Financial crises and economic theory

Pre-Keynesian models of financial crisis

Since the 19th century, economists have developed models to try to explain economic crises. John Steward Mill and Karl Marx, among others, advanced different explanations of these phenomena.

Mill asserted that there are recurring periods of “over-trading” and “harsh speculation” followed by periods when establishments are shut up and people are deprived of their incomes.

According to Marx, crises are the result of the contradiction between the tendency of the rate of profit to fall and the impetus to accumulate capital. Production accelerates to compensate for the decline in the rate of profit; this finally results in overproduction of commodities and the beginning of crisis.

However, financial crises as we know today are essentially a 20th century' phenomenon. For this reason, it is perhaps Wicksell the first economist who should be mentioned in connection with the subject of financial crises. In the Wicksellian approach, dynamic economic processes are explained by the interaction of two rates of return, which typically diverge. One is the money interest rate and the other one the natural rate of return which is determined in the real sphere. Whenever banks have an excess of reserves, they will decrease the nominal rate of interest to increase their loans. As soon as the money interest rate is lower than the natural interest rate, a cumulative investment process is triggered; the economy will come into a situation of overheating. A money interest rate below the natural interest rate, however, is a disequilibrium phenomenon, signaling to would-be investors a greater willingness than in fact exists on the part of agents in general to sacrifice current consumption for the sake of increasing it later. The money that banks create as they make loans enables those who borrow from them to outbid others for resources, forcing saving upon them. Finally, the money interest rate rises to its natural level and the imbalance thus created is revealed along with an inability on the part of borrowers to service their debts. A financial crisis marks the end of a period of forced saving brought about by credit creation. A reverse rush for liquidity starts; if the money interest rate rises above the natural interest rate a deflationary contraction process may result. In such a case, a sharp contraction will lead to systemic problems in the financial system.

Wicksell’s monetary model of cumulative inflationary and deflationary phases was taken over by several economists during the last century', among them Schumpeter, Hayek, Fisher and, to a certain extent, Keynes.

Although a generation apart and representing different strands, both Schumpeter and Hayek were part of the Austrian tradition. They share a common Wick-sellian heritage although their respective accounts of the dynamic economic processes are rather distinct analytical extensions of the original Wicksellian cumulative process.

For Schumpeter, the origin of business cycles lies in discontinuous changes arising from innovations. An increased activity in the investment goods sector pushed by a spurt of innovations triggers the upswing. Banks create credit to finance entrepreneurial ventures that introduce new products or new processes that increase productivity. Once the gestation period for the new goods has come to an end, the economy adjusts downwards to a new equilibrium position, eliminating some older firms.

Following Schumpeter’s terminology, in the “primary wave” there are only two phases: prosperity and recession. However, there may be secondary effects which reinforce the primary process. Owing to these secondary' effects, the economic process may overshoot the new equilibrium position at the end of a period of prosperity. In the same way, recession may deteriorate into depression.

For Hayek (2012 [1929], 2012 [1931]) the credit volume given by' banks does not necessarily' reflect the volume of savings. If credit demand increases for investment, for whatever reason, credit will expand independently of the volume of savings; the credit system is elastic. However, sooner or later a credit expansion will come to an end. During the following contraction the artificially increased capital stock will be destroyed. A financial crisis will restore equilibrium. As we can see, in Hayek’s model banks start the cycle, whereas for Schumpeter the prime mover is entrepreneurial action. That is why' Hayek criticizes Schumpeter for discarding “the monetary' causes which start the cyclical fluctuations” (Hayek, 1966: 17).

Irving Fisher developed a monetary theory' of economic fluctuations including a debt-deflation model of depressions aimed at explaining the Great Depression. Over-optimistic expectations lead to periods of expansion including asset price bubbles. Easy money stimulates over-indebtedness. Herding and speculative behavior trigger asset price inflations, which are usually combined with huge credit expansion. When the asset price inflation comes to an end an asset price deflation follows. Non-performing loans start to grow. Distress selling of assets in order to service debt leads to sharply falling asset prices. Firms with non-performing loans try' to sell everything in an attempt to survive. The combination of goods market deflation and high debt leads to an increase of the real debt burden by all debtors in the domestic currency. “Deflation caused by the debt reacts on the debt. Each dollar of debt still unpaid becomes a bigger dollar” (Fisher, 1933: 344). Economic downturns may lead to a cumulative breakdown of the financial system. Attempts to liquidate debt in the context of over-indebtedness are self-defeating. “Then we have the great paradox which, I submit, is the chief secret of most, if not all, great depressions: The more the debtors pay, the more they owe” (Fisher, 1933: 344).

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