Destabilizing an Unstable Economy - The Market Failures Issue

Challenge, Nov-Dec, 2002 by Charles Whalen, Jeffrey Wenger

IN HIS 1986 BOOK, STABILIZING AN UNSTABLE ECONOMY, Hyman Minsky argued that the major flaw of modem capitalism is that it is unstable. But Minsky also insisted that business cycles could be moderated--and that another depression could be prevented--through the use of sensible economic policies. "We can, so to speak, stabilize instability," he wrote (Minsky 1986, 10).

U.S. economic instability has indeed been contained during the last half century The economy has weathered nine contractions and an even larger number of domestic or international financial crises since 1950. Yet a repeat of the 1929-33 macroeconomic collapse has been avoided. The reason, according to Minsky: sound fiscal and monetary policies. In particular, public spending has offset reductions in private spending. Government debt has helped to steady financial markets. And the central bank has stepped in with monetary accommodation and lender-of-last-resort interventions (Minsky 1986; Fazzari and Minsky 1984).

Minsky's brand of fiscal policy--which he called "Big Government"--has a critical role to play during upswings and downturns. The Federal Reserve cannot do the job alone:

Monetary policy to constrain undue expansion and inflation operates by way of disrupting financing markets and asset values. Monetary policy to induce expansion operates by interest rates and the availability of credit, which do not yield increased investment if current and anticipated profits are low. (Minsky 1986, 304)

Big Government depends heavily on automatic stabilizers. Fiscal policy may have a discretionary component, such as the introduction of new taxes in a boom or new spending in a downturn. But Minsky understood that discretionary action usually comes with a long lag, when it comes at all: His goal was to present a structure of capitalism that would be more prosperous and stable. Minsky stressed that "the budget structure of Big Government must have the built-in capacity" to produce sizable deficits when the economy plunges, and to run surpluses during inflationary booms (Minsky 1986, 292).

But here is the rub: Instead of reinforcing the economy's automatic stabilizers, U.S. policymakers have allowed them to erode throughout the last few decades. Important progressive elements of the tax structure are gone. Unemployment insurance is in dismal shape, due to declining eligibility and shrinking real benefits. Welfare is now a block-grant program with strict time limits. The minimum wage is no longer enough to keep a family of three out of poverty.

This article discusses the importance of built-in stabilizers and the risks their erosion poses for the American economy. It reviews the erosion in each of the four areas listed in the last paragraph, and describes what corrective action can be taken. It also explores why the economy has, to date, avoided a more serious downturn despite the gradual weakening of its stabilizers.

The Importance of Automatic Stabilizers

Capitalism requires built-in fiscal-policy stabilizers because business cycles are an inherent feature of capitalist economies. Conventional economic theory misses this fact because it cannot shed light on economic performance through time, a problem that has been thoroughly examined by numerous scholars, including Joan Robinson and Nobel laureate Douglass North. Fortunately, an analysis of capitalist dynamics is at the heart of Minsky's perspective, which he called "financial Keynesianism" or "post-Keynesian economics."

Endogenous Cycles

Minsky's post-Keynesian theory stresses that macroeconomic conditions are transitory Booms are generated endogenously during recoveries. Conditions that lead to a contraction are an unavoidable by-product of robust expansions.

The precise path taken by the economy over time is not predetermined, however. As John Maynard Keynes stressed in 1937, the economic future is uncertain. We cannot even place firm probabilities on the matter: "We simply do not know" (Keynes 1937, 213-14). Business cycles have no natural periodicity. Rather, their path depends heavily on the nature and evolution of expectations and economic institutions.

To understand expectations, institutions, and the possibility of government stabilization, Minsky rejected the conventional notion that the economy can be thought of as a village bazaar. Instead, he started with the real world, where production must come before exchange--and where financing precedes production. Minsky's economy is one held together by financial relations, "a world of commitments to pay cash today and in the future" (Minsky 1982, 63).

That starting point explains why the institutions of money and credit are so important to Minsky's economics. Financial commitments are a crucial link between past, present, and future. They are shaped by expectations formed in the past because that is when existing contracts were negotiated. They are influenced by existing cash flows because those flows affect the ability to meet such commitments. And they look to the future because expectations are what determine decisions about new lending and borrowing (including refinancing).