What Caused The Global Financial Crisis (GFK)?
Professor L. Randall Wray, discussing the global financial crisis in broad strokes. The economist Hyman Minsky developed a theory of financial fragility and the long-run evolution of the economy, summarized briefly as “stability is destabilizing.” In the aftermath of the Great Depression, the worst banks had failed, the remaining ones were scarred by the memories of the disaster, and the government had put in place extensive regulation to ensure they behaved, and this variety of capitalism (what Minsky called “paternalistic capitalism”) proved very stable.
But stability is destabilizing. As time wore on and memories faded, people changed their outlook and changed their behavior. Banks took on greater risk, and fringe financial institutions (which came to be known as shadow banks) put increased pressure on the traditional banks by taking on even bigger bets. Politicians came to view financial regulation as burdensome, and academic economic theory became so far removed from reality that the models used by the top economists at the central banks didn’t even allow for the possibility of a financial crisis.
As a result of World War 2, government debt ballooned, and these safe government bonds served as private wealth which was leveraged in order to grow and keep full employment in the post-war era. But as fiscal policy tightened (the focus shifted from “full employment” to “balance the budget”), and real wages stagnated, further growth could only be accomplished by piling on private debt, which grew to astounding heights by the mid-2000s. These debts are liabilities for the borrowers, but assets for the holders, and so the huge increase in debt meant huge increases in financial wealth for the top 1%, and all this money needs to be managed, hence Minsky’s term “money-manager capitalism.”
Important changes were also happening to the way financial institutions were operating. The mid-century bank business model consisted of issuing deposits (bank money) in order to finance purchase of mortgage notes from borrowers, which the bank would then hold and collect the interest income. But to evade regulations, compete with shadow banks, and avoid a potential adverse change in the interest rate, banks shifted to a new much more fragile business model. In the new model, banks would make loans with the intent to package them into securities and sell them as quickly as possible, and as a result, the bank didn’t care very much whether you could pay back the loan, and didn’t bother to find out (which is sort of the whole point of having banks). Other institutions would then issue short-term or even overnight debt to yet other financial institutions, in order to finance their purchase of these packages of mortgages. These mortgage-backed securities would then be carved into sections and sold to yet other financial institutions. As a result of all of this, debt between financial institutions rocketed upward.
All of this private debt makes the system increasingly fragile, leading to what Minsky called “Ponzi finance.” If you are dependent on your income to be able to make your debt payments, then an unexpected fall in income could force you to default. If your creditors were counting on your debt payments to be able to make their own debt payments, then now they are forced to default as well. And so on. The result is a ripple of contagion, leading to bankruptcies, fire-sales of assets, and possibly bank runs. As financial institutions stop lending or even close down, normal business investment falls, and the result on Main Street is unemployment and people losing their homes.
To get more detail on the causes of the crisis and the long-run evolution of the financial system, as well as suggestions for what to do about it, read Wray’s book on Minsky’s work, entitled “Why Minsky Matters”: https://www.barnesandnoble.com/w/why-…
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