A Critical Analysis of the Financial Frictions Approach in a Minskyan Perspective

Abstract

The concept of financial frictions is at the core of the Financial Frictions Approach (FFA) which underlines that to explain the financial crisis of 2007–2008 it is sufficient to add the financial system to the New Keynesian Dynamic Stochastic General Equilibrium (NK-DSGE) model. Many economists have cited Hyman Minsky among those who “emphasized the importance of financial frictions.” The aim of this work is: 1) to show that Minsky cannot be considered the precursor of the FFA and that FFA does not allow for a solid explanation of financial crises; and 2) to present a sound explanation of the financial instability affecting capitalist economies based on two teachings characterizing Minsky’s work. The first consists in Minsky’s interpretation of John Maynard Keynes’s General Theory, which recovers the revolutionary elements of Keynes’s thought neglected by the Neoclassical Synthesis. The second teaching consists in underlining the need to integrate Keynes’s and Joseph Schumpeter’s theoretical frameworks.

Keywords:

• financial markets
• crises
• Keynes
• Schumpeter
• Minsky

JEL Classification Codes:

• E10
• E20
• E30
• E40
• E44

Disclosure Statement

The authors confirm that there are no relevant financial or non-financial interest to report.

Notes

1 See, for example, Paul De Grauwe (2012), Olivier Blanchard (2014; 2015; 2018), Kiminori Matsuyama, Iryna Sushko and Laura Gardini, (2016), Paul De Grauwe and Eddie Gerba (2018), Lawrence Christiano, Martin Eichenbaum, and Mathias Trabant (2018), Jordi Galì (2018), Mark Gertler and Simon Gilchrist (2018), Fabiano Ghironi (2018), David Hendry and John Muellbauer (2018), Patrick Kehoe, Virgiliu Midrigan, and Elena Pastorino (2018), Jesper Lindé (2018), David Vines and Samuel Wills (2018).

2 According to Blanchard and Summers: “Hyman Minsky […] had warned for decades about the consequences of buildups in financial risk. […] Yet prevailing macroeconomic paradigms largely ignored the possibility of financial developments as drivers of economic performances. Neither financial euphoria as a source of booms nor financial crisis as a cause of bursts played a prominent role in macroeconomic thinking of academics or policymakers” (Blanchard and Summers 2019, xvii).

3 Their answers have been published in 2018 by The Oxford Review of Economic Policy, vol. 34 (1–2).

4 Knut Wicksell defines the natural rate of interest by referring to: “the phenomena of capital and interest on capital, as they would appear if liquid capital, production’s means of support, was in reality lent in kind, without the intervention of money; and only then is it possible to distinguish what modifications are in reality caused by the introduction of money. In the former case, i.e., if capital was lent in kind, there would undoubtedly develop, through the supply of and the demand for available capital, a certain rate of interest on the lending market, which would be the natural rate of interest on capital in the strictest sense” (Wicksell [1898] 1958, 84).

5 According to Brunnermeier, Eisenbach, and Sannikov (2013, 1): “in a setting without financial frictions it is not important whether funds are in the hands of productive or less productive agents and the economy can be studied with a single representative agent in mind.”

6 See, for example, Stiglitz and Weiss (1981 and 1990), Bernanke (1993), Gertler and Gilchrist (2018).

7 “A common way to make financial market frictions endogenous is to introduce […] some type of informational asymmetry that leads borrowers to be more informed than creditors. […] Accordingly, rational lenders in this setting will impose constraints on the terms of lending, like credit limits, collateral requirements, and bankruptcy contingencies. […] [Informational asymmetry] makes raising funds externally more expensive than using internal funds, which Bernanke and Gertler (1989) call the ‘external finance’ premium. […] The link between borrower balance sheets and the external finance premium leads to mutual feedback between the financial sector and the real activity. A weakening of balance sheets raises the external finance premium, reducing borrowing spending, and real activity. The decline in real activity reduces cash flows and asset process, which weaken borrower balance sheets, and so on” (Gertler and Gilchrist 2018, 5–6).

8 “There seems to be a logical flaw in the asymmetric information argument, for perfect foresight is first postulated to obtain an equilibrium and then repudiated in order to get targeted results” (Minsky 1993a, 78).

9 Minsky believed that the crisis of the 1970s shed light on the limitations of the Neoclassical Synthesis: “The world is now performing in ways that can be interpreted as anomalous from the point of view of the current standard theory. In these circumstances a radical reformulation of economic theory such as Keynes attempted, once again seems attractive. The synthesis of classical formulations and Keynesian constructs that Professor Joan Robinson has characterized as Bastard Keynesianism seems to be dissolving” (Minsky 1975, 18).

