Keynes, Minsky and International Financial Fragility Jan Kregel, Levy Economics Institute

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1 Keynes, Minsky and International Financial Fragility Jan Kregel, Levy Economics Institute Draft Presentation prepared for 11th International Keynes Conference (IKC) On Globalized Capitalism Hitotsubashi University, March 20-22, 2015 Keynes gave us by way of a digression a marvelous proof of the fact that international investment always has been and always should be defaulted. 1 It is obvious that no country can go on for ever covering by new lending a chronic surplus on current account without eventually forcing a default from the other parties. 2 Introduction Both Keynes and Minsky suffer from the widespread belief that they had very little to say about open economies. The General Theory is often interpreted as applying only to a closed economic system, and Minsky s theory of financial fragility is often presented as being concerned only with the financial conditions of the United States. Yet, the body of Keynes work from his early book on Indian Currency and Finance, to the discussions of international monetary reform in the Tract, the Treatise and his proposals for the post-war international financial system suggest someone who was vitally concerned with the implications for theory and policy of an open economic system. While it is true that Minsky s initial work on central bank regulation and the operation of the lender of last resort discount mechanism was undertaken within the framework of the US Federal Reserve System, he was a student of the operation of the Bank of England and the impact of monetary policy in an international framework. But, in particular, they both had very clear ideas about the impact of international trade and payments on the ability of an economy to operate and independent economic policy. And it is against the background of the increasing tendency to impose uniform regulatory measures on the global economy in the form of the Basle Committee on Banking Supervision, the BIS housed Financial Stability Board, and the European Union s single rule book approach that I want to discuss the alternative views to be found in the work of Keynes and Minsky and to suggest that the moves to impose increasingly uniform financial systems may be a source of increased financial instability. Keynes on International Financial Stabilty from Managed Money to the Clearing Union proposal In Chapter 36 of the Treatise on Money, entitles National Policy Autonomy Keynes notes the conflict between free international investment flows and the implementation of economic policy to offset the 1 Reported in James Meade: The Law Mission in The Wartime Diaries of Lionel Robbins and James Meade, , edited by Susan Howson and Donald Moggridge, New York: St. Martin s Press, 1991, p Keynes, The Balance of Payments of the United States, Economic Journal, Vol. 56, No. 222 (Jun., 1946), pp

2 impact on the economy of the cyclical behaviour of domestic investment decisions. He notes that any international monetary standard, such as the gold standard, but the observation also applies to the gold-dollar standard of Bretton Woods, requires the Central Bank to relinquish control over domestic interest rates. Indeed, this implies that in equilibrium interest rates should be uniform across countries. Any attempt to use interest rates to offset domestic fluctuations in investment would then create interest rate differentials and international capital flows that would eventually undermine the country s commitment to the international standard. Indeed, the system could only function with compensating capital flows across borders. The main effect of [any international standard] is to secure uniformity of movement in different countries everyone must conform to the average behaviour of everyone else.... The disadvantage is that it hampers each central bank in tackling its own national problems. (Keynes 1971a, ) But, Keynes argues the support for the belief in an extreme mobility of international lending and a policy of unmitigated laissez-faire towards foreign loans has been based, on too simple a view of the causal relations between foreign lending and foreign investment. Because net foreign lending and net foreign investment must always exactly balance, it is been assumed that no serious problem presents itself. Since lending and investment must be equal, an increase of lending must cause an increase of investment and a decrease of lending must cause a decrease of investment; Indeed, the argument sometimes goes further, and -- instead of being limited to net foreign lending -- even maintains that the making of an individual foreign loan has in itself the effect of increasing our exports. All this, however, neglects the painful, and perhaps violent, reactions of the mechanism which has to be brought into play in order to force net foreign lending and net foreign investment into equality. I do not know why this should not be considered obvious. If English investors, not liking the outlook at home, fearing labor disputes or nervous about a change of government, begin to buy more American securities than before, why should it be supposed that this will be naturally balanced by increased British exports? For, of course, it will not. It will, in the first instance, set up a serious instability of the domestic credit system -- the ultimate working out of which it is difficult or impossible to predict. Or, if American investors take a fancy to British ordinary shares, is this going, in any direct way, to decrease British exports? It is, therefore, a serious question whether it is right to adopt an international standard, which will allow an extreme mobility and sensitiveness of foreign lending, while the remaining elements of the economic complex remain exceedingly rigid. If it were as easy to put wages up and down as it is to put bank rate up and down, well and good. But this is not the actual situation. A change in international financial conditions or in the wind and weather of speculative sentiment may alter the volume of foreign lending, if nothing is done to counteract it, by tens of millions in a few weeks. As a result Keynes suggests the necessity to control net capital flows -- the foreign capital balance. He notes that most countries have always had registration requirements for capital issues in their own markets and that these could be expanded internationally. He also suggests a tax on purchase of foreign securities not listed in the UK market of 10 per cent. But he also suggests the necessity of introducing measures to influence short-term controls on capital flows such as a dual rate structure that differentiates between financial flows and trade finance, given preference to the later. He also recommends a more flexible exchange rate structure through variation in the rates at which the Central Bank s bid and offer rates are set within the gold points He also

