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.

Section IV

International Economics (Krugman)