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Financial Crisis

The financial distress of the last two decades has revived interest on the question of the stability of the financial system. On the one hand, the "pessimist" view, associated primarily with Minsky argues that not only that the financial system is prone to such crises ("financial fragility" in Minsky's terms) but also that such crises are inherent on the capitalist system ("systemic fragility"). On the other hand, the monetarists see the financial system as stable and efficient where crises not only are rare but also are the fault of the government rather than the financial system as such. For many others, however, financial crises may be largely attributable to the financial system but they are also neither inescapable nor inherent in a capitalist economy.

Therefore, the issues we have to examine here are how common are such crises from a purely historical perspective; to what extent we can identify a common pattern between all crises which would suggest an endogenous process that leads to crises; a theoretical framework which explains both the process and the frequency of such crises and finally examine the extent to which these financial system characteristics that make it prone to crises are inherent on the capitalist system.

The first question, i.e. the frequency of financial crises partly depends on our definition of crisis. A financial crisis has been defined by Goldsmith as "a sharp, brief, ultra-cyclical deterioration of all or most of a group of financial indicators - short-term interest rates, asset (stock, real estate, land) prices, commercial insolvencies and failures of financial institutions". The question here is of what intensity and/or intersectoral spread should a financial disturbance be in order to be considered a crisis. In any case, it appears that though major crises leading to the (near) collapse of the financial system are quite rare (the only one being 1929 in the US), more moderate ones are frequent enough to allow the argument that the financial system does suffer from a certain degree of fragility. In the post-war period, after an almost complete absence of crises until the mid 60's, the financial system has been at strain on many occasions including the 1966 credit crunch, the 1969-70 and 1974-75 crises, the 3rd world debt problem of the early 80's and the stock market crash of 1987.

Again a casual observation of financial crises will find a wide variety of different causes and forms as each crisis seems to have occurred in response to a unique set of accidents and unfortunate coincidences. But quoting Kindleberger "for historians each event is unique. Economics, however, maintains that certain forces in society and nature behave in repetitive ways". Indeed, it is not difficult to distinguish a rough pattern which has been graphically presented by Minsky : crises tend to occur at the peak of the business cycle following a period of "euphoria". This has probably been initiated by some exogenous shock to the macroeconomic system ("displacement") which results in new profit opportunities. The boom is fuelled by an expansion of bank credit as new banks are formed, new financial instruments are introduced and personal credit outside the banks increases. During that period there is extensive "overtrading", a not very clear concept which generally refers to speculation for a price rise, or an overestimation of prospective returns due to euphoria. This stage is also often referred to as a "mania" emphasising its irrationality and "bubble" predicting the collapse.

Eventually, some insiders decide to take their profits and sell out and the increase in prices begins to moderate. A period of "distress" may then occur until speculators realise that the market can only go downwards. The crisis may be precipitated by some specific signal such as a bank or firm failure or a revelation of a swindle; the later are quite frequent in such circumstances as people try to escape the imminent collapse. The rush out of the real or long term assets ("revulsion" in Minsky's terms) lowers the prices of these real assets which were the object of the speculation and may develop into a panic. The panic continues until either the price falls so low that people are tempted to keep their illiquid assets or a lender of last resort intervenes and /or manages to convince the market that money will be made available in sufficient volume to meet the demand for cash.

Minsky, unlike many others who otherwise accept much of his model, believes that this process will always result to a crisis. Minsky classifies the demand for credit to "hedge finance" when cash receipts are expected to exceed the cash payments by a significant margin, to speculative finance" when, over some periods, expected earnings are less than payments and to "Ponzi finance" when the payable interest in the firm's commitments exceeds its net income cash receipts; thus a Ponzi unit has to increase its debt to be able to meet its commitments. Once the Ponzi finance situation becomes general, a crisis is inevitable. Others, however, believe that there are ways to prevent Ponzi finance from becoming too widespread.

This model described above implies that crises are in part endogenous and in part outcomes of exogenous disturbances. Whether this conclusion supports the "financial fragility" view depends on the weights given to the disturbance and the endogenous part of the process. If the shocks necessary to set off this process are of exceptional size and rare then obviously the financial system can be thought as stable. Indeed it has been suggested that the recent crises have in fact showed the resilience of the financial system against huge adverse shocks. If instead the speculative forces are triggered by even relatively small shocks we can then blame the financial system even if the shock were exogenous.

This is both an empirical and theoretical issue. Empirically the euphoria-distress-revulsion process seems to conform with the experience of many crises such as the 1929 stock market crash, though many others have not gone through the whole process. Theoretically, we have to explain the assertions of the above model, namely for the existence of speculation and other "irrational" behaviour as implied by "manias" and "overtrading".

Friedman rejects the notion of destabilising speculation completely as a destabilising speculator who bought when the price was rising and sold when it was falling, would be buying high and selling low