Hyman Minsky and asset price inflation versus consumer price inflation
Hyman Minsky’s financial theory of investment is unique. He looks at an economy as having two inherently different price systems. There’s one price system for goods and services. And there’s another one for assets. The econometrics that dominates economic projections deals exclusively with output and inflation in the first system. But it’s in the price system for assets where where stability breeds instability and crisis.
Hyman Minsky’s financial theory of investment rests on a bifurcation of an economy’s price systems. On the one hand, there’s the price system for goods and services. And inflation here is what central banks look to hold in check. But at the same time, there is a wholly separate price system for assets. And it’s here where stability leads to asset price inflation, a build up in debt, instability, and, eventually, crisis.
Hyman Minsky: The two price system model of the economy
Economics professor Randall Wray is a real Minsky scholar. He studied under Minsky at Washington University in St. Louis. And last year, he wrote a book “Why Minsky Matters: An Introduction to the Work of a Maverick Economist“. Here’s what Wray says about Minsky’s two price systems:
Current output prices can be taken as determined by “cost plus mark-up”, set at a level that will generate profits. This price system covers consumer goods (and services), investment goods, and even goods and services purchased by government. In the case of investment goods, the current output price is effectively a supply price of capital—the price just sufficient to induce a supplier to provide new capital assets. However, this simplistic analysis can be applied only to purchases of capital that can be financed out of internal funds. If the firm must borrow external funds, then the supply price of capital also includes explicit finance costs—including of course the interest rate, but also all other fees and costs—that is, supply price increases due to “lender’s risk”.
There is a second price system, that for assets that can be held through time; except for money (the most liquid asset), these assets are expected to generate a stream of income and possibly capital gains… The important point is that the prospective income stream cannot be known with certainty, thus is subject to subjective expectations… Minsky argued that the amount one is willing to pay depends on the amount of external finance required—greater borrowing exposes the buyer to higher risk of insolvency. This is why “borrower’s risk” must also be incorporated into demand prices.
Investment can proceed only if the demand price exceeds supply price of capital assets. Because these prices include margins of safety, they are affected by expectations concerning unknowable outcomes. In a recovery from a severe downturn, margins are large as expectations are muted; over time, if an expansion exceeds pessimistic projections these margins prove to be larger than necessary. Thus, margins will be reduced to the degree that projects are generally successful. Here we can insert Minsky’s famous distinction among financing profiles: hedge (prospective income flows cover interest and principle); speculative (near-term income flows will cover only interest); and Ponzi (near-term receipts are insufficient to cover interest payments so that debt increases). Over the course of an expansion, these financial stances evolve from largely hedge to include ever rising proportions of speculative and even Ponzi positions.
Minsky and Schumpeter
There’s a clear connection between Minsky’s work and how to think about innovation and how innovation gets financed. So Minsky is not merely a Keynesian. He is a post-Keynesian. His two price system is a hybrid.
Hyman Minsky had Joseph Schumpeter as his dissertation advisor. So think of Minsky’s money and finance model as a link between Keynes and his view of investment decisions determining output and employment and Schumpeter and his view of investment decisions determining innovation and growth. Minsky shows that the nature of how investment gets financed, including innovation, changes over the course of the business cycle.
At first, as we move out of the cycle trough, firms prefer to use retained earnings to finance investment. Start-up capital is hard to come by at this stage. But as the cycle continues, firms finance investment more and more through debt. Thus, the composition of investment changes. And you have more innovation as speculative capital increases. And that innovation is positive for productivity and for growth over the long-term.
Minsky, von Mises, and asset price inflation
But you also have more debt and higher debt service costs too. And so I like to think of Minsky’s financial stability hypothesis as being consistent with Ludwig von Mises’ concept of malinvestment.
Eventually, businesses (and households — think subprime mortgage flippers or cryptocurrency investors) feel comfortable taking on much riskier investments and financing strategies. And financial fragility increases as a result.
In von Mises’ narrative, a below equilibrium rate of interest drives this cycle. Irrespective, speculative and Ponzi financing, where debtors acquire more debt to pay off existing debt, increases in magnitude. And so fragility increases further still. Eventually, when the economic environment shifts – often due to the central bank’s tightening monetary conditions — you get failure, default. And these failures infect the lenders via credit writedowns. A financial crisis and credit crunch ensues. In worst case scenarios, you get a debt-deflation crisis like the one in 2008.
Asset price markets ‘clear’ differently than consumer price markets
But notice that you don’t get a natural rate of interest when you use Minsky’s model. There is no general equilibrium because you have two completely different price systems. You have the cost plus markup system of output financed out of retained earnings for current output. And you have a totally separate system for investment that is inherently more speculative and uncertain.
In the one system, you need the economy to operate flat-out to drive inflation higher. When at full employment, demand exceeds supply. And so price rises until demand and supply balance.
But that’s not what drives inflation in the other system – the system that creates financial crises and potentially debt-deflation. In that system, inflation is endemic, meaning asset price inflation rises as the cycle lengthens and financing risk-taking increases.
What if the economy isn’t at full employment?
Using the Minsky model, it’s wholly possible that asset price inflation is through the roof even while consumer price inflation barely budges. For example, say you have a credit crisis that throws people out of work and causes mass unemployment. In that case, it would take many years to get back to full employment. You won’t see inflation rising robustly. Yet, during that period, the central bank could set interest rates at a level that encourages an increase in speculative and then, eventually, Ponzi financing. That’s a recipe for asset price inflation without consumer price inflation.
Moreover, if the fiscal policy is restrictive, the central bank would feel compelled to offset that restriction. And because monetary policy works through the second price system, you would have an imbalance. Asset price inflation would rise while consumer price inflation lagged as the economy crept toward full employment. Similarly, if fiscal policy is loose – especially toward the end of the cycle – it encourages monetary policy to tighten excessively to offset fiscal policy.
Why Minsky Matters
People have different ways of expressing why Minsky matters. From my perspective, it’s not about guarding for that ‘Minsky Moment’. The reason it matters has to do with how economists think. Your normal econometric model gauged changes in prices and output in the near-term, say over the coming 3 to 6 months, quite well. And that’s because the cost plus markup inputs are all there to feed into the model as long as the data are good.
Yet, in the asset markets, a completely different cycle would be happening. Depending on where we are in the business cycle, we might have a predominance of hedge investors or an outsized percentage of speculative and Ponzi investors. And monetary policy, which will impact these investors, is totally geared to inflation in the cost plus markup system. In essence, economists could be completely correct about near-term consumer price inflation and growth. But they could simultaneously miss a build-up of speculative excess and financial fragility.
The lesson of the Great Financial Crisis is that Minsky matters. And he matters because he recognized the inherent instability of the second price system. Most economists modelled the economy without any reference to that second system. And they were caught by surprise by how fragile the financial system had become. So it’s not a moment in time, but the whole model that matters.
I don’t think much has changed in the interim, by the way. We will just have to wait and see how fragile the system is this go round.