The Financial Instability Hypothesis

The possibility that the financial system might be a source of instability leading to crises was frequently discussed in pre-Keynesian business cycle literature, which is reviewed briefly in the next section. The main focus of the chapter is the revival of interest in the financial instability hypothesis (FIH) in the 1970s and 1980s.

The FIH does not attempt to provide a complete theory of business cycles but concentrates instead on explaining speculative booms and subsequent crises. In most versions the speculative boom and the financial crisis that terminates it are both triggered by shocks; consequently it is implied that we should not look for too much regularity in the periodicity and amplitude of cycles in which such crises occur and that crises may not occur in all cycles.

They are essentially individual events with certain common features but the economy’s reaction to them may be cyclical and basically similar in the sense that the comovements of various macroeconomic time series will be similar.

As noted in the previous chapters, the role of the banking and the wider financial system has been largely neglected in mainstream post-war business cycle literature except to the extent that a role is attributed to the money supply1 or monetary shocks (e.g. Lucas 1975) in cycle generation. This is not the case in the historical literature. The main issue to be resolved is whether the banking system itself is a major source of instability, as postulated by the FIH, or whether its importance lies in its tendency to spread the effects of shocks hitting some sectors of the economy to others.

The following review of the theoretical literature does not resolve this issue. Empirical investigations need to be undertaken that are more rigorous than the existing historical analyses (such as that of Kindleberger 1978).

Although the post-war business cycle literature, particularly that inspired by Keynes’s ‘General Theory’ (GT) (Keynes 1936), largely ignored the role of the banking system in the business cycle, the FIH can in fact be regarded as being a descendant of the GT. Minsky, its main proponent, certainly sees it as such (e.g. Minsky 1982a, b and 1986).

Keynes did not progress to a full theory of the cycle. Instead he attempted to identify and explain the behaviour of variables which he regarded as essential components of cyclical movements. It was never absolutely clear which sectors and which variables were the prime movers and how they interrelated in cycles. Consequently various interpretations are possible.

Nevertheless, Keynes did emphasise the role of uncertainty, as opposed to risk, in the sense of Knight. Areas in which Keynes stressed decisionmaking under uncertainty, such as financial and investment decisions, should therefore feature strongly in a truly Keynesian theory of the cycle. Uncertainty is, however, more difficult to model than risk and leads naturally to instability if shocks or extraneous events cause rapid and fundamental reappraisals of the expectations concerning future events held by economic agents. It is perhaps because of the difficulty of analysing economic decisions under uncertainty  that it was essentially ignored in the multiplier-accelerator modelling of the cycle.

As noted in the previous chapter, more recent cycle literature concentrates mainly on risk rather than uncertainty, again probably because analysis of stochastic models is more tractable in this case and normally assumes that the distributions of real and monetary stocks are known to the economic agents.

Following the brief review of the pre-Keynesian cycle literature in which financial instability played a part, the FIH is discussed. The FIH does not fit well with modern analysis incorporating rational expectations (RE) but the latter has also been developed to provide models in which speculative bubbles can occur. Some of this work will be reviewed in section: Rational Speculative Bubbles.

The final section of the chapter will draw some conclusions concerning the implications of financial instability for economic policy designed to attenuate the business cycle, which may well need to encompass the regulation of the banking and perhaps the wider financial system.

The Role of Money and Credit in Pre-Keynesian Business Cycle Literature

Hansen (1951) and Haberler (1958) provide excellent reviews of pre-Keynesian business cycle literature. Hansen takes a critical stance and largely dismisses pre-Keynesian theories5 in favour of a multiplier-accelerator approach, stressing in particular the role of investment. In so doing he plays down the roles of innovation, uncertainty and the financial system in cycle generation and propagation. He is particularly critical of Hayek’s work (Hayek 1931), which is regarded by many as perhaps the major pre-Keynesian theory and which attaches weight to both monetary and real factors.

In the previous chapter it was noted that proponents of equilibrium theories of the business cycle regard Hayek’s work as a seminal contribution. Haberler is more cautious about the post-Keynesian multiplier-accelerator approach and, having reviewed the Keynesian and pre-Keynesian literature, provides his own synthetic exposition of the nature and causes of business cycles in which innovations, uncertainty and the monetary and financial systems feature more prominently. Haberler makes the following observation, for example:

Money and credit occupy such a central position in our economic system that it is almost certain that they play an important role in bringing about the business cycle, either as an impelling force or as a conditioning factor. (1958, p. 14)

Hansen (1951) traces concern over financial instability back to the early nineteenth century when “overtrading’ became a common explanation of commercial and financial crises. The original source of the ‘overtrading’ idea appears to be Adam Smith (1776), who described it as a general error committed by large and small traders when the profits from trade happen to be greater than normal.

Carey (1816) observed that banks contributed to and significantly amplified commercial and financial crises because, rather than checking the spirit of overtrading, they fostered and extended it by discounting freely on demand. Then at the first sign of crisis they abruptly changed their practice and adopted a dramatically opposite stance and diminished their loans violently and rapidly. Mill (1848) devoted three chapters to the causes and effects of commercial crises.

He perceived of a crisis as a commercial phenomenon caused by speculation in commodities - often, but not always, backed by an irrational extension of bank credit. Later Mills (1867)6 stated categorically that every ten years or so a vast and sudden increase of demand in the loan market occurs, followed by a revulsion and a temporary destruction of credit or discredit, as it was sometimes called. He argued that the credit cycle breeds optimism which in turn breeds recklessness and leads to a crisis and stagnation. It was, therefore, governed by moral or psychological causes.

Marshall and Marshall (1879) also regarded crises as being related to reckless inflation of credit, with the subsequent depressions attributed to a want of confidence which induced a state of commercial disorganisation. Hansen then turns to a critical review of the work of Hawtrey and Hayek, which he regards as monetary disequilibrium theories.

Haberler’s review of the literature draws a useful distinction between purely monetary theories of the cycle, monetary over-investment theories and psychological theories, all of which attach importance to money and credit. In his view, Hawtrey’s work is the leading example of a purely monetary theory.

Hawtrey argues that changes in the flow of money are the sole and sufficient cause of changes in economic activity, including the alternation of prosperity and depression and good and bad trade. In his theory aggregate demand, or consumer outlay as he calls it, is related to the money supply via the Cambridge version of equation of exchange, in which income velocity replaces transactions velocity.

Consequently changes in consumers’ outlay are principally due to changes in the quantity of money and the business cycle is a replica, on a small scale, of an outright money inflation and deflation. Depression results from a fall in consumers’ outlay in response to a reduction in the circulating medium of exchange8 and is intensified by a fall in the velocity of circulation. In prosperity the reverse holds. It follows that if the flow of money can be stabilised, cycles will disappear but, Hawtrey argues, stabilisation will not be easy because the modern money and credit system is inherently unstable.

Hawtrey assumes that bank credit is the main means of payment and the money supply consists of bank credit and circulating legal tender. The banking system creates credit and regulates its quantity. The upswing of the trade cycle is caused by an expansion of credit brought about by banks through the easing of conditions attached to loans, including reductions in the discount rate.

Merchants are particularly sensitive to interest rate charges and play a strategic role in Hawtrey’s theory. In the upswing prices will tend to rise, improving profitability, and so too will the velocity, thus reinforcing the expansionary tendencies. Prosperity is terminated when credit expansion is discontinued. In the expansionary phase the demand for transactions balances will increase, causing a drainage of cash from the banks and making them reliant on the central bank to alleviate the shortages. If the central bank declines to do so because of its exchange rate objective or out of concern over growing inflationary pressure, then the process of credit expansion will be terminated.

The downswing that follows is also cumulative and is caused largely by a reversal of the processes prevailing in the upswing. During the depression, loans are liquidated, bank reserves accumulate, excess reserves build up, and interest rates fall to very low levels. Hawtrey argues that the abundance of cheap money, reinforced by central bank policy, will eventually spark a revival but acknowledges the possibility of a credit deadlock in which pessimism prevails.

This he regards as a rare occurrence but one which can explain the drawn-out depression of the 1930s. Normally, however, banking policy can be relied upon to generate another upswing fairly soon after bank reserves have become excessive, and another over-expansion of credit will occur.

Haberler draws attention to the fact that Hawtrey’s theory contends that changes in the rate of interest influence primarily the demand for working capital and particularly stocks of goods, hence the importance attached to merchants rather than investment in fixed capital. It is, therefore, distinguishable from monetary over-investment or neo-Wicksellian theories.

In this category he places the work of Hayek (particularly 1931, 1933), among others.9 Like Hawtrey’s, such theories assume that the banking system regulates the quantity of money and recognise a complicated relationship between the interest rate, changes in the quantity of money and the price level. Wicksell (1907, 1934, 1936) provides the basis for their analysis by drawing a distinction between the money, nominal or market rate of interest, which is influenced by monetary factors including the policy of banks, and the natural rate of interest.

The latter is defined as the rate which equates the demand for loan capital with the supply of savings. If banks lower the market rate below the natural rate, the demand for credit will rise to exceed the supply of savings, leaving banks to expand credit to meet the excess demand, and inflation will result. If the market rate is raised above the natural rate, the demand for credit will fall and savings will not be used for productive purposes.

In monetary over-investment theories the boom is brought about by the market rate of interest falling below the natural rate, which leads to a credit expansion and rising prices. This encourages further borrowing and credit expansion, possibly by causing a reduction in the real interest rate.

Monetary expansion through the increase of bank credit does not lead to a parallel increase in savings, and the natural or equilibrium rate of interest will tend to rise. If banks try to maintain the prevailing interest rate then the gap between it and the natural rate will rise, requiring even greater credit expansion to meet the growing excess demand for credit. Prices rise still higher, profits are raised further, and the inflationary spiral continues. So far the theory runs parallel with the purely monetary theory, Haberler observes.

Complementary to the monetary expansion-induced upswing, however, there will be distortions in the real sector because the rate of interest also influences the allocation of factors of production. As capitalism develops, with the ultimate goal of expanding the output of consumer goods, the process of production lengthens - in the sense of involving a greater number of intermediate stages in the production of intermediate goods such as machinery, components, raw materials and half-finished products.

The percentage of capital stock in particular will tend to increase relative to the output of consumable goods, and entrepreneurs will tend to elongate the process of production in response to the availability of new capital and lower interest rates. If the rate of interest falls as a result of increased savings, then investment will increase, and the product in process will tend to lengthen.

The entrepreneur seeking to increase capital stock need not be concerned about whether the interest rate fall is due to an increase in voluntary saving or an expansion in bank credit. The fall in the interest rate will encourage investment, and means of production will be drawn away from consumption goods industries. This requires that the credit creation does not lead to an equivalent rise in the demand for consumer goods through rising aggregate income. Income may indeed rise but is assumed to do so after a lag so that prices will rise faster than disposable income and consumption will be curtailed.

The rising prices and lower interest rates induce people to save more and result in ‘forced saving’ which, like voluntary saving, restricts consumption and releases productive resources for the production of additional capital goods.

