Carbon, Tradable permits and Pigouvian Taxes.

The Stern Review of the Economics of Climate change has identified greenhouse gas emissions as the greatest market failure in history. Carbon dioxide (CO2) emissions are a leading cause of climate change and have been targeted by government and non-governmental organizations as an area of grave policy concern. Policy proposals to ameliorate CO2 emissions have centred around two broadly based methods: “ economic instruments” and “command and control regulations”. The adoption of economic instruments to regulate the problem of CO2 emissions can entail either the introduction of market mechanisms to price emissions and allocate the right to emit limited quantities of CO2, or price-based instruments such as tax regimes and subsidies. Command and control regulations are policies that involve direct government interventions into the forms of practices surrounding CO2 Emissions, from technological standards to performance targets. The mainstream economics literature on policy instruments has largely been couched in terms of economic efficiency according to marginalist principles. Ecological economics developed in opposition to the neoclassical approach and prioritizing the needs of the ecological system above short-run economic efficiencies. The environmental economics case for an emission trading system and carbon permits face two broad stumbling blocks. Firstly, from within neoclassical economics there is the case for command and control regulation or a hybrid policy that combines such regulation with economic instruments and secondly, theories developed outside of the neoclassical paradigm question its validity with regards to ecological sustainability.

In environmental economics, the problem of externalities and the issue of carbon emissions are often approached from two divergent perspectives influenced respectively by the work of Arthur Pigou and Roland Coase. Both advocated the use of economic instruments to reconcile social and private goods and overcome market failure. However, the tradition stemming from the work of Pigou heavily favoured price-based instruments (i.e. taxes) and the tradition that derives from the work of Coase favoured quantity-based instruments (i.e. tradeable permits). The relative merits of price and quantity based instruments have been a central nexus of environmental policy debates within neoclassical informed discourse. Prior to the work of Coase, Pigou’s position taken in The Economics of Welfare generally informed the discussion of environmental externalities.

Pigou’s approach to internalizing environmental externalities was by the imposition of a tax equal to the marginal social cost of the externality. The standard example of this, according to Coase, was of a factory emitting smoke that affected nearby residences. From the principle of polluter pay, central to Pigouvian taxes, the solution is to make the factory liable for the damages. However, from the perspective employed by Coase, this is not necessarily the most economically efficient solution to the problem of environmental externalities. The clear delineation between offender and victim that is exemplified in the polluter pay principle is therefore not unproblematic in Coase’s treatment of externalities. He argued that the problem was essentially reciprocal in nature. From Coase’s viewpoint, the above factory example is not merely a matter of the factories effect on the residences, but also the effect of the residences on the factory. Economic activity is often associated with positive and negative externalities; pollution from the Coasean perspective implies both utility and disutility. Therefore, with regards to externalities, the economic problem as conceived by neoclassical economics still applies: “how to maximise the value of production?” Coase’s proposed solution to the problem of externalities and imbalances between marginal costs and marginal benefits caused by such market failures is to introduce tradeable property rights to price and allocate resources efficiently. Emissions trading schemes are informed by the logic of Coase’s argument for tradable property rights and an economically efficient method to internalize environmental externalities.

The selection between quantity based and price based instruments to deal with environmental externalities is often defined by the nature of the externality. The cost associated with abetment and the social costs associated with the continued market failure at different levels of production have to be taken into account. Moreover, uncertainties with regards to the underlying scope of the externalities and information asymmetries within the market place and governmental bodies influence the policy instruments selected. Martin Weitzman’s work on the relative merit of price and quantity based instrument influenced the Stern Review on merit of adopting quantity based instrument such as emissions trading scheme to abate global climate change. Weitzman had concluded that price based instruments are beneficial when the price of mitigation is more pertinent than quantity of pollution. Conversely, when the cost of increased pollution levels outweigh the relative cost of abetment quantity based-instruments are preferable. The prospect of global climate change caused by the proliferation of greenhouse gasses and the resultant greenhouse effect renders the level of emissions crucial. Increased levels of CO2 emissions could lead to tipping points and feedback loops that could drastically increase global temperatures that would adversely impact numerous ecosystems. Consequently, given the cost of increasing emissions, quantity based instruments have been recommended to mitigate the market failure of CO2 emissions and other greenhouse gasses.

