Part 2 (1/2)

Friedovernovern a la Keynes-but they believed that a drop in the money supply could have been avoided had the Federal Reserve aggressively cut the rates at which banks could borrow from it More important, theas a lender of last resort,banks and financial institutions Had the Federal Reserve prevented the waves of bank failures in the early 1930s, they argued, the Great Depression would not have been so great, and the nation would have suffered through an ordinary recession before recovering

The monetarist interpretation of the Great Depression has some merit: the collapse of the money supply in the 1930s certainly exacerbated the credit crunch, and the Federal Reserve only made matters worse But other econoued that the collapse in aggregate demand was the priued, wascould have sustained aggregate deressive monetary policy would have contributed to the eventual recovery

Nonetheless, it was Friedly influential in the 1970s and 1980s One reason was that what little remained of Keynesian econonificant portions of Keynes's writings-not only The General Theory but his earlier A Treatise on Money-contained plenty of other insights that the postwar generation of econonored in their atteht, particularly the classical economists That effort, which came to be known as the neoclassical synthesis, was a(One critic called it ”bastard Keynesianisovern else Keynes wrote was ignored

Not everyone discounted the other implications of Keynes's work, however Hyton University in St Louis, dedicated his life to building a theoretical edifice on the foundation that Keynes had laid Minsky authored an intellectual biography of Keynes and an elaboration of his own distinct interpretation, pointedly titled Stabilizing an Unstable Econo with nuued that Keynes had been lected chapters of The General Theory that dealt with banks, credit, and financial institutions, and he synthesized theued, had ument that capitalism was by its very nature unstable and prone to collapse ”Instability,” Minsky wrote, ”is an inherent and inescapable flaw of capitalisinates in the very financial institutions that make capitalism possible ”Implicit in [Keynes's] analysis,” he wrote, ”is a view that the capitalist economy is fundamentally flawed This flaw exists because the financial systeor-which translates entrepreneurial animal spirits into effective demand for investment-contains the potential for runaway expansion, powered by an investment boorind to a halt because ”accuile”

Minsky repeatedly came back to Keynes's observation that financial inter role increditors and debtors in elaborate and complex financial webs ”The interposition of this veil of money,” wrote Keynes, ”is an especiallyto Minsky, Keynes offered a ”deep analysis” of how financial forces interact with variables of production and consumption, on the one hand, and output, employment, and prices on the other

All of this stood in stark contrast to the economics profession in the postwar era: the equations and models deployed by architects of the neoclassical synthesis had little or no place for banks and other financial institutions, despite the fact that their failure could wreak havoc on the larger econo how banks and other financial institutions could, as they beca the entire syste down The centerpiece of his analysis was debt: how it is accu Keynes, he saw debt as part of a dynaain, per Keynes, he recognized that this dynaood tirowth and profits allayed uncertainty But in bad times, uncertainty would pro, reduce risk and exposure, and hoard capital

In itself, this vieas not entirely revolutionary But Minsky's Financial Instability Hypothesis had another diiven econo they used: hedge borrowers, speculative borrowers, and Ponzi borrowers Hedge borrowers are those who can make payments on both the interest and the principal of their debts from their current cash flow Speculative borrowers are those whose income will cover interest payments but not the principal; they have to roll over their debts, selling new debt to pay off old Ponzi borrowers are the most unstable: their income covers neither the principal nor the interest paye their future finances by borrowing still further, hoping for a rise in the value of the assests they purchased with borroweda speculative booe borrowers declines, while the nue borrowers, now flush with cash thanks to their conservative invest to speculative and Ponzi borrowers The asset at the center of the boo all borrowers to take on even more debt As the amount of unserviceable debt balloons, the system becomes ever er is almost irrelevant: it could be the failure of a fire funds and major banks marked the end of the bubble in 2007 and 2008) or the revelation of a staggering fraud (like the Bernard Madoff scheme, exposed in 2008)

