Friday, December 03, 2004

Budget Deficits: K. Grease Plays Chicken Little


The old post-Keynesians, such as Hyman Minsky, made much of the increased financial interdependence, and consequent fragility, of our banking and credit system (see, for details, Minsky, 1971, 1982, 1995. For more than anyone could want to know, see Bellofiore and Ferri, 2001). Here was how Minsky put the problem, which he called “the economics of euphoria,” and which sounds familiar to anyone who lived through the 1990s:

The confident expectation of a steady stream of prosperity [creates a] … take what would have been considered in earlier times undesirable chances in order to finance the acquisition of additional capital goods...Those that supply financial resources live in the same expectational climate as those that demand them...An essential aspect of a euphoric economy is the construction of liability structures which imply payments that are closely cash flows due to income production...Withdrawals on the supply side of financial markets may force demanding units that were under no special strain and were not directly affected by financial stringencies to look for new financing connections. An initial disturbance can cumulate through such third- party or innocent-party bystanders...Financial instability occurs whenever a large number of units resort to extraordinary sources for cash [at the same time]. (Minsky, 1971; cited in Mayer, 1998).

I was lucky enough to take classes from Hy Minsky in the early 1980s, and I have to admit that at the time I thought he was paranoid. But looking at the quote above (and remember, this was from the early 1970s!), I am much more persuaded that the idea of fragility, and increased speed and power of transmission of economic crises, is plausible, though it may be hard to express rigorously.

Nonetheless, several scholars have recently taken the idea of financial fragility, or the increased susceptibility of an economic system to shocks, very seriously. One mechanism through which contagion can spread is the cross-market “rebalancing" of portfolios, much as Minsky was describing in the long quotation above. The key insight is that investors transmit idiosyncratic shocks from one market to others (either sectoral markets, within a nation, or in financial markets, across nations) by adjusting their exposures to macroeconomic risks.

But the attempted portfolio adjustments are by no means independent; again, as Minsky pointed out, “Those that supply financial resources live in the same expectational climate as those that demand them.” For present purposes, one of the most interesting contributions is the paper by Leung (2003). Leung claims that the external debt owed by less developed nations has increased the amplitude, as well as the duration, of cyclic fluctuations in aggregate economic activity. Using simulations, Leung shows how increased external debt may directly increase risk of ruinous and unpredictable business cycles.

But is “external” debt really a problem for the U.S.? Certainly the amount of debt (in the U.S. case, Treasury securities) in foreign hands has been increasing, but is it a problem? The answer is “probably not,” or “at least not yet.” The value of Treasury securities in foreign hands recently exceeded $1.3 trillion, with the plurality of that amount ($450 billion) held by the Japanese. While some of the foreign holdings can be explained by attempts to prevent other currencies (particularly, in this case, the yen) from appreciating too much against the dollar, there is the dangerous possibility that some tipping point can be reached.

The more general problem is that a financial crisis, even if it were to start with, or simply involve, the U.S., might propagate in ways that international monetary and financial institutions could not control. As two recent papers, by Lagunoff and Schreft (2001) and Kodres and Pritsker (2002) point out, the very fact that rational agents hold diversified portfolios means that financial positions are linked. If a shock, in financial, energy, or some other key global markets, causes some losses, there will be consequent separate-but-not-independent attempts at portfolio rebalancing. But the aggregate consequence of individual attempts to realize small changes in financial position, if the information that caused the readjustment is common knowledge, could well be a disastrous decline in entire sectors and their asset values. These cascades in values can cause other losses which cause additional reallocations by other investors, so that even isolated shocks might quickly metastasize throughout the financial system.

There is an element of Chicken Little here, I should admit. There is no specific prediction that U.S. deficits, at some particular point or for any particular reason, will cause disaster. Still, the increase in deficits “as far as the eye can see,” combined with the unrelated but potentially menacing private debt in the U.S., leads to an important question: Why is it that we have deficits? Why did the surplus disappear so quickly, and sink so rapidly?

Bellofiore, Riccardo, and Piero Ferri (eds). 2001. Financial Keynesianism and Market Instability: The Economic Legacy of Hyman Minsky (two volumes). Cheltenham, UK: Northampton, MA : Edward Elgar
Kodres, Laura and Matthew Pritsker. 2002. "A rational expectations model of financial contagion." Journal of Finance 57: 769-99.
Lagunoff, Roger, and S. Schreft. 2001. "A Model of Financial Fragility." Journal of Economic Theory, 99: 220-224.
Leung, Hing-man. 2003. “External Debt and Worsening Business Cycles in Less Developed Countries.” Journal of Economic Studies 30: 155-68
Mayer, Martin. 1998. “The Asian Disease: Plausible Diagnoses, Possible Remedies.” Economics Working Paper Archive—WUSTL (, Macroeconomics Series, # 9805015.
Minsky, Hyman P. (1971), “Financial Instability Revisited,” in Reappraisal of the Federal Reserve Discount Mechanism. Washington, DC: Federal Reserve System, pp. 100-105.
Minsky, Hyman P. (1982). Can "It" Happen Again? Essays on instability and finance. Armonk, NY: M.E. Sharpe.
Minsky, Hyman P. (1995), Longer Waves in Financial Relations: Financial Factors in the More Severe Depressions II, in Journal of Economic Issues, vol. 29, no. 1, March, pp. 83-96.

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