1st Draft of Chapter Two
I have not yet posted my first draft of Chapter 2 of my thesis. Here it is. Please feel free to comment. It is a theoretical discussion on how to explain the 2008 Global Financial Crisis. (Some of my friends recently complained about insomnia – this might be the remedy :) ).
Chapter 2: The Financial Instability Theory – The Theoretical Discussion
“A sophisticated, complex, and dynamic financial system such as ours endogenously generates serious destabilizing forces so that serious depressions are natural consequences of noninterventionist capitalism: finance cannot be left to free markets” (Minsky, 1986:292)
Hyman Minsky’s research has become a prominent source of reference by commentators, policy makers, and academics in their efforts to explain the 2008 Financial Crisis. For decades Minsky’s work was outside of the mainstream Economic and Political Economy paradigms. The 2008 Global Financial Crisis changed this.
In this chapter I will explain and motivate the use of the Financial Instability Theory (FIT) as an explanatory model for the 2008 Global Financial Crisis. I will start with a discussion regarding the evolution of Political Economy as a field of study, differentiating Political Economy from Political Science, Economics and International Political Economy (IPE). I will define the delimitation and limitations of the study by defining my conception of political economy, differentiating between the global political economic system and the national systems of political economy.
Finally, I will motivate the use of the FIT as the study’s explanatory framework, and discuss the evolution of the theory – its roots in Keynes’ General Theory, the Post-Keynesian institutional reinterpretation of the General Theory by Minsky, Minsky’s theory of capitalist development, Minsky’s formulation of the Financial Instability Hypothesis, Kindleberger’s expansion of the hypothesis, and the centrality of government policy as a remedy for financial instability.
2.1 The Evolution of Political Economy as a Field of Study
Political Economy as a field of study had its beginnings when Adam Smith published The Wealth of Nations in 1776. Wright (Gilpin, 2001:25) explains that Smith and also John Stuart Mill saw Political Economy as a guide to the prudent management of the national economy – it was a “science that teaches a nation how to become rich.” For the classical thinkers the political dimension was equal to the economic dimension; however, this conception became significantly narrowed in the late nineteenth century when Alfred Marshall, who is considered the father of modern economics, substituted the term “Economics” for “Political Economy” (Gilpin, 2001:26). Lionel Robbins provided the definition that is today widely accepted by economists, namely:
“Economics is the science which studies human behavior as a relationship between ends and scarce means which have alternative uses” (Gilpin, 2001:26).
Economics became dominated by neoclassical theory which integrated the concepts of supply and demand in a market theory of capitalism where equilibrium is reached in terms of price and quantity. Neoclassical economics, introduced around the 1900’s led to the birth of modern Economics’ focus on mathematical methods and models in line with the methodology of the natural sciences. Contemporary orthodox economic theories remain solidly embedded within the broad approach of neoclassical economics.
John Maynard Keynes published The General Theory of Employment, Interest and Money in 1936. The General Theory represented a paradigm shift in Economic theory challenging the foundation of neoclassical theory, namely the notion that “the market” could reach the optimal level of full employment without government intervention. In my view Keynes’ General Theory was one of the earliest attempts to bridge the politics-economics divide that at this time became firmly entrenched in the social sciences.
The General Theory gave rise to the birth of Macroeconomics. At the heart of The General Theory is the proposition that private sector decisions in a relatively free market system could sometimes lead to inefficient macroeconomic outcomes. To achieve full employment, the government needs to actively intervene to stabilize output over the business cycle, through both fiscal and monetary policy (Sullivan & Sheffrin, 2003). Several schools of thought lay claim to Keynesian economics, resulting in a reductionist understanding of Keynes’ legacy. Today, any government involvement in the “free” market is seen as Keynesian.
After the second World War various forms of Keynesian economics became the guiding theoretical underpinnings of the advanced capitalist states of the West. This theoretical approach became known as the Keynesian or neoclassical synthesis. Beginning in the 1960s a paradigm shift started occurring leading to the ascendancy of the monetarist approach and a movement away from the Keynesian integrated political economic outlook. Markets left to their own devices with minimal government intervention were efficient, argued the new the orthodox approach led by the so-called “Chicago school”.
The Chicago school maintained that government’s role should be limited to establishing the rules of the economic system – the maintenance of structure. The Chicago school was challenged by the so-called “Saltwater” economists (members of Economics Departments at prominent Atlantic and Pacific coastal universities in the US) which were predominantly adherents to various Keynesian approaches, and who argued that that the government had an important discretionary role to play in stabilizing the economy through fiscal spending. Chicago school theories espoused by the “freshwater” economists of the Great Lakes became the theoretical foundation of Republican and Conservative public policy under Reagan and Thatcher. These approaches became dominant in the functioning of the global political economy due to US dominance.
Gamble (2009) aptly refers to public policy based on Chicago school theories as the “financial growth model.” According to this model tax cuts need to be instituted to stimulate the economy, in conjunction with privatization of public assets and optimal deregulation of the private sector, particularly the financial sector. The growth model emphasized the expansion of credit, limiting regulatory restrictions to credit growth, which led to the evolution of the financial sector as an important driver of economic growth. The consequent result was the commanding position of investment banks in the global political economy. Until the onset of the 2008 Global Financial Crisis, Chicago school theories and the financial growth public policy model dominated the global political economic system.
Gilpin (2001:26) points out that “Political Economy” started making a comeback in Economics by the end of the twentieth century, although considerable controversy exists over the meaning of the term, and the contemporary use of the term differs quite significantly from the earlier classical notions. For Chicago school economists Political Economy means a broadening of the scope of what economists study, using the formal models and methodology of economics to study almost all types of human behavior. Gilpin refers to this broadening of the scope as “economic imperialism”, and it covers several scholarly areas such as neoinstitutionalism, public-choice theory, and what economists call “political economy.”
It is important to note that within mainstream Economics there is often a negative connotation to the term “political economy.” The “new political economy” approach within economics focuses on private groups using public policy as a distributional vehicle in furthering their own private interests (which is essentially what politics is all about!)
Within the discipline of Political Science there is no dominant paradigm on the level of the global political economic system. Political Science is arguably a much more methodologically diverse field of study compared to Economics. This diversity is aptly illustrated by the diverse disagreement of what Political Economy/IPE/Global Political Economy is.
