Thursday, January 01, 2004
An analysis of Minsky’s Financial Instability Hypotheis
Anthony Emmanuel

For Minsky, financial instability is a hallmark of the capitalist economy. He writes that, “The essence of the financial instability hypothesis is that financial traumas…occur as a normal functioning result in a capitalist economy.” (Minsky 50) But this is only situational and not endemic. For Minsky, the fragility of the economy is based on how investment is financed and under what terms. And a stable economy can become unstable in a manner he describes in an almost mechanistic way. Partly through the financing of investments done with high interest risky tools and partly through the government failing to intervene in a timely manner.

From prosperity to recession the Minsky way
The movement of an economy from prosperity to recession is summed up by Minsky:
“The normal functioning of an economy with a robust financial situation is both tranquil and on the whole, successful. Tranquility and success are not self-sustaining states, they induce increases in capital asset prices relative to current output prices and a rise in acceptable debts for any prospective income flow, investments and profits. These concurrent increases lead to a transformation over time of an initially robust financial structure into a fragile structure.” (Minsky 50)
He is describing an economy with investment as its backbone and profit as its goal. Profit is any residual of price leftover from input costs. In the simple model he proposes, prices and output will equalize meaning that profits equal investment. Minsky’s point is to propose that,” current investment determines whether or not the financial commitments on business debts can be fulfilled.” (Minsky 50) If the amount of investment is low (implying low profits), firms that have borrowed money will find it harder to meet their contractual commitments. So for Minsky the fluctuation of investment is important component of his hypothesis.
Minsky relates that in periods of “tranquility” the holding of money becomes less attractive by the public as the economy comes close to full employment. This means that the,” financial system endongenously generates at least part of the finance needed by the increased investment demand…” (Minsky 44because has investors wish to hold more capital assets in place of money, they will resort to riskier financial “postures” described by Minsky as speculative and Ponzi units. These units are recognized by their high short-term interest rates. What occurs now is that there is a need for higher cash flow to be generated by investments to cover the higher interest financing. This is part of Minsky’s process, for if the investment demand had not risen has a result of the “tranquil”, full employment economy then their would not have been a higher demand for non-money investment opportunities. So the higher interest rates arising from this increased demand would not have caused the need for higher cash flow thus reducing the pressure on firms to get ever more financing to constantly increase their “investment in process”. This type of investment is what the firms have working to produce the needed profits. They will only increase the investment if profit arises.
Minsky describes the outcome,”As more investment leads to greater profits, the prices of capital assets, at constant interest rates, increase. Such an increase is an incentive for more investment: the run-up of prices and profits that characterizes a boom will result.” (Minsky 45) The inflation implied by this boom will lead to automatic action of Central Bank authorities to tamp down the growth of prices by increasing short-term interest rates. This means less profit for the firms borrowing at the higher rate and a rise in long-term interest rates as well. For the investor, “This leads to a fall in the present value of gross profits after taxes (quasi-rents) that capital assets are expected to earn.” (Minsky 45) The result is lower supply of investment capital for firms to work with. The price of capital assets will fall as well and the ultimate price of “investment output” will also fall. This naturally suggest that firms will be harder pressed to fulfill their debt contracts because, “Once profits collapse, the cash flows to validate even initially hedge [less-risky] financing arrangements will not be forthcoming.” (Minsky 47)
Specualative finance units and Ponzi finance units will now become more unsure. Firms will then sell assets in order to meet their commitments. But this will now happen at prices lower than needed to cover their debt. Minsky writes, “ Once the selling-out of positions rather than refinancing becomes prevalent, asset prices can and do fall below their cost of production as an investment good. What has been sketched is the route to a financial crisis.” (Minsky 46)
This is the result of what is described by Minsky as “debt deflation”. “In this case the fall of profits has lowered the demand price for capital assets even as the rise in ‘lender’ risk has raised the supply of investment output for any given level of money wages.” (Minsky 47) In this situation there is a disconnect between supply and demand of investment.