According to the monetary over-investment theories, the process of monetary expansion and heavy investment cannot go on indefinitely because the artificial lowering of the interest rate encourages a lengthening of production which cannot continue unchecked. The structure of production becomes top-heavy as a result of over-investment, and it is increasingly evident that further investment should be curtailed; the investment boom then collapses.

The proximate cause for the breakdown of the boom, Haberler observes, is normally attributed to the inability or unwillingness of the banking system to continue to expand credit. The mere stoppage of expansion can cause a collapse because of the long gestation of newly started investment projects which rely on the availability of credit over a long period. If the flow of credit is not forthcoming, the completion of new schemes becomes impossible, and this means that various sectors may not be able to work at full capacity because of inadequate demand as a result of input-output relationships.

Members of the over-investment school argue that the problem is not a purely monetary one; consequently, monetary measures cannot avert the crisis but can only postpone it, Haberler observes. The sustained monetary expansion would instead lead to inflation and then hyperinflation and the complete collapse of the monetary system.

According to Haberler, Hayek provides the most elaborate analysis of the monetary over-investment process. At the end of the boom, near-full employment is likely to prevail, and it is postulated that there will be an increase in the demand for consumer goods relative to that for producer goods. It is not totally clear why this should occur. Hayek attaches importance to historic cost accounting which inflates the paper profits of entrepreneurs, tempting them to increase consumption, but the lagged effect of the over- investment boom on incomes might also stimulate consumer goods demands.

The relative increase in demand for consumer goods will ensure that consumer goods industries’ profitability will increase relative to that of producer goods industries, and factors of production will be bid away from ‘higher’ stages of production to ‘lower’ stages.

This rise, Hayek argues, increases the production costs of the higher stages of production more than it does those of the lower stages, and a breakdown in the investment-led expansion process can be expected. It can be averted only if people can be induced to save more and consume less, and the rise in interest rates is judged by adherents to the monetary over-investment school to be insufficient to achieve this.

They therefore conclude that every credit expansion will lead to over- investment and to a breakdown, and that it is impossible to achieve a continuous increase in the capital stock by means of ‘forced’ saving accomplished with the help of inflationary credit expansion. No collapse need occur if credit expansion and forced saving could continue indefinitely; but forced saving, it is argued, will end abruptly because the continuous expansion of credit will lead to accelerating inflation which will threaten the collapse of the monetary system.

Haberler feels that the explanation of the crisis in the monetary overinvestment theories is incomplete and that the theory of the depression is not as fully elaborated as the theory of the boom. The theories vary in the weight attached to monetary and non-monetary factors, such as the need to adjust the over-elongated process of production. Some (e.g. Strigl 1934) argue that after the breakdown of the boom, banks will not merely halt credit expansion but will go further and contract credit in order to restore their liquidity.

Influenced by widespread insecurity and pessimism, firms will also seek to strengthen their cash reserves. The general struggle to increase liquidity will induce hoarding. Prices will begin to fall, and the incentive to invest will be further reduced. Following the collapse of the boom, the money rate of interest will tend to rise above the natural rate but, as the banks’ liquidity position improves, the price fall comes to an end, pessimism gives way to a more optimistic outlook, the natural and market rates converge, and a state of equilibrium is approached. No special stimulus from outsiders, such as innovations or other shocks, is required. Haberler observes that the new upswing starts smoothly and imperceptibly out of the ashes of the last boom.

The behaviour of the banking system is crucial to the recurrence of such cycles of prosperity and depression. Mises (1928, pp. 56-61) argues that if the banks did not push the money rate below the natural rate by expanding credit, equilibrium would not be disturbed. It is therefore necessary to explain why the banks keep repeating their mistake. Mises contends that the root cause is an ideological preference for interest rate reduction and credit expansion among businessmen and politicians.

He further argues that the banking system’s ability to expand credit relies on central bank support, which in turn is reliant on its monopoly over the issuance of banknotes. If banks issued their own notes, unsound banks would be eliminated and sound banks would not indulge in imprudent credit expansion for fear of bankruptcy. Other exponents of the theory tend to believe that the solution is not this simple” because the problem is not always that banks reduce nominal rates below the natural rates. Instead the natural rate may rise above the prevailing nominal rate. Machlup (1931, pp. 167-78), for example, assumes a more passive role for banks, especially in the boom phase of the cycle, while trying to explain the recurrence of the cycle.

Haberler also considers over-indebtedness as a cause of the recurrence of economic depressions. He concentrates on the work of Fisher (1933), who argues that over-indebtedness and deflation tend to reproduce and reinforce one another, deflation swelling the burden of debts and over-indebtedness leading to debt liquidation, which in turn leads to a contraction in the money stream and a fall in prices. As noted in section: The Monte Carlo Hypothesis, Fisher regarded the business cycle as a myth, in the sense that there is no regular periodic movement.

He stresses the differing periods and amplitudes of the so-called cycles, regarding each one as a historical event. Nevertheless, he accepts that the economic system is subject to spirals of expansion and contraction. His description of the downward spiral which follows the onset of a depression is essentially similar to that of the purely monetary and monetary over-investment schools. Debts and over-indebtedness, however, play a crucial and destructive role in his theory. Large debts tend to intensify the deflation and over-indebtedness may be the cause that precipitates the crisis, Haberler observes.

The burden of debts aggravates depressions because it becomes heavier as prices fall and leads to distress selling and further falls in prices. Fisher argues that over-indebtedness occurs when debts are too large in relation to other economic factors and commonly occurs when opportunities to invest at large prospective profits appear, perhaps due to innovations and the opening of new markets. Easy money is seen as the main cause of over-borrowing.

Haberler observes that there is, therefore, a close connection between over-investment, which implies investment that later turns out to be unprofitable, and over-indebtedness. However, he stresses the fact that over-investment has relied on borrowed money. Fisher’s theory consequently adds to the monetary over-investment theory only to the extent that it stresses that debt can intensify the depression that would be expected in an over-investment cycle which relied entirely on internally generated funds, Haberler argues. But monetary over-investment theories tend to assume a role for bank credit in the funding of over-investment anyway.

Haberler next turns to the discussion of’psychological’theories, noting that there is no fundamental difference between these theories and other economic theories, which all make assumptions about human behaviour. The distinction he draws, however, is the following:

The ‘psychological’ theories introduce certain assumptions about typical reactions, mainly on the part of the entrepreneur and the saver, in certain situations; and these reactions are conventionally called psychological, because of their (in a sense) indeterminate character. (1958, pp. 142, 143)

But the distinction is one of emphasis rather than of kind, he notes. The psychological factors are used to supplement monetary and other economic determinants of business cycles and not as alternative elements of causation.They often feature less prominently, however, in other theories. The main channel through which psychological factors have an influence is that of expectations formation under uncertainty which, Haberler argues, is pervasive.

But it does feature prominently in such activities as investment. He observes that the psychological theories essentially introduce optimism and pessimism as additional, intensifying determinants of the prosperity and depression phases of the cycle respectively, and the turning points are marked by a switch from optimism to pessimism and vice versa.

Haberler notes that the psychological factor will reduce the stability of the relationship between investment and the rate of interest and can stimulate or encourage investment independently, as Keynes (1936) argued. Further, the optimism can become infectious, leading entrepreneurs into irrational herd behaviour. Lavington (1922, pp. 32-3) likens businessmen who infect each other with optimism to skaters on a pond, whose confidence in their own safety is reinforced by the presence of other skaters on the ice despite the rational judgement that the greater the number of skaters on the ice the higher the risk of it breaking.

Haberler observes that psychological theories also direct attention to the fact that following a period of rising prices and demand economic agents come to expect further rises in the future and this conditions their behaviour. This ‘psychological fact’ features prominently in the discussion of price bubbles and the financial instability hypothesis (FIH) in the subsequent sections of this chapter. Haberler also notes that theorists stressing psychological factors, especially Keynes (1936) and Pigou (1929, for example), point out that the discovery of ‘errors of optimism’ gives birth to the opposite ‘error of pessimism.

Reviewing Pigou’s work, Hawtrey (1928) argues that optimism and pessimism are wholly dependent on the policy of banks. They are optimistic when credit is rising and pessimistic when it is falling. This ignores the fact that reactions of investment to changes in interest rates may vary according to the circumstance, particularly in accordance with Keynes’s “animal spirits’ (1936, p. 162); and the banks’ behaviour also needs to be explained, perhaps in terms of infection by optimism and pessimism from businessmen.

Having reviewed the above and other theories of the business cycle, in which the financial system plays no major role, Haberler presents a synthetic exposition of the nature and causes of business cycles which basically incorporates money and the banking system in a Keynesian model in which the multiplier and accelerator are operative. He concludes that:

... a large part of contemporary economic theory has laid undue stress on ‘real’ factors and that ‘monetary’ factors . have been neglected and their importance grossly underestimated. (1958, p. 455)

By contemporary theory he means the Keynesian multiplier-accelerator literature in particular. He notes that not only have purely monetary theories become increasingly unpopular but also that, despite the fact that most current theories are mixed in the sense that monetary and real factors interact, the monetary factor has been increasingly de-emphasised and relegated to a passive or permissive role.

He cites Hicks (1950) as an example. In contrast he believes that monetary factors and policies play an important role in generating economic instability and that speculative excesses occur, in both the real and financial spheres, which are not possible on the large and disturbing scale on which they actually occur without excessive credit expansion.

By ‘monetary factors’ he means not just active policies of inflation and deflation but also the monetary repercussions of financial crises which frequently mark the upper turning point of the cycle. He asserts that:

the acceleration principle plus multiplier, unless combined with and reinforced by monetary factors, psychology and rigidities would hardly produce more than mild inconsequential fluctuations. (1958, p. 481)

He further argues that the propagation problem is more important than the impulse problem12 and that in the propagation mechanism, which describes how the economy reacts to shocks, monetary factors play a decisive role. With regard to the impulse problem, innovations are regarded as a particularly important source of shocks. Haberler (1958) also warned prophetically that in an environment with a low tolerance for unemployment and a fear of depression, policies based on the Keynesian models of the 1940s and 1950s might ultimately lead to a secular inflation.

The pre-Keynesian literature is therefore replete with theories that attach a major role to money and the banking system in the cycle generation process. In the next section more recent work, which attempts to develop some of these themes, is discussed.

The financial instability hypothesis, in particular, develops the idea that bank behaviour encourages over-expansion in the upswing. This leads to its eventual termination by a crisis which ushers in a more severe recession, and perhaps even a depression, than might otherwise have occurred. It seems to describe the 2007-9 Global Financial Crisis very well.

The Financial Instability Hypothesis (FIH)

Minsky on financial instability

Minsky wrote at length and on numerous occasions,13 on the FIH. No attempt is made to analyse the evolution of his theory, which appears to have increasingly stressed the endogeneity of the process and thereby reduced its reliance on external shocks. Kindleberger’s influential book (1978) develops a theory of financial crises based on Minsky’s earlier work, in which shocks are important, and this is discussed later. Minsky’s more recent expositions (1982a, b, 1986) will be considered first in order to outline his hypothesis.