Many contemporary definitions of Political Science revolve around notions that politics is the authoritative allocation of value as influenced by power (Easton, 1981), or that politics is about how societies make authoritative decisions where there are competing and divergent interests. At the heart of Political Science is the concept of power. Within Political Science, Political Economy was predominantly seen as the politics of economic relations, or the interactions between states and markets, or the interplay of power and economics.
International Relations evolved as a subfield of Political Science to study the international dimension of politics. It is within this field of inquiry that IPE was born. The origins of the birth of IPE has to do with the divorce of Political Science and Economics. Just like Keynes within the Economics discipline, so did IPE scholars try and bridge the artificial divide between Economics and Political Science – a divide aptly described by Strange (Cohen, 2008:19) as a “dialogue of the deaf.”
According to Palan (2000) the prominent competing paradigms in Political Economy are Realism, Liberalism and Structuralism. O’Brien and Williams (2007) organize the dominant paradigms of Global Political Economy by grouping the various theories together under the headings of the economic nationalist perspective, the liberal perspective and the critical perspective.
Theorists that focus on the role of the state and the importance of power in shaping outcomes adhere to the economic nationalist perspective. “Realism” is a prominent school of thought following this perspective. The foundational assumption of realism is that states are unitary actors who pursue their interests regardless of moral constraints. The structure of the international political system is Hobbesian, with an absence of a global sovereign authority, and therefore power becomes the most important mediating factor amongst states. Realism claims that hegemony lends sufficient stability for the international economy (Palan, 2000:5). Adherents to the economic nationalist perspective view the state as prior to the market, and therefore market relations are shaped by the state. The key dynamic of this approach is the struggle for power and wealth (O’Brien & Williams, 2007:14-17).
“Liberalism” or “pluralism” is a theoretical approach that does not view the state as a unitary volitional entity. The state is disaggregated and becomes an instrument for the achievement of societal goals. System optimization through the tools of public choice is advanced. Kindleberger’s Hegemonic Stability Theory, as well as Keohane and Nye’s complex interdependence and regime theories, are part of the liberal perspective (Palan, 2000:5-6). For liberal theorists the market lies at the center of economic life. The key actors are not only states, but also individuals, institutions, and corporations; however, in this perspective the starting point of analysis is the individual (O’Brien & Williams, 2007:18-21).
According to Palan (2000) “structuralism” conceptualizes the world as a capitalist economy – a unified economic system where states take a secondary role. Emphasis is placed on the evolution of the structure of the world capitalist economy. O’Brien and Williams (2007:21-25) classify structuralist theories as part of the critical perspective. Critical theories question the way the world is organized and often times challenge the established institutions. The critical tradition has its roots in growing opposition to rationalism. To rationalists International/Global Political Economy is a subfield of International Relations, which is a subfield of Political Science. IPE/GPE stands at the intersection between domestic and international politics, as well as trade and finance (Palan, 2000:16). Critical theories, on the other hand, seek holistic interpretations of social relations. Cox (1995:31), a prominent proponent of the critical perspective, claims there is no theory in itself, no theory independent of a concrete historical context.
“Theory thus follows reality in the sense that it is shaped by the world of experience. But it also precedes the making of reality in that it orients the minds of those who by their actions reproduce or change reality” (Cox, 1995:31).
Cox makes a distinction between ‘problem-solving’ theory and ‘critical’ theory, with ‘problem-solving’ theory seeing the world as a given and providing guidance to correct dysfunctions and problems that arise within the existing order. ‘Critical’ theory, according to Cox, is concerned with how the existing order came into being, exploring the potential for structural change and the construction of strategies for change.
Many realist and economic nationalist theorists focus mainly on studying the interaction between politics and economics. Many liberal scholars view Global Political Economy as the privileging of the global arena over international relationships, with the choices of individual actors determining the structure. Many critical and structural analysts have a more interdisciplinary approach, adhering to the underlying assumption that politics and economics are inextricably interrelated and mutually constituting. On the other hand some critical theorists, like Marxist approaches, and some liberal analysts give precedence to economics over politics. This study firmly plants a flag in the camp of seeing politics and economics as inextricably interrelated and mutually constituting. In addressing an issue like the 2008 Global Financial Crisis we need an approach that doesn’t exclusively focus on interactions. Rather, we need an interdisciplinary theory that can explain how the structure of the global political system and the global economic system operates as an integrated system within which the crisis occurred.
2.2 Defining Political Economy and the Global Political Economic System?
I define Political Economy as the study of how resources are allocated within societies as determined by power, authority, production and distribution. The structure of power, authority, production and distribution determines the specific system for the allocation of resources. These four structures constitute one another. They are interdependent, interactive, and in essence inseparable. The aforementioned definition encompasses and integrates definitional notions of both Economics and Political Science.
From the dawn of consciousness human societies had to address the issue of how to allocate resources amongst the members of society. For instance pre-historical hunter-gatherer groups had a political economy characterized by authority and power based on heredity and dictatorial rule; with a subsistence production process (mainly hunting and gathering), and a social-collective distribution of economic goods.
A system is a group of interrelated, interacting, and interdependent components forming a complex whole. The components making up a system represent the structure of the system. Structure is a fundamental and sometimes intangible notion covering the recognition, observation, nature and stability of patterns and relationships of entities. In other words a structure defines what a system is made of. It is a configuration of items, a collection of interrelated components (www.wikipedia.org).
The way scarce resources are allocated within a society forms a complex whole – the political economic system. Underlying this system is a social structure which is the product of human choices creating patterns of relations evolving over many years, even decades and centuries.
There are two primary dimensions or sub-systems involved in resource allocation. On the one hand we have the political dimension, or the subsystem of power and authority; on the other hand, the economic dimension or sub-system of production and distribution. The economic and political sub-systems of a society mutually constitute each other. Economics and politics are not separate systems, but rather integrated subsystems of a larger system – both economics and politics are sides of the same “coin”, which is how we as humans allocate the resources we need.
In studying the way humanity as a whole allocates resources the level of analysis becomes the global political economic system, thus Global Political Economy theorizes on this level. I prefer to simply use the term Political Economy as it is a semantic effort to move away from the rigid disciplinary walls academia has constructed. Political Economists can study how resources are allocated within a particular society, looking at the state-society complex of the US for instance, or study the allocation of resources for the entire planet. Focusing on theorizing about the subsystem of power and authority only is the ontology of the Political Scientist. Conversely, theories focusing on the subsystem of production and distribution of a particular society are the ontology of Economists.
