Minsky Archives – Page 2 of 2

Italy is Hungry for Expansionary Fiscal Policy

In a meeting with Angela Merkel and Francois Hollande on August 22, the Italian Prime Minister Matteo Renzi proudly announced that Italy has the lowest public deficit of the last 10 years, and will continue with structural reforms to reduce it further. Monti has long aimed to “restore credibility” by cutting the public deficit, and now the Finance Minister Pier Carlo Padoan enjoys praise on his achievement of a deficit as small as 2.4% of GDP. The FED (Financial and Economic Document) goes so far as say this makes Italy “among the most virtuous countries in the Eurozone.”

A closer look at Italy’s economy, however, shows this “virtuosity” has no basis in reality. In 2015, 1.5 million households lived in absolute poverty. Another 4.5 million individuals saw stagnant incomes. The situation has not been this bad since 2005. In addition, the Migrantes foundation informs us that there has been a boom of italians who go abroad, 107,000 in 2015 (+6,2%). Especially youth from 18 to 34 years old (36,7%).
Source: [Ansa.it “Rapporto fondazione Migrantes”]

The percentage of serious material deprivation index is 11,5% for total households members. Official unemployment rate is at 11,9% whereas the real unemployment rate is well above the 20%. The inactivity rate is at 36,0 % and the fixed capital investment ratio is stuck well below the pre-crises (2007-08) levels.
Source: [“Rapporto annuale Istat, 2016”]

It is clear that Italy is stuck in a deep depression. And it’s not alone. Many other euro countries are suffering the same fate. Cutting public spending cannot help them recover. We turn to Keynes to see why it cannot, and consult the work of Minsky and Wynne Godley to see what can.

Keynes and Aggregate Demand

In The General Theory, J.M. Keynes explains the challenges blocking achieving and maintaining full employment in a market economy. He argues that the booms and busts associated with capitalism make this state of equilibrium very difficult to reach. When a bust occurs, and businesses expect their profits to fall, there’s no reason to expect a magical market-force to step in and fix employment while costs are being cut.

This applies to Italy, too. After years of austerity and a Global Financial Crises, aggregate demand levels have declined sharply most people feel uncertain about the future. Additional demand for labor is close to zero and the private sector is pessimistic. Investment and spending is not sufficient to employ the unemployed. Cutting down government expenditure is not going to to help. It will simply make it worse.

Minsky and Fiscal Policy

A follower of Keynes, Hyman Minsky explained how any analysis of a monetary capitalist economy must start from the analysis of balance sheets and its relative financial interrelations ‘measured’ in of cash flows. If balance sheets and especially the relative financial relations are not taken into account within an analysis of an essentially financial and monetary economy, that analysis fails to reflect the full reality.

Minsky’s alternative analysis shows that in case of crisis, a nation needs a “Big Government” (The Treasury Department) and a “Big Bank” (The Central Bank) to step up. These institutions must focus on serving as an “Employer of Last Resort” and a “Lender of Last Resort”, respectively. This way, they can prevent wages and asset prices from dropping further, and tame the market economy. In the Euro-zone, this has not been realized. The Treasury Department is constrained, leaving them unable to reach full employment. Meanwhile, citizens continue suffer under austerity.

Wynne Godley and the Government Budget

Wynne Godley’s sectoral balance approach sheds more light on this Minskyian alternative. He shows the economy consists of two sectors: The government sector, and the private sector (all households and businesses).** The private sector can accumulate net financial assets only if the other sector, government, runs a budget deficit. That is, only if the flows of the government spends more than it receives in taxes. It is impossible for both sectors to run a surplus at the same time.

And as a simple matter of macro-accounting, for aggregate output to be sold, total spending must equal the total income generated in the production process. So given households’ decisions to consume and given firms’ decisions to invest, there will be involuntarily idle labour for sale with no buyers at current wages, if the government deficit spending is too small to accommodate the net desire to save of the private sector.

What Renzi and Padoan are Really Saying

We can now see what Renzi and Padoan are really congratulating themselves for. Having done nothing to lift a struggling private sector out of the recession, they patting themselves on the back for worsening it’s social and economic situation. Renzi may claim he will go to Brussels to “sbattere i pugni sul tavolo”, but his executives continue to respect the Stability and Growth pact regime, and decrease the deficit further.

