As a follow-up to my last post, here are four more paradoxes that can occur in a truly macroeconomic analysis. As before, what may be true for individual economic agents when acting alone or in small numbers can lead to the opposite outcome when this is applied to the economy as a whole. Once again, the ideas are taken from Marc Lavoie’s textbook Post-Keynesian Economics: New Foundations (2014), Ch.1, p.18-22.
- The paradox of debt. For firms and financial institutions, attempts to reduce leverage ratios (borrowing) may lead to them cutting back on investment. If all companies do this, it will cause a slowdown in growth, reducing overall profitability. This will make it harder to reduce leverage and may even lead to ratios rising if the slowdown is large enough. This could also apply to governments if public sector austerity reduces the growth rate. For the financial sector, reducing leverage could lead to large-scale sales of assets, driving down their price and creating losses; this will reduce the institutions’ own funds, and could lead to a rise in leverage ratios.
- The paradox of tranquillity. This idea comes from Hyman Minsky and is reflected in his famous quote “stability is destabilizing”. In short, successive periods of financial and economic stability encourage firms to take on more risk and become more highly leveraged, gradually reducing the gap between the flows of funds from new economic activity used in part to service debt, and the cost of servicing the debt itself. Minsky held that the financial system will thus tend towards increased fragility, heightening the risk of a crisis. In the aftermath of the Great Depression of the 1930s, and for several decades afterwards, investors were relatively risk-averse. But generations were succeeded and memories faded. It took until the Global Financial Crisis (GFC) of 2008 for Minsky’s work to be taken seriously again.
- The paradox of liquidity. New ways to create liquidity end up transforming liquid assets into illiquid ones. In a bear market, the large-scale selling of assets drives down their price, potentially creating one-way markets, and a total freeze, as happened in some cases during the GFC. In another example, financial innovation may seem to increase liquidity by creating new ways to finance business. In the process, in an ever more layered system, market participants believe that they can easily access means of payment, when in fact virtually nobody holds safe assets without capital-loss risk.
- The paradox of risk. The availability of individual risk cover leads to more risk overall. Once again, financial innovation such as the creation of new derivative products, designed to reduce risk at the microeconomic level by spreading it over many financial institutions, ends up increasing macroeconomic or systemic risk. The illusion of liquidity encourages agents to take increasingly risky decisions, which prove costly when sufficient numbers attempt to unwind them. Once again the GFC revealed this process in action.
(Update: part 1 of this post can be found here.)