Hendrickson financial crisis; the united states in the early 21st century (2013)

III Aim and scope IV Outline of the book 2 Theories of Financial Crises I Four theories II The Financial Instability Hypothesis III The Austrian Business Cycle Theory IV Speculative Inve

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NEW ISSUES IN FINANCIAL INSTITUTIONS MANAGEMENT

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AFFORDABLE HOUSING FINANCE

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FINANCIAL CRISIS

The United States in the Early Twenty-First Century

Jill M Hendrickson

REGULATION AND INSTABILITY IN U.S COMMERCIAL BANKING

A History of Crises

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CREDIT GUARANTEE INSTITUTIONS AND SME FINANCE

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RISK TOLERANCE IN FINANCIAL DECISION MAKING

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CORPORATE AND SOCIAL TRANSFORMATION OF MONEY AND BANKING

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BANK REGULATORY REFORMS IN AFRICA

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List of Figures and Tables

Part I Theories of Financial Crisis

1 Caught Off-Guard by Another Crisis

I Why were we surprised?

II What about next time?

III Aim and scope

IV Outline of the book

2 Theories of Financial Crises

I Four theories

II The Financial Instability Hypothesis

III The Austrian Business Cycle Theory

IV Speculative Investment

V Asymmetric Information

VI Summary of the theories

3 Assessment of the Theories

I Comparison of the theories

II Contrasting the theories

III Summary

Part II Financial Crisis in the US in the Twenty-First Century

4 Prologue to the Crisis: 2000–2006

I Real sector growth and optimism

II Developments in the financial sector

III Interaction between the real and financial sectors

5 The Crisis Unfolds

I Stages of the crisis

II Summary

Part III Evaluating Theories Against the Evidence

6 Using Theory to Analyze the Crisis

I Analysis of shared theoretical elements

II Analysis of common but nonconsensus elementsIII Summary

7 Theoretically on Guard for Crises

I What have we learned?

II How is this crisis unique?

List of Figures and Tables

Figures

2.1 Taxonomy of Minky’s Financial Instability Hypothesis

2.2 The Garrison framework

2.3 Monetary policy in the Garrison framework

2.4 Taxonomy of Garrison’s Austrian Business Cycle Theory

2.5 Taxonomy of Kindleberger’s Speculative Investment Theory

2.6 Taxonomy of Mishkin’s Asymmetric Information Theory

4.1 RGDP growth rate: 1930–2010

4.2 RGDP growth rate: 2000–2010

4.3 Mortgage-related security holdings by investor: 2000–2010

4.4 GSE subprime and Alt-A holdings: 2002–2010

4.5 Market share of ARMs and FRMs: 2000–2008

4.6 Loans by category per commercial bank: 2000–2011

4.7 House price index in selected cities: 2000–August 2011

4.8 Federal funds rate: January 2000–October 2011

4.16 Mortgage origination by selected product: 1990–2010

4.17 Senior loan officer survey results on C&I loans: 2000–2011

4.18 Senior loan officer survey results on residential mortgage loans: 2000–20114.19 Senior loan officer survey results on consumer loans: 2000–2011

4.20 Credit card and individual loans per commercial bank: 2000–2011

4.21 Home equity lines of credit per commercial bank: 2000–2011

4.22 Real debt levels for households and businesses: 2000–2011

4.23 Real per capita disposable personal income: 2000–2011

4.24 The real cost of credit for households and businesses: 2000–2011

4.25 Real investment expenditure by category: 2000–2011

4.26 Real corporate profit: 2000–2010

4.27 Mortgage delinquency rates: 2003–2010

5.1 Financial Stress Index: 2000–2011

5.2 The TED spread: 2000–2011

5.3 The agency spread: 2000–2011

5.4 Spread in Aaa corporate bonds to ten-year Treasury bonds: 2000–2011

5.5 Nonfinancial commercial paper outstanding: October 2003–January 2012

5.6 Asset-backed commercial paper outstanding: October 2003–January 2012

5.7 The Chicago Fed National Activity Index: 2000–2011

5.8 Percentage change in the leading economic indicator: 2000–2011

5.9 The financing gap: 2000–2011

5.10 The debt-to-maturity ratio: 2000–2011

5.11 Residential real estate loans extended by US commercial banks: 2000–2011

5.12 Loans extended by US commercial banks by category: 2000–2011

5.13 Construction and land development loans extended by US commercial banks: 2000–20115.14 Business and household net worth in the US: 2000–2011

5.15 Consumer confidence: 2000–2011

5.16 Real private fixed investment and real exports: 2000–2011

5.17 The number of problem banks in the US: 2006–2011Q3

5.18 The number of commercial bank failures in the US: 2000–2011

6.1 Real private fixed investment: 2003–2011

6.2 Real private residential investment: 2003–2011

6.3 Total loans and leases at domestically chartered US commercial banks

6.4 Residential mortgage loans per commercial bank: 2005–2011

6.5 Total deposits at domestically chartered US commercial banks

6.6 Past-due mortgage loans at US commercial banks: 2005–2011

6.7 Ratio of equity capital to total assets at US commercial banks: 2002–2011

6.8 ROE and percentage of unprofitable US commercial banks: 2005–2011

6.9 Percentage of failed commercial banks in the US: 1980–2011

6.10 Household debt service ratio: 2003–2011

6.11 Spread between the Baa corporate yield and ten-year Treasury yield: 2000–20116.12 Interest rates on a 30-year fixed rate mortgage: 2000–2011

6.13 The number of nonbank financial institutions in selected cities: 2000–2009

6.14 Building permits for new private housing: 2000–-2011

6.15 Real personal consumption expenditure: 2000–2011

6.16 The US personal savings rate: 2000–2011

7.1 The US unemployment rate: 2000–2012

7.2 The US labor force participation rate: 2000–2012

7.3 Homeownership rates in the US: 2000–2011

Tables

3.1 Summary of common and distinguishing elements

4.1 Summary of policies and laws and the impact on residential real estate prices4.2 Loan characteristics at the GSEs: 2003–2007

4.3 Hypothetical bank asset listing and capital requirement calculation

4.4 Private-label MBS ratings deals: 2002–2008

5.1 Destabilizing timeline and policy responses in stage one

5.2 Channels connecting the financial and real sectors

5.3 Destabilizing timeline and policy responses in stage two

5.4 Destabilizing timeline and policy responses in stage three

6.1 Weekly percentage change in loans and deposits: August 2008–January 7, 20096.2 The federal funds rate in historical perspective

6.3 Expansion of the Federal Reserve balance sheet

Part I

Theories of Financial Crisis

The first financial crisis of the twenty-first century hit the United States and the world with greatsurprise and force Indeed, the crisis blindsided governments, economists, policy-makers, businessesand households alike Once the dust had settled, we wanted to know how this happened and why wedid not see it coming One obvious place to look for an answer is financial crisis theory Certainly,theory exists to offer explanations and understanding of how crises develop A logical follow-upquestion is whether existing theory is still sufficient; does the existing theory still reflect actualbehavior and developments in the economy? The primary objective of this book is to provide ananswer to this last question To do so, it carefully explains existing theories of financial crisis andevaluates them in light of economic performance in the United States between 2000 and 2011.Chapter 1 offers some explanations for how the crisis provides new challenges to how economistsand policy-makers think about macroeconomics generally and, more specifically, financial crisis inthe future It also provides the motivation for the writing of this book and the contribution it may beable to make as crisis theory is reconsidered Chapter 2 outlines four important theories of financialcrisis that have made their way to prominence in light of the crisis The objective of this chapter is toprovide a thorough understanding of each of the theories so that later in the book each can beevaluated based upon actual crisis experience In Chapter 3, the four theories from Chapter 2 areanalyzed relative to one another and their similarities and differences are identified This frameworkfor understanding how the theories overlap and how they are unique is important when, later in thebook, the theories are put to the test with the most recent financial crisis

Caught Off-Guard by Another Crisis

Financial crises have a long tradition both in the United States and globally Despite this, most peoplewere caught by surprise in the fall of 2008 when markets exploded and a global financial crisiscommenced in earnest Could we have been more prepared? Do we have the tools to be moreprepared next time? The economics profession relies on theories of all sorts to make sense of whatactually happens in the world For our purposes, economists use theories of financial crises to helpexplain and understand financial crises However, only by testing the theories to the data will welearn which are relevant and which are not in today’s world That is the primary objective of thisbook – to determine which contemporary theories of financial crises stand up against empiricalscrutiny and which do not Because the health of the financial sector is positively related to the health

of the macroeconomy, it is vital to have crises theories which help us understand real-life events.1

This chapter begins with an explanation for why the most recent financial crisis caught almosteveryone by surprise It also explains the inevitable nature of crises This inevitably, in turn, meansthat we will need to be prepared for future crises The remaining sections of the chapter explain moreabout the objectives, methodology, terminology and outline of this book

I Why were we surprised?