Implications of Minsky’s analysis
Minsky distinguishes the above events from a normal situation, in which the prospects for long-term profits and the financial structure itself have not changed. Any shifts in investment demand and supply can. “be offset by minor changes in money market conditions, the government fiscal posture, and money wage rates.” (Minsky 48) In the non-normal situation outlined in the section preceding this one, “the position of the supply and demand curves for investment output reflect changes in the long-run expectation about profits and desirable financing structure.” (Minsky 48) In this situation, “short-term changes in proximate profits, market interest rates, money wages, and the government fiscal posture might sustain ncome and employment, but will not have a quick effect upon the supply and demand for investment output.” (Minsky 49)
The non-normal situation describes “the economy …well on its way to ---or already in—deep depression.” (Minsky 49) Government intervention may be able, in Minsky’s opinion, to halt or slow down the drag if intervention is timely enough an effective enough.
Minsky suggests that, “ inflation is one way to ease payment commitments due to debt. In the 1970s a big depression has been avoided by floating off untenable debt structures through inflation.” (Minsky 50) But he admits that such a strategy is limited in effectiveness if used too frequently. Another problem is moral hazard. He doesn’t use this word but implies it by suggesting that there will be less constraints on “foolish investments” if ,”the government stands ready to guarantee particular investors or investment projects against losses.” (Minsky 52)

Policy Implication of the Minsky analysis
In the current economy, the “tranquil” environment of Minsky does not exist. But neither are we in the depths of a depression and the general impression is that the U.S. has not been in a recession since late 2001. Inflation was tamed years ago and while unemployment is higher that in recent decades, we are not in anything like the stagflation years of the 1970s or the deep recessions of the 1980s.
Minsky works from a perspective in which a fear of inflation causes a mechanistic reaction by central banking authorities. A heating up economy will cause this and the problem of high-interest rate, high-risk financing cause even more problems.
But in the economy of our moment, very low interest rates have not caused a concomitant rise in investment because investment demand is somewhat low. Consumer’s may be buying in record amounts, but the fears of firms are only lately being allayed. The low short-term rates only recently seem to be causing a rise in investment spending and hiring because of the clearing of inventories and possible long-run demand growth. In this way, one can see how Minsky’s assumptions explicate the current situation. Further, Minsky’s policy proposals, that “the encouragement of the production of consumption goods by techniques that are less capital-intensive..will be less susceptible to financial instability and inflation.” are fine for an economy at risk of overheating. Our own economy has only recently been declared safe from deflation. Over-stimulation does not seem to be a great fear, and many pundits of economics are suggesting the Federal Reserve relax its hold on the contractionary reins, as the economy appears to begin a slow ascent from it recent doldrums.
So Minsky’s prescription, which were proposed and seemed right for his moment, are too precipitous for our own. One can take heed from his words; “…there is economic organization or magic formula which… solves the problem of economic policy for all time. Economies evolve…there is no way one generation of economists can render their successors obsolete.” (Minsky 53)

Minsky, H.P. “The Financial Instability Hypothesis: A Restatement” Post-Keynsian Economic Theory, edited by P. Arestis and T. Skouras. Armonk, N.Y. M.E. Sharp. Inc., 1985
Thursday, November 20, 2003
Marx and Friedman: Perspectives on Unemployment
By A.V. Clark

Note: This essay came about as a rumination on the NAIRU (NonAccelerating Inflation Rate of Unemployment) and differing perspectives on science and ideology within economic analysis. My thanks to Gary Langer for his inspiration.
Copyright 2003. Do not reprint or quote without permission.

Karl Marx and Milton Friedman have both referred to a level of unemployment necessary to maintain stability in market economies.
But both work from a perspective that relates the proof of this level they have found (in their respective moments of history) to deeper beliefs of an ideological nature. For Friedman, it is a belief in markets that finds support from his evidence of the failure of government-led demand policy. For Marx, it is a belief that markets benefit only the capitalist and not the worker that finds support in his evidence.