Societies interact, and the structure of their interaction can be described as the human society or human polity. The systems of resource allocation of particular societies constitute an overall global system. Structural changes over many centuries have resulted in a world characterized by a high degree of integration of different societies’ economic systems. This is “globalization.” I find Cohen’s definition useful (2008:79-80):
“…globalization is equated with an increasing close integration of national markets – a fundamental transformation of economic geography. In place of territorially distinct economies, we are said to be moving toward a more unified model, a truly global marketplace. Production processes and financial markets are becoming more international, transcending space. Economic networks are spreading without regard for distance and borders. Transactions are speeding up, compressing time, and relations are growing more and more intense, deepening linkages.”
The issue of ever increasing linkages is what makes contemporary globalization different from what we have seen in the past (Scholte, 2005). The contemporary global political economy consists of a capitalist economic system that has evolved from disparate regional, relatively autonomous markets for goods and services, to single interdependent markets for goods and services, which integrates nearly the entire world in a system that is characterized by “complex interdependence” (to use Keohane and Nye’s phrase). However, the world is characterized by fragmented subsystems of power and authority — the state-society complexes. Political power and authority predominantly rests in the hands of sovereign states, and although there is an absence of a central governing authority, political institutions and regimes loosely bind the fragmented political systems (Keohane, 2002).
2.3 A Political Economic Analysis of the 2008 Global Financial Crisis
The central problem of my study will be to answer the following research question from a Political Economic perspective: What caused the 2008 Global Financial Crisis?
In answer to this question I am postulating the following hypothesis: Within the structural evolution of capitalism there occurred an unprecedented political economic expansion of credit in the years preceding the 2008 Global Financial Crisis, which caused a fundamental distortion in the price of mortgage risk precipitating the crisis.
I will name this hypothesis The Political Economic Credit Expansion Mispricing of Mortgage Risk Hypothesis. The global credit expansion led to mispriced mortgage risk, and once the reality of mispriced risk started to spread through the financial system, panic and confusion ensued regarding the true extent of the risk. The panic led to massive debt deflation resulting in a global recession.
A secondary research question that will be addressed is: What are the lessons of the 2008 Global Financial Crisis for government policy? In answering the second research question only tentative observations regarding government policy related to financial crises will be made.
To analyze the crisis from only a political vantage point, or only an economic vantage point, would fall short in explaining the credit expansion and subsequent debt deflation. Both the political and economic dimensions of global resource allocation are inextricably at play in the expansion of credit that caused the crisis. There are of course many other approaches in other fields of study that can be used in answering the research question.
The argument can be made that since the crisis relates to “finance” or money, the sub-discipline of Finance should be the vantage point of analysis. “Finance” as a branch of economics concerns itself with the study of resource management, acquisition and investment. I am in agreement with this notion, and have selected a financial investment theory as the explanatory framework in which to posit my hypothesis – the Financial Instability Theory. However, the FIT encompasses not only elements of resource management, acquisition and investment, but also elements of public policy, fiscal policy, macroeconomics, and monetary policy, making it a political economic financial investment theory.
Psychology and Behavioral Finance are other sub-disciplines within which to analyze the crisis. As I will illustrate, the FIT contains important psychological and behavioral elements. However, to understand the cause as a political economic event one will have to go further than a mere focus on investment behavior. My selected theoretical framework encompasses a broad set of elements from different disciplines, however, the foundation of the framework remains firmly planted in Political Economy.
The FIT has its roots in post-Keynesianism, with Hyman Minsky one of the original and most prominent theorists of financial instability. Within the discipline of IPE his name remains inexplicably overshadowed by the likes of Keynes and Kindleberger. Susan Strange once described Minsky as a ‘loner’, a highly original political economist whose analytical framework and normative standpoint did not only stand in stark contrast to the ideas of his contemporaries, but were also developed in isolation from the big ‘intellectual armies’ of economic theory (Nesvetailova, 2007:57). Minsky’s theory had always been a heterodox theory until the 2008 Global Financial Crisis thrust it to the forefront in the search for answers.
The FIT redefines the role of the state in capitalist markets, and bridges the reductionist schism between Economics and Political Science. It is my contention that the theory is essentially a structuralist critical theory, since it highlights the historical structures in the evolution of capitalism, and aims to fundamentally change these structures to create a capitalist system with a more equitable distribution of wealth, more stability, smoother business cycles, and more stable full employment (Tymoigne, 2008). It is a theory that not only explains the functioning of modern capitalism, but has a very concrete social agenda for change.
I furthermore contend that the FIT has both realist and liberal notions. The theory is consistent with Gilpin’s (2001:23) argument that the way the global political economy functions is determined by both markets and the policies of nation-states. Markets and economic forces alone cannot account for the structure and functioning of the global economy. The nation-state has a central role in maintaining financial and economic stability through actively creating stabilizing financial regimes. The theory’s focus though, is on individual economic units, and the impact of these economic units’ decision making. Governments, corporations, banks, entrepreneurs etc. are all examples of economic units.
Minsky’s FIT should be understood within the context of his historical approach to political economic analysis. Indeed, the FIT is part of a broader theory of capitalist development proposed by Minsky (Whalen, 2001).
2.4 The Financial Instability Theory and Capitalist Development
Minsky outlined his theoretical vision as an attempt to integrate Joseph A. Schumpeter’s view of a resilient intertemporal capitalist process with Keynes’s view regarding the fragility produced by the capitalist financial structure in the capitalist accumulation process (Whalen, 2001:2). From Minsky’s perspective the economy was a complex, time-dependent system. He saw society as an “evolutionary beast,” changing in response to endogenous factors. According to Minsky the fundamental determinant of the path of capitalist development is the institutional structure of the political economy. It is this structure that regulates, facilitates, influences and constrains political economic activity. Consequently capitalism has many varieties.
Minsky was critical of standard economic theories of the day that emphasized exchange without incorporating time. In Minsky’s thinking time-dependency is an important structural variable of contemporary capitalism – production precedes exchange, and finance precedes production. Thus, credit creation is at the center of capitalist development (Minsky, 1990).
