In August 2007, the United Statesâ leading central bankers convened in Jackson Hole, Wyoming for the Federal Reserve Bank of Kansas Cityâs annual Economic Policy Symposium. The conferenceâs topic was the housing, housing finance, and monetary policy. Unlike the self-congratulatory mood of prior years, the 2007 meeting was downbeat and uncertain. The global economy faced the early stresses of the impending financial crisis. Housing prices were falling. âTeaser ratesâ on adjustable rate mortgages reset to higher levels, ballooning monthly payments and putting stress on consumers. Investors in subprime mortgages took significant losses. The investment bank BNP Paribas suspended redemptions on two housing-related hedge funds, while the Federal Reserve cut its discount rate to provide liquidity to troubled banks. Despite these early warning signs, few in attendance, including Federal Reserve Board Chairman Ben Bernanke, Federal Reserve Governor Frederic Mishkin, and former US Treasury Under Secretary John Taylor knew how bad things would get (Federal Reserve Bank of Kansas City 2007; Evans 2007).
However, Paul McCulley had a hunch. McCulley was the chief economist of Pacific Investment Management Company (PIMCO), one of the worldâs savviest and most influential asset managers. While many of the Jackson Hole participants concentrated on housing market vulnerabilities, McCulley focused on the overlooked plumbing of the global economy. McCulley described the mechanics of a parallel banking system that emerged in tandem with the housing bubble. Trillions of dollars flowed through the global shadow banking system daily but fell outside the purview of regulators. Shadow banks put people in homes, gave investors a safe place to park their cash, and earned US and European banks hefty profits during the bubble years. Few economists knew much about shadow banks, let alone studied them in depth, so the audience listened to McCulley.
McCulley spoke candidly. The global shadow banking system that profited so many stood on increasingly shaky foundations. Beneath the surface of the early 2000s bull market sat a global financial system that transformed from stability to fragility. Absent more extensive support from regulators, financial strains would persist. The global economy may have even been on the verge of a âMinsky momentâ in which declining asset prices sap the marketâs confidence, disrupting credit, and ultimately leading to a deep recession. Shadow banks put the solvency of the global financial system at risk (Lahart 2007).
McCulleyâs warning proved prescient. Asset prices remained volatile throughout late 2007 and early 2008. Investors lost billions of dollars on mortgage assets. Banks failed. Bear Stearnsâ sale to J.P. Morgan highlighted the risk of financing risky activities using short-term, runnable capital in the shadow banking markets. Lehman Brothersâ bankruptcy in September 2008 shattered financial stability, threatening the solvency of all firms and requiring a theretofore unthinkable regulatory response to save the global economy. Trillions of dollars of emergency support provided by the Federal Reserve and US Treasury helped prevent a second Great Depression, though the crisis left lasting scars on the real economy. Continued economic malaise contributed to a growing sense of political dissatisfaction that challenged the legitimacy of democratic institutions.
Scholars and practitioners have caught up to the trends McCulley identified during his Jackson Hole commentary in the years since the crisis. Viral Acharya, Tobias Adrian, Cornel Ban, Gary Gorton, Eric Helleiner, Perry Mehrling, Andrew Metrick, and Zoltan Pozsar, among others, argued that shadow banking was banking. 1 While the term âshadow bankingâ has come to mean different things, for the purposes of this book, shadow banking is defined as market-based financial intermediation in which the core banking transformations take place outside of the formal financial system. Shadow banks engage in credit, liquidity, and maturity transformation, just like traditional banks. Whereas traditional banks lent insured deposits directly to consumers and firms, shadow banks prior to the global financial crisis borrowed funds via commercial paper and repurchase agreements and lent to borrowers via securitized assets. Shadow banksâ reliance on runnable short-term capital and their lack of deposit insurance made them vulnerable to bank runs, as the global financial crisis made clear.
The crisis also popularized the work of Hyman Minsky, Charles Kindleberger, and other so-called âPost-Keynesianâ asset market theorists. Post-Keynesian vocabulary of bubbles, fragility, Ponzi financing, and the âMinsky momentâ entered the financial vernacular during the global financial crisis. Some of the crisisâ biggest players, including former US Treasury Secretary and Federal Reserve Bank of New York President Timothy Geithner, described the global financial crisis as a quintessential âMinsky crisisâ (Geithner 2014, 68). Janet Yellen, the former Federal Reserve Chair and Federal Reserve Bank of San Francisco President, said âMinskyâs work has become required readingâ in the wake of the crisis (Yellen 2009). Daniel Tarullo, former Federal Reserve Board Governor from 2009 to 2017 in charge of financial reform, referenced Charles Kindlebergerâs work in a speech shortly after the most acute phase of the crisis. Quoting Kindleberger, he noted that financial crises remained a âhardy perennialâ that were ârecurring stories in human historyâ (Tarullo 2009). In October 2017, Chinaâs former central bank governor Zhou Xiaochuan warned that without significant reform, Chinaâs economy might soon face a âMinsky momentâ of its own (Reuters 2017). And in April 2018, the International Monetary Fund warned of Minsky-Kindleberger style risk-taking due to prolonged easy financial conditions in the global economy (International Monetary Fund 2018, 61). 2
Social Finance: Shadow Banking during the Global Financial Crisis sits at the nexus of these intellectual currents. The premise of this book is that while Post-Keynesian asset market theory is broadly correct, several Post-Keynesian contentions are themselves things that need to be explained. Social Finance thus develops a modified Minsky model of financial crises and illustrates its applicability via a case study of the global financial crisis. This model reincorporates sociological insights from John Maynard Keynes (Minskyâs intellectual father) back into the Minsky model to present a more complete account of why bubbles form, why some financing structures are more vulnerable to panics than others, and why financial crises are so hard to predict. It borrows from scholarship on crises in international relations theory to examine the triggers of financial distress and the crisis dynamic. And it draws on perspectives from international political economy, particularly economic constructivism, to show how foundational economic ideas shape elite choices prior to, during, and after financial panics and how the effectiveness of regulatorsâ crisis responses depends on their credibility with the marketplace. This book demonstrates the utility of this new paradigm via a case study of shadow banking during the global financial crisis. It presents the results of interviews with some of the worldâs leading investors in London, Los Angeles, New York, and Toronto, a close examination of primary and secondary sources, and quantitative evidence to contribute to the collective understanding of shadow banking.
This chapter serves as a stand-alone summary of Social Finance. It describes the core arguments of the Post-Keynesian model and then outlines the bookâs theoretical arguments. A penultimate section explains why this book matters to both academic and policymaking audiences. The chapter concludes by setting the stage for the subsequent theoretical and empirical chapters.
Building on the Post-Keynesian Model: Alternative Paradigms and the Social Finance Synthesis
Post-Keynesians argue that bubbles, fragility, crises, and panics are natural features of capitalist economies. According to Post-Keynesian theory, a crisis begins with an exogenous âdisplacementâ that changes anticipated profits in a sector of the economy. This shock then triggers a boom in credit to the displaced sector, and asset prices rise. Market participants adopt increasingly risky financing structures to take advantage of newfound profit opportunities. Investors purchase assets to flip them for a future profit rather than because of their long-term income-generating potential. Eventually, economic fundamentals cannot keep up with expectations, and sellers outnumber buyers. Prices fall, exposing the systemâs underlying fragility. If fragility is sufficiently widespread, prices may fall pro-cyclically, p...