Download anatomy of a financial crisis

CRISIS – CONCEPTS AND THEORIES
Macro and Micro Perspectives
- An Introductory Lesson -
Motto:
“There is a shift from predictability to non-predictability, from order
and stability to instability, chaos and dynamics; from certainty and
determination to risk, ambiguity and uncertainty; from the control and
steering to the self-organisation of systems, from linearity to complexity,
circular and multidimensional causality; from reductionism to
emergentism, from being to becoming and from fragmentation to
interdisciplinarity.”
(C. Fuchs)
PART I. CRISIS THEORIES
CRISIS THEORIES
• Crisis is a stream of disturbances and dislocations of allocation of
resources.
• Some Classical Approaches:
– “Capitalism as automatically self-reproducing system”: “Since the system is
viewed as self-regulating , the process of regulations tends to be ignored. (…)
First and foremost, it can be argued that in principle crises need never occur;
that they do in fact occur may then be attributed to factors which are external
to the normal functioning of capitalist reproduction. Through no fault of its
own, the system is periodically disrupted by crises. In this tradition, we find
crises blamed either on Nature (sunspots, crop failures in general etc.) and/or
on Human Nature (psychological cycles of optimism and despair, wars,
revolutions, and political blur/-, ders).” Shaikh, Anwar. An Introduction to the History of Crisis
Theories. U.S. Capitalism in Crisis, U.R.P.E., New York, 1978
– Adam Smith: “Invisible Hand”: “Smith’s assertion was that purely selfish
individuals are led by an invisible hand to produce the greatest good for all.”
Frank, Robert H. The Invisible Hand Is Shaking. The New York Times, 2008
Criticism on Adam Smith’s “invisible hand”: Joseph E. Stiglitz: Externalities
– “Adam Smith, the father of modern economics, is often cited as arguing for the “invisible
hand” and free markets: firms, in the pursuit of profits, are led, as if by an invisible hand,
to do what is best for the world. But unlike his followers, Adam Smith was aware of
some of the limitations of free markets, and research since then has further clarified
why free markets, by themselves, often do not lead to what is best. As I put it in my new
book, Making Globalization Work, the reason that the invisible hand often seems
invisible is that it is often not there. “ Invisible hand - Wikipedia
– “Whenever there are “externalities”—where the actions of an individual have impacts
on others for which they do not pay or for which they are not compensated—markets
will not work well. Some of the important instances have been long understood—
environmental externalities. Markets, by themselves, will produce too much pollution.
Markets, by themselves, will also produce too little basic research. (Remember, the
government was responsible for financing most of the important scientific
breakthroughs, including the internet and the first telegraph line, and most of the
advances in bio-tech.) But recent research has shown that these externalities are
pervasive, whenever there is imperfect information or imperfect risk markets—that is
always. Government plays an important role in banking and securities regulation, and a
host of other areas: some regulation is required to make markets work. Government is
needed, almost all would agree, at a minimum to enforce contracts and property rights.“
Ibid.
Keynesian Economics
•
•
Keynesian economics: The Great Depression raised an important question on
whether the capitalist system would be able to self-reproduce. Keynes had
actually attacked Say’s Law (stating that “supply creates its own demand”),
“contended that the aggregate demand for goods might be insufficient during
economic downturns, leading to unnecessarily high unemployment and losses of
potential output.” Keynesian economics - Wikipedia, the free encyclopedia
“Conceding that there was indeed no automatic mechanism to make capitalist
reproduction smooth, efficient and crisis free, the neoclassical Keynesians (…)
turned to the State as the mechanism which would bring to life the society
pictured in the laissez-faire parables.” Shaikh, Anwar, op. cit., p. 221
“K-waves”: A Long-Term View
Kondratieff Theory: He postulates the existing of sinusoidal cycles (“K-waves”) of
alternating periods of booms followed by depressions.