Few people saw the most recent financial crisis coming For example, the Chair of the FederalDeposit Insurance Corporation admitted that regulators neither understood nor identified that a crisiswas brewing.2 Similarly, Alan Greenspan, the Chair of the Federal Reserve for the two decades prior

to the financial crisis, argued that it was not possible for regulators to foresee the crisis when hecommented that “History tells us [regulators] cannot identify the timing of a crisis, or anticipateexactly where it will be located or how large the losses and spillovers will be.”3 On March 16, 2008,the then Treasury Secretary Henry Paulson told CNN: “I have great confidence in our capital marketsand in our financial institutions Our financial institutions, banks and investment banks, are strong.”Eight months later, on November 16, 2008, Paulson observed: “We are going through a financialcrisis more severe and unpredictable than any in our lifetimes.”4 As a final example, consider that in

2006, before house prices started to fall and the crisis hit, scholars at the Federal Reserve Bank of St.Louis researched the growth of house prices and concluded that banks were at lower risk of loss ifhouse prices started to fall than at any time historically.5

At the same time, however, there were contrarian voices warning of mounting risk and a growing,unsustainable fragility For the most part, these voices were ignored or, perhaps even more to thepoint, were rarely heard outside of small circles For example, Peter Wallison, a scholar at theAmerican Enterprise Institute, warned in September 1999 of the danger of pressing for homeownership through the subprime mortgage market.6 Also in 1999, the then Treasury Secretary LarrySummers also warned of the rapid and dangerous growth of government-sponsored enterprises thatwould, at the height of the crisis, require a massive government bailout because of subprimemortgages and mortgage-backed securities.7 Yet, for the vast majority, the collapse of real estateprices, investment banks, commercial banks, and markets generally came as a real surprise It was notsimply the family down the street with dual incomes, two children, and a mortgage who weresurprised; it was also the economists from academia and the private sector, key leaders at centralbanks, policy-makers, businesses, and governments around the globe who were not prepared andfailed to anticipate the crisis.

Why were we caught so off-guard and unprepared? This is a difficult question to answer Ideally,

we could answer this question with precision and, in the process, be prepared for the future.Unfortunately, a precise answer is elusive and, instead, a range of expert opinions exist Here, twoprominent possibilities are explored

A Things are different today

One perspective that falls under the heading of “things are different today” is the idea thattechnological and financial innovation has allowed the economy generally and the financial sectormore specifically to become more efficient at allocating capital and handling risk Indeed, Bernankeremarked as much in 2004.8 The world of finance in the twenty-first century is, in many aspects, muchlike it has always been However, very important aspects are, at the same time, very different Asimple comparison of the balance sheets and income statements of financial institutions between 1995and 2005 illustrates such changes For example, bankers historically made loans and they remained asassets on the balance sheet until the loan matured or was paid off Today, bankers are increasinglysecuritizing loans In this process, loans are often sold off the balance sheet very soon after the loan isoriginated In another example, businesses historically took out loans from commercial bankers.Increasingly, businesses rely on commercial paper or loans from finance companies for short-termborrowing A final example is the increasing use of nonbanks for savings vehicles Traditionally,consumers would establish savings accounts at commercial banks or thrifts Today, consumers areincreasingly turning to mutual fund companies and alternative financial institutions to save andachieve higher investment returns The prevalent thinking was that things were different today; a crisiswould not happen again because of a highly integrated and technologically advanced financial sector

In their book This Time is Different, Reinhart and Rogoff argue that human psychology, often in the

form of confidence, has a long history of influencing financial crises.9 The unpredictability ofconfidence and the unreliable nature of human expectations make it difficult, if not impossible, topredict or anticipate crises In their own words, Reinhart and Rogoff maintain:

Perhaps more than anything else, failure to recognize the precariousness and fickleness ofconfidence – especially in cases in which large short-term debts need to be rolled overcontinuously – is the key factor that gives rise to the this-time-is-different syndrome Highly

indebted governments, banks, or corporations can seem to be merrily rolling along for anextended period when bang! – confidence collapses, lenders disappear, and a crisis hits.10

This means that even those who know of past crises can easily be lulled into thinking that this timearound the outcome will be better We fail to learn from our mistakes We get collectively swept up

in the confidence around us and act as if tomorrow will be better than today Perhaps some of thisconfidence comes from the technological innovation mentioned above In other words, it is likely thattechnology, and the financial innovations that followed, reinforced the confidence during the goodtimes and masked its fragility

B The failure of economic theory

Another perspective that may explain our inability to anticipate the crisis is that economists failed toprovide the tools necessary for us to expect such a development Indeed, the critique that pits differentempirical models against one another as evidence of such failure is popular in academic circles Inthe empirical model debate, it often appears to be staged as a version of Keynesianism versus theneoclassical model Within this debate, there is often the distinction between rationality on the onehand and “animal spirits” on the other The Keynesian approach, initially established by JohnMaynard Keynes shortly after the Great Depression, gave an important role to what Keynes called

“animal spirits,” a term meant to capture the uncertainty of human behavior.11 In sharp contrast, theneoclassical model assumes perfect competition and completely rational human behavior In light ofthe most recent financial crisis, many scholars are revisiting the efficacy of these models and theirtreatment of human action.12 I refer to this debate as the “model failure” explanation for why the crisiscaught us unawares Sufficient attention is afforded to this discussion, so it is not considered in thisbook

Much less attention has been given to analyzing how theories of financial crises may have failed toadequately warn us I refer to this possibility as the “theory failure” explanation The differencebetween model and theory failure is that the model debate focuses on empirical macroeconomicmodels derived from particular schools of thought As indicated above, this is typically some form ofKeynesian or neoclassical theory In contrast, the theory failure perspective asks if existing theories

of financial crisis, as opposed to macro, statistical models, are adequate for understanding financialcrises in the twenty-first century If the crises theories are not adequate, this would also explain, inpart, why the most recent crisis was unanticipated

Theories of financial crises are distinct from macroeconomic models in that they have a narrowerfocus In other words, macroeconomic models are empirical in nature and are designed to explain thebusiness cycle This means that the focus is on understanding fluctuations in output and employment in

an economy The model is necessarily concerned with explaining fluctuations in the whole economyand might (but often does not) include disturbances in the financial sector In contrast, theories offinancial crises explain crisis or turmoil that must include elements of disruption in the financialsector Further, many theories of financial crises do not treat a crisis as an anomaly but, rather, viewthe economy as crisis-prone

Financial panic and distress are not new Some of the earliest speculation and panics occurred inancient Rome during the second century B.C At that time, the Roman financial system was relativelywell developed with an established credit system.13 More famous was the tulip bulb panic in the

Netherlands in 1636 Several significant panics took place in 1720; two of the most prominent are theSouth Sea and Mississippi crises.14 With such experiences came scholars eager to understand andstudy them Since the use of credit is central to financial crises, one would assume that crises andtheir theories came about as a result of the widespread use of credit However, it is unclear if moneypredated credit; that is, most monetary theorists today believe that money came first in the evolution

of exchange and monetary systems, but this view is far from unanimous.15 This unresolved issue shedslight on the origins of crises and crises theory Since crises typically require credit and it is believedthat credit has been around almost as long as money, crises has an impressive history While theoriesemerged to understand crises, it has not been until the twentieth century that comprehensive, stand-alone theories of financial crisis were articulated Thorstein Veblen developed one theory offinancial crises in 1904, followed quickly by his student Wesley Clair Mitchell in 1913.16 Alsointerested in money and the possibility of crises was Irving Fisher, who entered the field of businesscycles and crashes following the Great Depression.17 Perhaps most famously, in 1963 Milton

Friedman and Anna Jacobson Schwartz published A Monetary History of the United States, 1876–

1960, which, although not a theory of financial crises, was a comprehensive analysis of the Great

Depression and the role of the financial sector Since the financial instability of the mid-1960s, therehas been more interest in developing theories of financial crises and so the field opens upconsiderably Several of these theories are considered in this book

II What about next time?

Make no mistake about it – there will be another financial crisis Despite rigorous mathematicalmodels, theories from prominent economists, innovation in financial markets, and increasingsophistication in risk assessment, it is inevitable that another crisis will occur In their historicalinquiry into crises around the world, Reinhart and Rogoff lament that we have failed to graduate fromthe cycle of financial crises both in the United States and globally.18 Perhaps even more alarming isthe fact that not only have we been unable to avoid crises, but they are also becoming increasinglymore severe and frequent.19

Even though crises are inevitable, we should not throw up our hands in defeat We can becomebetter educated on crises and, in the process, be more prepared the next time around Indeed, testingand improving financial crises theory will not, by itself, allow us to graduate from the crises cycle

We could, however, reconsider and improve theory through analysis and possibly synthesis In doing

so, we could be better prepared to anticipate and resolve upcoming crises The Chairman of theEconomic Development and Review Committee at the Organisation for Economic Co-operation andDevelopment (OECD) agrees:

Evidently, simply improving our analytical frameworks will not be sufficient to avoid futurecrises Nonetheless, such a reevaluation is necessary There are many dead ends from which toescape, but there are also many promising strands of thought yet to be pursued.20

Meteorologists and weather experts are always re-evaluating and studying national disasters such ashurricanes They know that they cannot stop hurricanes, but they can improve our understanding of

them and help us prepare for future events Just as we prepare for hurricanes, we need to prepare forfinancial crises This book is one attempt at preparedness by re-evaluating financial crisis theory.

