Obviously, economic modeling could not foresee a gathering financial crisis because conventional economic models don't model finance. Moreover, the financial crisis was not merely financial in origin. A significant contributing factor was forensic. As a matter of fact, the forensic factor was caught by authorities. The US Federal Bureau of Investigation warned of rampant fraud in the mortgage industry, and further wrongdoing was latter discovered as a consequence of investigating the crisis after the fact.
Minsky's (conceptual) financial model of the three stages leading to financial instability. Minsky's analysis shows that a financial boom-bust cycle is not the same as a business cycle resulting from over-investment and a consequent production cut back to reduce mounting unplanned inventory with supply outpacing demand. A business cycle is about firms perception of customer demand and the level of expectations about future demand. A financial cycle is about credit extension from overly tight to overly loose.
Stumbling and Mumbling
Forecasting vs explaining
Chris Dillow | Investors Chronicle
Stumbling and Mumbling
Forecasting vs explaining
Chris Dillow | Investors Chronicle
3 comments:
"the crisis was a financial crisis rather than an economic crisis."
Pretty much the point I made in the comments after Dillow's previous post. MMTers control other peoples' minds...:-)
But isn't it the case that a financial crisis is the outcome of an economic crisis? Today's finance may be parasitical and have almost no redeeming social and economic features, but it doesn't exist in a vacuum.
Finance was unleashed to paper over the widening cracks, now chasms, created by a totally dysfunctional economy. (An an aside, how finance can now be reined without unleashing further instability in is a very difficult question to answer.)
That, at least, is a narrative that makes sense. The counter narrative - finance went bonkers - is unsatisfactory, to say the least.
The crisis may have been, or appeared to be, financial, but it was a symptom of a deeper economic problem. Finance is an easy punching bag, not that it doesn't need to be punched.
Of course, in a modern capitalist economy finance and economics are joined at the hip. But finance is supposed to be in service to the economy, providing access to capital in addition to saving that is invested directly. Most of the money supply, which held as bank deposits, is generated from bank credit.
As Minsky pointed out finance has its own dynamics that distinguished financial cycles from business cycles. Business cycles are intermediate term while financial cycles are fairly long term. Generally there have been several business cycles within a longer term financial cycle.
MMT would say that both business and financial cycles are basically credit cycles, so they cannot be separated based on causality alone. Financial cycles exhibit a different pattern historically and follow a somewhat different dynamic, as Minsky described. The apex of a business cycle doesn't ordinarily exhibit a bubble-bust phenomenon but financial cycles do. Business cycles can be described in terms of a boom-bust instead.
The lead into the GFC was not an economic boom that was getting out hand. It was a bubble in the housing market and related financial instruments. It was driven by housing but it was a bust based on collapsing derivatives that undermined the financial industry. The liquidity freeze then went viral throughout the economy as debt deflation spread.
The significant factor was not that housing got overbuilt (over-investement) but rather than housing values became excessively inflated owing to a breakdown in the credit extension mechanism, the cause having been traced to massive fraud in the mortgage industry driven by banks hungry for paper to securitize regardless of its actual value.
Then the paper imploded after the monetary authority pulled the plug on Lehman and the system froze up overnight, leaving the authorities puking over the prospect of a global meltdown (this is no exaggeration).
Minsky describes this as the third or "Ponzi" phase of the financial cycle in which debt is financed based on expected continuous rise of the value of collateral to enable refinancing. As Chuck Prince admitted, the CEOs who participated in what Bill Black calls control fraud knew that this was a game of "musical chairs" in which the music would eventually stop and someone would be left without a chair. That was Dick Fuld at Lehman. But it turned out that all the chairs had broken legs.
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