Autocatalytic process: the outcome of the process is itself a catalyst for the process  Chain Reaction! Viking success propelled Viking success. … but then came Collapse (Jared Diamond) Realized profits repay debts … propel more debt … but then comes collapse (Hyman Minsky)

Minsky’s World Quasi – rents: cash flows available to pay debts P I – [supply] price of investment goods P K – [demand] price of kapital goods Borrower’s risk Lenders risk Hedge finance: E(cash flows) > Payment commitment Speculative finance: E(cash flows)<Commitment … but > Interest commitment  Roll over debt Ponzi finance: E(cash flows)<Interest commitment … Expect to increase debt Financial fragility: mix of Hedge – Spec – Ponzi Good times  Confidence  Risk-taking  Fragility

Minsky’s World – Keynes’ World Y = C + I Fluctuations in I  Fluctuations in Y Expectations and degree of confidence Animal spirits Subject to sudden and violent change Complex interactions of decisions/outcomes/liquidity/confidence Booms and Busts

The Minsky Footprint Realized expectations  Increased profits & Reduced risk  BOOM Disappointed expectations  Reduced profits & Confidence  Bust  Rush to liquidity  Debt deflation PkPk PIPI Borrower’s Risk Lender’s Risk Marginal lender’s risk Investment Internal funds

Stabilizing an Unstable Economy Hyman Minsky Financial Instability Hypothesis: Hedge finance Speculative finance Ponzi finance Two types of risk affect the volume of investment. …The first is the entrepreneur's or borrower's risk and arises out of doubts in his own mind as to the probability of his actually earning the prospective yield for which he hopes. If a man is venturing his own money, this is the only risk which is relevant. …But where a system of borrowing and lending exists, a second type of risk is relevant which we may call the lender's risk. GT, Chapter 11. Price of capital assets PIPI PKPK Investment Internal funds IoIo I1I1 Borrower’s Risk Lender’s Risk When expectations are disappointed, investment collapses … but debts remain A Minsky Cycle Displacement (invention, easy money) Boom…successful speculation Euphoria…financial innovation Profit taking Panic Student of Simons/Schumpeter

Akerlof and Shiller, Animal Spirits Confidence – Keynes-Minsky Hopes, Exuberance, Fears Waves of optimism and pessimism Corruption - Bad Faith  Loss of Trust S&Ls – Enron – Sub-prime crisis – Goldman Sachs Fairness Punish cheaters, even at own expense Relative position Money illusion “Illusion” is real in view of nominal contracts/accounts Money illusion  Inflation – unemployment tradeoff “So long as money retains its age-old power to deceive, inflation can be used to resolve economic conflict.” James Tobin Stories New eras – Irrational exuberance  Downward wage rigidity

Akerlof and Shiller: A brief history of macroeconomics Pre – Keynes: Say’s Law  Automatic adjustment to full employment Keynes: Animal spirits  Excesses  Inherent instability Minsky, JMK, Stabilizing an Unstable Economy, Can “It” Happen Again? Hicks: IS – LM  Keynes without animal spirits Consumption function – Liquidity preference function Hydraulic Keynesians Original Phillips Curve  Policy Menu Friedman: Monetarist counter-revolution Dispense with money illusion/enter expectations/natural rate  Wage Setting: W = P e F(u,z) New Classical Economics Rational expectations Real business cycles (dynamic stochastic general equilibrium) New Keynesian Economics Rational expectations – but sticky adaptation

Akerlof and Shiller: Prescription for Today A Second Target – A Credit Target “It is fairly easy now to project the fiscal and monetary stimulus necessary for aggregate demand to be at full employment—if financial markets are freely flowing…But, with the loss of confidence in the financial sector, macroeconomic planners must have a second target…—the amount of credit that would normally be given [to qualified borrowers] if the economy were at full employment.” Methods: Discount window (TALF)/Capital injections/GSEs Gotta replace the fallen Humpty-Dumpty (Securitization) A Credit Target—Whom to credit? Bernanke and Blinder (1988) Credit, Money and Aggregate Demand, AER, May. – In liquidity trap, expansion of credit is effective stimulus Aside: Also in AER, May Akerlof and Yellen, Fairness and Unemployment “…where it is advantageous to pay some employees highly, it is also … fair to pay other employees well.” Unfair pay  shirking

Back to Minsky – Keynes Variables: P K = volatile demand price of kapital asset P I = sluggish supply price of investment goods q = expected quasi-rent from the asset M = quantity of money  ease of credit c = cash-flow commitment from finance arrangements ĉ = “acceptable” cash flow commitments Then, P K = K(q, M, ĉ – c) “If the demand price of a capital asset … is not less than its replacement costs, new investment will take place.”

The Minsky Footprint Realized expectations  Increased profits & Reduced risk  BOOM Disappointed expectations  Reduced profits & Confidence  Bust  Rush to liquidity  Debt deflation PkPk PIPI Borrower’s Risk Lender’s Risk Marginal lender’s risk Investment Internal funds

Easy Money Policy Capital Inflows Eager Home Buyers Innovative Banks Rating Agencies Ambitious Mortgage Brokers Securitization  MBSs Escalating House Prices Gov’t Sponsored Enterprises Developer Clout Bank Regulators The best of times A “Global Saving Glut”

Easy Money Policy Capital Inflows Eager Home Buyers Innovative Banks Rating Agencies Ambitious Mortgage Brokers Securitization  MBSs Escalating House Prices Gov’t Sponsored Enterprises Developer Clout Bank Regulators The best of times

Financial System Meltdown At home Gov’t Supported Takeovers Countrywide  BofA Bear Stearns  JPMorgan Chase Silver State Bank  Nevada State Merrill Lynch  BofA Washington Mutual  JPM Chase Wachovia  Wells Fargo Security Saving  Bank of Nevada Interventions/ Nationalizations/ Pre-privatizations IndyMac Fannie Mae/ Freddie Mac AIG Bankruptcies New Century Financial Lehman Brothers Washington Mutual Inc. Abroad HBOS  Lloyds Bank Fortis  PNB Paribus Northern Rock Royal Bank of Scotland Dexia Glitnir/Kaupthing/ Landsbanki

Baa-AAA Interest Differential The Good News: 1932 was worse The Bad News: This downturn isn’t over until 2010

Responses Lender of Last Resort / Spender of Last Resort Tax Rebate $124 bil. Fed Fund Rate Cuts Fannie/Freddie $200 bil. Bear-Stearns $29 bil. AIG $174 bil. Fed “Facilities” Primary Dealer Credit Facility (PDCF) $58 bil. Treasury Security Loan Facility (TSLF) $133 bil. Term Auction Facility (TAF) $416 bil. Asset- Backed Commercial Paper Funding Facility (CPFF) $1,777 bil. Money Market Investor Funding Facility (MMIFF) $540 bil. More Fed Fund Rate Cuts … Hold At ~0% Fed Purchases of Long-Term Securities: GSEs & MBSs $600 bil. Term Asset-Backed Securities Loan Facility (TALF) $200 bil. Emergency Economic Stabilization Act/TARP $700 bil. Government Loans Government Equity Stimulus Package $787 bil. aka The American Recovery and Reinvestment Act TARP II Stress Tests