Kondratieff wave - Wikipedia
The Crisis of Capitalist System
- “The Depression: A Long-Term View” •
“The capitalist world-economy has had, for several hundred years at least, two major forms
of cyclical swings. One is the so-called Kondratieff cycles that historically were 50-60 years in
length. And the other is the hegemonic cycles which are much longer.“ Wallerstein, Immanuel. The
Depression: A Long-Term View. Fernand Braudel Center, Binghamton University, 2008
•
“The world came out of the last Kondratieff B-phase in 1945, and then had the strongest Aphase upturn in the history of the modern world-system. It reached its height circa 1967-73,
and started on its downturn. This B-phase has gone on much longer than previous B-phases
and we are still in it.“ Ibid.
•
“The characteristics of a Kondratieff B-phase are well-known and match what the worldeconomy has been experiencing since the 1970s. Profit rates from productive activities go down,
especially in those types of production that have been most profitable. Consequently, capitalists
who wish to make really high levels of profit turn to the financial arena, engaging in what is
basically speculation. Productive activities, in order not to become too unprofitable, tend to
move from core zones to other parts of the world-system, trading lower transactions costs for
lower personnel costs. This is why jobs have been disappearing from Detroit, Essen, and Nagoya
and factories have been expanding in China, India, and Brazil.“ Ibid.
The Crisis of Capitalist System
- “The Depression: A Long-Term View” •
“As for the speculative bubbles, some people always make a lot of money in them. But
speculative bubbles always burst, sooner or later. If one asks why this Kondratieff B-phase has
lasted so long, it is because the powers that be - the U.S. Treasury and Federal Reserve Bank,
the International Monetary Fund, and their collaborators in western Europe and Japan - have
intervened in the market regularly and importantly - 1987 (stock market plunge), 1989
(savings-and-loan collapse), 1997 (East Asian financial fall), 1998 (Long Term Capital
Management mismanagement), 2001-2002 (Enron) - to shore up the world-economy. They
learned the lessons of previous Kondratieff B-phases, and the powers that be thought they
could beat the system. But there are intrinsic limits to doing this. And we have now reached
them, as Henry Paulson and Ben Bernanke are learning to their chagrin and probably
amazement. This time, it will not be so easy, probably impossible, to avert the worst. “Ibid.
•
“There is however something new that may interfere with this nice cyclical pattern that has
sustained the capitalist system for some 500 years. The structural trends may interfere with
the cyclical patterns. The basic structural features of capitalism as a world-system operate by
certain rules that can be drawn on a chart as a moving upward equilibrium. The problem, as
with all structural equilibria of all systems, is that over time the curves tend to move far from
equilibrium and it becomes impossible to bring them back to equilibrium.”
Ibid.
The Crisis of Capitalist System
- “The Depression: A Long-Term View” •
“What has made the system move so far from equilibrium? In very brief, it is because over
500 years the three basic costs of capitalist production - personnel, inputs, and taxation have steadily risen as a percentage of possible sales price, such that today they make it
impossible to obtain the large profits from quasi-monopolized production that have always
been the basis of significant capital accumulation. It is not because capitalism is failing at
what it does best. It is precisely because it has been doing it so well that it has finally
undermined the basis of future accumulation. “Ibid.
•
“What happens when we reach such a point is that the system bifurcates (in the language of
complexity studies). The immediate consequence is high chaotic turbulence, which our
world-system is experiencing at the moment and will continue to experience for perhaps
another 20-50 years. As everyone pushes in whatever direction they think immediately best
for each of them, a new order will emerge out of the chaos along one of two alternate and
very different paths.” Ibid.
•
“We can assert with confidence that the present system cannot survive. What we cannot
predict is which new order will be chosen to replace it, because it will be the result of an
infinity of individual pressures. But sooner or later, a new system will be installed. This will
not be a capitalist system but it may be far worse (even more polarizing and hierarchical) or
much better (relatively democratic and relatively egalitarian) than such a system. The choice
of a new system is the major worldwide political struggle of our times.” Ibid.
From the “dependency theory” to the “asymmetrical
reputation of currencies”
•
The dependency theory rests on a flow of resources from a so-called “periphery” of less developed
and underdeveloped nations to a “core” of developed states. “In the 1960s advocates of
dependency theory—mostly social scientists from the developing world, particularly Latin
America—argued that former colonial nations were underdeveloped because of their dependence
on Western industrialized nations in the areas of foreign trade and investment.“Dependency Theory - MSN
Encarta
•
Y-Proposition: In free currency markets hard currencies fluctuate, while soft currencies
depreciate systematically Yotopoulos, Pan A. and Sawada, Yasuyuki. Free Currency Markets, Financial Crises and the
Growth Debacle: Is There a Causal Relationship?
