Galbraith: Financial stability creates instability

By now, you have heard the term ‘Minsky moment.’ It was coined by Pimco’s Paul McCulley to describe events in Russia that precipitated the LTCM crisis.  McCulley was referring to economist Hyman Minsky’s concept that long periods of stability cause people to take on ever more debt and ever more risk, leading to a gigantic meltdown.

James Galbraith does a good job of explaining this instability of stability in three videos below. Galbraith sees the latest episode of financial crisis as a Minsky moment predicated on ‘Ponzi’-style debt pyramiding that is the end game in the cycle of stability to instability, just as it was post-1929.

My view is that a lack of regulatory oversight allowed the system to veer away from macro-prudential finance (see my little playground analogy with Greenspan as headmaster here). This is not a case of Madoff-style fraud with everyone in finance cooking up schemes to defraud homeowners. Yes, these cases of predatory lending existed. However, I see the systemic risk as more pertinent.

Systemically-speaking, the Ponzi phase is one of risky behavior crowding out prudent behavior in a world free of regulatory controls. If risky behavior is temporarily rewarded with profit and this temporary period is long enough, then risky behavior wins and drives out good behavior.

In the last few years – even the last few decades, financial interests have used the lack of regulatory controls and their increased access to political power to profit using risky financial instruments. They have done so by creating a byzantine maze of Ponzi-style debt schemes (think CDOs levered on mortgage-backed securities or think credit default swaps). I consider this looting as it represents a transfer of income to them from everyone else. Galbraith calls this the Predator State.

How one deals with the intrinsic instability of the capitalist system in an environment of powerful special interests is the fundamental question we face in fixing finance. The natural tendency toward greater risk in a stable macro environment is toxic when mixed with lax regulatory oversight and crony capitalism. Bailing out the system without punishing the fraud while permitting risky actors and their investors to escape the full consequences of their behavior is a moral hazard. This invites more of the same in future.

As for the present day, Galbraith talks about government as the cushion between us and Depression. I see this as an accurate view. Whether this is the advisable way forward (i.e. should we take the pain now?), depends on your view on government’s role in the economy. I believe that witnessing yet more crony capitalism in this depressionary environment will almost certainly induce ‘big government revulsion’ and lead to a recessionary relapse. See my post “A few thoughts about the limitations of government.”

Running time about 45 minutes in three parts.


(three videos embedded above. If they don’t appear, go to the original post here.)

This is a guest post by Edward Harrison. A version of this post originally appeared at Credit Writedowns.

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