When pyramids of debt start to crumble and credit dries up, Minsky realized, otherwise healthy financial institutions, corporations, and consumers may find themselves short of cash, unable to pay their debts without selling off assets at bargain-basement prices As more and more people rush to sell their assets, the prices of those assets spiral doard, creating a self-perpetuating cycle of fire sales, falling prices, and ate deer econo day, each dollar purchases more than it did the day before

It sounds like a blessing, but for debtors it's a curse Irving Fisher, a Great Depression economist who coined the term ”debt deflation” (see chapter 6) to describe this process, observed that if the price of goods falls faster than debts are reduced, the real value of private debts will rise over tiine that someone borrows a million dollars to buy a house with no money down The house is worth a million dollars; the owner owes a million dollars Then deflation kicks in, and prices fall across the econo from the price of the house to the salary of the owner declines Everything costs less, but everyone has less e has increased: a er burden than it was previously

Because deflation increases people's debt burden, it also increases the probability of default and bankruptcy As defaults and bankruptcies soar, the doard spiral continues, dragging the economy into a depression Between October 1929 and March 1933, for example, the liquidations of assets reduced the nominal value of private debts by 20 percent But thanks to deflation, the real burden of those debts increased by a whopping 40 percent

In order to avoid a repeat of the Great Depression, Fisher (and for that matter, Friedman and Minsky) counseled that a central bank-the Federal Reserve, in the case of the United States-should step in to play the role of lender of last resort, providing the necessary financing for banks and even for corporations and individuals In extreovern the econo it with easy money

That's exactly what has been done in our own time Over the course of 2007 and 2008, as the financial crisis deepened, American policy makers looked to the lessons of the Great Depression and acted accordingly Rather than let thousands of banks and corporations go under, as Hoover had done in the early 1930s, the Federal Reserve made available unprecedented lines of credit That enabled investe funds, money market funds, and others to avoid insolvency and eventually halted the vicious cycle of fire sales, falling prices, and more fire sales Likewise, iven lines of credit to prevent thes, where their assets would have been liquidated Instead, the governanized and reborn It was all a far cry from the ”leave-it-alone liquidationists” of the Hoover administration

The policy response on the fiscal level also starkly contrasts hat happened during the Great Depression As the early 1930s crisis spiraled out of control, the idea of using governliovernet, which pro and tax hikes, both of which arrived at the worst possible tiest stimulus bill in the nation's history, which included plentiful tax breaks Between overnment's various levers of control over the overn that should have been done was done, however iardless of their theoretical inclinations, econo of the recent crisis, right? Wrong There's another way of looking at financial crises, one that points to an entirely different understanding of the Great Depression of the 1930s, the japanese near depression and Lost Decade of the 1990s, and the Great Recession of our own tiinated in the late nineteenth and early twentieth centuries with a loosely affiliated group of Austrian econoen von Bohm-Bawerk, and Friedrich Hayek These econo Joseph Schumpeter, were a fractious bunch and are next to iorize The same can be said of those twenty-first-century economists who consider theeneralizations are possible Being an Austrian econo libertarian econoovernment intervention in the economy-especially in the monetary system-is a pillar of the Austrian School For exa distinction between sustainable econos and unstable, ill-fated expansion financed by credit froree with Keynes and Minsky that excessive asset and credit bubbles lead to dangerous crises, they don't blaovernulations and interventions that allegedly interfere with the workings of the free oes hand in hand with another hallmark of the Austrian approach: a focus on individual entrepreneurs as the unit of econoh he was hardly a libertarian, Joseph Schumpeter developed a powerful theory of entrepreneurshi+p that is often distilled down to a pair of powerful words: creative destruction In Schumpeter's worldview, capitalism consists of waves of innovation in prosperous ti in ti is to be neither avoided nor minimized: it is a painful but positive adjustment, whose survivors will create a new economic order

For those who embrace the Austrian point of view, the Great Depression is an object lesson in the perils not of doing too little in the face of a crisis but of doing too ed the Great Depression by intervening in the econo that by overseeing the Reconstruction Finance Corporation, a governovernments, he too stood in the way of the necessary but painful process of ”creative destruction”

