Tuesday, May 12, 2009

Keynes vs Minsky "Financial Instability Hypothesis" and GREED

John Maynard Keynes formulated the body known today as Keynesian economics is his largest work "General Theory" of 1936. Keynesian economics with its microeconomic cousin, neoclassical economics, is the basis for the actions of world governments over the past year of financial bailout and of the economic structure that preceded it (likely even fueled it).

Keynesian economics states that in the long-run economic systems converge on an equilibrium of stability. Any divergence from that is a slight swing off the convergence on the path to enlightenment, I mean equilibrium. The role of government is to facilitate that convergence.

Likely the most quoted phrase from General Theory is:
"In the long run we are all dead."

But if the quote is taken in context Keynes becomes the first proponent against his whole body of work in
“But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.” (Keynes, 1923)

I seem to remember that he admitted that the chapter around that quote was a divergence hinting at another fundamental thought process but not developed enough to create another body of work.

Hyman Minsky developed the "Financial Instability Hypothesis" motivated from Keynes's above divergence and the interesting conversion story of Irving Fisher after financial ruin in the Great Depression. Financial Instability Hypothesis (FIH) in simplistic summary says that in very good environments economic decisions will be made with an overconfidence of financial stability. These decisions will typically (borrowing from Fisher's Debt Deflation Theory) motivate excess leverage that advance farther than a stable economy will allow. The result being a financial collapse.

For this theory to be true, an economy would start at a reasonably healthy period, follow with above average growth rates of investment, and borrowing that presumes and requires a new stability to last. At the same time, savings would drop (which also helps the economy grow through consumption or investment). This would necessitate a bubble burst bringing the economy to its knees.

If this school of thought had been introduced in my college econ classes, I am not sure I would have had the insight to decide which is more likely to be true. Currently I have no doubts. FIH explains our economy today where Keynesian economics by definition counts the current environment as a statistical impossibility and abberation.

I worry about our country solving a problem with a school of thought that says it could not even exist. Almost like a church getting consulting advice from an aetheist.

Fundamentally the analogy may be more applicable than at first glance. Keynesian theory says market participants will stop at good enough, FIH says they will want more. FIH not only allows the deceit we see today, but builds it in as a core assumption.

GREED.

It says that the GREED motivation grows as things get better until the Ponzi scheme ends (and that is the term used).

Keynes says that Madoff, Kenneth Lay, Jeffery Skilling really didn't happen.

Minsky says they happened and will happen more frequently the better things look because regulators become lazy or tied in, investors become lazy or too trusting, and excess money exists from excess borrowing. After a cleansing period where debt decreases, skepticism and fear rain, a higher level of decency will emerge.

So the question is one of original sin. Answer that and you will know which school of economics you should believe. For me I see far too much proof that greed and fear rule and stability is a pipe dream

--at least on this side of eternity.

Major proponents of Financial Instability Hypothesis:
James Kenneth Galbraith
Steve Keen

UPDATE 6/18/09
Here is a paper that more readily substantiates these claims by people far more equipped to make such claims.