From Wynne Godley, we know that further decreasing the government deficit corresponds to further deterioration the private sector surplus. So when the officials say they “need to put public accounts in order,” they are actually saying they will put households and business accounts in dis-order. So when they say that Italy has the lowest budget deficit of the last 10 years, they are actually stating that the government is draining more financial assets from the private sector than it has in a decade.

When they call Italy virtuous for keeping a smallest deficit, they assign virtue to the nation that most effectively perpetuates poverty and social disarray. When Renzi says that his non elected executive “will continue […] the reduction of the deficit for our children and grandchildren”, he is instead telling us that his government is going to reduce the net desire to save of the current population, to keep involuntary unemployment and part-time working levels high and to firmly deteriorate the (net) financial and real wealth of the future generations.

Unless Italy changes its approach and adopts expansionary fiscal policy, it will not serve the well-being of the society and its economy. The main goal of full employment will never be attained and maintained. Work will lack moral and economic dignity, public sector goods will fall short in quantity and quality, and basic human rights will be violated. Not only will policy goals fail to be achieved, they will be even farther out of reach. One thing is certain: either Renzi and his ministers don’t know what they’re doing, or they are doing it in bad faith. I am afraid of it may be both.

* To be as precise as possible, Italian public budget deficit has been systematically reduced from 1991, that is the year when the Treaty of Maastricht was ratified which, among other things, established the respect of the parameter of the 3% to the public deficit and 60% to the (flawed) public debt/gdp ratio.
** I do not take into account the foreign sector balance sheet, because the substance of my brief argument won’t be undermined.

The Brazilian Burden

On August 29th Dilma Rousseff, the democratically elected Brazilian ex-president, defended herself at the Senate against accusations of fiscal fraud, the so called “pedaladas fiscais.” Despite her defense, two days later, the president was formally impeached, putting an end to a process that has been carried on since May, when she first left office to face trial. The crime accusations were mainly accompanied by harsh criticisms of how the Workers’ Party (Partido dos Trabalhadores, PT) fiscal irresponsibility led to the poor economic condition that the country finds itself. Among the economic meltdown and several scandals of corruption, her approval rate and the popularity of her party collapsed in recent years. After 13 years of the leftist PT administration, the presidency is now occupied by the then vice-president Michel Temer, member of the centrist Brazilian Democratic Movement Party (Partido do Movimento Democrático Brasileiro, PMDB), a party also involved in corruption scandals, and whose popularity is as bad as his predecessor.

Political matters “apart,” the Brazilian economic situation is indeed dire. GDP is expected to contract 3.18% in 2016, a second year of contraction, following the 3.85% in 2015. Unemployment increased more than four percentage points from the beginning of last year, reaching 11.3% in June 2016. Despite the poor economic performance, inflation is still above the 6.5% target roof, being expected to accumulate 7.4% this year. The inflationary pressure comes mainly as an effect of the rapid exchange rate nominal devaluation of almost 54% within the years of 2015 and 2016, reaching now R$ 3.29 per dollar. As an attempt to control inflation and attract foreign capital, the Brazilian Central Bank – going in the opposite direction of the major Central Banks – sharply rose the short-term interest rate (Selic), sustaining it at 14.25% (!!!) since mid-2015. This also had a feedback effect on the government’s total deficit. (*)

Two questions remain open: what are the real roots of the economic crisis and will the new administration be able to tackle it? To understand the roots of the bust, it might be easier to refer to the very causes of the boom that preceded it.

The boom and bust

From 2002 to 2008, the Brazilian economy performed really well, growing at an average of 4% per year. This was possible mainly by a combination of policies aimed to reduce poverty and income inequality along with the positive international scenario.

Increasing worker’s real wages and government cash transfers to poor households – channeled mainly through social security and the famous Bolsa Família – established a virtuous cycle of increasing private consumption. Another important factor was the promotion of policies towards labor-market formalization, which guaranteed not only access to social security but also the availability of poor households to private lines of credit. Note, however, that not only poor households benefited from “cash transfers”: the historically high short-term interest rate guaranteed that rich households too enjoyed the fruits of the boom. The government managed to attend then both extremes of the income distribution.

