The Economics Book

299

only firms that are part of this
process. Governments finance
their national debts, and consumers
borrow large sums to buy cars and
houses. They too are part of the
complex financial market that
funds transactions over time.

Merchants of debt
Minsky argued that there was a
second big difference between
modern and pre-capitalist
economies. He pointed out that the
banking system does not merely
match lenders with borrowers. It
also strives to innovate in the way
it sells and borrows funds. Recent
examples of this include financial
instruments called collateralized
debt obligations (CDOs), which
were developed in the 1970s.

CDOs were made by pooling

different financial assets (loans)

together, some high-risk, others

low-risk. These new assets were

then cut up into smaller sections to

be sold. Each section contained a

mix of debts. In 1994, credit default

swaps were introduced to protect

these assets by insuring them

against the risk of default. Both of

these innovations encouraged the

supply of loans into the financial

system, which increased the

supply of liquidity, or money, into

the system. Minsky concluded that

these innovations meant that it was

no longer possible for a government

to control the amount of money in

its economy. If the demand for loans

was there, the financial markets

could find a way to meet it.

According to Minsky, after World

War II capitalist economies had

moved away from being dominated

by either big government or big

business. Rather, they were subject

to the influence of big money

markets. The influence of the

financial markets on the behavior

of people created a system that

held within it the seeds of its own

destruction. He argued that the

longer the period of stable

economic growth, the more people

believed that the prosperity would

continue. As confidence rose,

so did the desire to take risks.

Paradoxically, longer periods of

stability resulted in an economy

that was more likely to become

fatally unstable.

Minsky explained the pathway

from stability to instability by

looking at three different types

of investment choices that people

can make. These can be simply

illustrated by looking at the way

houses are bought. The safest

decision is to borrow an amount

that allows the person’s income

to repay the interest on the loan

and also the original value of ❯❯

See also: Financial services 26–29 ■ Boom and bust 78–79 ■ Economic bubbles 98–99 ■ Economic equilibrium 118–23 ■
Financial engineering 262–65 ■ Bank runs 316–21 ■ Global savings imbalances 322–25

CONTEMPORARY ECONOMICS

Money is a veil

behind which the

action of real, economic

forces is concealed.

Arthur Pigou

The longer an

economy remains

stable, the greater

people’s confidence

in the future...

... the greater people’s

confidence in the future, the

riskier their borrowing.

Over time in a stable

economy, debt grows,

asset prices rise, and

risky borrowing comes

to dominate.

Eventually, asset

prices peak and then fall,

and borrowers start to default.

Lending collapses, and

the economy goes into

recession.

Stable economies contain the

seeds of instability.