Financial instability: Recurrence and Severity
Financial instability has been a recurrent event that plagued economies both in distant and recent pasts and can render even the most advanced financial systems vulnerable. Its costs are unavoidable either in terms of widespread bankruptcies and deflation or in terms of runaway inflation that generates a wealth redistribution in favor of debtors at the expense of creditors, pensioners, and wage earners. It erupts when a speculative boom bursts. The object of speculation has varied from boom to boom. The list of assets and goods that may attract speculation could be endless, and may include all types of commodities futures, bonds, gold, agriculture land, buildings, housing, stocks, and foreign exchange. Often, financial instability has its roots in a previous instability episode and lays, in turn, the ground for another episode of financial instability. Hence, conventional banking system seems to be caught in cycles of instability. While financial instability has not been a rare occurrence, its severity and duration have varied. Instability may manifest itself though a temporary crisis of the banking system and limited spill over to the real economy. It may, however, evolve into a severe banking and economic crisis, as was the case in Argentina for example, resulting in large number of bankruptcies, deposits losses, deflation or inflation episodes, contraction in output and massive unemployment, collapse of exchange rates, paralysis of international trade and emergence of trade restrictions. Economic decline can persist for many years before recovery starts and activity returns to pre-crisis level.
The present financial crisis in the US and Europe, which finds its origin in the “Greenspan put” in the wake of the collapse of the stock market in late 1990s and the collapse of long-term capital management (LTCM) hedge funds, has manifested itself through a burst in housing bubble, collapse of credit derivatives and securitization, meltdown of sub-prime market loans, and massive bailout of financial institutions in the US and Europe. [The “Greenspan Put” refers to the monetary policy that Alan Greenspan, the former Chairman of the US Federal Reserve Board, fostered from the late 1980s to the middle of 2000. During this period, when a crisis arose, the Fed came to the rescue by significantly lowering the federal funds rate, often resulting in a negative real yield. In essence, the Fed pumped liquidity back into the market to avert further deterioration. The Fed did so after the 1987 stock market crash, the Gulf war, the Mexican crisis, the Asian crisis, the LTCM debacle, Y2K, and the internet bubble burst. The Fed set interest rates at record low levels during 2001-2004 causing a phenomenal credit expansion at about 12 percent per year. The Fed’s pattern of providing ample liquidity resulted in the investor perception of put protection on asset prices. This created a moral hazard problem where investors increasingly believed that when there is a financial crisis, the Fed would step in and inject liquidity until the problem got better. Invariably, the Fed did so each time, and the expectation became firmly embedded in asset pricing in the form of higher valuation, narrower credit spreads, and excess risk taking. The end result has been moral hazard in risk taking and successive bubbles in equities, real estate, and commodities].
As write downs have so far exceeded US$500 billion, old-established institutions have fallen (e.g., Lehman Brothers) and many financial giants are rescued through massive bailouts (including the recently rescued Fannie Mae, Freddie Mac, and AIG) the spread of the unfolding crisis attests to the severity of this episode of financial instability. Destabilizing financial and economic shocks are still intensifying in credit, commodities, and currency markets; as in the case of Japan during 1990-2001, they could foreshadow a prolonged contraction of output growth and employment. Although reminiscent of the 1970s stagflation, the present financial crisis has set off highest inflation in modern history in energy and food prices, triggering widespread food riots and protests, and has been reducing real incomes at a fast rate. The last-resort lending by central banks is eroding real savings, undermining capital accumulation, and long-term economic growth. As the crisis is still evolving, uncertainties are rising and economic recession could be longer and more severe than any other postwar recession.
Financial instability is not restricted to developed countries. It has played havoc with a number of major South East Asian economies, causing banking and corporation bankruptcies, severe contraction of output and employment (exceeding 10 percent in real terms), and loss of international reserves. Many highly indebted poor countries and middle income countries have experienced severe debt crisis which have disrupted their economic growth. In spite of major debt write-offs, many debt-burdened countries have not yet been able to experience sustained recovery or achieve debt sustainability.
