FINANCIAL CRISISMacro and Micro Perspectives

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

Kondratieff Theory: He postulates the existing of sinusoidal cycles (“K-waves”) of alternating periods of booms followed by depressions.

Kondratieff wave - Wikipedia

“K-waves”: A Long-Term View

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 A-phase 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 world-economy 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 betterinformation 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 keepthe 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.”Entropy-Wikipedia

• “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 30-year 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) .”Economic bubble - Wikipedia

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