An Overview Of Minsky's Theory of Finance And Its Relationship to Business Cycles

This is a wonkish article on the relationship between finance and the economy. The first part of the article is about an ongoing war between Paul Krugman and those who argue that neo-liberal economists make the mistake of regarding finance as exogenous to the real economy. They don't believe that most economists really understand how finance works. It is best to skip that part of the article and to learn about Seymour Minsky and his view of the relationship between finance and economics which is valuable.

Minsky's financial instability hypothesis received a lot of attention during the financial crisis. The model shows that finance is procyclical, That is, it exaggerates booms and makes the busts even harder to deal with. This idea is related to Keynes's idea of animal spirits. Borrowers and lenders take dangerous risks in good times in the pursuit of profits. In bad times they become risk averse. Business is reluctant to make investments with borrowed funds and lenders raise their lending standards. The money supply falls and government must take actions to boost the money supply and run budget deficits to stimulate demand.

Minsky also proposed an alternative to government welfare. He argued that government should be the employer of last resort in recession. Every household would receive one government job at the minimum wage. The spending of these households would have multiplied affect on GDP and federal tax revenues which would pay for the job provision. He argued that this was better than using welfare to create a dependent underclass.

Minsky also believed that finance moved through various stages over time. He called the current stage of finance "money manager finance." This is called shadow banking today. It is largely unregulated and dependent upon the ability to turn over short term debt, and to use leverage to maximize returns. The instability of this system only reinforces the inherent instability of capitalism. It is dependent upon government intervention to keep finance from collapse and to stabilize the wide swings in the business cycle.