Another important element of Minsky’s approach was the importance of profit-driven structural change. According to Whalen (2001:3) Minsky had long argued that present and prospective profits influence economic activity within the context of a given institutional structure. Most contemporary economic theories see finance and credit creation as merely a facilitating process within the production-distribution subsystem. This view ignores the fact that financial firms are also profit-seeking institutions, and that credit creation is a production process in and of itself. Moreover, credit creation is a profit-seeking production process that precedes other production activities in time. The financial system takes on special importance according to Minsky’s theory of capitalist development since the system exerts a strong influence on business activity, and is also prone to innovations in profit driven credit production. Another essential element in Minsky’s theory is public policy. In Minsky’s view capitalist development cannot be understood without incorporating government policy. Government policy is an inescapable determinant of the path of capitalist development. In summation – a particular capitalist political economic system is created by profit-seeking credit creation, preceding other capitalist production and distribution processes, and government policy.
Minsky identified five stages in the historical evolution of capitalism in the US (Whalen, 2001).
- Merchant Capitalism (1607-1813)
- Industrial Capitalism (1813-1890)
- Banker Capitalism (1890-1933)
- Managerial Capitalism (1933-1982)
- Money-Manager Capitalism (1982 – present)
Merchant Capitalism was characterized by owner-managed enterprises. Production was through labor and tools. The dominant source of financing was through merchant banking – vouching for the legitimacy of distant trade partners and financing goods in transit. Financing was also provided by commercial banks. Private economic power during this period was fragmented and dispersed.
The industrial revolution heralded the end of the merchant era. Finance had to evolve – the banking structure of the merchant era could not finance the capital development needs of the industrial economy. Financial organizations were needed that could provide financing for factory manufacturing, capital intensive transportation, mills and mines. To meet this demand the New York Stock Exchange was formed and we saw the rise of investment banking houses. Industrial Capitalism also gave birth to the corporation supplanting home production by factory production. Competition between corporations increased based on price, resulting in collusion between companies to fix prices.
The rise of Banker Capitalism in the 1890s was in response to corporate collusion and combination, providing financing to form cartels, trusts, mergers and acquisitions. According to Hailbroner and Singer (Whalen, 2001:4) one or two giant firms controlled at least half the output in seventy-eight different US industries by 1904. In transitioning from the merchant era to the era of investment bankers, private economic power became increasingly concentrated. Prior to 1933 US capital markets were absent significant government regulations.
The advent of the Great Depression brought another change in American capitalism with the rise of interventionist government regulation of the monetary system and banking. Managerial Capitalism was born. Minsky introduced the concept of “Big Government,” which he argued was essential to the stability of the post-war period. “Big Government” needed to be “…big enough to ensure the swings in private investment lead to sufficient offsetting swings in the government’s deficit so that profits stabilized” (Minsky, 1986:296-297). The postwar environment was also characterized by oligopolistic markets, insignificant foreign competition, and a high degree of government macroeconomic management. Corporate managers attained a high degree of independence from banker and stockholder pressures. Managerial independence led to the inhibition of innovation and complacency, producing considerable upheaval in the 70’s.
Due to postwar prosperity and the Federal Reserve System stepping in as a lender of last resort through monetary interventions, the financial system became more fragile. The fragility stemmed from increased risk taking due to reductions in margins motivated by consistent Federal Reserve interventions. Lender of last resort interventions and prosperity also encouraged greater reliance on debt financing, and a turn toward short-term financing. The current phase of US capitalism according to Minsky evolved due to an exponential increase in the activities of finance companies and non-bank financial institutions. Concomitantly, we witnessed an increase in financial innovations like securitization and off-balance sheet entities (the rise of the shadow banking system). Money-Manager Capitalism supplanted Managerial Capitalism due to the rising importance of managed-money funds – pension funds, mutual funds, bank trust funds, etc. Where corporate managers were the “masters of the private economy,” money-managers on Wall Street became the new “masters of the universe.” Between 1950 and 1990, money managers saw the fraction of US corporate equities under their control grow from 8% to 60% (Porter, 1992:69). Over the same period, pension funds increased their ownership of US business stock from 1% to 39%, and also increased their percentage ownership of US corporate bonds from 13% to 50% (Ghilarducci, 1992:117). These percentages grew through the 90’s into the 2000’s.
Money managers’ raison d’être is to maximize return for investors in their funds, making them increasingly sensitive to short-term profits and the stock-market valuations of their firms. The increase in the number of institutional investors provided ready buyers for securitized investments. Throughout the period of Money-Manager Capitalism government policy had two characteristics, namely lender of last resort stabilization and a dismantling of the New Deal’s financial regulations in line with the financial growth model.
Minsky (1990:71) contended that Money-Manager Capitalism was going global, and that it was rendering obsolete the notion that trade patterns determined short-run foreign exchange rates. He pointed out that global Money-Manager Capitalism would require a division of responsibilities to maintain stability. Hegemonic stability by one power would not suffice. In 1995, a year before his passing, Minsky hinted at the future of global Money-Manager Capitalism.
“Global financial integration is likely to characterize the next era of expansive capitalism. The problem of finance that will emerge is whether the financial and fiscal control and support institutions of national governments can contain both the consequences of global financial fragility and an international debt deflation” (Minsky, 1995:93).
2.5 The Financial Instability Theory and Finance
At this junction I would like to define “capitalism”. While there is little consensus on a definition, many definitions focus on the fact that capitalism is an economic system characterized by private property rights and the seeking of a profit. The following is a common definition of capitalism.
”[Capitalism is a]n economic arrangement, defined by the predominant existence of capital and wage labour, the former consisting of accumulation in the hands of private (i.e. non-governmental) owners, including corporations and joint stock companies, the latter consisting in the activities of labourers, who exchange their labour hours (or, according to Marxian theory, their labour power) for wages, paid from the stock of capital. The capitalist extracts not a wage but a profit, by realizing in a market the value of the goods produced. Capitalism presupposes private property in the means of production, a market economy, and the division of labour” (Scruton, 1982:52).
The above definition will serve as the starting point for how capitalism is seen in this study; however, what is missing from the above definition is the clear explication that capitalism is essentially a financial system. Moreover, the peculiar behavioral attributes of a capitalist political economy center around the impact of finance upon system behavior (Minsky, 1967:33). Mehrling (2000) provides a succinct explanation of Minsky’s conceptualization of capitalism as being essentially a financial system. In a capitalist economy every economic unit – every firm, household, individual, government and nation – is in essential respects like a bank facing the problem of daily balancing cash inflows against cash outflow. The key problem that every economic unit faces is the “survival constraint,” which necessitates that cash outflows not exceed cash inflow. All individual economic units each and every day have to make a multitude of decisions to meet this constraint, and these decisions in aggregate influence the structure of the capitalist system.