Unemployment according to Milton Friedman
Friedman sets his proposition about a “natural” rate of unemployment under a section titled “What monetary policy cannot do” in the transcription of his landmark lecture in 1966 for the American Economic Review.
What it cannot do, in his analysis, is to be directed in such a way as to control a target rate of unemployment. Friedman writes, “…the monetary authority controls nominal quantities…It cannot use its control over nominal quantities to peg a real quantity.”(Friedman 11) His proposition about a “natural” rate of unemployment rests on expectations regarding real wages and prices. He writes, “ A lower level of unemployment [than the natural rate] will produce upward pressure on real wage rates. A higher level of unemployment is an indication that there is an excess supply labor that will produce downward pressure on real wage rates.”(Friedman 8) Further on, when showing an example of price and wage increases, he explains, “Suppose…that everyone anticipates that prices will rise…[t]hen wages must rise at that rate simply to keep real wages unchanged. An excess supply of labor will be reflected in a less rapid rise in nominal wages than in anticipated prices, not in an absolute decline in wages.”(Friedman 9) He then continues with his example showing that because of anticipated inflation, there would be a rise in unemployment because, “under the influence of earlier anticipations, wages kept rising at a pace that was higher than the new price rise, though lower than earlier. This is result experienced and to be expected, of all attempts to reduce the rate of inflation below that widely anticipated.”(Friedman 9) “Real” wages and the expectations of workers and owners are behind his “natural” rate. This was to set his propositions in contradistinction with theories such as that behind the Phillips curve, which also showed a balance between unemployment and inflation but only from the perspective of nominal amounts.
Ultimately, the “natural” rate of unemployment, as shown by Friedman, refers to some threshold level of unemployment below which inflation will rise. But it appears that this rate is related as much to structural changes within the labor market and to institutional considerations as to monetary policy. Friedman writes that, “…many of the market characteristics that determine [natural rate] level are man-made and policy-made…” (Friedman 9) And it also appears by Friedman’s own admission, that this rate is an unknown quantity. He writes that, “ One problem is that [monetary authority] cannot know what the “natural” rate.”(Friedman 10) And he concludes by stating, “…there is always a temporary trade-off between inflation and unemployment; there, is no permanent trade-off.”(Friedman 11) With this, he makes final the distinction between his propositions and the somewhat similar Philips Curve.

Friedman: Ideology and Science
Mark Skousen writes of Friedman that, “In his autobiography, Friedman says he was "cured" of Keynesian thinking "shortly after the end of the war," but doesn't elaborate. In a recent letter, he denies ever being a thorough Keynesian. ‘I was never a Keynesian in the sense of being persuaded of the virtues of government intervention as opposed to free markets.’” Perhaps in the manner of a good convert, Friedman adheres strictly to the letter of his new dogma and allows for overcompensation towards his formers beliefs. This he sums up by writing,” The wide acceptance of [Keynesian] views in the economics profession meant that for some two decades monetary policy was believed by all but a few reactionary souls to have been rendered obsolete by new economic knowledge. Money did not matter.”(Friedman 2)
But Friedman saw the re-ascendance of monetary policy as necessary. In his findings, misdirected monetary policy had been the cause of the Great Depression. For him, “The Great Contraction [Depression] is tragic testimony to the power of monetary policy—not, as Keynes and so many of his contemporaries believed, evidence of its impotence.”(Friedman 3) And he believed the post-World War 2 inflation to be because of misdirected Keynesian prescriptions: “These views produces a widespread adoption of cheap money policies after the war. And they received a rude shock when these policies failed in country after country…”(Friedman 2)
But his thoughts on monetary policy went further than his historical studies of the failure of Keynesian policy. He declares monetary policy to be the ultimate tool of growth and stability. But not directed monetary policy, as this is too prone to error due to the “long and variable lags” he predicts afflict the ability to make policy. For him, “The Great Contraction might not have occurred at all, and if it had, it would have been far less severe, if the monetary authority had avoided mistakes, or if the monetary arrangements had been those of an earlier time when there was no central authority with the power to make the kinds of mistakes that the Federal Reserve System made.”(Friedman 12) For him the only role of monetary policy was to get out of the way of itself.
He suggests, using the words of John Stuart Mill, that money is a machine. And he goes further writing, “ True, money is only a machine, but it is an extraordinarily efficient machine.”(Friedman 12) And he claims that, “Every other major contraction in this country has been either produced by monetary disorder or greatly exacerbated by monetary disorder.” He continues by asserting that monetary policy can, “…provide a stable background for the economy--keep the machine well-oiled, to continue Mill’s analogy.”(Friedman 13) He goes further, writing, “Our economic system will work best when producers and consumers, employers and employees, can proceed with full confidence that the average level of prices will behave in a known way in the future—preferably that it will be highly stable” (Friedman 13)
He makes observations that relate directly to an ideology of the proper course of the economy in writing “But steady monetary growth would provide a monetary climate favorable to the effective operation of those basic forces of enterprise, ingenuity, invention, hard work, and thrift that are the true springs of economic growth. That is the most that we can ask from monetary policy at our present stage of knowledge.” (Friedman 16) And given that he didn’t see fiscal policy as efficacious, then he seems to proposing a policy of non-intervention. His observations support a laissez-faire ideology.
The message was clear: Hands off the levers, let the machine run with minimal settings.

