Here I summarize L. Randall Wray’s description of Hyman Minsky’s theory of the investment cycle, which is the part of his economics most based on Keynes. Keynes and Minsky viewed the investment cycle as an endogenous phenomenon generated from within the economy, not an exogenous phenomenon triggered by external events. As Wray puts it, “it is in the nature of capitalism to cycle due to ‘whirlwinds’ of optimism and pessimism.”
Making a shift from microeconomic thinking to macroeconomic thinking is essential for understanding Minsky. This is mainly a matter of avoiding the fallacy of composition, which is the logical error of assuming that whatever is true on the individual level is also true at the aggregate level.
When most people think about building wealth at the individual level, they think about the importance of thrift. People who spend their entire income on current consumption cannot build wealth, but people who save and invest can. But in the aggregate, thrift can work against economic growth, a phenomenon Keynes called the “paradox of thrift.” If all the households in the economy were to become more thrifty at once, businesses would respond to the lack of aggregate demand for their products by running at less than full capacity and employing fewer workers. That would reduce national income and the capacity to build national wealth.
Macroeconomic thinking also has implications for what really drives the economy. In the national accounting, the income side of the economy must balance the spending side, if all forms of spending are included. Everybody’s income is tied to somebody’s spending—if not consumer spending then business investment, government spending, or foreign purchases of our exports. But when income and spending both grow or shrink, which is driving which?
At the personal level, income seems to drive spending, since you don’t usually spend what you don’t have. You can buy things on credit, but how much credit a bank will extend to you also depends on your income. But macroeconomists like Keynes and Minsky argue that spending is what drives income. If businesses don’t spend on the means of production like land, labor and factories, they don’t create income for individual households. Notice also that capitalist enterprises do not just invest from their existing profits. They often borrow to build their businesses, even before they have turned a profit. And they are not necessarily just borrowing from someone else’s income either, since borrowing often involves the creation of money. Capitalist firms, in cooperation with the banking system (and, as we’ll see, with government), function as creators of income and wealth, not just spenders of income. This creative function is not automatic—automatic creativity would be a contradiction in terms—but is subject to endogenous fluctuations, the boom and bust cycles that are endemic to capitalism.
Not surprisingly then, a macroeconomic theory of capitalism must focus on the investment decisions of capitalists!
Wray’s economics text, coauthored with William Mitchell and Martin Watts, defines investment as the “flow of spending which is devoted to increasing or maintaining the stock of productive capital.” Suppose a firm is considering an investment in new equipment. Minsky argued that the decision to invest depends on a comparison of two prices:
- The demand price is how much the firm would be willing to pay for the equipment, given the firm’s expectations about how much the equipment would add to future revenues;
- The supply price is the price the firm would have to pay for the equipment, including the cost of financing the purchase if it is to be made with borrowed money.
If the demand price exceeds the supply price, the firm will normally make the investment. However, the calculation of a demand price depends on expectations of future revenue, which the firm cannot know with certainty. Optimism—a positive business outlook—plays an important role. One firm’s optimism helps create income for others because its spending puts money in the hands of other firms and their workers. In the aggregate, investment is one factor in the determination of overall business profit. Minsky incorporated Michal Kalecki’s macroeconomic theory of profit that derived this result mathematically. In the aggregate, it is investment that drives profits, not profits that necessarily fund or limit investment.
Once an economic expansion begins, what Minsky called the “peculiar circularity of a capitalist economy” can accelerate it. Optimism feeds investment; aggregate investment creates income; income enables consumer spending; spending creates profit; and profit helps maintain optimism. Profit does not automatically lead to more investment, but it does invite firms to infer that they are doing something right, and that more of the same kind of investment may lead to more profit.
Macroeconomics also includes the role of government, and the analysis of profits by Kalecki and Minsky takes that into account. In Kalecki’s profit equation, G – T (government spending minus taxes) is a positive determinant of profit along with I (investment). Think about it. If government spends more than it taxes, that creates more income for the private sector, some of which ends up as profits in the hands of capitalists. What winds up as wages for workers gets subtracted from the profit equation. This is, of course, relevant to Kelton’s The Deficit Myth, which pleads for a macroeconomic understanding of deficit spending. It can have more positive effects than a deficit in your household budget!
From boom to bust
What could possibly go wrong with an economic expansion driven by investment spending and fueled by optimism?
As optimism is validated by increasing profits, firms are tempted to engage in riskier behavior. They continue to invest, even if that means going more deeply into debt. They may reduce their margins of safety, such as the collateral they provide to qualify for financing, the positive net worth they can show on their balance sheet, and the liquid assets they can fall back on if revenues fall short of expectations. As the economy booms, some overoptimistic firms run into trouble and default on their obligations.
Once an economic boom has raised expectations sky high, “…anything that lowers expected future profitability can push today’s demand price of capital below the supply price, reducing investment and today’s profits below the level necessary to validate past expectations on which demand prices were based when previous capital projects were begun.” The price that firms are willing to pay for new capital goods declines because firms aren’t so sure they want to take on more debt for the sake of dubious future returns. At the same time, the supply price of capital rises if lenders charge higher interest rates to firms with more existing debt.
What would lower expected future profitability? Maybe markets for many goods have become saturated because consumers have already bought as much as they want or can afford. That suggests a lesson for firms: Creative investment requires imagination, not just producing more and more of the same thing.
Another factor that helps turn boom to bust is a reduction in fiscal stimulus by government. As an economic expansion proceeds, government collects more tax revenue from rising incomes and spends less on things like unemployment compensation and public assistance. It may also adopt a more restrictive monetary policy to prevent inflation, with higher interest rates that raise the cost of borrowing.
As confidence in future profits erodes, businesses shift their priorities from investing at all cost to improving their margins of safety to avoid financial problems. The decline in investment then reduces aggregate income and consumer spending. Not only does optimism turn to pessimism, but pessimism feeds on itself by producing poor aggregate results that validate the pessimism. Acceleration turns into deceleration, until expansion turns into contraction.
The role of the financial system in amplifying such boom and bust cycles will be the topic of the next post.