Eventually, some insiders decide to take their profits and sell out and the increase in prices begins to moderate. A period of "distress" may then occur until speculators realise that the market can only go downwards. The crisis may be precipitated by some specific signal such as a bank or firm failure or a revelation of a swindle; the later are quite frequent in such circumstances as people try to escape the imminent collapse. The rush out of the real or long term assets ("revulsion" in Minsky's terms) lowers the prices of these real assets which were the object of the speculation and may develop into a panic. The panic continues until either the price falls so low that people are tempted to keep their illiquid assets or a lender of last resort intervenes and /or manages to convince the market that money will be made available in sufficient volume to meet the demand for cash.
Minsky, unlike many others who otherwise accept much of his model, believes that this process will always result to a crisis. Minsky classifies the demand for credit to "hedge finance" when cash receipts are expected to exceed the cash payments by a significant margin, to speculative finance" when, over some periods, expected earnings are less than payments and to "Ponzi finance" when the payable interest in the firm's commitments exceeds its net income cash receipts; thus a Ponzi unit has to increase its debt to be able to meet its commitments. Once the Ponzi finance situation becomes general, a crisis is inevitable. Others, however, believe that there are ways to prevent Ponzi finance from becoming too widespread.
This model described above implies that crises are in part endogenous and in part outcomes of exogenous disturbances. Whether this conclusion supports the "financial fragility" view depends on the weights given to the disturbance and the endogenous part of the process. If the shocks necessary to set off this process are of exceptional size and rare then obviously the financial system can be thought as stable. Indeed it has been suggested that the recent crises have in fact showed the resilience of the financial system against huge adverse shocks. If instead the speculative forces are triggered by even relatively small shocks we can then blame the financial system even if the shock were exogenous.
This is both an empirical and theoretical issue. Empirically the euphoria-distress-revulsion process seems to conform with the experience of many crises such as the 1929 stock market crash, though many others have not gone through the whole process. Theoretically, we have to explain the assertions of the above model, namely for the existence of speculation and other "irrational" behaviour as implied by "manias" and "overtrading".
Friedman rejects the notion of destabilising speculation completely as a destabilising speculator who bought when the price was rising and sold when it was falling, would be buying high and selling low so that he would be losing money and fail to survive. The answer may be that we can distinguish in two groups of people: the "insiders" who are rational and possess a lot of information and the "outsiders" who may not be "fully" rational and/or not possess adequate information. In such a world, the insiders have incentives to speculate and gain at the expense of the outsiders. We may also distinguish in the 2 phases of the bubble, a first "rational" one based on "fundamentals" and a second where agents' behaviour is best described by 'mob psychology'. Other possibilities are that agents may choose a wrong model of the economy or fail to anticipate the quantitative rather than the qualitative reaction to a certain stimulus, especially if there are time lags.
The question, however, is whether outsiders learn by experience though it can be argued that in rapidly changing complex financial markets such learning may not be very effective. Still "euphoria" arguments may be a little naive when applied, for example, to contemporary bankers who have access to a wealth of sophisticated advice. Indeed a criticism of the Minsky model is that though it might have been true of some earlier time, it is no longer so as big unions, big banks, big government and speedier communications have improved the stability and efficiency of the system. Hansen similarly argues that since the mid 19th century the main outlets of finance were the industrialists rather than the traders and merchants reducing the instability of credit. As we shall see later on, especially after the recent deregulations such arguments are questionable.
The monetarists further object to this theory because they argue that we should distinguish between "real" or "true" crises which were caused by changes in money supply and "pseudo-crises" which were not. For example, Friedman has argued that the 1929-32 crisis was largely due to a fall in the money supply. There is little reason, however, why the supply of money is more than an element in financial flows and stocks and indeed Friedman's explanation of the Great Depression has been challenged.
Minsky has further argued that the fragility of the financial system relative to disturbances and speculator behavior depends on three factors: the mix of hedge, speculative and Ponzi finance in the economy, the levels of liquid asset holdings (what he calls "cash kickers" and Margins of Safety) and the way used to finance Investments of long gestation. He further argues that inherently and inevitably the capitalist system will result in the worst combination of the above as far as financial stability is concerned. Minsky bases such conclusions on what he calls a "Wall street economy" paradigm as contrasted to the essentially barter economy of the neoclassical paradigm. Minsky in fact traces his views on Keynes who also expressed his concern for an increasingly speculative and unstable financial system governed by animal spirits.