International conditions also played a major role in boosting the domestic economy. High international liquidity and the commodity-price super cycle guaranteed appreciation of the exchange rate, which beyond positively impacting domestic real wages, also helped to keep inflationary pressures under control by making foreign goods more accessible.

The Brazilian economy suffered its first hit with the 2008 financial crisis. Despite the GDP growth of 7.5% already in 2010, the fast economic recovery was mainly a result of aggressive counter-cyclical expansionary policies by the government, who acted through state-controlled enterprises (as the oil and energy companies, Petrobras and Eletrobras) and programs of investment in economic and social infrastructure. From 2011 on, GDP returned to low levels, making it necessary for the government to adopt a new set of policies that can be summarized in tax exemptions and subsidized credit expansion to private companies from public banks. As it happens, this attempt to increase private investment had the only effect of deteriorating the public fiscal situation.

The budget, the budget!!!

The change in orientation of government policies – from an expansion of public investment in 2008-10 to a provision of fiscal stimulus to private companies in 2012-14 – happened at the same time as the commodity boom ended. Already in 2011, commodity prices stagnated and, along with Brazilian terms of trade, started its downward path in 2014. The end of the commodity cycle had a harsh impact not only in economy’s aggregate demand but also on the fiscal budget.

Before we get to the fiscal issue though, please, don’t get me wrong. The cause of the Brazilian economic crisis is less a result of the end of the commodity boom in itself than by the productive structure that such cycle reinforced. Brazil’s external sector is highly dependent on the exports of primary goods, and this dependence only deepened in the past decade. In 2015, roughly 50% of Brazilian total exports were composed by primary products, a number that increased 4.5% per year since 2002, when it accounted for less than 30%. If we include natural resource-based manufactures on the calculus, it reaches nearly 70% of total exports! Furthermore, while labor productivity increased 5.3% per year from 2000 to 2013 in the agriculture sector, it decreased 0.6% per year in the manufacturing industry.

No wonder when commodity prices reverted trend the economy took a strong hit. Instead of setting the ground for the eventual bust, Brazil placed all its coins on booming commodities. Despite all the public investment programs and fiscal exonerations to the private sector, the PT administration did not manage to increase investment as share of GDP, which remained stagnant around the 18% level throughout 2002-2015 – with public investment accounting for less than 3% of GDP. Lack of investment in infrastructure and manufacturing industry perpetuated an anemic economy with low productivity and dependent on economic cycles.

Public consumption and investment decreased even further after 2014 when the rapid deterioration of the fiscal budget turned the 3%-of-GDP government fiscal surpluses to almost 3%-of-GDP deficits. It is interesting to notice that the decreasing surpluses started in 2011, not accidentally when commodity prices stagnated. We can look at the three institutional balances for the Brazilian economy, representing the government, private, and foreign sectors, as follows below in order to see these trends more clearly.

We already know from previous posts on this blog (see here and here) that the government sector has a “crowding-in” effect on the private sector, meaning that government expenditure will, by an account identity, revert in private sector savings. Of course, in an open economy, this is only true as long as we assume the foreign sector to remain “stable”. Both the private and government sectors can only simultaneously run a surplus if the foreign sector generates a surplus that is big enough to account for both. (The intention of the figure presented is not to show that the balances sum to zero – which could be demonstrated by inverting the sign of the private sector and using a bar graph – but to show the movements of the financial assets and liabilities between the three sectors).

In the case of the Brazilian economy, the improvement of the foreign sector in 2001 allowed an increase in the private sector savings and a decrease in government total deficits. Once the financial crisis struck at the end of 2007, despite the counter-cyclical policies, the deterioration of the current account was mainly absorbed by a decrease in savings of the private sector, with government persisting to run primary surpluses and to sustain its total deficit level – even decreasing it until late 2012. On that year, we observe a sharp deleveraging of the private sector which, given the steady trend of the current account, was completely mirrored by the public sector.

