Autocatalytic process : the outcome of the process is itself a catalyst for the process Chain Reaction! Viking success propelled Viking success.

• Autocatalytic process: the outcome of the process is itself a catalyst for the process Chain Reaction!

• Viking success propelled Viking success.… but then came Collapse (Jared Diamond)

• Realized profits repay debts … propel more debt… but then comes collapse (Hyman Minsky)

Minsky’s World•Quasi – rents: cash flows available to pay debts•PI – [supply] price of investment goods

•PK – [demand] price of kapital goods•Borrower’s risk•Lenders risk•Hedge finance: E(cash flows) > Payment commitment•Speculative finance: E(cash flows)<Commitment

… but > Interest commitment Roll over debt•Ponzi finance: E(cash flows)<Interest commitment

… Expect to increase debt•Financial fragility: mix of Hedge – Spec – Ponzi

Good times Confidence Risk-taking Fragility

Minsky’s World – Keynes’ World Y = C + I

Fluctuations in I Fluctuations in Y• Expectations and degree of confidence

• Animal spirits• Subject to sudden and violent change

• Complex interactions of decisions/outcomes/liquidity/confidence

Booms and Busts

The Minsky FootprintRealized expectations Increased profits & Reduced risk BOOMDisappointed expectations Reduced profits & Confidence Bust

Rush to liquidity Debt deflation

Pk

PI

Borrower’s Risk

Lender’s Risk

Marginal lender’s risk

Investment

Internal funds

Stabilizing an Unstable Economy

Hyman Minsky1919 - 1996

Financial Instability Hypothesis:•Hedge finance•Speculative finance•Ponzi finance

Two types of risk affect the volume of investment. …The first is the entrepreneur's or borrower's risk and arises out of doubts in his own mind as to the probability of his actually earning the prospectiveyield for which he hopes. If a man is venturing his own money, this is the only risk which is relevant.…But where a system of borrowing and lending exists, a second type of risk is relevant which we may call the lender's risk. GT, Chapter 11.

Pric

e of

cap

ital a

sset

s

PI

PK

Investment

Internal funds

Io I1

Borrower’s Risk

Lender’s Risk

When expectations are disappointed,investment collapses … but debts remain

A Minsky Cycle•Displacement (invention, easy money)•Boom…successful speculation•Euphoria…financial innovation•Profit taking

•Panic

Student of Simons/Schumpeter

Akerlof and Shiller, Animal Spirits• Confidence – Keynes-Minsky

• Hopes, Exuberance, Fears• Waves of optimism and pessimism

• Corruption - Bad Faith Loss of Trust• S&Ls – Enron – Sub-prime crisis – Goldman Sachs

• Fairness• Punish cheaters, even at own expense• Relative position

• Money illusion• “Illusion” is real in view of nominal contracts/accounts• Money illusion Inflation – unemployment tradeoff

“So long as money retains its age-old power to deceive, inflation can be used to resolve economic conflict.” James Tobin

• Stories• New eras – Irrational exuberance

Downward wage rigidity

Akerlof and Shiller: A brief history of macroeconomics• Pre – Keynes: Say’s Law Automatic adjustment to full employment• Keynes: Animal spirits Excesses Inherent instability

Minsky, JMK, Stabilizing an Unstable Economy, Can “It” Happen Again?• Hicks: IS – LM Keynes without animal spirits

• Consumption function – Liquidity preference function• Hydraulic Keynesians

• Original Phillips Curve Policy Menu• Friedman: Monetarist counter-revolution

• Dispense with money illusion/enter expectations/natural rate Wage Setting: W = PeF(u,z)

• New Classical Economics• Rational expectations• Real business cycles (dynamic stochastic general equilibrium)

• New Keynesian Economics• Rational expectations – but sticky adaptation

Akerlof and Shiller: Prescription for Today• A Second Target – A Credit Target

“It is fairly easy now to project the fiscal and monetary stimulus necessary for aggregate demand to be at full employment—if financial markets are freely flowing…But, with the loss of confidence in the financial sector, macroeconomic planners must have a second target…—the amount of credit that would normally be given [to qualified borrowers] if the economy were at full employment.”