History is replete with recurrent financial instability. Many episodes and their causes have been documented (e.g., Friedman and Schwartz, 1963, Galbraith, 1954, Kindleberger, 1977, Minsky, 1986). Severe financial turbulences occurred in1837, 1873, 1893, and 1907. In the wake of each episode, massive bankruptcies ensued, leading to millions of jobs lost and to economic decline. Certainly, the Great Depression of 1929-1933 was the worst episode of financial instability in modern history. It hit hard in the US and Europe, causing large scale bankruptcies, debt deflation, steep fall in output (by over one third in real terms) and prices, and massive unemployment and poverty. It was responsible for monetary chaos that prevailed in 1930s, leading to the human tragedy of the Second World War. Soon after the war, warring powers rushed to establish the Bretton-Woods system with the mandate to stabilize world economy, adopt fixed instead of highly volatile and flexible exchange rates, and take steps to mitigate the causes that led to monetary instability of the pre-war period.
Financial instability led to abandonment of the gold standard after the First War 1914-1918 and its replacement by the gold exchange standard and flexible exchange rates (1922 Genoa agreement). It was then replaced by the fixed exchange rates system, which was in turn abandoned and replaced by a return to floating exchange rates. The suspension of gold standard has made inflation a regular feature of the conventional monetary system leading to prolonged and destabilizing inflationary episodes.
Causes of financial instability
In view of its devastating effects, considerable research effort has been devoted to explaining the causes of financial instability and to prescribe remedies that would reduce the risk of instability and spare the economy dire and needless costs in terms of deep contraction in output, large scale unemployment, bankruptcies, dramatic fall in real incomes, and social hardship. Financial instability has often been caused by war or large fiscal deficits which were financed by printing money. However, financial instability could also be caused by ill-designed monetary policies, abundant liquidity and excessive and imprudent credit expansion, or by market forces endogenous to the financial system.
1. Over-indebtedness and Deflation
Irving Fisher (1933) reviewed many possible causes that may lead to financial instability. He argued that two dominant factors were responsible for each boom and depression: over-indebtedness in relation to equity, gold, or income which starts a boom, and deflation consisting of a fall in asset prices or a fall in the price level which starts a depression. He noted that over-investment and over-speculation are often important, but they would have far less serious results if they were not conducted with borrowed money. That is, over-indebtedness may reinforce overinvestment and over-speculation. Disturbance in these two factors: debt and the purchasing power of a monetary unit, will adversely impact all other economic variables. If debt and deflation are absent, other disturbances would be powerless to bring on crises comparable in severity to those of 1837, 1873, or 1929-1933.
Fisher found that easy money was the great cause of over-borrowing. When an investor thinks he can earn high returns by borrowing at low rates, he will be tempted to borrow and to invest or speculate with borrowed money [Henry Simons (1948) advanced similar analysis for financial instability. He wrote “It is no exaggeration to say that the major proximate factor in the present crisis (i.e., 1929-1933 Great Depression) is commercial banking. We have reached a situation where private-bank credit represents all but a small fraction of our total circulating medium.” Fast expansion of bank credit at the expense of creditworthiness was followed by sharp credit contraction as banks attempt to restore the quality of the assets and recover from their losses. The power of banks to create and destroy money on a large scale has caused large fluctuations in output and employment and became a source of considerable monetary uncertainties. In Simons (1948), financial instability is compounded by price and wage rigidities, with the brunt of adjustment born by decline in quantities (i.e., output and employment)]. He maintained that this was the prime cause leading to over-indebtedness of 1929. Low interest rate policy adopted by the US to help England to return to the gold standard in 1925 contributed to unchecked credit expansion. Brokers’ loans, with very small margins and low interest rates, expanded very fast and fueled stock market speculation. Inventions and technological improvements created investment opportunities leading to large debts. Other causes were the left-over domestic and foreign war debts and the reconstruction loans to Europe.
The depression was triggered by debt liquidation which led to distress selling and to contraction of deposit currency as bank loans were paid off, and to a slowing down of velocity of circulation. The contraction of deposits caused a fall in the level of prices. There followed a greater fall in the net worth of businesses, precipitating bankruptcies, a fall in profits leading to a reduction in output, trade, and employment, which in turn led to hoarding and slowing down of the velocity of circulation.
Fisher’s analysis showed that financial instability of the scale of the Great Depression was avoidable if over-indebtedness was precluded. He emphasized the important corollary of his debt-deflation theory that great depressions are curable through reflation and stabilization. He maintained that the government can reflate the price level through printing money to finance deficit needed to kick-start economic recovery. The central bank can also re-inflate through open market operations or lending as a last resort. Referring to Sweden where economic policy was able to maintain stability during 1929-33, he believed that price level was controllable through appropriate policy instruments.
