Why capitalism fails

The value of a scientific theory is based on its ability to predict phenomena and events, and at least amongst those of a more rationalist persuasion, its explanatory power. Yet free market economics completely failed to predict and explain the financial crisis of 2008-2009. Many are now leaving the free marketeers to their ever increasing Ptolemaic circles, excuses and epicycles and are looking for explanations outside the free market religious cannon.

This has lead to a resurgence of interest an American economist who did see what was coming, Hyman Minsky. Stephen Mihm in The Boston Globe recently wrote about how Minsky's ideas are being given new life in the context of the financial crisis (Hat tip Sam F).

"Minsky called his idea the “Financial Instability Hypothesis.” In the wake of a depression, he noted, financial institutions are extraordinarily conservative, as are businesses. With the borrowers and the lenders who fuel the economy all steering clear of high-risk deals, things go smoothly: loans are almost always paid on time, businesses generally succeed, and everyone does well. That success, however, inevitably encourages borrowers and lenders to take on more risk in the reasonable hope of making more money. As Minsky observed, “Success breeds a disregard of the possibility of failure.”

"As people forget that failure is a possibility, a “euphoric economy” eventually develops, fueled by the rise of far riskier borrowers - what he called speculative borrowers, those whose income would cover interest payments but not the principal; and those he called “Ponzi borrowers,” those whose income could cover neither, and could only pay their bills by borrowing still further. As these latter categories grew, the overall economy would shift from a conservative but profitable environment to a much more freewheeling system dominated by players whose survival depended not on sound business plans, but on borrowed money and freely available credit."

"Once that kind of economy had developed, any panic could wreck the market. The failure of a single firm, for example, or the revelation of a staggering fraud could trigger fear and a sudden, economy-wide attempt to shed debt. This watershed moment - what was later dubbed the “Minsky moment” - would create an environment deeply inhospitable to all borrowers. The speculators and Ponzi borrowers would collapse first, as they lost access to the credit they needed to survive. Even the more stable players might find themselves unable to pay their debt without selling off assets; their forced sales would send asset prices spiraling downward, and inevitably, the entire rickety financial edifice would start to collapse. Businesses would falter, and the crisis would spill over to the “real” economy that depended on the now-collapsing financial system."

From the 1960s to the last years in the 1990s, Minsky warned of the dangers of securitisation and other forms of 'financial innovation'. John Kenneth Gailbraith's (1990) explanation of financial innovation seems particularly relevant: "The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets". In tracking the changing face of New Zealand capitalism in the 1980s and 1990s, Bruce Jesson tracked the 'financial innovations' that accompanied Rogernomics.

For nearly half a century few economists listened to Minsky.
"By the end of the 20th century, the financial system that Minsky had warned about had materialized, complete with speculative borrowers, Ponzi borrowers, and precious few of the conservative borrowers who were the bedrock of a truly stable economy. Over decades, we really had forgotten the meaning of risk. When storied financial firms started to fall, sending shockwaves through the “real” economy, his predictions started to look a lot like a road map.

“This wasn’t a Minsky moment,” explains Randall Wray. “It was a Minsky half-century.”