ISSN 2330-717X

Does Capitalism Itself Create Economic Instability Or Is Central Banking The Culprit? – Analysis

By

By Frank Shostak*

Advertisement

Instability in financial markets has brought back the ideas of post-Keynesian school of economics (PK) economist Hyman Minsky. Minsky held that the capitalist economy inherently is unstable, culminating in severe economic crisis, accumulation of debt being the key mechanism pushing the economy toward a crisis.

During “good” times, according to Minsky, businesses in profitable areas of the economy are well rewarded for raising their level of debt. The more one borrows the more profit one seems to be making. The rising profit attracts other entrepreneurs to join in and encourages them to raise their level of debt.

Since the economy is doing well, and borrowers financial health shows a visible improvement this makes lenders more eager to lend. Over time, however, the pace of debt accumulation starts to rise much faster than borrower’s ability to repay and serve the debt. At this stage, the foundation for an economic bust is set in motion.

Minsky distinguishes between three types of borrowers. The first type he labels hedge borrowers that can meet all debt payments from cash flows. The second type are speculative borrowers who can only meet interest payments but must constantly roll over their debt to be able to repay their original loans.

The third group of borrowers Minsky labels as Ponzi borrowers that cannot repay neither the interest nor the original loan. These borrowers rely on the appreciation of the value of their assets to refinance their debt.

Advertisement

This framework comprises what Minsky calls the financial instability hypothesis (FIH). According to the FIH, financial structure of a capitalist economy becomes more and more fragile during the period of prosperity. The longer the prosperity the more fragile the system becomes. According to Minsky:

In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance.

Another aspect of the FIH is that during good times, banks and other intermediaries by means of sophisticated innovations try to lure investors to buy the debt. Minsky labelled them as “merchants of debts.” The chase for profits causes investors in financial markets to place their money in various investments with little substance.

However, once economic conditions change the true state for borrowers, a crisis begins. Lenders curtail their supply of funds and borrowers are pushed to bankruptcy for they cannot renew their borrowing to pay debts—a financial crisis emerges.

According to Minsky, as time goes by both borrowers and lenders tend to become reckless, leading to a financial crisis. However, why should it be this way?

Does the Expansion of Credit Lead to Instability?

Note that loaned savings are the key for economic expansion, as they fund the production of tools and machinery, which then permits the expansion of final goods. This increase, in turn, permits a further increase in savings that then can now support the buildup of a more sophisticated production structure.

The introduction of money does not alter the situation. Through money, individuals can channel savings, permitting the widening of the wealth generation process. Whenever an individual lends money, the borrower via money can secure final consumer goods that will support him while he is engaged in the production of various goods and services.

The expansion of credit because of the increase in savings is good for the economy. Such credit, which is fully backed by savings, is the agent of economic growth. Note that the expansion of fully backed credit does not result in natural tendencies, as suggested by Minsky, for the good times to be a precursor for bad times. Contrary to Minsky, the accumulation of capital makes the economy more robust and less vulnerable.

Unbacked Credit and Economic Instability

Trouble erupts, however, when savings do not back up lending. The borrower holding the empty money, so to speak, exchanges it for final consumer goods, taking from the pool of savings without any additional savings have taken place, all other things being equal. The genuine wealth producers who have contributed to the pool of final consumer goods—the pool of saving—will discover that the money in their possession will get them a smaller number of final goods.

The reason for that is that borrowers have consumed some of the final goods. There is a diversion of wealth (final consumer goods) from wealth generating activities toward the holders of money, which emerged out of “thin air.”

As the pace of unbacked credit expands relative to the supply of savings, less becomes available to genuine wealth generators. Consequently, with less savings less wealth can be now generated. In the extreme case if everybody were to just consume without contributing to the pool of saving, eventually there would be nothing left to consume.

Free market economy and unbacked credit expansion

In a free market economy, intermediaries such as banks will have difficulty expanding unbacked credit, since banks would likely to encounter difficulties to honor their checks because of lending unbacked by savings. The threat of bankruptcy would likely deter banks from pursuing the expansion of unbacked credit.

Hence, there is no inherent tendency in the capitalist economy to generate unbacked credit that will destabilize the economy. In the modern capitalist economy, what enables banks to engage in the reckless expansion of credit that makes the capitalist system unstable is the existence of the central bank.

Using monetary expansion policies, the central bank makes it possible for banks to expand unbacked credit. Thus, if Bank A is short of $50, it can sell some of its assets to the central bank for cash, thus preventing the Bank A being “caught.” Bank A can also secure the $50 by borrowing them from the central bank. Where does the central bank get the money? It generates it from “thin air.”

The modern banking system can be seen as one huge monopoly bank which is guided and coordinated by the central bank. Banks in this framework can be regarded as the branches of the central bank. By means of monetary injections, the central bank makes sure that the banking system is “liquid enough” so banks will not bankrupt each other.

While the Minsky framework describes the present financial market volatility, it doesn’t provide a satisfactory explanation based on previously established and identified phenomena. Hence, Minsky describes but does not explain. It arbitrarily places the blame for instability on the capitalistic economy without establishing verification for this claim.

Contrary to Minsky, we conclude that there is nothing wrong with capitalism. To avoid the menace of boom-bust cycles, the loopholes responsible for the creation of money out of “thin air” must be closed.

Not so, argue Minsky and post-Keynesians. On the contrary, they hold that any attempt to revert to a proper free market laissez-faire economy is a prescription for economic disaster.

This response is not surprising, since Minsky accepted beforehand that capitalism is unstable and hence never questioned his premise. For Minsky, the only way to fix the supposedly unstable capitalism is through larger dosages of government and central bank interference with the economy.

Contrary to post-Keynesians and Minsky, the existence of the central bank makes the present capitalistic framework unstable. In addition, it is not the expansion of credit as such that leads to instability but the expansion of credit out of “thin air.”

Conclusion

It is through unbacked credit that savings are diverted from productive activities to nonproductive activities, which then weakens the process of wealth expansion. The instability that Minsky has identified has nothing to do with capitalism but rather with the central bank that prevents the efficient functioning of capitalism.

*About the author: Frank Shostak‘s consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.

Source: This article was published by the MISES Institute

MISES

The Mises Institute, founded in 1982, teaches the scholarship of Austrian economics, freedom, and peace. The liberal intellectual tradition of Ludwig von Mises (1881-1973) and Murray N. Rothbard (1926-1995) guides us. Accordingly, the Mises Institute seeks a profound and radical shift in the intellectual climate: away from statism and toward a private property order. The Mises Institute encourages critical historical research, and stands against political correctness.

Leave a Reply

Your email address will not be published.