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
- George Berkeley had already developed a sophisticated analysis of financial crises by the 1730s. - His policy recommendations still have much to teach us today as we come to grips with the current financial crisis. - Berkeley’s work: combines his insights about human sociality and his knowledge of real-world banking successes and failures with his concern for the public. - Berkley’s theory on human behavior and his theories of economic development: consistent framework for understanding 18th century style financial crises that provides concrete policy conclusions. - Berkeley’s multi-faceted argument draws on three main works: The Querist, The Ruin of Britain and National Bank plan.
Berkeley's Approach to Money, Credit, and Debit
Berkeley worked along the lines of the Theory of the Second Best (argued that his beloved country of Ireland ought to make the best of a difficult situation). He judged policy in terms of the Greatest Happiness of the Majority: the wellbeing of all of the people not just a select few. To promote economic prosperity, the majority ought to be made better off. “Power refers to actions and action follows appetite or will. Fashion creates appetite and the prevailing will of a nation is the fashion. The current of industry and commerce is determined by the prevailing will. Power is the ability to take action to express the appetite and will.” Money is a circulating medium based on credit: “all circulation…is like a circulation of credit, whatever medium (metal or paper) is employed…” (Query #426).”The true idea of money is that of a ticket or counter” (Query #23) What is real wealth then? It is not the token money but rather it is the “power to command the industry of others”, that is “real wealth” and money is merely “tickets or tokens for conveying and recording such power” (Query #35). A country is made wealthy by “the industry of its inhabitants…they prove to inexhaustible funds of real wealth…” (Query # 40) Land itself is not wealth. (Query #38) It is the” industry of the people” that makes wealth possible (Query #38). A number of queries emphasize that it takes human labor and industry to generate wealth. Money is seen as an aid to and not a substitute for human effort.
Human Motivation
Berkeley realizes that the human actor must be involved and so he attempts to set incentives and to separate functions as to minimize malfeasance. He does not rest his economic arguments on the assumption of benevolent agents. Thus, he proposes that the government and legislature is the ultimate overseer of the bank. However, Berkeley sees human agents as flawed. Hence, he provides checks and balances in his bank plan and seeks the improvement of politicians (a number of queries calling for those with influence and power to improve themselves). Within his writings, there are numerous examples of the fallible human actor and his instruction on their self-improvement (he was a Bishop after all). He sees market failure with private banks and calls for government action to avert market failure. Berkeley is also not blinded by the actions of self-interested and fallible politicians who ultimately oversee the bank which final authority emanates. Thus, he suggests checks and balances to try to get the incentives right, believing that the human actors will need the disciplining effects of an open and transparent system of governance.
Functions of Banks and Commonly Accepted Aspects of Regulation
Berkeley’s writings demonstrate an awareness of what have become the commonly recognized economic functions of banks (a testament to how far ahead he was compared to the time period in which he lived in). For Berkeley, banks receive deposits and ought to create loans to promote industry. Hence, banks act as financial intermediaries helping to channel savings from borrowers by moving funds from “lenders” (the depositors of the bank) to borrowers. Berkeley’s public bank would help coordinate lending with sound borrowers and would encourage “manufacturers of several kinds, which are not likely to be set on foot and carried on to perfection without great stock, public encouragement, general regulations and the concurrence of many hands”. (Query 226) Banks issue banknotes, hold deposits, and lend out reserves in excess of the combined legal and desired level of reserves. Banks deposits would count as part of the money supply. Depositors could write checks against their account. Hence, banks play an important role in the creation and contraction of the money supply. Given their role in the credit creation process, Berkeley’s banks play an integral role in the collection and payments system. From Berkeley’s perspective, his proposed bank is merely a well thought out extension of this principle (economy would rise to credit endogenously) that arises naturally out of economic relations when a surplus beyond subsistence exists. As Berkeley argues, his public bank will be better able to enforce agreements and vet good and bad risks. Back by the power of the state and with legislative oversight, a public bank would be better able to reduce the problems of asymmetric information (adverse selection and moral hazard) which might otherwise mean that fewer loans would take place.
Berkeley's Rules of Sound Banking to Avert Financial Crisis
1.) Restrictions on Entry. Not just anyone should own or operate a bank: “too much power in the hands of private men…gives handle to monopolies, stock jobbing, and destructive schemes.” (Query 216)
2.) Disclosure and Transparency to help prevent fraud: subscriptions, shares, dividends, and stock jobbing. The opacity (transparency) of financial activities has played a role in the current financial crisis. “The secrecy of private banks” is “the very thing that renders them so hazardous” (Query 45”) Policy goal ought to be promotion of industry.
3.) Regulatory Monitoring: “Those things that are subject to the most general inspection are the least subject to abuse.” (Query 56) Proper regulation and supervision allowing for regular and routine inspection by the state.
4.) Banks and Investment firms ought not to be overseeing their own regulation. Through vigorous lobbying, the financial industry has played a large role in the helping to reduce regulation: “But, whether a private interest be not generally supported or pursued with more zeal than a public.” (Query 28)
5.) Structure to ensure that private interests are aligned with the public interest.
6.) Policy should enhance actual and perceived security to provide for stability. Not only the physical makeup, construction and layout of the bank.
7.) Restrictions on Assets and Activities: There should be a wall of separation between Banks and firms that engage in risky investments (Query 106). “A means of idleness and gaming, instead of a motive and help to industry” (Query 229), circulating without industry (Query 250), “subscriptions, shares, dividends, and stock jobbing” (Query 246)
8.) Separation of Powers: separate powers for directors, auditing inspectors and governing bodies that have oversight over the bank managers and the directors of the bank. (Query 111) Separate bodies choose directors (Query 230), are not part of the legislature which would help to oversee the bank. Directors would “be subject to the audit and visitation of a standing committee of both houses” (Query 231) To prevent conflicts of interest and power to be accrued the “committee of inspectors should…be changes every two years, one-half going out, and the another coming in by ballot” (Query 232).
9.) Adequate Ready Cash Reserves on Hand to promote stability in banking system and lessen risk of default.
10.) Deposit Insurance and lender of last resort (LOLR): Berkeley’s public bank had the full backing of the legislature and the public.
11.) Money need not have intrinsic value or be “a commodity, a standard, a measure, or a pledge” (Query #23). Indeed, “the true idea of money…is that of a ticker or counter” (Query #23).
12.) Berkeley warned about “permitting all persons to take out what bills they pleased, upon the mortgage of lands” (Query #215).
13.) Conducting monetary policy is another important aspect of banking. Banks play such an important role in the money supply creation process. Berkeley also recognized this important role with his emphasis on preventing inflation from becoming too great. KEPP INFLATION IN CHECK. Berkeley cautioned that there must exist limits on the creation of notes and he suggests some guides to policy making, pointing to inflation and asset price inflation especially of land prices and mortgages. Emphasized that policy makers ought to keep an eye on land prices and to avoid the formation of bubbles. Making the prevention of asset bubbles a policy goal and explicitly pointing to relevant asset prices (ie. land for his day). He sees a monetary goal allowing for slow increase in prices over time, keeping an eye on inflation and the rise in the price of lands. Monetary Policy is a trial and error procedure where “the quantum of notes ought…to bear proportion to the public demand” (Query 245). “Too small a proportion of money would…hurt the landed man, and too great a proportion the monied man” (Query 245). In these queries, Berkeley points to the crises that came about because of failure to limit the number of notes issued.
14.) Monetary policy ought to help meet the financing needs of business (Query 134) and to provide for stable prices (Query #123).
Section IV
International Economics (Krugman)