10 In the book published in 1975, Minsky maintains that: “[t]he position taken in this book is that the evaluation by Keynes […] of the General Theory as revolutionary is correct; the work does contain the seeds for a deep intellectual revolution in economics and in the economists’ view of society. However, these seeds never reached their full fruition. The embryonic scientific revolution was aborted” (Minsky 1975, 3).

11 For an analysis of Minsky’s thought see Minsky (1975; 1980; 1982; 1986b; 1996), Tymoigne and Wray (2013), Mazzucato and Wray (2015), Wray (2016), and Nikolaidi and Stockhammer (2017).

12 “Schumpeter and Keynes are best viewed as complements, not as substitutes. It is useful to integrate their work. In so doing we should reveal the power of Schumpeter’s vision, fill in gaps left by the standard interpretations of Keynes, and hopefully make some progress in our main scientific concern, to understand the ways of capitalism” (Minsky 1990, 54; see also Minsky 1986a and 1993b).

13 “Railroads have not emerged because any consumers took the initiative in displaying an effective demand for their service in preference to the services of mail coaches. Nor did the consumers display any such initiative wish to have electric lamps or rayon stockings, or to travel by motorcar or airplane, or to listen to radios, or to chew gum. The great majority of changes in commodities consumed has been forced by producers on consumers who, more often than not, have resisted the change and have had to be educated up by elaborate psychotechnics of advertising” (Schumpeter [1939] 1964, 47).

14 “[O]utside these accustomed channels the individual is without those data for his decisions and those rules of conduct which are usually very accurately known to him within them. Of course, he must still foresee and estimate on the basis of his experience. But many things must remain uncertain, still others are only ascertainable within wide limits, some can perhaps only be ‘“guessed”.’ In particular this is true of those data which the individual strives to alter and of those which he wants to create. […] Carrying out a new plan and acting according to a customary one are things as different as making a road and walking along it” “(Schumpeter [1912] 1949, 84–85).

15 “The banker […] is not so much primarily a middleman in the commodity ‘purchasing power’ as a producer of this commodity. […] He is essentially a phenomenon of development. […] He makes possible the carrying out of the new combinations, authorizes people, in the name of society as it were, to form them. He is the ephor of the exchange economy” (Schumpeter [1912] 1949, 74). For more details on the link between bankers and entrepreneurs, see, for example, Hanusch and Pyka (2007), Callegari (2018), Bertocco and Kalajzić (2019a).

16 “[A] Monetary Circuit perfectly fits the major characteristics of the Monetary Production Economy Keynes had in mind in the Treatise, in the first draft of the General Theory, and in the General Theory itself […]” (Parguez 1996, 158).

17 “In the perspective of the circuit theory […] the starting point for a construction of a macroeconomic model can only be the identification of the social groups present in the community. […] circuit theorists introduce a preliminary distinction between producers and wage earners, producers having access to bank credit and wage earners being excluded from it. The two groups enter the market having different initial endowments” (Graziani 2003, 19).

18 In addition to Graziani’s works, for a description of the monetary circuit see, for example, Parguez and Seccareccia (1999), the essays contained in Deleplace and Nell (1996), Arena and Salvadori (2004), Fontana and Realfonzo (2005), Rochon and Rossi (2003), and Rochon and Seccareccia (2013).

19 “The principle of consumers preferences […] is unknown to the theory of the circuit. Here the traces of Schumpeter’s teaching can be detected once more” (Graziani 1989, 22).

20 “An important point […] is that finance requirements […] are not specifically connected with investment activity. The problem of financing investment is a different one, appearing […] not at the beginning but at the end of the economic circuit” (Graziani 1989, 6).

21 Similarly, Keynes ([1933b] 2013, 89) states that: “The firm is dealing throughout in terms of sum of money. It has no object in the world except to end up with more money than it started with. That is the essential characteristic of an entrepreneur economy.” And Graziani points out that: “in a capitalist economy money performs the fundamental role of determining the distribution of income. In fact, the very formation of profits is explained by the presence of money, as well as by the way in which money is created and introduced in the market circuits” (Graziani 1996, 142).

22 See, for example, Charles (2008), Nishi (2012), Passarella (2012), Keen (2013 and 2020), Nikolaidi (2014), Sordi and Vercelli (2014), Nikolaidi and Stockhammer (2017).

