Annina Kaltenbrunner Lecturer in the Economics of Globalisation
& The International Economy Leeds University Business School
Developing Countries in the Global Financial Crisis: A Minskyan
Account
Slide 2
Motivation
Slide 3
Outline Neoclassical Models of Financial (Foreign Exchange)
Crisis Post Keynesian Theories of Financial Crisis Keynes: Chapter
12 of the General Theory Hyman Minsky: The Financial Instability
Hypothesis > Policy Implications and Open Economy Applications
Developing Countries (Brazil) in the Global Financial Crisis
(September 2008)
Slide 4
Neoclassical Models Overview First Generation Models (Krugman
1979) Rational speculators attack central bank in face of
fundamental disequilibria (current account and/or fiscal deficit)
Second Generation Models (Obstfeld, 1996) Self fulfilling
expectations about deteriorating fundamentals Government Trade-off
Third (Asian) Generation Models (e.g. McKinnon and Pill, 1996;
Radelet and Sachs, 1998; Chang and Velasco, 2002) Concern about
external repayment capacity Net short-term external debt (original
sin)
Slide 5
Neoclassical Models Assumptions Efficient markets Underlying
real fundamentals run the show (dichotomy between monetary and
real) Heterodox approaches to Asian crisis (foreign currency debt)
Rational agents First Generation: No doubt Third
Generation/Asymmetric information: Constrained information (moral
hazard and adverse selection) (Behavioural Finance:
Heterogeneous)
Slide 6
Neoclassical Models Policy Recommendations Fix Fundamentals
Current account, fiscal balance, inflation etc. Reduce net foreign
currency debt Develop domestic financial markets Accumulate foreign
exchange reserves Asymmetric Information: Transparency Further
reduce State involvement in financial markets (e.g. rule-bound,
flexible exchange rates) Further open capital account
(macroeconomic discipline, liquidity for domestic financial market
etc.)
Slide 7
Post Keynesian Theories of Financial Markets/Financial Crisis
Monetary Production Economy Creative agency/expectations
Fundamental Uncertainty (non-ergodicity) Rationality pointless
Inter-subjective nature of price formation
Slide 8
John Maynard Keynes General Theory: Chapter 12 What determines
Investment? Rate of interest and the schedule of the marginal
efficiency of capital Rate of Interest (GT: Chapters 13-17) Reward
for parting with the security provided by money in a world of
fundamental uncertainty and historical time >> money as
secure abode of purchasing power and medium of contractual
settlement (Paul Davidson) Marginal Efficiency of Capital Relation
between the supply-price of capital asset and its prospective
yield
Slide 9
Chapter 12 Prospective Yield The considerations upon which
expectations of prospective yields are based are partly existing
facts which we assume to be known more or less for certain, and
partly future events which can only be forecasted with more or less
confidence. We may sum up the state of psychological expectation
which covers the latter as being the state of long-term
expectation...
Slide 10
Chapter 12 Speculation Conventions and State of Confidence
Conventions: Assuming that the existing state of affairs will
continue indefinitely, expect in so far as we have specific reasons
to expect a change Speculation vs. Enterprise Stock Market
(Secondary Market) It is as though a farmer, having tapped his
barometer after breakfast, could decide to remove his capital from
the farming business between 10 and 11 in the morning and
reconsider whether he should return to it later in the week
Precariousness of Conventions Musical Chair/Beauty Contest
Displaces enterprise
Slide 11
Chapter 12 Speculation Speculators may do no harm as bubbles on
a steady stream of enterprise. But the position is serious when
enterprise becomes a bubble on a whirlpool of speculation. When the
capital development of a country becomes a by-product of the
activities of a casino, the job is likely to be ill-done.
Slide 12
Chapter 12 Summary and Policy Implications Swings in asset
prices detached from fundamentals inherent feature of capitalist
economies Worse in more liquid markets Negative implications for
investment and capital formation Animal Spirit: spontaneous urge to
action rather than inaction Policy Implications: Stabilizing
conventions? Investment permanent and indissoluble >>
Illiquidity? Force socially beneficial investment State
investment
Slide 13
Chapter 12 Applications and Extension Keynes: stock market Paul
Davidson, John T. Harvey: foreign exchange market Sheila Dow:
financial markets in general Alves et al. (among others): Asian
financial crisis But: Keynes not a theory of financial crisis
>>> Minsky
Slide 14
Hyman Minsky The Financial Instability Hypothesis John Maynard
Keynes (1975); Stabilizing an Unstable Economy (1986) Missing link
in General Theory is finance (credit) liability side of balance
sheets Theory of inherent and endogenous fragility of financial
markets and capitalist economies Balance sheet/Wall Street view of
capitalist economies Financial fragility and instability due to
changing cash flow configurations over the business cycle (profits
vs. debt payments) >Financial Instability Hypothesis
Slide 15
The Financial Instability Hypothesis Building Blocs 1.
(Subjective) Expectations change over course of the cycle:
stability breeds instability Rising investment > higher profits
and rising asset prices > feedback to investment >
boom/euphoria 2. Increasingly fragile financial structures - match
between cash flow commitments (debt service and principal) and cash
income (investment yields) Hedge: income meets interest rates and
principal Speculative: income meets interest rates but not
principal Ponzi: income does not cover interest rates >>
Margin of safety falls >> Increased vulnerability to changing
(financial) market conditions
Slide 16
The Financial Instability Hypothesis Building Blocs 3.
Endogenous shock (rise in interest rate) which turns fragility into
instability Central bank raises interest rate to cool economy Banks
raise interest rate reacting to high demand for external finance 4.
Debt deflation (Fisher (1933)) Rising interest rates > higher
borrowing costs, falling net-worth, lower credit ratings >
inability to meet cash flow requirements Falling profits and asset
prices Defaults > banking crisis
Slide 17
The Financial Instability Hypothesis Summary and Policy
Implications Financial instability and crisis inherent feature of
capitalist economies with mature financial markets Financial crisis
not due to misaligned fundamentals but increasingly fragile
financial structures balance sheets and cash flow requirements
Policy Implications: Big Government > stabilize firm profits Big
Bank > stabilize asset prices Regulate Finance
Slide 18
The Financial Instability Hypothesis Applications and
Extensions Capitalist firm > banks, households, states Open
economy/Emerging Markets Exogenous shock? Exchange rate >
super-speculative units (Arestis and Glickman, 2002)
Slide 19
Developing Countries in the Global Financial Crisis
Slide 20
Neoclassical Models Fundamentals and Foreign Currency Debt
Slide 21
Post Keynesian/Minskyan Account Unprecedented Amount of Capital
Flows
Slide 22
Post Keynesian/Minskyan Account In complex, very short-term
domestic currency assets
Slide 23
Post Keynesian/Minskyan Account Which created Balance Sheet
Vulnerabilities
Slide 24
Post Keynesian/Minskyan Account The Crisis Shock (rising
interest rates and increased risk aversion in developing financial
markets) Rising funding costs for international banks Speculative
and Ponzi Units need to make position Do so in overexposed and
liquid assets > Brazil Falling asset prices and exchange rate
depreciation exacerbate financing difficulties > Stampede and
exchange rate depreciation by 60% unrelated to Brazilian
fundamentals
Slide 25
Conclusions Neoclassical vs. Post Keynesian: Different
Ontological assumptions of how financial markets (economic dynamics
generally) work Neoclassical: stable underlying fundamentals which
will be aligned with expectations as long as frictions are removed
(government, noise traders etc.) Post Keynesian: Symbiotic
relationship between real and finance; no underlying fundamentals;
inherent fragility of financial markets and economic systems
>>> State and Government Control