Financial crisis

The global financial crisis of 2008-09 led to some questioning of the neoclassical orthodoxy on the grounds that it had failed to foresee this momentous event (see The Economist, 2009; Krugman, 2009; Colander, 2010). Such criticism is justified. The main- stream's principal notions - the rationality of its homo oeconomicus, the self-balancing propensity of markets, money's neutrality, and macroeconomic models devoid of any sig- nificant role for finance - all combine to make it conceptually hard to imagine how finan- cial crises may ever develop from within the growth dynamics of capitalist economies. If financial crises arise at all, in this view, they do so as exogenous shocks in response to which asymmetric information problems between lenders and borrowers (for instance, adverse selection and moral hazard) intensify to the point of destabilizing credit. (An early proponent of the information-asymmetry school of financial crises is Mishkin, 1991.) Corollary to this benign view is a theory of finance known as the efficient-market hypothesis (Fama, 1970), according to which financial markets always price the various claims correctly, making it impossible to conceive of sudden financial-market crashes as a recurrent feature.

It is a fact, however, that we have had a pattern of repeated incidences of financial instability, and a good number of them have proven capable of disrupting economic activity. Students of financial crises (Kindleberger, 1978; Wolfson, 1986; Reinhart and Rogoff, 2009) conclude that this is a phenomenon intrinsic to our economic system. The major heterodox economists - Karl Marx, John Maynard Keynes, Joseph Schumpeter - all built their alternative theoretical frameworks on the notion that business-cycle fluctua- tions of industrial production were driven forward by a parallel credit cycle emanating from the financial sector, whereby the build-up of excess productive capacity got fuelled by credit over-extension until these intertwined processes could no longer be sustained. It is at this point that a financial crisis erupts so as to trigger necessary adjustments correcting the excess accumulations of debt and productive capacity. (Whereas Marx (1894 [1957]) emphasized overproduction and falling profit rates, Keynes (1936) saw inadequate demand as the main culprit ("underconsumption").) If allowed unchecked, such a crisis-driven adjustment process may get out of hand and set off, as highlighted in convincing fashion by Fisher (1933), a debt-deflation spiral pushing the economy straight into depression.

One pertinent theory of financial crises has been developed by Minsky (1986, 1992), who argued that financial instability arises typically when a euphoric upswing phase has induced too many economic actors to take on too much debt relative to their income- generation potential, so that they find themselves having to borrow more just to service their old debts. Another post-Keynesian viewpoint, as in Stockhammer (2012) and Tridico (2012), relates financial crises more structurally to growing income inequality and the need to sustain spending levels in the face of stagnant incomes through increased indebtedness.

We know from history that there are all kinds of financial crises. We may experience stock-market crashes exerting powerful squeezes on the corporate sector and making investors feel suddenly much poorer, or currency crises forcing brutal devaluations, or sovereign-bond crises imposing painful austerity. We may have crises that are strictly local or ones that engulf the entire globe. They may pass rapidly without too much impact on the "real" economy or they may have strongly negative effects on employment and production for a long time. Amidst that great divergence in cause and scope, three things stand out about the kinds of financial crises that truly matter. First, they often occur in the framework of financial innovations opening up new avenues of wealth accumulation, most powerfully in the form of asset bubbles that eventually burst and so trigger a crisis (see Guttmann, 2009). Second, they are highly dynamic and interactive processes that have a lot of contagion potential, as they disrupt transactions, destroy values, and homogenize expectations into panics. Third, they become a serious threat to the well- being of entire societies when they hit the banking sector to the point of a credit crunch (see Wojnilower, 1980).

Because of their potential for spreading paralysis, financial crises have to be managed lest they be allowed to depress the whole economy. Following the trauma caused by non- intervention during the Great Depression of the 1930s, governments have introduced a growing number of crisis-management tools such as safety regulations for strategic markets and institutions (for instance, minimum capital requirements), deposit insur- ance, "lender-of-last-resort" facilities for emergencies, and asset-purchase programmes. Central banks, in particular, have the responsibility to intervene during financial crises and the means to do so effectively. These interventions are inherently difficult, since they must be targeted correctly and are often politically controversial. After each systemic financial crisis, there are major lessons to be learned for better crisis management the next time around.

See also:

Asymmetric information; Debt deflation; Efficient markets theory; Financial bubble; Financial innovation; Financial instability; Lender of last resort; Marx, Karl; Minsky, Hyman Philip; Money neutrality.