Once again, the mistake – to name one – of the PT administration is that instead of increasing fiscal stimulus through direct government expenditure and investment in infrastructure it bet on providing credit and fiscal exonerations to the private sector as an attempt to increase private investment. In a scenario in which – to use Minsky’s terminology – the demand price of capital decreases at a faster rate than the supply price of capital, investment will not take place. In other words, despite the stimuli reducing the cost of new investment, expectations of profits were falling at a faster rate. In a situation of lack of aggregate demand, the government has to directly spend in order to create the necessary stimulus to the private sector through the generation of profits. Its avoidance led to the deterioration of the fiscal budget through the revenue side, surpassing now 10% of GDP, a result of the economic meltdown.

Instead of stimulating the economic activity by driving aggregate demand and adjusting the economy by sustaining the levels of output and employment, the government opted, mainly after 2014, for a “building confidence” strategy in which it compromises to reducing inflation, generating primary surpluses by increasing interest rates, and cutting government deficits, an adjustment that comes, in such case, through deepening the economic recession. All of it with the intention to attract market’s attention and foreign capital inflows. It, in fact, has a huge potential to generate financial fragility – but this is subject for another post.

And what now?

To address the second question posed at the beginning of this text, it is hard to believe that the new administration will be able to revert the dire scenario. It is still unsure if Temer will have the political leverage to pass important fiscal structural reforms in Congress, such as pension reform. Temer’s pledge to sharply reduce the government deficit can be summarized in the attempt to pass a law that will impose a limit to government expenditure indexed to the inflation level of the previous year. Besides reducing the ability of the government to invest, it also means cutting spending on areas such as education and public health, thus reducing the welfare state that was established in the previous decade, a major element in the virtuous cycle.

Whether or not promising to reduce inflation and the public deficit will be miraculously enough to stimulate agents confidence in the future, it will for sure hurt the economy and lead to a further decrease in demand price of investment in the short-run. In a situation of deleveraging private sector and slow global trade, it is unlikely that private investment will rise anytime soon. Until then, workers will be the ones to suffer from the increasing unemployment levels. The interest rate, beyond undermining any conceivable investment effort that could come from private agents, also carries a feedback effect to government budget and a distributive matter, as mentioned in the beginning of this text. When the pressure to cut government spending increases, “attend both extremes of the income distribution” becomes a hard job. We already know which side was chosen. Unfortunately, very often the adjustment burden comes from the weaker side.

(*) All the data presented in the text are extracted from the Brazilian Central Bank (BCB) and the Brazilian Institute of Geography and Statistics (IBGE).

Can we Learn from Minsky Before the Next Crisis?

Earlier this month I had a conversation with a regional manager from a major insurance company. She explained to me the many aspects of her industry: the commission based salaries, strategies to sell life insurance to one year-old children, and how to retain employees. To be honest, I don’t find insurance to be the most riveting topic out there, but I did have a question I wanted answered: What does her company do with the money their clients pay for their insurance packages? Her response surprised me for its candor, she said:

“You know, insurance companies don’t make their money from premiums and things like that anymore. Most profits come from investing in the stock market.”

We truly are in the era, as Minsky called it, of money manager capitalism. What this means is that insurance companies are no longer in the business of insurance, they are just another player in the financial markets; the only thing that differs is how they get their capital. Combine that with the fact that many of their employees have their entire pay check dependent on commissions and we have companies that are trying to sell as many policies as possible – sometimes to people who do not need it or can’t afford it – in order to have more capital for financial investments.

If that sounds familiar it is because those are the kind of practices (while obviously not the only one) that led to the Great Recession and specifically to the crash of insurance giant AIG (which was bailed out with 182 billion dollars). It is, to say the least, disheartening to see that those practices are still in place by insurers and elsewhere, but it is hardly surprising. To know why we must turn to Minsky’s Financial Instability Hypothesis.

minsky (1) — Illustration: Heske van Doornen

The Hypothesis is possibly the most notable part of Minsky’s extensive work, it is indeed brilliant in its accuracy and simplicity. Nevertheless, it seems to escape from the spotlight of economics and politics in an counter-cyclical manner: every time the economy does well, people seem to forget about it – but during the crisis his book Stabilizing an Unstable Economy went from costing less than 20 dollars, to over 800 (that is, if you could find it). Another example, The Economist had only mentioned him once while Minsky was alive, but since the 2007 crisis his ideas have appeared in over 30 of their articles. As the British newspaper puts it, “it remained until 2007, when the subprime-mortgage crisis erupted in America. Suddenly, it seemed that everyone was turning to his writings as they tried to make sense of the mayhem.” Therein lies the irony, it is exactly when the economy is booming that we should pay the most attention to the Financial Instability Hypothesis.

