“Most of what we have been doing in macro for the past 30 years has been spectacularly useless,” pronounced The Professor in his third and final lecture at the LSE last night, entitled: “The Night they Reread Minsky.” “If you’ve got a model where everyone is rational it would be hard to get the abrupt collapse of the world financial system,” he admitted.
Economics, everyone but economists knows, is bunk. The dominant neoclassical synthesis begins with absurd axioms (we are utterly rational, all knowing of past, present, and future, obsessively utility maximising) and from that derives a vision of the world that naturally has little to do with the one you and I make our livings in every day. Glory—and tenure—no longer goes to the economist who best explains the actual workings of our economy but rather to the one who derives the most elegant mathematical models from those inaccurate axioms. No wonder economists missed the plot.
Not all economists. Hyman Minsky never won a Nobel prize, didn’t teach at Princeton, wasn’t a big name in the profession. He was a bit of a cult figure (if Krugman is Springsteen, then Minsky is Iggy Pop) but when he died 13 years ago, few outside the post-Keynesian subculture knew his name. No more. Now he is quoted everywhere from Financial Times columns to Goldman Sachs reports to the “Talk of the Town” section of the New Yorker. The reason: even though he is dead, he, more than anyone, predicted our financial disaster.
Minsky was a devout Keynesian, convinced that most other economists who considered themselves Keynesians were heretics bowdlerising the great man’s thought. For Minsky, Keynes’s key insight was the role of uncertainty. Unlike neoclassical agents who are all knowing as well as rational, Minsky’s men have no clue what the price of copper will be in five years. Uncertainty about the profitability of investment allows a role for emotion, for irrational exuberance, and makes booms and busts inevitable. In the mathematised world of rational agents that has dominated academic economics, business cycles can only be created outside the system, through technological change. For Minsky, they are endogenous, the instability of capitalism built into its very nature.
In good times, Minsky’s men are optimistic: invest more, borrow more, because, during a boom, bankers are also optimistic and it is easy to get more credit. If your cash flow is insufficient to meet interest payment that come due, no worries, just add the interest to your existing debt. The bank is happy to increase its assets, you are happy to have more cash at hand. Minsky calls this a Ponzi financial structure, in which further borrowing is required just to pay interest on existing loans. He says that during a boom, over-leverage is inevitable, causing borrowers and bankers to drift to ever more precarious financial structures.
The “Minsky moment” (a term not invented by Minsky) is when fear finally trumps greed. At a certain point in any financial crisis, previously sanguine investors look around, smell the air, check their balance sheets and decide maybe the good times could be coming to an end. A few months before, they were desperate to buy the tulip, the share in the Mississippi Corporation, the CDO-backed by subprime mortgages. Now, they would rather have gold, or its modern equivalent: short-term US treasuries. The stampede out of now toxic securities dries up liquidity, which makes the cattle—I mean bankers—ever more frightened, and in turn making the stampede ever more furious.
Our Minsky moment was 9th August 2007. Liquidity disappeared, deleveraging began, and Northern Rock quickly went bust.
A personal note. A few months before, in April 2007, I wanted to change jobs, from war photographer to hedge fund analyst. As this is not the most traditional of career transformations, I was pleased when a colleague in Baghdad told me her father was CEO of a major investment bank. I inveigled his email address and wrote him a long letter exaggerating my accomplishments. He kindly wrote back, told me that my chances of getting a job in finance were less likely than my climbing Mount Everest but nonetheless we fell into an epistolary relationship, discussing the state of world economy. Eventually I asked him the big question: could declining US real estate prices cause systemic risk to the financial system? He scoffed at the notion, noted “the spreading of risk through instruments such as securitisation and the greater sophistication of central bank governers” ensured the financial system was sound.
Why was he, along with most of his colleagues so wrong? They had imbibed the economic orthodoxy that markets were efficient, that the market, second by second, was rational, always right. I had read Minsky, they had not. The silver lining of this financial debacle may be that economics will return to its roots, to its traditional goal of understanding the ordinary business of how humans make a living—instead of acting as a mathematised branch of free-market theology.