The economic arguments rendered by Coase and Weitzman in favour of quantity based instruments to that of Pigouian taxes are augmented by a theory of government failure. F.A. Hayek argued for the superiority of the market in conditions of imperfect information. When conditions of imperfect completion prevail, the determination of economic organization rests upon the ability to efficiently utilize information. From Hayek’s perspective, the implementation of Pigouvian taxes would require that governments have information of the individual production functions of firms. Whereas, by employing quantity based instruments, governments can set the level of desired outputs and allow the firms to find the most cost-efficient method of production. The economic rationale for the adoption of quantity based instrument, such as the tradable carbon emissions permit, is that they theoretically provide the most cost effective and least uncertain method of internalizing environmental externalities.

Tradable permit schemes have been successfully adopted to deal with negative environmental externalities in the past. In 1990, the United States’ legislature passed amendments to the clean air bill which established an emissions trading scheme for the emission of sulphur that had lead to widespread acid rain in the 1980s. The stated goal of the scheme was to reduce sulphur emission by 10 million tons annually through the gradual reduction of permit allowances. Before the introduction of the program, prices per allowance were predicted at $300 per permit, the actual average cost early in the program was $100 per allowance. This is evidence that the cost of emissions reduction was miscalculated by planner and that individual firms found a more cost efficient method to reduce emissions given the prospect of having to purchase permits. However, the problem of sulphur emissions and the issue of global climate change differ considerably in scope.

In mainstream environmental economics, the argument advanced either for quantity and price based instruments is crouched in the logic of the marginal principle and partial-equilibrium analysis. This is both a policy benefit and pitfall. Unlike local externalities, such as the smoke from a factory irritating local residences, carbon emissions and the prospect of global climate change affect the entire economy and ecological systems. Both Coase and Pigou’s analysis of the problem of social and private goods are subject to this weakness of scope. However, carbon permits could provide the intermediate means to signal the need to transform the economy to a low-carbon state. The economic case for carbon emission provides a rationale that preferences economic efficiency above that of ecological sustainability. Intuitively, there should be no divergence between these two goals, however, the problem of uncertainty remain whatever policy measures are adopted to address the issue of climate change and carbon emissions.

Written by Mathew Toll.

Bibliography.

Coase, R.H. (1960), “The Problem of Social Cost”, The Journal of Law and Economics, Vol. 3, pp. 1-44.

Harris, Jonathan M. (2006), Environmental and Natural Resource Economics: A Contemporary Approach, Boston; Houghtoni Mifflin Co.

Helm, Dieter. (2005), “Economic Instruments and Environmental Policy”, The Economic and Social Review, Vol. 36, No. 3, pp. 205-228

Hepburn , Cameron. (2006), “Regulation by Prices, Quantities, or Both: A Review of Instrument Choice”, Oxford Review of Economics Policy, Vol 22, No. 2, p. 226-247.

Koldstad, Charles D. (1999), Environmental Economics, New York; Oxford University press.

Mckibbin, Warwick J. and Wilcoxen, Peter J., “The Role of Economics in Climate change Policy”, The Journal of Economic Perspectives, Vol. 16, No. 2, pp. 107-129.

Stern, Nicholas. (2006), Stern Review of the Economics of Climate change, Cambridge; Cambridge University press.

La Dolce Vita

Marx and Keynes: The Problems of Unemployment and Crisis.

