a doctoral candidate at Washington University. What was he like to work with?
“He was always the smartest guy in any room – and I don’t mean that in any disparaging way. He was gregarious and highly entertaining, and could pull out of his hat obscure facts, dates and data. He had a way of speaking so that understanding was just beyond your reach; he’d give a little wink acknowledging that he was testing you. It would take years of listening to him to really grasp what he meant. He had a soft spot for his undergraduate students, but could be tough on the graduate students. It was not uncommon for a graduate student to be ‘ABM’ – all but Minsky, ie with an outstanding incomplete in his class – rather than ‘ABD’ (all but dissertation). I actually wrote two dissertations for him. He rejected the first because he thought it would be too difficult (that is, too heterodox) to get through the department, but offered a suggestion for the second that got me on a path to a good career.
“When I received a Fulbright grant to write my dissertation in Bologna, Italy, he and I took an Italian language class together (he was hopeless at languages). He loved Italy and from that point forward, he was a great mentor and friend. While it was a bit difficult to break through the barrier – he supervised remarkably few dissertations – once you did, he became a loyal supporter. He was among the most ethical people I have met in academia – as a teacher, and as a colleague. After his death I read much of his correspondence, which is filled with evidence of his generosity, compassion and high moral standards.”
Many people have argued that lessons have not been learned from the financial crisis. Does Wray think Minsky would have been surprised?
“Believe it or not, Minsky was an optimist. I know that might sound strange for someone who is seen as always warning of a coming crisis, and who is associated with the phrase ‘stability is destabilizing’ – which seems to be about as pessimistic as one can be. But he was optimistic about the possibilities for policy and as well for the economics discipline itself. His hope for his own work, he said, was ‘to move the discipline, at least a little’. On his deathbed he pleaded with us to reach out to the mainstream, which he thought was ready to move in the ‘right’ direction. So while I am sure he would have hoped for more reform in the aftermath of the crisis, he would not be despondent. I think he would be back at work, writing more papers advocating for the ‘reconstruction’ of the financial system.”
What gives Wray hope?
“The chance that criminal behaviour by the banking elite might someday be prosecuted. Another thing that gives one hope is the way the world has changed since I was a kid in the 1950s, or a teen in the 1960s. While we’ve fallen far short of our dreams for universal peace and love, one cannot help but notice the real advances made. As economists, we tend to think in terms of per capita income, unemployment and poverty rates, and income and wealth distribution. By those measures, there’s really very little to celebrate – it has been pretty much downhill since 1970 unless you happen to reside in the top one per cent of the distribution. But in many other areas, major advances have been made – social mores, racial and gender equality, and environmental awareness. We need to keep that in mind as we face the possibility of a Trump vs Clinton election campaign!”