Financial and economic bubbles
The financial bubble is representing difference between the equilibrium price and
the fundamental value. The shift of risk is on place when too many people are
investing in the asset, and thus increasing the equilibrium price. There are two main
factors determining the size of the bubble: The amount of available financing for
speculative investments and the uncertainty of the market ( Allen and Gale, 1999)1
Allen and Gale2 suggest that the bubble in asset prices is initiated by a financial
liberalization and credit expansion, which is increasing the risk- shifting problem
between intermediaries. Later the bursting of the bubble leads to crisis and recession.
Allen and Gale are considering different studies and theories from different authors,
trying to analyze how to prevent the bubbles in asset prices, and to form perspective
policies, which could prevent the spillover effect over the real economy.
The financial bubble, which is evolving later into an economic bubble, has three main
phases according to the Theory of Crises.3
Phase 1: Financial liberalization and Credit expansion. Usually the national
bank decides officially by government policy, regime or using some other event, to
increase the lending. Both the current credit expansion and the expectation about
its future trend are feeding the bubble. Anticipated credit expansion is built into the
current asset prices, and the continued credit expansion is supposed to allow the
speculators to pay their debts. Allen and Gale make difference between robust and
fragile credit expansion, where the first is related with a contract during a non- crisis
time, and the second is related with prevention of a financial crisis. There is an
uncertainty in the credit expansion and the central bank, which can not control the
credits given by the banks.
Phase 2: Rise of asset prices. In different countries all over the world, and
historically from the Tulip Mania in the 17th century till the current financial crisis since
2008, they often start with initial expansion in the asset prices. Typically there is a rise
of the publicly traded stocks with more than 40 percent, increase of prices of real
estates and other assets. This period might continue several years, until the bubble
inflates. Than for a short period of days, months or longer, the stock and asset prices
collapse and the bubble bursts.
Phase 3: Burst of the bubble and market default – In this phase the stock
market and the real estate markets collapse, leading further to collapse of other markets
and assets. Many companies and financial intermediaries are in default because
they have to pay the money they have borrowed to pay the inflated assets. After
one- one and a half year is coming the bank crisis due to overexposure to risk
assets and real estates. Subsequently the government is trying to fix the problem
with the banks by alternating the interest rate, which is causing volatility in the
exchange rates of currencies and foreign exchange crisis. At the end of the phase,
Allen F., Galle D., “ Bubbles, Crises, and Policy”, Oxford Review of Economic Policy, 1999, Vol. 15,
no.3, p.4
2 Allen F., Galle D., “ Bubbles, Crises, and Policy”, Oxford Review of Economic Policy, 1999, Vol. 15, no.3,
p.1
3
Allen F., Galle D., “ Bubbles, Crises, and Policy”, Oxford Review of Economic Policy, 1999, Vol. 15,
no.3, pp.3,5,11
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a significant decrease in the real output or reduction in the growth rate is
occurring, and the crisis lasts for about year and a half or even number of years. One
of the reason for the spillover effect over the real economy is the fact that under the
financial crises, the credits are very limited and both financial intermediaries and
companies are credit- restrained.
Allen and Gale are summarizing three main possible reasons for the common
market failure4:
- The Risk- shifting problem : Investments are debt financed, and agencies
and intermediaries are receiving funds from external sources, which do not control
the return on investments. Investors are bidding- up the fundamental value of the
asset, as majority of the investors are targeting the most risky assets because of
their higher yields, thus they are increasing the equilibrium price of the assets. In
this respect it is very important what is the volume of the credit provided for
speculative investment in the asset prices. Besides the intermediaries have limited
responsibility in case of failure, but at the same time they have incentive as bonuses
if they have very positive performance.
- The guarantees given by the government to the banks - Bank deposits are
guaranteed by the government, but the banks are not controlled for their
speculative investments in asset prices, which create bubbles and sometimes
bursts.
- A real shock in the real economy of finance – The reason for the shock
could be a momentum from the business cycles, or any policy and intervention
that affects the normal functioning of business in the real economy , affecting the asset
and stock prices. The shocks in the financial system are more complex, but a good
example is the tightening of the credits, which also leads to collapse of the asset
prices.
Desirable policies in case of financial bubbles could be either initiatives preventing
the bubble, or in case of a bubble burst- decreasing the spillover effect on the real
economy.(Allen and Gale, 1999) 5
- First the government should try to avoid forming of a bubble. Even though
Fama has recognized the relationship between the monetary policy, inflation and
asset prices in 1981, only recently governments have debated whether and how to
target the asset prices. The main idea under the theory of money is that when the
money supply increases, the wages and prices also will increase in the long run. Stock
prices might be influenced by fundamental inputs, outputs, decrease or increase
in inflation. The empirical results are showing that the rise in the inflation is
decreasing the stock prices. Other authors are suggesting that the key link between
the monetary policy and the asset prices is the volatility of the credits for asset –
investing, and thus in the price determination. That’s why the national bank, should
Allen F., Galle D., “ Bubbles, Crises, and Policy”, Oxford Review of Economic Policy, 1999, Vol. 15,
no.3, pp.2-3
5
Allen F., Galle D., “ Bubbles, Crises, and Policy”, Oxford Review of Economic Policy, 1999, Vol. 15,
no.3, pp.15-17
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have higher requirements for bank reserves to guarantee liquidity. Besides, the
credit expansion if needed, should be proceeded slowly andj carefully.