Minsky builds on Keynes (1937), which attempted to highlight the General Theory’s essential ingredients and explain why output and employment are so liable to fluctuations. Like Shackle (1938, 1974) and others, Minsky regards Keynes (1937) as the ultimate distillation of Keynes’s thoughts on money and finance and as providing a source for an alternative - to the IS-LM model and neoclassical synthesis - interpretation of Keynes’ General Theory (GT). Classical and neoclassical economists tend to regard financial crises and major fluctuations in output and unemployment as anomalous and offer no theoretical explanation of them.

Keynes (1937) implies that the GT is a theory of the capitalist process able to explain financial and real sector instability as a result of market behaviour in the face of uncertainty. Investment decisions are seen as the key determinant of aggregate economic activity and can be understood only within the context of capitalist financial practices.

Both investment and financial decisions are made on the basis of uncertain outlooks, and disequilibriatory forces therefore operate in financial markets where investors must raise finance. These forces affect the price ratio between capital assets and current output which, along with financial market conditions, determine investment. The two sets of prices in the ratio are determined in separate markets, which are influenced by different forces; consequently the economy is prone to fluctuations.

One interpretation of Keynes’s work is that shocks emanate from financial markets and are spread by way of investment decisions. Because investment and financial decisions are made under uncertainty they can undergo marked changes in short periods of time. Changing perspectives affect the relative prices of various capital and financial assets as well as relative prices of capital assets and current outputs. ‘Money enters into the economic scheme in an essential and peculiar manner’ (Keynes 1936, p. vii), as a ‘financing veil’ (Minsky 1982a, p. 61) interposed between the real asset and the wealth owner. Wealth owners frequently have claims on money, rather than real, assets. The banking system plays a major role in the financial system by collecting deposits and lending them to finance the purchase of real assets.

The ‘financing veil’ encompasses bank credit and other short-term financial instruments and does not correspond to a narrow or base money concept. This contrasts with the neoclassical synthesis in which money does not affect the essential behaviour of the economy (see Patinkin 1965).

Minsky (1982a, Ch. 3) builds on his interpretation of the GT to present the FIH as a theory of the business cycle. He views financial crises as systemic, endogenously generated events rather than accidents. To support his view he cites pre-Second World War history and the post mid-1960s period in which he believes financial instability is amply illustrated. This leaves the twenty post-war years, in which financial crises were notably absent, to be explained.

Minsky attributes the stability in this period to a recovery from the deep depression of the 1930s and to the favourable conditions created by the need for post-war reconstruction. Others would argue that it represented the upswing of a long wave16 and/or the fruits of post-war economic co-operation which created the IMF, the IBRD and GATT.17 Since the mid-1960s, however, he argues that the historic, crisis-prone behaviour of economies with capitalist financial institutions has reasserted itself.

Until now the Federal Reserve (Fed), the US central bank and lender of last resort (LOLR), has aborted embryonic crises which, he argues, are in any event unlikely to be similar in magnitude to previous crises because the government sector, which acts as borrower of last resort (BOLR) and which has introduced automatic stabilisers,19 is immensely larger.

The Fed has acted as LOLR both domestically and, as issuer of the major international reserve currency, internationally, along with the IMF. Minsky further argues that the side-effects of aborting financial crises have been bouts of accelerating inflation.

Minsky observes that economies with modern financial systems are built on commitments to pay cash today and in the future. Money today is exchanged for money in the future by contracts and commitments to pay and cash in the future is exchanged for cash today. The viability of such relations rests upon cash flows received as a result of income-generating activities.

Minsky focuses particularly on business debt, which is an essential characteristic of capitalist economies. To service business debts, firms must generate sufficient net reserve to meet gross payments due or to permit refinancing, which takes place only if expected future revenue is deemed to be sufficient. The net revenue is in turn largely determined by investment.

Thus ability to debt-finance new investment depends on the expectation that new investment will be sufficient to generate cash flows large enough to allow current debts to be repaid or refinanced. An economy with private debt is, therefore, especially vulnerable to changes in the pace of investment, which is an important determinant of both aggregate demand and the viability of debt structures. In an economy in which debt finance is important, instability follows from the subjective nature of expectations about the future level of investment and returns from it and the subjective determination by banks and their business clients of the appropriate liability structure for the financing of positions in different types of capital assets. Uncertainty becomes a major determinant of cycles.

In analysing the relation between debt and income, Minsky starts with an economy that has a memory of a recession, which is regarded as a disequilibrium phenomenon. Outstanding debt reflects the recent history so that acceptable liability structures and contractual debt payments are based on margins reflecting the risk that the economy may not perform as well as expected.

As the period over which the economy performs well lengthens, the margins for safety decline and leverage increases because views of acceptable debt structures change. Increasing leverage raises the market price of capital assets and increases investment, and boom conditions emerge. Minsky argues that the fundamental instability of capitalist economies is upward, beyond stable growth. Periods of steady growth are transformed into speculative investment booms.

This process is reinforced by financial innovation, including the introduction of new financial instruments which appear at times when the economy is thriving. The quantity of relevant, broad money increases and so too does the incidence of speculative finance.

Speculative economic units expect to fulfil their obligations by raising new debt and are vulnerable on a number of fronts. They must return to the markets to refinance debt and are particularly vulnerable to rises in nominal interest rates - which increase their cash repayments relative to their expected future receipts, whose discounted present value may well decline. Further, they are subject to sudden revaluations of acceptable financial structures. Not all units will engage in speculative finance.

The more risk-averse will, for example, normally continue to operate with hedge finance, which takes place when cash flows from operations are expected to be large enough to meet payments commitments on debts as they fall due. This contrasts with speculative finance, in Minsky’s usage, which occurs when anticipated capital flows are not expected to be sufficient to meet payments commitments and refinancing will be required. In addition to hedge and speculative finance there is what Minsky calls Ponzi finance, which is a sort of super-speculative finance which takes place when payments on debt are met by increasing the debt outstanding.

High and rising interest rates can force hedge finance units into speculative finance and speculative finance units into Ponzi finance, Minsky argues. Ponzi finance cannot carry on for long because feedback from the revealed financial weakness of some units affects the willingness of banks and businessmen to debt-finance others. Unless offset by government spending, the decline in investment that follows from the curtailment of finance will lead to a decline in profitability and ability to sustain debt. Quite suddenly a panic can develop as pressure builds to reduce debt ratios or ‘overindebtedness’.

Minsky’s FIH, therefore, attempts to explain how capitalist economies endogenously generate a financial structure which is susceptible to financial crises and how the normal functioning of the financial system in a recovery period will lead to a boom and a financial crisis. As the crisis approaches, the LOLR and BOLR must act to abort it and prevent debt deflation.

Nevertheless, debt-financed investment and perhaps consumption expenditure will normally fall after the aborted debt deflation as a result of a reappraisal of the economic outlook, and a recession will follow. The government’s expansionary fiscal activities and built-in stabilisers lead to an increase in the government deficit as income falls or growth slows down. The deficits sustain income and corporate profitability and feed secure negotiable financial instruments into portfolios hungry for safe and secure assets.

The recovery from the recession can be quite rapid and can soon result in an inflationary boom if the government deficit financing persists. The implication of the FIH for policy in a financially sophisticated capitalist economy is that there is a need to curb the tendency of businesses and banks to engage in speculative and Ponzi finance while the economy is thriving and profits are seemingly validating the decision of lenders and borrowers.

The upper turning point becomes completely endogenous if it is accepted that interest rates rise in an investment boom and that the successful functioning of the economy induces profit-seeking bankers and their customers to engage in speculative and Ponzi financial arrangements and to economise on holdings of cash and liquid financial assets (Minsky 1982b). For the interest rate not to rise in an investment boom, the supply of finance must be infinitely elastic, which implies that a flood of financial innovation is taking place or the central bank is supplying reserves on demand (Minsky 1982b, 1957a).

This in turn implies that investment is an ever-increasing proportion of output and accelerating inflation is tolerable (Minsky 1982b, 1957b). The 2007-9 Global Financial Crisis (GFC) in contrast was driven by a mortgage credit boom with the supply of finance sustained both by capital inflows from China, Japan, the Middle East and elsewhere and financial innovation involving securitisation and the growth of a shadow banking system, Rajan (2010).

The extent of the recession/depression following the crisis depends on the effectiveness of LOLR and BOLR intervention in restoring confidence. The post GFC recession was so precipitous that unconventional monetary policy, in the form of quantitative and credit easing involving central bank purchases of governance and other bonds, was required.

The FIH described by Minsky (1982a,b) is, therefore, a semi-endogenous investment theory of the cycle based on a financial theory of investment. The full cycle is not endogenous unless the BOLR and LOLR are activated by policy rules or substantial built-in stabilisers are in place and are sufficient to abort the crisis and terminate the recession.

Consumption is regarded as a stable function of income and plays a minor role, except implicitly via a stable multiplier. Investment, however, depends on finance, and sudden changes in expectations, which are likely under uncertainty, can both influence investment decisions and lead to a collapse in the financial relationships supporting investment.

The FIH explains how a sustained expansion can be endogenously converted into a speculative boom which will ultimately lead to crises even in the absence of shocks. Adverse shocks might, however, be expected to terminate a boom prematurely in an economy where decisions are made under uncertainty. If they do not, however, short- and eventually long-term interest rates can be expected to rise and the discounted present value of future profit flows will be reduced.

Speculative and Ponzi units will have to sell assets to meet their payment commitments but will find that the revenue from asset sales does not cover their debts; they may also incur ‘fire sale’ losses.21 Even if the LOLR and BOLR (and quantitative easing) avert the crisis, long-run expectations are likely to be adversely affected, risk premiums will increase and speculative finance will decline.

The FIH has been accepted by a number of economists, some of whose work is discussed below, and derided by others. A sample of the latter work is provided by comments on Minsky’s (1982b) paper in Kin-dleberger and Laffargue (1982). Flemming (1982) argues that Minsky’s FIH is based on the assumption that economic agents cannot distinguish between a run of good luck and a structural shift in their environment.

The crisis results from reductions in risk premiums and increases in speculative and Ponzi finance because economic agents incorrectly believe that there has been a structural improvement in economic performance. The implication of Flemming’s remark is that, under rational expectations, the instability would disappear. In section: Rational Speculative Bubbles some of the literature on rational speculative bubbles, which demonstrates that this is not necessarily the case, is reviewed.

Flemming also observes that LOLR and BOLR intervention to abort the crisis and the ensuing recession creates a moral hazard which will itself increase risk-taking and is apparently inconsistent with the post-war stability which Minsky attributes to the enlarged role of government.

This argument can, however, be turned round to support Minsky. The moral hazard may have increased the potential for a buildup of risky positions in the post-war period but the buildup may have been slow or held in check by regulations imposed on the US banking and financial system following the 1929 stock market crash and the rash of bank failures in the early 1930s. This buildup may have become critical by the mid-1960s; and/or competition in banking of finance, which increased from the mid-1960s onwards due to deregulation and internationalisa-tion, may have increased the level of financial instability. It is a widely held view that subsequent developments, through the 1970s and early 1980s, have resulted in an increased riskiness in bank portfolios supported by relatively lower capital holdings.

