Theories Of Financial Crisis - Minskyan

Question 1

Investment as a driver of the crisis

Answer 1

Investment is financed using internal and external funds

During booms, firms are even more willing to borrow and commit their expected profits to servicing debt

But this exposes the firm to high risks: if profits are less than expected and/or interest rates rise firms may not be able to repay

Question 2

Minsky fundamental eq

Answer 2

Pie = I + D + XN + C -S

Pie = profit
I= investment, D= gov deficit, XN = net exports 
C= consumption out of profit
S= saving out of wages

Thus higher investment generates higher profits, but this can make the economy more unstable if profits exceed expectations and firms borrow more

Question 3

3 types of investor

Answer 3

Hedge - can repay debt out of income flows

Speculative - can repay interest but must rollover principal

Ponzi - must borrow to repay interest

After a sequence of ‘good times’, euphoria starts and hedge investors are replaced by speculative
Eventually some speculative realise they can’t repay interest and gamble for resurrection

When lenders realise that they’re rolling over debt to ponzi, they stop financing and this brings about the crash

Question 4

Debt deflation

Answer 4

Debt deflation theory:

When a borrower collapses,all of its creditors suffer losses and some will default on their own debts causing a snowball of defaults

Uncertainty and pessimism prevails, investment declines sharply and income and consumption follow the same fate, paving the way to a recession

However Minsky doesn’t claim that all financial crisis lead to a Great Recession

Question 5

Countercyclical policy

Answer 5

According to Minsky government action could act as a stabilising mechanism

Government should act countercyclically using fiscal policy

Run surpluses in booms and deficits during recessions

This would smooth economic activity with gov deficit replacing inflation in the fundamental equation

However m policy doesn’t stabilise the economy. Investment is driven by euphoria and raising interest rates during booms can lead to more risky behaviour by financial investors

Question 6

Lender of last resort (LLR)

Answer 6

Only positive function of central bank is to be lender of last resort putting a floor to asset prices, reducing debt deflation process

Also avoids distressed financial institution having to recur to fire sales to cover depositors’ withdrawals

LLR function helps reassure markets and prevent panic (bank runs). This is what occurred in 1987 stock market crash

However according to Minsky this floor function can only work with greater financial regulation, otherwise LLR may only induce moral hazard at taxpayers expenses

Question 7

Global crisis

Answer 7

Problem of recurrent crisis is seen by Minsky as a global problem due to a combination of factors

1. Highly leveraged funds seeking for max returns
2. Lack of regulation at international level
3. LLR interventions by IMF, WB, Federal reserve to prevent global crisis via pumping money into system
4. Rating agencies not assessing properly risky assets
5. Credit default swaps that were insuring risky behaviour

Question 8

Instability of capital system

Answer 8

Dynamic forces of capitalist system are explosives and must be contained by institutional ceilings (financial regulation) and floors (social safety net)

However, if the crash due to speculative euphoria is protected by a safety net this will only increase the reward for risky investment and speculation