This dispute over distant crises may seem academic, but it's not: Austrian School economists make a historical case that the policy response to the recent crisis will eventually give us the worst of all worlds Instead of letting weak, overleveraged banks, corporations, and even households perish in a burst of creative destruction, thereby allowing the strong to survive and thrive, govern an econo to life with endless lines of credit from central banks; zoovernment ownershi+p for their continued survival; and zoislation that keeps creditors at bay and that spares the homes they could not afford in the first place

In the process, private losses are socialized: they becoe and, by iet deficits lead to unsustainable increases in public debt In tiovernrowth In extreovernment to default on its debt, or alternatively, to start printing er bouts of dangerously high inflation In either case, the Austrians argue, the best course of action would have been to let the inevitable liquidations take place as quickly as possible If Andrew Mellon were alive today, he would find friends in the Austrian camp

Economists of the Austrian persuasion are also deeply skeptical of the rush to regulate that so often occurs in the wake of a crisis In their view, too ulation was the cause of the crisis in the first place, and adding more will only make future crises worse This seeulation cause a crisis? The Austrians would respond that innovations like deposit insurance and lender-of-last-resort support, while offering security to anyone with a savings account, have nonetheless increased bankers' appetite for risk Much as someone ears a seat belt reater risks-and the potential for accruing greater profits-secure in the knowledge that if they failed, the federal governht with their depositors

This saovernment interventions in the economy Earlier this decade, Wall Street analysts spoke of the ”Greenspan put”-the belief that the Federal Reserve would rescue financial firms with easy money, special lines of credit, and lender-of-last-resort support (A put is an option that an investor can purchase to hedge against a sharp market downturn) The Greenspan put is precisely what happened when the crisis hit: the Federal Reserve stepped into the breach, rewarding incoesse-or at least, that is how the Austrians would interpret it In the process, they argue, it only fostered a bigger and more disastrous booue that many of the common cures for financial disasters are worse than the disease On the one hand, if governments run fiscal deficits in order to keep the economy afloat, levels of public debt becoovern off whatever recovery may be under way The Austrians are equally critical of the easy solution to this probleue, will invariably lead to inflation and aneflation that crippled the United States in the 1970s Either way, the Austrians believe, government can only er bubble down the line, as everyone comes to believe that in the event of a future financial crisis, a bailout will be forthco

Much of the Austrian vision seems extreme, or at the very least heartless It is the antithesis of Keynesian thinking, nificant rival of Keynes when both were alive If Keynes advanced a vision of capitalisht occasionally becoovernment intervention), Schumpeter believed instability to be the necessary consequence of the kind of innovation that made capitalism possible in the first place

From the Austrian perspective, the fear now is that the United States is heading down the road that japan paved in the 1990s, when it responded to its own slow- up zo interest rates down to zero, flooding the econoovernment also ran enor that Keynes prescribed Instead of allowing ”creative destruction,” the japanese built bridges to nowhere that merely put enorovernment The result, the Austrians maintain, was japan's Lost Decade

Does the Austrian view have any ue that japan failed to implement the appropriate fiscal stiovernment waited two years after the collapse of the bubble to start its stiht years to cut interest rates from 8 percent to 0 percent Then it moved away from this zero-interest-rate policy (better known as ZIRP) too soon Just as FDR curtailed fiscal andin a severe recession, japan triggered a recession that lasted froic, the United States, should it curtail stihten the monetary reins while the recovery has barely started, risks repeating this uided when it conized, in the absence of government intervention, a crisis caused by financial excesses can becoins as a reasonable retreat from risk can turn into a rout When the ”animal spirits” of capitalism vanish, the ”creative destruction” hailed by the Austrians can swiftly turn into a self-fulfilling collapse of private aggregate demand As a consequence, distressed but still-solvent firain access to the credit necessary for their continued survival It's one thing if truly insolvent banks, firether when innocent bystanders to an economic crisis are forced into bankruptcy because credit dries up

