Itay Goldstein and Assaf Razin — Theories of financial crises

Broadly speaking, there are three types of economic crisis: banking crises and panics, credit frictions and market freezes, and currency crises. This column argues that features from these types of crises have been at work and interacted with each other to shape the events of the last few years. From an extensive review of literature on these issues, it’s clear that the biggest challenge policymakers and economists face is in developing integrative models that better describing contemporary economic realities.

VOX.eu
Theories of financial crises
Itay Goldstein, Professor of Finance at the Wharton School of the University of Pennsylvania, and Assaf Razin, Barbara and Steven Friedman Professor of International Economics, Cornell University; Bernard Schwartz Professor (Emeritus), Tel Aviv University

Dr. Housing Bubble does FHA

The dramatic rise in FHA insured loans in a time of historically low rates demonstrates two key aspects of the current American economy. The first point is that many US households have the inability to save for an adequate down payment on housing. Forget about the historical 20 percent down payment but many households cannot scrimp up even a modest 10 percent down payment. The second point is the American economy is still living on leverage. Debt is an elixir best served in moderation but as we are seeing with the low mortgage rates, the country is now setting a threshold where low rates are expected. As a case and point we now see FHA insured loans playing a major role in the housing market. Since Q2 of 2007 the number of FHA insured loans outstanding has more than doubled. This would not be such an issue if they weren’t defaulting in mass.

Read it at Dr. Housing Bubble
The resurgence of the low down payment market – The number of FHA insured loans has doubled from Q2 of 2007 to Q2 of 2012.
Dr. Housing Bubble

Short post well worth reading.

Moritz Schularick — Credit booms gone bust

Carmen Reinhart and Kenneth Rogoff tell the history of financial crisis as a tale of excessive public debt. But what more commonly drives financial instability, says Moritz Schularick, is excessive private debt. Financial crises are credit booms gone bust. Schularick and his collaborators compile a long-run data set of disaggregated credit flows, separating loans for productive investment from loans for the purchase of existing assets. A marriage of economic history and modern statistical methods to investigate the role of finance in the macroeconomy -- this is new economic thinking. 

INET video interview
Credit Booms Gone Bust

by Moritz Schularick, professor of economics at the John F. Kennedy Institute of the Free University of Berlin, Germany. His current work focuses on credit cycles, the determinants of financial crises, and the international monetary system.

Credit crunch developing?

Europe’s worsening sovereign debt crisis has spread beyond its banks and the spillover now threatens businesses on the Continent and around the world.

From global airlines and shipping giants to small manufacturers, all kinds of companies are feeling the strain as European banks pull back on lending in an effort to hoard capital and shore up their balance sheets.

The result is a credit squeeze for companies from Berlin to Beijing, edging the world economy toward another slump....

Read the rest at The New York Times

Crisis in Europe Tightens Credit Across the Globe

by Eric Dash and Nelson D. Schwartz

(h/t Calculated Risk)

Thom Hartmann & Neil Howe: Are we in the Fourth Turning?

(h/t Raw Replay)

Martin Wolf schools BIS on sectoral balances

Martin Wolf has an interesting post from the MMT perspective today in his column at The Financial Times.

Now turn to the yet more debated question of fiscal policy. The question I have is this: does the BIS know that every sector cannot run financial surpluses at the same time?

Few doubt there is excessive private sector debt in a number of high-income countries. But how is it to be reduced? The BIS notes four answers: repayment; default; higher real incomes; and inflation. Let us rule out the last and focus on the first. Repayment means spending less than one’s income. That is what is happening in the US private sector (see chart). Households ran a financial deficit (an excess of spending over income) of 3.5 per cent of gross domestic product in the third quarter of 2005. This had shifted to a surplus of 3.3 per cent in the first quarter of 2011. The business sector is also running a modest surplus. Since the US has a current account deficit, the rest of the world is also, by definition, spending less than its income. Who is taking the opposite side? The answer is: the government. This is what a controlled depression means: every sector, other than the government, is seeking to strengthen its balance sheet at the same time.