III Aim and scope

The first financial crisis of the twenty-first century opened the doors to reconsidering virtuallyeverything we thought we knew about crises and macroeconomic theory, as well as monetary andregulatory policy In this book, the crisis serves as a springboard to reconsider existing theories offinancial crisis As mentioned earlier, this book does not enter the “model failure” debate; rather, it is

an attempt to offer insight into what I have called the “theory failure” possibility In 1994, Martin H

Wolfson’s book Financial Crises: Understanding the Postwar U.S Experience was published in its

second edition In this book, Wolfson surveys theories of financial crises and applies them to the realsector performance between 1966 and the early 1990s in the United States This was an importantbook because of its connection between theory and experiences of actual crises Unfortunately, in the

18 years since its publication, there has been little evaluation of crisis theory Indeed, scholars lamentthe void in crisis theory following the work by prominent scholars such as Kindleberger and Minsky,

to name two contemporary theorists.21

This book attempts to fill this gap by offering a comprehensive explanation of important financialcrises theories This will expose the reader to existing frameworks constructed to understandepisodes of crisis These theories are then “tested” against actual experience of crisis in the UnitedStates during the twenty-first century Strong emphasis is placed on attempting to determine if thetheories hold up to the data and empirical evidence from the 2000–11 experience In the end, the goal

is to help students, the public, and policy-makers gain a deeper appreciation of contemporary crisesand, possibly, to learn how to prepare for these possibilities in the future

There are more financial crisis theories in existence than can adequately be covered in this book.Consequently, choices need to be made regarding which to include and which to exclude Onecriterion for making the decision is to look at Wolfson and understand his criteria He largely focusedhis book on what he terms “cyclical theories,” which are theories of financial crises that take placewithin the context of the business cycle, typically near the peak From the cyclical theories, heconsiders several historical scholars including Thorstein Veblen, Wesley Clair Mitchell, and KarlMarx and several contemporary theorists, including Hyman P Minsky, Albert M Wojnilower, andAllen Sinai Late in his analysis, he also briefly surveys noncyclical theories He defines these to bemore broad crisis theories in which the actual crisis may or may not take place within the context ofthe business cycle In the end, he is able to filter through the financial crisis literature by largelyfocusing on cyclical theories

The approach taken here to filter through the theories considers the criteria in Wolfson, but alsoconsiders the current literature and the re-evaluation that is ongoing in contemporary literature in light

of the most recent crisis As scholars begin the process of reconsidering theory, they have turned tocontemporary and prominent theories These often include the work of Minsky, as is done in Wolfson,but also include the work of Austrian economists and other noncyclical theorists In this book, I takethe cyclical theories of Minsky and Roger Garrison and add to it two contemporary noncyclicaltheories that maintain prominence in contemporary literature The noncyclical theorists included here

are Charles Kindleberger and Frederic S Mishkin This is not to suggest that other noncyclicaltheories are not worthy of investigation; rather, these have received consideration because of thecrises and so were deemed worthy of re-evaluation.22

IV Outline of the book

The following two chapters introduce and analyze four theories of financial crisis that have garneredattention in light of the first crisis of the twenty-first century In Chapter 2, each of the four theories isintroduced in sufficient detail so that the theories may be used later to try and understand the mostrecent crisis Chapter 3 considers similarities and differences between the four theories It isimportant to generate an analytical framework of each theory relative to the other theories so that itmay be possible to determine the strengths and weaknesses of these theories in light of the changingnature of both the financial and real sectors of the economy In other words, while the currentfinancial crisis has elements found in earlier crises, other aspects are unique to the twenty-firstcentury Because of this, it is important to determine whether or not existing crisis theories remainadequate

Chapters 4 and 5 break from the discussion of theories to a discussion of the crisis itself Morespecifically, Chapter 4 is an analysis of the prologue to the crisis and offers an explanation of howprices increased substantially in the residential real estate market Chapter 5 offers an explanation ofthe actual crisis by breaking the crisis down into three distinct stages In this chapter, the financialcrisis, in each of these stages, is analyzed, along with the channels through which financial distress istransmitted to the real sector Collectively, Chapters 4 and 5 provide an understanding of the financialsector and the wider economy during the first 11 years of the twenty-first century

Chapter 6 is perhaps the heart of this book This is because this chapter relies on the previous fourchapters to address the primary objective of the book, which is to determine whether existing crisistheories adequately help us understand modern financial crises Thus, in Chapter 6, the theories fromChapters 2 and 3 are analyzed in light of the experiences outlined in Chapters 4 and 5 The goal is toanswer the following questions: 1) does any one theory do a more compelling job of explaining themost recent financial crisis?; and 2) does any one theory sufficiently explain the crisis so that a newtheory is not necessary?

In the final chapter, the implications from Chapter 6 are considered in light of the ongoing struggles

to bring about recovery in the US economy

Theories of Financial Crises

This book surveys four contemporary theories of financial crises These four were chosen from alarger collection of work because they maintain prominence in current discussions In other words,the first financial crisis of the twenty-first century has garnered significant interest in rethinking manyaspects of macroeconomic and financial economics Some of the focus is on the effectiveness oftheory, including theories of financial crises It is clear from these discussions that the theoriespresented in this book hold a central place in the re-evaluation Consequently, these four theories arethe focus of both this chapter and several of the later chapters

I Four theories

Two of the theories take place within the context of the business cycle The first is the FinancialInstability Hypothesis of Hyman P Minsky Minsky developed this perspective of financial crisesafter witnessing increasing financial instability in the post-war period in the United States Hisprimary influence was the work of Keynes.1 The second is the Austrian Business Cycle Theory ofRoger Garrison, which is a major refinement of earlier Austrian scholarship on financial crises.Earlier work from the Austrian perspective includes scholarship from Friedrich A Hayek andLudwig von Mises, among others.2 Garrison adds coherence to this existing work and, in the process,generates a unified theory of financial crises from the Austrian perspective Both Minsky andGarrison offer theories of financial crisis that take place within the context of the business cycle, but

do so from different underlying perspectives

The other two theories surveyed here are considered noncyclical theories because they do notrequire the crisis to take place within the context of a business cycle Certainly, while the crisis maytake place, and often does take place, within a larger business cycle, it is not a precondition to thetheory The first of these is the Speculative Investment perspective of Charles Kindleberger Thistheory, in which speculative behavior plays a central role, was inspired by the earlier theoreticalwork of Adam Smith, John Stuart Mill, Knut Wicksell, and Irving Fisher as well as Minsky.3 Thefourth and final theory considered here is the Asymmetric Information Theory of Frederic Mishkin Inthe 1970s and 1980s, Mishkin took a new and burgeoning literature on asymmetric information andapplied it to the understanding of financial disturbances In the process, he constructed a theory offinancial crisis in which parties with unequal information inject inefficiencies into the financial sectorthat may lead to crisis

In this chapter, the cyclical theories are surveyed first, followed by the noncyclical theories Theobjective is to expose the reader to the most important points and concepts in each theory These

theories are analyzed relative to one another in Chapter 3, and later, in Chapter 6, the theories areused to try and understand the first financial crisis of the twenty-first century.

II The Financial Instability Hypothesis

The Financial Instability Hypothesis was developed by Hyman P Minsky in the 1970s.4 Born in

1919, Minsky witnessed the incredible stability of the financial sector and the macroeconomy duringthe 20 or so years following the Second World War At the same time, he also witnessed the growinginstability that began with a credit crunch in 1966 This was followed by growing instability duringseveral episodes in the 1970s.5 Minsky wanted to try and understand the Keynesian framework inlight of these increasingly severe financial disturbances The result of his efforts was his FinancialInstability Hypothesis While it is rooted in the Keynesian tradition, it was important to Minsky thathis work, first and foremost, offered a meaningful explanation of real economic events Figure 2.1 isthis author’s attempt to capture this theory visually and is meant to help the reader understand theverbal description which follows

A Stability creates instability

Because the Financial Instability Hypothesis is a cyclical theory of crises, it makes sense tounderstand this perspective from within the business cycle At the heart of Minsky’s FinancialInstability Hypothesis is the idea that a business cycle expansion, which is a stable time in aneconomy, necessarily becomes unstable Stability, to Minsky, breeds instability To understand howstability is transformed into instability, Minsky emphasized four crucial concepts from the Keynesiantradition: uncertainty, business cycles, disequilibrating forces, and finance.6

These four Keynesian concepts in turn influence the amount of productive investment spending thattakes place during the expansion For Minsky, investment is a key component to maintaining economicexpansion and stability, and is financed using both internal and external (borrowed) funds Investment

is determined by financial developments such as debt levels, liquidity, and interest rates Whenfinancial conditions are favorable (investment booms), external financing grows faster than internalfinancing and profits and incomes rise At the same time, however, the financial variables are heavilyinfluenced by uncertain expectations about the future Consequently, uncertainty plays a central role.7

However, the uncertainty is not random; rather, it is a part of the natural fluctuations in the businesscycle More specifically, when an economy is in the expansion phase of a cycle, expectations are highand acceptable risk levels rise with expectations As the expansion continues, the entire expansionbecomes increasingly fragile, i.e disequilibrating, because of changes in risky behavior that emergesduring an expansion to engender greater risk The point is that the Keynesian concepts of the businesscycle – finance, disequilibrating tendencies, and uncertainty – all influence investment in the Minskytheory

B Systemic fragility

The instability that is created within the context of an expansion is considered by Minsky to be anatural outcome of a business cycle Minsky called this systemic fragility.8 The degree to which theeconomy becomes fragile depends on three elements: 1) borrowers’ susceptibility to financial

hardship; 2) the degree to which borrowers rely on debt; and 3) the degree of liquidity in the financialsector Each is considered here.