In short, Minsky postulated that stability is destabilizing, as Oscar Valdes-Viera has awesomely explained before in this blog. In his post, Oscar tells us to be skeptical of politicians who say the economy is doing well; that is when individuals and institutions are moving from hedge, to speculative, to Ponzi positions. In most cases, economic actors will become eerie of risk after a crisis and shun from risky investments such as CDOs. It seems, however, that this aversion to risk has not happened. One can speculate many reasons for this behavior, among which is the bailing-out of so called “Too-Big-to-Fail ” organizations.

As such, it is clear that although Minsky’s popularity increased during the last crisis, the people making important financial decision did not learn from his work. The problem of irresponsible behavior and borderline fraudulent financial innovations still remain. It is time to enact on a less popular, although still important, part of Minsky’s work: the “Big Bank”. That bank, naturally, is the Fed and it plays a number of roles: it sets interest rates, it regulates and supervises banks, and it acts as lender of last resort. However, as Randall Wray explains in a 2011 paper, “most Fed policy over the postwar period involved reducing regulation and supervision, promoting the natural transition to financial fragility.”

Case and point, the SEC and the IRS had their budget severely cut in 2014 and do not currently have the capacity effectively regulate the financial industry. To make matters worse, shadow banks and traditional banks – as demonstrated anecdotally by my conversation with the insurance agency manager – still intermingle in financial innovations. Common sense dictates that after the 2008 crisis companies should have reset to the more sustainable and safer hedge position, but it seems that many financial actors went right back to the more unsustainable speculative position after the crash. One could also have expected that financial jobs would decline in popularity post-2008, but the opposite has occurred; finance as an industry now takes 25% of corporate profits, but only makes up 4% of jobs in the US. The rising importance of the finance industry has other adverse effects besides increasing the possibility of crisis, it means that companies are not investing in producing real output for they can earn more by playing the markets.

Hence is the place in which we found the economy: misguided policy has created a weak regulatory environment where irresponsible risk-taking is ‘insured’ by the precedent set by bail outs, and where even the highest ever levels of liquidity do not lead to real investment and a strong economy. This bad omens have inspired many economists to declare that a crisis is coming. Add to that the fact that recently Minsky has been featured in mainstream media sources like The Economist, and that his seminal book in financial instability was recently the number one best seller on Amazon for Public Finance, and one has reason to feel a bit uneasy about the coming year.

Carbon Trading, Sustainable Development and Financial Fragility

The response to climate change is one of the most pressing policy issues of our time. Carbon trading assets are currently worth more than $100 billion. This market is expected to reach $3 trillion by 2020. In Stabilizing an Unstable Economy Hyman Minsky notes that the markets for financial assets are inherently unstable, leading to the cyclical behavior of the economic system. How effective then are market-based solutions to solving climate change? It might just be that carbon markets have not reduced environmental instability and may increase financial instability of the entire economic system.

The core of carbon trading isnot trading of physical GHGs, but the trading of the right to emit GHGs and the unit of account is a ton of carbon dioxide equivalent (tCO₂e). The carbon market stems from the Kyoto Protocol, and its specifics are target of discussion as scholars debate about the legal characteristics of the carbon unit. Some countries view it as a commodity while others see it as a monetary currency.

Under the Kyoto Protocol trading mechanisms were made up of three types: international emissions trading, the Clean Development Mechanism (CDM), and Joint Implementation (JI). The European Union Emission Trading System (EU ETS) is the world’s largest carbon market. According to the 2016 ICAP worldwide emissions report, there are 17 emissions trading systems operating around the world, which are currently pricing more than four billion tons of GHG emissions. In 2017, two new systems will be launched: China and Ontario, the former will become the largest of such systems, and will drive worldwide coverage of ETSs to reach seven billion tons of emissions by 2017.

Voluntary markets exchanges (carbon markets outside the Kyoto) are also on the rise because they make trading, hedging and risk management easier by providing liquidity. Furthermore, they develop sophisticated financial instruments such as CER futures, options, and swaps, which will help establish a price forecast for carbon. Some of these markets are the Chicago Climate Exchange (CCX), Multi-Commodity Exchange of India (MCX), and Asian Carbon Trade Exchange.