The BIS insists this is not good enough: highly leveraged countries are running structural fiscal deficits, which must be eliminated as soon as possible. Fair enough, but where are the offsetting adjustments to occur?

Read the whole post at Why austerity alone risks a disaster.

I posted a comment there commending him. Consider lending your support, too.

Zero Hedge: The Blame Game

WSJ — Not withstanding the euro zone's problems, Mr. Juncker said that both the deficit and overall debt in the U.S. and Japanese economy are substantially higher than in Europe.

"The debt level of the USA is disastrous," Mr. Juncker said. "The real problem is that no one can explain well why the euro zone is in the epicenter of a global financial challenge at a moment, at which the fundamental indicators of the euro zone are substantially better than those of the U.S. or Japanese economy."

Tyler — Translated: "why are you picking on us?" and "Have you looked at the US and Japan recently?" Translated even more: the Nash equilibrium of the mutually assured avoidance of the topic of global insolvency is now broken. Next up: the US and Japan bash Europe and confirm that Europe's PIIGS are actually far risky than the US and Japan, plus they can't print their money etc. Then Europe retaliates. And so forth.

The blame game avalanche has officially started.

Read all at Zero Hedge: The Unwind Begins: Eurogroup President Juncker Redirects From A Broke Europe By Throwing US And Japan Under The Insolvency Bus: "The Debt Level Of The USA Is Disastrous"

Stay tuned. This is going to get "interesting" as the wheels start to come off.

Notice that Tyler gets it that the members of the EZ are not currency issuers, whereas the US and Japan are.

Neil Barofsky — Get Ready For the Next Crisis

Excerpt from Dan Rather Reports, HD Net

(h/t Washington's Blog)

Steve Keen on debt-deflation

The [debt-deflation] process eventually exhausts itself as the debt to GDP ratio falls. But given that the current private debt level is perhaps 170% of GDP above where it should be (the level that finances entrepreneurial investment rather than Ponzi Schemes), the end game here will be many years in the future. The only sure road to recovery is debt abolition—but that will require defeating the political power of the finance sector, and ending the influence of neoclassical economists on economic policy. That day is still a long way off.

Read the whole post: Dude! Where’s My Recovery?

The equations don't show up in HTML. If you want to see the equations, then download the PDF.

Michael Hudson — "EU: Politics Financialized, Economies Privatized"

Here is an excerpt from Kansas City School economist Michael Hudson's forthcoming book, taken from a longer excerpt introducing it that he recently posted:

"Politics is being financialized while economies are being privatized. The financial strategy was to remove economic planning from democratically elected representatives, centralizing it in the hands of financial managers. What Benito Mussolini called 'corporatism' in the 1920s (to give it its polite name) is now being achieved by Europe’s large banks and financial institutions – ironically (but I suppose inevitably) under the euphemism of 'free market economics.'

"Language is adopting itself to reflect the economic and political transformation (surrender?) now underway. Central bank 'independence'was euphemized as the 'hallmark of democracy,' not the victory of financial oligarchy. The task of rhetoric is to divert attention from the fact that the financial sector aims not to 'free' markets, but to place control in the hands of financial managers – whose logic is to subject economies to austerity and even depression, sell off public land and enterprises, suffer emigration and reduce living standards in the face of a sharply increasing concentration of wealth at the top of the economic pyramid. The idea is to slash government employment, lowering public-sector salaries to lead private sector wages downward, while cutting back social services.

"The internal contradiction (as Marxists would say) is that the existing mass of interest-bearing debt must grow, as it receives interest – which is re-invested to earn yet more interest. This is the 'magic' or 'miracle' of compound interest. The problem is that paying interest diverts revenue away from the circular flow between production and consumption. Say’s Law says that payments by producers (to employees and to producers of capital goods) must be spent, in the aggregate, on buying the products that labor and tangible capital produces. Otherwise there is a market glut and business shrinks – with the financial sector’s network of debt claims bearing the brunt."