Minsky created a classification to help understand how susceptible a borrower is to financialdistress It is a threefold taxonomy of hedge, speculative, and Ponzi borrowers What distinguishesone from another is the degree to which the borrower is able to use cash receipts to meet debtobligations A hedge borrower expects to have sufficient cash receipts to meet debt payments In theimmediate future, a speculative borrower will not expect to have the cash to cover debt payments.Typically, the speculative borrower is expected to come up short because of short-term debtobligations that are expected to be refinanced Speculative borrowers accumulate additional debt tocover the gap between cash receipts and debt payments, i.e they pay back the interest but mustrefinance for the principal Like the speculative borrower, a Ponzi borrower does not anticipate beingable to cover debt payments Rather, the Ponzi borrower expects to need to borrow to even make theinterest payment on the debt and not simply the principal, as with the speculative borrower

We can take the three types of borrowers and add in the other two elements of fragility (debt andliquidity) to paint a complete picture of Minsky’s systemic fragility As an economy is expanding,borrowers, relying on debt, witness rising profits Psychologically, the debt is tied to the profit,which generates confidence to take on additional levels of debt If a strategy has been successful inthe past, why change it? In addition, growing debt requires that more of the profit be devoted toservicing the debt Further, Minsky maintains that much of the new debt is short term in nature.Typically, short-term interest rates are lower than long-term rates, i.e there is a positive yield curve,

so that short-term borrowing may be more profitable Since confidence is rising, borrowers do notexpect debt repayment problems, so there is no roadblock to short-term debt The rising confidencealso allows borrowers to replace large cash holdings Borrowers no longer feel the need to maintainmeaningful cash balances because of their optimism regarding the future A reduction in cash holdingsnecessarily reduces liquidity Thus, for Minsky, as the economy is expanding, investment, profit, debt,and confidence are rising while liquidity is falling

However, also during expansion, the susceptibility of the borrower to default is rising Ifborrowers are generally taking on greater financial commitments, this means that hedge, speculative,and Ponzi borrowers are all accumulating more debt In other words, if debt commitments cannot befinanced out of profits (as in the case of hedge borrowers) but, rather, require additional debt, thenspeculative and Ponzi borrowing is on the rise In the process, susceptibility to default rises Coupledwith falling liquidity, the system is becoming more fragile

Figure 2.1 Taxonomy of Minky’s Financial Instability Hypothesis

C Rising interest rates

The fragility of the system is exacerbated by endogenously rising interest rates For Minsky, demandfinancing is inelastic while supply is much more elastic Certainly, from the demand side, the risingshort-term debt obligations coupled with falling liquidity make the borrower less sensitive to interestrates Even in an environment of rising interest rates, they require debt to remain viable and sodemand funds, regardless of the price The supply of funds tends to start out elastic because bankshave several sources of loanable funds and can expand these channels during the economic expansion.Indeed, later in his career, Minsky emphasized that banks were an important source of financialinnovation and that often the innovation expands the supply of loanable funds.9 With rising profits,bankers also have the incentive to make more funds available because they feel more confident thatthe loan will be repaid Minksy also notes that tight monetary policy at the Federal Reserve willcontribute to rising interest rates, but is not necessary to produce the higher rates

The rising interest rates that accompany the expansion are pivotal to the Financial InstabilityHypothesis Rising interest rates put incredible pressure on a system that is already fragile Let usrecall that as the economy expands, so too does debt and the susceptibility of borrowers torefinancing difficulties At the same time, liquidity is falling In this fragile setting, rising interestrates can trigger the crisis

For Minksy, rising interest rates have three consequences First, debt obligations rise relative tocash receipts This is particularly true given the dependence on short-term debt Second, the value ofmost assets falls relative to liabilities to the extent that the assets are of a longer-term nature Finally,

as a result of the first two consequences, lenders alter their outlook and begin restricting lending Onthis final point, Minsky notes that lender expectations can change rather quickly so that there can be a

sudden cut-off of borrowed funds Collectively, the three consequences make it increasingly difficultfor borrowers to obtain credit in order to continue spending Further, investment projects that had, atthe beginning of the expansion, once appeared viable may no longer be seen in the same light, soplanned investment spending is cancelled As a result, productive investment spending in the economydeclines.

D Crisis appears

Rising interest rates reduce investment spending, which can lead to a financial crisis in the FinancialInstability Hypothesis The decline in investment spending reduces profits Falling profits, in turn,exacerbate the susceptibility of financial distress for borrowers If refinancing is not an option, andMinsky argues it often may not be, borrowers are forced to sell assets in order to raise cash and meetdebt payment obligations Of course, the rush to sell off assets leads to a sharp decline in asset prices.When borrowers are shut out of refinancing and assets prices fall quickly, Minsky indicates that thecrisis has arrived Indeed, when banks stop lending, Ponzi borrowers are in significant crisis modebecause they cannot meet even the interest payments on outstanding debt

While much of the Financial Instability Hypothesis surrounds the real sector expansion, Minskynotes that the crisis is not confined to nonfinancial borrowers but can also lead to a banking crisis.When speculative and Ponzi borrowers are unable to refinance and meet their debt obligations,bankers, and any other creditors, are left with a deteriorated balance sheet Their financial health canquickly deteriorate if they are unable to obtain additional funds themselves Moreover, as the crisisspreads across sectors, uncertainty and pessimism spread and reinforce the deterioration

As is evident, the Financial Instability Hypothesis is a crisis theory that is deeply embedded in thecycles of the financial sector of the economy The very nature of the expansion and the pervasive use

of debt to finance investment spending set the stage for creating a fragile environment Financialfragility can easily be disrupted, and a frequent cause of the disruption is rising interest rates.Because of the fragility of the financial sector, rising interest rates quickly lead to a reduction ininvestment spending and profits Unable to refinance, borrowers begin a panic of selling assets to try

to raise cash Crashing assets prices signal that the crisis has arrived

III The Austrian Business Cycle Theory

The second crisis theory contained within the business cycle comes from Roger W Garrison, anAustrian scholar.10 His interest in cycles and crises came about in something of an accidental fashion

Garrison found himself reading Failure of the “New Economics,” a book by Austrian scholar Henry

Hazlitt, which is critical of the Keynesian perspective.11 Thinking that it would be best to readKeynes so that he could understand the argument of Hazlitt, Garrison did just that Returning toHazlitt, Garrison followed references in this book which led him to Friedrich A Hayek and Ludwigvon Mises, two scholars synonymous with the Austrian school It was the conflicting vision of theKeynesian perspective, on the one hand, and the Austrian perspective, on the other, that propelledGarrison to devote much of his scholarly life to understanding cycles and crises in moderneconomies

As mentioned earlier, Garrison’s theory is a careful refinement of previous Austrian scholarship

His work remains true to the work of old-guard Austrians and specifically of Hayek and von Mises.Like Minsky, Garrison believes that his theory captures actual market developments and, morespecifically, believes that it, above other frameworks, best explains the most recent financial crisis.12

Since the Austrian perspective is less well known than the Keynesian influence in Minksy, moreattention is given here to the important elements of the Austrian school of thought The application ofthese elements in the crisis theory is examined in detail following the introduction of essentialelements

Prior to exploring the Austrian framework, it is important to clarify why Garrison’s theory belongs

in a book about theories of financial crises In Chapter 1, a distinction was made between the modeland theory failures in economics that have come to light with the recent financial crisis We shouldrecall that this book is concerned with understanding more about the possibility that theories offinancial crisis failed Given that the theory of financial crisis coming from the Austrian perspective

is known as the Austrian Business Cycle Theory, one might challenge its inclusion in this book Afterall, such a title suggests that it should more appropriately be placed within the model failureliterature Despite its name, this theory is, at its core, an understanding of how an economic expansionleads to a contraction or crisis Indeed, Garrison describes the Austrian theory as a “CreditExpansion Theory of the Unsustainable Boom.”13 It should be noted that central to this theory is theuse of credit and the role of monetary policy This makes it a financially driven theory that, within thecontext of a business cycle, may lead to crisis Not all expansions, even in Minsky, lead to crisis.However, with both Minsky and Garrison, conditions are created within the context of the businesscycle that make a financial crisis a possibility