Friedman and Schwartz (1963), and Friedman (1959, 1969, 1972) conceived of financial instability as a monetary phenomenon–described as faster money expansion due to unchecked credit expansion– and significantly downplayed real factors. In each financial crisis, banks suspended conversion of deposits into currency, and a wave of bank failures ensued. The analysis of the causes of the Great Depression by Friedman and Schwartz (1963) sheds light on the causes that led to the present financial crisis characterized by meltdown of sub-prime loans and the burst of the housing boom. They argued that fierce competition among banks and financial innovation evaded prudential regulations, contributed to over borrowing for speculation in housing and stock markets and a deterioration of the quality of loans. They noted that financial instability of the scale of the Great Depression did not happen prior to the creation of the Federal Reserve System (Fed) in 1913. The founders of the Fed were expecting that financial instability of the 19th and early 20th century would be thwarted or significantly reduced by the creation of a central bank. With regard to the Great Depression, Friedman and Schwartz held the view that the Fed was accountable for two policy errors: it was reluctant to prevent a speculative boom at an early stage and it was not able to move fast enough to avoid massive bank failures and deep depression. Based on a comprehensive study of the US monetary history, they observed that financial stability prevailed only when money supply was increasing at a stable and moderate rate of 2-3 percent. In line with Simons (1948), Friedman strongly rejected discretionary and unpredictable monetary policy and prescribed the rule of setting fixed targets for the growth of monetary aggregates in line with the expansion of economic activity [Maurice Allais (1999) was a strong supporter of fixed rule. In full agreement with Friedman, he proposed a fixed target for money supply, compatible with a long-term inflation at about 2 percent a year].
Galbraith (1954), Kindleberger (1977), and Soros (2008) found that speculative manias gather speed through expansion of money and credit. During a speculative euphoria, many credit instruments become ‘monetized”, fueling speculation. The Radcliffe Commission in Britain in 1959 claimed that in a developed economy there is a wide range of financial institutions and many highly liquid assets which are close substitutes for money, as good to hold, and only inferior when the actual moment for a payment arrives. Call money, more specifically brokers’ loans, combined with small margins and low interest rates, financed stock market speculation in 1929. Credit instruments can be monetized during a speculative boom; these instruments include bills of exchange, negotiable CDs, installment credit, NOW accounts, credit cards, mortgages, and students loans. When a speculative boom bursts, these credit instruments become illiquid and there is a rush back to liquidity and safety.
2. Minsky: stability is unstable
Minsky (1986, 1992) considered financial instability to be endogenous to conventional financial system. His core model is known as Financial Instability Hypothesis (FIH), which simply declares stability is inherently unsustainable. A fundamental characteristic of a conventional financial system, according to Minsky, is that it swings between robustness and fragility and these swings are an integral part of the process that generates business cycles. His theory “stability is unstable” was influenced by Keynes’s notion of the fundamental instability of market expectations, and by Schumpeter’s notion that capitalism renews itself through competition and innovation – ‘creative destruction’ that chucks out the bad and ushers in the good. But while Schumpeter focused on technology’s role in driving capitalism, Minsky’s focus was on banking and finance. Minsky contended that nowhere is evolution, change and Schumpeterian entrepreneurship more evident and the drive for profits more clearly a factor in making for change than in the conventional banking and finance. Financial innovation as a destabilizing influence becomes evident with the burst of a speculative boom.
Minsky looked at all participants in the economy — households, companies and financial institutions — in terms of their balance sheets and cash flows. Balance sheets are composed of assets and liabilities, while cash flows validate the liabilities. Minsky’s economy comprises what he calls a “web of interlocking commitments” — a vast and complex network of interconnected balance sheets and cash flows that is always changing and evolving. During periods of stability people feel more confident. According to Minsky, they respond by increasing their liabilities relative to income; the “margin of safety” declines.