Unemployment according to Karl Marx
Marx describes the accumulator (whom I shall refer to as “the capitalist”): “ His aim is augmentation of his capital, production of commodities containing more labour than he pays for, containing therefore a portion of value that costs him nothing, and that is nevertheless realized when the commodities are sold. Production of surplus-value is the absolute law of this mode of production.”(Marx 4)
Marx ties the demand for labor to the need to accumulate, that is, to profit. For Marx, the accumulation of capital is the cause of shifts in employment. He writes, “To put it mathematically: the rate of accumulation is the independent, not the dependent, variable; the rate of wages, the dependent, not the independent variable.”(Marx 4)
Marx writes that, “Since the demand for labour is determined not by the amount of capital as a whole, but by its variable constituent alone, that demand falls progressively with the increase of the total capital, instead of, as previously assumed, rising in proportion to it…. With the growth of the total capital, its variable constituent or the labour incorporated in it, also does increase, but in a constantly diminishing proportion…. it is capitalistic accumulation itself that constantly produces…a relativity[sic] redundant population of labourers, i.e., a population of greater extent than suffices for the average needs of the self-expansion of capital, and therefore a surplus-population.”(Marx 11)
Marx goes further, declaring that the existence of a surplus of laborers is not just a consequence of the system, but an important component within it: “But if a surplus labouring population is a necessary product of accumulation or of the development of wealth on a capitalist basis, this surplus-population becomes, conversely, the lever of capitalistic accumulation, nay, a condition of existence of the capitalist mode of production. It forms a disposable industrial reserve army, that belongs to capital quite as absolutely as if the latter had bred it at its own cost.”(Marx 11) This surplus grows, “…because the technical conditions of the process of production themselves—machinery, means of transport, [etc.] now admit the rapidest transformation of masses of surplus-product into additional means of production…Overpopulation supplies these masses.”(Marx 12) This population comes about precisely because of their own labors,” The labouring population therefore produces, along with the accumulation capital produced by it, the means by which it itself is made relatively superfluous, is turned in to a relative surplus-population; and it does this to an always increasing extent.”(Marx 11)
For Marx, it is only by the addition of the surplus workers who, “nourishes capital”(Marx 5) that makes wages rise. Once the unemployment rate of these workers goes below the point of surplus, “a smaller part of revenue is capitalized accumulation lags, and the movement of rise in wages receives a check. The rise of wages therefore is confined within limits that not only leave intact the foundations of the capitalistic system, but also secure its reproduction on progressive scale.”(Marx 5)

So it seems that, for Marx, the stability of the market led system relies on a rate of unemployment. But the forces of an invisible hand do not set this rate. The hand is quite visible and it belongs to the capitalist. He considers,

”The demand for labour is not identical with increase of capital, nor supply of labour with increase of the working-class. [The dice are fixed]. Capital works on both sides at the same time. If its accumulation, on the one hand, increases the demand for labour, it increases on the other the supply labourers by the ‘setting free’ of them, whilst at the same time the pressure of the unemployed compels those that are employed to furnish more labour, and therefore makes the supply of labour, to a certain extent, independent of the supply of labourers. The action of the law of supply and demand of labour on this basis completes the despotism of capital.”(Marx 16)

