Minsky on stagflation and the limits to state intervention

MinskyCanItHappenAgainGovernment can be a major force for promoting progressive economic and social development. History tells us that this is rarely sustained indefinitely: the political pendulum swings back and forth, and development proceeds unevenly across space and time.

I was reminded of some of the potential limits to state intervention by the quote below from Hyman Minsky in his collection of essays Can “It” Happen Again? , published in 1982. “It” refers to the Great Depression of the 1930s. His Financial Instability Hypothesis argued that ‘stability is destabilising’: periods of successful economic performance tend to encourage an increasingly risky financial structure, leading eventually to a financial crisis. This outcome could take decades to occur, but it seems that he was proved right by the crisis and recession of 2008-9.

Minsky is not an easy read. His writing is often dense and technical terms are sometimes not defined. However, he is worth some serious study for his major insights into the co-evolution of the financial system and the real economy, and the potential of their interaction to cause instability in investment, output and employment.

Here he is on p.55-7, from a paper written in 1980:

“In our current “big government” capitalism, this…[fall in investment]…is soon halted by the impact of government deficits in sustaining profits. Whenever the deficit explodes that aggregate flow of profits to business increases. Investment turns out to be profitable even if the investments that come on stream are inept. The impact on profits of the deficits that big government generates can override the failure of investments to increase the productivity of labor; big government is a shield that protects an inefficient industrial structure. When aggregate profits are sustained or increased, even as output falls and the ratio of output to man hours worked does not increase, prices will rise. Thus the generation of sustained and rising profits by government deficits is inflationary whereas rising profits that are due to increases in output when labor productivity increases relative to money wages can be associated with falling prices.

…The analysis indicates that stagflation is the price we pay for the success we have had in avoiding a great or serious depression. The techniques that have been used since the mid-sixties to abort the debt-deflations have clearly been responsible for the stepwise acceleration in the inflation rates. The argument we have put forth indicates that stepwise accelerating inflation has been a corollary of the validation of an inept business structure and poorly chosen investments by government deficits and thus inflation has been associated with a decline in the rate of growth.”

For a post-Keynesian economist like Minsky, this is a remarkable statement. He is saying that the stagflation (slowing growth and rising unemployment together with rising inflation), which affected the advanced economies from the late 1960s, is a consequence of recession prevention by what he calls “big government”, or expansionary fiscal policy in the face of an economic downturn.

Keynesians, and even moreso, the radical post-Keynesians, tend to argue that macroeconomic policy should aim to mitigate or prevent recessions. Thus cuts in interest rates and larger budget deficits are required to prevent large falls in output and rises in unemployment. Minsky is not really disputing this in the quote above, but he is saying that it can have undesirable side-effects in the longer term: by sustaining private sector profits which would otherwise be falling, less productive firms are prevented from going bust. A less expansionary macroeconomic policy would allow them to fail, leaving the more competitive and stronger firms to drive the recovery through investment.

A less efficient private sector will result in weaker productivity growth, and continued fiscal and monetary stimulus in the face of this could therefore tend to produce rising inflation even as output growth slows.

This sort of evolutionary view of the capitalist economy is admittedly not very Keynesian, and seems to go against much of Minsky’s writing. But Minsky did study under Joseph Schumpeter who coined the phrase ‘creative destruction’; some economists use this idea to legitimise the positive impact of economic cycles on the evolution of the economy, as productivity increases with the failure of weaker firms and the survival of stronger ones in a process of ongoing structural change.

Minsky’s answer to all this was for the government to intervene in the financial sector to prevent the build-up of fragile financial structures and debt that ultimately cannot be repaid. This might need to include a counter-cyclical fiscal policy, which should aim to promote ‘safer’ private investment portfolios which would contain a higher proportion of government bonds. So he remained an interventionist at heart who believed that the capitalist economy could evolve more successfully and equitably with the right policies.

It is interesting to note that some Marxists put forward a similar argument to Minsky’s on the limits of Keynesian policies in preventing recessions, and their potential to lead to stagflation. Like Minsky, they argue that expansionary policies can prevent the restructuring of the private sector in a downturn which would otherwise restore the rate of profit and provide the foundation for an upturn driven by private investment on the part of the stronger surviving firms and sectors.

Despite all this, a case can still be made for the importance of public investment in infrastructure, education, and research and development among other vital government functions. To the extent that these can support productivity growth in the private sector, they remain essential. Thus public investment can crowd in private investment, although this is more of a long term effect, often beyond the length of the business cycle, as these kinds of investment can take many years to generate a return.

Some might see Minsky’s argument above as providing a case for a continuous balancing of the government budget, and to allow stronger upturns and downturns to promote structural change. But the outcome would be a more unstable economy, with larger fluctuations in output and employment, which is clearly undesirable.

The key limit on the efficacy of fiscal and monetary policy is the rate of profit. The state could therefore adopt industrial and employment policies which support structural change and growth in productivity in the private sector necessary for sustaining rising prosperity. In this way, the potential stagflation caused by counter-cyclical policies could be mitigated.


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