Theories of Crisis
Introduction: Minsky, Marxist and Berkeley
On September 15, 2008, the bankruptcy of the United States investment bank Lehman Brothers and the collapse of AIG, the world's largest insurance company, triggered the 2008 Global Financial Crisis. The end result was a global recession, which cost the world tens of trillions of dollars and rendered 30 million people unemployed. In addition, the crisis doubled the national debt of the United States. In our senior seminar final project, we plan to explore the relevant theories provided by economists Karl Marx, Hyman Minsky and George Berkeley on the financial crisis.
Following the Marx and Minsky theories, we will 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. Karl 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.
Within the Berkeley approach, we will examine human motivation, Berkeley's functions of a bank, regulatory monitoring, separation of powers, transparency, elimination of conflicts of interest, speculation and economic crisis and artificial appetites. Furthermore, we will apply these sections of analysis to Wall Street.
Section I Marxist
Inspired by Mill and Ricardo, Marx argues that profits of firms in a Capitalist market have a tendency to fall as competition increases. As a result, firms will experience a boom-bust cycle, which could become an economic recession. The primary assumptions Marx make includes labor exploitation, falling profit rates and finally the innate crises of Capitalism.
Ricardo and Mill’s Inspiration
The Marxist theory follows the tradition of Ricardo and J.S.Mill. The Ricardian theory of distribution explains that “wages and profits vary inversely, prices were determined by labor costs, and long-run wages will fall to subsistence levels” (126, Skousen). The initial idea that is later developed into the labor exploitation and surplus theory. Mill expands the labor theory to a discussion of Socialism which inspired Marx’s ideas. Ricardo and Mill were the first intellectuals to employ the concept of classes to analyze economies. This class view of society greatly influenced Marx’s economics theories. In particular, Mill questioned the legitimacy of private ownership and advocates three types of socialism: Utopian Socialism, Revolutionary Socialism and Fascist Socialism (128, Skousen). Marx continued the tradition of Revolutionary socialism by calling for violent abolishment of private ownership.
Labor Exploitation
According to Marx, the value of products are determined by the amount of hours workers spend to produce and machines are forms of working hours stored in metals (Buchholz,130). He also insists that labor is the only determinant of product value. In an ideal system, the prices of products should always be equivalent to the labor wages. However, in a Capitalist society, owners of the firms make profits by deriving “surplus values” from workers who live on small wages (Buchholz, 131). This process is called labor exploitation by Marx. In order to demonstrate the surplus value, he invented a formula: P=s/(v+c) in which P is profit, s is surplus value, v is variable capital and c is constant capital (152,Buchholz). According to this formula, profit derived from production is directly related to surplus value, or exploitation. He also comments on women and child labor as an extreme example of exploiting surplus value.
Falling Profits and Accumulation of Capital
He further explains the technology advancement such as replacements of machinery in a way benefit the exploiters, as they will need fewer workers for the same production process. However, according to the surplus formula, P=s/(v+c), an increase in machinery will drive down profits. Big firms stay in business due to their larger scale of production whereas small businesses fail. More workers will become unemployed from small firms. In addition, competitions among producers will coerce producers to substitute workers for newer equipment and result in larger unemployment rate. A direct consequence of such unemployment is that people now have less purchasing power for more goods produced due to the lack of substantial income. Economic instability thus results from the surpluses of output.
The Crisis Cycle
The natural tendency of expansion in output is the real driving force to economic downturns. Thus Marxist believes crises are buried in the root of Capitalism. “lowering costs, falling profits monopolistic power, under consumption, massive unemployment of the proletariat class---all these conditions lead to more extensive and more destructive crises and depressions for the capitalistic system.” (153, Skousen) Unaware of profit-seeking activities will lead to economic downturns, firms will continue to fall into the same cycle as they expand. Crisis cycles will inevitably occur as the Capitalistic system functions. A credit cycle occurs in accordance with the business cycle. Businesses expansions increase credit demand. In a capitalist system, this will allow temporary increase in services and producst sold. As a result, the economy will experience a boom. However, as the debts will eventually have to be paid back, artificial surplus values added could become a potential credit crisis (1,Mandel).
Marxist Solution
The solution Marx proposes is to overthrow the capitalist government by revolutions. The working class should redistribute means of production to workers. The problem of overproduction will then be solved because workers make more sensible production decisions than firm owners. Marx also calls for an international alliance of workers. In the long term, economic crisis will not happen again if working class rules the world.
Section II: Minsky
Section II Minsky’s Theory
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 businesses expand. At the international level, the interdependence of economies largely increases the instability of the international financial system because of international lending activities. Governments and central banks therefore must play a supervising role and act as “lender of the last resort”. Following Keynes’s countercyclical theory, Minsky strongly advocates government regulation in times of financial crisis. Empirical data shows an example of successful government intervention in 1970s. Similar conclusion can be drawn from the current crisis.