A Essential ideas in Austrian thought

In an attempt to understand Garrison’s theory, it is important to have a working understanding of someessential ideas of the Austrian tradition While it is beyond the scope of this book to provide anexhaustive survey of this school of economic thought, it is necessary to understand several elements inorder to give meaning to the nuances of the Garrison theory.14

In contemporary economies, resources are vast and our ability to use them, substitute them, or alterthem in the production process is endless Nonetheless, the wants and needs of society outpace whatcurrent resources are able to produce This leads us the most fundamental problem of economics:how to use scarce resources to meet the needs and wants of society Inevitably, in a market economy,the answer is to employ the resources in their most valued use where the value of the resource isdetermined by how useful society determines the resource to be In this process, in a moderneconomy, resources are highly specialized Indeed, with the technological advancements at the end ofthe twentieth century and the early years of the twenty-first century, economies are increasinglyspecialized This specialization leads to an important idea of Austrian economics: knowledge ishighly dispersed.15 Each individual has a very limited knowledge base and as society becomesincreasingly specialized, the individual knowledge base shrinks There are fewer and fewer points ofcommon knowledge Further, contained in each knowledge base are expectations about the unknownfuture and about how others will behave So, knowledge, to the Austrian economist, is not onlylimited but also imperfect since it includes expectations that may or may not yield fruit

Austrian scholars take limited knowledge and make a further distinction between “orders” ofknowledge users.16 First-order users of knowledge know the cause(s) of change in economic data For

example, a first-order user recognizes the source of an increase in credit caused by expansionarymonetary policy Higher-order users, by contrast, do not have the direct knowledge; they see changes

in economic data such as prices or interest rates, but do not know the cause of the change Austriantheory is concerned with the quality of knowledge as it moves away from the first order Indeed,Austrian scholars see higher-order knowledge as containing a lower quality of information As will

be shown later in this section, this reduced quality of knowledge plays an important role in thedevelopment of a possible financial crisis

If individual knowledge is limited or imperfect, how does society communicate how it wantsresources used? How do resources get placed into their highest-valued use? The Austrian answer isthr ough trial and error in the market process In other words, individual consumers andentrepreneurial producers act with their imperfect and specialized knowledge in the market to signalthe value of resources The interaction of consumers and producers generate market prices However,prices, and other economic data such as interest rates, inflation, etc., are constantly changing andevolving as the imperfect knowledge of the participants evolves and changes; that is, the marketprocess reveals information as participants act, but their very action creates changes in knowledge,including expectations, which alters the market process

Of particular importance in the Austrian perspective is the role of the entrepreneur Theentrepreneur is constantly seeking new opportunities for profit and this relentless quest leads toaltered expectations and, consequently, to new opportunities and necessarily to new knowledge This

is why the Austrian scholars envision markets as a process and not as an equilibrium It is a dynamicand fluid relationship in which knowledge continues to evolve, along with entrepreneurialexpectations, and information (i.e prices) in the market process as entrepreneurs chase new profitopportunities

Because markets are seen as a process and not as an equilibrium, the Austrian perspectivenecessarily includes the element of time All expectations concern the uncertain future Theentrepreneur, operating with a set of expectations, invests funds today to acquire the capital necessaryfor future production Those projects with the highest anticipated future returns attract resourcestoday Costs and future prices are expected When the production process creates value in excess ofthe capital expenditure, the entrepreneur earns income The element of time is important to theconsumer as well Both entrepreneurs and consumers are constantly revising their expectations aboutthe future because of persistent changes in market conditions Thus, decisions about consumption orsavings are continuously up for re-evaluation, as are entrepreneurial decisions in the Austrianframework

Related to time, in Austrian thought, is interest rates Consumers value final goods and servicesmore today than in the future Because of this, interest rates reflect the ratio of the value of presentgoods to the value of future goods; that is, the consumer must be compensated for waiting for a goodand the uncertainty that necessarily characterizes that wait The compensation is interest rates onsavings To finance future consumption, the consumer must save today An adjustment in savingsbehavior alters interest rates When preferences and expectations change so that a greater valuation isplaced on present goods, interest rates will increase Similarly, if preferences change to value futuregoods over present goods, interest rates fall Fluctuating interest rates impact the entrepreneurbecause interest rates are the price of credit used for investment spending Higher interest ratesdiscourage investment spending because of higher credit costs The higher interest rates, caused by

lower savings, are a signal to entrepreneurs that consumers place greater value on the currentconsumption of goods and services, and so there is not a need for additional investment.

These elements – specialized knowledge, the market as a process, entrepreneurial expectations,uncertainty, time, and interest rates – are fundamental to the Austrian perspective generally As will

be shown below, they are also necessary to understanding Garrison’s crisis theory

B The framework for possible crises

Garrison constructs a three-part framework as the foundation of his Austrian Business Cycle Theory.First, he relies on the market for loanable funds to illustrate the relationship between savings andinvestment spending which establish the market interest rates mentioned above The supply ofloanable funds comes from the savers who depend on their preferences for consumption now orwillingness to delay for future consumption The demand for loanable funds comes from theentrepreneurs who will need to borrow to carry out investment spending in order to produce the finalgoods and services The market interest rate, also called the natural rate in Austrian thought, provides

a signal to entrepreneurs; this is the amount of investment that will not interfere with preferences forcurrent consumption The loanable funds framework is illustrated in graph (c) of Figure 2.2

The second element in Garrison’s framework is the production possibilities frontier, whichestablishes the trade-off between intertemporal decisions for present consumption and present capitalinvestment This is shown as graph (b) in Figure 2.2 The extent to which an economy grows reflectsthe extent to which choices are made to devote more resources to capital goods In this framework,capital expenditures account for both spending on new capital and replacement for any depreciation.This means that on the frontier, total capital investments offset any depreciation, so the economy is notgrowing An important characteristic that distinguishes the Austrian school from others is its mandatethat capital be recognized as heterogeneous Heterogeneous capital is related through differentdegrees of complementarity and substitutability This means that entrepreneurs employ resources andmachines, equipment and other capital for specific purposes Trying to employ the capital foralternative uses comes at a price Combining this capital in different ways allows for the production

of consumer goods at varying future dates How capital is used in the production process is addressed

in the third element of the Garrison model

Figure 2.2 The Garrison framework

The third, and final, fundamental element is the intertemporal structure of production or, to useGarrison’s term, the Hayekian triangle This triangle illustrates the many stages of production that agood must pass through before becoming a final good Capital, in this framework, is a sequence ofstages of production Each stage takes time As illustrated in graph (a) in Figure 2.2, the horizontal leg

of the triangle represents production time The element of time enters horizontally in two ways: first,

it indicates goods moving through the production process; and, second, it represents the separatestages of the production process The vertical leg captures the value of the final good or service thatemerges from the production process It is vertical to capture the notion that, unlike production,consumption takes no time.17 The slope illustrates that one must wait longer, i.e the productionprocess is longer, for higher-end final goods

Garrison relies heavily on the essential ideas of the Austrian school outlined in the previoussection to tie together these three elements in the coherent theory Figure 2.2 puts all threefundamental elements together to illustrate the upper turning points of a business cycle expansion.Like Minsky, Garrison’s theory holds that it is at this point that the economy is vulnerable to a crisis

In what follows, the essential ideas are tied into the three-prong framework to illustrate the AustrianBusiness Cycle Theory It should be noted that at the heart of the matter is that consumer timepreferences determine the natural interest rate (in the loanable funds market) and also influence theprofitability of production plans through interest rate variability Changes in consumer expectationsand preferences, which are always uncertain because of variability in the market process, can alterinterest rates Changes in interest rates, in turn, change the signal sent to entrepreneurs regarding theprice of capital For example, if consumers alter preferences for goods today, interest rates will rise(via a decrease in the supply for loanable funds), sending a signal to entrepreneurs that they shouldinvest more in present consumer goods and less in future goods This can easily be seen in Figure 2.2.Notice that, at this point, there is a shift in the composition of consumer and investment goods, but not

an unstable expansion or crisis Indeed, in the Garrison model, a boom or crisis requires an artificialinjection of funds from the central bank

C Artificial booms

For Garrison, economic booms are really “artificial booms” in which money enters the economyexogenously from central banks To return to the Garrison framework, monetary policy sends thewrong signal to the entrepreneur regarding intertemporal consumer preferences by altering interestrates even though there has not been a change in consumer preferences for consumption today relative

to consumption in the future For example, expansionary monetary policy increases the supply ofloanable funds and, in the process, reduces the interest rate below the natural rate This increases thereserves of the banking system, so banks are able to extend more loans even though there is noincrease in savings The lower interest rates that result from monetary policy signal that consumersare willing to wait for the production of longer-term consumption goods However, consumerscontinue to demand as they did prior to monetary policy changes because their preferences have notchanged Figure 2.3 illustrates this increase in the money supply (i.e the supply of loanable funds)

As above, this signals to the entrepreneur that he or she should invest in lengthening his or herproduction and substitute current consumption for more future consumption This credit expansion

leads to an inflationary misallocation of resources that cannot be sustained.

