The Economist explains economics
What causes financial crises?
This week “The Economist explains” is given over to economics.
For each of six days until Saturday, this blog will publish a short
explainer on a seminal idea.
IN A narrow sense, the global
financial crisis of 2008 was unprecedented. It was the result of a range
of problems that had built up over time: light regulation of banks,
overly complex credit products, tighter cross-border linkages and
irrational exuberance in the housing market. But while that precise
combination of factors had never been seen before, the trajectory from
excessive risk-taking to financial chaos was a familiar one, whether to
students of America’s volatile banking industry in the 19th century or
to investors who remembered Asia’s woes in the late 1990s. Each crisis
is unique, but meltdowns occur regularly enough that they exhibit
certain patterns. What causes financial crises?
It is a big
question. For decades, though, it was one that economists rarely
discussed. Sure, there were stockmarket bubbles and currency crashes,
but central banks seemed to have perfected their responses, preventing
the emergence of systemic crises. Finance, a sub-discipline of
economics, focused on topics such as how to price assets. The carnage of
2008 changed that. Economists, investors and central bankers turned
back to the big question. One answer, which had been crafted decades
earlier but largely marginalised, received more attention than most:
Hyman Minsky’s financial-instability hypothesis. Having grown up during
the Great Depression and served on a bank board, seeing first-hand how
risky a business it could be, his was a scepticism informed by
experience.
Starting with a look at how companies pay for
investment, Mr Minsky described three kinds of financing. The first,
which he called hedge financing, is the safest: companies can repay
debts with their earnings. They have limited borrowings and good
profits. The second, speculative financing, is a little riskier:
companies can cover their interest payments but must roll over their
principal. This works fine normally but not in downturns. The third,
Ponzi financing, is the most dangerous. Earnings cover neither principal
nor interest; firms are betting that their assets will appreciate. If
not, they are in trouble. Economies dominated by hedge financing—those
with strong cashflows and low debt levels—are stable. When speculative
and, especially, Ponzi financing become popular, economies are
vulnerable. If asset values fall, overstretched investors must sell
their positions. This further hits asset values, causing pain for even
more investors, and so on—a downward spiral now sometimes called a
“Minsky moment”. Investors would have done better to stick to hedge
financing. But over time, particularly when the economy is healthy, debt
is irresistible. When growth seems guaranteed, why not borrow more?
Banks add to the dynamic, lowering their standards the longer booms
last. If defaults are minimal, why not lend more? Mr Minsky’s conclusion
was unsettling: periods of stability breed financial fragility.
Previously in this seriesMonday: Akerlof’s market for lemons
Tuesday: The Stolper-Samuelson theoremWednesday: The Nash equilibrium
Thursday: The Keynesian multiplier
Tuesday: The Stolper-Samuelson theoremWednesday: The Nash equilibrium
Thursday: The Keynesian multiplier
Coming up
Saturday: The Mundell-Fleming trilemma
Saturday: The Mundell-Fleming trilemma
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