Methods: Discount window (TALF)/Capital injections/GSEs• Gotta replace the fallen Humpty-Dumpty (Securitization)

• A Credit Target—Whom to credit?• Bernanke and Blinder (1988) Credit, Money and Aggregate

Demand, AER, May.– In liquidity trap, expansion of credit is effective stimulus

Aside: Also in AER, May 1988. Akerlof and Yellen, Fairness and Unemployment“…where it is advantageous to pay some employees highly, it is also … fair to pay

other employees well.” Unfair pay shirking

Back to Minsky – Keynes • Variables:

PK = volatile demand price of kapital asset PI = sluggish supply price of investment goodsq = expected quasi-rent from the assetM = quantity of money ease of creditc = cash-flow commitment from finance arrangementsĉ = “acceptable” cash flow commitments

Then, PK = K(q, M, ĉ – c)“If the demand price of a capital asset … is not less than its replacement

costs, new investment will take place.”

The Minsky FootprintRealized expectations Increased profits & Reduced risk BOOMDisappointed expectations Reduced profits & Confidence Bust

Rush to liquidity Debt deflation

Pk

PI

Borrower’s Risk

Lender’s Risk

Marginal lender’s risk

Investment

Internal funds

Easy MoneyPolicy

Capital Inflows

Eager Home Buyers

InnovativeBanks

Rating Agencies

AmbitiousMortgage Brokers

SecuritizationMBSs

EscalatingHouse Prices

Gov’t SponsoredEnterprises

Developer Clout

Bank Regulators

The best of times

A “Global Saving Glut”

Easy MoneyPolicy

Capital Inflows

Eager Home Buyers

InnovativeBanks

Rating Agencies

AmbitiousMortgage Brokers

SecuritizationMBSs

EscalatingHouse Prices

Gov’t SponsoredEnterprises

Developer Clout

Bank Regulators

The best of times

Financial System MeltdownAt home

Gov’t Supported Takeovers

•Countrywide BofA•Bear Stearns JPMorgan Chase•Silver State Bank Nevada State•Merrill Lynch BofA•Washington Mutual JPM Chase •Wachovia Wells Fargo•Security Saving Bank of Nevada

Interventions/Nationalizations/Pre-privatizations

•IndyMac•Fannie Mae/ Freddie Mac

•AIG

Bankruptcies

•New Century Financial•Lehman Brothers•Washington Mutual Inc.

Abroad

•HBOS Lloyds Bank•Fortis PNB Paribus

•Northern Rock•Royal Bank of Scotland•Dexia•Glitnir/Kaupthing/

Landsbanki

Baa-AAA Interest Differential The Good News: 1932 was worse

The Bad News: This downturn isn’t over until 2010

0.00

1.00

2.00

3.00

4.00

5.00

6.00May 325.64%

Apr 383.17%

Sep 822.69%

Dec 083.38

Responses Lender of Last Resort / Spender of Last Resort• Tax Rebate $124 bil.• Fed Fund Rate Cuts• Fannie/Freddie $200 bil.• Bear-Stearns $29 bil.• AIG $174 bil.

Fed “Facilities”• Primary Dealer Credit Facility (PDCF) $58 bil.• Treasury Security Loan Facility (TSLF) $133 bil.• Term Auction Facility (TAF) $416 bil.• Asset- Backed Commercial Paper Funding Facility (CPFF) $1,777 bil.• Money Market Investor Funding Facility (MMIFF) $540 bil.• More Fed Fund Rate Cuts … Hold At ~0%• Fed Purchases of Long-Term Securities: GSEs & MBSs $600 bil.• Term Asset-Backed Securities Loan Facility (TALF) $200 bil.• Emergency Economic Stabilization Act/TARP $700 bil.

Government LoansGovernment Equity

• Stimulus Package $787 bil. aka The American Recovery and Reinvestment Act

• TARP II• Stress Tests