Read the whole post at EU: Politics Financialized, Economies Privatized

Here is a post by Jim O’Reilly at Comments on Global Political Economy that looks at this issue from a global perspective:

The face of the enemy: The “Global 500″ corporations

What is the problem? Rent-seeking, defining economic rent as land rent, monopoly rent, and financial rent.

From a Minskyian viewpoint of financial instability arising from private debt, this political/economic model is unstable and is not going to end well. Iceland has already said, "No deal," and we are already seeing social unrest rising in MENA, the EU periphery, the UK, and parts of the US.

Yves Smith suggests a solution:

"Here is Hans Gersbach’s solution:
 When banks failed, the government paid up. But the bankers responsible kept their bonuses from the years of excess. This column argues for 'crisis contracts'….

"Crisis contracts are designed specifically for members of the bank’s management. The nature of a crisis contract is as follows:

"Definition of a crisis: A crisis occurs when the average equity capital in the banking system (relative to the assets) falls below a critical predefined threshold.
When a crisis occurs, the top managers of major or highly interconnected banks contribute a portion of their earnings from the previous years to a rescue fund for the recapitalisation of the banking system."

A Better Way to Make Bankers Pay for Crises?

This is similar to re-instituting the partnership model that dominated banking and finance until recently. That was a good model since it placed responsibility on the shoulders of those ultimately responsible for extending credit and aligned incentives with reality.

World Bank Concern

BBC: World Bank president: 'One shock away from crisis'

Robert Zoellick cited rising food prices as the main threat to poor nations who risk "losing a generation"....

IMF chief Dominique Strauss-Kahn raised particular concerns about high levels of unemployment among young people....

"Especially because of youth unemployment... there is now a risk that this will be turned into a life sentence, and that there is a possibility of a lost generation," he said.

Hmm. Rising food prices and no income. Sounds like a powder keg to me.

"Too much finance? "

Jean-Louis Arcand, Enrico Berkes, Ugo Panizza summarize the conclusion of their research into the size of the financial system in relation to the economy in Too much finance? at voxeu.org.

"Over the last three decades the US financial sector has grown six times faster than nominal GDP. This column argues that there comes a point when the financial sector has a negative effect on growth – that is, when credit to the private sector exceeds 110% of GDP. It shows that, of the advanced countries currently suffering in the fallout of the global crisis were all above this threshold."

Short and to the point. Useful read.

Daniel Gros: "Europe’s Subprime Quagmire"

Daniel Gros, Director of the Centre for European Policy Studies, warns in Europe’s Subprime Quagmire,

"Europe is making a fundamental mistake by allowing the two key elements of any resolution of the crisis – namely, debt restructuring and real stress tests for banks – to remain taboo. As long as successive EU summits persist in this mistake, the crisis will fester and spread, eventually threatening the stability of the eurozone’s entire financial system."

Branko Milanovic on Inequality and the Global Crisis

In Inequality and the Global Crisis, Branko Milanovic makes a case that the global financial crisis arose out of the hoard of savings at the top resulting from fiscal policy that reduced taxes at the top, rather than from the Ponzi finance now recognized as the proximate cause.

Milanovic observes:

The current financial crisis is generally blamed on feckless bankers, financial deregulation, crony capitalism and the like. While all of these elements may be true, this purely financial explanation of the crisis overlooks its fundamental reasons. They lie in the real sector, and more exactly in the distribution of income across individuals and social classes. Deregulation, by helping irresponsible behavior, just exacerbated the crisis; it did not create it.