Because of the nature of capitalist production and distribution, economic units invariably face cash flow issues when cash flow falls short of required or desired outflows. Economic units require a source of refinance that will allow them to promise future cash flow in exchange for credit to meet current cash flow requirements. For Minsky the heart of the financial system, and by extension the heart of the capitalist system, is the money markets. The money market is the place where economic units meet one another to adjudicate their competing needs to refinance. The most critical asset-price in the political economy is the price of refinance – the short-term money market rate of interest. The money market is the place where the coherence of the entire system is tested daily.
What appear to us as assets are in actuality nothing more than expectations about future cash flows. Minsky distinguishes between two types of capital assets, namely financial capital assets and non-financial capital assets. A financial capital asset is two-sided since it is comprised of future cash outflows from a debtor and future cash inflows to a creditor. All other assets are only one-sided since the receiver of future cash flows receives the flows from the production and distribution process.
If economic units aim to meet their survival constraint by keeping their cash outflow within the limits of their cash inflows emerging from their ownership of non-financial assets, the system is stable. However, capitalism requires credit or financing. This is where Minsky’s concept of time-dependency comes into play. Before most products or services can be distributed they have to be produced; however, production and distribution will require cash outflow before cash inflows are realized. Credit needs to be accessed to facilitate the process.
Credit is also accessed by economic units to achieve more than otherwise possible by merely matching current cash outflows with inflows. For instance, most households would never be able to afford the luxury of a modern home if not for exchanging their future cash inflow for present cash outflow through a mortgage. By the same token, governments and politicians aim to increase the standard of living of their nations by accessing credit through deficit spending.
Credit is about the issuing of financial assets to trade future cash flows – for instance government bonds are issued to finance government programs over and above current tax inflows, with the promise to use future tax inflows to redeem the bonds at maturity. A crucial point about borrowing and credit in Minsky’s theory is that it does not relax the survival constraint of a particular state-society complex in the aggregate. This is due to the two-sided nature of financial assets – they only transfer the constraint from one economic unit to another. The only way for a state-society complex to relax the survival constraint in the aggregate is through the creation of new non-financial capital assets through investment.
On the level of analysis of individual economic units the incentive of investment is the expectation that current investment will be profitable in the future, i.e. the future cash inflows are expected to exceed by some margin the cash payment commitments required to finance the initial investment. This represents a potential relaxation of the survival constraint, thereby functioning as a powerful incentive factoring into the decision making of individual economic units. However, these decisions cause instability on the aggregate level – what Minsky refers to as “upward instability” (Mehrling, 2000:2).
This “upward instability” lies at the heart of the FIT. Minsky originally referred to the process of fragility over time in the capitalist system as the Financial Instability Hypothesis. The cause of the instability is obvious – some investments work out and others do not, but the debt-financed owners of both face the same cash commitments. Think of Greece’s recent struggles to meet their debt servicing commitments due to poor governmental investment.
“At the aggregate level, the natural upward instability of the system leaves behind a residue of financial commitments that pose problems for the continuation of growth. At the individual level, these problems take the form of a sharply binding survival constraint that forces distressed units to reduce expenditure, sell assets, and/or borrow at high interest rates, all in order to raise cash to meet immediate commitments. At the level of the market, the problems of individuals are reflected in conditions in the money market, which means at the very least a higher price of refinance, and at the worst a disruption and even breakdown of exchange. If the money market is the heart of the system, then financial crisis is the heart attack” (Mehrling, 2000:2).
When we think of the global political economy we think of a planet with human beings organized into different state-society complexes, each with its own subsystem of power and authority and the absence of a sovereign authority over all. The vast majority of these state-society complexes, and the vast majority of human beings, are engaged in a relatively integrated capitalist production and distribution subsystem. Needs are met through the accumulation of capital, and maximization of profit and surplus. The global political economic system is essentially a financial system. The use of money as a means of exchange and a store of value is ubiquitous throughout the system. Credit creation and money markets are at the heart of the system. People utilize credit to produce, distribute and consume. All government operations are funded by taxing profits and surplus cash flows, and almost all governments borrow in the money markets and bond markets to invest in their societies, to pay for services when taxes on profits fall short, or to meet other cash outflow commitments (like wars). Governments’ utilization of finance determine their legitimacy. In those state-society complexes with democratic elections power is often times lost when government finances are mismanaged. In the state-society complexes without regular democratic elections, mismanagement of government finance leads to political instability. I don’t want to reduce all politics to finance, but the point I am trying to convey is that the modern global political economic system is essentially a financial system – a fact not emphasized adequately by contemporary political economic theories. If the premise is accepted that the current political economic system is financial in nature, then the 2008 Global Financial Crisis represents a challenge to the structural cohesion of the entire system.
2.6 A Minsky Moment – The Financial Instability Hypothesis
At the heart of the FIT is Hyman Minsky’s formulation of what he referred to as the Financial Instability Hypothesis. According to Whalen (2007:10-11) Minsky believed there were two fundamentally distinct views of the workings of a market economy. There is the view that internal and inherent (endogenous) processes of markets generate an economic equilibrium and that business cycles are the result of exogenous shocks. In contrast Minsky believed that these so-called endogenous economic forces breed financial and economic instability, not equilibrium. Booms and busts are inherent parts of the system. These ups and downs are products of the internal dynamics of markets, and the instability is considered a social problem because of the increase in involuntary unemployment.
As a challenge to the “Efficient Market Hypothesis”, which is the dominant financial economic theory of our time, Minsky formulated his “Financial Instability Hypothesis.” The Efficient Market Hypothesis states that individuals may guess asset prices wrong, but the market as a whole gets them right. Minsky’s hypothesis claims the financial structure of a capitalist political economy becomes more fragile over a period of prosperity. As the economy grows and profits increase those businesses in highly profitable areas of the economy are rewarded handsomely for increasing the amount of debt they use. This success encourages others to increase their leverage so as to increase their profits. The increasing profits fuel the creation of credit as lenders are satisfied by the ever increasing profits regarding borrowers’ ability to repay the loans.