Flemming concludes his critique23 by calling for a more explicit and quantitative development of the theory of financial instability, which he finds to be ambiguous.

Goldsmith (1982) entirely agrees with Minsky’s plea for an integration of the theory of the financial system with that of the real economy and the need to understand financial development in any analysis of the modern economic process, but that is where his agreement ends. He is concerned by the absence of a definition of financial crisis in Minsky’s and Kindleberger’s work.

Goldsmith therefore provides his own, which will be discussed in section: The Financial Instability Hypothesis (FIH). He argues, appealing to the evidence of economic history and the absence of crises, in terms of his definition, since the 1930s, that financial crises are a childhood disease of capitalism and not an affliction of old age. This is because, in his view, as capitalism has aged the financial system has not only become more complex but also more stable.

The absence of major crises could of course be attributed instead, as implied in Minsky’s work, to a better understanding of the capabilities of LOLR and BOLR intervention, improved automatic stabilisers and the existence of the FDIC24 in the United States. Goldsmith also takes exception to Minsky’s use of the terms speculative and Ponzi finance. He believes that the former is a prejudicial term for an activity that is widespread and essentially sound because it is based on the law of large numbers and forms the foundation of the business of banks and other financial institutions that legally hold assets of longer maturity than liabilities. (See McCulloch (1986) for a contrary view.)

Melitz (1982) also argues that so-called speculative finance is basically sound and goes on to question the general applicability of Minsky’s FIH to all capitalist economies. He notes that the basic examples are derived from US experience, while Kindleberger (1978) draws attention to a wide range of historical and international examples of financial crises.

He doubts whether Minsky’s arguments are applicable under alternative institutional arrangements, such as those prevailing in countries where banks have ready access to the LOLR, and calls for a fully specified financial fragility model with a plausible application somewhere. It is to be noted, however, that Kindleberger (1978) takes Minsky’s work as a basis for his analysis of crises and seems happy with its widespread applicability.

Financial instability and the banking sector

In the course of an analysis of the relationship between competition and regulation in banking, Revell (1986) briefly surveys some of the literature on financial crises associated with the work of Minsky and Kindleberger. He argues that aggressive competition in the financial sector tends to lead to financial crises and provides a motivation, beyond that of the desire to form a cartel to secure supernormal profits, for banks to form agreements to avoid taking on unduly risky business and adopting risky practices.

Such agreements to suspend interbank competition can be regarded as a primitive form of self-regulation to preserve the safety of the financial system and the continued existence of established institutions. He acknowledges the paucity of empirical backing for Minsky’s statements.25 The main evidence presented by Minsky (1977), for example, is the deterioration of a few financial ratios between 1950 and 1974. However, despite the lack of evidence, Revell declares a ‘gut feeling’ that Minsky is right and goes on to suggest a method that might be used to verify the FIH (see below).

Revell draws attention to a study by Barclay (1978) in which nineteenth century financial crises in Britain are compared with the 1973-4 secondary banking crisis. Barclay develops a sort of cobweb model of crises in which surplus profits in one sector of the economy, perhaps resulting from technological innovation or government regulatory changes, attract a large entry which is dangerous to the banking sector. The economic system is regarded as unstable and highly competitive so that a large entry is attracted and profits are forced below normal levels.

The new entrants do not all know about each other’s intentions, and there is a time lag before they can start production. Assuming that all firms do not have identical cost structures, some will leave the industry as profits fall, some will stay and some will go to the wall.

The model can be applied directly to the banking sector, where self-imposed or government-imposed regulations lead to supernormal profits. Established banks will have qualities of reputation and reliability. New entrants, so called fringe or secondary banks, must offer differentiated products, leading to a tendency towards innovation, or price more cheaply.

They may therefore attract more risky business without fully compensating by adding appropriate risk premiums to their charges. The profits derived from risky business will be higher as a rule, in the absence of failure, so that imprudent bankers will do better than prudent ones. Competition leads to a lowering of the quality of banking products and this increases the potential for crises since depositors are interested primarily in the security of their deposits rather than the profitability of the bank.

However, at the first sign that deposits are not secure, withdrawals will occur, and these can have domino effects which reverberate around the system. Influxes of producers attracted by high profits are, therefore, potentially more serious for the banking sector than for other sectors, while the inherent instability creates regulatory conditions that are likely to result in excess profits and encourage established banks to innovate.

When a shock hits the system profitability declines and capital, which is commonly run down relative to assets and risks taken in the euphoria of boom markets, proves inadequate. This is because past failures come to be regarded as anomalous as memory of them decays and regulators adopt more liberal attitudes.

Fringe or secondary banks are commonly allowed to fail by the regulators. The profitability of the remaining ‘core’ banks will eventually be restored, and the process could be cyclical. Recent banking history furnishes numerous examples, including the Latin American debt crisis, of established banks tapping into new and profitable lines of business only to find that competition from smaller banks gradually erodes margins and encourages mispricing of risks.

Barclay argues that the preconditions for attracting new entrants, namely surplus profitability, existed prior to the UK secondary banking crisis of 1973-4 because banking was organised as a cartel supported by the Bank of England. He suggests that the banking cycle could be grafted on to the general economic cycle as innovations in the nonbank sector, leading to supernormal profits, attract new entrants which require bank finance for their ventures in the manner described by Schumpeter (1939) - whose work is discussed in section: Schumpeter on Economic Evolution .

The banks then have a tendency to become over-exposed to the sector with supernormal profits and can face bad debts in the future as a result. The involvement of the UK secondary banks in the commercial property sector can be seen as a combination of both these themes. Government regulations created pockets of excess profitability in the property markets and attracted entry. This led to a property boom and stimulated the growth of the fringe banking sector, which became over-exposed and provided speculative finance to companies in the property sector.

The 1987-8 Texas property market collapse and its effects on the banking sector leading to the bail-out of the state’s largest bank holding company, First Republic Bank, is another example of the potentially damaging effects that the tendency towards over-exposure to excessively profitable sectors can have.

The 2007-9 Global Financial Crisis had its origin in the US home loan market, rather than the commercial property sector, but also involved the development of a large fringe, or ‘shadow banking’ sector, as it became known, Rajan (2010).

The Barclay model, Revell claimed, could be developed to show that increases in competition in banking lead in almost all cases to growth of bad banking practices involving excessive risk-taking. Such practices are likely because retribution only follows in the next crisis, which might be caused by an adverse shock but is unlikely to occur until the banking system is in a state of what Minsky would call fragility. Losses and failures resulting from bad banking are, therefore, likely to be bunched.

Before the crisis, the profit advantage lies with the aggressive banks that indulge in unsound and speculative practices, but established banks are likely to be drawn into bad banking in order to boost their profitability. A sort of Gresham’s Law of banking holds in the sense that bad banking drives out good.

Particular features of boom periods that draw banks into unsound practices can be identified, Revell argues. The general price level will be rising, and prices of equities and properties will rise with it so that capital gains will be an important component of financial calculations.

Banks not only speculate on rising price levels themselves but also issue loans that can only be serviced if the price of borrowers’ output, and that of their collateral, rises continuously. During the boom, Revell argues, the yield curve usually implies that financing long-term assets with short-term deposits and liabilities yields high profits. The importance of these factors is magnified when, as in the post-war period and particularly the 1970s, accelerating inflation is superimposed on the business cycle. He further argues that risk varies over time and that his analysis implies that the probability of loss increases with each year that has passed since the previous crisis. The behaviour of bank managements, however, ignores this factor.

Provisions for loan losses and assessments of capital adequacy by banks are normally based on the averaging of losses over the immediate past; consequently, what might be regarded as in-house bank insurance28 declines once the cyclical upswing is under way. This tendency is reinforced, Revell argues, by the fast growth of asset values, which usually outstrip the provisions for bad debts and additions to capital, and by the growing feeling of euphoria as speculation continues to be rewarded with profits.

He observes that the next step in the argument has not been documented satisfactorily. It consists of the hypothesis that one of the reactions of the established banks, which have by definition survived one or more crises, is to face the continuation of the boom (in which increased risk and competition went hand in hand) by banding together to restrain bank competition. It is necessary, he notes, to examine the history of interbank agreements or ‘cartels’ in a number of countries to see if wider support for the hypothesis, which relies heavily on UK experience in the way that Minsky’s FIH does on US experience, can be found.

The shift from primitive self-regulation to regulatory involvement by the authorities becomes necessary as soon as it is demonstrated that the former can break down (Goodhart 1985, Ch. 4). Revell suggests that this point was not reached in most countries until the 1930s. The ‘cartels’ proved inadequate because they lacked the means to enforce behaviour (Goodhart 1985, Ch. 4), especially once threatened by a competitive fringe. It is significant, Revell feels, that many of the agreements were continued with official blessing after the 1930s, and it was not until the mid-1960s that there were significant developments leading to increased competition in many banking systems around the world that involved disbandment or modification of the cartel agreements.

This process is particularly evident in the United Kingdom and has continued in the 1970s and 1980s (Llewellyn 1985, 1986). Competition in the US banking system also began to increase in the 1960s and accelerated in the 1970s and early 1980s (Mullineux 1987c,e). The latter development was led by the broadly defined banking industry, which successfully exploited regulatory loopholes, and permissive legislation followed later. Also in the United States, and then elsewhere, financial innovation was stimulated in the 1970s and 1980s by advances in information technology, improved telecommunications networks, high inflation and volatile exchange and interest rates.

Revell draws attention to the fact that changes in regulatory regimes in Europe since the late 1960s were designed to increase competition in the broadly defined banking sector and were followed in a very few years by the most significant financial crisis since the War. He infers that the authorities in many countries thought competition would lead established banks to drive out fringe operators.

This idea seemed to lie behind the Competition and Credit Control arrangements introduced in the United Kingdom in 1971 (see Bank of England 1971). The clearing banks were instructed to abandon their interest-setting cartel and in return were released from certain controls, allowing them to compete more effectively with the fringe banks. The result, Revell argues, was the secondary banking crisis which erupted in the United Kingdom in 1973 and, as a result of similar structural changes elsewhere, particularly in Europe, failures in other countries.

Revell attributes the failures to bad banking. A number of failures in the early 1970s were associated with losses on foreign exchange markets,29 but closer inspection, Revell concludes, demonstrates that these banks were tempted to speculate on the foreign exchange markets in order to recoup losses made on domestic banking operations.

The UK secondary banking crisis is a classic example of bad banking. The fringe banks raised short-term wholesale funds and invested them in long-term loans to finance speculative ventures, particularly in the property market. These ventures yielded no immediate income so that interest due had constantly to be added to the principal. In Minsky’s terminology, they therefore participated in Ponzi finance. In addition to speculative banking, there were many cases of fraud and embezzlement.

A worrying feature of the buildup to the crisis was that the fringe banks were able to raise finance from the established banks, which were prevented by the regulatory authorities from participating in the binge directly. The euphoria of the period was such that few saw the dangers -possibly because bank managers had no personal experience of the previous crisis in the 1930s, regarding it as an anachronism, Revell postulates.