Marx's analysis of capital was an attempt to uncover the fundamental laws of motion that govern the capitalist mode of production. Marx differed from many of his contemporaries in that he conceived of capitalism as necessarily dynamic and incapable of homeostasis . This resulted from a complex array of factors, the ultimate source of which is the need to produce surplus-value. Marx claimed this amounted to the “absolute law’ of capitalist production. However, the expansionary impetus of capital is not a smooth linear process of growth and the accumulation of capital is subject to recurrent interruptions and crises. Marx argued that this tendency toward crisis arises from the competition between capitalists and the success of prior accumulation. In apparent contradiction to Marx, Keynes formulated a theory of effective demand that explained economic fluctuations and downturns in terms of insufficient aggregate demand. For Keynes, the causal factor that leads to below capacity economic activity and involuntary unemployment are low entrepreneurial expectations and inducement to invest that result in ineffective demand. Thus, while capitalism has no innate tendency toward an equilibrium of full employment it is not incompatible with the system either. In contrast, Marx held that capitalism required unemployment and underemployment to moderate the demands of labour upon capital. Marx and Keynes, despite some substantive difference of opinion, are not polar opposites in their respective conceptions of capitalism. Differences in political philosophy and technical vocabulary belie many common elements of economic analysis.

In many respects, Marx’s theory of growth was a re-working of earlier models developed by François Quesnay, Adam Smith and David Ricardo. As stated above, the concept of surplus-value is of central importance to Marx’s theory of capital accumulation. The centrality of this notion has given rise to much controversy. However, Paolo Sylos Labini has argued that much of this criticism is confused and can be dispensed with, if it is remembered that the concept of surplus-value largely coincides with the concept of net income developed in the works of Quesnay, Smith and Ricardo and its explanatory power does not require acceptance of the labour theory of value . Labini did note differences; for Quesnay net income consisted of ground rents, whilst for Marx, Smith and Ricardo net income (or surplus-value) is constituted in rent, profit and interest . Marx differed from Smith and Ricardo in that he placed considerable importance upon the expansion of “constant capital” (machines and raw materials that comprise the means of production) and not just “variable capital” (the wage-fund that sustains labour-power) and rent. Marx employed two schemes of reproduction to illustrate the dynamics of economic activity and the nature of surplus-value, constant and veritable capital.

The first of Marx’s schemes of reproduction, simple reproduction, is largely a heuristic tool that models a stationary capitalist economy in which there is no growth. Simple reproduction, heavily influenced by Quesnay’s economic table, helps to define the necessary conditions of economic reproduction. Simple reproduction demonstrates two straightforward ideas: 1) the process of production must also be one of reproduction, and 2) this circular process reproduces the relations of production. The direct implication of simple reproduction is that to maintain economic viability the constituent elements that comprise the process of production must be recreated anew in each cycle of production. Thus, both the constant capital and variable capital required for the next cycle of production must be produced in the last. Marx’s scheme of simple reproduction is often illustrated by sector models. Luigi Pasinetti provides a three-sector model of Marx’s scheme of simple reproduction that contains; 1) a capital goods sector, 2) a wage goods sector and 3) a luxury goods sector. The capital goods sector produces constant capital (C), the wage good sector produces variable capital (V) and the luxury goods sector provides an outlet for surplus-value (S). It follows that in order for simple reproduction to occur, the value of C produced in the first sector must equal the constant capital requirements of all sectors. Similarly, the value of V produced in the wage goods sector must equal the variable capital needs of all sectors. And finally, the value of S extracted from all sectors must be consumed within the luxury goods industry. The assumption that all surplus-value appropriated by the owners of the means of production is consumed in the form of luxury goods is the crucial distinction between simple and expanded reproduction. From the perspective of Marx, his scheme of simple reproduction is an abstraction and leaves aside the issue of accumulation of capital . However, this model demonstrates the circular nature of production that is itself reproduction of its constituent elements. Moreover, the scheme highlights the interrelated nature of production and consumption.

Importantly, simple reproduction can only be maintained when the values that comprise production (C, V and S) are recreated in proportionate quantities. If say, the quantity of C produced in the first sector vastly exceeds the needs of all sectors then the price of C will not reflect the value imbued in the commodities of the sector. Disproportionality between sectors of the economy can result in a form of “realization crisis” if the imbalance is significant enough and within a crucial sector of the economy. Realization crises are defined by the quantitative gap between consumption and production that end in the inability to sell commodities at their value within the market. Crises that stem from a disproportionality between the sectors are only one form of realization crisis. Paul M. Sweezy argued persuasively that disproportionality crises are of secondary importance when compared with realization crises that result from the “underconsumption of the masses”. Marx’s called this lacuna between the consumptive and productive powers of the capitalist mode of production its “fundamental contradiction”. Moreover, Marx argued that: “the conditions of direct exploitation and those of the realization of surplus value are not identical” . In Marxian terms, the rate of surplus-value is determined by the ratio of value embodied in commodities and the replacement costs of production . From this it follows that, the aggregate wages of workers is exceeded by the aggregate cost of commodities. This results in a precarious situation in which the drive for increased surplus-value on behalf of capital can undermine its ability to realize this surplus value in the market.