To go to the origins of the crisis, one needs to go to rising income inequality within practically all countries in the world, and the United States in particular, over the last thirty years. In the United States, the top 1 percent of the population doubled its share in national income from around 8 percent in the mid-1970s to almost 16 percent in the early 2000s. That eerily replicated the situation that existed just prior to the crash of 1929, when the top 1 percent share reached its previous high watermark American income inequality over the last hundred years thus basically charted a gigantic U, going down from its 1929 peak all the way to the late 1970s, and then rising again for thirty years.

While the wealthy account for about 40% of consumption, there is a limit to how much the wealthy can consume. The rest is saved. Those who are sophisticated about money know that they cannot compound their savings through their own efforts as well as they can by hiring others to do for them. This generated a demand for above average returns from a bevy of financial professionals. Soon the better opportunities were identified and bid up, leaving a still large pot looking for spaces to occupy. The obvious solution for financial professionals was to "innovate" and create opportunities that did not yet exist.

One avenue would be to invest the funds in new ventures, but that is risky and good primary investments are limited. Clients were looking for regular performance that could be measured period over period. This meant generating credit instruments, such as securitization and other derivatives. This push to innovate in the financial sector lead to financialization.

Financialization exhausted normal channels, so financiers looked for new ways to expand credit. This led to extending credit to poorer and poorer risks as firms reached down into the pool of prospective borrowers. Competition resulted in a race to the bottom. As result credit quantity increased substantially, while credit quality decreased markedly.

Another problem was that real wages were not keeping up with productivity gains. The top was getting richer while the middle was stagnating and the bottom was losing ground, as welfare was cut. In MMT terms, demand leakage was not being offset by sufficiently large deficits, so either incomes had to increase or the economy had to contract, unless net exports increased, or the private sector increased indebtedness. What actually happened was that deficits were too low to offset the increase in net imports, which provided cheaper prices and tamed inflation, along with the increased saving taking place at the top. Worker incomes were held in check by neoliberal policy, e.g., weakening of labor and global labor arbitrage. Lax credit standards and competition for loans led to increasing private debt accumulating at the margin. The result is shown in the rising indebtedness at the middle and bottom that culminated at the cresting of the wave.

So "the first part of the equation" was the gathering of wealth at the top looking for a place to park at an attractive return, and "the second part of the equation" was the predicament of the middle and lower classes, who were not participating proportionately in economic growth. Moreover, they were becoming increasing indebted to maintain their standard of living, or even increasing lifestyle due to easy credit. Eventually, the level of private debt became unsustainable and finally imploded, drying up liquidity and plunging the world into a financial crisis from which it is still trying to recover as the middle class continues to deleverage.

Milanovic concludes:

The root cause of the crisis is not to be found in hedge funds and bankers who simply behaved with the greed to which they are accustomed (and for which economists used to praise them). The real cause of the crisis lies in huge inequalities in income distribution which generated much larger investable funds than could be profitably employed. The political problem of insufficient economic growth of the middle class was then “solved” by opening the floodgates of the cheap credit. And the opening of the credit floodgates, to placate the middle class, was needed because in a democratic system, an excessively unequal model of development cannot coexist with political stability.

Could it have worked out differently? Yes, without thirty years of rising inequality, and with the same overall national income, income of the middle class would have been greater. People with middling incomes have many more priority needs to satisfy before they become preoccupied with the best investment opportunities for their excess money. Thus, the structure of consumption would have been different: probably more money would have been spent on home-cooked meals than on restaurants, on near-home vacations than on exotic destinations, on kids’ clothes than on designer apparel. More equitable development would have removed the need for the politicians to look around in order to find palliatives with which to assuage the anger of the middle-class constituents. In other words, there would have been more equitable and stable development which would have spared the United States, and increasingly the world, an unnecessary crisis.

The Bank of England Investigates Credit Cycles and Macro-Prudential Policy

David Aikman, Senior Manager, Prudential Policy Division, Financial Stability Directorate, Bank of England, Andrew G Haldane, Executive Director, Financial Stability, Bank of England, and Benjamin Nelson, Economist, Financial Stability Directorate, Bank of England posted on Curbing the credit cycle at Voxeu.