Minsky classified borrowers, according to their balance sheet and ability to make interest and principal payments, in three distinct categories, which are labeled as hedge, speculative, and Ponzi finance. Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows. According to Minsky’s definition, the greater the weight of equity financing in the liability structure, the greater the likelihood that the unit is a hedge financing unit. Speculative finance units are units that can meet their commitments on interest payment, even as they cannot repay the principal out of income cash flows. Such units need to roll over their liabilities — issue new debt to meet commitments on maturing debt. For Ponzi units, the cash flows from operations are not sufficient to fill either the repayment of principal or the interest on outstanding debts. Such units can sell assets or borrow. Borrowing or selling assets to pay interest (and even dividends) on common stocks lowers the equity of a unit. The key feature of a Ponzi scheme is its need to attract ever greater sums of money. To survive, Ponzi units must refinance, either by selling assets or by raising more debt. For this to happen asset prices must continue to rise. Ponzi finance typically emerges during a speculative bubble, when the margin of safety has been undermined.
Minsky stated that if hedge financing dominates, then the economy may well be an equilibrium-seeking and containing system. In contrast, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation-amplifying system. The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable, and financing regimes in which it is unstable. The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system.
Minsky observed that financial institutions compete furiously, both when investing and when providing credit to others. Inspired by Schumpeter’s notion of “creative destruction”, he described the proliferation of financial innovations as means to attract more borrowers and to bypass existing regulations. The level of product innovation has run far in advance of the capacity to utilize these products and the ability to understand the characteristics of risks and long-term consequences. Recent instruments– based on the idea of “originate and distribute”, instead of “originate and hold”, as well as securitization models–include mortgage backed securities (MBS), collateralized debt obligations (CDO), and CDO tranches, let alone CDO-squared (tranches from CDO tranches), CDO-cubed (tranches on top of CDO-squared) or the most abusive credit default swaps (CDS). The more the layers of derivatives on top of each other, the more sensitive they are to even small changes in the underlying variables and assumptions (No wonder that many AAA rated CDOs have only a 50% rate of recovery, and everything else including AAs and single As are pretty much wipe outs).
Banks are not the only financial institutions competing fiercely with one another for profits. Swindles, fraud, theft, embezzlement, and deceptive rating dominate as Ponzi financing units multiply. They make large gains in the process. When their liabilities become valueless, losses are born by banks, and massive bankruptcies erupt. Present day hedge funds, as contrasted with Minsky’s notion of hedge unit, play an increasingly important role in the credit markets, providing liquidity to the housing market by buying mortgage-backed securities and fueling the growth of leveraged buyouts and structured finance. As hedge funds are not regulated, little is known about the true extent of their leverage or the positions they take.
However, their capacity to leverage is potentially enormous. By borrowing five times its assets and investing in the riskiest part of a structured security such as collateralized mortgage obligations, a credit hedge fund could in theory become lender of $850 million worth of residential securities by committing just $10 million of its own funds. Credit hedge funds rely on short-term financing to pursue leveraged strategies. A synchronous deleveraging of credit hedge funds could become a new risk element in the credit markets.
Following the teaching of Irving Fisher, Minsky held that the crisis has a deflationary impact as people seek to pay off debts. His prescription was conventional: more government spending and lower interest rates from the central bank could prevent debt deflation. His view on the consequences of these actions was less conventional. Minsky contended that successful interventions during crises discouraged financial conservatism. If the boom is unwound with little trouble, it becomes quite easy for the economy to enter a new phase of instability. Financial institutions respond to the fact that the authorities are protecting them from financial catastrophe by plunging anew into risky activities; hence an enhancement of moral hazard risk.
The successful resolution of a crisis further strengthens moral hazard. Moreover, large government deficits combined with low interest rates and high inflation reduce dramatically real savings and erode capital accumulation, thus reducing economic growth or even bringing it to a halt [In the Harrod-Domar model, real economic growth rate is equal to the savings rate, i.e., ratio of savings in percent of GDP, divided by the incremental capital output rate. The lower the savings rate, the lower economic growth will be. In the United States, low interest rates have caused large external deficits during 2001-2008, about 6-7 percent of GDP, negative national savings, and full dependence on foreign financing of economic growth].
Fisher and Minsky’s prescription for massive bailouts and large scale last resort lending could be debatable from social equity and economic point of views. Recent large bailouts by the Fed was extended to investment banks which did not pay insurance premium to the FDIC, and were not regulated; they were therefore not eligible for Fed’s lending facilities. Moreover, bailouts validate uncontrolled credit expansion and socialize losses from speculative booms while the gains enjoyed by speculators remain private. High Inflation resulting from last resort lending erodes real incomes of pensioners and wage earners. While the Fed has prevented bank liquidations, it has set off liquidation of real savings and investment, agonizing economic slowdown, and loss of jobs and incomes.