Similarly, Keynes, in his outline of the theory of effective demand, argued that increased wealth can also increase the gap between the possible production of a society and its actual production. Deficient aggregate demand and the resultant involuntary unemployment form the core of what Keynes called the “paradox of poverty in the mist of plenty”. Like Marx, Keynes had theorized that entrepreneurs (that is, capitalists) are motivated by the desire for profits. Employment of workers is only rational from this premise if the benefits derived from employment exceed the costs of said employment. Expectations of profits are therefore the key determinate in what Keynes called the “inducement to invest”. If aggregate demand, determined in any given society by their propensity to consume and the rate of new investment, is insufficient to achieve effective demand then unemployment and sub-optimal levels of economic activity will ensue. The problem arose, Keynes felt, that the wealthier a given community becomes the harder it is to sustain adequate levels of aggregate demand. This resulted from the inability to of the community to absorb commodities beyond their propensity to consume, that Keynes claimed increased with income, but not by the same proportion. Therefore, new investment has to fill the gap between the community’s propensity to consume and effective demand. However, there is no inherent law that inducement to invest increase in proportion to the existing level of wealth in a society. Marx differed from Keynes, in that; the ability of the community divided between classes to absorb surplus-production was not limited a given propensity to consume, but was derived from its inability to acquire commodities given the narrow basis of their consumptive power relative to productive power.

The contradiction between the consumptive power and productive power of the capitalist mode of production is the result of the drive for surplus-value and capital accumulation. Importantly, the process of capital accumulation does not necessarily reproduce each variable of production in exact proportions. The accumulation of capital, at fist expands quantitatively without qualitative change. This affects the demand for labour-power and therefore increases the bargaining power of workers. Given that profit is defined by an inverse relation to the wage rate, when the latter reaches a point where it threatens the rate of accumulation capitalist introduce technical innovation that displaces labour and relives downward pressure upon profits . Marx’s noted the effect of war demands and legal reductions of the absolute rate of surplus value on the agricultural industries between 1849 1859. At first, it seemed that the agricultural workers had made considerable gains given the shifted nature of supply and demand. However, this quickly gave agricultural capitalist the incentive to revolutionize the means of production. Unemployment, in the form of a reserve labour of army, is a necessary mechanism for the accumulation of capital. However, this moderation of the wage rate functions both ways. Michel Kalecki argued a decline in real wages and therefore consumption can undermine wage-good industries and therefore cause decreased output it not counteracted with increased capitalist consumption or investment for which he saw no necessary reason to assume.

Marx’s conception of capitalism was developed in dialogue with classical political economy that he simultaneously attempted to overcome and absorb. His focus, like much of political economy, was on the phenomenon of economic development and capital accumulation. The circulation of capital and the resultant accumulation of capital is a dynamic process that requires the production of surplus-value above that required to sustain the economic process of production and reproduction. However, this dynamism is subject to contradictions between the productive capacity of capital and the consumptive capacity of labour. As Keynes noted, the gap between the community’s propensity to consume and production becomes increasingly problematic as economic development continues. This derives more so from the inability to the proletariat to consume the products of capitalist production given the extraction of surplus value. In the process of accumulation of capital, whenever demand for labour outstrips that of supply, the wages of labour will increase and can affect the rate of profit. Incentive to introduce labour-displacing technologies then increase and the reserve labour of army is reestablished to adequate levels. As Kalecki noted, decreases in the real wage can also affect the ability of capital to realize their profit and undercut the process of capital accumulation. That is to say, from the perspective of capital, optimal wages are consistent with Aristotle’s ethical aphorism: a mean between two extremes.

