The financial crisis. A crititcal analysis of its causes and consequences


Term Paper, 2015
51 Pages, Grade: 1,7

Excerpt

List of Contents

List of Abbreviations

List of Figures

1 Introduction
1.1 Problem description
1.2 Objective
1.3 Approach

2 Theoretical background of the financial instability hypothesis
2.1 Interpretations of the General Theory by M. Keynes
2.1.1 The “wall street paradigm”
2.1.2 Influence of uncertainty
2.1.3 Portfolio choice and preference for liquidity
2.1.4 Theory of investments
2.2 The financing structure of economic players
2.3 The role of financial institutions
2.3.1 Schumpeter’s theory of economic growth
2.3.2 The theory of endogenous money supply
2.3.3 Financial innovations and Money-Manager Capitalism

3 The financial instability hypothesis
3.1 Expansion phase
3.2 Contraction phase
3.3 Implications for economic policy
3.3.1 Big Government
3.3.2 Big Bank and regulation of the financial markets
3.4 Limitations of economic policy
3.5 The economy until the 1970s
3.6 Evidence for Money Manager Capitalism
3.7 Reasons for the crisis
3.7.1 Political reasons and monetary factors
3.7.2 Financial innovations and wrong incentives
3.7.3 Ponzi finance and a downward spiral
3.8 Consequences

Conclusion

Bibliography

List of Abbreviations

illustration not visible in this excerpt

List of Figures

illustration not visible in this excerpt

1 Introduction

1.1 Problem description

In 2007 the biggest financial crisis after the ‘Great Depression’ of 1939 took place. One theoretical framework explaining financial crises of that kind was envisioned by Hyman P. Minsky (1919-1996) in the latter half of the 20th century and was not considered in this context for a long time.[1] The most prominent part of the theoretical framework, the financial instability hypothesis (FIH), emphasises that “modern capitalist system is prone to bouts of relative instability and financial collapse.[2] When the storm in 2007 broke it was discovered again and the world began to talk about a ‘Minsky moment’.[3] Prominent economics called the theory a required reading and championed it as visionary.[4] Therefore it is no surprise that the book about his FIH was traded at prices over 2000 US$ right after the financial crisis.[5]

Until the year 2007 the economic world followed another school of thought. The so-called neoclassic described a world in which financial crises would only occur if exogenous shocks would disturb the self-regulating power of the markets.[6] In detail this is called the efficient market hypothesis (EMH). In addition means this that financial crises caused by systemically reason are not part of the theoretical model.

On the contrary, Minsky described a cyclical model which tries to implement loan relationships, financial institutions, financial innovations and uncertainty in the analysis of the modern capitalism.[7] An emphasis lays on the financing structure of different economic players and the role of financial institutions regarding their influence on the real economy. Minsky’s theory is based on the whole economic cycle and really tries to explain how financial crises are actually caused.[8] Additionally other authors see the thoughts of Minsky as an acknowledged theory regarding financial crises in the past.[9] Although all these factors make the theory interesting for the recent crisis and different economics had called the financial crisis a Minsky moment a huge discussion if the theory is really applicable came up. Further if the theory is really applicable the next question would be which consequences have been drawn in order to prevent another crisis.

1.2 Objective

In order to answer the first question of this term paper the financial crisis is analyzed regarding Minsky’s theoretical framework. The focus lays at this point on the question if an endogenous instability of the economic system can be proven.[10] Furthermore the second question if consequences as a reaction have been drawn is answered but it has to be said that an evaluation of the effect of the consequences goes beyond of the scope of this work.

1.3 Approach

The following term paper begins with the description of the theoretical background of Minsky’s theory. It has to be mentioned that the theories of J. M. Keynes play an important role regarding Minsky’s work. Therefore interpretations of the ‘wall-street paradigm’ and the role of uncertainty made by Minsky are explained. After that the portfolio choice of economic players is outlined. In the following section the behavior regarding investments is described with the help of the investment theory. Further the classification of Minsky regarding the financing structure of economic players is examined. Then the relevance of financial institutions and innovations is highlighted. With all these theoretical background knowledge the FIH is explained. Minsky’s linked implications for economic policy are examined as well. After that the analysis of the recent financial crisis follows. Afterwards the consequences of the financial crisis are highlighted. At the end the term paper concludes with a summary of the findings.