3 recommends the active use of intervention in the forward market, a suggestion that was first made in the Tract on Monetary Reform in order to influence short-term interest rates on short term capital transactions. However, he notes that it would be more efficient to introduce flexible exchange rates, indeed from the time of the Tract on Monetary Reform Keynes had argued that a flexible exchange rate system was preferable to a fixed rate system as long as there was a forward foreign exchange market in which commercial traders could hedge the risks of higher exchange rate volatility. But the experience of the 1930s and the failed British return to the gold standard caused Keynes to harden his position on controls of capital movements and temper his belief in the efficacy of flexible exchange rates. In his analysis of the pre-war system Keynes pointed out that international coordination provided under the gold standard was neither equitable nor stabilizing: the main cause of failure... of the freely convertible international metallic standard, he wrote, was that it throws the main burden of adjustment on the country which is in the debtor position on the international balance of payments (Keynes 1980, 27). It has been an inherent characteristic of the automatic international metallic currency... to force adjustments in the direction most disruptive of social order, and to throw the burden on the countries least able to support it, making the poor poorer (29). Indeed, the historical performance of the gold standard confirms this assessment. When debtor countries are faced with adjustment via credit restriction and declining domestic prices, the pressure on the financial system leads to a domestic financial crisis and to an eventual suspension of the gold standard. Thus Keynes s insistence on symmetric adjustment, involving both creditor and debtor countries which is often explained by a desire to allow the UK to implement policies to maximize employment and prevent systemic deficiency of global demand, has a more fundamental explanation, It is the asymmetric adjustment mechanism that acts as a destabilizing element in the international system based on an international standard. Thus, Keynes identifies the existence of a freely convertible international standard as the major constraint on national policy autonomy, and the asymmetric adjustment under such a system as the cause of financial instability. Indeed, this instability is aggravated by a further defect in the supposed automatic coordination of adjustment under the freely convertible international standard: the remittance and acceptance of overseas capital funds for refugee, speculative or investment purposes (1980, 30). In contrast to earlier periods, capital funds flowed from countries of which the balance of trade was adverse into countries where it was favourable. This became, in the end, the major cause of instability (31). His conclusion was that since we have no security against a repetition of this after the present war... [n]othing is more certain than that the movement of capital funds must be regulated (31). It is, therefore, a serious question whether it is right to adopt an international standard, which will allow an extreme mobility and sensitiveness of foreign lending, whilst the remaining elements of the economic complex remain exceedingly rigid. If it were as easy to put wages up and down as it is to put bank rate up and down, well and good. But this is not the actual situation. A change in international financial conditions or in the wind and weather of speculative sentiment may alter the volume of foreign lending, if nothing is done to counteract it, by tens of millions in a few weeks. Yet there is no possibility of rapidly altering the balance of imports and exports to correspond. (1971a, 300)

4 Indeed, a characteristic of the post-smithsonian, Bretton Woods system has been the tendency for international capital to flow from debtor to creditor countries. This was first seen in Europe as speculative funds flowed to Germany, forcing repeated exchange rate adjustments, and in the global economy in the negative net flows of financial resources from developing to developed countries in the 1980s. And the euro area provides a perfect example of the financial instability created when capital flows from creditor to debtor countries and there is asymmetric adjustment concentrated in the debtor country. Indeed, Keynes assessment that to force adjustments in the direction most disruptive of social order, and to throw the burden on the countries least able to support it, making the poor poorer would seem to apply perfectly to the conditions currently facing Greece. Keynes s post-war proposal thus sought to support financial stability by ensuring that a balance between imports and exports, with any divergence from balance providing automatic financing of the debit countries by the creditor countries via a global clearing house or settlement system for trade and payments on current account. Since the credits with the clearing house could only be used to offset debits by buying imports, and if not used for this purpose they would eventually be extinguished, the burden of adjustment was shared equally credit generated by surpluses had to be used to buy imports from the countries with debit balances. Alternatively, they could be used to purchase foreign assets foreign direct or portfolio investment but the size of these purchases would be strictly limited by the size of the surplus country s credit balance with the clearing house. Once an agreed limit for each country on the size of multilateral debits and credits was reached called its quota penalties, in the form of interest charges, exchange rate adjustment, forfeiture, or exclusion from clearing, would be applied and the outstanding balances would automatically be reduced. Although Keynes s initial proposals did not take developing countries into account, the subsequent drafts suggest that the interest charges on the credit and debit balances generated could be provided as additional credits to support the clearing accounts of developing ( backward ) countries (1980, 120). For Keynes, the idea was to [discard] the use of a currency having international validity and substitute for it what amounted to barter, not indeed between individuals, but between different economic units. In this way he was able to return to the essential character and the original purpose of trade whilst discarding the apparatus which had been supposed to facilitate, but was in fact strangling, it. (1980, 23) The key was thus a mechanism to limit the size of the current account balance and to use that limit to control the flow of capital across borders. Minsky and Hedge Finance and the Basis of Financial Stability Minsky s explanation of the endogenous crisis dynamic of capitalist economies was not limited to closed economies (e.g. Minsky, 1986). Although he was most concerned with the dynamic of American capitalism, he did analyze the financial stability of the global economy. First, it is important to emphasize differences between Minsky s analysis of a closed, national economy, and an economy open to international trade and capital flows suggested above. While it is possible to formulate the conditions of hedge finance for a national economy operating in a globalized international system, what has been less evident is that these flows cannot produce global stability. Minsky s analysis of the financial instability of an economic unit operating in a national economy is based on a debt repayment profile given the balance sheet position of a private firm with incomegenerating capital investments on the asset side financed by liabilities carrying cash payment

