Minsky's Analysis of Capitalism

Following is a digest of a paper "Minsky's Analysis of Financial
Capitalism," by Dimitri B. Papadimitriou and L. Randall Wray, of
Jerome Levy Economics Institute, July 1999.
The late Hyman Minsky (1919?1996) was a leading authority on monetary
theory and financial institutions. For much of Minsky?s career,
mainstream economics paid little attention to the role of the
financial system in macroeconomic theory. But in recent years, there
has been an outpouring of new research, both theoretical and
empirical, much of which validates his remarkable insights.

Capitalism's Many Stages

Capitalism is constantly evolving. We can identify several distinct
stages in its evolution going back to the early 1600s. Today,
capitalism is quite different from what it was just 30 years ago, and
it may now be in the process of evolving into a new stage through
globalization. The one constant throughout is the profit-seeking
motive in money terms that leads to continual innovation, especially
in finance. Firms spend money to earn more money.

Financial institutions play a critical but delicate role, since they
are themselves profit-seeking enterprises. They not only supply the
funds, but may have a direct stake in the potential profits of the
enterprise. Banks increase the money supply whenever they share the
belief of the borrower that positions in assets or financed activity
will generate sufficient cash flows. Money is thus created as a
result of normal economic processes.

The Key Role of Firms

A modern economy is ultimately dependent on the viability of its
firms, all of which are owned by the household sector, and which
provide the main source of household income as wages. The focus
should therefore be on firms, not households, and on investment and
its finance, not on consumption and saving out of household income
flows. This is in sharp contrast to the exposition found in
textbooks, which begins with households and their consumption versus
saving decision, with thrift determining investment and therefore

Two Price Model

Minsky?s analysis involves two sets of prices. One set consists of
the prices of current output -- consumption, investment, government,
and export goods and services. The other set is the prices of
assets-- capital assets used by firms in production and financial
instruments that firms issue to gain control of fixed and working
capital. The second set of prices is critical in determining how much
investment will be undertaken. The two sets of prices reflect what
happens in two different sets of markets, and thus will vary
independently. This is in marked contrast to the single price system
of the consumption versus investment model typically used in

Spending on investment depends on the demand price of capital assets
(what firms are willing to pay) relative to supply prices (what
suppliers require to produce them). For capital assets to be produced
and thus generate profits, demand prices must exceed supply prices by
enough to cover the risks. The resulting investment will then
validate previous investment. Investment today determines whether
investment yesterday was a good idea. But investment today depends on
expectations about the future regarding demand and supply prices of
investment goods. Whether there will be aggregate profits to
distribute depends on aggregate capitalist spending.

The Role of Profits

Capitalism involves the acquisition of expensive assets that usually
necessitate financing of positions in those assets. A firm must have
sufficient market power to assure lenders that it will earn enough to
service its financial liabilities. Thus a goal of every firm is to
gain market power in order to control its markup. The ability to set
price is critical in determining who gets credit.

At the micro level, each firm must be able to obtain a markup over
labor costs. However at the macro level there won?t be any profit
unless there is spending in excess of aggregate wages in the
consumption sector. Aggregate profit of firms is equal to the sum of
investment plus consumption out of profits, plus the government?s
deficit, plus the trade surplus, less saving out of wages.

In the simple case with no government deficit, no trade imbalance, and
no saving out of wages, capitalist profit equals investment plus
capitalist consumption. As long as the price is set high enough that
workers cannot buy all the output, capitalists can get the rest so
long as they spend. The amount of surplus available at the aggregate
level depends on the aggregate markup. It is aggregate spending on
investment that generates the profit, and validates the accumulated
capital. Neither thriftiness nor technology has anything to do with
capital accumulation.

Financial Positions of a Firm

Minsky defines three financial positions of increasing fragility:

(1) Hedge finance: income flows are expected to meet financial
obligations in every period.

(2) Speculative finance: the firm must roll over debt because income
flows are expected to only cover interest costs.

(3) Ponzi finance: income flows won?t even cover interest cost, so
the firm must borrow more or sell off assets simply to service its

Over a protracted period of good times, economies tend to move from a
financial structure dominated by hedge financing to a structure with
increasing speculative and Ponzi financing. The shift toward
speculative positions occurs intentionally and more or less inevitably
because of the way in which success in a boom enhances expectations.
However the shift from speculative toward Ponzi finance is usually

Business Cycles

Business cycles are endogenously generated, and are not due to shocks.
In large part they are due to the interplay between the two price
systems and the way the financial system naturally evolves toward
fragility. Exogenous effects can precipitate a crisis, but only when
the system has already evolved to a fragile position.

Conventional wisdom argues that the economy is naturally stable, with
the invisible hand guiding the economy to equilibrium. Rather than
treating institutions as contributing to stability, orthodoxy views
them as barriers to achieving equilibrium. Minsky argues that
institutions and interventions thwart the inherent instability of
financial capitalism by interrupting the endogenous process and
restarting the economy under more favorable conditions.

System Instability

As Minsky observed, capitalism is inherently unstable. As each crisis
is successfully contained, it encourages greater speculation and risk
taking in borrowing and lending. Financial innovation makes it easier
to finance various schemes. To a large extent, borrowers and lenders
operate on the basis of trial and error. If a behavior is rewarded,
it will be repeated. Thus stable periods naturally lead to optimism,
to booms, and to increasing fragility.

A financial crisis can lead to asset price deflation and repudiation
of debt. A debt deflation, once started, is very difficult to stop.
It may not end until balance sheets are largely purged of bad debts,
at great loss in financial wealth to the creditors as well as the
economy at large.

Big Government and Big Bank

Before World War II, government spending was no more than 3% of GNP.
Whenever the economy faltered, there was little countercyclical
deficit spending to offset the loss in private spending. The era was
marked by several depressions. Government has since grown to more
than 20% of GNP. Its spending effectively sets ceilings and floors on
prices of current output, helping to constrain the natural tendency of
aggregate demand toward boom and bust cycles. It is notable that
there has been no depression in the Big Government era.

Government deficits may not be sufficient to prevent a debt deflation.
If one occurs on a large enough scale, asset prices can become so
depressed that revenue from sales of assets does not permit servicing
of debt. Defaults can spread and bring down more creditors. Minsky
argues that the prevention of such a financial crisis is the primary
purpose of the central bank and not, as orthodoxy assumes, control of
the money supply or inflation. To reduce the moral hazard effects,
any lender of last resort activity must be accompanied by Big Bank
supervision of balance sheets.