Written by Mathew Toll.

Bibliography.

Kalecki, Michal. (1966), Studies in The Theory of Business Cycles, London; Basil Blackwell.

Keynes, John Maynard. (1937), “The General Theory of Employment”, The Quarterly Journal of Economics, Vol 51, No. 2, pp 209-223.

Keynes, John Maynard. (1951), The General Theory of Employment Interest and Money, New York; Harcourt, Brace and world.

Labini, Paolo Sylos. (1984), The Forces of Economic Growth and Decline, Cambridge; MIT Press.

Marx, Karl. (1986), Capital: A Critique of Political Economy, Vol 1, Trans Samuel Moore and Edward Aveling, Edited Frederick Engels, Moscow; Progress Publishers.

Pasinetti, Luigui. (1977), Lectures on the Theory of Production, New York; Columbia University Press.

Schumpeter, Joseph A., (1950), Capitalism, Socialism, and Democracy, New York; Harper & Brothers Publishers.

Sweezy, Paul, (1970), The Theory of Capitalist Development: Principles of Marxian Political Economy, New York; Modern Reader Paperbacks.

Nabokov on "Lolita".

Vladimir Nabokov and Lionel Trilling discuss Lolita. 

Marx on Religion.

" The foundation of irreligious criticism is: Man makes religion, religion does not make man. Religion is, indeed, the self-consciousness and self-esteem of man who has either not yet won through to himself, or has already lost himself again. But man is no abstract being squatting outside the world. Man is the world of man – state, society. This state and this society produce religion, which is an inverted consciousness of the world, because they are an inverted world. Religion is the general theory of this world, its encyclopaedic compendium, its logic in popular form, its spiritual point d’honneur, its enthusiasm, its moral sanction, its solemn complement, and its universal basis of consolation and justification. It is the fantastic realization of the human essence since the human essence has not acquired any true reality. The struggle against religion is, therefore, indirectly the struggle against that world whose spiritual aroma is religion.

Religious suffering is, at one and the same time, the expression of real suffering and a protest against real suffering. Religion is the sigh of the oppressed creature, the heart of a heartless world, and the soul of soulless conditions. It is the opium of the people.

The abolition of religion as the illusory happiness of the people is the demand for their real happiness. To call on them to give up their illusions about their condition is to call on them to give up a condition that requires illusions. The criticism of religion is, therefore, in embryo, the criticism of that vale of tears of which religion is the halo.

Criticism has plucked the imaginary flowers on the chain not in order that man shall continue to bear that chain without fantasy or consolation, but so that he shall throw off the chain and pluck the living flower. The criticism of religion disillusions man, so that he will think, act, and fashion his reality like a man who has discarded his illusions and regained his senses, so that he will move around himself as his own true Sun. Religion is only the illusory Sun which revolves around man as long as he does not revolve around himself.

It is, therefore, the task of history, once the other-world of truth has vanished, to establish the truth of this world. It is the immediate task of philosophy, which is in the service of history, to unmask self-estrangement in its unholy forms once the holy form of human self-estrangement has been unmasked. Thus, the criticism of Heaven turns into the criticism of Earth, the criticism of religion into the criticism of law, and the criticism of theology into the criticism of politics."

From "A Contribution to the Critique of Hegel’s Philosophy of Right" by Karl Marx.

Minsky and the Financial Crisis.

Hyman P. Minsky’s “Financial Instability Hypothesis” has received renewed interest in light of the current malaise. Minsky attempted to formulate an endogenous theory of financial instability and in this pursuit he focused primarily on income-debt relations and the negotiation between bankers and businessman. This hypothesis is predicated upon the existence of an intricate and highly evolved financial system operating within a capitalist economy. Based upon this assumption Minsky’s hypothesis is a partial explanation of the current crisis. The scope of analysis presented in the hypothesis does not venture to explain the interconnections between the financial sector and the real economy. The increased relative importance of finance and the process of financialization that underlay the current financial crisis are completely outside of the parameters of the financial instability hypothesis. From the perspective of policy formation, explanations of the crisis in terms of both its proximal and ultimate causes inform efforts for an adequate response. To follow this line of enquiry; Minsky’s financial instability hypothesis will be given fuller exposition with reference to different interpretations and extrapolations of his perspective, and moreover the hypothesis will be evaluated as an explanation of the current crisis. Finally, the policy implications of Minsky’s hypothesis will be analysed in light of its explanatory power and in relation to other explanations of the proximal and ultimate causes of the crisis.