5 commitments on the liability side. The repayment profiles classify the relation between the future debt service flows generated by the liabilities and the expected future income flows from operating the capital assets. The most conservative financing profile, which Minsky called hedge finance, is one in which in every future period the firm has a large cushion of expected cash flow receipts over debt service. Even in the case of a chance rise in interest costs or a decline in sales or prices or increases in wage or other production costs the cash cushion is always sufficient to meet the servicing of the debt. The firm with a hedge financing profile is thus virtually a risk free borrower. But, a capitalist system is one in which firms borrow to take risks and finance investment. A period of successful investments in which expectations are generally satisfied will lead to a shift in financing profiles of the majority of firms as cash cushions become smaller relative to the likely volatility in cash inflows leading to what Minsky calls a speculative profile. Here cash flows in some periods may not be sufficient to meet payments commitments, but over the life of the investment project the firm will have earnings excesses that enable it to make good any periodic shortfall. Note that a speculative profile requires an accommodating financial system in which the banks are willing to fund any periodic shortfall in debt service. In the language of managerial finance the net present value of the investment is positive. The third profile arises when some unexpected and unforeseen event occurs to a firm with a speculative financing profile that makes it impossible to meet current and future cash commitments. To stay current on its commitments and remain in operation the firm has to contract new lending to pay what it owes in debt service each period. It thus has to convince the original lender to increase the size of the existing loan, or get new loans from other lenders, even though it has little prospect of being able to service its existing loans - unless it is successful in getting additional funding in the future. In reference to a pyramid scheme Minsky calls this a Ponzi scheme, although there is no intention that it arises from illegal or fraudulent behavior. Since such conditions liabilities cannot be met by liquidating its assets at their current fair market value the firm is insolvent. While lenders may be willing to provide financing to such a firm for some time, eventually it will withdraw support and then activities will cease and the de facto insolvency becomes de jure bankruptcy. The proportion of firms with particular financing profiles then provide an indication of the potential for a financial crisis. An economy with the majority of firms showing hedge profile requires the largest changes in receipts or commitments to transform the economy into speculative profile; but once speculative profiles become dominant Ponzi financing profiles may start to spread into the system with a much smaller variation in internal or external conditions since its margin of safety represented by the excess of expected receipts over certain commitments is lower. Minsky argues that capitalist economies will evolve from hedge to speculative to Ponzi" finance as the result of an endogenous process in which investors and lender both underestimate the size of the cushion of safety to meet possible shortfalls in cash inflows. Thus a run of good results in which realizations exceed expectations may produce a historical distribution of results in which the size of the standard deviation around the mean expected performance declines in absolute magnitude. Thus, even though the lender and investor maintain a risk cushion of say two standard deviations, the size of the cushion will be smaller and thus less able to cover an unexpected shortfall in cash inflows. Note that this type of behavior is not irrational, nor does it require fat tails on the distribution, representing black