In order to prevent this kind of collateral dae, it makes sense to follow the playbook devised by Keynes in the short ternificant portions of the economy are not only illiquid but insolvent In the short term, it's best to prevent a disorderly collapse of the entire financial syste and the creation of bulwarks: via lender-of-last-resort support, for exa banks It's also best to prop up aggregate de so will prevent a financial crisis fro comparable to japan's Lost Decade or, worse, the Great Depression

But when it co ter to teach us Even Minsky correctly pointed out that resolving a financial crisis over theterm requires that everyone from households to corporations to banks reduce their level of debt Putting this off is always a serious e, banks, firms, and households drown in debt, unable to lend, spend, consu governet rid of these debts by trying to inflate the currency These actions merely move the proble term, it is absolutely necessary for insolvent banks, fir theeneral, the followers of Keynes and the followers of Schumpeter don't talk to each other That's unfortunate, because both thinkers-and the larger schools of econo to say about what should be done The insights of both schools can be synthesized and brought to bear on the problems we face now; indeed, the successful resolution of the recent crisis depends on a prag that while sti, bailouts, lender-of-last-resort support, and monetary policyer term in order to achieve a return to prosperity

What we counsel is a kind of controlled ”creative destruction” Financial crises are a bit like nuclear energy: they are enory is released at once, but much less so if channeled and controlled The overnht the financial crisis under control But much remains to be done: radioactive assets the world over ulations must be written, and international financial institutions reborn

How toquestion of our time Keynes once observed that ”economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storain” The waters will eventually stop churning, but how long it takes them to subside depends on how economists approach the problem, craft solutions, and es, it's worth adding one more arrow to the quiver of crisis economics The study of crises cannot be confined to economic theories alone A final perspective is necessary, one that is not easily distilled to a school of thought, a model, or an equation: the study of the past

The Uses of History

In June 2009 the legendary economist Paul Samuelson sat doith an interviewer Samuelson, who remained as productive as ever into his nineties, is widely considered the greatest economist of the last half century A founder and codifier of the neoclassical school, he oversaw his profession's e timeless economic phenomena But when the interviewer innocently asked, ”What would you say to soave an unexpected answer ”Well,” he said, ”this is probably a change froer Have a very healthy respect for the study of economic history, because that's the raw s will coht-economic history is important, far more than theories of efficient markets and rational investors would lead one to believe That's not because history repeats itself in soh parallels between past and present are plentiful Rather, history is useful precisely because its raw material can inforritty, real-life detail into elegant mathematical models, like those devised by Saious faith in models helped create the conditions for the crisis in the first place, blinding traders and market players to the very real risks that had been accu for years History pro crises, which so often coant proclaer apply

We are hardly alone in our desire to harness history As long as there have been crises, there have been attempts to put them in historical context Amateurs like the Scottish journalist Charles Mackay, whose Extraordinary Popular Delusions and the Madness of Croas published in 1841, began the effort Though only partially concerned with economic crises (and chock-full of inaccuracies), Mackay's book may have been the first attempt to draw lessons from the history of econos are an irrational lot, prone to fits of economic exuberance and euphoria-anticipated both behavioral econo on crises

Several professional historians and economists followed in Mackay's footsteps, but not until the econoer wrote Manias, Panics, and Crashes in 1978 did so historical theory of crises It becah its conclusions were evidently ignored in the years leading up to the recent disaster, its spirit of inquiry ani So too does it aniorous work of Caroff In This Tiht Centuries of Financial Folly (2009), these two economists assembled athat while the details of currency crashes, banking panics, and debt defaults change, the broader trajectory of crises varies little fro with the work of numerous other historians and econoins of crises as well as their lingering aftereffects Clearly the best way to understand crises is to see them as part of a broader continuu after the acute phase of the crisis In this spirit, we turn next to tracking some of those deeper structural forces that over e for a crisis

Chapter 3

Plate Tectonics

A fa like this: A housing bubble in the United States got out of control soes they couldn't afford and eventually defaulted on thees went on to infect and topple the global financial system