•
“Mexico cannot service its foreign debt from the proceeds of producing nontradables. These are
traded in pesos. It has instead to shift resources away from the nontradable sector to produce
tradable output in order to procure the dollars for servicing the debt (...) The process (...) can create
a negative feedback loop that leads to resource misallocation in soft-currency countries (...) This
shift of resources represents misallocation and produces inefficiency and output losses (...)
Distortions inherent in free currency markets lead to a systematic devaluation of soft currencies –
to „high“ nominal exchange rates. Devaluation of the exchange rate means increasing prices of
tradables and leads to increased exports. But not all exports are a bargain to produce compared to
the alternative of producing nontradables (...) Countries graduate from being exporters of sugar and
copra to exporting their teak forests, and on to systematically exporting nurses and doctors, while
they remain underdeveloped all the same. If this happens, it may represent competitive
devaluation trade as opposed to comparative advantage trade.” Ibid.
•
“Not unlike the case of the incomplete credit market where moral hazard and
adverse selection of risk can lead to defaulting portfolia (Stiglitz and Weiss, 1981),
price competition in setting the exchange rate also constitutes a “race for the
bottom” in spiral evaluations of the soft currency. The only difference between the
credit and the foreign exchange market is that in the former the cause of
incompleteness is asymmetric information, while in the latter it is asymmetric
reputation.” Ibid.
Markets with Asymmetric Information
Information asymmetry: When one party in a transaction has more or better
information than the other. Information asymmetry - Wikipedia, the free encyclopedia
•
Examples: “Borrowers know more than the lender about their repayment prospects; the
seller knows more than buyers about the quality of his car; the CEO and the board know
more than the shareholders about the profitability of the firm; policyholders know more than
the insurance company about their accident risk; and tenants know more than the
landowner about their work effort and harvesting conditions.”The Prize in Economics 2001 Information for the Public
•
George Akerlof – “The Market for Lemon: Quality Uncertainty and the Market Mechanism”
– “He analyses a market for a good where the seller has more information than the buyer
regarding the quality of the product. This is exemplified by the market for used cars; "a
lemon" – a colloquialism for a defective old car – is now a well-known metaphor in
economists' theoretical vocabulary. Akerlof shows that hypothetically, the information
problem can either cause an entire market to collapse or contract it into an adverse selection
of low-quality products.”The Prize in Economics 2001 - Information for the Public
Markets with Asymmetric Information
•
“A lemon market will be produced by the following:
– Asymmetry of information, in which no buyers can accurately assess the value
of a product through examination before sale is made and all sellers can more
accurately assess the value of a product prior to sale
– An incentive exists for the seller to pass off a low quality product as a higher
quality one
– Sellers have no credible disclosure technology (sellers with a great car have no
way to credibly disclose this to buyers)
– Either there exist a continuum of seller qualities OR the average seller type is
sufficiently low (i.e. buyers are sufficiently pessimistic about the seller's
quality)
– Deficiency of effective public quality assurances (by reputation or regulation
and/or of effective guarantees / warranties .”The Market for Lemons - Wikipedia, the free
encyclopedia
•
Credit markets with asymmetric information – Stiglitz and Weiss argued that “it
may be optimal for bankers to ration the volume of loan instead of raising the
lending rate” in order to reduce the bad-loans risks.The Prize in Economics 2001 - Information for
the Public
Causes and Effects of the Actual Financial Crisis
“Asymmetric Effect of Diffusion Processes: Risk Sharing and Contagion”
•
“(…) interdependencies in real and financial assets are beneficial from a social
point of view when the economic environment is favorable and detrimental when
the economic environment deteriorates. In the latter case, private incentives are
such that too many linkages are formed, with respect to what is socially desirable.
