Many economists think that an economic recovery requires the renewal of lending by banks. Instead, I think that we need to step over the corpses in the financial sector. A revival of business investment will come from profits, not from lending.
My analysis harkens back to the thinking of Hyman Minsky, a heterodox Keynesian economist with a small but devoted following in the financial community.
I saw him speak about 25 years ago. Although Hy Minsky sounds like the name of a short Jewish tailor, he was a big bear of a man, with a bulbous nose, wearing a suit that looked like it had been taken on a fishing trip. He was speaking at the Federal Reserve Board in Washington, DC, but there were only a handful of us junior staff in attendance. I probably attended because I knew that he was from Washington University in St. Louis, and we St. Louisans have a real streak of home-town loyalty.
Minsky's talk was all over the map. Sometimes, he offered clever insights. At other times, he said things that would make you wince if you saw them written on a freshman's midterm.
Minsky's key insight is that risk tolerance is cyclical. Investors will be risk averse for a while, and then gradually they will loosen up. Eventually, they become more and more complacent, until euphoria sets in, leading to bubbles and manias. This continues until a crash takes place, after which investors revert to being highly risk averse.
Minsky described this risk tolerance cycle in terms of three phases: hedge finance; speculative finance; and ponzi finance. During the hedge finance phase, investors are allergic to risk. You can say, "Here is a project that is probably going to offer some really nice returns," and the investors reply, "No, I don't want to touch it. I'm not buying anything that has a down side."
During the speculative finance phase, investors make reasonable trade-offs between risk and return. During the ponzi finance phase, investors ignore risks. Giving subprime borrowers option ARM mortgages was ponzi finance in every sense of the word.
Applying the Minsky framework to the current environment, I think it is pretty clear that we have gone from ponzi finance to hedge finance. Investors have unloaded risky assets in order to buy Treasury securities. The word of the day is de-leveraging, meaning that firms are trying to shed their excessive debt loads, build up cash reserves, and strengthen their capital.
The instinct of policymakers is to fight this deleveraging process. TARP and the various financial bailouts are based on the assumption that we need an active financial sector to keep the rest of the economy running. This may be correct. As I have indicated, most economists seem to think along these lines.
However, my thinking is that the financial sector is vital only in the phases of speculative finance and ponzi finance. In an environment of hedge finance, nonfinancial firms are reluctant to borrow while individuals are reluctant to lend. Perhaps we should deal with the situation as it is, rather than try to foster financial intermediation that nobody wants.
Under the circumstances of hedge finance, the only way that businesses are comfortable expanding is by financing investment out of profits. Another element of Minsky's thinking is that profits are the key to escaping a recession. Government deficits can contribute to this process by raising profits.
Profits are the most cyclical component of national income. From the third quarter of 2007 through the third quarter of 2008, Commerce Department figures show that wage and salary disbursements rose by three percent. Meanwhile, profits fell by 9 percent. Fourth quarter figures, which will be available in a few weeks, are likely to show an even wider discrepancy.
Economic recovery will not come from bank bailouts. It will not come very quickly from the various public works projects in the pending stimulus proposal. The fastest way to recovery would be to inject more profits into the system. Bryan Caplan, the GMU economist who co-blogs with me at EconLog, has suggested reducing the employer contribution to payroll taxes. In today's economy, this will flow directly into profits. It would encourage business to expand. Moreover, by lowering the cost of labor, it would encourage hiring.
During the ponzi finance phase that pervaded until recently, profits became excessive, particularly in the financial sector. Now, however, during the hedge finance phase of the risk preference cycle, profits are the necessary fuel for the recovery.