Washington refuses to understand that debt can be an essential tool for economic growth. Can we overcome this irrational and destructive fear?
Minsky proceeded from two key insights, both of which diverged sharply from the orthodoxy of the day (he died in 1996): first, the centrality of debt to a functioning economy, and second, the tendency of financial markets toward instability. As I stressed at the beginning of this essay, the basic idea of debt is not only sound but essential to growth. Borrowing from the future to invest in the present is one way to improve that future. And some of the economic gains that flow from the investment will be used to pay down the debt.
Minsky’s second insight, about instability, was once nicely summed up by the great game theorist Yogi Berra, who pointed out, “It’s tough to make predictions, especially about the future.” So uncertainty and risk must be accounted for, and in a rational market, the rate of interest would put a price on the loan that accurately reflected its risk. And in fact, that’s often the case at the beginning of economic recoveries. Growth is newly back on the scene, businesses and households start to get active again, and lenders tend toward a reasonable degree of caution in evaluating their loan prospects.
However, as the recovery ages and growth picks up speed, risk aversion diminishes. Loans that didn’t seem creditworthy a year ago start looking pretty good. Minsky also recognized that new forms of lending often begin to sprout up at this stage—“innovations” that enable their inventors to lend into the accelerating cycle ahead of their competitors. These innovations may be poorly understood, and not just by the borrower, but by the lender as well. They may involve gambles that can’t possibly end well, such as loans whose repayment is wholly dependent on a price bubble in the underlying asset, or even outright fraud, like what came to be called “liar loans,” where lending intermediaries ignored or falsified documentation to create the appearance of credit worthiness.
Minsky’s model could be viewed mistakenly as simple common sense: a) Debt financing is pro-cyclical, and b) lenders get sloppy (or cryptic) as the cycle proceeds. But his model says more than this. As Cassidy puts it, “At the risk of oversimplifying, Minsky’s argument can be reduced to three words: stability is destabilizing.” Under this model, debt can be like a virus in the body of a business cycle. It starts out supporting the organism in ways salutary and safe, but is unable to modulate its growth, and it ultimately infects the system under the weight of leverage.
Our failure to understand this dynamic has led to our current pass: a fixation on debt when the system needs more of it, and complacency about debt when we need vigilance. Minsky would have recognized the signs that something was amiss as the 2000s debt cycle shifted into overdrive. The underpricing of risk, financial innovations, leverage ratios that were multiples of their historical averages, and the shadow banking system—all signaled that the virus had been activated and would soon destabilize the system.
Where Does This All Leave Us?
As I’ve stressed throughout, debt is not just important—it is an essential tool of economic growth. Neither families nor firms nor governments can adequately help themselves or their constituents without the ability to borrow from the future to spend or invest in the present. Yet market and political failures have undermined this essential function, and the politics of budget deficits have devolved to the point where, at least rhetorically, any debt is bad debt. It is impossible to overemphasize the lasting harm done by this anti-deficit fervor.
The good news is that—putting politics aside—all of this is fixable. The United States still hosts mature, flexible, adequately capitalized credit markets. In fact, credit markets are working exactly as they should be right now, with interest rates signaling us—if not screaming at us—to borrow and apply fiscal stimulus. Over at the Federal Reserve, the interest rate has been stuck at zero. But households are still deleveraging and still on insecure economic ground, so they’re not much moved by the low rates. It’s the same with firms that are flush with cash reserves but not moved to use them unless they see a profitable reason to do so.
What’s needed is more demand, more customers, more factory orders. Absent those, monetary stimulus—the Fed’s Operation Twist, quantitative easing—risks “pushing on a string.” But if more folks could get back to work and increase their hours and paychecks, then businesses would see more foot traffic and investors could see some profitable openings. As Vice President Biden’s chief economist, I saw up close that the Recovery Act helped significantly in this regard. Upon its passage, the loss rates of both GDP and jobs began to diminish; GDP turned positive in mid-2009 and employment began to grow in the spring of 2010. But while the Recovery Act (along with aggressive monetary policy by the Federal Reserve) arrested the decline, it only helped shift the economy from reverse into neutral. We’re stuck in the doldrums with deep excess capacity, and monetary policy alone can’t get us out. We need temporary measures that would borrow a lot more; I liked the President’s jobs plan but I’d have gone twice as large (though truth be told, in today’s climate it’s actually an ambitious plan). But we won’t do it because we’re too damn scared of deficits and debt.
We also have the means to take a solid stab at fixing the instability cycle in financial markets. That’s the purpose of the Dodd-Frank financial reform legislation, which I view as the first real attempt at “Minsky insurance”—that is, of protecting against the next financial instability cycle-debt bubble—in decades. It’s not perfect, but it has the right attributes, all of which could be fine-tuned if we can only fight back against the amnesiacs who can’t remember what happened a few years ago.
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