The capital development of a capitalist economy is accompanied by exchanges of present money for future money. Present money finances the resources for the production of investment output. Future money is the profit that will accrue to the owners of capital assets. Investment by producers is financed through liabilities. Money is connected with financing through time, with banks and financial intermediaries as the central players. The key economic exchanges are the negotiations between financial intermediaries and businesspeople. These negotiations revolve around the cost and profit expectations of businesspeople.
Money flows from depositors to banks, and then from banks to firms and companies needing investment financing. Money also flows from investors to investment funds, and from these funds to companies or governments needing investment finance. At a future date the flow is from firms, companies and governments back to banks and funds, and then to the depositors and investors. This flow is important to understand since it explains the linkage between the creation and ownership of capital assets on the one hand, and the structure of financial relations and changes in this structure on the other. The Financial Instability Hypothesis attempts to explain the impact of debt on system behavior. Bankers (the generic term Minsky uses to depict all financial intermediaries) are key players in his theory as merchants and innovators of debt.
Minsky (1992) identifies three different types of income-debt relationships, namely, hedge, speculative and Ponzi finance. Hedge Financing Units can fulfill all of their contractual payment obligations by their cash inflows. These Units’ cash inflow allow them to pay both interest and principal on their liabilities. However, as economies, earnings and profits grow – over protracted periods of good times – the economy will transit to a structure with an increase in so-called Speculative Finance Units. Speculative Finance Units can meet their payment commitments, although their cash inflow will not allow them to repay the principle, requiring them to roll over their liabilities. The US government is the largest Speculative Finance Unit in the world. It can make interest payments on all outstanding US bonds, but does not have adequate cash inflows to honor redemptions at maturity. When older bonds come due, new Treasuries are issued to honor redemptions. Lastly as the economy continues to prosper, more Ponzi Financing Units will become part of the structure. Ponzi Financing Units cannot fulfill either repayment of principle or the interest due on outstanding debts from cash inflows from operations, requiring them to borrow more to pay interest commitments, or sell assets to fulfill commitments. Regarding these three debt regimes Minsky (1992:7-8) states:
“It can be shown that if hedge financing dominates, then the economy may well be an equilibrium-seeking and containing system. In contrast, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation amplifying system. The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable, and financing regimes in which it is unstable. The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system.”
A Minsky Moment occurs when Ponzi Financing Units are forced to sell assets to meet their obligations. It is that moment in the business and credit cycle when financing units have such severe cash flow problems due to the increasing debt that large scale selloffs begin which leads to a precipitous collapse of market prices and a sharp drop in market liquidity.
The phrase “Minsky Moment” was coined by Paul McCulley, a director at Pacific Investment Management Company during the 1998 Russian debt crisis. Although McCulley originated the term it is George Magnus, senior economic advisor at UBS that offers perhaps the most succinct explanation (Whalen, 2007:9).
”…the stage is first set by ‘a prolonged period of rapid acceleration of debt’ in which more traditional and benign borrowing is steadily replaced by borrowing that depends on new debt to repay existing loans. Then the ‘moment’ occurs, ‘when lenders become increasingly cautious or restrictive, and when it isn’t only overleveraged structures that encounter financing difficulties. At this juncture, the risks of systemic economic contraction and asset deprecation become all too vivid.’ “
Both Bear Stearns and Lehman Brothers are examples of Ponzi Financing Units that collapsed during a Minsky Moment in 2007. Greece is the prime example of a country that was a Ponzi Financing Unit bailed out by an EU and IMF rescue package during its Minsky Moment. Households that purchased homes with no-down payment mortgages at teaser rates, depending on an increase in the value of the home to refinance in the future to affordable payments, are also examples of Ponzi Finance Units. There is wide concern by purchasers of US Treasuries that the US government is about to become a Ponizi Financing Unit. If the US government should have a Minsky Moment the current global political economic system might collapse.
2.7 The Financial Instability Theory in Global Context
Minsky’s original model was developed in analyzing a closed economy. It was Charles Kindleberger (2000) who used the Minsky model to develop the so-called Minsky-Kindleberger hypothesis in examining a series of international financial crises. According to Nesvetailova (2007:65) Kindleberger drew on both theoretical analysis and historical evidence to chart a pattern of financial cycle. It unfolds in five stages:
- Displacement: Some change in political economic circumstances creates new and profitable opportunities for certain financing units.
- Euphoria: Investment and production picks up, and the boom is fed by an expansion of bank credit that enlarges the total money supply. There is an urge to speculate and it is translated into effective demand for goods or financial assets.
- Mania: The prospect of easy capital gains attracts newcomers and swindlers. There may be pure speculation for the benefit of rising prices, an overestimation of prospective returns, or excessive “gearing.” Speculation for profits leads away from normal, rational behavior to a “mania” or a “bubble.”
- Distress: As the speculative boom continues, interest rates, velocity of circulation, and prices all continue to increase. A few insiders realize that the future expected profits cannot possibly justify the exorbitant prices, and they take their current profits by selling out. The top of the market is now being balanced with insiders withdrawing and new speculators entering. Hesitation enters the market. There is an awareness on the part of a considerable segment of the speculative community that a rush to liquidity might ensue.
- Revulsion: This phase is characterized by bankruptcies and liquidations. Banks discontinue lending on the collateral of certain commodities and securities. The revulsion may go so far as to lead to panic. The panic will feed on itself until one of three things occur. Prices falling low enough to attract investments back to less liquid assets; trading could be curtailed or limited; or a lender of last resort steps in to provide liquidity.
In order to ensure stability Kindleberger argued for a general stabilizer – the lender of last resort. Like Minsky, Kindleberger was critical of the monetarist view that monetary policy alone is adequate to manage financial crises (Nesvetailova, 2007:68-69). He contends monetary policy could moderate and even eliminate some crises; however, even optimal policies would still leave a residue of considerable dimensions. Even if there were the ideal amount of liquidity in the system, over the long-run there could still be crises and the need for additional liquidity.
Kindleberger was highly skeptical of existing international institutional arrangements where the IMF functions as the main institution engaged in ameliorating global financial crises (Nesvetailova, 2007:69). The IMF has a number of drawbacks to properly serve as a global lender of last resort. It takes time to make decisions and it cannot create money – it can merely advance monies made available to it by member states.
Governments and central banks are usually the lenders of last resort for domestic crises, but the international arena is without such an institution tasked at providing liquidity for the global economy. Kindleberger noted:
“…there is ‘no meeting of minds’ on the issue of a global [lender of last resort], nor is there strong leadership. As a result, the world economy remains in danger of severe recession, if not depression, and distress persists…” (Nesvetailova, 2007:69).
