Research Programs

Monetary Policy and Financial Structure

Monetary Policy and Financial Structure

This program explores the structure of markets and institutions operating in the financial sector. Research builds on the work of the late Distinguished Scholar Hyman P. Minsky—notably, his financial instability hypothesis—and explores the institutional, regulatory, and market arrangements that contribute to financial instability. Research also examines policies—such as changes to the regulatory structure and the development of new types of institutions—necessary to contain instability.

Recent research has concentrated on the structure of financial markets and institutions, with the aim of determining whether financial systems are still subject to the risk of failing. Issues explored include the extent to which domestic and global economic events (such as the crises in Asia and Latin America) coincide with the types of instabilities Minsky describes, and involve analyses of his policy recommendations for alleviating instability and other economic problems.

Other subjects covered include the distributional effects of monetary policy, central banking and structural issues related to the European Monetary Union, and the role of finance in small business investment.


Program Publications

  • In the Media | May 2015
    Congress Launches New Attacks on America's Central Bank
    The Economist, May 16, 2015. All Rights Reserved.

    During a financial panic, said Walter Bagehot, a former editor of The Economist, a central bank should help the deserving and let the reckless go under. Bagehot reckoned that the monetary guardians should follow fourrules: lend freely, but only to solvent firms, against good collateral and at high rates. Many American politicians complain that the Federal Reserve is all too happy to lend, but that it ignores Bagehot's other dictums. On May 13th two senators of very different hues—Elizabeth Warren, a darling of the left, and David Vitter, a southern conservative—joined forces to introduce a bill that would restrict the Fed's ability to lend during the next financial panic. Does that make sense?

    Emergency lending under Section 13(3) of the Federal Reserve Act was one of the most controversial policy responses to the financial crisis. In a letter to Janet Yellen, the chair of the Fed, Ms Warren and Mr Vitter say that from 2007 to 2009 the Fed provided over $13 trillion to support financial institutions. The loans were cheap. A study from 2013 by the Levy Institute, a nonpartisan think-tank, found that many of them were "below or at the market rates" (sometimes less than 1%). Many of the banks that benefited were insolvent at the time. And much of the $13 trillion went to just three banks (Citigroup, Merrill Lynch and Morgan Stanley), leading many to suspect that the Fed was indulging favoured firms.

    Critics focus on details but miss the big picture, counters the Fed. Elizabeth Duke, a former governor, says that the Fed targeted its lending programmes at the right markets, such that it helped to stop the crisis from getting even worse. Jerome Powell, a current governor, points out that "every single loan we made was repaid in full,on time, with interest."

    But whether the Fed should be able to offert his kind of financial support at all is a different question. Choosing certain firms or markets to receive credit over others is inherently problematic, says a recent paper from the Federal Reserve Bank of Richmond. The prospect of easy money encourages firms to take excessive risks. And according to a paper by Alexander Mehra, then of Harvard Law School, the Fed "exceeded the bounds of its statutory authority" when it bought privately issued securities as well as making loans.

    The Dodd-Frank Act, passed in 2010, was supposed to ensure that the Fed never again made such large, open-ended commitments. Congress told the Fed's board to ensure that emergency lending propped up the financial system as a whole, not individual firms. However, say Ms Warren and Mr Vitter, the Fed has not implemented the new rules in the spirit of the law. The new bill proposes a number of Bagehot-like changes: to toughen up the definition of insolvency, such that the Fed lends only to viable firms; to offer any lending programme to many different institutions; and to ensure that when the Fed does lend, it charges punitive rates.

    This battle is not the only one the Fed faces. On May 12th Richard Shelby, a Republican senator and chair of the Senate Banking Committee, introduced his own bill, which he hopes will rein in the Fed's powers in different ways. It would increase the threshold at which a financial institution became "systemically important" (and thus subject to tougher regulatory scrutiny) from assets of $50 billion to $500 billion. Mr Shelby also wants to shake up the structure of the Federal Reserve System, including changing how the president of the New York Fed, which oversees big banks, is appointed. They may have different complaints, but lots of America's lawmakers agree that the Fed must change.

    From the print edition: Finance and economics
  • Working Paper No. 837 | May 2015
    A Keynes-Schumpeter-Minsky Synthesis

    This paper discusses the role that finance plays in promoting the capital development of the economy, with particular emphasis on the current situation of the United States and the United Kingdom. We define both “finance” and “capital development” very broadly. We begin with the observation that the financial system evolved over the postwar period, from one in which closely regulated and chartered commercial banks were dominant to one in which financial markets dominate the system. Over this period, the financial system grew rapidly relative to the nonfinancial sector, rising from about 10 percent of value added and a 10 percent share of corporate profits to 20 percent of value added and 40 percent of corporate profits in the United States. To a large degree, this was because finance, instead of financing the capital development of the economy, was financing itself. At the same time, the capital development of the economy suffered perceptibly. If we apply a broad definition—to include technological advances, rising labor productivity, public and private infrastructure, innovations, and the advance of human knowledge—the rate of growth of capacity has slowed.