Figure 2.3 illustrates within the Garrison framework how a crisis may develop Monetary policyinjects funds into the economy, causing the supply of loanable funds to increase (S2) This causes theinterest rate to fall to i2, which is below the natural interest rate We should recall that the naturalrate, in Austrian thought, is the rate that would prevail in the absence of the policy-induced change (i1

i n Figure 2.3) The lower interest rates cause a divergence between savings and investments;investments increase to I2, while savings decrease to S2 Consumption is the other side of the savingscoin, so the situation is now one of increased consumption spending and capital spending At the sametime, the higher-order knowledge users are not aware that the new credit was not from savings butfrom central bank policy Only first-order knowledge users have this information This means thatthere are two sets of entrepreneurs acting on the lower interest rates: a first set that knows the source

of the credit and a second that does not

From the loanable funds in graph (c) in Figure 2.3, we trace I2 up to graph (b) and the productionpossibilities frontier to show the over-investment that results from the lower interest rate Notice thatthis is also shown in the Hayekian triangle in graph (a) The slope of the triangle is altered initially infavor of early-stage investment In other words, the conflict of more investment and moreconsumption as shown as I2 and C2 in graph (b) leads to a reallocation of resources to early stages ofproduction because cheap credit means investors favor longer-term investment projects The steeperslope illustrates that resources have been bid away from the intermediate and late stages ofproduction

Figure 2.3 Monetary policy in the Garrison framework

Notice the fundamental tension: both investment and consumption spending are increased as aresult of the policy-induced low interest rates There is both over-investment and over-consumptioninitially This comprises the solid new slopes of the Hayekian triangle Increased competition for

these resources bids up their prices Higher resource prices lead to higher prices for final goods andservices, which creates inflation Also contributing to inflationary pressures is the over-consumption

of consumers Lower interest rates discourage savings, which means an increase in consumption andthus higher-priced final goods and services

The broken line in graph (a) of Figure 2.3 indicates investment that is not, ultimately, feasiblebecause the boom is not sustainable The higher demand for resources to fund capital investmentscoupled with higher demand for consumption goods cannot last Indeed, the tension betweenconsumption and investment spending results in increasingly scarce resources Since credit is utilized

to finance much of the investment spending, demands for credit put pressure on interest rates to rise(not shown here, but this is an increase in the demand for loanable funds) Entrepreneurialexpectations begin to change as resources become scarcer and the price of credit increases Changingexpectations force entrepreneurs to re-evaluate their investment plans, particularly those in the laterstages of the production process Most frequently, this investment is now too expensive in light of thechanging economic conditions and so is abandoned (the broken line in graph (a) of Figure 2.3).Capital investment spending falls Further, investment that had previously appeared profitable isactually not profitable Insolvencies and bankruptcies in the real sector become numerous The boomturns into a bust

At this point in the Garrison theory, it appears to simply be a model of the business cycle.However, Garrison indicates that the trouble in the real sector translates into trouble in the financialsector as well The connection between the boom in the real sector and the financial sector is mademore concrete by returning to the taxonomy of ordered knowledge users More specifically, the creditexpansion from the central bank creates profit opportunities that had not existed prior to the policychange Indeed, the business of watching, forecasting, and speculating in the financial sector becomesprofitable Entrepreneurs shift their focus from consumer demands in the real sector (the stages ofproduction in the Hayakian triangle) to focus on the financial sector As this shift takes place, priceswill rise in the financial sector because more resources are increasingly being devoted to it The realsector boom spreads to the financial sector However, higher-order knowledge users do not know thatthe boom is fragile because they do not know why the shift has occurred First-order knowledgeusers, in contrast, do know that the boom is fragile and, at some point, they will stop investing in bothsectors and will ultimately start selling off assets They know to sell off assets because they areaware that the lower interest rates and resulting inflation in both real and financial assets cannot last;there is too much early-stage production, too much demand for consumer goods, and too much capital

in the financial sector Policy-induced interest rates have led the market process down a fragile paththat is unsustainable

As first-order knowledge users begin the process of liquidating assets and exiting both real andfinancial markets, prices in both sectors begin to fall, and along with falling prices come fallingprofit Higher-order entrepreneurs, who were often late to enter the financial sector, are typically thefirst to experience losses since they entered when prices were already rising Real sectorinsolvencies and bankruptcies mean that bank loans are not repaid Banks are now holdingnonperforming loans Nonperforming loans as well as defaults impinge upon bank capital, makingbanks increasingly unstable and vulnerable to failure Further, deterioration in the real sector causesbanks to re-evaluate lending policies The credit expansion comes to an end Once the creditexpansion ends, the boom necessarily ends For Garrison, there is a distinction between a boom and a

bubble A “bubble” to Garrison is an artificial boom run amok; the most intense artificial boom Thistypically comes from an extended period of credit expansion A financial crisis may follow a bubble.

Figure 2.4 is the author’s visual interpretation of Garrison’s theory and is meant to put this theoryinto a similar taxonomy as Minsky in Figure 2.1 It is important to interpret Figure 2.4 within itsproper context The Garrison theory is not a linear story as there are feedback loops that occur.Further, Garrison does not stress a particular ordering that is suggested in this figure Indeed, thisfigure is simply an attempt to help the reader understand the general ideas behind Garrison’s crisestheory It illustrates that monetary policy is the proximate cause of financial crises Policy forcesinterest rates below the natural rate Entrepreneurs behave as though consumers have changed theirtime preferences even though they have not.18 The lower interest rates are the product of monetarypolicy, not a desire to save more and spend less today Indeed, consumers continue to want toconsume today while entrepreneurs are investing more for future goods This, in the Austrian view,cannot last The devotion of resources to investment spending becomes inappropriate in light of thedesire for goods today Further, as more resources are devoted to investment, prices, including theprice for credit, increase This means that those planned investment projects in the later stages of aboom become too expensive and are not undertaken Further, investments that had appeared profitablebecome unprofitable Investment spending necessarily falls and bankruptcies follow

IV Speculative Investment

The third theory of financial crises surveyed is the work of Charles Poor Kindleberger.19 Born andraised in the northeast of the US, Kindleberger spent 33 years teaching at the Massachusetts Institute

of Technology (MIT) Early in his career, his research focused on international trade, before moving

on to growth economics and, finally, to financial history At the end of his career, he consideredhimself to be an historical economist and, as illustrated in this section, this is reflected in his theory

of financial crises.20 Much like Minsky, his understanding of financial crises was developed, in part,just as the US financial sector was experiencing increasing turmoil Specifically, the book that

outlines his crisis theory, Manias, Panics, and Crashes, was published in its first edition in 1978,

which coincided with a period of large bank failures, scandals in commodities markets, and marketspeculation in the US Despite this timing, his theory is first and foremost an historical account offinancial crises across the world He carefully considered crises deep into global history andconnected patterns across these experiences to develop his own theory His writings are rich withhistorical examples and anecdotes of behavior and experiences that corroborate his theory

Figure 2.4 Taxonomy of Garrison’s Austrian Business Cycle Theory

Prior to explaining Kindleberger’s theory of financial crises, a few words must be said about theexact nature of his theory Both Minsky’s and Garrison’s theories are clearly crisis theories within thecontext of a business cycle; both begin with expansion and follow through to the bust and crises Atfirst blush, it also appears that Kindleberger’s is a cyclical theory:

The thesis of this book is that the cycle of manias and panics results from the procyclicalchanges in the supply of credit: the credit supply increases relatively rapidly in good times, andthen when economic growth slackens, the rate of growth of credit has often declined sharply.21

And:

Virtually every mania is associated with a robust economic expansion, but only a fewexpansions are associated with a mania Still the association between manias and economicexpansions is sufficiently frequent and sufficiently uniform to merit renewed study.22

Certainly, these quotes suggest a cyclical theory However, I have classified Kindleberger as anoncyclical theorist of financial crisis This is because he suggests that crises, while usually withinthe context of an expansion, need not be within the cycle framework There are many historicalinstances of crises outside an expansion For example, a crisis may begin with foreign exchange orcommodities speculation or the outbreak of a war, which may or may not be during an expansion.Further, Kindleberger argues that bubbles can be sector-specific and may or may not spread to thewider economy If they do not spread, even if the wider economy is in a business cycle expansion, thebubble and crises are not a part of the cycle and are only contained within a smaller portion of theeconomy Finally, Kindleberger himself admits that his theory is not a model of the business cycle

because he does not focus on the entire cycle, but, rather, on the upswing and initial downswingonly.23 For these reasons, Kindleberger is classified here as a noncyclical theorist of financialcrises.24 In the end, this classification has no bearing on the analysis; rather, it is simply aclassification to help the reader mentally organize these theories relative to one another.

