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

1. Lecture 4A 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, A perspective on Minsky moments: Revisiting the Core of the Financial Instability Hypothesis, in Review of Political Economy, vol.23(1), 2011, pp.49-67. 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 of Minsky moment based on a simple model of financial fluctuations that restates the core of the Financial Instability Hypothesis in the 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. 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

5. 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, etc.)

6. 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

7. 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 Revisitation of the FIH { updated and somewhat developed I intend to argue that the moment of Minsky should not be confined to Minsky moments

8. 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

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

10. Instrumental use of Minsky Reference to Minsky moments and meltdown as the only possible theoretical endorsement for a policy in contradiction with 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; in any case priority to full employment

11. 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

12. Why regularism is flawed • 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)

16. 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, 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

17. 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

18. 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»

19. 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 The eccentric chicken saved himself because he had a more general point of view than “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

20. 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 standard 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

21. 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

22. 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

23. Distinction speculative/Ponzi a) Different time profile of net inflows (n is the time horizon): 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 (big) for: t = n Ponzi { mt* > 0 b) different gravity and urgency of liquidity problems: -speculative can repay maturing interests but not the principal in some t -Ponzi cannot repay even the maturing interest in all t but the last one

24. 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 s small and surplus >>

25. A further category: distressed units We should consider a further category of financial units: units in financial distress Distressed unitsvirtually insolvent: net worth mt* 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 definitionvirtually 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)

26. 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

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

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

29. 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 do not want to breach to avoid unnecessary risk The main margin of safety is the 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 expressed as a desired min distance from 1:1- μ → I can represent the dynamic space of the financial conditions of each financial unit in the following diagram

30. 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*

31. 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

32. 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

33. 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

34. 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

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

36. 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?

37. 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

38. 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 This policy strategy succeeded until 2007

39. 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

40. 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

41. Policy implications Mainstream view on Minsky meltdown before the crisis: impossible event black swan:unpredictable event (“once in a century”) two viewpoints { grey swan:recurrent event (phase of a recurrent cycle)

42. The black swan view

43. Black swan view black swan view:you cannot prevent it: “act of god” → only ex post therapy -ex ante: max. returns: probability too low to be considered in the usual ex ante rational calculations Rationality { -ex post:rationality of survival: different from max returns/min loss In this view the main preventive measure: ↑ buffer stocks: liquid reserves -however, only for shocks ≤ ε to absorb exogenous unpredictable shocks { -ignores intrinsic determinants: periodic increase of financial fragility

44. Liquid reserves This criticism may be clarified through the above model ↑Δ liquid reservesof financial units: shifts the solvency line to the right typically a small percentage θof unit’s net worth (no more than 10-20%): A higher requirement may play a significant role when the lack of liquidity is short-lived and not particularly serious; however: -cannot be increased too much without jeopardizing the ROE of FIs -rapidly depleted when the unit breaches the solvency line: consistent liquid reserves can be burned out within a few days -the desired margin of safety would shift with liquid reserves so that financial fragility risk would remain unaffected (sort of ‘Lucas critique’ applied to liquidity requirements)

45. Liquidity reserves constraint kt 1+λ 1 ω ω’ 1-μt’+ θ k*t 1-μt 1-μt’ 1 1+θ

46. The grey swan view

47. The grey swan view Grey swan view: this approach shifts the attention towards systematic and continuous prevention → cap to financial fragility such that shocks cannot trigger a meltdown → cyclical policy framework: -Counter-cyclical policies (abandoned with Keynesianism in the early 1980s) to be revived with the necessary cautions liquidity constraints -Ceiling to the financial cycle { leverage constraints

48. Liquidity constraint (flows) liquidity constraint, i.e. a cap λto the maximum value of the imbalance between outflows and inflows the financial deficit ratio Dit of the unit i at time t may be defined by ( 14 ) The constraint kit≤1 +λ (→ Dit ≤λ ) translates in graphic terms in a horizontal line above the liquidity line and sufficiently close to it this constraint may be quite powerful: bounds the upward fluctuations constraining the increase of financial fragility → it can greatly mitigate the Minsky processes avoiding Minsky meltdowns

49. Leverage constraint Let’s assume that the unit i trespasses the liquidity line at time τ and that finances deficits by borrowing. The stock of debt Hit, of the financial unit i at time t, for t > τ is thus given by ( 15 ) t > τ, h > τ. the additional debt increases continuously in fields 2 and 3 → a leverage cap would have effects similar to those of an illiquidity cap A compulsory requirement of liquid reserves is insufficient, a compulsory cap on liquidity imbalances, and/or on the admissible maximum leverage, look much more decisive: capital requirements are less efficacious because buffer stocks are typically used too late when they are easily depleted

50. Liquidity reserves constraint and leverage constraint kt 2 3 1+λ 1 ω ω’ 1 4 k*t 1-μt 1-μt’ 1