Sustainable Development

From their foundation, carbon markets have failed to address the underlying root causes of climate change. They divert money from technological investment that will actually reduce the use of fossil fuels towards the financial markets. Furthermore, they are causing instability in the environment through the use of carbon offsets, which have caused massive green grabs to occur in the global South, and through outsourcing emissions to developing nations. Carbon offsets were created by Kyoto to describe emissions reductions projects that are not covered by an ETS. For instance, tree plantations, fuel switches, wind farms, hydroelectric dams…etc.

The world’s richest have over-consumed the planet to the brink of ecological disaster. Instead of reducing emissions within their own countries, they have created a carbon dump in poorer regions. As such, emissions trading system represent the world’s greatest privatization of a natural asset. The Kyoto protocol is set up in a way that carbon sink projects (forests, oceans, etc.) are only accepted when people with official status manage them. Hence, it expands the potential for neocolonial land-grabbing to occur. Rainforest inhabited by indigenous people will only qualify as “managed” under the Kyoto when they are run by the state or a registered private company.

Furthermore, carbon trading has also failed to reduce global GHGs emissions. When a country claims to have reduced its carbon emissions, one must question whether it is by adopting low-carbon technologies, like how Sweden used well-crafted public policies and market incentives to decarbonization, or by outsourcing its emissions to another country, most likely to developing nations. For example, the Chinese government has questioned whether the emissions coming out of Chinese smokestacks were really ‘Chinese’ or should they be accounted to those in Western countries who are consuming Chinese goods or are owned by joint venues with developed countries. The question arose because Europe claimed that it was making progress on climate change based on tabulating the physical locations of molecules. Larry Lohmann phrased it perfectly when he said that Europe’s statistical claim “[conceal[s] an important fact that it has offshored much of its emissions [to China].” Take the UK, it has not in fact reduced its emissions it merely offshored one-third of its emissions by not accounting for emissions of imported goods and international travel.

Carbon markets have had many fraudulent activities within them. In 2002, the UK had a trial emissions trading scheme worth £215 million, which resulted in fraud. Three chemical corporations had been given £93 million in incentives when they had already met their reduction target. Another famous fraudulent activity revolved around international offset projects whereby companies would create GHGs just to destroy them and make money off of the credits.

As nature is being commodified and privatized,the current policies for sustainable development, under the guise of conservation, are alienating the poor from their means of livelihood by securing resources for organizations. These indigenous people — land users — are seen as needing to be saved from their primitive ways and to be educated on utilizing sustainable development within the bounds of the market. If it sounds like colonialism that is because it is.

For example, there exists specific types of green grabs known as conservation enclosures where the market is seen as the best way to conserve biodiversity. Hence, authorities are privatizing, commercializing and commoditizing nature at an alarming rate through payment for ecosystem services to wildlife derivatives. The Convention on Biological Diversity (CBD), a multilateral treaty set up at the 1992 UN Earth Summit has a target the protection of 17 percent of terrestrial and inland water and 10 percent of coastal and marine areas. For instance, Conservation International (CI) pushed the government of Madagascar to protect 10 percent of its territory, while in Mozambique a British company negotiated a lease with the government for 19 percent of the country’s land. President Elizabeth Sirleaf Johnson of Liberia called for the extradition of a British businessman accused of bribery over a $2.2 billion carbon offsetting deal. The deal was to lease one-fifth of Liberia’s forests, which account for 32 percent of its land. In Uganda, a Norwegian company leased land for a carbon sink project, which evicted 8,000 people in 13 villages.

In Oxfam Australia’s 2016 report on land grabs, palm oil has become “responsible for large-scale deforestation, extensive carbon emissions and the critical endangerment of species… India, China and the European Union (EU) are the largest consumers of palm oil globally.” The European Union’s renewable energy policy being a significant driver of global palm oil demand due to its aim to source 10 percent of transport energy from renewable sources by 2020, which has increased its palm oil usage by 365 percent.

