On a recent blogpost that I wrote there was some confusion in the comments section regarding Hyman Minsky’s theories and their relationship to the phenomenon of rising asset prices. I have seen this confusion made many times before — even by some otherwise good Post-Keynesian economists — but I think that it is time to finally clear it up once and for all.
The confusion runs something like this: “Hyman Minsky’s theory of rising asset prices is that debt drives asset prices. If we want an explanation for rising asset prices we simply look at the levels of debt in the economy. This is tied to the fact that Minsky was a proponent of Post-Keynesian endogenous money theory and this theory states that private banks create money which, if this creation process is allowed to spiral out of control, will lead to rising asset prices.”
Okay, before I go into what Minsky actually wrote in this regard I think I should make one crystal clear comment: the above argument is a monetarist argument. In Post-Keynesian endogenous money theory money = debt. So, if we say that debt is the cause of rising asset prices we are effectively saying that money is the cause of rising asset prices. That is a monetarist conception of how price levels in markets operate.
Monetarists maintain that rising prices — whether they be asset prices or the prices of goods and services — are due to increases in the money supply; and since saying that increases in the level of debt leads to rising prices is just another way of saying that increases in the level of money leads to rising prices, this is an absolutely identical argument to the monetarist one. All we have done is changed the words.
Post-Keynesian endogenous money theory never posits debt as the cause of anything. Rather it is decisions by economic agents that cause increases in the price levels of any given market. The debt that follows from these decisions is merely a residual.
We can see this clearly in the original statements of endogenous money theory. For example, in Basil Moore’s seminal paper Unpacking the Post-Keynesian Black Box: Bank Lending and the Money Supply he writes,
The behavior of the money wage rates, both as a component of companies’ demand for working capital finance and as determinants of disposable personal income, plays a central role in determining private demand for bank credit. (p555)
In that paper what Moore was describing as the ‘black box’ was the causal element that leads to increases in money lending and, hence, increases in the money supply. Through extensive empirical investigation he finds that the inflation of the 1970s was mainly caused by rising money wages.
As we can see for Moore an increase in bank lending does not truly cause anything. Rather it is the phenomenon that must be explained through reference to a causal variable. In the case of the 1970s inflation this causal variable was money wages. If Moore were to explain the inflation of the 1970s by saying that it was caused by an increase in bank lending he would be making an identical argument to the monetarists except that rather than saying that the ‘money supply’ caused rising prices he would say ‘bank credit’; but since the two things are two sides of the same coin (change in bank lending = change in money supply) he would be saying the same thing in different words.
The exact same holds true in asset markets. If Minsky had been saying that the cause of rising asset prices was changes in bank credit he may as well have been saying that the cause of rising asset prices was changes in the money supply. The arguments are the same; only the words are different.
Okay, so all that said, what was Minsky’s argument? How did he explain rising asset prices? Well, he deals with this in a section of his book Stabilizing an Unstable Economy entitled ‘Quasi-Rents and Capital Asset Prices’. This section can be found on pages 200-205 in that book. In this section he argues that capital asset prices are dependent on (that is, caused by) two things: expected cash-flows and perceived liquidity. Minsky writes,
In a world with a wide variety of financial markets and in which capital assets can be sold piecemeal or as collected in firms, all financial and capital assets have two cash-flow attributes. One is the money that will accrue as the contract is fulfilled or as the capital asset is used in production; the second is the cash that can be received if the asset is sold or pledged. The ability of an asset to yield cash when needed and with slight variation in the amount is called its liquidity.
The price, PK , of any capital asset depends upon the cash flows that ownership is expected to yield and the liquidity embodied in the asset. The cash flows a capital asset will yield depend upon the state of a market and the economy, while the liquidity embodied in an asset depends upon the ease and the assuredness with which it can be transformed into money. The price of a financial asset such as a bond or even a savings account depends upon the same considerations as the price of a capital asset: the cash flow and the breadth, depth, and resilience of the market in which it can be negotiated. (p202)
Note that nowhere does Minsky mention debt is discussing how asset prices are determined. It is true that when assets are purchased debt is often incurred but this is only a residual of a decision taken by investors with respect to expected cash-flows and perceived liquidity**. Debt is not the explanatory or causal variable in Minsky’s theories of asset prices. And that is because Minsky is not a monetarist but rather a Keynesian.
Minsky’s theory, as he always insisted, built on Keynes’ theory of financial markets as laid out in the General Theory and the Treatise on Money. For Keynes too it was these two variables that caused asset prices to rise or fall. The money that was used to purchase them — whether debt financed or not — was a residual; an important residual, as Ponzi debts might lead to asset price deflations, but still a residual. In these theories debt does not cause anything any more than money causes anything — indeed, the two entities are actually two sides of the same coin.