2.8 Stabilizing an Unstable Economy
In Minsky’s 1986 “Stabilizing an Unstable Economy” he laid out his descriptive vision on how to address the financial fragility within modern capitalism. Minsky concluded that capitalism is a highly dynamic system permeated by dialectical forces and circularities (so-called feedback loops) specific to the system (Minsky, 1986:173). Minsky criticized Monetarists for being too restrictive in their definitions of financial crises by reducing them to bank panics, as well as for brushing aside events that would have been catastrophic if not for government intervention (Tymoigne, 2008:6). The dialectical nature of capitalism means both market forces and government policy, as well as the market-state interaction, may promote stability as well as instability. Minsky contends that governments, through their buffer programs and regulations, promote economic stability; however, these stabilizing policies lead to instability through the generation of inflationary pressures and the promotion of moral hazard. Furthermore, private competition provides an incentive to evade the regulatory barriers to profit accumulation. One of the main evasion techniques is innovation, especially financial innovation. If the government is too slow in responding to changes in the economy, regulations may become obsolete and may promote instability (Tymoigne, 2008:6).
A critically important stabilizing role of government is the cash-flow and balance sheet impacts of government and central bank activities. Government expenditures and transfers (like the US social security system and unemployment insurance) are a source of income to the private sector. This represents the cash-flow impact of government. Government deficits inject virtually default-free liquid assets into the private sector (government bonds). Consequently, deficits assist in sustaining asset prices due to the fact that asset prices depend on the discounted value of expected future profits, which partly depends on current profits. Deficits thus contribute to asset price sustainability through government’s balance sheet impact. Central banks also sustain asset prices by acting as lenders of last resort.
Tymoigne (2008:8-10) contrasts Minsky’s view of government policy with the monetarist view, where Monetarists want a temporary and limited role for government involvement in the markets, Minsky promotes permanent and broad government intervention. This theoretical divergence of the role of government policy originates from diametrically opposed theoretical views of capitalism and capitalist development between Monetarists and Financial Instability Theorists.
The contemporary monetarist view is that government has only a limited role to play when there are market imperfections, like price rigidities or asymmetrical information. Government policy should be quick, limited, temporary and targeted to compensate or rectify those imperfections and put the economy back on its “natural” path. Since the so-called “natural” path is not verified or defined, state-society complexes need economic policy institutions that are isolated from political influences or constrained by rules. Long-term government economic policy should be the promotion of competition so that the market mechanism can optimally function, the Monetarists insist.
Minsky’s contrary view is that the government is a necessary complement to the private sector. Minsky’s hypothesis states that the market mechanism tends to promote inflationary pressures and financial instability as the economy trends toward full employment. Minsky wants the government to promote stable full employment – i.e. non-inflationary and financially “sound” full employment. The government needs to permanently intervene over the course of the business cycle, not just sporadically during downturns and upturns. Since financial developments always tend to generate recessions according to the Financial Instability Hypothesis, government policy should aim at preventing or constraining recessions, regardless of short-term profitability or welfare gains.
“The policy problem is to devise institutional structures and measures that attenuate the thrust of inflation, unemployment, and slower improvements in the standard of life without increasing the likelihood of a deep recession. … The current [(1986)] strategy seeks to achieve full employment by way of subsidizing demand. The instruments are financing conditions, fiscal inducements to invest, government contracts, transfer payments, and taxes. This policy strategy now leads to chronic inflation and periodic investment booms that culminate in financial crises and serious instability. The policy problem is to develop a strategy for full employment that does not lead to instability, inflation, and unemployment” (Minsky, 1986:295,308).
It is important to note that Minsky did not see a definitive solution to the problem of fragility. The government has to continuously respond and anticipate changes in the institutional structure of the economy.
Minsky proposed the creation of structural macroeconomic programs that directly manage the labor force, pricing mechanisms, investment projects, and consistently monitor financial developments. He wanted these programs to be isolated from the political cycle and political deliberations. These programs and policies are part of what Minsky referred to as “big government.”
A “big government” was one sizeable enough that swings in the government’s budget would be sufficient to offset swings in private investment. He wanted government spending to be approximately “the same order of magnitude as or larger than investment” (Minsky, 1986:297). Minsky recommended government balance its budget at 20% of GDP at full employment. During recessions deficits are used to stabilize aggregate demand and profits and spending would rise above 20% of GDP (Papadimitriou & Wray, 1997:19-21).
Minsky promoted the creation of an “employer of last resort” – broad government employment programs. The programs would be permanent and would employ anyone willing and able to work but unable to find employment in the private sector. By fixing the base wage the programs would check the growth of the average wage rate, which is inflationary. It dampens salary pressures as employment grows. The programs would also contribute to the elimination of the inflationary tendencies of the existing welfare and unemployment insurance programs that provide an income even though no current economic value is added. Employer of last resort programs would also serve as a buffer for those who lost their jobs in the private sector – the program would thus act as a stabilizer of aggregate demand (Papadimitriou & Wray, 1997:21-23).
Another macroeconomic approach Minsky promoted was a substantially more expanded role for a central bank. He advocated a greater reliance on the prudential supervision of banks, coupled with a greater use of the discount window to regulate reserves. He recommended using the discount window to reward banks with more favorable discounting if the banks tied their lending to specific assets, so called to-the-asset lending, which Minsky believed promoted a more stabilizing debt structure (Papadimitriou & Wray, 1997:23-24).
Minsky was critical of giant corporations and financial firms. In capitalist systems with small governments, collusion was often used to maintain price and profits during conditions of low demand. However, in a big government form of capitalism countercyclical deficits maintained profits, therefore Minsky saw no need for policies that fostered market power. Moreover, giant firms lead to the moral hazard of too big to fail. Minsky favored active government policies that would reduce incentives to “bigness.” Setting policies favoring medium-sized community banks would consequently lead to medium-sized firms, since bank size to a large extent influence firm size. Only giant banks have the capacity to serve giant corporations (Papadimitriou & Wray, 1997:24-26).
Minsky referred to the above recommendations as a policy agenda, and he expanded on these ideas in many later writings in his promotion of a more stable and “fairer” capitalism. He later developed the idea of the greater “socialization of investment” through such policies as dedicated taxes for infrastructure investment, capital budgeting, development banks, and government holding companies (Papadimitriou & Wray, 1997:32-33). It falls outside the scope of this study to analyze the public policy aspects of the FIT in detail. There is disagreement on the efficacy of many of Minsky’s policy prescriptions even by those who adhere to the logic of the FIT.
