Émile Durkheim was a pioneering French sociologist who advanced the theory that really big ideas, what he called "social facts," have an existence of their own, separate from those who identify or popularize them. These social facts float, as it were, above society until time and circumstances are ripe for their emergence.
This is the story of very big social fact, a theory of applied economics that is poised to define how we view financial markets and their regulation for years to come. The theory was propounded in a 1986 book called Stabilizing an Unstable Economy, written by Hyman Minsky. An economist who taught at Washington University, Brown, and Harvard, Minsky developed his theory through a close analysis of the work of the great British economist JM Keynes. Minsky believed that Keynes’ insights had been distorted by the then-prevailing economic orthodoxy, and he meant to set things right. Like all great ideas, Minsky’s can be stated very simply:
"The fundamental propositions of the financial instability hypothesis are:
1. Capitalist market mechanisms cannot lead to a sustained, stable-price, full-employment equilibrium.
2. Serious business cycles are due to financial attributes that are essential to capitalism."
A core tenet of the standard theory, or "neo-classical synthesis," that held sway in 1986 was that major disruptions in a capitalist economy are caused by "evil outside forces". Minsky argued just the opposite, that "instability is an inherent and inescapable flaw of capitalism." Our economy is in a constant state of change. Banks (that is, all entities that extend credit) and borrowers (all entities that use credit) make decisions based on margins of safety that change over time with experience. Margins of safety can include interest rates charged for loans, required collateral, and other terms and conditions that protect the lender and are a cost to the borrower. In general, margins of safety decrease during periods of economic well-being and increase in bad times. In a full-fledged boom, margins of safety become extremely thin, making the subsequent bust even worse. The lax underwriting of sub-prime mortgages in 2005-07 is a perfect example of this process in action.
It is not the only recent example. The word "borrowing," as Minksy uses it, should be understood to mean not just simple loans. It extends to the alphabet soup—SIVs, CDOs, ABCP—of today’s complex financial instruments. These structured financial devices are part of the natural evolution of an economy dependent on short-term borrowing to fund long-term investment. Minsky explained that the more often short-term financing must be renewed and rolled-over, the more vulnerable it becomes to unpredictable market forces such as changes in interest rates, fluctuations in liquidity, and similar disruptions.
The thinking of Minsky and the economists of his generation was grounded in the events of the 1930s. The Great Depression was only the last and most violent in a string of slumps and panics involving widespread unemployment, business bankruptcies and
general misery since the US began industrializing in the 1830s. In its searing wake, the Federal Reserve’s powers were strengthened and Federal insurance for bank deposits was initiated. The Fed became a lender of last resort to banks that needed liquidity. The FDIC provided reassurance to the general public that their savings would be protected. By accepting securities and bank loans as collateral from banks that needed to borrow from it, the Fed in effect set a floor on the value of those assets. Similarly deposit insurance "socialized some of the private risks that exist in an economy in which borrowing and lending are important."
But, as the song goes, "every form of refuge has its price." Beginning in the 1960’s, the US economy faced a series of (now largely-forgotten) calamities that triggered Federal Reserve assistance. Each episode involved some new financial instrument—the SIVs of their day—or a financial institution that had bet heavily on that instrument. According to Minsky’s instability hypothesis, the Fed’s intervention to save the financial system from their effects had the unwanted but inevitable consequence of legitimizing them. "By validating the past use of an instrument, an implicit guarantee of its future value is extended." Once the immediate crisis passes, the markets are encouraged to take even greater risks with even more complex financial instruments. If worst comes to worst, the Fed or the Treasury or somebody w
ill step in to prevent catastrophe.
Minsky published Stabilizing an Unstable Economy in 1986. In October 1987, the stock market crashed and no evil outside force or incident has ever been identified as a cause. But, the stock market recovered all its losses within a year. Not only the US economy but economies throughout the developed world entered into a long period of low inflation and low interest rates that Ben Bernanke has called the Great Moderation. Minsky was seen as just another failed Jeremiah, prophesying a doom that never materialized. Stabilizing an Unstable Economy went out of print. In 1996, Hyman Minsky died.
The longer a volcano stays dormant, building up pressure, the bigger the blow-off when it erupts. The financial crisis sparked by the subprime mortgage meltdown and the Federal Reserve’s responses followed Minsky’s script to the letter. Stabilizing an Unstable Economy was rediscovered. The phrase "Minsky moment," used to describe the unraveling of speculative excess, entered the Wall Street lexicon.
On June 5, Jeffrey Lacker, President of the Federal Reserve Bank of Richmond gave a speech in London so steeped in Minsky’s thought, that his name wasn’t even mentioned. The social fact of the endogenous instability of the capitalist financial system has found its time.
Lacker makes a critical distinction between fundamental and non-fundamental bank runs (again, like Minsky, using "bank" in the broadest sense to include investment companies as well as commercial banks.) Non-fundamental runs are irrational panics, typified by the run on Bailey Building and Loan in It’s a Wonderful Life. The Fed has a legitimate social role in preventing non-fundamental runs through its lender-of-last-resort powers. Fundamental runs, however, occur when people have good reasons for believing that a bank or other financial intermediary will not be able to meet its obligations to them. The
Fed, per Lacker, should stand aside. "In the case of runs driven by fundamentals, government support interferes with market discipline and distorts market prices."
Lacker stops just barely short of saying that the Fed’s intervention in the sale of Bear Stearns to JP Morgan Chase was a mistake. He also indirectly criticizes the recently broadened use of the Fed’s lender-of-last-resort powers: increased lending to commercial banks, lending to investment banks for the first time, and relaxed standards of acceptable collateral. The central argument against Fed interference is that "it is likely to affect perceptions of market participants regarding future [Fed] intervention, and thus alter their incentives and future choices."
This is the problem, originally described by Minksy, that Lacker calls moral hazard. The term "moral hazard" is unfortunate in that, for non-economists, it implies qualitative or subjective forces that are somehow outside the normal boundaries of economics. Quite the contrary, moral hazard is a direct consequence of the implicit bargain that evolved out of the Depression-era reforms. Active governmental fiscal and monetary policy will protect the economy against future depressions but at the cost of increasing the inherent instability of our system of capitalism.
Are we at the point that moral hazard has been pushed too far? Will the Fed’s unprecedented intervention in the financial markets this spring serve to encourage ever more dangerous risk taking once the present crisis is over? Lacker’s conclusion is unequivocal. "If actions speak louder than words in the case of central bank credit policy…then the only way to limit expectations of future lending is to incur the risk of short-run disruptions in financial markets by disappointing expectations and by not lending as freely as before." The Fed must draw a line and stick to it, no matter the short-term pain. Otherwise, risk-taking will someday spiral out of control and any Fed action will be futile.
In August 2006 and again in September, Jeffery Lacker was the only member of the Federal Open Market Committee, the Fed’s policy arm, to vote for raising the fed funds rate to 5.50% from 5.25%. (The rate remained at 5.25% from June 2006 until September 2007, when the FOMC began the process of lowering it to its current 2.00%.) These votes marked Lacker as both someone with a strong anti-inflation bias and a strong independent streak. He is not now a voting FOMC member but will be again next year. His voice will certainly be heeded in the ongoing debate on the limits and usages of the Fed’s considerable authority. And that’s a social fact.
Notes: Quotations are from the 2008 reprintng of Stabilizing an Unstable Economy by Hyman Minsky published by McGraw Hill. Jeffery Lacker's speech can be found at www.richmondfed.org.