Kindleberger advances five critical elements to a financial crisis: speculation; monetaryexpansion; rising asset prices; a sharp decline in asset prices; and a rush to liquidity.25 These criticalelements, in turn, can be understood in the four phases of the Kindleberger model: 1) displacement; 2)euphoria; 3) overtrading or mania; and 4) revulsion In other words, Kindleberger outlines fourphases that the economy experiences during a crisis period Moving from phase to phase, the criticalelements are all in place This is made clear below as each phase of the crisis is outlined, and can beseen in Figure 2.5 This illustrates the Kindleberger theory of financial crises, often called theSpeculative Investment Theory

A Displacement

The crisis theory begins with some exogenous, positive shock to the economy This is called thedisplacement phase of the Kindleberger model The importance of the shock is that it serves totransform expectations and the economic outlook Optimism soars, profit expectations are brighterthan they have been, and both consumers and investors are eager to be a part of something new andprofound

The nature of the shock can, and does, vary Kindleberger’s extensive historical accounts offinancial crises reveal a wide range of events that have initiated the displacement phase of a crisis.Shocks may be caused by war, technological advancements, financial innovations, importantinventions that alter economic life (e.g railroads), changes in monetary policy, natural disasters thatsignificantly alter crop yields, etc Several US financial crises serve as examples of the variation inthe nature of these important shocks.26 The first financial crisis in the US occurred in 1792 when theFirst Bank of the United States over-injected money early in the year only to reverse its policy soonafterwards Later, the 1857 crisis started with rising land prices in Kansas that ultimately spread east.Three years later, an impressive harvest coupled with a poor harvest in Europe sparked greatoptimism and growth, only to lead to another crisis The increase in auto production and use in the1920s was sparked by new production technology A more contemporary example, with which weare all familiar, is the technology shock of the 1990s

The shock, for Kindleberger, changes the outlook of investors in at least one sector of the economy.Opportunities for profit improve and more investors are eager to get on board Sectors of theeconomy expand and the expansion may spread more generally To finance the expansion, investorsrely on credit Here, Kindleberger follows Minsky closely; the economic expansion is fuelled by anexpansion of credit Investors are willing to take on more debt because of their optimism As theexpansion continues, prices rise as resource capacity cannot meet demand Higher prices in turnattract more investment, which requires more borrowing

At the same time, banks are increasingly willing to extend credit For Kindleberger, banks areafraid of losing market share in the expanding economy and so they are willing to expand creditquickly He also suggests that they will make every effort to participate in the expansion Indeed,Kindleberger envisions bankers creatively finding ways around regulation or becoming engaged infinancial innovation in order to meet credit demands during the displacement phase For example, in

the 1970s, when bankers could not attract deposits, they created new deposit accounts to avoidregulatory constraints The new deposits allowed the bankers to meet loan demands from producersand investors Thus, in the displacement phase, a shock occurs that changes the economic outlook infundamental ways Investors begin to act on that optimism and banks oblige the new demands forcredit.

B Euphoria

In the second phase, euphoria, Kindleberger distinguishes between two stages of investmentdecisions In the sober stage, investment decisions reflect expected returns on a project Theinvestments that took place in the euphoria phase of the crisis are of this type In the second stage,capital gains matter to the investor and the investor hopes to profit from higher asset prices.Kindleberger offers many historical examples One is in historical Vienna, in which building siteswere initially used for construction but were later used for speculative resale.27 Much of the capitalgains spending takes place in the next phase of the crisis theory: mania

There are two types of investors, or, to use Kindleberger’s term, speculators According toKindleberger, there are insiders and outsiders Insiders have more information than outsiders and so,generally, act differently from the outsiders Insiders are those who drive up asset prices and, in theprocess, embellish the upswing and downswing in asset prices Outsiders buy from the insiders whenprices are high and so Kindleberger sees the outsiders as the victims of euphoria

Figure 2.5 Taxonomy of Kindleberger’s Speculative Investment Theory

C Mania

The mania phase is the development of the second type of investment spending Investment or

speculation is now about cashing in on rising asset prices and no longer about the initial use of theinvestment or commodity To return to the earlier example, rising land prices in Kansas were initiallyabout having fertile land for farming, but turned into overtrading when land purchases were no longerabout crop yield but, rather, about buying land to sell later at a higher price.

This phase is characterized by further optimism and expansion Further, the psychology ofspeculators changes so that no one wants to be left behind:

A follow-the-leader process develops as firms and households see that others are profiting fromspeculative purchases “There is nothing as disturbing to one’s well-being and judgement as tosee a friend get rich.” Unless it is to see a nonfriend get rich.28

At the same time, banks continue to want to keep pace Access to credit increases even faster than inearlier phases Further, the demand for credit is even higher as those who were not investing duringthe first two phases now jump in Kindleberger insists that mania “gather[s] speed” as increasing

innovation, the expansion of money is endogenous in this theoretical framework

Kindleberger is deliberate in his use of the term “mania” since it reflects irrationality He arguesthat while market participants may believe that they are acting rationally, there are occasions whentheir collective behavior may be irrational He offers a number of ways this may occur One is mobpsychology, where all market participants change their views at essentially the same time Anotherpossibility is when different individuals change their views at different stages Perhaps initialdecisions are rational but become less so over time A third possibility is that different groupspossess different degrees of rationality For example, stock traders may give way to frenzied trading

as prices rise Kindleberger argues, in the end, that in most instances rationality prevails, butoccasionally the behavior of the wider group may be irrational

D Revulsion

In the final phase of this theory of financial crisis, the optimism that fueled earlier phases has run itscourse and is replaced with intense pessimism Kindleberger refers to this as revulsion and it followsthe mania Buyers become less eager to be a part of something that was once great but is now nolonger so Sellers begin to outnumber buyers Awareness emerges among a considerable number ofinvestors that the time has come to liquidate; prices have reached their peak and now is the time toexit There is an intense demand for liquidity and a selling of assets Of course, this leads to a steadyfall in asset prices Some investors hold on, thinking that this is just a temporary correction and thatprices will recover However, as prices continue to fall, there is an increasing desire to sell, whichfurther depresses prices This change from optimism to caution, or pessimism, creates instability incredit markets because some borrowers realize that they have borrowed too much They start toreduce spending to pay off debt Lenders also feel the momentum change and recognize that their loanportfolio may be too risky They become unwilling to extend new loans and may even try to call inexisting loans Both the supply and demand for credit falls This leads to higher interest rates in mostmarkets

Kindleberger posits a signal that alerts all investors to the fact that the crisis has arrived This may

be a failure of a large firm or bank, a sharp fall in security prices, or the revelation of fraud or a

swindle by an investor Following the signal, selling becomes more intense, prices fall, andbankruptcies increase Banks either stop or significantly pull back on new credit At this point, apanic may occur and the bubble has certainly burst The panic, or crisis, continues until prices havedeclined far enough that investors are once again willing to buy rather than sell.

V Asymmetric Information

The fourth, and final, crisis theory presented here is the Asymmetric Information perspective ofFrederic S Mishkin Mishkin, like Kindleberger, grew up and attended school in the east of the US.With his Ph.D from MIT, he has held several important posts within academia and other institutions.Among other positions, he was on the Board of Governors at the Federal Reserve, a senior fellow atthe Federal Deposit Insurance Corporation’s Center for Banking Research, and is currently aprofessor at Columbia University His theory of financial crisis stems from a synthesis of work onasymmetrical information and financial instability Interest in applying asymmetric informationconcepts to the financial sector took hold in the 1970s and 1980s with a significant expansion of theliterature.30 Mishkin is a part of that movement and his primary contribution has been to take theasymmetric information perspective and create a comprehensive theory of financial crisis Mishkin,unlike the first three theorists, offers his own taxonomy of US financial crisis Here, in Figure 2.6, hisfigure is modified slightly and offered to help the reader visualize how a crisis may developmentwithin the Mishkin framework.31

A Problems and solutions of asymmetric information

Efficiency in financial markets results when the funds from savers are channeled to those withproductive investment opportunities.32 If a financial system is not efficient and this channel is notopen, macroeconomic growth will be compromised Consequently, the overall health of an economy

is at risk when the financial sector is underperforming According to Mishkin, one important reasonwhy financial sector efficiency may fail is as a result of asymmetric information and the problems thatarise from the asymmetries Indeed, for Mishkin, this is the primary reason not only for inefficienciesbut also for financial crises

Asymmetric information is the situation in which parties have unequal information One partyknows more than the other when trying to engage in a market exchange For example, borrowersseeking loans generally have more information than lenders about the possible risks and returns fromthe loan Even though the lender can, and does, gather information about the potential borrower tohelp even out the information gap, in the end the borrower still has more information As is shown byMishkin, this information inequality can keep funds from flowing efficiently because of two problemsthat result – adverse selection and moral hazard – which may interfere with the efficient channeling offunds in a financial system

Adverse selection is an asymmetric information problem that occurs prior to a market transaction

In financial markets, a typical example is the scenario in which those most likely to produce anundesirable outcome are the ones most likely to seek a loan and, consequently, are most likely to beselected An individual with big but risky plans is more likely to seek a loan than a moreconservative, low-risk individual The risky borrower does not worry as much about repayment as

the low-risk individual Lenders recognize this problem and so may be reluctant, or unwilling, tolend, even though some borrowers represent acceptable credit risks.

