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The global financial crisis and the shift to shadow banking

Yeva Nersisyan* and L. Randall Wray*

While most economists agree that the world is facing the worst economic crisis since the Great Depression, there is little agreement as to what caused it. Some have argued that the financial instability we are witnessing is due to irration- al exuberance of market participants, fraud, greed, too much regulation, etc. However, some post-Keynesian economists following Minsky have argued that this is a systemic problem, a result of internal market processes that allowed fragility to build over time. In this paper we focus on the shift to the rsaquo;shadow banking systemlsaquo; and the creation of what Minsky called the Money Manager phase of capitalism. In this system, rapid growth of leverage and financial lay- ering allows the financial sector to claim an ever rising proportion of national income – what is sometimes called rsaquo;financializationlsaquo; – as the financial system evolved from hedge to speculative and finally to a Ponzi scheme.

The policy response to the financial crisis in the US and elsewhere has largely been an attempt to rescue money manager capitalism. Moreover, in the case of the US the bailout policy has contributed to further concentration of the financial sector, increasing dangers. We believe that the policies directed at saving the system are doomed to fail – and that alternative policies should be adopted. The effective solution should come in the way of downsizing the fi- nancial sector by two-thirds or more, and effecting fundamental modifications.

JEL classifications: G21, G23, G28

Keywords: Institutional Investors; Financial Crisis; Financialization; Money Managers; Financial Concentration; Shadow Banking; Subprime Mortgages; Securitized Mortgages

* University of Missouri-Kansas City, USA.

Correspondence Address:

Yeva Nersisyan / Randall Wray, Haag Hall 211, Economics Department, University of Missouri-Kansas city, 5100 Rockhill Road, Kansas city, MO 64110, USA, e-mail: ysnz72@mail.umkc.edu / wrayr@umkc.edu.

Received 03 February 2010, accepted 06 July 2010

copy; INTERVENTION 7 (2), 2010, 377 – 400

378 Intervention. European Journal of Economics and Economic Policies

Introduction

There is little doubt that the current crisis is the worst since the Great Depression. Proffered explanations regarding the causes include: irrational exuberance, perverse incentives, greedy bankers, and misguided policy. Some economists who follow Minsky, however, have argued that the current crisis resulted from the fundamental flaws of capitalism, and particular- ly of what Minsky called money manager capitalism (Wray 2009). It was not unexpected, and came as a rsaquo;shocklsaquo; only to the rsaquo;true believerslsaquo; of free markets, like Alan Greenspan and economists of the Chicago persuasion. As Minsky warned, stability is destabilizing and it is not surprising that in the context of deregulation and de-supervision starting in 1970s the financial system had become prone to repetitive crises that became more frequent, se- vere, and longer-lasting.

This paper sheds light on the changes that have occurred in the US financial system over the post war period as it came to take an ever larger share of income flows. Similar transformations have taken place in the global financial system, but here we will focus on the US. An examination of the shift of the relative weights of various types of financial in- stitutions as well as other developments in the financial sector shows how the whole sys- tem evolved toward fragility. Increased concentration in the banking sector has created a few large rsaquo;too big to faillsaquo; institutions said to be of rsaquo;systemic importancelsaquo; – institutions we would prefer to designate as rsaquo;too big to savelsaquo; because they are rsaquo;systemically dangerouslsaquo;. This problem is exacerbated after each crisis as institutions that survive the crisis become big- ger and more powerful.

Meanwhile, even though large portions of managed money have been wiped out dur- ing the crisis, it is obvious that it has made a comeback and is looking for another bubble. And policy is actually pursuing a strategy of increasing the size and importance of the most dangerous institutions. The response in Washington has been to save these dangerous in- stitutions and then to propose creation of a rsaquo;systemic regulatorlsaquo;. We believe the mega-in- stitutions are too complex and too politically powerful to effectively regulate. Hence, we propose downsizing institutions as well as the financial system as a whole. Despite its re- cent anti-Wall Street rhetoric, the Obama administration has failed to bring any significant changes to the way finance operates. Even Obamarsquo;s timid proposals, such as taxing banks that received bail-out money, are facing major resistance from the financiers, thus, are un- likely to pass. As memories of the crisis fade away, the momentum for real change has been lost. Indeed, the policy response to date has sown the seeds for another crisis. We do not have the space to delineate specific alternatives, but argue that downsizing finance is a pre- requisite to achieving any success at restoring stability to the financial system.

Financialization of the US economy

Minsky adopted a stages approach to the evolution of the financial system, calling the cur- rent phase Money Manager Capitalism, characterized by raquo;highly levered profit-seeking or-

Nersisyan/Wray: The shift to shadow banking 379

ganizationslaquo; such as money market mutual funds, mutual funds, sovereign wealth funds, and private pension funds (Minsky 1986/2008: 274). A number of structural changes have contributed to creating a fragile financial system. The ultimate outcome is repetitive bub- bles, which turn into financial crises aft

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