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A world in crisis: the fundamentals of a financial crisis

23/12/2017

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This series is a three-part exploration on our next financial crisis. This first article explores the fundamental questions behind the theory of financial crises: what is a financial crisis; what causes it; and why is there an increasing number of them?

According to The Economist, in a recent report on long-term asset returns, Deutsche Bank defines a financial crisis as having at least one of the following four characteristics: a fifteen percent annual decline in equities; a ten percent fall in the currency or government bonds; a default on the national debt; or a period of double-digit inflation. In recent decades, spotting one of the four characteristics has become increasingly easy.

Among the prevalent theories about what causes a financial crisis is Hyman Minsky’s financial instability hypothesis, which argues that overconfidence during times of financial stability inevitably begets financial instability, and this cycle leads to booms and busts. To read more about Minsky’s theory of booms and busts, click here. Along the same lines of placing behavioral factors as the main drivers of financial crises is Robert Shiller’s theory of social contagion of boom thinking. In his book, “The Subprime Solution”, Shiller argues that booms and busts are analogous to a virus, which has a contagion rate and a removal rate (the removal rate is the point where the individual is no longer contagious). Epidemics follow when the contagion rate is higher than the removal rate.

Take, for example, the Global Financial Crisis. Feverish excitement about the property market prevailed in the US, and poorly-backed-up statements such as “property prices have nowhere to go but up” permeated most conversations about property. The prominence of such statements was confirmation of their truth to people. People then disregarded their own judgments and opinions in favor of this general information. Consequently, their contrarian views were never shared with the rest of society, and did not feature in the collective judgement. Thus, over time, the quality of group information declined. Shiller refers to this a feedback loop, in which optimism begat more optimism.

Shiller’s theory of social contagion is further aggravated by herding, where, according to John Cassidy, “at the peak of a bubble, stories of ordinary people getting rich circulate widely, exerting great psychological pressure on others to join the herd”. In a YouTube interview, Shiller elaborates on his point: “We emerged into the 21st century, believing that nothing could go wrong, and so we bought tons of houses. However, the biggest factor is our general complacency.”

The busts were similarly exacerbated by social thinking. At the height of the 2008 crash, nobody knew which bank had exposure to what bad assets, and the overconfidence and hubris that had built rapidly during the boom suddenly turned into to a lack of confidence, which was equally as contagious as the previous build-up of confidence.

Shiller also discusses in depth the role of the media in exacerbating both the booms and busts. For example, in the Global Financial Crisis, the type of stories that interested the media were the ones about poor people getting rich, instead of complicated collateralized debt obligations (CDOs, i.e. sub-prime mortgages that were packaged together and sold to investors). In an essay, Narrative Economics, Shiller explains the role of media in the Great Depression, this time on its crash: “The first narrative of the Great Depression was that of the stock market drop on October 28, 1929. This narrative was especially powerful, in its suddenness and severity, focusing public attention on a crash as never before in America.”

Concrete examples of Shiller’s theory of social contagion during the Global Financial Crisis are abundant. Take, for example, the Icelandic Financial Crisis, and Ireland’s financial crisis. Iceland is a small island and was very closely networked, both socially and politically. There was no one in either politics or business that did not go to the same school or mix in the same circles. This provided a fertile ground for social contagion of thought patterns, which perpetuated the belief that markets could only go up, leading the Icelandic banks to assume ever greater amounts of debt in pursuit of profits. The close interconnectedness of the Icelandic economy meant that the feedback loop was quicker and more vicious.

Ireland, like Iceland, was a small island that was characterized by homogeneity. The small size of the country ensured that politicians and financiers knew each other well, and were thus rendered subject to herd behavior. The media in Ireland exacerbated the boom it faced: it had close ties to the property market, and consequently, huge incentives to keep up property prices. According to Shiller, the media talked up the boom, and the bust was consequently much rougher.

In all previous crises, we have seen telltale signs of financial stability breeding instability, and social contagion causing booms and busts. These have been constant factors in the human nature, but still we see more crises in the last few decades than ever before. Why is there an increasing number of financial crises?

Deutsche Bank argues that the answer lies in the monetary system. Before the early 1970s, when the Bretton Woods fixed exchange rate system was in place, money creation was limited. A country that increased its supply of money too quickly faced inflation. This led to the price of exports increasing, which led to a decrease in exports, which led to exchange rate depreciation, which led the central bank to no longer expand money supply too quickly. In other words, it was hard for financial bubbles to form, given the central bank’s control over money supply.

However, following the abolition of Bretton Woods in the early seventies, most developed countries switched to a floating exchange-rate regime. This new system allows them to not “subordinate other goals to maintaining a currency peg” (to see a central bank’s goals in relation to a currency peg, read this article on the Mundell-Fleming trilemma). This allows for greater trade imbalances, as the currency can bear the burden of it – at least for a while.

