In this paper the impact of fiscal policy is analyzed within the context of an endogenous growth and cycles model. The investigation shows the different situations in which government expenditure can lead to both crowding-in and crowding-out of output and employment. With regard to the cycle, an increase in the share of government spending leads to an expansion of output, which is given a greater stimulus with a higher degree of monetization. Expansionary monetary policies accompanying the fiscal expansion tend to make the upswing longer and the downswing more shallow, i.e., the cycle becomes more asymmetric. The medium-run dynamics of the model along its warranted growth path essentially rest on the relative movements of business retained earnings (i.e., the private savings rate since household savings are ignored) and the government spending share. With the private savings rate fixed, a rise in the government spending share leads to medium-run crowding-out. On the other hand, if policies such as investment tax credits, lower rates of corporate taxation, and accelerated deductions for capital depreciation stimulate the growth of the business retained earnings, then an increase in the government spending share may either not have any effect on the warranted path or may even raise it, i.e., there might be crowding-in. Moreover, abstracting from any changes in retained earnings, an increase in the level of government spending produces an expansionary cyclical effect with no medium-run crowding-out. Finally, the model exploits the empirical finding that infrastructure investment by the government lowers business costs. This relationship is used to demonstrate that the warranted growth path can be increased via a shift from government consumption expenditures to infrastructure investment. In contrast to mainstream analyses these complex results imply that, within limits, the state has a number of policy levers at its disposal to regulate output and employment.
The so-called credit crunch of 1966 has long been recognized as the first significant postwar financial crisis and one that required the first important intervention by the Federal Reserve Bank. In the midst of the robust postwar expansion, the Fed began to fear inflation and tightened monetary policy to the point at which profitability of financial institutions was threatened. As Minsky argued, "By the end of August, the disorganization in the municipals market, rumors about the solvency and liquidity of savings institutions, and the frantic position-making efforts by money-market banks generated what can be characterized as a controlled panic. The situation clearly called for Federal Reserve action." The Fed was forced to enter as a lender of last resort to save the muni bond market, which in effect validated practices that were stretching liquidity. As a result of Fed intervention, the economy continued to expand, new financial practices emerged and were validated, leverage ratios increased, memories of the Great Depression faded, and markets came to expect that big government and the Fed would come to the rescue as needed. That 1966 crisis was only a minor speed bump on the road to Minskian fragility. To some extent, 1966 proved to be the first verification of the "financial instability hypothesis" that Minsky had been developing since the late 1950s, and the events of that year would stimulate further development of his analysis of the early postwar transition from a "robust" financial system toward a "fragile" financial system.
Over the past 40 years, regulatory reforms have been undertaken on the assumption that markets are efficient and self-corrective, crises are random events that are unpreventable, the purpose of an economic system is to grow, and economic growth necessarily improves well-being. This narrow framework of discussion has important implications for what is expected from financial regulation, and for its implementation. Indeed, the goal becomes developing a regulatory structure that minimizes the impact on economic growth while also providing high-enough buffers against shocks. In addition, given the overarching importance of economic growth, economic variables like profits, net worth, and low default rates have been core indicators of the financial health of banking institutions.
This paper argues that the framework within which financial reforms have been discussed is not appropriate to promoting financial stability. Improving capital and liquidity buffers will not advance economic stability, and measures of profitability and delinquency are of limited use to detect problems early. The paper lays out an alternative regulatory framework and proposes a fundamental shift in the way financial regulation is performed, similar to what occurred after the Great Depression. It is argued that crises are not random, and that their magnitude can be greatly limited by specific pro-active policies. These policies would focus on understanding what Ponzi finance is, making a difference between collateral-based and income-based Ponzi finance, detecting Ponzi finance, managing financial innovations, decreasing competitions in the banking industry, ending too-big-to-fail, and deemphasizing economic growth as the overarching goal of an economic system. This fundamental change in regulatory and supervisory practices would lead to very different ways in which to check the health of our financial institutions while promoting a more sustainable economic system from both a financial and a socio-ecological point of view.