    The past quarter century witnessed the greatest explosion of financial innovation the world had ever seen. Financial fragility grew until the economy collapsed into the global financial crisis. At the same time, we saw that much (or even most) of the financial innovation was directed outside the sphere of production—to complex financial instruments related to securitized mortgages, to commodities futures, and to a range of other financial derivatives. Unlike J. A. Schumpeter, Hyman Minsky did not see the banker merely as the ephor of capitalism, but as its key source of instability. Furthermore, due to “financialisation of the real economy,” the picture is not simply one of runaway finance and an investment-starved real economy, but one where the real economy itself has retreated from funding investment opportunities and is instead either hoarding cash or using corporate profits for speculative investments such as share buybacks. As we will argue, financialization is rooted in predation; in Matt Taibbi’s famous phrase, Wall Street behaves like a giant, blood-sucking “vampire squid.”

    In this paper we will investigate financial reforms as well as other government policy that is necessary to promote the capital development of the economy, paying particular attention to increasing funding of the innovation process. For that reason, we will look not only to Minsky’s ideas on the financial system, but also to Schumpeter’s views on financing innovation.

  • One-Pager No. 49 | May 2015
    Shadow Banking and Federal Reserve Governance in the Global Financial Crisis

    The 2008 Federal Open Market Committee (FOMC) transcripts provide a rare portrait of how policymakers responded to the unfolding of the world’s largest financial crisis since the Great Depression. The transcripts reveal an FOMC that lacked a satisfactory understanding of a shadow banking system that had grown to enormous proportions—an FOMC that neither comprehended the extent to which the fate of regulated member banks had become intertwined and interlinked with the shadow banking system, nor had considered in advance the implications of a serious crisis. As a consequence, the Fed had to make policy on the fly as it tried to prevent a complete collapse of the financial system.

  • This monograph is part of the Levy Institute’s Research and Policy Dialogue Project on Improving Governance of the Government Safety Net in Financial Crisis, a two-year project funded by the Ford Foundation.

    This is the fourth in a series of reports summarizing the findings of the Research and Policy Dialogue Project on Improving Governance of the Government Safety Net in Financial Crisis, directed by Senior Scholar L. Randall Wray. This project explores alternative methods of providing a government safety net in times of crisis. In the global financial crisis that began in 2007, the United States used two primary responses: a stimulus package approved and budgeted by Congress, and a complex and unprecedented response by the Federal Reserve. The project examines the benefits and drawbacks of each method, focusing on questions of accountability, democratic governance and transparency, and mission consistency.

    The project has also explored the possibility of reform that might place more responsibility for provision of a safety net on Congress, with a smaller role to be played by the Fed, enhancing accountability while allowing the Fed to focus more closely on its proper mission. Given the rise of shadow banking—a financial system that operates largely outside the reach of bank regulators and supervisors—the Fed faces a complicated problem. It might be necessary to reform finance, through downsizing and a return to what Hyman Minsky called “prudent banking,” before we can reform the Fed.

    This report describes the overall scope of the project and summarizes key findings from the three previous reports, as well as additional research undertaken in 2014.  

  • Working Paper No. 834 | March 2015

    John Maynard Keynes held that the central bank’s actions determine long-term interest rates through short-term interest rates and various monetary policy measures. His conjectures about the determinants of long-term interest rates were made in the context of advanced capitalist economies, and were based on his views on ontological uncertainty and the formation of investors’ expectations. Are these conjectures valid in emerging markets, such as India? This paper empirically investigates the determinants of changes in Indian government bonds’ nominal yields. Changes in short-term interest rates, after controlling for other crucial variables such as changes in the rates of inflation and economic activity, take a lead role in driving changes in the nominal yields of Indian government bonds. This vindicates Keynes’s theories, and suggests that his views on long-term interest rates are also applicable to emerging markets. Higher fiscal deficits do not appear to raise government bond yields in India. It is further argued that Keynes’s conjectures about investors’ outlooks, views, and expectations are fairly robust in a world of ontological uncertainty.

    Associated Program(s):
    Tanweer Akram Anupam Das
    Related Topic(s):

  • Policy Note 2015/1 | February 2015
    Financial Fragility and the Survival of the Single Currency
    Given the continuing divergence between progress in the monetary field and political integration in the euro area, the German interest in imposing austerity may be seen as representing an attempt to achieve, de facto, accelerated progress toward political union; progress that has long been regarded by Germany as a precondition for the success of monetary unification in the form of the common currency. Yet no matter how necessary these austerity policies may appear in the context of the slow and incomplete political integration in Europe, they are ultimately unsustainable. In the absence of further progress in political unification, writes Senior Scholar Jan Kregel, the survival and stability of the euro paradoxically require either sustained economic stagnation or the maintenance of what Hyman Minsky would have recognized as a Ponzi scheme. Neither of these alternatives is economically or politically sustainable. 