23 See, for example, Taylor and O’Connell (1985), Fazzari, Ferri, and Greenberg (2008), Delli Gatti et al. (2010), Chiarella and De Guilmi (2011), Ryoo (2013), Stockhammer and Michell (2017), Dafermos (2018), Gusella and Stockhammer (2021).

24 This is equivalent to assume that, in each period, the workers expect an inflation rate equal to zero, independently from the inflation rate observed in the past.

25 See also Bertocco and Kalajzić (2020)

26 The introduction of this hypothesis implies the elimination of the dimension of uncertainty associated to the decisions of the farmers. Nevertheless, we do not eliminate uncertainty from the model. In fact, the decisions of the entrepreneur-innovator planning to realize the railway and those of the bankers who must decide whether or not to fund the investment project, are taken under conditions of uncertainty.

27 “The view that instability is the result of the internal processes of a capitalist economy stands in sharp contrast to neoclassical theory, whether Keynesian or monetarist, which holds that instability is due to events that are outside the working of the economy” (Minsky 1975, 123),

28 “Profits are critical in a capitalist economy because they are a cash flow which enables business to validate debt and because anticipated profits are the lure that induces current and future investment. It is anticipated profits which enable business to issue debts to finance investment and positions in capital assets. Any theory that aims to explain how an investing capitalist economy works must focus upon the determination of total profits” (Minsky 1982, 34–35).

29 On this point, see Rochon (2005).

30 For more details on this issue, see Zazzaro (2003), Fontana and Realfonzo (2005), Messori and Zazzaro (2005).

31 “[S]uccess breeds a disregard of the possibility of failure; the absence of serious financial difficulties over a substantial period leads to the development of a euphoric economy in which increasing short-term financing of long positions becomes a normal way of life. As a previous financial crisis recedes in time, it is quite natural for central bankers, government officials, bankers, businessmen, and even economists to believe that a new era has arrived. Cassandra-like warnings that nothing basic has changed, that there is a financial breaking point that will lead to a deep depression, are naturally ignored in these circumstances” (Minsky 1986a, 237).

“An act of individual saving means—so to speak—a decision not to have dinner to-day. But it does not necessitate a decision to have dinner or to buy a pair of boots a week hence or to consume any specified thing at any specified date. […] the act of saving implies […] a desire for ‘wealth’ as such, that is for a potentiality of consuming an unspecified article at an unspecified time” (Keynes [1936] 2013, 210–211).

33 “Whenever full employment is achieved and sustained, businessmen and bankers, heartened by success, tend to accept larger doses of debt-financing. During periods of tranquil expansion, profit-seeking financial institutions invent and reinvent ‘“new’” forms of money, substitutes for money in portfolios, and financing techniques for various types of activity: financial innovation is a characteristic of our economy in good times. Each new type of money that is introduced or an old one that is used to a greater extent results in the financing of either some additional demand for capital and financial assets or of more investment. This results in a higher price of assets. Financial innovation therefore tends to induce capital gains, to increase investment, and to increase profits: the economy will try to expand beyond any tranquil full-employment state” (Minsky 1986a, 199).

34 “A Schumpeterian insight […] is that capitalism is resilient because it takes many particular forms. In one sense this is trivial: big government and active central banking have contained the endogenous dynamic processes that, from time to time, made the market system behave in an incoherent fashion. In another sense it is not trivial, for the endogenous evolutionary dynamics of capitalist economies change the relations between financial and real economic variables which, in turn, change the dynamic pattern of the economy” (Minsky 1990, 65).

35 In particular, Minsky has underlined the relevant role played by mutual and pension funds. According to Minsky, their performances fundamentally depend on capital gains: “The pension and mutual funds have made business management especially sensitive to the current stock market valuation of the firm. They are essential ingredient in accentuation of the predatory nature of current American capitalism” (Minsky 1996, 363).

36 On this point, see Bertocco (2017), and Bertocco and Kalajzić (2018).

Additional information

Notes on contributors

Giancarlo Bertocco

Giancarlo Bertocco is senior professor of Macroeconomics and Monetary Economics in the Department of Economics at the University of Insubria, Varese, Italy. Andrea Kalajzić is in the Department of Economics, at the University of Insubria, Varese, Italy. This research did not receive any specific grant from funding agencies in the public, commercial, or not-for-profit sectors.

Andrea Kalajzić

Giancarlo Bertocco is senior professor of Macroeconomics and Monetary Economics in the Department of Economics at the University of Insubria, Varese, Italy. Andrea Kalajzić is in the Department of Economics, at the University of Insubria, Varese, Italy. This research did not receive any specific grant from funding agencies in the public, commercial, or not-for-profit sectors.