Arnold Kling  

Patterns of Financial Crises

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Michael Bordo writes,


A well known tradition in monetary economics which goes back to the nineteenth century and in the twentieth century was fostered by Wesley Mitchell ( 1913), Irving Fisher (1933), Hyman Minsky( 1977), Charles Kindleberger and others. It tells the tale of a business cycle upswing driven by what Fisher called a displacement (an exogenous event that provides new profitable opportunities for investment) leading to an investment boom financed by bank money (and accommodative monetary policy) and by new credit instruments-financial innovation. The boom leads to a state of euphoria where investors have difficulty distinguishing sound from unsound prospects and where fraud can be rampant. It can also lead to a bubble characterized by asset prices rising independently from their fundamentals. The boom inevitably leads to a state of overindebtedness, when agents have insufficient cash flow to service their liabilities. In such a situation a crisis can be triggered by errors in judgement by debtors and creditors in an environment changing from monetary ease to monetary tightening. The crisis can lead to fire sales of assets, declining net worths, bankruptcies, bank failures and an ensuing recession. A key dynamic in the crisis stressed by Mishkin(1997) is information asymmetry, manifest in the spread between risky and safe securities, the consequences of which(adverse selection and moral hazard) are ignored in the boom and come into play with a vengeance in the bust.


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COMMENTS (10 to date)
Gary Rogers writes:

Economic crises are interesting because:


  • They are preceded by economic activity that is clearly unsustainable.

  • Before the crisis everyone wants the unsustainable activity to continue so they either ignore it or have some reason to explain why it is really sustainable.

  • The exact timing of the crisis event is fast and unpredictable.

  • Once the crisis happens you cannot put things back the way they were.

  • We look back and see that a major segments of the economy were unsustainable and wonder why nobody did anything to stop it.


I think our current government debt falls into the potential new crisis category. It is unsustainable. We ignore the consequences of it collapsing because we want things to go on as they are even though we know this is unsustainable. We know the result of a collapse will be bad but we cannot predict exactly when it will happen or what might be the trigger. Once things collapse, we cannot go back to our current situation.

By continuing to pile up debt we are playing a very dangerous game.

Maniel writes:

I concur with Mr. Rogers. We are exchanging unsustainable private debt for (more) unsustainable (than ever) public debt.

Gary Rogers writes:

Not only are we trading private debt for public debt; we have other ways of dealing with private debt called bankruptcy, but have no good mechanism for handling the failure of the worlds reserve currency.

8 writes:

Should people become more cyclical in their behavior? We have a cyclical economy because we think in linear terms and extrapolate current trends into the future. However, if we became cyclically oriented, we would create a society with a steady up trend in growth, the type that could easily be extrapolated into the future...

David Beckworth writes:

Arnold:

Does your posting of this paragraph mean that you agree that an "accommodative monetary policy" can after all play an important role in these cycles?

El Presidente writes:

The boom leads to a state of euphoria where investors have difficulty distinguishing sound from unsound prospects and where fraud can be rampant.

Euphoria: AKA "irrational exuberance"?

What is the role of income & wealth distribution in the cycle? Does concentration of either/both fuel the boom by stoking profit expectations, and does it tip the balance pushing us over a cliff when velocity plummets because individuals cease to come to terms on exchanges? "Me too, me too" becomes, "Not me, man."

Why are we often timid about pondering this question? Is it too "normative"?

Jeremy, Alabama writes:

[The boom leads to a state of euphoria where investors have difficulty distinguishing sound from unsound prospects]
A "sound" choice of, say, DJIA, just lost ten years of gains. Another "sound" choice, GM, lost 50 years of gains. Booms may be driven by unsound prospects but the resulting bust makes sound investments unsound. If sound choices are not rewarded, then the best strategy is to choose unsoundly and get out before the bust.

[and where fraud can be rampant.]
- In an "abundance mentality" typical of booms, investors may even accept that a fraudulent cut is just part of the deal.

[In such a situation a crisis can be triggered by ...]
- absolutely anything. The market "knows" that the assets are over-priced, individual investors are waiting for a telltale so that they can cleverly and knowledgeably unwind their positions which hitherto have been earning 20%+ year on year. Of course, there are by this time no buyers. Was it Rothschild who said you can't time the top, you must always "leave some for the other fellow"?

aaron writes:

Don't thing economic activity is unsustainable, except on that whole on a long enough time-line everyone is dead sense. What we have is inefficienct economic activity promoted by unsustainable financial actitivies, and a bunch of confusion.

The Snob writes:

"A "sound" choice of, say, DJIA, just lost ten years of gains.... If sound choices are not rewarded, then the best strategy is to choose unsoundly and get out before the bust."

What do you suggest, a passbook savings account? Just wait until the inflation from all this magic bailout money kicks in and those accounts start to lose 5-7% of their real value every year. Gold? The guys who bet big on gold in 1980 spent the next 20 years working the night shift to make up for that brilliant idea.

You could stick to fixed-income securities but history shows that a portfolio that shifts weighting from equities to fixed-income as the adult-diaper years approach is the best bet.

Greg Ransom writes:

This doesn't sound too much different from the trade cycle described in Hayek (1933), only Hayek includes the time structure microeconomics of production goods to the account.

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