  • One-Pager No. 48 | February 2015
    The developed world’s policy response to the recent financial crisis has produced complaints from Brazil of “currency wars” and calls from India for increased policy coordination and cooperation. Chinese officials have echoed the “exorbitant privilege” noted by de Gaulle in the 1960s, and Russia has joined China as a proponent of replacing the dollar with Special Drawing Rights. However, none of the proposed remedies are adequate to achieve the emerging market economies’ objective of joining the ranks of industrialized, developed countries. 

  • Public Policy Brief No. 139 | February 2015
    Back to the Future
    Emerging market economies are taking an ill-targeted and far too limited approach to addressing their ongoing problems with the international financial system, according to Senior Scholar Jan Kregel. In this policy brief, he explains why only a wholesale reform of the international financial architecture can adequately address these countries’ concerns. As a blueprint for reform, Kregel recommends a radical proposal advanced in the 1940s, most notably by John Maynard Keynes.   Keynes was among those who were developing proposals for shaping the international financial system in the immediate postwar period. His clearing union plan, itself inspired by Hjalmar Schacht’s system of bilateral clearing agreements, would have effectively eliminated the need for an international reserve currency. Under Keynes’s clearing union, trade and other international payments would be automatically facilitated through a global clearinghouse, using debits and credits denominated in a notional unit of account. The unit of account would have a fixed conversion rate to national currencies and could not be bought, sold, or traded—meaning no market for foreign currency would be required. Clearinghouse credits could only be used to offset debits by buying imports, and if not used within a specified period of time, the credits would be extinguished, giving export surplus countries an incentive to spend them. As Kregel points out, this would help support global demand and enable a shared adjustment burden.   Though Keynes’s proposal was not specifically designed for emerging market economies, Kregel recommends combining this plan with current ideas for regionally governed institutions—to create, in other words, “regional clearing unions,” building on existing swaps arrangements. Under such a system, emerging market economies would be able to pursue their development needs without reliance on the prevailing international financial architecture, in which their concerns are, at best, diluted. 

  • Working Paper No. 833 | February 2015
    A Blueprint for Reform
    If emerging markets are to achieve their objective of joining the ranks of industrialized, developed countries, they must use their economic and political influence to support radical change in the international financial system. This working paper recommends John Maynard Keynes’s “clearing union” as a blueprint for reform of the international financial architecture that could address emerging market grievances more effectively than current approaches.
      Keynes’s proposal for the postwar international system sought to remedy some of the same problems currently facing emerging market economies. It was based on the idea that financial stability was predicated on a balance between imports and exports over time, with any divergence from balance providing automatic financing of the debit countries by the creditor countries via a global clearinghouse or settlement system for trade and payments on current account. This eliminated national currency payments for imports and exports; countries received credits or debits in a notional unit of account fixed to national currency. Since the unit of account could not be traded, bought, or sold, it would not be an international reserve currency. The credits with the clearinghouse could only be used to offset debits by buying imports, and if not used for this purpose they would eventually be extinguished; hence the burden of adjustment would be shared equally—credit generated by surpluses would have to be used to buy imports from the countries with debit balances. Emerging market economies could improve upon current schemes for regionally governed financial institutions by using this proposal as a template for the creation of regional clearing unions using a notional unit of account. 

  • Working Paper No. 832 | February 2015
    The Contributions of John F. Henry
    This paper explores the rise of money and class society in ancient Greece, drawing historical and theoretical parallels to the case of ancient Egypt. In doing so, the paper examines the historical applicability of the chartalist and metallist theories of money. It will be shown that the origins and the evolution of money were closely intertwined with the rise and consolidation of class society and inequality. Money, class society, and inequality came into being simultaneously, so it seems, mutually reinforcing the development of one another. Rather than a medium of exchange in commerce, money emerged as an “egalitarian token” at the time when the substance of social relations was undergoing a fundamental transformation from egalitarian to class societies. In this context, money served to preserve the façade of social and economic harmony and equality, while inequality was growing and solidifying. Rather than “invented” by private traders, money was first issued by ancient Greek states and proto-states as they aimed to establish and consolidate their political and economic power. Rather than a medium of exchange in commerce, money first served as a “means of recompense” administered by the Greek city-states as they strived to implement the civic conception of social justice. While the origins of money are to be found in the origins of inequality, a well-functioning democratic society has the power to subvert the inequality-inducing characteristic of money via the use of money for public purpose, following the principles of Modern Money Theory (MMT). When used according to the principles of MMT, the inequality-inducing characteristic of money could be undermined, while the current trends in rising income and wealth disparities could be contained and reversed.