These problems are reflected in government debt, which, since floating rate regimes, has been rising as a ratio to GDP. Governments find no pressing reasons to reduce the debt-to-GDP ratio: according to The Economist, “Japan has had a deficit every year since 1966, and France since 1993. Italy has managed just one year of surplus since 1950.” Consumers and companies, as well, have been taking on more debt as well.

This is especially worrying. In previous crises, such as the Global Financial Crisis, debt has financed the purchase of assets to cause an upwards spiral, i.e. a boom, and this similar downwards spiral can happen during a bust. To understand the role of debt in a bust, it is important to understand leverage. Leverage is the degree to which an investor is using borrowed money as opposed to his own funds (equity).

Consider, first, an asset bubble. Assume an asset price goes up. This enables investors to borrow more against the assets, while maintaining the proportion of debt. In fact, encouraged by the rising asset prices, lenders are willing to raise the proportion of debt. With the additional debt available, investors are able to buy more assets, raising the asset prices further in an upward spiral.

A similar process in reverse happens during the deleveraging stage. In fact, the longer the deleveraging cycle persists, the worse the situation gets. During deleveraging, firms usually sell the easy-to-sell assets that are the most liquid. The longer this goes on, the worse the quality and liquidity of the remaining assets.

A sudden fall in asset prices during a deleveraging cycle does not happen randomly: it is often caused by an external event. CNBC refers to the Deutsche Bank report, and cites a multitude of potential triggers for a fall in asset prices, if we are, in fact, in an asset bubble. Among these triggers is a potential Italian crisis. Deutsche states: "A country nearing an election and with high populist party support, with a generationally underperforming economy, a comparatively huge debt burden, and a fragile banking system which continues to have to deal with legacy toxic debt holdings ticks a number of boxes to us for the ingredients of a potential next financial crisis." Other triggers that Deutsche has cited are Brexit, and a rise in populism.

If we are in a bubble, then we can expect to see a bust in the coming years. If this is the case, central banks must have enough tools to protect the economy from this bust. As a reaction to the crisis, in 2008, central banks cut interest rates and bought assets directly in a mechanism known as quantitative easing. This stopped the previous crisis, but each boom and bust cycle has reflected higher debt levels and asset prices. Now we see that the combined valuation of bonds and equities in the developed world is at its record high.
 
If this really is the case, all evidence points to a debt-related boom-and-bust cycle. If we are in an asset bubble, we should be able to see the social contagion of thinking exacerbated by the media, as well as risky investments replacing safe ones. In the next article, I will look at signs that we are currently in an asset bubble, including the prices of stocks, equities, and property.
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2. “Minsky’s Moment” – The Economist

17/8/2016

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Synopsis: The second in the series about the Minsky Moment and how it changed economics.

Click here to read the original article.

1. Click here to read the introduction post.
2. Click here to read the first post on asymmetric information.
Discussion:
 
Hyman Minsky
 
Hyman Minsky is best known for his work on what causes a financial crisis. His work remained unnoticed throughout his lifetime and for a long while after. This is, in large part, due to the fact that his work was not in conformity with mainstream economics. While the majority of economists believed that markets were efficient (explained under ‘Context’), Minsky argued that inefficiency is what causes financial crises, and called this hypothesis the “financial-instability hypothesis”.
 
The financial-instability hypothesis
 
This describes how “long stretches of prosperity sow the seeds of the next crisis”, according to The Economist.
 
First, Minsky defined investment as giving money in the present in return for getting money back in the future.  For example, an ice cream machine is an investment. An ice cream parlor gives money right now to buy an ice cream machine. Due to the ice creams the machine produces, the firm gets money back in the future.
 
Where does the ice cream parlor get the money to buy the machine? It can get it from two sources: its own funds or others’ funds (e.g. the bank). The balance between the two sources is key to explaining financial instability.
 
Next, Minsky describes three types of investments.
 
  1. Hedge financing: All of a firm’s borrowing is repaid with its future cash flow (explained in ‘Key Terms’). In order for this to work, a firm must have little borrowing and lots of profits. This is the most stable type of investment.
  2. Speculative financing: Cash flow covers interest payment but firms must roll over their debt to repay the principal (explained in ‘Context’). This is riskier than hedge financing.
  3. Ponzi financing: Cash flow covers neither principal nor interest; thus, a firm is forced to rely on the value of the asset to cover its costs (explained in ‘Context’). If the value of the asset falls, either due to contractionary monetary policy or an external shock, the firm will have to default.
 