2 Theoretical background of the financial instability hypothesis

2.1 Interpretations of the General Theory by M. Keynes

2.1.1 The “wall street paradigm”

The following chapter highlights the interpretations of Minsky regarding the General Theory written by M. Keynes due to the fact that “Minsky regards his own work, above all else, as an interpretation and extension of Keynes”.[11]

An exceptional focus in Minsky’s work lays on the so called “wall street paradigm” which is missing in opinion of Minsky in various standard models that embody elements from the General Theory.[12] In order to understand the paradigm, the contrary model called barter economy which is part of the general equilibrium theory has to be considered.[13] The general equilibrium theory studies supply and demand fundamentals with the objective of proving equilibrium of all prices in multiply markets. Within this theory a barter economy is characterized by economic operators that are able to improve their situations by performing barter transactions with certain basic equipment. The use of money has no influence on the outcome of the transactions besides a certain simplification of the model itself. Furthermore the structure and the agents in the financing process are seen as irrelevant.[14] Assuming complete information of the current and future profits and losses gained by barter transactions the activities of the market members lead to equilibrium of the market. This is based on the assumption that market members can adjust their prices in present decisions to future events.[15] Once the equilibrium is reached only exogenous shocks can unbalance markets. In today’s school of thoughts the neoclassical approach modelled after Léon Walras supports this view of the barter economy.[16]

Keynes criticises this theory of the barter economy because of the fact that in his opinion the economy is not described adequately. His interpretation of the capitalism is characterized by the deviating assumption that goods are produced before the transaction takes place. The production in general is heavily influenced by the subjective expectations of demand and supply. Further the production facilities have to be financed and provided prior to the barter transaction which is performed in a competitive environment. Taking these considerations into account it becomes clear why Keynes states out that more factors have to be analyzed in order to describe economic processes.[17]

Minsky based his arguments on these critical thoughts of Keynes. He argues that key elements of Keynes critic are missing in the neoclassical synthesis which represents a combination of the neoclassical school of thought and the Keynesian approach described above.

Minsky explains that interdependent, financial institutions play a role before the production and distribution industries begin their work.[18] Those financial institutions generate profits through trading with debt instruments and other financial vehicles[19] which means that there are financial activities besides the trade of goods and services. Furthermore these institutions are important regarding money supply for asset investment thus they deserve special attention in order to understand an economy as a whole.[20] In the next step Minsky argues that the the financial system is the basis for endogenous instability which contradicts the neoclassical theory described above.[21] The neoclassical theory follows the approach of the neutrality of money which means that amount of money available never affects the real inflation-adjusted economy in the long-run. Minsky questions if the financial institutions really have to be left out of the model of a working economy. For him the economy is a bunch of past, current and future cash-flows.[22] In contrast to the theory of the barter economy Minsky assumes that current cash-flows are the result of payments in the past and current payments are the basis for future cash-flows. The payments can be called investments and are the trigger for economic growth. These investments cause volatility because of the fact that they are based on subjective expectations for the future and the linked potential cash-flows.[23] The uncertainty of the market members plays a certain role at this point.

2.1.2 Influence of uncertainty

In his argumentation Minsky explains another element of the General Theory which he considers as one of the most important achievements of Keynes. Minsky sees the implementation of fundamental uncertainty into economic models as one of the central parts of the theory. Therefore he argues that: “Keynes without uncertainty is something like Hamlet without the Prince”.[24] In the contrary neoclassical theories the decision making process is based on all possible, thinkable alternatives evaluated by the present values weighted according to occurrence possibilities.[25] The central statement of Keynes considering this is that investors act under fundamental uncertainty because of the fact that they are not able to measure profits correctly by using probability calculation. The result of an investment depends on future events which cannot be foreseen.[26] Further he describes events which cannot be evaluated without a scientific basis on which to form any calculable probability e.g. the rate of interest twenty years hence or the obsolescence of a new innovation.[27] Minsky states out that this uncertainty plays an exceptional role regarding two points. First the financing structure of economic players and second the transactions in financial markets.

The financing or balance structure of economic players reflects the relation of capital assets and debt instruments. Minsky argues that Keynes emphasized that these structures are like annuities because of the fact that they are expected to yield cash flows over some future span of time.[28] The point is that these future incoming cash-flows are not predictable because of the fact that they are based on subjective expectations. Further the balance sheet on the one hand contains liabilities which are the result from past investment decisions and on the other hand current investment decisions determine the liability structure of the future.[29] Furthermore there are varying maturities of assets and liabilities which means that long-term investments are financed by short-term liabilities.[30] In total this can lead to a divergence between receivables and payables. In a stabile system these positions can balance each other but with just little deviations from the amount needed in order to finance the current credits the system can be destabilized because of the fact that the payables still become due.[31] All in all investments influence the current and future financing structure and in combination with the linked uncertainty about the future cash-flows the risk of companies (e.g. the bankruptcy risk) and of financiers (e.g. the default risk) rises.[32]