The period of euphoria came to an abrupt end with the acceleration of inflation, the freezing of the property market and the drop in equity prices. After the first hint of bank failure, the supply of wholesale funds to the fringe banks, via the interbank market, dried up, and the Bank of England’s ‘lifeboat’ operation was launched.30 Subsequent examples of widespread bad banking can be found in the United States, where many savings and loan associations got into trouble in the late 1970s, for example; and, on an international scale, in connection with the Latin American debt problem. When the Mexican crisis broke in 1982 it was realised that the country risks involved in sovereign lending to developing countries, which needed to refinance their debts continuously to meet interest payments, had been severely underestimated.

Revell also examines other bank failures in Europe and the United States in the early 1970s and is struck by the similarity of the business undertaken by the failed fringe banks, most of which were linked in some way with the property market. The fact that there were incidences of bad banking in many countries suggests the possibility of a common cause. Revell believes this to be the relaxation of structural controls over banking systems with a view to making them more competitive and the association of these developments with accelerating inflation and the general euphoria that accompanied it.

He postulates that there might have been no ill effects if liberalisation had taken place at a time of financial stability, but the combination of greater competition with inflation and euphoria proved lethal. This begs the question of why inflation increased in the first place. In terms of Minsky’s FIH, it could have been a result of a rise in government deficit financing to head off a perceived increase in the risk of crises as the economic expansion in the early 1970s built towards a euphoric boom and financial instability increased.

Revell is troubled by the fact that failures occurred even in countries with the strictest prudential regulatory regimes, since this implies that competition may not be able to ensure sound banking and that increased prudential regulation cannot be relied upon to contain the tendency of increased competition to generate bad banking practices. He feels that the prevalence of bad banking might, however, be attributable to widespread euphoria.

All regulatory systems, he observes, even the most formal statutorily backed ones, leave a lot of discretion to the supervisor. If supervisors are also influenced by the euphoria, they will not act to prevent the development of unusual practices which do not contravene the rules. This implies that regulators and supervisors should not relax their vigilance in times of euphoria and that the regulatory and supervisory system must be sufficiently flexible to deal with rapid structural changes.

Metcalfe (1982) shares Revell’s view that crises are a recurrent phenomenon in banking systems and feels that the generic characteristics have been succinctly described in Kindleberger (1978). He argues that crises originate with events that significantly increase profit expectations in one sector of the economy and stimulate an increased demand for finance. Innovations could play an important role here, as Barclay (1978) observed.31 The 2007-9 Global Financial Crisis (GFC) with its subprime mortgage lending boom are the associated increased issuance of mortgage backed securities and the innovation of credit default swaps and collateralised debt obligations (CDOs), bears this out, Tett (2009).

The extension of bank credit then increases the money supply and self-exciting euphoria develops in the manner described by Minsky and Kindleberger. More and more firms and households are tempted into speculative finance and are led away from rational behaviour, and manias or bubbles result. As Kindleberger observed (1978, p. 17), the term mania emphasises the irrationality and the term bubble foreshadows the bursting.

Even the suspicion that the tissue of expectations is weakening can spark a crisis. Only a small incident is needed to transform manic behaviour into panic behaviour, which inflicts widespread damage. Metcalfe argues that banks exemplify a general characteristic of all organised social systems, which is that of the management of a system of expectations under conditions of risk and uncertainty.32 Like other social systems, the effective functioning of the banking system depends on a fabric of co-ordinated expectations. Mutual expectations guide the behaviour of participants and are modified in a process of interaction.

To form their own expectations, individuals must draw on assumptions and beliefs about the rules and values of others. Value consensus cannot be assumed but values do coalesce into more or less coherent doctrines, myths or ideologies, which provide the intellectual rationale and moral basis for legitimate actions. This feature of social organisation, he argues, is particularly prevalent in banking where the extension of credit creates webs of rights and obligations spread over time.

The fulfilment of expectations depends on confidence in the continuing viability of the whole system and vice versa. As Hicks (1967) observed, however, stability of the banking system cannot be taken for granted because it is potentially unstable in two directions. Performance will fall short of potential if there is a lack of confidence; but overconfidence, as in the buildup to a crisis, will produce unrealistically high expectations.

Because expectations are never precisely fulfilled in any complex social organisation, there is a continuous management problem of avoiding the extremes of mistrust and overconfidence. The maintenance of balance requires an institutional framework or regulatory system that encourages confidence while restraining constituent organisations.

Before leaving the topic of instability in the banking sector, Diamond and Dybvig’s (1983) contribution should be considered. In their model, the illiquidity of assets provides the rationale for both the existence of banks and their vulnerability to runs. It is assumed that even if assets are traded on competitive markets with no transactions costs, low returns are received by agents forced to ‘liquidate’ early.

Agents are, therefore, concerned about the cost of being forced into early liquidation and will write contracts reflecting these costs. Investors face private risks which are not directly insurable because they are not publicly verifiable, due to the existence of information deficiencies and asymmetries. The onset of the GFC in August/September 2007, involved a North Atlantic Liquident Squeeze, Mullineux (2008), in which banks, which had become increasingly reliant on wholesale financing through the interbank market, found that they could not renew that funding due to increased perception of the liquidity risk associated with lending to bank counterparties.

Banks serve the function of indirectly transforming illiquid assets by offering highly liquid liabilities, such as demand deposits which are redeemable at their nominal value; they thereby provide indirect insurance that allows agents to make payments when they want or need to and, in so doing, share the risks. Efficient risk-sharing can result if confidence is maintained but if agents lose confidence and panic, incentives are distorted and a bank run results.

To prevent loss of confidence, Diamond and Dybvig advocate comprehensive, government-backed deposit insurance. Its provision is, however, likely to create moral hazard problems, which must be dealt with if an optimal bank regulatory regime is to be developed. The GFC indeed prompted widespread extension of deposit insurance cover. Risk-related deposit insurance premiums or capital adequacy requirements would appear to be needed to contain the moral hazard, but such issues are beyond the scope of this book.

Kindleberger’s model and the international dimension

Minsky’s work provides the basic framework for the Kindleberger (1978) analysis of historical financial crises. He notes that some crises have a minor economic impact but concentrates on crises of major size and effect, normally with an international scope. He regards speculative excesses, or bubbles, as irrational events or manias which are followed by revulsion from the excesses and a crisis, crash or panic which can be shown to be common, if not inevitable.

He notes that by no means does every upswing lead to a mania or panic but that the pattern occurs with sufficient frequency and conformity to merit renewed study. Initially some event changes the economic outlook. New opportunities for profit are seized and overdone in ways so resembling irrationality as to constitute mania. In the manic phase people of wealth and credit switch out of money or borrow to buy real or illiquid financial and capital assets. In the panic phase the reverse takes place, and the excessive characteristics of the upswing are realised.

In Kindleberger (1978), the background to speculation and crisis is discussed in terms of the classical ideas of overtrading followed by revulsion and discredit.34 He acknowledges Minsky as the most recent exponent of such ideas and feels that even if it did not apply to the United States at the time, the FIH provides a useful framework for analysing past crises. Kindleberger’s model of crises (1978, Ch. 2) is based on Minsky’s earlier writings, which relied more heavily on shocks than the later writings, reviewed above, which attempt to develop an endogenous theory of financial crises.

As in Minsky’s earlier work, the events leading up to a crisis start with a shock or displacement to the macroeconomic system, and Kindleberger tries to identify historical examples of such displacements (1978, Ch. 3). He finds that the source of displacement varies from one speculative boom to another and in that sense historians are correct in arguing that each speculative boom or cycle is unique. Economists, who argue that cycles are a repetitive process, are also correct since the reaction to the shocks and the subsequent evolution of the economy are similar.

The shock alters the outlook by changing the opportunities for profit in at least one important sector of the economy. Displacement occurs as businesses switch from unprofitable to profitable lines of business and there are new entrants to the perceived high profit markets. If this process leads to a net increase in production and investment then a boom ensues. The boom is fed by an expansion of bank credit which enlarges the money supply and if the urge to speculate is present, euphoria develops and overtrading and excessive gearing can result.

As speculation spreads to members of the population normally aloof from such ventures, who abandon their normal behaviour, then a mania or a speculative bubble develops. In the latter phases of the mania, speculation detaches itself from really valuable objects and turns to delusive ones, and swindlers and fraudsters flourish.

As the manic boom continues, interest rates, the velocity of circulation and prices all rise and at some stage a few insiders decide to take profits and sell out. It should be noted that the periodic taking of profits could explain the saw-toothed progress of asset prices and is likely to result if individuals hold sufficiently diverse expectations35 and periodically hedge their bets on the continuation of the boom by taking profits and refinancing.

This may explain the finding that stock market prices follow a random walk with drift, discussed in the next section. Kindleberger argues that at the peak of the boom, there is often a pause as new recruits to speculation balance those selling out. Prices level off, and there may be an uneasy period of financial distress. The probability of a flight to liquidity increases in the eyes of a segment of the speculative community, and risk increases. When it is widely accepted that the market price will go no higher, the balance will tip in favour of selling out. There will be a race to withdraw, which may develop into a stampede, in order to maximise existing capital gains and minimise prospective capital losses.

Kindleberger notes that the special signal that precipitates the crisis could be one of a number, but it is often a bank failure or the revelation of fraud or defalcation. Prior to the crisis a state of revulsion against certain commodities or securities is often observed, and banks cease lending on the collateral of such assets. This is sometimes called discredit in the classical literature.

Once crisis arrives and panic sets in, it feeds on itself, as did the speculation, until one or more of the following occurs:

  • Prices fall so low that investors are again attracted by less liquid assets.
  • The exchange on which the asset in which there has been speculation is traded is closed, or trade is otherwise inhibited.
  • The LOLR intervenes to stem flight to liquidity by guaranteeing an ample supply of money.

Kindleberger argues that his Minsky-inspired model describes the nature of financial crises under capitalism and rejects the view that each crisis is unique because he is able to identify certain common features in crises, despite the existence of differing individual features.

This view recently supported by Reinhart and Rogoff (2009), whose book draws on the famous title of Minsky (1982a). He also rejects the view that it is no longer applicable to modern capitalism, and the 2007-9 Global Financial Crisis demonstrated that he was correct. He supports Minsky’s view that Keynesian ISLM and neoclassical synthesis models missed an important point contained in Keynes’s writing.

As a result Hansen (1951), a leading proponent of Keynesian multiplier-accelerator business cycle analysis, incorrectly dismissed previous theories of business cycles, based on uncertainty, speculation and overtrading, as inapplicable to the twentieth century because industry had become the main outlet for funds seeking a profitable return from savings and investment. Kindleberger argues that room for speculation in commodities and securities remains, and prices and credit continue to be unstable. Hansen concentrated on savings and investment but ignored uncertainty, speculation and instability, which featured prominently in Keynes’s work.