Reducing Emissions from Deforestation and Forest Degradation (REDD+) is an effort to create a financial value for the carbon that is stored in forests. It is used to justify green grabbing and is expected to be one of the biggest land grabs in history. By using REDD+ as a conservation mechanism and a financial stream, “the CDB is both legitimating the commodity of carbon itself and helping to create the market for its trade.” The CDB is forming new nature markets along with new nature derivatives whereby investors speculate on future values encompassed in, for instance, species extinction like that of tigers.

Financial Fragility

Hyman Minsky was fully aware that a capitalist system was a monetary system with financial institutions that were prone to instability. Minsky is famous for saying that the strength of capitalism is that it comes in at least 57 varieties. The last and current stage is Money Manager Capitalism, which was made up off highly levered profit- seeking organizations like that of money market mutual funds, mutual funds, sovereign wealth funds, and private pension funds. The financial instability hypothesis argues that the internal dynamics of capitalist economies over time give rise to financial structures, which are prone to debt deflations, the collapse of asset values, and deep depressions. Minsky has always warned, “Stability is Destabilizing.”

Money managers act as agents. They pursue short-term profits by trading instruments that are not easily verifiable, which makes fraud likely possible in carbon markets. The dramatic rise in securitization has opened up national boundaries leading to the internationalization of finance. Securitization within the carbon markets increases the risk of leading to boom-bust cycles. At present, speculators are the major players in carbon trading and their dominance in carbon markets is growing at an alarming rate. Financialization is an important precondition for the rise and operation of carbon offsets. The financial innovation in this scheme is that it uses nature itself as a financial instrument. Moreover, it is selling nature to save it and then saving nature to trade it.

‘Green bonds’ are carbon assets that are sold to the Northern hemisphere, backed by Southern land and Southern public funds. Lohmann shares that financial speculation of collateralized debt obligations (CDOs) are at least based on specifiable mortgages on actual houses while climate commodity or subprime carbon cannot be specified, quantified, or verified even in principle. Even conservatives and Republicans have said, “if you like credit default swaps, you’re going to love carbon derivatives.” It has become apparent that carbon markets are not only driven by trade, but also by speculation. Carbon derivatives are growing at a fast rate as speculators are moving from other assets towards carbon. Whereas once investors bet on the collapse of the US housing market, there are some traders who are betting on the collapse of the carbon credit market.

As more investors, specifically hedge funds, enter the carbon markets, they increase market volatility and create an asset bubble or ‘carbon bubble’. Money managers by acting as agents trade carbons and increase financial fragility. Their income is driven by assets under management and short-term rates of return. Hence if they miss the benchmark, they will lose their clients. So they act on short profit bases by taking risky positions, and carbon trading provides those risks. In brief, using Minsky’s theory, we can predict with confidence that the carbon market is inherently unstable and that in addition to its not achieving its goal of reducing emissions, it is also heading to a financial disaster.

Even though Minsky pushed for regulation when it came to financial markets, regulating carbon markets will not solve the problem. Tighter regulation of carbon markets, particularly secondary and derivative markets is just a Band-Aid solution and will fail to affect fundamental change. Financial markets have had to be bailed out again and again. However, as a British Climate Camp activist said “nature doesn’t do bailouts.” On a global scale, GHG emissions have gone up. There is an offshoring of emissions. The best policy would be eliminating offsets, specifically from the developing world. Furthermore, there needs to be policies that encourage low-carbon technology as used in Sweden. Another policy recommendations would be a harmonized carbon tax.

Written by Mariamawit F. Tadesse
Illustrations by Heske van Doornen

Stability is Destabilizing

In a recent interview with Andrew Ross Sorkin, published in The New York Times, President Obama argued that the U.S. economy is in fine shape, despite public feelings that it might not be. Then a few days later the same newspaper ran an interview with William C. Dudley, the president of the Federal Reserve Bank of New York, in which he foresaw continued economic growth. And like the president of the Richmond Fed, Mr. Dudley made the case for slowly raising interest rates because the economy is “on track” and global conditions are “dramatically better.”

The rhetoric coming from these top policymakers can seem rather soothing to most people, including many economists. However, we know that Hyman Minsky would have remained highly skeptical. In fact, Minsky famously argued that “stability is destabilizing,” and that is because periods of economic instability and recessionary episodes emerge naturally out of the normal functioning of a prosperous modern capitalist economy.

