B. THE ADJUSTMENT FOR CHANGING Reserve RequiremenTS

We assume that the preceding adjustment to reserves has been made, and that E is given by (2), except that R = R'. Suppose that a prevailing reserve requirement, rs, is replaced by a new one, r,. This may be due to a shift of deposits between time and demand, a regional shift of deposits, or an an nounced change. The maximum level of E changes simultaneously from E' to E". We want to express this movement of E as a function of reserves, holding the requirement constant at Trs. That is, we want a reserve level, R", such that

we obtain the level of "effective" reserves by taking

the difference between the two equalities, and solving for R":

In general, rr is the fixed or "standard" requirement in terms of which all reserves are expressed, and r, is the reserve requirement of any currnt period.20

Having made the adjustments for effective reserves, can the observed figure, E, be retained for comparison to R"? That is, does the observed level of earning assets, relative to R", express the same propensity to invest present in the unadjusted data? It does, if we define the propensity to hold earning assets as

the ratio of the observed to the maximum level of earning assets obtainable under the current requirement. We define E(max.), as the maximum level obtainable under the standard requirement. Then it follows that

(9)

η E(max.),, = E (obs.)

upon substituting R'(-1) for E (max.),,

and (7) for R".21

in

R" η,

(-1) for
1) for E (max.) r

20 It can be shown that effective reserves based on a given standard reserve requirement differ by a constant factor from those based on another standard requirement. Let R" be a series based on r'rs, and R", a series based on "rs. Then, substituting expressions of the form of (7), R”./R′′d = r′r. (1 − 7′′ r.) /r′′r. (1 — r′rs), a constant.

21 One of the underlying assumptions of this whole analysis is that E and R" are not effectively the same variable, as they would be if the Federal Reserve bought or sold securities directly to the member banks. However, an examination of the data shows little or no evidence of such direct transactions during the periods studied.

6. CAN "IT" HAPPEN AGAIN?

By HYMAN P. MINSKY

In the winter of 1933 the financial system of the United States

collapsed. This implosion was an end result of a cumulative deflationary process whose beginning can be conveniently identified as the stock-market crash of late 1929. This deflationary process took the form of large-scale defaults on contracts by both financial and nonfinancial units, as well as sharply falling income and prices.1 In the spring of 1962 a sharp decline in the stock market took place. This brought forth reassuring comments by public and private officials, that recalled the initial reaction to the 1929 stock-market crash, as well as expressions of concern that a new debt-deflation process was being triggered. The 1962 event did not trigger a deflationary process like that set off in 1929. It is meaningful to inquire whether this difference is the result of essential changes in the institutional or behavioral characteristics of the economy, so that a debt deflation process leading to a financial collapse cannot now occur, or merely of differences in magnitudes within a financial and economic structure that in its essential attributes has not changed. That is, is the economy truly more stable or is it just that the initial conditions (i.e., the state of the economy at the time stock prices fell) were substantially dif ferent in 1929 and 1962?

I. GENERAL CONSIDERATIONS

The Council of Economic Advisors' view on this issue was stated when they remarked, while discussing fiscal policy in the 1930's, that ". . . whatever constructive impact fiscal policy may have had was largely offset by restrictive monetary policy and by institutional failures failures that could never again occur because of fundamental changes made during and since the 1930's." The Council

11. Fisher, Booms and Depressions (New York: Adelphi Co., 1932); Staff, Debts and Recovery 1929-37 (New York: Twentieth Century Fund, 1938).

2 Economic Report of the President (Washington, D.C.: U.S. Government Printing Office, January, 1963), p. 71.

does not specify the institutional changes that now make it impossible for instability to develop and lead to widespread debt-deflation. We can conjecture that this lack of precision is due to the absence of a generally accepted view of the links between income and the be havior and characteristics of the financial system.

3

A comprehensive examination of the issues involved in the general problem of the interrelation between the financial and real aspects of an enterprise economy cannot be undertaken within the confines of a short paper. This is especially true as debt-deflations occur only at long intervals of time. Between debt-deflations, financial institutions and usages evolve so that, certainly in their details, each debt-deflation is a unique event. Nevertheless it is necessary and desirable to inquire whether there are essential financial attributes of the system which are basically invariant over time and which tend to breed conditions which increase the likelihood of a debt-deflation.

