The euro sovereign debt crisis and the irrationality of the bond markets:the need for a lender of last resort

Throughout the history of the capitalist system the markets have played a pivotal role. Of course, the Walrasian conception of markets that inevitably clear temporary gluts and misallocations through the process of tatonnement and the invisible auctioneer is obviously a utopian notion that avoids the realistic impact of oligopolies, near monopolies and other less than perfectly rational influences on the real economy.

Depressions borne out extraordinary popular delusions and the madness of crowds, and other manias , panics and crashes have been a regular part of financial market history. Ponzi finance and outright fraud have also been a persistent problem. Hyman Minsky brilliantly developed an entire theory of financial instability on the basis of this sort of analysis. In Minsky’s view as in Keynes there were three reasons for holding money, the spending transactions motive, the precautionary motive and the speculative motive. But in Minsky the speculative motive is developed further than in Keynes although Keynes was clearly familiar with the terrain of speculation. Minsky outlines it as follows: ”securing profit by speculation involves the appreciation(or depreciation) of asset prices.The fundamental speculative demand for money centers around the extent to which borrowing takes place to finance positions in assets whose price may vary; these expected asset prices as well as the terms on money loans are the determinants of the speculative demand for money.

Keynes writes the demand for money states Minsky as follows. M=M1+M2= L1(Y) +L2(R). where L1(Y) consists of both the transactions demand and the precautionary demand and L2(R) the speculative demand for money.(See Minsky, John Maynard Keynes, p.72& Keynes,(GT) p.199.Minsky rewrites this equation as M=M1+M2+M3-M4 = L1(Y) + L2(r,Pk) + L3(F) -L4(NM) where L3 is the precautionary motive due to the outstanding private financial commitments, F. F increases as planned or ex ante investment increases as increases in investment activity require a greater precautionary reserve of money. In addition near monies(NM) as represented by certain financial instruments offset part of the insurance and precautionary demands for money. (Minsky JMK, p.73) Minsky makes the striking argument that the creation of near monies reflects a demand for financing and thus a period of financial innovation (such as we have gone through). This can lead to a rising price of capital assets side by side with rising interest rates on money loans.

However, as we now well understand a highly leveraged asset boom can implode and asset values can crash. In such circumstances the incentive to hold cash increases dramatically as cash becomes a form of insurance against the potential  losses of various asset classes.

Sovereign debt is normally seen as a very secure and less risky asset. However, if interest rates are low, bond prices are high and should rates rise bond holders can experience capital losses hence the move to cash is accelerated. In addition the fundamental irrationality which dominates contemporary markets is far removed from the idyllic world of Walras and the market clearing process. Hence, it becomes possible for very secure assets to become viewed irrationally as very risky. This is clearly the case of European sovereign debt of the leading economic powers in the euro zone. In such circumstances it is necessary and highly prudent for central banking institutions and governments to intervene to ensure that the financial instability is moderated and systemic stability restored. As Minsky puts it they have to ensure that central bank exercise its role as a lender of last resort. This means with respect to financial institutions it short circuits the process by which the financial house in order to raise funds is forced to sell its position in real and financial assets which can lead to enormous losses. (H.Minsky, A Deep Recession But Not a Depression: the impact of Lender of Last Resort Intervention , in Stabilizing an Unstable Economy, p.49.) We can now amend this to include participating in sovereign debt management.With respect to governments lending needs it means intervening directly in the bond markets to temporarily acquire government treasuries and bonds when the demand for them  is insufficient to ensure low enough interest rates to promote an economic recovery or avoid a serious crisis.

The real question that investors should be asking is where if not in the sovereign debt markets of the leading economic powers or in the equity markets should they be placing their cash ? Hoarding it will be self defeating helping to bring out the very circumstances they fear.

Unfortunately, thus far in Europe the central banking and government leading players have stumbled in resolving their differences over the role of the ECB and the degree of intervention they are willing to live with and in understanding the role of lender of last resort in the operations of a central bank.

Its a pity because as Minsky clearly shows without sensible and substantial intervention considerable instability may result.


About haroldchorneyeconomist

I am Professor of political economy at Concordia university in Montréal, Québec, Canada. I received my B.A.Hons (econ.&poli sci) from the University of Manitoba. I also completed my M.A. degree in economics there. Went on to spend two years at the London School of Economics as a Ph.D. student in economics and then completed my Ph.D. in political economy at the University of Toronto. Was named a John W.Dafoe fellow, a CMHC fellow and a Canada Council fellow. I also was named a Woodrow Wilson fellow in 1968 after completing my first class honours undergraduate degree. Worked as an economist in the area of education, labour economics and as the senior economist with the Manitoba Housing and Renewal Corporation for the Government of Manitoba from 1972 to 1978. I also have worked as an economic consultant for MDT socio-economic consultants and have been consulted on urban planning, health policy, linguistic duality and public sector finance questions by the governments of Manitoba, Saskatchewan,the cities of Regina and Saskatoon, Ontario and the Federal government of Canada. I have also been consulted by senior leaders of the British Labour party, MPs from the Progressive Conservative party, the Liberal party and the New Democrats on economic policy questions. Members of the Government of France under the Presidency of Francois Mitterand discussed my work on public sector deficits. I have also run for elected office at the municipal level. I first began to write about quantitative easing as a useful policy option during the early 1980s.
This entry was posted in business cycles, classical economics, European debt crisis, European financial stability fund, J.M.Keynes, labour market clearing and tagged . Bookmark the permalink.

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