Dodd-Frank, Liability Structure, and Financial Instability Cycles: Neither a (Ponzi) Borrower Nor a Lender Be

Abstract

The financial sector has by now mostly sprung back from the crisis that began in 2007, as have corporate profits; but the labor market still sags, mortgage credit is scarce, and the future prospects for the economy, while not bleak, are not rosy either. Seeing this ongoing harm to the real economy caused by financial activities, Congress enacted the Dodd-Frank Act (“Act”) with an eye to limiting future financial instability. The Act hopes to do this by updating financial regulation and creating better incentives for the private sector.To see how the crisis developed and whether the Act will work, we need to understand how financial instability develops in capitalist market systems like ours. Economist Hyman Minsky claimed that the financial sector in capitalist market systems tends to chase returns by gorging on risk until its own financial structure becomes unstable, leading to a crisis like the last one that started in 2007. The claim – known as the financial instability hypothesis – merits our attention because, though critical of the financial sector, evidence for it is derived from observing how banks actually operate over the business cycle.I use the hypothesis in Part I to show what animated the last corporate leverage cycle: escalating expectations for profit financed on progressively riskier credit terms. In fact, the hypothesis thesis belongs to a larger critique of conceptual approaches that deny the intrinsic instability of capitalist market systems, so I also use Minsky’s work to challenge claims made by nabobs of neoliberal negativism who are resisting the implementation of the Act. Part II addresses two aspects of the Act that bear directly on how the financial sector creates potentially destabilizing liabilities: (i) new requirements that leverage caused by financial swaps be margined and cleared; and (ii) a new mandate that federal regulatory capital requirements go in the opposite direction of the boom-bust dynamics characteristic of the business cycle.