Figure 2.6 Taxonomy of Mishkin’s Asymmetric Information Theory

In contrast, moral hazard is an asymmetric information problem that occurs after a markettransaction In this case, there exists a risk to the lender that the borrower will engage in suspectbehavior, thereby reducing the probability that the loan will be repaid With moral hazard, there is anincentive for the borrower to take risks because the lender will suffer the majority of the loss if therisk does not pay off Just as with adverse selection, the lender knows of the moral hazard probabilityand, as a result, may restrict lending to less than efficient levels

Mishkin argues that financial institutions are often able to minimize, but not eliminate, asymmetricinformation problems More specifically, when financial institutions make private loans, they are able

to reduce moral hazard and adverse selection One solution to adverse selection is the private sale ofinformation regarding the borrower When a firm wants to borrow, it can often sell bonds Ratingagencies analyze the firm’s balance sheets, history, and investment activities, and grade the firm Thisinformation can reduce adverse selection Audits, accounting standards, and information disclosurerequirements from the Securities and Exchange Commission can also reduce adverse selection.Further, borrowers with collateral or high net worth can reduce adverse selection because something

is at risk for the borrower If the borrower defaults on the loan, the lender can recoup some of thelosses from either the collateral or the net worth

Mishkin offers solutions to moral hazard as well In equity markets, moral hazard problems arealso known as the principal-agent problem With equity, management owns a small fraction of thefirm; it is the shareholders who own the majority of the stock Yet, the vast majority of theshareholders have nothing to do with operating the firm Thus, there is a separation of ownership and

operational control Often, the incentives facing management are different from those facing theshareholders Shareholders want profits maximized Management may want to maximize sales with noregard to costs Worse, management may be tempted to steal or perpetrate fraud In both cases, themoral hazard problem arises Solutions may include monitoring management or the use of financialinstitutions such as the venture capital firm In a venture capital firm, owners are also a part of themanagement team, which can reduce moral hazard.

Moral hazard also characterizes debt contracts such as bonds and loans Since debt contractsrequire the borrower to repay the contracted amount but keep all the profits, this is an incentive forborrowers to behave in a riskier way than lenders may desire One solution is to require collateraland net worth to properly incentivize borrowers not to behave with excess risk Another possibility is

to include restrictive covenants in the contract which stipulate acceptable or unacceptable behavior.Certainly, this requires both monitoring and enforcement, but could discourage undesirable behavior.Banks make private loans with restrictive covenants and are able to reduce moral hazard

Mishkin sees asymmetric information problems as a blockage in the flow of funds from savers toborrowers In other words, when asymmetric information is minimized, the financial sector operatesefficiently However, financial instability and the possibility of crisis occur when a shockexacerbates asymmetric information and the channeling of funds is interrupted Mishkin’s theory offinancial crisis begins with the understanding that asymmetric information can seriously disrupt thechanneling of funds in the financial sector for productive uses in the real sector Developments whichexacerbate asymmetric information “clog” the channel and create conditions for instability and crisis

B Stage one: factors causing financial instability

For Mishkin, there are four fundamental factors which can lead to financial instability The first ishigher interest rates (see Figure 2.6) Higher interest rates make adverse selection worse becausewhen borrowing costs rise, those less likely to default are no longer willing to take out loans.However, a bad credit risk is still willing to borrow, so the pool of borrowers in an environment ofhigher interest rates is disproportionately high risk This may lead to credit rationing, where lenderscannot distinguish between the few good and many bad risks in the credit pool Often, according toMishkin, the response of the lender is to reduce the number of loans Higher interest rates exacerbateadverse selection and with a reduction in lending, economic activity may decline Mishkin argues thateven a small increase in interest rates can lead to a large decrease in lending and a possible collapse

in the loan market.33

A second factor which may lead to financial instability in the Mishkin theory is an increase inuncertainty in financial markets This may result from a failure of a large firm, such as Bear Stearns orLehman Brothers, a stock market crash, a political election or instability, or a recession Increaseduncertainty makes reliable information more scarce and so both moral hazard and adverse selectionincrease In this environment, it is harder for lenders to screen out the bad credit risks, making themless willing to lend Like the higher interest rates, this leads to a decline in lending and economicactivity

The deterioration in financial institutions’ balance sheets marks the third possible factor ininitiating a financial crisis For Mishkin, innovation and financial liberalization may lead to a decline

in the balance sheet Financial liberalization occurs when primary restrictions on financial institutionsare reduced and banks respond by increasing their risk The introduction of major innovations, such

as subprime residential mortgages, can also adversely impact the balance sheet Mishkinacknowledges that there are important, long-term benefits to innovation, but is concerned that if theyare not properly managed, they can lead bankers to take on additional risk in the short term.Innovations or liberalizations, according to Mishkin, are typically followed by a credit boom with arapid pace of credit expansion The credit expansion, combined with increased risk taking, cannotlast At some point, loan losses appear and the asset side of the balance sheet begins to deteriorate.Lower loan values drive down the net worth or capital of the institution With lower capital, banksneed to cut back on lending, a process called deleveraging Further, lower capital can lead banks andother financial intermediaries to take on additional risk Thus, there are fewer but perhaps riskierloans being made With banks no longer lending, asymmetric information problems in the market arenot addressed and, as a result, accumulate and are made worse.

The fourth and final factor that may initiate a crisis in the Mishkin theory is the boom and bust inasset prices Mishkin argues that this is the most critical factor in initiating a financial crisis because

it can create the most severe asymmetric information problems Here, the value of an asset, be it inthe stock market, the energy sector, the technology sector, the real estate sector, etc., is driven upabove economic values by investor psychology Often, these asset bubbles are financed by credit.When large increases in credit are used to purchase these assets, their prices increase significantly.When the bubble bursts, the declining asset price leads to a decline in net worth which, in turn, makesasymmetric information problems worse With rising asymmetric information problems, banks andother institutions rein in lending Further, as shown in the discussion of the third factor, the bursting of

an asset bubble can also harm the balance sheet at the bank when the quality of the loan deteriorates.Taken together, the four factors account for the first stage of the Mishkin theory (see Figure 2.6) Inthe first stage, conditions are set for the financial crisis as the factors exacerbate asymmetricinformation, which, in turn, interrupts the flow of funds from the financial sector to the real sectorwhere profitable investment takes place

C Stage two: banking crisis

In Mishkin’s second stage of crisis, both bank and business conditions have declined since stage one.There is uncertainty about the ability of the bank to bounce back from the crisis, which changes thebehavior of depositors When depositors become concerned about the viability of their bank, thenatural reaction is to pull out deposits and either hold on to them for a period or redeposit them in adifferent bank Mishkin argues that when depositors begin removing their funds, a bank panic mayresult A reduction in the number of reliable banks, in turn, makes asymmetric information problemsworse, since it was the banks that were functioning to reduce the asymmetric problems initially Thisstage becomes one of sorting out insolvent from healthy banks Once this information is determined,Mishkin argues that uncertainty in financial markets declines and the crisis subsides In other words,the crisis may resolve itself in the second stage

D Stage three: debt deflation

However, it is also possible that the bank crisis from stage two may develop into a third stage ofcrisis: debt deflation If the decline in prices is sharp, the recovery from sorting out strong from weakbanks in stage two may not be enough A sharp decline in price levels leads to a further deterioration

in net worth because of increased indebtedness When this happens, asymmetric information problems

are made much more severe, so that lending by financial institutions falls off significantly and, in theprocess, so does possibly productive investment spending Sharp debt deflation takes a long time torecover from and this, for Mishkin, is the exception and not the rule The Great Depression is anexample of a financial crisis that included stage three of his theory, while most crises are resolved instage two.

VI Summary of the theories

In this chapter, four relevant theories of financial crises are presented As is clear, there is overlapbetween some of these theories as well as unique perspectives The first two, the Financial InstabilityHypothesis of Minsky and the Austrian Business Cycle Theory of Garrison, take place within thebusiness cycle They both begin at the peak of the cycle and cover how a financial crisis brings aboutthe downturn Kindleberger recognized the cyclical nature of crises but also contends that the crisisneed not permeate an entire economy and that many crises, particularly those abroad, are not a part ofthe business cycle Mishkin focuses on situations when asymmetric information problems areexacerbated and conditions that may or may not be within the context of the business cycle Thisbusiness cycle distinction is used in this chapter to organize the four theories The next chapter offers

a comprehensive analysis of the four theories relative to one another