6 swans or 100 year floods. It is the natural result of a run of sustained growth in what Joan Robinson called tranquil conditions. Financial Fragility on the global level Minsky notes that in the most general terms, Every liability of a firm, household, government or financial institution, and every instrument traded in a financial market, must be supported by cash flows. These cash flows are derived from participation in productive activity that generates wages, profits, and taxes. The same requirement that cash flows support asset values holds for international indebtedness, the only difference being that the supporting cash flows may be derived from income denominated in one currency while the payments are denominated in another. The terms upon which dollars are available for [foreign currency] then determines whether commitments can be fulfilled. The availability of foreign currency depends upon the balance of payments of the country and the character of the national assets that can be sold or pledged to foreigners. To examine the problems of availability, it is convenient to divide the balance of payments into tiers that reflect sources and uses of foreign exchange. Minsky identifies four tiers of sources and uses in the external accounts: 3 Tier 1: Trade (Goods and Services) Balance Tier 2: Income from Foreign Lending (Factor Service Balance) Tier = Current Account Balance Tier 3: Net New Foreign Lending = Long term Capital Account Tier 4: Short-term capital movements = Balancing Items It is quite easy to extend this analysis to international economic instability of the basis of his suggestions (e.g. Kregel, 1998a, 1998b, 1999). This has been particularly useful in the analysis of financial crises that have become endemic in developing economies since they have adopted policies to open their economies to direct investment by international corporations and their financial markets to international money managers. It is also clearly relevant to the problems facing the southern tier Euro zone countries, in particular Greece. We can transfer this framework to the international context by noting that countries have cash inflows generated by export sales, factor earnings from abroad, emigrant remittances and capital inflows while cash commitments are generated by imports, non-capital factor foreign services, foreign lending and debt servicing created by foreign borrowing to fund development strategies. Thus, a hedge profile for a country would be one in which it has a sufficiently large surplus on goods and services and other non-capital factor service earnings that it will always have available a large multiple of its debt service commitments. This definition fits a country with a large negative net transfer of resources. The cost of holding the foreign financial assets that are the counterpart of the current account surplus represent the cushion of safety in Minsky s terms. If the return on those assets is lower than the return on domestic assets used to sterilize the impact on domestic monetary conditions or to stabilize 3 A 1983 Centro di Studi Americani paper inverts the order of the first two tiers on the argument that interest and dividends may be considered equivalent to overhead or fixed costs and as such have to be met before profits resulting from income producing activity on trade account can be booked to available reserves.

7 the exchange rate, this negative net carry will represent the cost of the hedge against a shortfall in export earnings causing a failure to meet external payments or a withdrawal of foreign assets. It may be viewed in term of Keynes s liquidity preference and the costs of the hedge the liquidity premium on holding foreign money assets. A speculative position for a country could then be defined as one in which there was an occasional deficit on external account which had to be funded by additional borrowing since the cushion of safety was by definition not sufficient to meet any possible shortfall in debt service capacity. Hedge and Speculative profiles and Financial Fragility Note that Minsky s analysis of global financial stability follows Keynes in placing the primary responsibility on the control of the current account balance as a means to control capital flows. However, the recipe for domestic financial stability in the form of hedge finance for individual entities cannot be transferred to the global level. By definition it would not be possible to have a hedge global financial system since that would require all countries to hold current account surpluses, which would unsustainable since it would imply chronic deficiency of global demand, exchange rate volatility as countries employed beggar-my-neighbour policies to capture foreign markets. As Keynes recognized, the best that the global system could do would be a system of speculative financing in which deficit countries could access clearing house credits from the multilateral clearing of creditor countries. As noted, under speculative financing, the borrower may need to be periodically borrowing additional funds from his banker. But, on the global level there is no banker, and Keynes solution was the Clearing House. And just as the speculative financing scheme was to have a positive net present value over the life of the scheme, it was necessary for every debtor to have a net present value, which meant that the size of the credits that it could access would be limited so that the borrower could always meet its debt service. 4 Thus, in addition to imposing financial stability on countries in the form of speculative financing profiles, thus system had the global benefit of keeping exchange rates stable there would be no private foreign exchange transactions and all exchange rate adjustments would be agreed in the Clearing house membership. Indeed, this mechanism provided an implicit debt resolution mechanism in the case that a country had an external imbalance that could not be corrected. Thus the major difference in Minsky s analysis of financial stability on the global level is that while hedge financing is possible for a closed economy it is impossible for a global economy. Thus, speculative financing is the best possible scheme for global stability. The question is how the period short-falls in cash flows due to current account deficits will be financed. Keynes suggested that they be handled via a clearing house, with strict limits on the exposure of any one country. This would impose symmetric adjustment which he considered a prerequisite for financial stability. It would also place precise limits on the size of capital flows. Bretton Woods also sought a similar speculative financing framework, but it allowed for the financing of imbalances via private market financial institutions. This allowed the possibility that speculative profiles could deteriorate into Ponzi financial profiles, which is precisely what occurred after 4 Note the difference with the system adopted at Bretton Woods with foreign exchange reserves the cushion of safety to meet any shortfall in debt service from a deficit, and borrowing of foreign currency from the quotas of other IMF members when reserves were insufficient.

8 the introduction of floating free market exchange rates after the breakdown of the Smithsonian Agreements. For both Keynes and Minsky, global financial stability required prevention of Ponzi finance, which meant an international financial architecture that imposed speculative finance as the limiting case for international finance. This solution has been seen to be incompatible with private market financing of international current account imbalances and market based currency trading.