Theories of Crisis

Introduction Minsky, Marxist and Mathematics

The financial crisis in 2008 is often compared to the Great Depression and was considered the most serious recession by many economists. In our senior seminar final project, we plan to explore the theories provided by different schools of economists such as Marxist and Minsky. Following the theories, we will also examine the empirical evidence from the Great Depression and the recession in the 70s as well as the current financial crisis. The Marxists think recessions are imbedded in the capitalism system and business cycles are the direct result of profit maximizing actions in the market. Carl Marx developed the major theory of business cycle, which draws heavily from J.S. Mill. As a post Keynesian economist, Minsky explained the fragility of the financial system is a feature of a Capitalist system. In particular, an integrated international financial market only increases the instability of individual economy. In addition to the theories presented by Marxist and Minksy, we also plan to explore the mathematical approach to the global financial crisis by examining methods and theoretical models (coordination games, herding and learning models) that are largely derived from major international economic theories such as Obstfeld’s Model of the Financial Crisis.

Section I

Minsky

Marx argues that profit of firms in a Capitalist market has a tendency to fall as competition increases. As a result, firms experience a boom-bust cycle, which could become a economic recession. In other words, recessions are part of business cycles.

Section II

Marxist

Minsky’s idea concerns the fragility of the financial system at the national level and the international level. He explains the tendency of firms in both financial and non-financial sectors to take greater risks in liabilities as the business expands. Governments and central banks therefore must play a supervising role and act as “lender of the last resort”. Following Keynes’s countercyclical theory, Minsky strong advocates government regulation in times of financial crisis. Empirical data from the Great Depression shows that the Depression was a direct result of the risky lending in the early 20s, while the New Deal serves as an example of successful government intervention. In the 70s, similar conclusion can be drawn from the recession in 1975. At the international level, the interdependence of economies largely increases the instability of the international financial system because of international lending activities.

Section III

George Berkeley

Economist Maurice Obstfeld’s model largely follows the “currency crisis” (also called a balance-of-payments crisis), which is a speculative attack in the foreign exchange market (it occurs when the value of a currency changes quickly, undermining its ability to serve as a medium of exchange or a store of value). Furthermore, currency crises can be especially destructive to small open economies or bigger, but not sufficiently stable ones. Obstfeld represents the “second generation approach”, which presents doubts about whether the government is willing to maintain its exchange rate peg lead to multiple equilibria, suggesting that self-fulfilling prophecies may be possible, in which the reason investors attack the currency is that they expect other investors to attack the currency. Recessions attributed to currency crises also include the 1994 economic crisis in Mexico, 1997 Asian Financial Crisis, 1998 Russian financial crisis, and the Argentine economic crisis (1999-2002)

Section IV

International Economics (Krugman)