Ralph Hawtrey, the British economist whose textbook Currency and Credit was the standard for an earlier generation, saw financial instability as the abiding tendency of credit markets, and the attempt to tame that instability as the abiding task of central bankers. His hope was that attentive discount rate policy could stem divergence, either upward or downward, before it built up strength and became unstoppable. Lender-of-last-resort responsibility brought with it an interest in avoiding the last resort
Hawtrey’s vision of the underlying problem and the consequent mission of central banking, was the origin of both monetary thinking and monetary practice in the years of the fledgling Federal Reserve System of the 1920s. At both Harvard and Chicago, academic centers that would become poles of macroeconomic dispute in later years, Hawtrey was where everyone started.
In the event, discount policy proved to be a rather weak reed against the forces of instability, and policy attention consequently turned elsewhere, toward institutional constraints to control instability (the banking legislation of the 1930s) and then fiscal policy to moderate business fluctuation (the legacy of Keynes).
That the inherent instability of credit had not been solved, only suppressed, was the central message of Hyman Minsky in his so-called “financial instability hypothesis”. A Depression-era student at both Harvard and Chicago, Minsky found his life’s work in the task of updating Hawtrey for the conditions of post WWII United States, the 1950s and 1960s.
The idea that the Global Financial Crisis of 2007-2009 was a “Minsky Moment” has by now entered general consciousness. But the location of that financial crisis was not at all where Minsky had focused his attention.
Minsky was all about credit-fuelled spending for business investment; our crisis was clearly about credit-fuelled spending for household residential expenditure. Minsky was all about expansion of bank credit; our crisis was clearly about expansion of non-bank credit in the emerging capital market-based credit system. And Minsky developed his thinking in a largely closed-economy framework of the immediate post-Bretton Woods period; our crisis was clearly global, and its global reverberations continue to echo.
So we can hardly say “Minsky was right”, and stop there. Rather, what Minsky was right about was the same thing that Hawtrey was right about, the inherent instability of credit. That also is not a place to stop so much as it is a place to start. Minsky found his life’s work in updating Hawtrey, and the current generation will find its life’s work in updating Minsky.
The big thing that has happened since Minsky is the rise of finance, and the globalization of finance. The institutional change was dramatic, and so was the intellectual change that came with it. As modern capital markets took over credit functions formerly served by bank lending, not only did we achieve increased efficiency but also we put behind us the inherent fragility of banking. That was the hope anyway.
False hope. The most important lesson of the global financial crisis is that the brave new world of capital market-based credit has inherited the “inherent instability of credit” gene, big time. The question facing us is, what to do about it?
Dodd-Frank is no Banking Act of 1933. Congress made a list of all the bits and pieces that went wrong in the crisis, and Dodd-Frank is the corresponding list of measures to address each of the bits and pieces. But there is no overall vision, and it is not at all clear that the individual measures are even consistent with one another.
Now comes the academic response. “Regulating Wall Street” is a critique of Dodd-Frank, concluding that the Act has not gone far enough in internalizing the externalities that are rife in the interconnections of financial balance sheets. The hope, apparently, is that if we get the prices right we will tame financial instability. Maybe so, but also maybe not. As Bagehot memorably said back in 1873, “Money will not manage itself, and Lombard Street has a great deal of money to manage.”
“Can “It” Happen Again?” asked Minsky, and his answer was “No”, given the enlarged and hence stabilizing role of government that had grown up since the Depression. But for our own Minsky moment, Big Government was not much help. It was the Fed that caught the financial system as it collapsed, expanding its own balance sheet as others contracted, not only domestically but also internationally.
I conclude that rethinking the role of the Fed is the place to start. Dealer-of-last-resort responsibility brings with it an interest in avoiding last resort.
