Commentary on Political Economy

Sunday 10 July 2011

Review of Bernanke and Gertler Paper - Part of Draft 'Krisis' Chapter titled "Notes on Minsky"

In this paper on “Financial Fragility and Economic Performance” ( ) , Bernanke and Gertler identify the "ultimate source" of asymmetries in the "borrowers' net worth position" - the lower the net worth, the higher the risk of implosion. Again, this fails to isolate "the virus" responsible for the disease, but it offers some hints. The first hint is that "high net worth firms" will be "ensconced" from debt-deflation initially by their "oligopolistic" and hence "systemic" importance (too big to fail). And the second is that each successive "crisis" brings about a series of "mergers and acquisitions" whether voluntary or "shot-gun marriages" that increases further the degree of "oligopoly" of capitalist enterprise and therefore its future "fragility" - the "systemic riskiness" of the system. (See this FT story on M&A activity following GFC ) And finally, the growing "systemic riskiness" of the structure of capitalist enterprise, together with the parallel "centrality" of State authorities in "crisis management", mean that central banks become "lenders of first (not last) resort".

Indeed, Bernanke and Gertler zoom into this specific “chasm” or “lacuna” (Keynes’s “slip ‘twixt the cup and the lip”) seeking to determine what “factor” would trigger a debt-deflation implosion of the credit pyramid (remember: a pyramid of term contracts enabled by low inflation for prolonged periods). This is what they come up with at p88:

“In this paper we take a step toward an operational definition of
financial stability. We argue that financial stability is best under-
stood as depending on the net worth positions of potential borrow-
ers. Our basic reasoning is as follows: generally, the less of his own
wealth a borrower can contribute to the funding of his investment
"project," the more his interests will diverge from those of the
people who have lent to him. When the borrower has superior
information about his project, or the ability to take unobserved
actions that affect the distribution of project returns, a greater
incompatibility of interests increases the agency costs associated
with the investment process. We define a financially fragile situa-
tion to be one in which potential borrowers (those with the greatest
access to productive investment projects, or with the greatest
entrepreneurial skills) have low wealth relative to the sizes of their
projects. Such a situation (which might occur, e.g., in the early
stages of economic development, in a prolonged recession, or
subsequent to a "debt-deflation"') leads to high agency costs and
thus to poor performance in the investment sector and the economy
We illustrate this general point in the context of a specific
model of the process of investment finance. In this model individual
entrepreneurs perform costly evaluations of potential investment
projects and then undertake those projects that seem sufficiently
worthwhile. The evaluation process gives the entrepreneurs (who
must borrow in order to finance projects) better information about
the quality of their projects than is available to potential lenders. As
in Myers and Majluf [I9841 and others, this informational asymme-
try creates an agency problem between lenders and the entrepre-
neurs-borrowers. This agency problem (which is more severe, the
lower is borrower net worth) raises the prospective costs of invest-
ment finance and thus affects the willingness of entrepreneurs to
evaluate projects in the first place. We show that,, in general
equilibrium, both the quantity of investment spending and its

1. The term is due to Irving Fisher [1933]. See Bernanke and Gertler [I9891 for
an analysis.


expected return will be sensitive to the "creditworthiness" of
borrowers (as reflected in their net worth positions). Indeed, if
borrower net worth is low enough, there can be a complete collapse
of investment.

Now, the thing to be noticed instantly is that, unlike Mishkin who leaves the question of the precise “operation” of “asymmetric information” in the actual structure and function of capitalist enterprise might give rise to these “asymmetries”, preferring to attribute them to “exogenous factors” (listed above), B&G concentrate here on the structural “endogenous” factors that might “pre-dispose” the system to debt-deflation and find (or hypothesize) that it is “the net worth position” of the borrower that is determinant. This would seem to support our initial hypothesis that the “functional” predisposition of the “lending” aspect of capitalist investment is to reduce risk, even at the cost of sacrificing profit maximization. This stands to reason because maximizing profit is never the real goal of capital – it is merely the pursuit of safe profit above what is called “the risk-free rate of interest” which merely represents the interests of “social capital”.

Note (!) that B&G look at “fragility” from an “ex post” position, that is, “after” a debt-deflation” has occurred and therefore what they mean by “fragility” is the inability of the investment cycle “to re-start” owing to the low net worth of entrepreneur-borrowers. But in fact it can be argued that this situation can arise even “ex ante”, that is, that instability increases “before” debt-deflation. A surfeit of capital in the sense of either excessive liquidity vis-a-vis actual “productive activity” (note that B&G themselves refer to “productive [!] investment projects” and fail to specify what they  m e a n  by this!) and therefore the ability to find “productive investment projects” except those of entrepreneurs lacking the requisite skills… - either of these possibilities reduce the “net worth”, the “skin in the game” of the entrepreneurs selected by lenders for loans. – Hence the “fragility”  b e f o r e  debt-deflation occurs once the volume of investments reaches a “critical” stage. Again, Fisher’s “debt-deflation”, or Minsky’s “hypothesis”, only tackle the “implosion” of Ponzi finance – but not its “generation”!