They note, "Credit lies at the heart of crises. Credit booms sow the seeds of subsequent credit crunches. This is a key lesson of past financial crashes, manias and panics (See e.g. Minsky 1986, Kindleberger 1978, and Reinhart and Rogoff 2009). It was a lesson painfully re-taught to policymakers during the most recent financial crisis."

This is an important step forward. When Her Majesty the Queen asked her economists why they did not see the global financial crisis coming, they had no good explanation. In the neoliberal model, which holds that money is neutral, that is, does not impact the real economy, there was no indication that the world was headed for deep recession due to a financial meltdown. The only explanation for such an event in that model is external shock, and the expectation of the model is that the economy will right itself (return to equilibrium) automatically after the shock through the "invisible hand" of the market. Of course, this turned out to be wide of the mark when credit collapsed, bringing the debt-driven boom to an end. A "balance sheet recession" ensued as people struggled to deleverage, thereby curtailing demand.

It is therefore heartening to see representatives of the Bank of England recognizing the work of Hyman Minsky, which, incidentally, underlies MMT. According to Minsky's financial instability hypothesis, there is a financial cycle different from the business cycle. Aikman, Haldane, and Nelson investigate this cycle.

Whereas business cycles culminate in malinvestment and overproduction, financial cycles culminate in Ponzi finance, driven by price momentum. Whereas business cycles result in supply gluts that markets eventually clear, credit cycles result in bad debt that must be restructured or defaulted on. Depending on the level and quality of debt overhang, this can be difficult to clear without resulting in debt-deflation, which can lead to depression if not addressed by appropriate policy. In the recent global financial crisis, the level was high and widespread, and the quality of debt was low, since much of the lending had been imprudent.

Business and financial cycles are inherently different and require different policy responses when they emerge. It is also possible to head off credit cycles to some degree with macro-prudential policy.

Micro-prudential policy, aimed at tackling financial imbalances in individual financial institutions, may also be ineffective for dealing with aggregate credit cycles. That is because bank-specific actions will not, by themselves, internalise the spillovers that arise across banks over the credit cycle. They may even worsen them if they allow individual banks to steal a reputational march over their competitors.

This coordination problem suggests systematic, across-the-system actions are needed to curtail effectively credit booms and busts. This is one dimension of macro-prudential policy. To be effective, these policies need to increase the long-term cost of credit extension to banks during booms and, as importantly, to lower these costs during busts. These actions would help smooth out credit supply over the cycle. There are a variety of macro-prudential tools which could have this effect, including pro-cyclical capital and liquidity requirements, or remuneration packages that tie individual earnings more closely to long term performance (Bank of England 2009, Kashyap et al. 2010, G30 2010).

Credit spillovers occur across borders as well as across banks. This suggests macro-prudential policies need also to have an international dimension if they are to tackle credit externalities. This is recognised in the macro-prudential policy framework currently being discussed by the international regulatory community (BIS 2010). For example, judgements on local credit conditions determine the amounts of capital to be held by international banks on their exposures in those countries. This reciprocity feature should help to reduce the arbitrage risks posed by the internationalisation of the credit cycle.

Their post is short and worth reading in full. It is a welcome relief from the who-could-have-seen-it-coming excuses that have been proliferating up until now from "the experts," even though a few people did see it coming, and why, and said so some time before it arrived. One of these was Wynne Godley, ironically formerly of Her Majesty's Treasury and later one of its "six wise men," although he was long retired from his position there by the time of the GFC. The sectoral balance approach Godley developed at Treasury is integral to MMT. The gathering financial storm was also foreseen by UMKC professor L. Randall Wray, one of the developers of MMT and a student of Hyman Minsky.

Good to see the Bank of England catching up with things. Hopefully, MMT will follow their interest in Minsky.