Kindleberger's model and the international dimension

Minsky's work provides the basic framework for the Kindleberger (1978) analysis of historical financial crises. He notes that some crises have a minor economic impact but concentrates on crises of major size and effect, normally with an international scope. He regards speculative excesses, or bubbles, as irrational events or manias which are followed by revulsion from the excesses and a crisis, crash or panic which can be shown to be common, if not inevitable. He notes that by no means does every upswing lead to a mania or panic but that the pattern occurs with sufficient frequency and conformity to merit renewed study. Initially some event changes the economic outlook. New opportunities for profit are seized and overdone in ways so resembling irrationality as to constitute mania. In the manic phase people of wealth and credit switch out of money or borrow to buy real or illiquid financial and capital assets. In the panic phase the reverse takes place, and the excessive characteristics of the upswing are realised.

In Kindleberger (1978), the background to speculation and crisis is discussed in terms of the classical ideas of overtrading followed by revulsion and discredit. He acknowledges Minsky as the most recent exponent of such ideas and feels that even if it did not apply to the United States at the time, the FIH provides a useful framework for analysing past crises. Kindleberger's model of crises (1978, Ch. 2) is based on Minsky's earlier writings, which relied more heavily on shocks than the later writings, reviewed above, which attempt to develop an endogenous theory of financial crises.

As in Minsky's earlier work, the events leading up to a crisis start with a shock or displacement to the macroeconomic system, and Kindleberger tries to identify historical examples of such displacements (1978, Ch. 3). He finds that the source of displacement varies from one speculative boom to another and in that sense historians are correct in arguing that each speculative boom or cycle is unique. Economists, who argue that cycles are a repetitive process, are also correct since the reaction to the shocks and the subsequent evolution of the economy are similar. The shock alters the outlook by changing the opportunities for profit in at least one important sector of the economy. Displacement occurs as businesses switch from unprofitable to profitable lines of business and there are new entrants to the perceived high profit markets. If this process leads to a net increase in production and investment then a boom ensues. The boom is fed by an expansion of bank credit which enlarges the money supply and if the urge to speculate is present, euphoria develops and overtrading and excessive gearing can result. As speculation spreads to members of the population normally aloof from such ventures, who abandon their normal behaviour, then a mania or a speculative bubble develops. In the latter phases of the mania, speculation detaches itself from really valuable objects and turns to delusive ones, and swindlers and fraudsters flourish.

As the manic boom continues, interest rates, the velocity of circulation and prices all rise and at some stage a few insiders decide to take profits and sell out. It should be noted that the periodic taking of profits could explain the saw-toothed progress of asset prices and is likely to result if individuals hold sufficiently diverse expectations35 and periodically hedge their bets on the continuation of the boom by taking profits and refinancing. This may explain the finding that stock market prices follow a random walk with drift, discussed in the next section. Kindleberger argues that at the peak of the boom, there is often a pause as new recruits to speculation balance those selling out. Prices level off, and there may be an uneasy period of financial distress. The probability of a flight to liquidity increases in the eyes of a segment of the speculative community, and risk increases. When it is widely accepted that the market price will go no higher, the balance will tip in favour of selling out. There will be a race to withdraw, which may develop into a stampede, in order to maximise existing capital gains and minimise prospective capital losses.

Kindleberger notes that the special signal that precipitates the crisis could be one of a number, but it is often a bank failure or the revelation of fraud or defalcation. Prior to the crisis a state of revulsion against certain commodities or securities is often observed, and banks cease lending on the collateral of such assets. This is sometimes called discredit in the classical literature. Once crisis arrives and panic sets in, it feeds on itself, as did the speculation, until one or more of the following occurs:

1. Prices fall so low that investors are again attracted by less liquid assets.

2. The exchange on which the asset in which there has been speculation is traded is closed, or trade is otherwise inhibited.

3. The LOLR intervenes to stem flight to liquidity by guaranteeing an ample supply of money.

Kindleberger argues that his Minsky-inspired model describes the nature of financial crises under capitalism and rejects the view that each crisis is unique because he is able to identify certain common features in crises, despite the existence of differing individual features. This view recently supported by Reinhart and Rogoff (2009), whose book draws on the famous title of Minsky (1982a). He also rejects the view that it is no longer applicable to modern capitalism, and the 2007-9 Global Financial Crisis demonstrated that he was correct. He supports Minsky's view that Keynesian ISLM and neoclassical synthesis models missed an important point contained in Keynes's writing. As a result Hansen (1951), a leading proponent of Keynesian multiplier-accelerator business cycle analysis, incorrectly dismissed previous theories of business cycles, based on uncertainty, speculation and overtrading, as inapplicable to the twentieth century because industry had become the main outlet for funds seeking a profitable return from savings and investment. Kindleberger argues that room for speculation in commodities and securities remains, and prices and credit continue to be unstable. Hansen concentrated on savings and investment but ignored uncertainty, speculation and instability, which featured prominently in Keynes's work.