Kindleberger then considers whether an active LOLR can forestall crises, making it possible to eliminate them altogether. The counterview that the existence of LOLR cover on a reliable basis might actually increase risk-taking and, therefore, the likelihood of bubbles is acknowledged by Kindleberger, but he observes that since 1930 the greater willingness to undertake LOLR intervention has apparently increased stability.

This view would tend to be confirmed by the rapid response by central banks to the October 1987 stock market crashes around the world and the absence of their significant impact on the performance of the economies in which they occurred. With the benefit of hindsight, the supply of liquidity by LOLRs appears to have been excessive and slightly inflationary. It should also be noted that the FDIC, established in the 1930s, has probably increased stability in the United States.

In fact the period of stability seems to date back further in countries such as the United Kingdom, where the LOLR established credibility following the 1866 banking crisis. (See Gilbert and Wood (1986) for further discussion.) Kindleberger also draws attention to the fact that despite the decline in domestic crises in the post-war period, there has been an increase in the incidence of international crises implying the need for an international LOLR (ILOLR) or credible contingency plans for co-ordinated LOLR intervention by national central banks.

Like Minsky, Kindleberger fails to provide a definition of crises. He merely replaces old words, such as overtrading, revulsion and discredit, with new ones, such as manias, speculative bubbles, panics and crashes. Goldsmith (1982), in his comments on Minsky (1982b), suggests the following definition: a sharp, brief, ultracyclical deterioration of all or most of a group of financial indicators, such as short-term interest rates and asset (stock, real estate, land) prices, commercial insolvencies and failures of financial institutions.

This would exclude several of Minsky’s so-called crises, Goldsmith observes, and particularly the minor ones in the United States in the 1960s and 1970s, to which Minsky attaches such importance. His definition achieves the goal of discrediting Minsky’s thesis but is merely a description of an event which might be termed a widespread financial crisis. Unlike the FIH, it does not attempt to identify the cause of crises.

Like Kindleberger, Eichengreen and Portes (1987) are particularly interested in the generation and propagation of crises in an international setting. They define a financial crisis as a disturbance to financial markets, associated particularly with falling asset prices among debtors and intermediaries, which spreads through the financial system, disrupting markets’ capacity to allocate capital. The definition implies a distinction between generalised financial crises and isolated bank failures, debt defaults and foreign exchange market disturbances.

It is, therefore, in a similar vein to Goldsmith’s definition. Such distinctions are clearly important, since while it is clear that the economy should be protected from the negative externalities resulting from systemic crises, it is not obvious that individual bank failures should be prevented. Such prevention might even increase the risk of systemic failures by creating a moral hazard problem.

Eichengreen and Portes (1987) observe that capital flight36 plays a role in international financial crises similar to that played by bank runs in domestic crises and argue that institutional arrangements in the financial system are critical determinants of the system’s vulnerability to destabilising shocks, which emanate primarily from macroeconomic events rather than events limited to the financial system.

Their point about institutional arrangements is similar to that made by Melitz (1982) and discussed above. It implies that capitalist economies are not necessarily prone to financial instability if they adopt the appropriate institutional arrangements. Their analysis involves a comparison of the 1920s and 1930s with the 1970s and 1980s. In both the 1920s and 1970s institutional arrangements were drastically altered by changes in foreign exchange markets, international capital markets and the structure of domestic banking systems.

There are certain similarities in these changes, but Eichengreen and Portes believe that the changes in the 1920s on balance increased vulnerability and the crisis in the 1930s was the consequence, while the changes in the 1970s worked in the opposite direction so that events such as the 1982 Mexican debt crisis and the subsequent October 1987 stock market crash proved containable.

Eichengreen and Portes argue that macroeconomic shocks can cause a rapid change in the credit regime, from high lending to rationing, by conveying new information to lenders. They note that Guttentag and Herring (1984) postulate that an extended period without adverse shocks creates conditions in which such a shock will provoke discontinuous market behaviour.

They find this hypothesis more specific and rigorous than Minsky’s FIH, although it appears to be based on a similar premise: that as time elapses since the last major shock or crisis, the lenders become more disposed to greater risk-taking. In the case of the 1982 Mexican crisis the ‘disaster myopia’ emphasised by Guttentag and Herring, which had led to inadequate ‘spreads’ or risk premiums on sovereign lending and what Minsky would call speculative finance - because the Latin American (LA) debtors were not expected to be able to service the interest payments on their debts in the short or medium term except through further loans -was dispelled, and this changed the banks’ overall perception of LA debtors in an environment of imperfect information.

Capital flight significantly increased the disaster probability. When the disaster scenario suddenly took on a non-negligible subjective probability, lenders reacted by pulling out of the market as fast as the IMF and their central banks would allow. Rather than gradually tightening the terms attached to loans, the banks suddenly shifted to credit rationing, which the IMF tried to offset through ‘forced lending’.

The LA debt problem of the 1980s differed significantly from the one in the 1930s because banks had assumed credit risks formerly borne by purchasers of sovereign bonds. There was consequently a need to contain any menace the crisis posed for the banking and wider financial system in the 1980s.

This was done by the US Treasury and the Fed in conjunction with the IMF and the Bank for International Settlements, which launched a rescue operation.38 Banks now appear to have been protected long enough to build up provisions and capital sufficient to withstand a reversion of the LA debt problem to crisis proportions.

While no formal ILOLR exists, it seems that contingency arrangements are in place.39 The key weakness of current policy, Eichengreen and Portes contend, is the failure to block capital flight in a time of increasing international capital mobility. Other problems emanate from sustained exchange rate misalignments and consequent protectionist pressure.

Eichengreen and Portes argue that the shift from bank lending to borrowing on the capital markets, or securitisation, evident in the 1980s should in principle reduce systemic vulnerability, but the Cross Report points to countervailing aspects - see Bank for International Settlements (1986.) They acknowledge that the trade-offs are complicated but believe that the developments are on balance positive from the viewpoint of financial stability.

They argue that imperfect information favours the generalisation of adverse shocks into full crises and that macroeconomic instability is the main source of shocks, but that the appropriate action by the regulatory and monetary authorities can block the most dangerous linkages. Co-ordinated action, embodied in the ‘Third World debt strategy’, has avoided defaults and widespread bank failures, but action should have been taken earlier to prevent the expansion of bank lending to sovereign borrowers leading to the accumulation of excessive debt burdens.

Eichengreen and Portes believe that securitisation will get more information into the market-place, reduce adverse selection and remove from the banking system the heavy burden of acting as a buffer when shocks do occur.

The Eichengreen and Portes analysis implies that the real dangers lie not in disturbances originating from the financial market but in the malfunctioning of the real economy. To reduce the latter, greater economic co-operation and co-ordination are required, which might lead to a new international monetary constitution. This would provide rules on exchange market intervention and choices of international reserve assets, constraints on fiscal and monetary policy, and a well defined responsibility for ILOLR intervention.

On both imperfect information and externality grounds, they feel that there is a rationale for government intervention in financial markets in general and the regulation of the banking system in particular, since it is the latter that acts as a buffer when shocks to the real economy impact on the financial system. Regulatory policy should, they argue, channel financial innovation in directions that leave the world economy less vulnerable to financial collapse.

The downside risk is that the trend towards greater cooperation and co-ordination will evaporate when the world economy enjoys a period of sustained stability. Disaster probabilities may be reassessed and reduced to negligible levels as the last shock or crisis recedes into the distant past and disaster myopia or euphoria will again prevail, bringing the next crisis closer.

Further analysis and evidence on crises in economic and financial structures is presented in a collection of papers edited by Wachtel (1982). Wachtel himself observes that market bubbles or speculative explosions in one market could potentially lead to widespread crises.

He notes that although there are numerous examples of crises, the economics profession does not have a framework for dealing with the topic and the problem of definition is consequently an important one. He feels that the basis for such a framework is provided by Meltzer (1982), who draws on Knight’s (1921) distinction between risk and uncertainty and suggests that economic crises should be associated with uncertainty of outcomes.

A crisis may emerge when there is a shift in the underlying distribution of outcomes of the economic events. Meltzer treats uncertainty as a shift in expected value following a shock to either aggregate demand or aggregate supply and claims that this is consistent with the usage of Knight and Keynes. However, papers postulating rational bubbles, such as Flood and Garber (1982) and Blanchard and Watson (1982), deal with a world of risk in which outcomes often differ from their expected value but with a known or calculable probability, rather than uncertainty, which is due to unpredictable changes in the distribution of outcomes. Economic units can prepare themselves for the consequences of risky outcomes but not for uncertain ones.

Rational Speculative Bubbles

Flood and Garber (1982) show that price bubbles can arise in models in which the current market price depends on expected future price changes. Under rational expectations, such models tend not to yield a unique expression of agents’expectations.

The indeterminacy arises out of trying to solve for two endogenous variables40 from one equilibrium market condition. As a result, arbitrary, self-fulfilling expectations of price changes may drive actual price changes independently of market fundamentals, causing price bubbles.

The fundamentals are described by the precise model of market operation. Some models preclude rational bubbles and others do not; consequently it is not possible to prove that they exist at the theoretical level. They observe that empirical work attempting to identify bubbles has turned up mixed results and is, therefore, inconclusive.

They also note that the previous literature has attributed runs and panics to mass hysteria rather than to rational behaviour. Salent and Henderson (1978) regard runs as predictable events, however. They are regarded as events which terminate price fixing schemes.

The viability of such schemes requires the economic agents running them to hold stocks and stand ready to buy and sell at a fixed price. If other agents perceive the scheme to be temporary and expect prices to rise, yielding a capital gain, they will draw down the stock backing the scheme. If stocks are depleted entirely in one final discrete withdrawal, then a run has occurred.

Flood and Garber note that systemic bank collapses are the most famous examples of runs. Banks fix the price of deposits in terms of government currency and hold reserves of the currency as backing. If a capital loss on deposits is feared, then depositors deplete the bank’s reserves forcing the bank to cease fixing the price of its deposits. Similarly, currency crises are associated with runs on government foreign exchange reserves which are held to fix the price of the domestic currency against other currencies.

Following the rational expectations (RE) revolution in the mid-1970s, it was a widely held view, Blanchard and Watson (1982) observe, that asset prices must reflect market fundamentals in the sense of depending on information on current and expected future returns on assets. Deviations from market fundamentals were viewed as evidence of irrationality. Market participants, however, often believe that fundamentals are only part of what determines the price of a security.

Extraneous events will influence asset prices if other participants believe they will do so, and crowd psychology becomes an important determinant. Meltzer (1982) suggests that the two views can be reconciled if rational expectations under risk is replaced by decision-making and expectations formation under uncertainty, since under uncertainty extraneous events or shocks can cause fundamental and sudden reappraisals of expected future returns.

Blanchard and Watson (1982) demonstrate that economists have overstated their case because rationality in behaviour and expectations formation does not prevent asset prices from deviating from fundamentals or rational bubbles occurring.

They observe that there is little doubt that most large historical bubbles, such as those investigated by Kindleberger (1978), contained elements of irrationality and that such bubbles are much harder to deal with theoretically. They therefore concentrate on the analysis of rational bubbles. Their model assumes maximising behaviour, RE and continuous market clearing and implies that, given private information and information revealed by prices, assets are voluntarily held and there is no incentive to reallocate portfolios. With additional assumptions, including common and current information sets, the efficient market or no arbitrage condition can be derived from it.