The most fundamental shortcoming of QE—or, in fact, of using monetary policy in general to combat the recession—is that it only “works” if it somehow induces the private sector to spend more out of current income. A much more direct approach, particularly given much-needed deleveraging by the private sector, is to target growth in after tax incomes and job creation through appropriate and sufficiently large fiscal actions. Unfortunately, stimulus efforts to date have not met these criteria, and so have mostly kept the recession from being far worse rather than enabling a significant economic recovery. Finally, while there is identical risk to the federal government whether a bailout, a loan, or an asset purchase is undertaken by the Fed or the Treasury, there have been enormous, fundamental differences in democratic accountability for the two institutions when such actions have been taken since the crisis began. Public debates surrounding the wisdom of bailouts for the auto industry, or even continuing to provide benefits to the unemployed, never took place when it came to the Fed committing trillions of dollars to the financial system—even though, again, the federal government is “on the hook” in every instance.
During the 1980s, there was a sharp increase in speculative financing resulting from the trend toward leveraged buyouts and the rising demand for short-term marketable corporate liabilities. A main characteristic of a capitalist economy that is stagnant or immersed in a depression is that the capital development of the economy is not progressing. The 1980s were filled with examples of financing inept investments, while the current climate is one of grossly inadequate investment levels to create a progressive full-employment economy.
The institutional roadblocks included in the interventionist model were sufficient to avert large disequilibriums in asset and output prices, thereby sustaining profits and precluding a deep recession. (Indeed, the Federal Reserve was not forced to act to avert a financial crisis until 1968, when problems arose in the commercial paper market.) The interventionist model, however, was abrogated during the 1980s with the reinstitution of a new laissez-faire model. The new model eliminated many of the restrictions imposed on financial sector, massive increases in national deficits through unproductive public sector spending (made even more inefficient by the resulting interest on the debt), and the growth of speculative financing schemes that left us with too many highly indebted firms. A large, financially induced depression was contained only through the reintroduction of massive governing monetary and fiscal intervention in the form of the S&L bailout and the maintenance of profits with massive deficits. Although the subsequent drop in interest rates has resulted in a rise in asset values and somewhat abated the turmoil in the financial markets, the economy continues to stagnate.
In this working paper, Distinguished Scholar Hyman P. Minsky and Visiting Scholar Charles Whalen search for reasons to account for the split in post-World War II economic performance—that is, the difference in performance between the 1946–66 period and the 1966–96 period. The authors discuss a number of economic problems that have arisen during the past quarter of a century, including slower growth, stagnant earnings, rising financial instability, and increasing inequality. Minksy and Whalen concede that factors such as globalization and technological change have undoubtedly played a role in the split performance. An additional important and often overlooked element is the evolution of the US financial structure. The authors explain that a key component influencing the evolution of the financial sector during recent decades has been the rise of "money manager" capitalism. Important features of money manager capitalism are increased financial fragility (lower margins of safety in indebtedness and a greater reliance on debt relative to internal finance) and the introduction into the financial structure of a new layer of intermediation. In particular, managers of pensions, trusts, and mutual funds currently control the largest share of the liabilities of corporations. These managers are judged by only one criterion: how well they maximize the value of funds. As a result, business leaders have become increasingly sensitive to the stock market valuation of their firm.
Minsky's "hypothesis" was proposed to explain instability in a large, insulated, developed economy. Despite its intuitive appeal, it was not widely accepted among financial economists (Charles Kindleberger being a notable exception) because, they said, they could not find historical illustrations to fit the theory. The financial economist's machine runs smoothly in the best of all possible worlds. What makes trouble in the financial economist's world is the exogenous shock that affects everyone (war, oil prices) or government error (fiscal imbalance, monetary policy). "Financial distress," Barry Eichengreen and Richard Portes write in their study of sovereign debt rescheduling, "normally results from a real shock or bad policies." But Asia presents a cumulation of apparently rational decisions that are precisely those Minsky predicted.
Minsky defined three types of financing. Hedge financing is a position in which a firm's expected cash flow always exceeds the financing costs and operating expenses by a wide margin of safety. Speculative financing is a position in which a firm has a positive net present value, but the expected cash flow will not be sufficient to meet all financial commitments in all periods. Ponzi financing is a position in which a firm has to borrow funds just to meet its current cash flow commitments. According to Minsky, a change in macroeconomic variables, such as the interest rate, can change a firm's financial position from hedge to speculative or even to Ponzi by reducing the present value of the firm's current cash flow and increasing its cash flow commitments. A bank will respond to a deterioration of the financial position of its debtors by reducing lending and attempting to recall lending. If so, firms will find themselves in Ponzi positions and will be forced to sell assets just to meet their current cash flow commitments. Selling assets creates a generalized downward pressure on output and asset prices. Thus, the term “debt deflation.”