They do this desultorily in the Conclusion:
“Putting aside the reasons for the increase in leverage, it still
may be asked whether the higher level of debt implies greater
financial fragility. Our answer is, "It depends." We believe that the
focus on debt versus equity ignores the primary determinant of [p111]
financial stability-the net worth of borrowers, or, as we may call it
for the purposes of this discussion, the "insiders' stake."z3 If the
insiders' stake is high, debt need not be harmful. For example, as
has been frequently pointed out, Japanese corporations have tradi-
tionally relied much more on debt than have U. S. firms. This has
not posed a problem for the Japanese, however, because managerial
decisions are tightly monitored by financial backers-banks or
parent corporations. Effectively, insider stakes in Japan are high;
among other things, this means that firms' finances can efficiently
be restructured when circumstances change. Thus, whether the
U. S. economy is in a financially fragile condition depends funda-
mentally more on the magnitude of insiders' stakes in the United
States than on the composition of firms' external liabilities.
There have been factors pushing insiders' stakes in both
directions in the United States during this decade. For example, to
the extent that the wave of takeovers and buyouts has represented
the seizure of corporate control by well-financed management
teams, there may have been an effective increase in insiders' stakes;
likewise, increased monitoring of management by takeover special-
ists and investment banks may have had a salutary effect. Working
in the other direction, increasing securitization (for example, the
greater reliance on junk bond financing a t the expense of commer-
cial bank loans4)has typically reduced the overlap between the
providers of financial capital and the insiders in the corporation;
greater use of "arm's length" financing trends to increase financial
fragility. Measurement of the effects of these countervailing forces
on the stability of the U. S. financial system is a difficult, but not
impossible, empirical challenge.”

So here we have an evident “divide” between “social capital” (capital as a whole represented by finance capital) and individual capitals. And when B&G remind us that the “creditworthiness” of borrowers is a function of their “net worth position”, then we know we are on to something extremely important. – Because this “net worth” will depend in large part not merely on the individual position of the borrower, but above all on the specific weight (weight!) that this individual capitalist plays in the capitalist economy, in terms of how “pivotal” it is to social reproduction overall and its specific role in a certain “sector” (or “market”, if you like) – in other words, on the degree of “oligopoly” (recall Sylos-Labini’s point on how “lollies differ from steel”!). B&G touch briefly on this at Part V on “debtor bail-outs”.

Indeed, the ultimate significance of State intervention in a “crisis” to restore the “flow” of capitalist activity threatened by the “disintermediation” of financial institutions and the emergence of the central bank as “lender of first resort” have to do with the impossibility at a certain level of debt-deflation of the monetary authorities to distinguish between liquidity and solvency and between “idiosyncratic” and “systemic shocks” or crises (p108), that is , to tell apart the “real” and the “fictitious” parts of capitalist activity or investment in terms of “use value” and of arms-length allocation of social resources between individual capitalists. In the end, it is the “systemically important” capitalist firms that simply must survive – they become “too big to fail” once a relevant degree of “oligopoly” is achieved. Mishkin, to be fair, had already insisted on the ability of large firms (oligopolies) to issue securities to finance themselves – an evident adoption of the B&G thesis on the importance of net worth for surviving debt-deflation. Worse still, each “crisis” simply tolls the death-knell for smaller capitalist firms (financial and industrial) that are then acquired and merge with bigger ones in a growing spiral of capitalist “concentration”. – Until, that is, the collective capitalist has to intervene “in first person”, through financial disintermediation, tighter regulation and supervision, and (in extremis) outright “nationalization” (anathema but nearly a reality in the latest US crisis!).

We find here a curious but undeniable and significant inversion or contra-diction of Schumpeter’s “entrepreneurial spirit”, in that the “trustification” of capital either saps and suppresses or at least “internalizes” the “Innovationsprozess” that he had singled out as the differentia specifica of capitalism. It is in this perspective or dimension that one must read Schumpeter’s late doubts about the very survival of capitalism as a form of social organization. Thus, here not only the process of innovation but also that of concentration – that is to say, the “internalization” of “information” within individual firms or “units of command” which the NIE had attributed (foolishly) to the reduction of “transaction costs” - become critically “subordinate” to that of wage-relation antagonism. It is the capitalist imperative to preserve the “private” character of the allocation of resources, the artificial “separation” of the social division of labour – the need of capital to avoid at all costs the “democratization” of the process of production in the face of its “re-composition” by workers (by “society”! even by “social capital”!) that leads inevitably to the “crisis”. And, in an apparent paradox, it is the higher level of social interdependence or integration of production – the very process of capitalist concentration – that provokes crises and necessitates ever-higher levels of State intervention to restore the broken “co-ordination”, to abolish the “asymmetries” that had emerged as a result of the peculiar “private” character (or Trennung) operated by capitalist private ownership of the means of production and their “separation” of workers from them and from one another.

Bernanke and Gertler have not ceased to surprise us with their insights, however. This one is at p89:

This paper also contains some novel policy results, not dis-
cussed in our earlier work. The most striking of these is that, if
"legitimate" entrepreneurs are to some degree identifiable, then a
policy of transfers to these entrepreneurs will increase welfare. We
show that a number of standard policies for fighting financial
fragility can be interpreted along these lines.”

We will look closer at what “legitimacy” means here. The central problem is that from being purely “friction” and relegated to “externalities” such as “transaction costs”, which together were bundled up in the “unification” of micro- and macroeconomic theory – just the embarrassing “fact” that money is central to a capitalist economy (Patinkin’s “you can’t buy goods with goods”; see also Wicksell on Walras in ‘IandP’, p22) -, now these “frictions” (impossibly “generalized” by Williamson’s “NIE” to the point of destroying any and all “economic theory”) come to the fore of the entire bourgeois “science” to the point that they “replace” the maximization of “welfare” as the sine qua non of economic activity and regulation. In other words, truly with Hayek we have shifted from an “economics of price” to an “economics of information”. (On all this, see the wonderful review by Klaes link here.

In his sweepingly devastating conclusion,

“While the folk history of transaction costs is often told as a story of
remarkable success, the historical sketch presented here, which focuses on the
transaction cost notion itself, suggests a rather different picture. The study of
the use of transaction costs in the literature of modern economics turns out to be
the history of the quixotic struggle of the discipline to endogenize one of the
most pervasive residual categories of the neoclassical heritage—the category of
institutional friction.” )

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