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Annina KaltenbrunnerLecturer in the Economics of Globalisation & The International EconomyLeeds University Business School Developing Countries in the Global Financial Crisis: A Minskyan AccountMotivation

2OutlineNeoclassical Models of Financial (Foreign Exchange) Crisis Post Keynesian Theories of Financial CrisisKeynes: Chapter 12 of the General TheoryHyman Minsky: The Financial Instability Hypothesis > Policy Implications and Open Economy Applications Developing Countries (Brazil) in the Global Financial Crisis (September 2008)

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Neoclassical ModelsOverviewFirst Generation Models (Krugman 1979) Rational speculators attack central bank in face of fundamental disequilibria (current account and/or fiscal deficit) Second Generation Models (Obstfeld, 1996)Self fulfilling expectations about deteriorating fundamentals Government Trade-off Third (Asian) Generation Models (e.g. McKinnon and Pill, 1996; Radelet and Sachs, 1998; Chang and Velasco, 2002) Concern about external repayment capacity Net short-term external debt (original sin)

Neoclassical ModelsAssumptionsEfficient marketsUnderlying real fundamentals run the show (dichotomy between monetary and real) Heterodox approaches to Asian crisis (foreign currency debt) Rational agents First Generation: No doubt Third Generation/Asymmetric information: Constrained information (moral hazard and adverse selection) (Behavioural Finance: Heterogeneous)

5Neoclassical ModelsPolicy RecommendationsFix FundamentalsCurrent account, fiscal balance, inflation etc. Reduce net foreign currency debt Develop domestic financial marketsAccumulate foreign exchange reserves Asymmetric Information: TransparencyFurther reduce State involvement in financial markets (e.g. rule-bound, flexible exchange rates) Further open capital account (macroeconomic discipline, liquidity for domestic financial market etc.)

Post Keynesian Theories of Financial Markets/Financial Crisis Monetary Production EconomyCreative agency/expectations Fundamental Uncertainty (non-ergodicity) Rationality pointless Inter-subjective nature of price formation

7John Maynard KeynesGeneral Theory: Chapter 12What determines Investment? Rate of interest and the schedule of the marginal efficiency of capital Rate of Interest (GT: Chapters 13-17)Reward for parting with the security provided by money in a world of fundamental uncertainty and historical time >> money as secure abode of purchasing power and medium of contractual settlement (Paul Davidson) Marginal Efficiency of Capital Relation between the supply-price of capital asset and its prospective yield

8Chapter 12Prospective Yield The considerations upon which expectations of prospective yields are based are partly existing facts which we assume to be known more or less for certain, and partly future events which can only be forecasted with more or less confidence.

We may sum up the state of psychological expectation which covers the latter as being the state of long-term expectation...

9Chapter 12SpeculationConventions and State of Confidence Conventions: Assuming that the existing state of affairs will continue indefinitely, expect in so far as we have specific reasons to expect a change Speculation vs. EnterpriseStock Market (Secondary Market) It is as though a farmer, having tapped his barometer after breakfast, could decide to remove his capital from the farming business between 10 and 11 in the morning and reconsider whether he should return to it later in the weekPrecariousness of Conventions Musical Chair/Beauty ContestDisplaces enterprise

10Chapter 12SpeculationSpeculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes a bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.

Chapter 12Summary and Policy ImplicationsSwings in asset prices detached from fundamentals inherent feature of capitalist economies Worse in more liquid markets Negative implications for investment and capital formation

Animal Spirit: spontaneous urge to action rather than inaction

Policy Implications: Stabilizing conventions?Investment permanent and indissoluble >> Illiquidity? Force socially beneficial investment State investment

12Chapter 12 Applications and ExtensionKeynes: stock marketPaul Davidson, John T. Harvey: foreign exchange marketSheila Dow: financial markets in general Alves et al. (among others): Asian financial crisis

But: Keynes not a theory of financial crisis >>> Minsky

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Hyman Minsky The Financial Instability Hypothesis John Maynard Keynes (1975); Stabilizing an Unstable Economy (1986)

Missing link in General Theory is finance (credit) liability side of balance sheets Theory of inherent and endogenous fragility of financial markets and capitalist economies Balance sheet/Wall Street view of capitalist economiesFinancial fragility and instability due to changing cash flow configurations over the business cycle (profits vs. debt payments) >Financial Instability Hypothesis

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The Financial Instability HypothesisBuilding Blocs1. (Subjective) Expectations change over course of the cycle: stability breeds instability Rising investment > higher profits and rising asset prices > feedback to investment > boom/euphoria

2. Increasingly fragile financial structures - match between cash flow commitments (debt service and principal) and cash income (investment yields) Hedge: income meets interest rates and principal Speculative: income meets interest rates but not principal Ponzi: income does not cover interest rates>> Margin of safety falls >> Increased vulnerability to changing (financial) market conditions 15The Financial Instability Hypothesis Building Blocs3. Endogenous shock (rise in interest rate) which turns fragility into instabilityCentral bank raises interest rate to cool economy Banks raise interest rate reacting to high demand for external finance

4. Debt deflation (Fisher (1933)) Rising interest rates > higher borrowing costs, falling net-worth, lower credit ratings > inability to meet cash flow requirements Falling profits and asset prices Defaults > banking crisis

16The Financial Instability HypothesisSummary and Policy Implications Financial instability and crisis inherent feature of capitalist economies with mature financial markets Financial crisis not due to misaligned fundamentals but increasingly fragile financial structures balance sheets and cash flow requirements

Policy Implications: Big Government > stabilize firm profits Big Bank > stabilize asset prices Regulate Finance 17The Financial Instability Hypothesis Applications and Extensions Capitalist firm > banks, households, states

Open economy/Emerging Markets Exogenous shock? Exchange rate > super-speculative units (Arestis and Glickman, 2002)

Developing Countries in the Global Financial Crisis

19Neoclassical Models Fundamentals and Foreign Currency Debt

So that speaks against mainstream; 20Post Keynesian/Minskyan AccountUnprecedented Amount of Capital Flows

21Post Keynesian/Minskyan AccountIn complex, very short-term domestic currency assets

Post Keynesian/Minskyan AccountWhich created Balance Sheet Vulnerabilities

Post Keynesian/Minskyan AccountThe Crisis Shock (rising interest rates and increased risk aversion in developing financial markets) Rising funding costs for international banks Speculative and Ponzi Units need to make position Do so in overexposed and liquid assets > Brazil Falling asset prices and exchange rate depreciation exacerbate financing difficulties > Stampede and exchange rate depreciation by 60% unrelated to Brazilian fundamentals Conclusions Neoclassical vs. Post Keynesian: Different Ontological assumptions of how financial markets (economic dynamics generally) work Neoclassical: stable underlying fundamentals which will be aligned with expectations as long as frictions are removed (government, noise traders etc.) Post Keynesian: Symbiotic relationship between real and finance; no underlying fundamentals; inherent fragility of financial markets and economic systems >>> State and Government Control