Minsky stated that his financial instability hypothesis was developed in large part as an alternative interpretation of John Maynard Keynes’ “General Theory”. He borrowed from economic literature informed by the experience of the great depression and concerned with the nature of boom and bust cycles. Famously, Minsky asked the question: “can ‘it’ happen again?” He answered that ‘it’, another great depression, was unlikely to occur given the role of central banks in the monetary system. However, consistent with the influence of Keynes, Minsky remained concerned with role of expectations and uncertainty in the economy and the possibility of these variables contributing to instability. The insistence of instability stands in stark contrast to the vision of financial markets held by supporters of the “efficient market hypothesis” who conceive of rational actors pushing asset-prices toward their “fundamental value”. From within the Keynesian tradition, Minsky questioned the extent to which financial actors can be construed as rational actors and instead characterized actors as subject to certain attitudinal dispositions and mentalities that affect their decision making processes.

Similarly, Fisher Black, who co-derived the Black-Scholes formula to price financial derivatives, once made the point that: “expectations follow no rational rules”. Minsky’s hypothesis is therefore based upon a psychological understanding of individual actors and their collective dynamics. Alongside of the influence of Keynes, Minsky incorporated the work of Charles Kindleberger on the five stages of speculative bubbles into his financial instability hypothesis. Importantly, the hypothesis is not advanced on an appreciation of subjective elements alone and incorporates an interpretation of over-indebtedness developed by Irving Fisher and the credit view of money developed by Joseph A. Schumpeter. Thus, the central nexus of Minsky’s financial instability hypothesis is the relationship between income, credit, debt and the ability of cash flows to sustain the given level of liability. This relationship is, of course, dependent upon the expectations and impressions of bankers and businessman.

In expansionary economic conditions, where the inducement to invest is strong, businessman are willing to take on debt to finance their investments. Fisher argued that an appetite for debt-fueled investment in buoyant economic conditions leads to economic crisis. Technological progress and new inventions opened up investment opportunities that were expected to return rates of profit in excess of interest rates and the cost of money. Levels of debt increased dramatically; however, the accumulation of debt is not the single factor that results in over-indebtedness. In reference to the early 1970s, David Laibman noted that debt to equity ratios were marginally above 1929 levels and this was taken to be a sound basis to predict an imminent collapse of the financial system. Despite minor recessions and tremors, no major economic downturn occurred within the U.S economy until four decades later. Obviously, the sheer quantitative dimension of debt is not sufficient to explain cyclical downturns and economic crashes. Both Fisher and Minsky emphasized the crucial relationship between debt and income, Minsky took this a step further and developed a tripartite typology of debt-income structures for financial units.

The first debt-income structures for financial units, “hedge financing units”, are characterised by the ability of the unit to realise all of their payment obligations. Higher rates of equity to debt are indicative of hedge financing units. Secondly, “speculative” units are able to meet commitments on interest repayments, but are unable to pay down the principle of the debt from their incoming cash flows. Thirdly, ponzi units are unable to finance either interest repayments or repayments on the principle with exiting cash flows. Ponzi units can only be sustained from the liquidation of assets or the leveraging of more debt, both of which can only ever be stop gap measures. Financial systems that are dominated by hedge units are said by Minsky to be “equilibrium seeking”, while systems characterised by significant portions of ponzi units are said by Minsky to be “deviation amplifying”. Minsky argued that, when conditions of prosperity continue for an extended period of time, the financial system undergoes a qualitative transformation from hedge finance to unsustainable finance dominated by speculative and ponzi units. This transformation is affected largely by the prior success of finance and its effects on the expectations of financial actors.