Besides influencing the financing structure the uncertainty has a certain influence on financial markets. Like described above the uncertainty leads to a higher risk exposure of companies and investors. Therefore these economic players try to protect themselves against those risks through the participation on financial markets. This means that financial markets are the instrument where the expectations and the following cash-flows have an effect on the whole economic system.[33]

Although there is uncertainty in the market it has to be mentioned that investments still are carried out. The underlying expectations of the investment decision are derived from the present situation. Further it is assumed that the evaluation of the asset prices is based on correctly estimated future cash flows. Besides that the decisions of the masses are used an indicator within the investment process. Furthermore at this point the so called ‘animal spirits’ have to be taken into account. This term expresses the influence of emotional fact on the investment decision.[34] All in all it can be said that the expectations may vary and thus heavy asset price changes are possible.[35]

2.1.3 Portfolio choice and preference for liquidity

The portfolio profile is the way in order to generate annuities to cover the future liabilities in terms of debts.[36] A positive cash-flow is generated through the operative business, assets, debts or the liquidation of existing assets.[37] The difficulties described in the last section are known and therefore the economic players try to protect themselves against financial difficulties.[38] Financial resources in terms of cash play a key role regarding this plan because of the fact that cash represents a good way in order to meet liabilities when they are becoming due. The availability differentiates cash from other assets which have to be liquidated before they can be used for the described purpose.[39] In order to liquidate an asset there has to be a liquid market which can be a critical point when in times of a crisis the market only has limited liquidity.[40] Then companies can only raise their liquidity through emergency sales while suffering from heavy losses through discounts on the proceeds. The disadvantage of cash as an asset is that it does not generate a cash-flow.[41] The clear advantage is that cash is like an insurance against bad economic situations because of the fact that a surplus in cash can compensate differences if the cash-flow out of the operating business is too low in order to maintain the business activity.[42] Minsky argues that economic players have a preference for liquidity which also was noticed by Keynes when he said that cash is a barometer of the degree of our distrust of our own calculations and conventions concerning the future.[43]

2.1.4 Theory of investments

Investments are the basis of future cash-flows. The investment volume following the approach of Minsky’s investment theory is determined by the demand and supply of assets and the conditions on the financial markets.[44] The price of investments, goods and services can be defined as the costs per unit and a profit mark-up.[45] The mark-up depends on the influence of the company on the market. Minsky argues on the basis of Keynes that investment goods have the offer price (PI) which represents the price where a producer is prone to produce another unit. This is the case if the goods are financed by internal resources. In general a company has the choice between internal and external resources as a mean for financing an investment good.[46] Internal resources are profit surpluses of past periods or the cash-flow generated by liquidations of assets.[47] The higher the liquidity preference the lower the available internal capacities for investments. Another possibility is using external financing resources. In such a case the offer price includes the financing costs (PIs) which are determined by factors like the debt ratio and the credit securities. Further the determination is influenced by information asymmetries which lead to the fact that external financing means become more expensive than internal ones.[48] Further it is assumed that the creditors risk rises in accordance with the debt ratio and therefore the liability costs for the debtor rise too. The following figure shows until the point OIF an internal financing structure of a certain company.

Source: Own depiction in accordance with Wray, L. R., Tymoigne, É. (2008), p. 8.

Figure 1: Determination of the investment volume

illustration not visible in this excerpt

Ongoing from this point the slope of the curve represent the adjustment of the creditor according to the risk evaluation which is based on changing conditions of the financial markets, the economic growth or a changed behaviour regarding liquidity preference.[49]

In accordance with Keynes Minsky developed another concept which is called the ask price for assets. While the offer price is for the currently produced goods, investments assets and services the demand or ask price refers to the fixed supply of asset goods in a period.[50] These assets except for cash are characterized by the fact that they are generating cash-flows through the operating business or the liquidation of assets.

At this point the expected discounted cash flows of an asset or the market price for existing assets can be used in order to find the ask price (PId) for those assets.[51] Important at this point is that the cash-flows are based on subjective expectations and therefore they are uncertain. In case of a crisis the ask price would be rather low because of the fact that bad expectations lower the level of the price. In contrary in a boom phase the ask price would be high.

