Mechanisms of Financial Crises and their Effects on the Real Economy

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Mechanisms of Financial Crises and their Effects
on the Real Economy

• Erik S. Reinert
• www.othercanon.org
• Saarbrücken, August 5, 2008

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The Circular Flow of Economics
The real economy Güterwelt
Financial economy Rechenpfennige
Black Box Production of goods and services
Money/capital
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WHEN THE ACCOUNTING UNITS ATTACK THE REAL
ECONOMY

• In the years preceding the first world war there
  were in common use among economists a number of
  metaphors ... Money is a wrapper in which goods
  come Money is the garment draped round the
  body of economic life etc. During the 1920s
  and 1930s ... money, the passive veil, took on
  the appearance of an evil genius the garment
  became a Nessus shirt the wrapper a thing liable
  to explode. Money, in short, after being little
  or nothing, was now everything... Then with the
  Second World War, the tune changed again.
  Manpower, equipment and organization once more
  came into their own. The role of money dwindled
  to insignificance..
• C. Pigou, The Veil of Money, 1949, pp.18-19.

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Three basic and complementary mechanisms behind
the conflicts between the real economy and the
financial economy (financial crises)
THE HAMMURABI EFFECT (Babylonia ca. 1795 1750
BC) The Effect of Compound Interest. THE PEREZ
EFFECT(Carlota Perez, Venezuelan
economist) Technological Revolutions Create
Financial Bubbles. THE MINSKY EFFECT (Hyman
Minsky, US, 1919-1996) Liquidity preference
turning point bad projects killing credit to
healthy projects.
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THE HAMMURABI EFFECT

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

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THE PEREZ EFFECT.

• Financial markets with some logic have a love
  affair with a new breakthrough technology (US
  Steel, Microsoft).
• Role of financial innovation 1720 stocks, 1990s
  hedge funds, that create illusion of gravity
  lost.
• Illogically the market wants to bid up all shares
  as if they were hi-tech (US Leather).
• Enters fraud Parmalat ENRON.
• Gravity rediscovered collapse.

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DUBIOUS PROJECTS IN 1720 BUBBLE
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DUBIOUS PROJECTS IN IT-BUBBLE
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THE MINSKY EFFECT

• Types of financing
• Hedge financing, low risk.
• Speculative financing involves future
  renegotiating of the debt (rollover). A typical
  speculative position consists on financing long
  term assets with short term liabilities.
• Ponzi financing is when expected revenues can not
  afford even interest payments, and agents are
  submitted to increasing debt.
• Ponzi schemes (such as subprime loans) cause
  financial institutions to redefine the game
  they no longer compete for market share but
  instead pull out in order to be more liquid. IN
  THIS WAY ALSO SOUND PROJECTS ARE REFUSED CREDIT,
  AND A DOWNWARD SPIRAL STARTS.

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HOW DEREGULATION CREATED A PONZI SCHEME

• The role of banks has historically been to
  evaluate risk and keep these risks on their
  balance sheets.
• A 1999 US deregulation allowed banks to sell
  packages of subprime loans that were not on
  their balance sheets. Rating and regulatory
  agencies did not understand what was happening
• that creditworthy banks were offloading junk
  packages from their balance sheets.

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WHAT TO DO?

• BALANCING SCHUMPETER
• IT HAS TO BURN OUT ALONE
• AND KEYNES
• REPAIR IT, BUT WITHOUT ENCOURAGING THE VERY
  BEHAVIOUR THAT CAUSED THE PROBLEM IN THE FIRST
  PLACE!