Their model is typical of a class in which expectations of future variables affect current decisions and does not have a unique solution. As a result the market price can deviate from the present value of the asset, without violating the no arbitrage condition. If a deviation occurs, the structure of the model implies that it can be expected to grow over time and constitute a bubble. Using examples they show that the bubble can take various forms. They also demonstrate that bubbles can occur even when agents are risk-averse and are no longer assumed to have identical information sets.

They are not, however, able to make much progress on such issues as whether differential information permits a wider class of bubbles or whether some aspects of real world bubbles involve differential information. They also note that, while the efficient market condition itself does not preclude bubbles, there may be other conditions imposed institutionally or from market clearing, or implicit in rationality that rule them out.

Further, standard analysis assumes that bubbles themselves do not affect market fundamentals, but Blanchard and Watson feel this is unlikely. The rise in price associated with bubbles may well encourage an increase in the supply of assets affected. When the bubble bursts, prices will fall below the pre-bubble level because of the increased supply.

Additionally, a price bubble in one asset will increase its price relative to other assets not subject to bubbles, and this will lead to portfolio redistribution. It should be noted that this may be a mechanism by which non-speculators are drawn into speculation because if they do not redistribute their portfolios, their relative returns will decline.

Because of the potential for real effects, it is important to ascertain whether bubbles are theoretical constructs of little relevance or whether they are witnessed frequently in the real world. Blanchard and Watson therefore turn to a review of the empirical literature. They observe that testing for bubbles is not easy because rational bubbles can follow many types of process.

They show that certain bubbles will violate the variance bounds implied by a certain class of RE models and present empirical evidence that demonstrates such violations. They note that irrational bubbles would also cause such violations. Runs and tails tests are suggested when only price data is available, but it is demonstrated that such tests have low power.

Despite Blanchard and Watson’s misgivings, Garbade (1982) argues strongly that bubbles are unlikely to occur in the New York Stock Exchange (NYSE). This is attributed largely to the Fed’s margin requirements, which limit the amount of credit that can be used to purchase stocks. The margin requirements were introduced for the specific purpose of inhibiting speculative bubbles following the 1929 crash. (See Galbraith (1954, Ch. X) for further discussion.) In addition the Securities and Exchange Commission (SEC) has encouraged the provision of broader and more detailed information, and empirical evidence implies that stock prices are efficient in the sense of reflecting publicly available information, Garbade observes. Greater and more accurate information, he believes, should reduce the likelihood of bubbles. Empirically, he finds little evidence of bubbles.

The stock market should demonstrate a run of increases as the bubble builds and a run of decreases as it collapses. On average, he finds a stock price increase is equally likely to be followed by another increase or a fall. It is implicit in Garbade’s discussion that the 1929 crash could have been the collapse of a bubble and that this prompted the Fed to introduce margin requirements in 1934 to inhibit the development of bubbles in the future. The NYSE crash of October 1987 is also viewed by many analysts as the bursting of a bubble. It is argued that stock prices lost touch with fundamentals in the speculative bubble that preceded the crash.41

Santoni (1987) notes that the 1924-9 NYSE bull market is widely accepted to have been a speculative bubble and that the same theory of stock market price formation has been used to describe the 1982-7 bull market. They are normally regarded as irrational rather than rational bubbles.

He challenges the view that these events were speculative bubbles, arguing instead that stock prices reflected fundamentals in each period and presenting empirical support for his hypothesis. He accepts that current stock prices depend on forecasts of future outcomes and the expected returns derived from them, which are subject to changes as new information becomes available and which do not depend on current dividends observed.

Consequently, relatively small changes in forecasts can lead to large changes in the fundamental price. Fundamentals cannot be observed directly, however, and proxies must be used that are believed to provide information on fundamentals, though they can only give a rough guide to the behaviour of fundamentals. When the market crashed in October 1987, commentators pointed to the proxies and claimed that stock prices were overvalued prior to the crash. An alternative explanation, he notes, is that the proxies gave a misleading impression of the fundamentals.

To examine the proposition that stock prices in the 1920s and 1980s were driven by factors extraneous to fundamentals, it is necessary to derive alternative hypotheses from the competing theories and test them. Santoni considers three different hypotheses:

  • The efficient market hypothesis.
  • The irrational bubble hypothesis.
  • The rational bubble hypothesis.

The efficient market or no arbitrage hypothesis assumes that stock prices are determined in efficient markets so that relevant known information is reflected in them. Prices change only in response to new information, which cannot be predicted ahead of arrival and is just as likely to be good or bad. If it is correct that past information on price changes contains no useful information about future changes, then the observed changes in stock prices should be uncorrected, and price changes should exhibit no long sequence of successive changes that are greater or less than the median change for the sample.

This proposition should hold even if the level of prices appears to drift up or down. The fact that prices drifted up in both bull markets does not imply that price changes are correlated or that market participants were able to predict future changes by observing past changes. The irrational bubble hypothesis argues that self-feeding expectations drive up prices. Fundamentals are regarded as largely irrelevant. Stocks are bought in the belief that they can be sold at a higher price in the future for capital gain. Extrapolating from past price rises, speculators expect the rise to continue.

The hypothesis implies that there are times when past changes matter. There should therefore be positive correlation in past sequences of price changes and long runs of positive changes that exceed the median change for the sample period, Santoni argues.

The rational bubble hypothesis also postulates that there will be occasions when stock prices deviate from the fundamental price and that deviations will tend to persist and explode leading to bubbles that cannot be negative. Santoni concludes that the efficient markets hypothesis implies that stock price changes should follow a random walk while both the rational and irrational bubble hypotheses imply that stock price changes should not follow a random walk but should instead be positively serially correlated.

Despite the growing literature on rational bubbles, Santoni is concerned about the absence of a well specified theory. Following Brunner and Meltzer (1987), he argues that a complete theory of bubbles should identify their cause in terms of phenomena that can be observed, separately from the bubbles themselves. On occasions when a bubble was observed then so too would be the causal event.

This would allow a direct test of the theory and could explain why bubbles are observed on some occasions and not on others. In the case of irrational bubbles, the unusual behaviour is attributed to euphoria and manias, which do not identify the cause of the bubble but merely give it another name, he argues. Brunner and Meltzer (1987) go further and argue that bubbles are inconsistent with the rational exploitation of information invoked by the analysis demonstrating their existence. It is clear that they are criticising the rational bubble literature.

Their argument may well be true for rational bubble models which assume a risky environment, although Blanchard and Watson (1982) were unable to prove that RE prevents bubbles. It is not so clear that it applies to the so-called irrational bubble hypothesis which, as Meltzer (1982) observed, is more likely to hold in an environment of uncertainty. Kindleberger (1978) in fact attempts to identify events that generated fundamental re-evaluations of expectations of future returns leading to bubbles and also tries to identify events that lead to their bursting.

The irrational bubble and FIH literature is much richer because it attempts to explain the creation and bursting of bubbles and provides some insight into how to prevent them in the future by regulating the financial system. The rational bubble literature, which attributes crashes to bursting bubbles without adequately explaining why they burst, is of little help to the policy-maker.

Santoni (1987) concludes with an examination of the evidence to see if it supports the efficient markets or the bubbles hypotheses. He uses samples of more than 400 observations from each of two periods, the 1920s and the 1980s. In each period there was rapid price advance. Autocorrelation coefficients were estimated for price changes, and the Box-Pierce test was applied, but no significant autocorrelation was evident. The data was, therefore, consistent with the efficient market hypothesis.

The upward drift was undeniable but at the time, he argues, it was not something that investors could have bet on with confidence. He also applied the runs test, which Blanchard and Watson noted has low power, and this too rejected the bubble hypotheses.

Despite these results, and others like them, the so-called upward price drift in these periods remains a cause for concern to some economists.

The price levels, rather than changes, were clearly positively correlated, and a trend term would have contributed strongly to any equation explaining price levels without lagged price terms. It may be that this is the important feature, implicit in calling such periods bull markets, and that the random walk in price changes can be readily explained.

For example, speculators could, and probably did, bet on the medium-term rise in the trend price. But because of diverse expectations,45 which might be the result of non-homogeneous information and differing perceptions, speculators might take profits periodically and refinance their positions. It is after all the rising price levels that deliver the capital gains.

A detailed analysis of the behaviour of speculators during the bull markets appears to be called for. In this case daily fluctuations in prices would not necessarily lead speculators to assume that the medium-term trend had altered. Further, if the stock prices were not overvalued, why did they drop so precipitously in 1929 and 1987? If the no arbitrage hypothesis holds, how was it possible that the government bond markets got so out of line with the equity markets prior to the 1987 crash? It is also notable that regardless of whether or not stock markets are subject to bubbles, other markets seem to demonstrate speculative behaviour consistent with the bubble hypothesis.

This is particularly true of the property market, possibly as a result of the long gestation periods and potential for oversupply. There are numerous examples of property market bubbles and crashes, the most recent being the Texan crisis of the mid-1980s, which led the largest bank holding company in the state, First Republic Bank, to seek a capital injection from the FDIC in March 1988 and left many office blocks empty.

Recent literature on rational bubbles has not confined itself to stock market prices. It has also featured applications to the analysis of exchange rates, which many analysts believe have shown excessive short-run fluctuations and sustained periods of misalignment, neither of which are consistent with the fundamentals.

Brunner and Meltzer (1987) argue that neither the efficient asset market approach of the 1970s nor the theories based on balance of payments fundamentals that preceded them can explain the exchange rate behaviour observed in the post-1973 floating exchange rate period. The natural approach in the 1980s was to return to the analytical framework of the efficient markets approach and extend it. This resulted in the literature on bubbles and sunspots.

As in asset markets, the theories of bubbles in exchange markets exploit the non-uniqueness of solutions in RE equilibria. Standard RE models relate the exchange rate (yt) to fundamentals (ft), which are determined by a linear combination of exogenous variables. But yt = ft + bt will also be a solution where bt follows a possible stochastic time path imposed on the system. The bubble term (bt) is determined by extrinsic information and refers neither directly nor indirectly to any observable phenomena.

The choice of extrinsic information is entirely arbitrary and is difficult to reconcile with the rationality and information postulates used in the analysis, Brunner and Meltzer argue. The basic model provides a continuance of convergent equilibrium paths while the supplementary, and arbitrary, specification of information extrinsic to the basic model determines the specific path taken by the exchange rate. They find this unsatisfactory because it offers no explanation of the volatility of exchange rates or the serially noncorrelated changes in exchange rates discovered in empirical analysis.

The problem arises, they argue, from attempting to explain phenomena crucially conditioned by a pervasive uncertainty with an analysis incorporating RE that assumes that the probability distribution of shocks is known and, therefore, that risk rather than uncertainty prevails.