The risk of contagion increases the volatility of the outcome and thus reduces the
ability of the financial networks to provide risk-sharing.” Mauro Galegatti et al. Asymmetric
Effect of Diffusion Processes: Risk Sharing and Contagion. Global Economy Journal, Vol 8, Issue 3, Article 3, 2008
•
“(…) interconnectivity is beneficial, insofar as it reduces the likelihood of individual
defaults, but only when the general economic conditions are good. In harsh times,
that is when the expected return on investments turn negative, being interlinked
becomes socially detrimental: not only is it that the expected number of defaults is
higher when the economic agents are connected, but defaults become a systemic
failure. However, private incentives are likely to drive individual behavior toward
establishing these linkages anyway.” Ibid.
Minsky’s “Financial Instability Hypothesis”
•
“The financial instability hypothesis is a model of a capitalist economy which does not rely
upon exogenous shocks to generate business cycles of varying severity. The hypothesis holds
that business cycles of history are compounded out of (i) the internal dynamics of capitalist
economies, and (ii) the system of interventions and regulations that are designed to keep
the economy operating within reasonable bounds.” Minsky, Hyman P. The Financial Instability Hypothesis
•
Minsky identified three types of “income-debt relations for economic units which are labeled
as hedge, speculative, and Ponzi finance (…).”Ibid.
–
–
–
“Hedge financing units are those which can fulfill all of their contractual payment obligations by their
cash flows: the greater the weight of equity financing in the liability structure, the greater the
likelihood that the unit is a hedge financing unit. “Ibid.
“Speculative finance units are units that can meet their payment commitments on "income account"
on their liabilities, even as they cannot repay the principle out of income cash flows. Such units need
to "roll over" their liabilities: (e.g. issue new debt to meet commitments on maturing debt).
Governments with floating debts, corporations with floating issues of commercial paper, and banks
are typically hedge units.”Ibid.
“For Ponzi units, the cash flows from operations are not sufficient to fulfill either the repayment of
principle or the interest due on outstanding debts by their cash flows from operations. Such units
can sell assets or borrow. Borrowing to pay interest or selling assets to pay interest (and even
dividends) on common stock lowers the equity of a unit, even as it increases liabilities and the prior
commitment of future incomes. A unit that Ponzi finances lowers the margin of safety that it offers
the holders of its debts.”Ibid.
Minsky’s “Financial Instability Hypothesis”
•
We argue that the economic system may be either stable or unstable depending
on which type of financing dominates: “It can be shown that if hedge financing
dominates, then the economy may well be an equilibrium seeking and containing
system. In contrast, the greater the weight of speculative and Ponzi finance, the
greater the likelihood that the economy is a deviation amplifying system.” Ibid.
•
Minsky indirectly undermines the idea of crises generated by factors external to
the normal functioning of capitalist system by postulating that “over periods of
prolonged prosperity, the economy transits from financial relations that make for a
stable system to financial relations that make for an unstable system.” Ibid.
•
“In particular, over a protracted period of good times, capitalist economies tend to
move from a financial structure dominated by hedge finance units to a structure in
which there is large weight to units engaged in speculative and Ponzi finance.” Ibid.
“The Neoliberal Paradox”
•
“Nonfinancial corporations“(NFC) “performance was adversely affected by two
major changes created by neoliberal globalization: (1) a slowdown in the rate of
global growth and an increasing intensity of competition in key product markets
that caused a downturn in NFC profit rates; and (2) a shift from “patient” finance
to impatient financial markets that raised real interest rates, forced NFCs to pay an
increasing share of their cash flow to financial agents, drastically changed
managerial incentives, and helped shorten NFC planning horizons.” Crotty, James. The
Neoliberal Paradox, 2003
•
“NFCs were eventually placed in a neoliberal paradox: intense product market
competition made it impossible for most NFCs to achieve high earnings most of
the time, but financial markets demanded that NFCs generate ever-increasing
earnings and ever-increasing payout ratios to financial agents or face falling stock
prices and the threat of hostile takeover.” Ibid.
The Entropy – A New Parameter in Economics
•
“Entropy – a measure of disorder; the higher the entropy the greater the disorder.”EntropyWikipedia
•
•
•
•
“Entropy – in thermodynamics, a parameter representing the state of disorder of a system
at the atomic, ionic, or molecular level; the greater the disorder the higher the
entropy.”Ibid.