Minsky’s approach to domestic fragility
Minsky’s theory includes two aspects: the increasingly fragile nature of the financial system and the importance of authorities to counter the fragility. In chapter nine of his Stabilizing the Unstable Economy, he pointed out the main reason for different economic behaviors are “financial practices and the structure of financial commitments change” (197,Minsky). He also compares the post-war economic stability, a result of financial conservation and the instability in the 1970s and 1980s, a direct consequence of profit-seeking activities in the economy. The profit-driven economy will also impact the financial structure through merge, acquisition and other restructuring activities. The financial market, driven by profits, is open to innovative financial activities such as inventions of financial products, techniques and strategies. A successful financial activity, as he points out, will inevitably be imitated by the market without considering the risks. The financial market will be thus run by the most risk-taking groups. To counter risky financial activities, Minsky thinks that the central banks and governments should play a critical role in overseeing financial activities.
The Instability of the International Financial System
Minsky is particularly concerned with internationalization of the financial market. On one hand, he states the inevitability of integration because of the increasing economic interdependence among countries. On the other hand, Minsky is critical about this tendency of a connected international financial system. A domestic economy will be affected by foreign originated shocks. As lending decisions are made by domestic executives with limited access to foreign borrowers’ credit history, international transactions might be riskier than domestic financial activities. Moreover, the domestic economy experiences more “disturbances and mistakes that have their origin in foreign but connected systems.”(150, Pollin) The integrated instability is also dependent upon relative sizes of economies. For example, the international system will be sensitive the U.S. domestic economic activities than a smaller country.
Empirical evidence
Minsky is a strong advocate for Big Government in times of instability. In his Stabilizing an Unstable Economy, he drew the economic data from the 1973-1975 recession to illustrate the effectiveness of government intervention which eventually prevented another Great Depression. The 1973-75 recession underwent two phases: the first four quarters of mild economic downturn and the drastic drop in the last two quarters (Minskky, 15). During the first phase, uncertainty made it more difficult to make decisions in the short term. In particular, businesses shifted investment preferences to “large immediate financial gains that can be made by being right on the swings over the more lasting and secure gains”(Minsky,17). The change in investment behaviors in turn aggravated the recession in the following period.
To counter the recession, the government increased federal deficits to “affected income, sustained private financial commitments and improved the composition of portfolios” (Minsky,19). In addition to aggressive fiscal policy, the Fed also acted as lender of last resort to encourage refinancing activities. The Big Government actions were perceived to be effective in various aspects such as the income and employment effect, budget effect and portfolio effect during the recession. Being the most direct influence, the increase in government spending on goods and services; budget effect creates more sectoral surplus; the portfolio effect reflects the financial instruments change in both the private and public sectors.
The Minsky Moment and Reform
According to Paul McCulley, an economist and fund manager at Pacific Investment Management Co. the world's largest bond-fund manager "we are in the midst of a Minsky moment, bordering on a Minsky meltdown." (Lahart,Wall Street Journal) A Minsky moment refers to a time when borrowers have to sell of their good debts to pay off excessive loans, which often follows by cash flow problems. The current crisis starting from 2007 is described as such a moment. Although Minsky did not live to see it happen, he proposed a constructive reform to the current financial system. According to traditional economic theories, financial risks can be reduced by pooling among large integrated financial institutions (11, Bard Levy Institute of Economics working paper). The mainstream financial reform is based on two ideas: regulations should help financial institutions better manage their risks and the means to force them into bankruptcy (11, Bard Levy Institute of Economics working paper). In contrast to the traditional effort to prevent risk-taking activities, Minky thinks crisis is imbedded in the operations of the financial system and it is therefore impossible to prevent financial disruption. Reforms should focus on the operations. Instead of “too big to fail”, he is in favor of allowing banks to fail without public assistance. In other words, banks will naturally reconstitute into bigger banks to retain good liabilities. He also mentioned a structural change in the profit-generating model for many financial institutions. In particular, instead of limiting financial rewards from risk-taking activities, Minsky advocates a shift from short-term profit seeking of financial products to profit generation from long-term assets and commission fees (12, Bard Levy Institute of Economics working paper). Financial institutions thus will not have the incentives to take excessive risks but maintain financial stability for their long-term benefit. Minsky proposed a fundamental solution to alter the fatality of the current financial system by changing the motivations of financial institutions. In the long term, banks will be more responsible for their lending activities.
Section III: George Berkeley
This section can now be found on the moodle course
References
Buchholz, Todd G. New Ideas from Dead Economists. N.p.: A Plume Book, n.d. Print.
Dymski, Gary, and Robert Pollin. New Perspectives in Monetary Macroeconomics. N.p.: The University of Michigan Press., n.d. Print.
Mandel, Ernest. "Karl Marx." Marx's Theory of Crises. N.p., n.d. Web. 8 May 2011. <http://www.marxists.org/archive/mandel/19xx/marx/ch09.htm>.
"MINSKY ON THE REREGULATION AND RESTRUCTURING OF THE FINANCIAL SYSTEM." Levy Economics Institute. N.p., n.d. Web. 8 May 2011. <http://www.levyinstitute.org/>.
Minsky, Hyman P. Stabilizing a Unstable Economy. New Haven: Yale University Press, n.d. Print.
Skouse Mark. The Making of Modern Economics: the Lives and Ideas of the Great Thinkers. 2nd ed. Armonk : n.p., n.d. Print.