Previous attempts to explain exchange rates in terms of purchasing power parity (PPP),47 which postulate rational expectations in the context of complete and homogeneous information among agents, also eliminate all manifestations of the pervasive uncertainty. They argue that, with such an analysis, an explanation of volatility is inaccessible. Singleton (1987) examines the consequences of replacing complete and homogeneous information among agents with imperfect and heterogeneous information.

This captures some of the dimensions of uncertainty and radically changes the implications. It allows for much greater volatility than standard exchange rate models but fails to settle the remaining major question: the integration of the observed random walk behaviour of exchange rate changes into the analysis. If, as seems undeniable, speculators are present in the exchange markets, then the explanation could lie in non-homogeneous information and perceptions among agents and the tendency for individual agents to take profits periodically and refinance positions, as a method of hedging, as outlined earlier.

Singleton (1987) provides a critical review of the burgeoning literature on the potential importance of speculative bubbles and sunspots for explaining the time series behaviour of exchange rates. He expresses doubts about such explanations of exchange rate behaviour and argues that speculation has not had a stabilising effect in exchange markets as previously argued by proponents of floating exchange rates. (See, for example, Friedman 1953, pp. 157-203.)

Singleton notes that bubble and sunspot models adopt fairly simple, and inadequate, specifications of the interplay between and the information of agents by commonly imposing current and homogeneous information and assuming that the distribution of shocks is known. This, as Brunner and Meltzer (1987) observed, eliminates uncertainty in the sense of Knight (1921). There is a strange incoherence in models that imply that past price changes are no guide to future price changes and yet future shocks will follow the distribution of past shocks.

These bubble and sunspot models abstract entirely from the dynamics introduced by incomplete information and heterogeneous beliefs and/or information, he observes. The rejection of the PPP and economic fundamentals theories, based on balance of payments analysis, has led to the development of bubbles and sunspot theories; but, he argues, changes in fundamentals can easily generate exchange rate behaviour that resembles a rational bubble.

Agents may believe, with time-varying degrees of confidence, that major changes in the stochastic processes governing fundamental economic variables, such as the money stock or income, may occur in the future. It is unlikely that all the fundamentals are observed by econometricians conducting empirical analysis, and consequently there may appear to be bubbles in the misspecified models being investigated.

With the addition of some of the features of uncertainty, this misspecification explanation of broad swings in exchange rates can be extended to explain their short-term volatility, Singleton argues. If agents believe that changes in the environment will occur with some small probability, then misspecifying the model by ignoring this possibility may lead to an underestimation of volatility. He argues that the probability attached to such events is also likely to change over time, adding to the swings.

Further, incorporating nonlinearities into the model will create a much more important role for informational problems. To illustrate this point, he extends his basic model to include risk aversion. He also demonstrates that reducing the information available to agents can increase volatility relative to the full current information model. When he allows risk aversion to vary across agents, volatility also increases.

Singleton demonstrates in addition that by altering the information structure so that shocks and real variables are observed at discrete time intervals while trading in continuous, current and past shocks can have persistent effects on exchange rates, which again become more volatile. Heterogeneous information further magnifies the reaction of the exchange rate to shocks. He argues that it is likely that some traders will be more interested in hedging, importers and exporters for example, while others may take uncovered, speculative positions. With imperfect competition of this sort, volatility may be further increased.

Singleton’s examples employ models in which PPP holds. He concludes that to develop an alternative fundamental interpretation of the dollar’s appreciation up to 1985, which is generally regarded as an overvalued position, it is necessary to identify credible sources of uncertainty which, when combined with risk aversion, explain the appreciation.

One source of uncertainty might have been the growing budget deficit which could have led to a rise in the real rate of interest, and he considers others as well. He argues that a fundamentalist explanation of the dollar appreciation cannot be easily dismissed while doubts remain about the correct specification of current PPP-related models. He concludes that volatile exchange rates do not constitute evidence of inefficient trading or justify central bank exchange intervention.

Rather they reflect decision-making in an uncertain environment which may be enhanced by uncertainty about future government policies leading to medium-term swings and increased day-to-day movements in exchange rates. This implies that these features of exchange rate movement could be reduced if the uncertainty regarding future government policies, especially those relating directly to exchange rates, was removed and policy rules were announced instead.

Singleton therefore rejects bubbles and argues that correctly specified models of the fundamentals will be able to explain medium-term movements in exchange rates and their short-term volatility under uncertainty. The latter is approximated by relaxing the current and homogeneous information assumption while the medium-term movements are attributed to omitted variables, including government policy stances, whose future evolution is also uncertain.

While some of the medium-term movements may be explicable by omitted variables, the perception that they have frequently led to sustained misalignments is hard to dispel. This implies that better-specified models of the fundamentals may not be sufficient, and irrational bubbles based on speculative euphoria, which are more likely to occur under uncertainty than risk (as Meltzer (1982) observed), may still be present.

The problem may be that the so-called fundamentals are not immutable in the complex social organisation we call the economy but depend themselves on the interaction of the perceptions of the economic agents at a specific time. The fashions and myths evident in dominant economic doctrines at various times and their tendency to change over time, perhaps even cyclically, may be a reflection of this problem. It is also highly likely that individual economic agents hold perceptions of the set of fundamental variables and their future evolution, and attach weights to them that vary at least as much as those infamously held by members of the economic profession.


Behaviour consistent with bubbles, namely a shock followed by a rapid fall, a slow change and then a rapid recovery can be described by catastrophe theory. (See discussion at end of section: Nonlinear Cycle Theory.) Cusp catastrophe models, Varian (1979) demonstrates, can be used to explain cycles containing recessions, and also cycles containing depressions, in which the return from the crash is gradual and drawn-out.

The path followed is dependent on the severity of the shock. The shock examined by Varian is a wealth shock which might, for example, emanate from a stock market crash. The links between financial market crashes and economic recessions and depressions remain uncertain, however, as Galbraith’s (1954) analysis of the possible links between the 1929 New York Stock Exchange crash and the subsequent depression demonstrates. In contrast, the October 1987 crash appears to have had relatively minor effects, which suggests that the impact of financial crashes depends on the underlying condition of the economy at the time and the distribution and proportion of wealth-holding in the form of stocks and shares at the time.

If bubbles exist, then plans to save and invest may be subject to erratic change because, in a world of uncertainty, the expectations on which decisions are based are liable to change rapidly and over-optimism or euphoria can build up. As a result, Keynes argued (1936, p.322), misguided over-optimistic expectations can lead to investment that would normally be deterred at the prevailing rate of interest.

The identification of the cause of the buildup to euphoria, which encourages the speculation that underlies bubbles, remains a problem. Even in the most notorious case of the speculative orgy of 1928-9, Galbraith (1954) finds it difficult to pin down the exact cause.

He notes that easy money was not the cause because interest rates were relatively high. He observes, however, that speculation on a large scale requires a sense of confidence and optimism and a feeling of trust in the intentions of others. Savings must be plentiful in aggregate, but speculation can rely on borrowed funds.

If people feel well off, then they may be willing to ‘have a flutter’ and take more risks in the hope of enhanced return. He postulates that speculation is, therefore, likely to follow a long period of prosperity which leads to rising expectations of future incomes. He cites the South Sea Bubble of 1720 as an example. Savings had grown rapidly and domestic returns had declined. The collapse of the bubble destroys the mood that fosters speculation but, with time and the dimming of memory, immunity to speculation wears off and a recurrence becomes possible, he argues.

Minsky’s FIH and related work49 imply that bubbles entail elements of irrationality, but bubbles can apparently also occur under rational behaviour. The rational bubble models, however, add little to our understanding of the phenomena, and some of those who have demonstrated the possibility of their existence believe that irrationality is displayed in historical accounts of bubbles.

The irrational bubble theories imply that financial markets provide vehicles for speculative excesses. Minsky views the financial system itself as basically unstable. Others, such as Eichengreen and Portes (1987), see the financial system as potentially sound, once appropriately regulated, but as playing a significant role in generalising the effects of shocks emanating from the real sector.

If the financial system is fundamentally unstable, then regulation is clearly required. Minsky (1986), however, argues that it will not be possible to assure financial stability through regulation since instability laid to rest by one set of reforms will eventually emerge in a new guise. Those that do not share Minsky’s views have a greater belief in the potential for regulation to prevent speculative excesses and the resultant crises.

Nevertheless, the rapid financial innovation in the 1970s and 1980s ensures that regulators and supervisors must be ever-vigilant and develop flexible systems to contain the speculative urge and associated risks. In this vein the Brady Report50 recommended that margin requirements in the US futures markets should be tightened following the October 1987 crash. In addition, should a financial crisis occur, the LOLR and BOLR should act swiftly to prevent it leading to a multiple credit contraction and recession or depression.

Eichengreen and Portes (1987) postulate that the banking system serves as a buffer between the real sector and the wider financial system. As a result of deregulation, however, banks are becoming increasingly integrated with the wider financial system (Mullineux 1987b, c). This has a number of regulatory and supervisory implications.

The risk of ‘contagion’ is increased, in the sense that banks are more likely to be adversely affected by depositors’ reactions to losses in securities markets in which banks are known or believed to be participating. To the extent that securities markets, as well as the real sector, are a source of shocks, then the banking system’s buffer role will be expanded.

The LOLR cover provided by central banks to support the banks’ buffer function, and thereby to protect the payments system and the credit relationships it entails, will implicitly have to be extended to cover the wider financial system in order to protect banks from ‘contagion’. (See Dale 1988 for further discussion.)

The discussion of the role of money and finance in pre-Keynesian business cycle theories in section: The Role of Money and Credit in Pre-Keynesian Business Cycle Literature, and of the FIH in section: The Financial Instability Hypothesis (FIH), revealed a tendency to concentrate on the behaviour of banks rather than the wider financial system.

The implication appeared to be that there is something special about banks. It has been asked,51 however, if banks differ from other financial intermediaries because they are more heavily regulated or if the regulatory strictures are applied because they are different. We have no space to explore such issues here but, to the extent that the financial system increases the ability of the economy to bear risks and in so doing allows more investment and faster growth to take place, then it has a key role and its ability to absorb and manage risk must be assured.

This provides a rationale for regulation. In most financial systems banks continue to play a key role, despite the apparent shift away from traditional bank loan finance towards funding through marketable securities. By virtue of their risk-bearing or insurance role, they probably remain the most important shock absorbers or buffers in the financial system. This implies that in order to ensure that their buffer role is not impaired, it is particularly important to regulate banks.

If the banks do indeed perform a key buffer function, then the role of the banking sector in the economy is more complex than envisaged by Schumpeter (1939) and Shackle (1938), whose work will be discussed in the next chapter, and Minsky. Schumpeter and Shackle assumed that banks provided finance for innovatory investment and a secondary wave of expansion, while Minsky argues that banks engage in speculative and Ponzi finance.

It may well be that financial fragility develops as the expansionary phase is sustained, as Minsky argues, and that this creates conditions that ensure a more severe downswing than would otherwise have occurred, as Schumpeter (1939) argued. If this is the case, then bank regulation, aimed at curbing speculatory excesses and maintaining the banking sector’s ability to perform its buffer function, would be an essential component of anticyclical policy.

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