“Entropy – a measure of disorder in the universe or of the availability of the energy in a
system to do work.”Ibid.
Nicholas Georgescu Roegen – “The Entropy Law and the Economic Process”: “The thesis
of Professor Georgescu Roegen’s book is that the basic concern of the economic process is
with entropy; and, as a corollary, he wishes to see economics established not after the
model of a mechanical science (as in so-called classical physics), but as a science that can
accommodate the complexity, the indeterminism, and human factors of economic
process.” Review: Four Reviews of Nicholas Georgescu-Roegen: "The Entropy Law and the Economic Process"
Roegen’s book “Entropy Law and the Economic Process” might be just the starting point in
explaining that the global capitalist system is not a “pendulum-like world”, being rather
governed by the Entropy Law or the principle of irreversibility.
PART II. CAUSES OF FINANCIAL CRISIS
“Strategic Complements” vs. “Strategic Substitutes”
• “In economics and game theory, the decisions of two or more players are
called strategic complements if they mutually reinforce one another, and
they are called strategic substitutes if they mutually offset one another.
These terms were originally coined by Bulow, Geanakoplos, and Klemperer
(1985)." Bulow et al. Multimarket oligopoly: strategic substitutes and strategic complements, Journal of Political
Economy, 1985
•
“Strategic substitutes imply that aggressive behavior by one firm will lead to less
aggressive behavior of the other firm. Strategic complements imply that aggressive
behavior by one firm will lead to more aggressive behavior of the other firm.”
Besanko et al. Strategic Commitment
“The Theory of Reflexivity”
•
“Reflexivity is, in effect, a two-way feedback mechanism in which reality helps
shape the participants’ thinking and the participants’ thinking helps shape reality
in an unending process in which thinking and reality may come to approach each
other but can never become identical. Knowledge implies a correspondence
between statements and facts, thoughts and reality, which is not possible in this
situation. The key element is the lack of correspondence, the inherent divergence,
between the participants’ views and the actual state of affairs. It is this divergence,
which I have called the “participant’s bias,” which provides the clue to
understanding the course of events.” Soros, George. The Theory of Reflexivity, 1994
“Self-fulfilling Prophecy”
•
“The self-fulfilling prophecy is, in the beginning, a false definition of the situation evoking a
new behaviour which makes the original false conception come 'true'. “
•
Merton, Robert K (1968). Social Theory and Social Structure. New York: Free Press. pp. 477
•
“Merton took the concept a step further and applied it to recent social phenomena. In his
book Social Theory and Social Structure, he conceives of a bank run at the fictional bank of
Cartwright Millingville(Yung AZ). It is a typical bank, and Millingville has run it honestly and
quite properly. As a result, like all banks, it has some liquid assets (cash), but most of its
assets are invested in various ventures. Then one day, a large number of customers come to
the bank at once—the exact reason is never made clear. Customers, seeing so many others at
the bank, begin to worry. False rumors spread that something is wrong with the bank and
more customers rush to the bank to try to get some of their money out while they still can.