In an initially robust financial system, he claims, agents will overestimate the stability and success of the system and will increase their indebtedness (an "euphoric economy"), so that speculative finance will become the norm. Similarly overconfidence will make agents reduce their Cash Kickers although such margins are crucial for speculative finance units. These mean that the economy and the financial system become very sensitive to variations in interest rates. Finally, investment projects which have a long gestation period can be financed either sequentially or by prior financing. For similar reasons agents generally chose the risky way of financing projects sequentially which not only further increase the interest sensitivity of the financial sector but increases the volatility of interest rates themselves as they imply an inelastic demand for finance given sunk costs plus possible effects in the real economy through falls in Aggregate Demand. This, however, does not sound a very robust argument as one would expect that as Wallich argued, once the system becomes fragile, the agents will get scared and reverse the trend towards speculative finance.
Moreover, the Stiglitz paradox argues that destabilising speculation is an inherent characteristic of the system. A financial system is an information infrastructure and as any infrastructure being a public good poses problems in being paid by the price system. Hence "noise" is needed to remunerate active financial markets.
Here we could also mention that many of the disturbances which cause financial crises, may in fact, be endogenously caused by the capitalist system. Nevertheless, this argument cannot be stretched too far and on the other hand one could attribute the apparent greater instability of the financial system the last 2 decades to the hardships of the real economy (oil price shocks, stagflation). In this later case the financial system emerges as particularly resilient , certainly more so than the real economy. Indeed, many people such as Kindleberger, believe that financial disturbances are neither inherent in the system nor is it inevitable that they will develop into crises. Most concentrate on the issues of appropriate monetary policy, regulation structure and lender of last resort facilities.
Monetarists obviously support that a monetary rule is adhered though others, including Minsky, fear the consequences of high volatility of interest rates. The lender of last resort facility has generally proved to be quite effective in preventing financial collapse throughout the post-war period. The problem, however, is that it creates a moral hazard problem as agents are encouraged to be more risky. This problem may increase in significance in the future as the importance of the commercial banks relative to other financial institutions declines and for most of these institutions the moral hazard costs are considered to be much higher and lender of last resort protection is not generally widely available to them. Also in our increasingly globalised financial system, there is none really able and willing to play the role of the international lender of last resort; the collapse of 1929-32 is often partly attributed to a similar lack of lender of last resort as Britain was unable to play this role anymore and the US were unwilling.
The widespread deregulations of the last two decades have also attracted attention regarding their effect on financial stability. On the one hand, it is argued that the subsequent rationalisation not only increased efficiency, the quality and the variety of financial services but helped stability as well by for example allowing a better allocation of risk towards those who can bear it more easily. Others, however, point to the increased difficulties for conducting monetary policy, the increase in indebtedness, the increase in credit risk as business finance shifted towards securities and the greater freedom in speculative behaviour. Furthermore, as Kaufman feared, completely liberated markets will increase instability by allowing crises to quickly spreading to other sectors and countries. In many respects, the Savings & Loans debacle is typical of the problems of deregulation: Though most people would agree that deregulation was long overdue, its timing (coincided with a crisis in the S&L industry which encouraged speculative behaviour) and the easing of "safety-and-soundness" regulation proved catastrophic. Indeed there is a significant group of economists who while support deregulation, strongly recommend the imposition of restricted safety and soundness regulations to increase the stability of the system.
If through either of the above instruments, crises can relatively easily be prevented or stopped then it is clear that they are much less dangerous and less important. Indeed, since one could include such government actions as part of the actual financial system, then one could conclude that the system endogenously prevents crises from occurring.
Concluding, I believe that the financial market has in fact shown remarkable resilience and adaptability in the face of the condition of the real economies, the shocks experienced and the rapid deregulation. The issue of financial instability is and should be a concern but probably the best policy towards that objective is to have a healthy and stable "real" economy. How to achieve this is indeed another question.
It may be useful to summarize the argument. A system of financial regulation was crafted out of the financial turmoil of the 1930s. It had two defining characteristics, the restriction of competition and government protection. This institutional structure was created in conformity with the concrete conditions at the time (low debt, high liquidity, low inflation, and low interest rates). It was successful in the postwar period in the United States in part because of that conformity. The high profit rates in the early postwar period also helped to create a situation in which no financial crises occurred.
Eventually, however, those conditions changed: debt increased, liquidity declined, profits fell, and inflation and interest rates increased. The worsening financial conditions in the later postwar period contributed directly to the reemergence of financial crises. The old institutional structure, rather than leading to stability and profitability for financial institutions, resulted in instability and financial difficulties in the context of these new conditions. Banks and thrifts found themselves in a difficult situation intensified by the tight monetary policy beginning in the early 1980s. Financial crises increased, as did failures of thrifts and commercial banks. Eventually the banks and thrifts searched for riskier, potentially more profitable, but ultimately more speculative areas of lending.
Bibliography:
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