Like the concept of the offer price the ask price can include external financing costs. When external financing resources are used the ask price curve declines because of the fact that the debtor sees the rising ratio of external financing resources as some kind of safety margin. That means that the debtor want to secure himself against a default.[52] Generally the ask price rises in case of rising optimism in the market, a declining liquidity preference or rising liquidity in the market.[53]

[...]


[1] Cf. Flanders, J. M. (2015), p. 84.

[2] Cf. Behlul, T. (2011), p. 137.

[3] Cf. Vercelli, A. (2009), pp. 2.

[4] Cf. Yellen, J. L. (2009), p. 1.

[5] Cf. Braunberger, G. (2007)

[6] Cf. Minsky, H. P: (1986), p. 280.

[7] Cf. Keen, S. (2011), p. 327.

[8] Cf. Assenza, T., Gatti, D. D.; Gallegati, M. (2010), p. 183.

[9] Cf. Kindleberger, C. P. (1996), pp 14.

[10] Cf. Wray, L. R. (2013), p. 61.

[11] Dymski, G. A.; Pollin, R. (1992), p. 29.

[12] Cf. Minsky, H. P: (2007), p. 81.

[13] Cf. Heine, M., Herr, H. (2003), p. 14.

[14] Cf. Tymoigne, É. (2010), p. 48.

[15] Cf. Tymoigne, É. (2010), p. 48.

[16] Cf. Heine, M., Herr, H. (2003), p. 14.

[17] Cf. Tymoigne, É. (2010), p. 49.

[18] Cf. Minsky, H. P. (1977), p. 141.

[19] Cf. Minsky, H. P. (1982a), p. 19.

[20] Cf. Minsky, H. P. (1975), p. 57.

[21] Cf. Dymski, G. A., Pollin, R. (1992), p. 29.

[22] Cf. Minsky, H. P. (1986), p. 195.

[23] Cf. Keen, S. (2011), p. 226.

[24] Minsky, H. P. (1975), p. 57.

[25] Cf. Akerlof, G. A., Shiller, R. J. (2009), p. 32.

[26] Cf. Keen, S. (2011), p. 226.

[27] Cf. Keynes, J. M. (1937), pp. 213.

[28] Cf. Minsky, H. P. (1986), p. 194.

[29] Cf. Minsky, H. P. (1982a), p. 19.

[30] Cf. Dymski, G. A., Pollin, R. (1992), p. 30.

[31] Cf. Minsky, H. P. (1986), p. 219.

[32] Cf. Dymski, G. A., Pollin, R. (1992), p. 30.

[33] Cf. Dymski, G. A., Pollin, R. (1992), p. 31.

[34] Cf. Keynes, J. M. (1936), p. 137.

[35] Cf. Minsky, H. P. (1975), p. 68.

[36] Cf. Tebroke, H., Laurer, T. (2005), p. 18.

[37] Cf. Minsky, H. P. (1982a), p. 126.

[38] Cf. Minsky, H. P. (1986), p. 133.

[39] Cf. Minsky, H. P. (1975), p. 72.

[40] Cf. Minsky, H. P. (1975), p. 71.

[41] Cf. Minsky, H. P. (1986), p. 202.

[42] Cf. Minsky, H. P. (1975), p. 77.

[43] Cf. Keynes, J. M. (1937), pp. 216.

[44] Cf. Minsky, H. P. (1986), p. 254.

[45] Cf. Minsky, H. P. (1986), p. 177.

[46] Cf. ibid., p. 192.

[47] Cf. Edmunds (2001), p. 249.

[48] Cf. Assenza, T., Gatti, D. D., Gallegati, M. (2010), p. 186.

[49] Cf. Bellofiore, R. und Ferri, P. (2001), p. 9.

[50] Cf. Emunds, B. (2001), p. 255.

[51] Cf. Wray, L. R., Tymoigne, É. (2008), p. 9.

[52] Cf. Wray, L. R., Tymoigne, É. (2008), p. 9.

[53] Cf. Wray, L. R. (1992), p. 167.

Excerpt out of 51 pages

Details

Title
The financial crisis. A crititcal analysis of its causes and consequences
College
University of Applied Sciences Essen
Grade
1,7
Author
Year
2015
Pages
51
Catalog Number
V320269
ISBN (eBook)
9783668198401
ISBN (Book)
9783668198418
File size
963 KB
Language
English
Tags
Great Depression, Minsky, financial instability hypothesis, efficient market hypothesis, financial institutions, economic
Quote paper
Tim Borneck (Author), 2015, The financial crisis. A crititcal analysis of its causes and consequences, Munich, GRIN Verlag, https://www.grin.com/document/320269

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