Kindleberger then considers whether an active LOLR can forestall crises, making it possible to eliminate them altogether. The counterview that the existence of LOLR cover on a reliable basis might actually increase risk-taking and, therefore, the likelihood of bubbles is acknowledged by Kindleberger, but he observes that since 1930 the greater willingness to undertake LOLR intervention has apparently increased stability. This view would tend to be confirmed by the rapid response by central banks to the October 1987 stock market crashes around the world and the absence of their significant impact on the performance of the economies in which they occurred. With the benefit of hindsight, the supply of liquidity by LOLRs appears to have been excessive and slightly inflationary. It should also be noted that the FDIC, established in the 1930s, has probably increased stability in the United States. In fact the period of stability seems to date back further in countries such as the United Kingdom, where the LOLR established credibility following the 1866 banking crisis. (See Gilbert and Wood (1986) for further discussion.) Kindleberger also draws attention to the fact that despite the decline in domestic crises in the post-war period, there has been an increase in the incidence of international crises implying the need for an international LOLR (ILOLR) or credible contingency plans for co-ordinated LOLR intervention by national central banks.

Like Minsky, Kindleberger fails to provide a definition of crises. He merely replaces old words, such as overtrading, revulsion and discredit, with new ones, such as manias, speculative bubbles, panics and crashes. Goldsmith (1982), in his comments on Minsky (1982b), suggests the following definition: a sharp, brief, ultracyclical deterioration of all or most of a group of financial indicators, such as short-term interest rates and asset (stock, real estate, land) prices, commercial insolvencies and failures of financial institutions. This would exclude several of Minsky's so-called crises, Goldsmith observes, and particularly the minor ones in the United States in the 1960s and 1970s, to which Minsky attaches such importance. His definition achieves the goal of discrediting Minsky's thesis but is merely a description of an event which might be termed a widespread financial crisis. Unlike the FIH, it does not attempt to identify the cause of crises.

Like Kindleberger, Eichengreen and Portes (1987) are particularly interested in the generation and propagation of crises in an international setting. They define a financial crisis as a disturbance to financial markets, associated particularly with falling asset prices among debtors and intermediaries, which spreads through the financial system, disrupting markets' capacity to allocate capital. The definition implies a distinction between generalised financial crises and isolated bank failures, debt defaults and foreign exchange market disturbances. It is, therefore, in a similar vein to Goldsmith's definition. Such distinctions are clearly important, since while it is clear that the economy should be protected from the negative externalities resulting from systemic crises, it is not obvious that individual bank failures should be prevented. Such prevention might even increase the risk of systemic failures by creating a moral hazard problem.

Eichengreen and Portes (1987) observe that capital flight36 plays a role in international financial crises similar to that played by bank runs in domestic crises and argue that institutional arrangements in the financial system are critical determinants of the system's vulnerability to destabilising shocks, which emanate primarily from macroeconomic events rather than events limited to the financial system. Their point about institutional arrangements is similar to that made by Melitz (1982) and discussed above. It implies that capitalist economies are not necessarily prone to financial instability if they adopt the appropriate institutional arrangements. Their analysis involves a comparison of the 1920s and 1930s with the 1970s and 1980s. In both the 1920s and 1970s institutional arrangements were drastically altered by changes in foreign exchange markets, international capital markets and the structure of domestic banking systems. There are certain similarities in these changes, but Eichengreen and Portes believe that the changes in the 1920s on balance increased vulnerability and the crisis in the 1930s was the consequence, while the changes in the 1970s worked in the opposite direction so that events such as the 1982 Mexican debt crisis and the subsequent October 1987 stock market crash proved containable.