The number of customers at the bank increases, as does their annoyance and excitement,
which in turn fuels the false rumors of the bank's insolvency and upcoming bankruptcy,
causing more customers to come and try to withdraw their money. At the beginning of the
day—the last one for Millingville's bank—the bank was not insolvent. But the rumor of
insolvency caused a sudden demand of withdrawal of too many customers, which could not
be answered, causing the bank to become insolvent and declare bankruptcy. “ Self-fulfilling
prophecy - Wikipedia, the free encyclopedia
“Asset-Liability Missmatch” and Its Risk
•
“Situation in Asset-Liability Management when interest-earning assets and interest
expense liabilities do not balance. An example is when an asset is funded by a
liability of a different maturity. The conventional circumstances in banking are that
banks and savings institutions borrow short and lend long. This means funding 30year mortgages with short-term deposits, expecting that short-term deposits can
be rolled over at maturity dates. Also known as a mismatched book.” Definition from
Answers.com
•
“Asset-liability mismatch risk is the risk of adverse movements in the relative value
of assets and liabilities. Assets and liabilities are considered to be well matched if
their changes in value in response to market movements are highly correlated. If
assets and liabilities are not well matched, the possibility of a reduction in asset
value, that is not offset by a reduction in liability value, or an increase in liability
value, that is not offset by an increase in asset value.“ Prudential Practice Guide, Australian
Prudential Regulatory Authority, 2007
Regulatory Failures
•
“Some financial crises have been blamed on insufficient regulation, and have led
to changes in regulation in order to avoid a repeat. For example, the Managing
Director of the IMF, Dominique Strauss-Kahn, has blamed the financial crisis of
2008 on 'regulatory failure to guard against excessive risk-taking in the financial
system, especially in the US‘ (Strauss Kahn D, 'A systemic crisis demands systemic solutions', The Financial
Times, Sept. 25, 2008).” Financial crisis - Wikipedia, the free encyclopedia
Contagion
•
“Contagion refers to the idea that financial crises may spread from one institution
to another, as when a bank run spreads from a few banks to many others, or from
one country to another, as when currency crises, sovereign defaults, or stock
market crashes spread across countries. When the failure of one particular
financial institution threatens the stability of many other institutions, this is called
systemic risk." George Kaufman and Kenneth Scott (2003),'What is systemic risk, and do bank regulators retard or
contribute to it?' The Independent Review 7 (3) in Financial crisis - Wikipedia, the free encyclopedia
“Financial Accelerator” and “Flight to Quality”
•
“Adverse shocks to the economy may be amplified by worsening credit-market
conditions-- the financial 'accelerator'. Theoretically, we interpret the financial
accelerator as resulting from endogenous changes over the business cycle in the
agency costs of lending. An implication of the theory is that, at the onset of a
recession, borrowers facing high agency costs should receive a relatively lower
share of credit extended (the flight to quality) and hence should account for a
proportionally greater part of the decline in economic activity. “ Bernanke, Ben et al. The
Financial Accelerator and the Flight to Quality, NBER Working Paper, 1994
“Flight-to-Liquidity”
•
“A flight-to-liquidity is a financial market phenomenon occurring when investors
sell what they perceive to be less liquid or higher risk investments, and purchase
more liquid investments instead, such as US Treasury. Usually, flight-to-liquidity
quickly results in panic leading to a crisis.” Flight-to-liquidity - Wikipedia, the free encyclopedia
PART III. TYPES OF FINANCIAL CRISES
Banking Crises
•
“When a bank suffers a sudden rush of withdrawals by depositors, this is called a
bank run. Since banks lend out most of the cash they receive in deposits (…), it is
difficult for them to quickly pay back all deposits if these are suddenly demanded,
so a run may leave the bank in bankruptcy, causing many depositors to lose their
savings unless they are covered by deposit insurance.“ Financial crisis - Wikipedia
Speculative Bubbles and Crushes
•
•
“A stock market crash is a sudden dramatic decline of stock prices across a
significant cross-section of a stock market. Crashes are driven by panic as much as
by underlying economic factors. They often follow speculative stock market
bubble.” Stock market crash. Wikipedia
“An economic bubble (sometimes referred to as a speculative bubble, a market
bubble, a price bubble, a financial bubble, or a speculative mania) is “trade in high
volumes at prices that are considerably at variance with intrinsic values” (King, Ronald
R. et al. (1993). "The Robustness of Bubbles and Crashes in Experimental Stock Markets". in R. H. Day and P. Chen. Nonlinear
Dynamics and Evolutionary Economics. New York: Oxford University Press, cited in Wikipedia)
Wikipedia
.”Economic
bubble -
International Financial Crises:
Currency Crisis, Capital Flight, Sovereign Default
•
“When a country that maintains a fixed exchange rate is suddenly forced to
devalue its currency because of a speculative attack, this is called a currency crisis
or balance of payments crisis. When a country fails to pay back its sovereign debt,
this is called a sovereign default. While devaluation and default could both be
voluntary decisions of the government, they are often perceived to be the
involuntary results of a change in investor sentiment that leads to a sudden stop in
capital inflows or a sudden increase in capital flight.” Financial crisis - Wikipedia