As Fisher noted, the primary cause of over-indebtedness that underlay the great depression was the existence of good investment opportunities. The abundance of investment opportunities in the 1920s led to financial euphoria and over-confidence, this in turn led to over-indebtedness on behalf of entrepreneurs seeking profitable investment. In Minsky’s terms, hedge finance geared toward the advancement of capital to business operations became increasingly speculative and unsustainable Ponzi finance. Once financial actors realised that the system had become unable to validate current debt levels there was a fall in confidence and the process of debt-deflation and economic contraction set in. The process by which hedge finance is transformed into Ponzi finance via the evolution of expectations has been labeled the “basic Minsky cycle” by Thomas Palley. More controversially, Palley discussed the nature of a “super Minsky cycle” that links optimism within the financial market itself to increased optimism within regulatory institutions. Both cycles help explain the financial dynamics that led to the collapse of the sub-prime mortgage market in early 2007. Whilst the first cycle has gained wide acceptance, the latter cycle is controversial because its relation to Minsky’s hypothesis has been questioned . Despite this, the super cycle thesis advanced by Palley is clearly inspired by Minsky’s financial instability hypothesis and helps to broaden it perspective with regards to financial regulation.

John Bellamy Foster and Robert W. McChesney have argued that by introducing the notion of a “super cycle”, Palley has converted Minsky into “a theorist of a financial long wave”. They contend however, that it is precisely in terms of long-run trends that Minsky’s hypothesis has least explanatory power. To leave aside Foster and McChesny’s criticisms of Minsky’s short-run perspective for now, the extent to which Minsky’s hypothesis adequately explains the proximal causes of the crisis has been questioned. Jan Kregel has highlighted two important short falls of Minsky’s hypothesis when applied to the recent crisis. Firstly, the primacy of entrepreneur-banker negotiations has shifted since the 1980s with increased importance of proprietary trading, and secondly given this, the mechanism by which the financial system degenerated into Ponzi finance was not declining margins of error between liabilities and cash flows as classically outlined by Minsky, but new models of banking operations that were inherently risk-riddled. Kregel placed central importance on the “originate and distribute” methods that bank employed leading up to the crisis . To accrue quick profits by fees and commissions, banks would form new securitised assets and sell them on. The ‘originate and distribute’ model involved a complex set of institutional relationships that Peter Gowan labeled the “new wall street system” that facilitated excessive levels of leveraging via a series of adjunct financial institutions that have been characterised as a “shadow banking system”.

The shadow banking system linked traditional commercial and investment banks to hedge funds and private equity funds. These along with other structured investment vehicle (SIV) provided the context for new financial instruments that hid liabilities and risk allowing for increased leveraging and regulatory escape. Not surprisingly, Minsky had noted the possibility that creative accounting can mask the transition from hedge to ponzi finance. New forms of financial instrument that developed alongside the shadow banking system help facilitate such creative accounting. Credit derivatives, in the form of Collateralized Debt Obligations (CDOs) and Credit Default Swaps (CDSs), were two such financial instruments that caused much of the damage to the financial system. Between 2001 and 2006 the total nominal value of sub-prime mortgages increased from $160 billion to $ 600 billion . Banks packaged these loans into CDOs and sold them over the counter (OTC) without a market mechanism to determine the CDOs ‘fundamental value’. Rating agencies, who underwrite CDOs for a fee, would for an additional fee rate these credit derivatives as “AAA”. The complexity of CDOs and the OTC nature of the transitions meant that the financial instruments are extremely difficult to price effectively. This is compounded by the fact that unlike traditional commodity based derivatives the notional value of mortgage tranches was not determinable as the components of any given CDO were not know. It is clear that the over-investment and over-indebtedness that preceded the great depression is qualitatively different than that which precipitated the latest financial crisis. Minsky’s insistence on the primacy of banker-businessman negotiations and the steady decline of margins of error in the transition from hedge to ponzi finance are brought into contestation when applied to the financial crisis of the late 2000s. However, Minsky’s general theorem that extended periods of prosperity bred optimism that lead to over-indebtedness and speculative manias remains valid. Allen Greenspan’s reference to “irrational exuberance” in 1996 underscores this point. The stock market bubble to which Greenspan referred to was overcome by the bubble within real-estate and the financial system layered one problem upon another. While Minsky’s hypothesis remains somewhat helpful for an explanation of the proximal causes of the crisis, he remains silent on long-term trends and the nature of financialization that underlay the financial crisis.