Eichengreen and Portes argue that macroeconomic shocks can cause a rapid change in the credit regime, from high lending to rationing, by conveying new information to lenders. They note that Guttentag and Herring (1984) postulate that an extended period without adverse shocks creates conditions in which such a shock will provoke discontinuous market behaviour. They find this hypothesis more specific and rigorous than Minsky's FIH, although it appears to be based on a similar premise: that as time elapses since the last major shock or crisis, the lenders become more disposed to greater risk-taking. In the case of the 1982 Mexican crisis the 'disaster myopia' emphasised by Guttentag and Herring, which had led to inadequate 'spreads' or risk premiums on sovereign lending and what Minsky would call speculative finance -because the Latin American (LA) debtors were not expected to be able to service the interest payments on their debts in the short or medium term except through further loans -was dispelled, and this changed the banks' overall perception of LA debtors in an environment of imperfect information. Capital flight significantly increased the disaster probability. When the disaster scenario suddenly took on a non-negligible subjective probability, lenders reacted by pulling out of the market as fast as the IMF and their central banks would allow. Rather than gradually tightening the terms attached to loans, the banks suddenly shifted to credit rationing, which the IMF tried to offset through 'forced lending'.

The LA debt problem37 of the 1980s differed significantly from the one in the 1930s because banks had assumed credit risks formerly borne by purchasers of sovereign bonds. There was consequently a need to contain any menace the crisis posed for the banking and wider financial system in the 1980s. This was done by the US Treasury and the Fed in conjunction with the IMF and the Bank for International Settlements, which launched a rescue operation.38 Banks now appear to have been protected long enough to build up provisions and capital sufficient to withstand a reversion of the LA debt problem to crisis proportions. While no formal ILOLR exists, it seems that contingency arrangements are in place. The key weakness of current policy, Eichengreen and Portes contend, is the failure to block capital flight in a time of increasing international capital mobility. Other problems emanate from sustained exchange rate misalignments and consequent protectionist pressure.

Eichengreen and Portes argue that the shift from bank lending to borrowing on the capital markets, or securitisation, evident in the 1980s should in principle reduce systemic vulnerability, but the Cross Report points to countervailing aspects - see Bank for International Settlements (1986.) They acknowledge that the trade-offs are complicated but believe that the developments are on balance positive from the viewpoint of financial stability. They argue that imperfect information favours the generalisation of adverse shocks into full crises and that macroeconomic instability is the main source of shocks, but that the appropriate action by the regulatory and monetary authorities can block the most dangerous linkages. Co-ordinated action, embodied in the 'Third World debt strategy', has avoided defaults and widespread bank failures, but action should have been taken earlier to prevent the expansion of bank lending to sovereign borrowers leading to the accumulation of excessive debt burdens. Eichengreen and Portes believe that securitisation will get more information into the market-place, reduce adverse selection and remove from the banking system the heavy burden of acting as a buffer when shocks do occur.

The Eichengreen and Portes analysis implies that the real dangers lie not in disturbances originating from the financial market but in the malfunctioning of the real economy. To reduce the latter, greater economic co-operation and coordination are required, which might lead to a new international monetary constitution. This would provide rules on exchange market intervention and choices of international reserve assets, constraints on fiscal and monetary policy, and a well defined responsibility for ILOLR intervention. On both imperfect information and externality grounds, they feel that there is a rationale for government intervention in financial markets in general and the regulation of the banking system in particular, since it is the latter that acts as a buffer when shocks to the real economy impact on the financial system. Regulatory policy should, they argue, channel financial innovation in directions that leave the world economy less vulnerable to financial collapse. The downside risk is that the trend towards greater cooperation and co-ordination will evaporate when the world economy enjoys a period of sustained stability. Disaster probabilities may be reassessed and reduced to negligible levels as the last shock or crisis recedes into the distant past and disaster myopia or euphoria will again prevail, bringing the next crisis closer.

Further analysis and evidence on crises in economic and financial structures is presented in a collection of papers edited by Wachtel (1982). Wachtel himself observes that market bubbles or speculative explosions in one market could potentially lead to widespread crises. He notes that although there are numerous examples of crises, the economics profession does not have a framework for dealing with the topic and the problem of definition is consequently an important one. He feels that the basis for such a framework is provided by Meltzer (1982), who draws on Knight's (1921) distinction between risk and uncertainty and suggests that economic crises should be associated with uncertainty of outcomes (see also sections 2.1 and 3.2). A crisis may emerge when there is a shift in the underlying distribution of outcomes of the economic events. Meltzer treats uncertainty as a shift in expected value following a shock to either aggregate demand or aggregate supply and claims that this is consistent with the usage of Knight and Keynes. However, papers postulating rational bubbles, such as Flood and Garber (1982) and Blanchard and Watson (1982), deal with a world of risk in which outcomes often differ from their expected value but with a known or calculable probability, rather than uncertainty, which is due to unpredictable changes in the distribution of outcomes. Economic units can prepare themselves for the consequences of risky outcomes but not for uncertain ones.

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