Long-run Roots of Generic Financial Crises

Erik S. ReinertThe Other Canon Foundation &Tallinn University of Technology

Chennai, January 24, 2012.

The impact of financial crises on the publication of economics books.

Hayek’s ’overshooting’ mechanism.

’Never will man penetrate deeper into error than when he is continuing on a road which has led him to great success’

Friedrich von Hayek, Austrian economist.

i.e. economic success leads to theoretical oversimplification which leads to crisis.

Compare Hyman Minsky’s ’destabilizing stability’ as a mechanism behind financial crises.

Three Times Rise and Fall of ’Physics-based’ Economics

School Starting point Peak Death

Physiocracy Quesnay 1758 1760s 1789(’Rule of Nature’)

Classical Ricardo 1817 1840s 1848

Economics

Neoclassical Samuelson 1948 1990s NOW

synthesis

Financial Crises: A theoretical axis independent of right and left

Financial crises a natural part of capitalism: • Marx• Lenin• Hilferding• Hitler’s men• Schumpeter • Keynes• Minsky

Fails to see financial crises:• Quesnay• Ricardo & followers• Neo-classical economics + neo-liberalism

The Circular Flow of Economics

”Black Box”

Production of goods

and services

Money/capital

The real economy“Güterwelt”

Financial economy“Rechenpfennige”

WHEN THE ’ACCOUNTING UNITS’ ATTACK ’THE REAL ECONOMY’

“In the years preceding the first world war there were in common use among economists a number of metaphors ... ‘Money is a wrapper in which goods come’; ‘Money is the garment draped round the body of economic life’; etc.

During the 1920s and 1930s ... money, the passive veil, took on the appearance of an evil genius; the garment became a Nessus shirt; the wrapper a thing liable to explode. Money, in short, after being little or nothing, was now everything... Then with the Second World War, the tune changed again. Manpower, equipment and organization once more came into their own. The role of money dwindled to insignificance..” C. Pigou, The Veil of Money, 1949, pp.18-19.

THE HAMMURABI EFFECT (Babylonia ca. 1795 – 1750 BC)

The Effect of Compound Interest.

THE PEREZ EFFECT(Carlota Perez, Venezuelan economist)

Technological Revolutions Create Financial Bubbles.

THE MINSKY/KREGEL EFFECT (Hyman Minsky, 1919-1996)Destabilizing stability and Ponzi schemes.

Three basic and complementary mechanisms behind the conflicts Three basic and complementary mechanisms behind the conflicts between the real economy and the financial economybetween the real economy and the financial economy

(financial crises):(financial crises):

THE HAMMURABI EFFECT

‘A shilling put out at 6% compound interest at our Saviour’s birth would . . . have increased to a greater sum than the whole solar system could hold, supposing it a sphere equal in diameter to the diameter of Saturn’s orbit.’  Richard Price, English Economist, 1769.

THE PEREZ EFFECT.

1. Financial markets – with some logic – have a love affair with a new breakthrough technology (US Steel, Microsoft).

2. Role of financial innovation: 1720 stocks, 1990s hedge funds, that create illusion of ’gravity lost’.

3. Illogically the market wants to bid up all shares as if they were hi-tech (US Leather).

4. Enters fraud: Parmalat & ENRON. 5. Gravity rediscovered: collapse.

Types of bubbles (Perez):

• Technology bubbles that in the end are useful (1990s technology boom)

• Useless bubbles based on easy credit (NOW!)

DUBIOUS PROJECTS

IN 1720 BUBBLE

THE MINSKY EFFECT

Types of financing:

Hedge financing, low risk.

Speculative financing involves future renegotiating of the debt (rollover). A typical speculative position consists of financing long term assets with short term liabilities.

Ponzi financing is when expected revenues can not afford even interest payments, and agents are submitted to increasing debt.

Ponzi schemes (such as subprime loans) cause financial institutions to redefine the game – in this case not only causing a financial crisis but also a permanent (?) shift in profitmaking from the real economy to the financial economy in the West.

1990s NASDAQ Bubble 2000s easy-liquidity bubble=

Major technology bubbles are part of CREATIVE DESTRUCTION in market economies

Credit-pumped bubbles leave destruction and recession in their wake

ICT and finance as percent of total IPOs in US stock markets 1970-2007

0%

10%

20%

30%

40%

50%

60%

70%

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Per

cen

t o

f to

tal I

PO

s

ICT as % of total IPOs Finance as % of total IPOs

Major Technology Bubble

Common financialBubble

ICT and finance IPOs as percent of total in US stock markets 1993-2007

Per

cen

t o

f to

tal i

nit

ial p

ub

lic

off

erin

gs

Finance IPOS

Information andcommunicationstechnology IPOs

ICT and finance as percent of total IPOs in US stock markets 1970-2007

0%

10%

20%

30%

40%

50%

60%

70%

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Per

cen

t o

f to

tal I

PO

s

ICT as % of total IPOs Finance as % of total IPOs

Major Technology Bubble

Common financialBubble

ICT and finance IPOs as percent of total in US stock markets 1993-2007

Per

cen

t o

f to

tal i

nit

ial p

ub

lic

off

erin

gs

Finance IPOS

Information andcommunicationstechnology IPOs

Source: Piketty and Saez

The major technology bubbles change the trends in income distributionstrongly in favor of the few at the top

…and in this surge the trends have changed on a global scale

Percentage of income earned by the top 1% in the USA 1913-2007

Installation 4th

RecessionRecession

0%

5%

10%

15%

20%

25%

30%19

13

191

8

192

3

192

8

193

3

193

8

194

3

194

8

195

3

195

8

196

3

196

8

197

3

197

8

198

3

198

8

199

3

199

8

200

3

Sh

are

of

tota

l in

com

e

Turning Turning Point 4thPoint 4th

Deployment 4th

Installation 5th

The 1920s bubble

The Post WWII boom The 1990s bubble

The 2000s bubble

Fragilities + Retrogression.• Financial fragility (Hyman Minsky)• Wage fragility• Pension fragilities• Livelihood fragility• Technological fragility• and so on, including ’reduced marriage fragility’

(number of US divorces down by 25 % in the 1930s).

Increased social tensions, increased migration (’Grapes of Wrath’), neo-Medievalism, ’madmen in authority’ (Keynes 1936)

Latvian Ministry of the Economy 1994:

Forces set in motion:

• De-industrialization

• De-agriculturalization

• De-population Examples; Southern Mexico, Moldova,

Caribbean states

Destruction of real wages:• In small Latin American countries from the

mid 1970s.• Stagnating wages in the US from about the

same time. • De-industrialization of The Second World

starting in 1990 (from Latvia to Mongolia). • Argentina late 1990s (real wages down by 40

per cent from peak) + Asian crisis. • Western Europe is being hit now.