In this paper I will not attempt to review the changes in financial institutions and practices since 1929. It is my view that the institutional changes which took place as a reaction to the Great Depression and which are relevant to the problem at hand spelled out the permissive set of activities as well as the fiduciary responsibilities of various financial institutions and made the lender of last resort functions of the financial authorities more precise. As the institutions were reformed at a time when the lack of effectiveness and perhaps even the perverse behavior of the Federal Reserve System during the great downswing was obvious, the changes created special institutions, such as the various deposit and mortgage insurance schemes, which both made some of the initial lender of last resort functions automatic and removed their administration from the Federal Reserve System. There should be some concern that the present decentralization of essential central bank responsibilities and functions is not an efficient way of organizing the financial control and protection functions; especially since an effective defense against an emerging financial crisis may require coordination and consistency among the various units with lender of last resort functions.

The view that will be supported in this paper is that the essential characteristics of financial processes and the changes in relative magnitudes during a sustained expansion (a period of full-employment growth interrupted only by mild recessions) have not changed. It

3 J. G. Gurley and E. S. Shaw, Money in a Theory of Finance (Washington, D.C.: The Brookings Institution, 1960).

will be argued that the initial conditions in 1962 were different from those of 1929 because the processes which transform a stable into an unstable system had not been carried as far by 1962 as by 1929. In addition it will be pointed out that the large increase in the relative size of the federal government has changed the financial characteristics of the system so that the development of financial instability will set off compensating stabilizing financial changes. That is, the federal government not only stabilizes income but the associated increase in the federal debt, by forcing changes in the mix of financial instruments owned by the public, makes the financial system more stable. In addition, even though the built-in stabilizers cannot by themselves return the system to full employment, the change in the composition of household and business portfolios that takes place tends to increase private consumption and investment to levels compatible with full employment.

In the next section of this paper I will sketch a model of how the conditions compatible with a debt-deflation process are generated. I will then present some observations on financial variables and note how these affect the response of the economy to initiating changes. In the last section I will note what effect the increase in the relative size of the federal government since the 1920's has had upon these relations.

where SI is the gross surplus of the private sectors (which for convenience includes the state and local government sector) and T-G is the gross surplus of the federal government. The surplus of each sector ; (j = 1 . . . n) is defined as the difference between its gross cash receipts minus its spending on consumption and gross real investment, including inventory accumulations. We therefore have

Equation 3 is an ex post accounting identity. However, each , is the result of the observed investing and saving behavior of the various sectors, and can be interpreted as the result of market processes by which not necessarily consistent sectoral ex ante saving and investment plans are reconciled. If income is to grow, the financial markets, where the various plans to save and invest are reconciled, must generate an aggregate demand that, aside from brief intervals, is ever rising. For real aggregate demand to be increasing, given that commodity and factor prices do not fall readily in the absence of substantial excess supply, it is necessary that current spending plans, summed over all sectors, be greater than current received income and that some market technique exist by which aggregate spending in excess of aggregate anticipated income can be financed. It follows that over a period during which economic growth takes place, at least some sectors finance a part of their spending by emitting debt or selling assets.*

For such planned deficits to succeed in raising income it is necessary that the market processes which enable these plans to be carried out do not result in offsetting reductions in the spending plans of other units. Even though the ex post result will be that some sectors have larger surpluses than anticipated, on the whole these larger surpluses must be a result of the rise in sectoral income rather than a reduction of spending below the amount planned. For this to take place, it is necessary for some of the spending to be financed either by portfolio changes which draw money from idle balances into active circulation (that is, by an increase in velocity) or by the creation of new money.

In an enterprise economy the saving and investment process leaves two residuals: a change in the stock of capital and a change in the stock of financial assets and liabilities. Just as an increase in the capital-income ratio may tend to decrease the demand for additional capital goods, an increase in the ratio of financial liabilities to income (especially of debts to income) may tend to decrease the will. ingness and the ability of the unit (or sector) to finance additional spending by emitting debt.

A rise in an income-producing unit's debt-income ratio decreases the percentage decline in income which will make it difficult, if not

4 Ibid.

5 H. Minsky, "Monetary Systems and Accelerator Models," American Economic Review, XLVII:859-83 (December, 1957).