Chapter 7:
Hyman Minsky and the Rise of Economic Instability

The Instability of the economy
The plae of investment

No more powerful explication of economic thought has been propounded than that of Hyman Minsky.  Relatively unknown during his lifetime, Minsky is the theoretical main line of Demand Side theory from Keynes to today.

Perhaps the most powerful line of Minsky's thought derives from the work of Michal Kalecki (kah-les-key), a Polish economist from the era of Keynes.  (It is reported that at the London School of Economics, Keynes' model was taught as the Keynes-Kalecki model.)  Kalecki's assumptions and equations were simple and plausible.  Kalecki's elegant application of the mechanical logic of algebra began with them and then opened up prices, productivity, wages, profits, and investment.  Alegebra is a mechanical logic and its proofs are logical proofs.  Contrast this with the use of calculus in economics.  The latter although complex and impressive in its precision, implies assumptions that are never explicit, the integrity of variables and a closed system that  is belied by economic reality.

Michal Kelecki's most simple assumption was that workers consume all their income.  Of course the assumption is not completely true, but it is more true than not and is not fatal to the analysis when it deviates.  Deviation, for example, in Neoclassical economics from the assumption that all firms are price takers is fatal to that analysis.  In Rational Expectations, it is fatal, in that the analysis falls apart when we see that the assumption that market participants, indeed all economic actors, are imbued with economic omniscience deviates from reality.

Kalecki showed that when his assumption was allowed and in an economy with small government and little trade, investment equals profits, or profits equal investment.  Minsky then demonstrated first that price is positively related to the wage rate and to the ratio of investment goods to consumption goods production, and negatively related to labor productivity.  (See pp. 140ff in Stabilizing an Unstable Economy.

But let's consider what Minsky's relationships mean.  It's a no-brainer that prices vary in the opposite direction as productivity, because, productivity simply means producing more with the same labor.
But the second part of this finding is very instructive.  The algebra shows what we might also derive from common sense.  As investment goods are emphasized over consumer goods, the price of consumer goods tends to rise, because, basically, workers in both sectors are bidding for the output of the consumer goods sector.  So when the ratio favors investment goods more, demand for consumer goods is higher and output is lower.

But the implications are not all so common-sensical.  The Kalecki demonstration that profits equal investment combines with this revelation that as new investment goes up, so do prices, to produce a condition in which higher prices, higher investment and higher profits coexist.  Since investment also connects positively with output and income, we can expect these two -- output and income -- to be in the same virtuous soup.

This indeed was a somewhat surprising empirical finding of our research on economic performance by president, which you will see in Chapter xx.  We found that in the postwar period employment is higher, unemployment lower, investment higher, corporate profits higher and GDP growth better when a Democrat is in the White House.  It surprised us somewhat that with all the effort by Republicans to push companies into profitability, some would say at the expense of others, that  is, the whole supply side idea, that they were not able to accomplish profits better than Democrats.  The Kalecki-Minsky analysis demonstrates why it has to be.   

Prices, Minsky says, carry profits, the raison d'etre for investment.  Most basic treatments of microeconomics begin and end with fixed costs, variable costs, average costs and marginal costs.  Prices are determined by marginal costs and where the marginal cost curve intersected the demand curve.  This may be true, Minsky says, for price takers.  But a whole great swath of the economy, including the dominant capital-intensive sectors, is composed of firms which more or less set prices and vary output according to demand.

These firms operate on the basis of a set of nesting average cost curves, the highest of which includes capital asset validation cost, or profits in the normal use of the word.  Such firms keep prices at the requisite level when demand falls by their market power, pricing power.  Without this ability to constrain price movements, they may not be able to employ expensive and highly specialized capital assets and large-scale debt financing, Minsky observes.  So a control of the market that is not allowed in primitive economics is actually necessary in the practice of capitalism.

We include that mention here not because we expect you to get it, the nesting average cost curves and so on, but just to let you know it is there in Minsky, as it is in the real world, and it informs what follows.

Returning to the propositions derived from the insights of Kelecki.  Minsky expanded these by introducing big government and trade and workers who save.  Elegant and simple algebra yields some remarkable insights.

Note here and we'll explain more in a minute that Minsky's profit is not the same profit with which we are familiar, nor that which we measured in our comparisons of economic performance by president. 

Nevertheless, when government and taxes and deficits are introduced, something remarkable appears.  It can be shown that after-tax profits equal investment plus the government deficit.  When there is no investment, profits equal the deficit.  See the details on page 148.

What are the implications of this?  One implication is certainly that the big business types who encouraged the tax cuts to promote business should not now be bellyaching about the deficits.  They are supporting profits.  Now let's look at exactly what profits they are supporting.

Minsky's profits he also terms the "surplus," and it is not only the return on capital we normally think of as profit, but all the returns which are not technologically determined costs of production.  These include advertising and professional services, executive salaries and overhead costs, costs of financing and the aforementioned costs to validate capital assets.

Two things jump out at me.  One is that the profit or surplus feeds the white collars and presumably the big salaries as opposed to the blue collars on the production side.  The other is that price-taking firms are disciplined into being more lean and less top heavy.  It appeals to me as justification for taxing incomes progressively.

But let's go back to the price takers versus the price makers.  What happens when demand falls?  In the case of price takers, demand is reflected by a price that runs back along the marginal cost curve.  In the case of price makers, who set the price and prevent its falling by market power, something else happens.

If output drops below the first critical average cost curve, capital asset prices are no longer validated and investment in new capital assets stops -- with implications across the economy for incomes and output.  If output drops below the second critical curve, fixed debt payments can no longer be supported, and the various financing instruments come under pressure.  Of course, the overhead and executive costs are compressed to some extent, but these may be resistant.  For example, firms may increase advertising in attempts to gin up demand.

And when overall demand affects many firms, the same kinds of financial instruments come under pressure and we walk into the kind of crisis we have today.

See that the deflation is resisted by such firms on their products, because they have individual pricing power, but that the drop in output affects incomes and investments and financial arrangements dramatically -- without affecting price.

So my take here is that we ought not to be too ecstatic that deflation is not spiraling.  The cost-cutting and absence of investment and the pressure on the financial sector, all too evident in the current stagnation and apparent in declining payrolls may likely mean more bad jujus.

AND of course, business cash flow is being supported mightily by government deficits.

I hope this is semi-clear.  It is new to us in this form, and it is a lot to digest.  But here at the micro level, you can see what about modern capital-intensive corporate capitalism Minsky found so unstable.

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