This study will analyze the 2008 Global Financial Crisis from a Political Economic perspective. The study sees politics and economics as inextricably interrelated and mutually constituting. For the purposes of the study Political Economy is defined as the study of how resources are allocated within societies as determined by power, authority, production and distribution. The current global political economy consists of a capitalist economic system that has evolved from disparate regional, relatively autonomous markets for goods and services, to single interdependent markets for goods and services, which integrates nearly the entire world in a system that is characterized by complex interdependence. Furthermore, the structure of the system is characterized by fragmented subsystems of power and authority – the so-called state-society complexes tied together by institutions and regimes.
In the endeavor to explain the crisis the study will move away from the implicit assumption that economics and politics are two separate and parallel realms. This divide has had an overly reductionist impact on the type of answers produced to explain political and economic phenomena.
In answering the research question, “What caused the 2008 Global Financial Crisis?” an integrated political economic theory will be used as the analytical framework. The selected theory is the Financial Instability Theory (FIT) originally promoted by Hyman Minsky and expanded on by Charles Kindleberger. The FIT has its roots in Post-Keynesianism and was considered a heterodox theory until the 2008 Global Financial Crisis. The theory has a number of realist, liberal, structural and critical notions.
The FIT posits that at the aggregate level there is a tendency during boom times for increasing fragility, with financial commitments that pose a problem for continued growth. The problems take the form of distressed financial units reducing risk, selling assets, or borrowing at high interest rates in order to get the cash for immediate commitments. These problems result from ever increasing fragile debt structures during the boom times. A “Minsky Moment” occurs when overleveraged finance units (Ponzi Units) are forced to start selling assets to meet obligations regardless of price. This leads to a precipitous collapse of market prices, a sharp drop in market liquidity, and large scale debt deflation.
Kindleberger identified five stages in the unfolding of a financial crisis, namely displacement, euphoria, mania, distress and revulsion. In order to ensure stability a lender of last resort needs to step in. This lender is typically a central bank and/or government. However, there is no such stabilizer that can step in to provide liquidity for a major global financial crisis.
Minsky indentified a number of actions governments should take to counter the implications of the FIT. He was critical of the structure of what her referred to as Money-Manager Capitalism. Minsky argued for a “big” government that can use its deficit to offset swings in private investment. He also recommended the creation of an employer of last resort since he did not want the level of employment to be controlled by the market mechanism. He promoted a much expanded role for central banks to be pro-active as to avoid severe financial crises, and to promote community banks to counter large firms’ market power. Minsky wanted a “fairer” capitalism and developed the idea of the “socialization of investment.”
In terms of the FIT the study will explain the 2008 Global Financial Crisis in terms of the following hypothesis: Within the structural evolution of capitalism there occurred an unprecedented political economic expansion of credit in the years preceding the crisis, which caused a fundamental distortion in the price of mortgage risk. This expansion of credit was both political and economic in nature.
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 The neoclassical synthesis was an academic approach which blended Keynesianism and neoclassical economic thought, with Keynesian ideas applied to Macroeconomics and neoclassical ideas applied to Microeconomics. The neoclassical synthesis is still an important theoretical thread in mainstream economics, although Keynesian elements have been vastly watered down and reinterpreted by the monetarist and the efficient market approaches.
 The Chicago school of Economics is an American economic school of thought promoted by prominent economists at the University of Chicago. The Economics Department at the University of Chicago is considered one of the world’s most foremost departments. The Chicago school economists are also referred to as the so-called “freshwater” economists, due to Chicago’s proximity to the Great Lakes.
 It should be noted that Minsky’s theories were all based on his study of the American economy. Originally the theories were formulated based on the concept of a closed American economy.
 The financial intermediaries involved in facilitating the creation of credit across the global financial system, but whose members are not subject to regulatory oversight, are referred to as the shadow banking system. The shadow banking system also refers to unregulated activities by regulated institutions. Examples of intermediaries not subject to regulation include hedge funds, unlisted derivatives and other unlisted instruments. Examples of unregulated activities by regulated institutions include credit default swaps.
The shadow banking system has escaped regulation primarily because it did not accept traditional bank deposits. As a result, many of the institutions and instruments were able to employ higher market, credit and liquidity risks, and did not have capital requirements commensurate with those risks. Subsequent to the subprime meltdown in 2008, the activities of the shadow banking system came under increasing scrutiny and regulations (www.investopedia.com).
 The “mortgage” of a home buyer represents what Minsky classifies as a financial capital asset. It is a security with an obligation. The home itself is a non-financial capital asset. If the home is destroyed by a flood, and the owner has no flood insurance, the mortgage obligation is not removed. The aforementioned is an example of debt deflation. When the home is valued at zero, after the flood waters washed it away, what is the value of the mortgage? Remember, the mortgage is an asset that can be sold and purchased, i.e. traded.
 Minsky’s use of the term “Ponzi’ does not refer to the more common usage denoting an illegal scheme; however, his Ponzi Financing Units have certain similarities with an illegal Ponzi scheme, but Ponzi Financing Units are entirely legal in modern capitalist economies.
 Moral hazard occurs when a party insulated from risk behaves differently than it would have if it were fully exposed to the risk (www.wikipedia.org).
 There is criticism to the assertion that fixing a base wage through an employer of last resort (ELR) program inhibits inflationary pressures through inhibiting wage growth. The logic of the assertion boils down to the fact that, especially during boom times, private employers can recruit from the ELR pool of workers, paying a mark-up over the ELR wage. The ELR pool then acts like a reserve of the employed, dampening wage pressures as private employment grows. However, critics will argue according to a version of the Phillips Curve, job guarantees during lower employment lead to higher inflation (http://neweconomicperspectives.blogspot.com/2009/08/job-guarantee.html).
 The discount window is an instrument of monetary policy that allows banks to borrow directly from the central bank on a very short-term basis. The interest rate charged on such loans by the central bank is called the discount rate. In the US the discount window is used very sparingly and only when a Federal Reserve member bank is unable to obtain credit from another bank. In the US and European system central banks rely mostly on open market operations (the purchase and sale of government bonds from and to banks) to influence the target rate which banks charge one another for ultra short-term loans.