The ‘Clinton Surplus’ and Causality
Joe Weisenthal has written a now widely-circulated post on the budget surpluses during the final years of the Clinton administration for the popular finance blog Business Insider. In general, his analysis is better than most, at least in the sense that he does not adhere to the popular dogma that the federal government should strive for a fiscal suplus. He recognizes the inherent fallacy of comparing both the government’s annual budget and its accumulated debt to those of a household (over-simplified version: only the latter has to ‘pay it back’ and do so in a currency it cannot issue). However, there is a structural flaw in his analysis that deserves to be pointed out, and it is readily apparent in his grand finale toward the end of the article;
The bottom line is that the signature achievement of the Clinton years (the surplus) turns out to have been a deep negative. For this drag on GDP was being counterbalanced by low household savings, high household debt, and the real revving up of the Fannie and Freddie debt boom that had a major hand in fueling the boom that ultimately led to the downfall of the economy.
Throughout Weisenthal’s argument he portrays the government’s fiscal position as a direct actor driving the developments within the private economy. This is simply not true. A proper understanding of the role of the government’s fiscal policy should always take into account the fact that the government’s fiscal position (i.e. surplus or deficit) is largely determined exogenously by the current state of the private economy. The budget suplus did not actively create an artificial boom based on unsustainable levels of household debt in the private economy. Instead, it was the debt-fueled expansion within the private economy that directly led to the Clinton surplus. Hence the title of the post, Weisenthal appears to completely misread the chain of causation!
The IT boom led to an expansion in private investment for both capital and labor that, when combined with soaring asset prices, produced a surge in government tax revenues. At the same time the need for government expenditures on unemployment, food stamps, and the like were reduced. This is natural tendency of the government’s budget to respond counter-cyclically to developments in the private economy. The budget was not an active agent, it was a reactive one. The surpluses were not the cause of the debt-laden boom, they were the effect.
Complexity and Financial Markets
It should come as no great surprise to anyone with even the most casual interest in financial markets that the latter has become maddeningly complex in recent years. The overarching trend toward increasingly opaque and unintelligible financial products, capital structures, and market transactions has progressed steadily, undeterred by either the tech bubble of late 1990s or the current economic malaise resulting from the Great Recession (both of which had their roots at least partially embedded in the recent ‘financialization’ of western capitalism). While many have noted the adverse effects of highly complex and intertwined financial markets on efficient capital formation, particularly in terms of the resulting tendency toward the accumulation of systemic risk and fragility, too few have fully considered the effects from a regulatory perspective. However, Andrew Haldane, executive director for financial stability at the Bank of England, has done just that in a recent paper presented at the Jackson Hole conference.
While most observers will no doubt focus primarily on the latest musings of Ben Bernanke concerning the future of Fed policy, Haldane’s paper should be the primary focus of those hoping to understand the recent crisis and certainly those working diligently to avoid the next one. In it Haldane combines some of the more basic insights of behavioral finance with an economic historian’s grasp of financial crises and then applies the kind of astute, levelheaded, and (justifiably) cynical reasoning that one hopes a man attains after maneuvering through the worst financial panic of the last eighty years. What results is an excellent critique of our growing reliance on increasingly complex financial markets and the utter absurdity of attempting to address the problem through the implementation of an even more complex regulatory framework.
In modern finance it appears that increasing complexity has become somewhat synonymous with higher efficiency and falling levels of friction in market transactions. This, as Haldane rightly points out in much of his work, is rubbish. There is absolutely no iron law of finance which dictates that increasingly elaborate products and mathematical model-based and formulaic operations are inherently advantageous over their more simplified forebears. In a way it seems like those who advance this view suffer from the same bias as those who believe that Darwin’s evolution is a continual drive toward more complex and intricate natural design. Neither is true. Evolution does not select for complexity, merely for adaptability, which can lead to either a more intricate or a more simple organism. Complexity is not necessarily a hallmark of increased resiliency and versatility in the face of risk.
This is a vital point to consider when talking about the current state of financial markets. The modern megabanks are now considered “financial supermarkets,” where customers are supposedly able to go one-stop-shopping for all of their financial needs (odd terminology to champion for financial consumers, as convenience over competence seems quite a bit more harmful in billion-dollar structured products than in soup and batteries). Financial institutions have become amalgamations of fragility. Complex entities already systemically important to the financial system have been melded together in a process that has only served to layer complexities over other complexities in a manner that has created an interconnected web of financial frailty.
Adding to the confusion are new regulations that, instead of confronting head-on the absurd complexities of modern financial institutions, have further codified their systemic importance by accepting their position in modern finance as fundamentally sound and using them as the basis for re-regulation and bank supervision. Where banks were once regulated by commonsense and concrete ratios they are now given relative guidelines based on mathematical models with embedded assumptions that give far too much leeway to bank management and allow the notoriously volatile guesstimates of financiers to maintain far more authority than they have ever deserved. This is a recipe for disaster. The veneer of prudent regulation and financial resiliency is far more dangerous than its overt absence. The latter at least warns the wise and the cautious. While the former only serves to induce increasingly speculative risk-taking amongst those who foolishly associate the fusing together of unintelligible financial complexities and 9,000 page regulatory bills with sound markets and judicious oversight.
Stability Breeds Instability?
The argument that “stability breeds instability” is commonly associated with Post Keynesian economist Hyman P. Minsky. This observation is a core tenet of Minsky’s financial instability hypothesis; a theoretical model of the modern capitalist business cycle that melds Keynes’ investment-driven model with the capital structures that support it. Simply put, Minsky realized that Keynes’ framework was fundamentally flawed, because the latter largely ignored how firms financed their respective investments. Consequently, Keynes could not adequately explain the role of finance in destabilizing the economy and facilitating the boom & bust dynamic inherent within capitalism.
Minsky addressed this problem by arguing that as the business cycle progresses, profits rise, and unemployment falls, private firms, in the pursuit of maximizing profits, will adopt increasingly unstable capital structures. I will further detail the reasons for this in a later post, but for simplicity’s sake they can be narrowed down to 1) Rising profits make increasing leverage look less dangerous, interest payments appear to be well covered by abnormally high cash flows 2) More profitable (and safer) investment opportunities are exhausted at the beginning of the cycle, this profitability also feeds into number 1 as early investment increases aggregate income and employment 3) Financial firms exhaust safe lending opportunities early in the cycle, credit standards are relaxed in order to maintain volume and associated fees, and 4) Both consumers and firms adopt the rose-colored glasses that mark all economic boom cycles, as past downturns fade from consciousness and recent expansion is extrapolated far into the future.
What I find particularly appealing about Minsky’s theory, and why it inspired the name of this blog, is that it embraces the idea that economic downturns are endogenous to the capitalist system. It is far too common for recession to be blamed on exogenous factors, e.g. “If only we could get the Government/Regulators/Fed, etc. out of private business everything would fix itself.” This is a fallacy based on the antiquated notion that a capitalist economy naturally seeks out “equilibrium,” or a romanticized state in which private capital and labor are simultaneously engaged in an optimum state of economic activity that maximizes productivity and employment. In a later post I will go into more detail about why I think the concept of economic equilibrium, as it is commonly discussed, is a myth.
Lastly, Minsky’s argument that stability is destabilizing is thought-provoking and timely because it cuts to the core of the neoliberal argument that The Market, an unfaltering and seemingly divine complex organism, should be trusted to freely allocate income, wealth, and resources throughout the economy. Minsky provides an integral piece of the heterodox deconstruction of this fallacy. His work shows how the capitalist marketplace sows the seeds for its own malinvestment, financial fragility, and eventual recession.