** Note that with a given state of expected cash-flows and perceived liquidity the rate of interest (which is chosen by how much reserve cash the central bank wishes to release to the banking system) will determine the price of assets. But in Minsky’s theories, as in Keynes’, we cannot expect a static state of expectations and thus the rate of interest will be of secondary importance to the determination of asset prices; the key driver is, as in Keynes, the animal spirits of investors or the state of confidence.
The wage increases of the 70s were largely the result of cost-of-living increases. This means that wages were increased to offset increases in prices that had already occurred. Prices forced wages; not vice versa. Inflation happened, wages followed.
“The wage increases of the 70s were largely the result of cost-of-living increases.”
And the cost of living increases seem to me to be largely the result of trying to allow price to remove demand for inelastic goods and services – particularly imported ones.
Ultimately domestic financial policy has no effect on the demand for the same goods in Bejing.
When you’re confronted with a standard of living decrease, you need to use a more direct mechanism – such as rationing – to distribute the loss.
First off, I’m very much in agreement in not liking the way money is dragged into the analysis of what causes asset price rises. This has been my main complaint about Steve Keen’s approach – that it’s fundamentally just old school monetarism.
However, a couple of points.
I would not equate debt and money, simply because money is generally understood as liabilities of banks, but debt is wider than assets of banks. For sure, bank lending is a very important chunk of it, but to then ignore the rest would be a mistake.
Cause and effect can be tricky concepts, but it is worth noting that changes in debt levels can follow from developments on either side. So it is true that a rise in debt may just be a consequence of an increased desire to borrow due to a change in expected returns on investments. However, we may also see cases where there is an increased appetite to lend following perhaps from financial innovation reducing regulatory capital cost. That development may lead to reduced interest rates or maybe to looser credit criteria.
There is therefore a plausible story whereby financial innovation leads to credit being provided to borrowers who were previously credit constrained, thereby increasing effective demand for assets. This may not be Minsky’s story but it is a post-Keynesian story. Money should not figure in this, because the debt does not need to come from a bank, so it does not depend on an increase in the money supply.
Agreed on the debt. I was just simplifying to make the point that saying debt “drives” things is the same anthropomorphic argument as saying that money “drives” things.
Yes, lower interest rates can have an effect. See the note at the end of the post. In Minsky’s theories, if we assume expectations fixed then lending will depend on the interest rate. But this is a secondary component. As JK Galbraith pointed out long ago: there are many historical instances where there are low interest rates and no asset bubbles; it is expectations etc. that are key in understanding asset prices.
Financial innovation is just a method to lower interest rates. So you can count financial innovation in that aspect.
“Financial innovation is just a method to lower interest rates.”
And increase quantities.
The expectations we have at the moment are based on the belief that banks are largely unlimited in capacity at whatever the interest rate is.
In other words that the haircut level on collateral and the purpose of the loan are largely irrelevant.
If you have a decollateralised narrow banking system that is required to police purpose correctly (say by being ‘in the bank’ and therefore at real risk of having its licence withdrawn if it is found funding financial speculation) then you have a different structure.
Arguably you could say you just have a different shaped interest rate curve – but it’ll be more square shaped than it is now.
“And increase quantities.”
I’d agree with this.
Both before and after the crisis, many banks were operating under capital constraints. In theory, it’s all just a question of price, but in practice you can’t get just get in more capital like turning on a tap, so being able to cut regulatory capital requirements effectively boosted lending capacity.
“In theory, it’s all just a question of price, but in practice you can’t get just get in more capital like turning on a tap”
It is a question of price, but that price can be very high to infinite due to lack of liquidity in that market.
Ultimately, in the current system, banks get capital by convincing people holding the deposits the bank creates to swap them for bank bonds that pay more income.
In normal times that works fine, but if there is a leverage wobble the market can dry up very quickly.
So in normal times capital doesn’t really constrain a bank at all other than to put the price of loans up a bit, but causes a liquidity crunch if things get rocky.
A very silly control system when you have the option of just making all the deposits belong to the central bank – which is also the regulator. That way loans made are controlled properly during normal times, and during a crunch nothing much changes.
Largely agree, but I was thinking more of the Tier 1 constraint which is basically common equity. So obviously you need to persuade people to switch out of deposits, but doing a common stock issue is a big deal – it’s not like issuing bonds. As much as anything else, it makes a statement that the bank may not wish to make. So, I think the price has to move significantly to trigger that step. Until it does, the bank works with the Tier 1 it has, which effectively provides a capacity constraint.
Preferred shares and non-controlling interests are included in the Tier 1 Capital Ratio – along with bank ‘retained earnings’.
All of which are very easy to manipulate – that old ‘financial innovation’ again.
Even common stock is easy to issue if you know how. For example just pay your executives and traders using very large share option packages…
Which would point again to financial innovation as a way of addressing the capacity constraint, leading to a quantity response, which is a point I think we agree on.