The quantitative dimension of the crisis and its consequences can only be understood with relation to the financialization trend in the U.S economy from the 1970s and with increasing velocity through the 1990s. By the 1990s, financial profits were far in advance of non-financial profits. Keynes’ concern that: “speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirl-pool of speculation” is brought into play when the financial sector grows out of proportion with the real economy. Two general theses have emerged to explain the growth of finance and its correlation with stagnation in the real economy. The issue is that of precedence, either financialization causes stagnation in the real economy by luring capital away from productive enterprise, or a lack of real economy investment opportunities leads to the development of finance to employ surplus capital and generate profits. If the latter, the stagnation thesis, is accepted over the financialization thesis the prognosis is dire. Capital accumulation has reached a point of saturation and the possibilities of productive real economy investments have become scarce. Recurrent financial crises will emerge from the attempt of capital to overcome this underlying over-accumulation. At best, reform can lead only to momentary relief. However, if the financialization thesis is adopted, re-regulation of the financial system is possible and can limit its demonstrated proclivity to instability. The financial instrument that hid liabilities and allowed for the half-conscious slip into ponzi finance could be addressed, along with the regulation of bank and non-bank financial institutions. However, Palley’s extension of Minsky’s financial instability thesis demonstrated that optimism within the financial market can lead to unfounded optimism within the regulatory institutions and therefore the long-term ability to overcome financial instability is brought into question.

Minsky formulated a theory of endogenous financial instability. To construct his hypothesis he drew on the Keynesian tradition, the theories of bubbles developed by Charles Kindleberger, Schumpeter’s credit theory of money and Irving Fisher’s debt-deflation theory of the great depression. He was concerned with issue of the possibility of future great depressions. Minsky’s policy recommendations fit within this tradition and focus on the central bank as lender of last resort and the importance of reflation to fight debt-deflation processes that can lead to sharp contractions in economic activity. Like Fisher, Minsky sought to analyse the financial system in terms of income-debt relations and developed his typology of financial units. He argued that on the basis of prior successes and the extrapolation of these trends, sound financial systems based predominantly around hedge finance can be transformed into speculative and ponzi finance. In regards to the latest financial crisis, the precise mechanisms outlined by Minsky have less applicability than to prior crises. This is linked with institutional changes that occurred in the banking system during the 1980s and the increased importance of proprietary trading and the interconnected web of institutions that formed the shadow banking system that obscured the health of the financial system. On the proximal causes of the financial crisis, Minsky’s hypothesis is moderately useful. Given its endogenous character, the deeper causes of the financial crisis and the process of financialization are wholly unexplained. The nature of such trends and their importance for policy formation are not appreciated by Minsky. Minsky’s hypothesis is partially vindicated by the financial crisis and stands to caution financial operatives and regulators of the continued relevance of uncertainty and expectations in financial markets. 

Written by Mathew Toll.

Bibliography.


Barberis, Nicholas and Thaler, Richard, (2002), “A Survey of Behavioral Finance”, Working Paper, No. 9222, National Bureau of Economic Research, Cambridge, Massachusetts, pp. 1-8

Black, Fisher, (1986), “Noise”, The Journal of Finance, Vol. 41, No. 3., pp. 529-543.

Blackburn, Robin. (2008), “The Subprime Crisis”, New Left Review, 50, pp. 63-106.

Fisher, Irving. (1933), “The Debt-Deflation Theory of Great Depressions”, Econometrica, Vol. 1, No. 4. pp. 337-357.

Foster, John Bellamy, (2008), “The Financialization of Capital and the Crisis”, Monthly Review, Vol 59, No. 11, pp. 1-19.

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