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Alexander Larman

What happened to the Rishi Sunak I knew at school?

Enter Hyman Minsky. A child of Depression-era Chicago, he sought a framework in which such a slump could never happen again, but unlike the economic mainstream, he recognised that financial innovation always threatened a return to 1929. Though he died in 1996, his now-rediscovered ‘financial instability hypothesis’ describes the inescapable path of private finance towards ever-riskier practices. A better Cassandra than most, he offers a persuasive alternative.

The golden age of postwar stability was all about prudent lending. Banks lent to projects whose cash flow would pay interest and repay principal. But prudence contains the seeds of its own destruction. A banker uses his good standing to finance long-dated, risky projects with rolled-over, short-term debts. The secret of all banking fortunes is to borrow short and cheap, lend long and dear. Prudent lending thus gives way to speculative lending. Boardrooms reward those who find new and more lucrative ways to borrow short and lend long. We enter ‘money-manager capitalism’.

The mortgage securitisation behind our current mess is just the latest in a long tradition of edgy innovations. Pooled mortgages brought new short-term lending into the housing market. Intermediaries such as Northern Rock tapped these new sources — until they ran out of lenders and of standing.

Speculative lending inevitably becomes ‘Ponzi lending’, in which short-term funding can no longer finance long-term loans, and boardroom incentives have left no margin for failure. This is the ‘Minsky moment’ when bubbles burst. Lenders have to take a haircut, or the central bank has to rescue them. Since August 2007, almost all our banks have entered Ponzi territory.

Financial innovators will always be with us, and economic instability cannot be eliminated. Instead, we need to build an economy in which their creativity is encouraged but their destructiveness diluted. Unlike more recent Cassandras such as George Soros and Nouriel Roubini, Hyman Minsky spent 30 years researching the implications of his analysis for taxation, industrial policy, the size of government, employment, education, competition law and financial regulation.

Diluting destabilising tendencies works better, he argued, than directly countering them with regulation. For example, long-term state investments in education or infrastructure, which Hayekians argue have negative effects because they ‘crowd out’ efficient private investment, are doubly attractive. They provide direct benefits, and they dilute the basic source of instability: private financing of long-dated projects. Active competition policy is needed, especially to keep banks small; big ones are not only bad because they are ‘too big to fail’, but also because they are rewarded for creating big corporations. Small local banks should finance the needs of households and small business. Government spending should be focused on investment rather than redistribution. The dependency-creating welfarism associated with late Keynesian policy is bad because a productive workforce is a collective good. Government should be an employer and trainer of last resort as much as a lender of last resort.

These policies seek intelligently to dampen the inevitable shocks created by inventive money managers. The Minskian state avoids the blunt interventions of late Keynesianism and Hayek’s denial of state effectiveness. It has two special powers, as lender and spender of last resort. Of course this state can be abused. The spender of last resort was overextended in the crumbling phase of Keynesianism; the lender of last resort has been abused in this last Hayekian phase.

In Can ‘It’ Happen Again?: Essays on Instability and Finance (1982), Minsky described the economy we should aim to build, but left no ready recipe to transform a Britain traumatised by the failure of the economic doctrines of 1966 to 2007. That is the detailed political work that will earn someone else a place in history.