These three types of financing are illustrated in the diagram below.
Picture
​Thus, an economy with mostly hedge financing is the most stable. An economy dominated by Ponzi financing, on the other hand, would mean that all asset values are vulnerable to external shocks of any kind, which, in turn, would hurt the economy. An economy could restrict itself to hedge financing, but will not do so. During times of healthy economic growth, firms are increasingly tempted to invest in riskier projects, and banks are increasingly tempted to finance these projects through riskier means, i.e. speculative and Ponzi financing. This is because they believe that a firm can ultimately pay back its debt, given the good growth.
 
Thus, an economy dominated by hedge financing slowly becomes an economy dominated by Ponzi financing, and a drop in asset values leads to a financial crisis. In other words, economic stability breeds instability.
 
The point at which asset prices start plunging is called a “Minsky moment”, which is a term coined by PIMCO’s former chief economist Paul McCulley. A Minsky moment is now synonymous with a financial crisis. This is illustrated in the diagram below.
Picture
Neither The Economist nor Minsky himself provided an explanation for the trough in the business cycle, but an explanation can be extrapolated from the cause of a Minsky moment. The Minsky moment is the point at which asset values collapse through some external shock (e.g. monetary tightening), or, more importantly, banks stop lending due to faltering confidence. Thus, the trough might be when banks once again resume lending when confidence picks up and they believe that the investment projects are safe.
 
If we assume this to be the reason for a trough, then we can assume that even without any external shocks (such as government intervention or a war), the business cycle would occur.
 
Minsky today
 
At the time, Minsky’s work was disregarded. People believed that markets are efficient and stable. Now, behavioral economics has adopted the idea that markets are not efficient.
 
Minsky and the nature of economics
 
The financial-instability hypothesis explains a very specific situation in which a stable economy leads to an unstable economy due to increasingly risky investments and financing. This goes against the grain of economic theory, which aims to explain a general concept. Take, for example, the theory of demand, which states that for any normal good, the increase in the price results in a decrease in demand. Thus, the theory of demand explains a multitude of economic situations – the financial-instability hypothesis does not.
 
For this reason, mainstream economics ignored Minksy’s hypothesis. After his death, and after the financial crisis, his work gained popularity and relevance.
 
The implications of the hypothesis
 
The world is still shaken up by the Global Financial Crisis (GFC) and its aftermath. Investment is much less risky now than it was pre-GFC. But if we were to look at the future of the global economy using Minsky’s hypothesis, the conclusion is clear: economic actors will forget, or perhaps ignore, the warnings of the GFC in favor of riskier and riskier financing.
 
Looking further
 
Looking past The Economist article, there are some things worth mentioning.
 
The application of the Minsky moment can be seen in the financial world. Firms have to make two types of decisions: which investment projects are worth pursuing, and how to finance them (i.e., through their own funds or borrowed funds). As the economy picks up steam, firms start undertaking riskier projects and they also start financing them with more of borrowed funds. This eventually leads to a Minsky moment of instability.
 
The other interesting point about Minsky’s work is what generates business cycles, and why they are self-adjusting. Mainstream thinking follows Keynesian economics: peaks and troughs are determined by whether an economy is above or below full employment. Minsky provides an alternative explanation to why the business cycle is self-adjusting.

Key Terms:
 
Cash flow: The amount of money generated by a business.
 
Context:

1. What does “markets are efficient” mean?

This refers to a hypothesis called the efficient market hypothesis.
 
The efficient market hypothesis states that all the available information in a market is already reflected in the price. One of the implications is that it is impossible to “beat the market”.
 
For example, assume the price of Disney shares is $10 per share. Disney then releases the news that a new movie is coming out, and everyone reacts immediately by buying Disney shares in the hope that when the movie comes out, the value of the share will appreciate. The share now costs $11. When the movie actually comes around, the market would have already reacted to the news and the price of the share will stay at $11.
 
An individual might try to beat the market by investing in a share given new information, but ultimately, according to the efficient market hypothesis, he or she will not be able to.

2. What does it mean to roll over debt to repay principal?

A firm rolls over its debt by borrowing principal from another bank.
 
Suppose an ice cream firm borrows $100 to buy an ice cream machine from Bank 1. The interest rate at Bank 1 is 10% a year. Thus, after a year, the ice cream firm must pay $110 to Bank 1.
 
At the end of year 1, the ice cream firm has made $30. Thus, it still needs to get $80 from somewhere to pay back Bank 1. The firm goes to Bank 2 and borrows $80 at 10% a year. It can now pay back Bank 1.
 
At the end of year 2, the firm owes Bank 2 $88. If the firm has made $30 again during year 2, it must borrow again to repay the principal from Bank 2.
 
This is how a firm rolls over debt. In theory, as long as the profits exceed the interest rate, a firm will ultimately be able to pay back all its debt.

3. How would an asset cover a firm’s costs?
​
Selling off an asset would get a firm money, which it can then use to pay back the bank. If the value of the asset falls, then it may not be able to cover the principal or the interest rate it owes the bank.
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    A gap year student trying to explore real-world economics

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