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Woodward, John R.

Community Development and Applied Economics

2012

M.S.

Minsky's Financial Instability Hypothesis (FIH) proposes a view of the modern capitalist economy as inherently fragile with a chronic tendency toward overindebtedness and' subsequent debt deflation. In Minskyan system, expansions of investment are fueled by endogenous debt leveraging behavior that commits an increasing share of an economic unit's future cash inflows to debt service payments. This process cycles the economy from a Hedge basis, where payment obligations are easily met from revenues, to a Speculative or Ponzi basis, where payment obligations are defaulted on unless refinanced or paid with new borrowings. As a "monetary production economy" comes to be dominated by Speculative and Ponzi units, it becomes more susceptible to a cascade of defaults that destroys financial wealth and leads to a selfreinforcing shortage of purchasing power. Though Minsky emphasized business investment, the FIH claims that not just firms, but households and state and local governments (SLG) can also swing from Hedge to Speculative or Ponzi finance positions.
The goal of this research paper is exploratory and theoretical, making use of data from national income and flow of funds accounts to test-fit the subnational public sector into the Minskyan model of "upward instability." The guiding question of whether state and local government behaves according to the depictions of the FIH, sacrificing liquidity during booms and deleveraging in busts, led to the determination that Minsky's Hedge-Speculative schema is not as properly descriptive of subnational fiscal cycles as it is of private sector investment cycles. When evaluating the causes and degree of financial fragility in a mixed economy, subnational government financial behavior should not be viewed in the same light as that of firms and households. Though budget-constrained, SLGs do not face the same type of liquidity constraints that endanger the solvency of indebted private sector agents.
This discrepancy calls for a broader investigation into foundational Post-Keynesian theories of endogenous money in order to formulate a working framework for analyzing subnational fiscal policy's macroeconomic effects. Through an examination of the details of endogenous money concepts, it is posited that, though the sector generally runs little risk of widespread default, subnational government can have only minimal stimulative effect on aggregate demand and largely only through redistributive measures. Without municipal banking and without federal revenue sharing, SLGs have little choice but to behave procyclically, relying on unsustainable investment booms to supply revenue, and exacerbating deflationary forces by increasing tax efforts during contractions. While the SLG sector could be considered stable in strict Minskyan terms of Hedge and Speculative units, the typical set of subnational fiscal behaviors serves, to diminish the overall financial robustness of the economic system. Contrary to the prescriptions of fiscal federalism and orthodox public economics, it is proposed that greater federal aid to the states in service of an employer of last resort program could eliminate the positive feedback effects of SLG fiscal behavior.