We need to step over the corpses in the financial sector, Arnold Kling says:
Many economists think that an economic recovery requires the renewal of lending by banks. Instead, I think that we need to step over the corpses in the financial sector. A revival of business investment will come from profits, not from lending.
Kling’s analysis draws on an insight from Hyman Minsky:
Minsky’s key insight is that risk tolerance is cyclical. Investors will be risk averse for a while, and then gradually they will loosen up. Eventually, they become more and more complacent, until euphoria sets in, leading to bubbles and manias. This continues until a crash takes place, after which investors revert to being highly risk averse.Minsky described this risk tolerance cycle in terms of three phases: hedge finance; speculative finance; and ponzi finance. During the hedge finance phase, investors are allergic to risk. You can say, “Here is a project that is probably going to offer some really nice returns,” and the investors reply, “No, I don’t want to touch it. I’m not buying anything that has a down side.”
During the speculative finance phase, investors make reasonable trade-offs between risk and return. During the ponzi finance phase, investors ignore risks. Giving subprime borrowers option ARM mortgages was ponzi finance in every sense of the word.
The word of the day is de-leveraging, Kling notes, as firms try to shed debt and build up cash reserves:
The instinct of policymakers is to fight this deleveraging process. TARP and the various financial bailouts are based on the assumption that we need an active financial sector to keep the rest of the economy running. This may be correct. As I have indicated, most economists seem to think along these lines.However, my thinking is that the financial sector is vital only in the phases of speculative finance and ponzi finance. In an environment of hedge finance, nonfinancial firms are reluctant to borrow while individuals are reluctant to lend. Perhaps we should deal with the situation as it is, rather than try to foster financial intermediation that nobody wants.
Profits are the necessary fuel for the recovery, he says.