By Pallavi Mehra
Edited by, Shambhavi Singh, Senior Editor, The Indian Economist
“The Post Keynesian project represents both a recovery and an extension of the economic paradigm developed by Keynes.” – Thomas Palley, world renowned Post Keynesian economist.
According to Post Keynesian (Hereafter PK) economists, people who classify themselves as Keynesian or New Keynesian economists have fundamentally misunderstood the central message of the General Theory. In other words, they misinterpreted the General Theory, which was the original contribution of Keynes. The goal of Post Keynesian economists is to recover the original contribution of the General Theory and to further extend the analysis to make it more suitable to today’s economic conditions (King 2002).
The PK school of thought has its origins in the mid 1930s, with John Maynard Keynes and Michal Kalecki as the founding fathers. However, it was only in the 1970s, when the PK approach clearly emerged as a distinct economic school of thought. The economists that are associated with laying the foundation of PK economics include Joan Robinson, Richard Kahn and Nicholas Kaldor in the UK, and Sidney Weintraub and Hyman Minsky in the US (King 2002).
One of the most important features of the Post Keynesian movement is the argument that the private sector is inherently unstable in a capitalist economy. This gains further importance with the global economic crisis that commenced in October 2008. There are numerous PK theories explaining the instability of the private sector.
One of the theories that explain why the private sector is inherently unstable is Minsky’s “financial instability hypothesis.” Hyman Minsky links the function of money as a unit of account and the uncertainty about the economy in his “financial instability hypothesis.” According to Minsky, the government, households, and firms undertake debt financing which he calls Hedge, Speculative, and Ponzi financing. He states that these institutions put aside a part of their present liquidity to make sure that there will be liquidity in the future. The institutions make interest payments from current profit. Hedge financing is when the current profit is higher than the interest payments and other debt commitments such as principal payments. Additionally, Hedge financing “is not directly susceptible to adverse effects from changes in the financial markets” (Rousseas 1986).
However, when the security margin disappears and the debt commitments are more than the profit, the institution moves into Speculative financing. Speculative financing occurs when the institution can meet its payment commitments through refinancing. Thus, the institution may not be able to repay its debt commitments, but only for a short period of time. In other words, the organization eventually has the ability to pay back its debt commitments. However, the real problem arises when short-term interest rates begin rising causing the debt obligations to increase dramatically as compared to the profits earned. This causes the institution to become a Ponzi financing unit (Lavoie 1992).
A Ponzi financing unit is one that cannot afford to repay its debt because of increasing interest rates as well as an increasing debt burden. A Ponzi unit is forced to take up additional loans to repay its existing debt resulting in a larger debt burden. This results in a vicious cycle resulting in eventually the unit going bankrupt. This is because the unit is forced to take up additional loans at a higher interest rate to repay old debt causing the unit to ultimately go under. This can happen on a large scale, when the central bank increases short-term interest rates or there occurs some exogenous shock such as an increase in oil prices like the one in the mid 1970’s which would result in a financial crisis. This would cause a debt deflation in the entire economy as the collective debt obligations of all institutions would be more than the aggregate cash flows resulting in bankruptcies of firms, households and governments on a large scale (Lavoie 1992).
Minsky’s “financial instability hypothesis” can be applied to the recent global economic meltdown. In the US, institutions that began with Hedge financing were forced into Speculative financing, and then Ponzi financing with the Fed’s decision to increase interest rates right before the economic crisis. The financial sector over-leveraged and invested in risky securities. With regards to the household sector, the Fed’s choice to increase interest rates during the period of 2001-2005 resulted in the interest rate of the adjustable rate mortgages to increase causing numerous households to start defaulting on interest payments. This eventually led to many households unable to repay their mortgage payments causing widespread foreclosures (Tymoigne and Wray 2009).
Minsky, in this theory asserts that the federal government’s intervention is the only force that can prevent a Hedge unit from becoming a Ponzi unit in times of increasing interest rates or exogenous shocks. He states that the central bank and the federal government can avert disaster by being the lender of the last resort and “contracyclical deficit” spending respectively. Applying this to the latest US economic crisis, the Fed had attempted to stimulate the economy by bailing out the financial sector, while it prevented massive bankruptcies in the financial sector; it failed to have an impact on the real economy. Consequently, the Federal government had to resort to deficit spending to get the economy out of the recession (Tymoigne and Wray 2009). This is in line with Minsky’s solution to the inherent instability of the private sector.
Economist Wray, talking about the recent financial crisis asserts that “stability is destabilizing”. He claims that the type of capitalism that exists in the US economy presently is that of money manager capitalism and risky innovations were used on a massive scale because they were profitable in the beginning. Furthermore, the only reason that instability was controlled was because of the “Big Bank and the Big Government ” (Wray 2011). In other words, the private sector without the propping effect of the government would naturally collapse.
Fontana, Giuseppe. 2009. Money, uncertainty and time. London and New York: Routledge. Fulwiller, Scott, and Wray, L Randall. 2011. It’s time to rein in the Fed. Levy Economics
King, J.E. 2002. A history of Post Keynesian economics since 1936. Cheltenham, UK and Northampton, USA: Edward Elgar Publishing.
Lavoie, Marc. 1992. Foundations of post-keynesian economic analysis. Cheltenham, UK and Northampton, USA: Edward Elgar Publishing.
Rousseas, Stephen W.1986. Post-Keynesian monetary economics. New York and London: M.E. Sharpe.
Tymoigne, Eric, and Wray, L. Randall. 2009. It isn’t working: Time for more radical policies. Levy Economics Institute of Bard College Public Policy Brief 105.
Pallavi Mehra is constantly consumed by wanderlust, is a concert enthusiast and a lover of food. She graduated from Dickinson College, USA as an Economics Major with Honors and was the President of the Model UN club. She has been taught by world-renowned Economics experts such as Vera Zamagni, the former president of a regional Italian government, and Gianfranco Pasquino, a former Italian Senator. Her areas of interest are contending economic perspectives, environmental economics, post Keynesian economics and European economic history. Pallavi is currently working at Rajvin Chemicals, Mumbai. Rajvin manufactures environmentally friendly crop-care products. She begins her Masters in Economic Policy Management at SIPA, Columbia University in July 2015. Email her at [email protected]