For Minsky the nature of instability is linked to the relation between finance and investment in capital assets during the business cycle. Economic agents often compromise future incomes in order to secure the assets they need to undertake production. The accumulation of capital in the economy is largely financed by borrowing, which is recorded as liabilities on balance sheets. The liabilities represent a group of payment commitments on a future date, while the assets held represent a series of expected cash receipts from operations. The performance of the economy will later either validate or invalidate the structure of those balance sheets. Even though Minsky was talking about the capital development of the economy, his argument can be broadly extended to any economic unit; from a corporation borrowing to build its new headquarters to a person borrowing to buy a car or pay for college.

In his Financial Instability Hypothesis (FIH), Minsky identified the degree of financial fragility in the system by defining three income-debt relations for economic units: hedge, speculative, and Ponzi finance. For hedge financing units, the income flows from operations are enough to fulfill debt commitments outflows in every period. For units involved in speculative finance, the income flows are only enough to meet the interest component of their obligations and they will have to roll over debt because they cannot repay the principal. For Ponzi finance, the income flows from operations are not enough to cover the interest costs of their loans or the repayment of principal. Ponzi units highly depend on the possibility of refinancing their debt, otherwise they have to resort to the liquidation of assets or issuing new liabilities in order to meet their obligations.

The movement to more units engaged in Ponzi finance happens as a natural consequence of periods of stability and prosperity. During economic expansions, borrowers and lenders become confident in the ability of the former to meet cash commitments, which is a rational response based on recent past experiences and on the higher probabilities of success associated with the expansionary environment.

Thus, economic units are not likely to have difficulties to meet their payment commitments as they come due during economic expansions. However, such optimistic expectations lead to relaxing lending standards and reducing margins of safety. They also validate riskier projects, the use of more debt relative to assets, and lower liquidity; all of which increase the fragility of the economic system (for more see here and here).

Borrowers and lenders seem to operate on a hit-or-miss basis; if a behavior is successful, it will be rewarded and it will be repeated. So the behaviors described above will continue, and in fact be encouraged, until the turn of the economic cycle. Thus, while the economy prospers, financial positions are becoming increasingly fragile under the stable surface. Indeed, according to Minsky, during prolonged periods of prosperity the modern capitalist economy tends to move from a robust financial structure dominated by hedge financing units, to what he called a “deviation amplifying system” dominated by abundant speculative and Ponzi financing units.

The boom gives way to the bust when interest rates suddenly rise or when realized income flows fail to meet what was projected (note that economic units need not incur losses, but just have revenues depart from expectations – so basically any small shock to a fragile economy can potentially trigger a crisis). When the economic environment changes, income flows begin to fall and Ponzi units find it impossible to borrow to sustain their positions. They will then try to make position by selling out position; this means selling assets to meet their payments. The consequence of a generalized sell-off is to put downward pressure on asset prices, which can make the market prices too low as to generate sufficient income to meet the commitments – making this operation self-defeating. These dynamics, plus the excess supply, reinforce the necessity to sell and raise the real debt burden, leading to a potential Fisher-style debt deflation. These processes reset the system, starting again from a robust financial position – because all the fragile positions were washed off by the debt deflation – but will eventually give way to another crisis.

The idea that “stability is destabilizing” is summarized by Minsky’s two theorems of financial fragility in the FIH: (I) the economy has financing regimes under which it is stable (hedge) and financing regimes in which it is unstable (speculative and Ponzi); and (II) over periods of prolonged prosperity, the economy transitions from financial relations that make for a stable system to financial relations that make for an unstable system. In other words, the economy tends to move from a financial structure with abundant units engaged in hedge finance to a structure dominated by speculative and Ponzi units. The natural shift from hedge positions to speculative to Ponzi is a required condition for instability to arise, and, as explained above, the move (and the erosion of margins of safety) happens during periods of economic stability and prosperity. One of Minsky’s most important contributions was to point out that the process leading to an unstable system is an inevitable, endogenous, and evolutionary process of the modern capitalist economy.

So, what can we learn from all of this? Well, the next time you hear politicians or big shot economists talking about how stable the economy is and how on track it is, remember Minsky and remain skeptical.

Written by Oscar Valdes-Viera