During the last few weeks, economists Paul Krugman and Steve Keen have engaged in a lengthy (and ugly) blogger debate about the role of banks in expanding the monetary base.
But beyond the jargon, the nitpicking, and the insults (from both sides) the point they debated is a crucial one: Does the Fed have sufficient power to control the monetary system? Or are the Fed and other central banks given more credit than they are due?
The impetuses for this debate are the theories of Hyman Minsky, an American economist who wrote that markets are intrinsically in a state of disequilibrium.
According to Keen, Minsky thought that irrational market actors can exacerbate disequilibrium’s when they perceive future stability in the markets. For example, banks in the early 2000s continued extending loans to home-buyers with poor credit because they did not foresee (or did not want to accept) that home prices could not continue rising. Even the initially conservative activity of extending loans to creditworthy homebuyers soon became speculative, as home prices skyrocketed out of control because of unsustainable demand in the market.
While it is quite conceivable that bank behavior did indeed exacerbate the housing bubble in this manner, Keen argues that this behavior demonstrates a deeper ideology: Fiscal and central bank policy have far less power in controlling credit conditions than we would like to believe. He writes:
We cannot rely upon laws or regulators to permanently prevent the follies of finance. After every great economic crisis come great new institutions like the Federal Reserve, and new regulations like those embodied in the Glass-Steagall Act. Then there comes great stability, due largely to the decline in debt, but also due to these new institutions and regulations; and from that stability arises a new hubris that “this time is different”—as the debt that causes crises rises once more. Regulatory institutions become captured by the financial system they are supposed to regulate, while laws are abolished because they are seen to represent a bygone age. Then a new crisis erupts, and the process repeats. Minsky’s aphorism that “stability is destabilizing” applies not just to corporate behaviour, but to legislators and regulators as well.
Banks, Keen insisted, form the crux of the problem since they are in control of the monetary base. Banks’ assessments of the risks and rewards to lending grows virtually without reference to the deposits they receive, so banks—and not the government—ultimately determine credit standards.
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