I have used this long passage to make clear the connection Marx sees between exploitation by capitalist with a rate of unemployment. He believes the system requires some workers to be unemployed, but not because of drags on growth of total economy through inflation as Friedman would suggest. For Marx, the system is only about the growth of capital to be accumulated by those few who have provided the capital and hire the workers: “the law of capitalistic accumulation, metamorphosed by economists into pretended law of Nature, in reality merely states that the very nature of accumulation excludes every diminution in the degree of exploitation of labour…It cannot be otherwise in a mode of production in which labourer exists to satisfy the needs of self-expansion of existing values, instead of, on the contrary, material wealth existing to satisfy the needs of development on the part of the labourer.(Marx 5)
Marx also sees the unemployed or surplus-population, as he calls it, in, “…three forms, the floating, the latent, the stagnant.”(Marx 16) Thus he seems to innovate the structure of unemployment we now know.
He also seems to disparage an early version of the monetarists stating,” The so-called currency school concludes from this that with high prices too much, with low prices too little money is in circulation. Their ignorance and complete misunderstanding of facts are worthily paralleled by the economists, who interpret the above phenomena of accumulation by saying that there are now too few, now too many wage-labourers.”(Marx 5)

Friedman and Marx: Ideology and Science
Joan Robinson wrote, “We must go round about to find the roots of our own beliefs…economics itself…has always been partly a vehicle for the ruling ideology of each period as well as partly a method of scientific investigation.”(Robinson 1)
If we are to believe in a separation of positive and normative statements in economics (a seeming impossibility) it may be said that to identify those parts of Friedman’s and Marx’s respective argument that should be resisted because of their normative properties would require one to indulge fully in an normative counterargument. That is, for one to say that the evidence of economics is separate from the belief system that created it.
Friedman’s ideology is in his faith in market economies and the need to husband its growth without managing its movements. He seemingly separates the science of his perspective from ideology, referring to his historical research into the primacy of Keynesian interventionist policy and its observed failings up to and including the post-World War 2 period. His belief system is subsumed in his findings. He promotes an almost self-perpetuating engine for economic stability through almost non-existent monetary policy. He does not question the reason for the need of this stability or its outcomes. He writes, “There is wide agreement about the major goals of economic policy: high employment, stable prices, and rapid growth.”(Friedman 1) The natural question is “agreement among whom?” For Friedman the question is merely reflexive. His beliefs are present in the statement and his proposal supporting the efficient way to achieving the goals in the statement.
This is distinct from Marx, who questions the whole structure of the market economy. He examines the engine only to point out the flaws in the entire vehicle. Economic analysis, as he saw it, was “economic apologetics”. He presents examples of theory only to brush them away as “effrontery” (Marx 15) The fate of worker is to be exploited and the prospect of improvement because of movements in the structure of the labor-wage construct is, for him, unlikely because, “ A rise in the price of labor, as a consequence of accumulation of capital, only means, in fact, that the length and weight of the golden chain the wage-worker has already forged for himself, allow of a relaxation of the tension of it.”(Marx 4)
Friedman’s perspective is obvious in his use of language. The term “natural” seems to imply a state of perfection. That this perfection is reliant on non-interventionist monetary policy set in motion and then left to run itself gives one the impression of a deity creating a state of nature and then watching it run from afar. For Marx, the system is set to work to the advantage of those who hold capital. The intervention is implied and complete. Their respective science found in their historical analyses and statistical gatherings is in the support of their perspective. Which came first, the ideology or the science? I cannot speak for either gentleman. But the ideology is certainly supported by the evidence. And their respective perspective certainly would have influenced their viewing of the evidence.

Friedman, Milton “The Role of Monetary Policy”, The American Economic Review, Volume 58, Issue 1. March 1968.
Marx, Karl Capital: Volume 1.
Marx, Karl The German Ideology. Part 1
Robinson, Joan Economic Philosophy, Aldine Publishing. Chicago. 1962
Skousen, Mark “The Freeman”, Volume 48, Number7. July 1998

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