- In case the bubble occurs, the government and the central bank should try to
decrease the spillover of the burst into the real economy. Possible government
policies are the monetary intervention of the central bank, nationalization of the
banks in bankruptcy, and the “liassez – faire” policy ( non- intervention). The
burst of the bubble could cause huge debt overhang. In such case the central bank
should try to provide enough liquidity, in order to prevent the liquidation of the
costly assets. At the same time it should not try to prevent the banks from passing
the real shocks to the economy through the depositors.
Financial Instability Hypothesis
The Financial Instability Hypothesis ( FIH ) was developed first by Minsky in 1982 and
later by other authors including Keen in 1995 ( Keen, 2011)6 , building qualitative
macroeconomic model, based on real and monetary characteristics of the “ Great
Moderation” and “ The Great Depression” periods in the last fifteen years. This
non- neoclassical model integrating both macroeconomics and finance, helped Keen to
predict the current economic crisis before it occurred. Minsky rejected the neoclassical
economists abstract model, which can not generate instability, because it was built in a
time when some economic phenomena didn’t exist - the capital assets, the uncertainty
of the futures, the new bank finances and the money creation based on liabilities. In his
theory Minsky is developing theory based on business cycles leading to debtdeflationary crisis, using some ideas from Schumpeter, Fisher and Keynes. Keen
is arguing that we live in a mixed economy depending on the pure capitalism from one
side and the intervention of the government into the market economy from the other
( Keen, 1997)7.He also states that the previous single sector economic models can
not explain the debt- deflation and can not capture the price dynamic behind the
financial instability. The FIH is explaining the modern capitalism, where the
general government idea is to have balanced budgets and the low price inflation of
commodities is criticized.
As part of the FIH, Minsky,Kalecki and Keen are generating the Price Mark- up and
Input- Output Analysis ( Keen, 1997)8. The main idea in this theory is that the
commodity prices are set- up by markups of prime costs, which are determined by the
level of monopoly in each sector. Later Steedman corrects the theory stating that the
level of the prices are depending also on the input- output levels, and the theory
should be corrected with the long- run equilibrium model and multi-sectoral
analysis of price dynamics. Some other ideas are : the prices should have an
average mark- up, the average rate of profit, the level of wages and technologies
Keen, S., “A monetary Minsky model of the Great Moderation and the Great Recession”, Journal of
Economic Behavior and Organization,2011,p.1
7 Keen, S. “ Economic Growth and Financial Instability”, PhD Thesis, University of New South Wales
School of Economics, 1997, pp.7,8
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Keen, S. “ Economic Growth and Financial Instability”, PhD Thesis, University of New South Wales
School of Economics, 1997, pp.181, 181, 201
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should be also taken into account, as well as the vertical integration of industries.
Still, the model didn’t include the quantities and the finance, which would change the
dynamic. Different linear an non- linear models have been developed, but they all
lead to unstable equilibrium, especially when not taking into account the wages
and the input- output analysis.
Later within the Multisectoral Model with Finance, Keen is trying to create a nonlinear model using variables from the macro, micro and finance economy. The
model is determining that the money have endogenous source, which means the
amount of the money in the economy are independent on the monetary base of the
economy. (Keen, 1997)9.This preliminary model sets assumption for certain
consequence of the economic activity: 1) Interest rates paid for deposits and debts;
2) Planned production based on last year output and effective demand; 3 ) The inputs
for the planned production are bought from the previous period at previous level
prices; 4) There are hired workers for the planned production 5) Workers spend all
their incomes on consumption; 6) Bankers are consuming only part of their income
and another part is saved ; 7) Capitalists consume only part of their income. In his
preliminary model, Keen is calculating the current level of debt, planning the production
(output) and demand (input), employment and labor costs, assessing banker’s
balances. It is difficult to include the capitalist’s consumption and balances, because of
the different levels of profits by firms and industries and by the fact that they are
interrelated within the industry trough competition, and between the industries- trough
vertical or horizontal integration or input- output connection. Thus Keen calculates the
capitalists consumption, their income ( profits plus interest), but not their savings. In
addition the market mark- up is calculated, which depends on the competition within
each industry sector. Unfortunately the complexity of the model due its
assumptions, the missing correct data and technical devices is preventing from
computer simulation and checking the consistency of the model. Additional
variables as the stocks, fixed capital, population growth and technical change
should be involved in the model, to become more realistic.
The application of the Financial Instability Hypothesis could be found as guideline for
governments in their attempts to fix the economy in case of financial and economic
speculative bubbles and bubble bursts, stock crashes, debt- deflation, low inflation, low
or negative money growth, collapse of investments and fragile recovery of the economic
activities. According to Minsky, the use from the FIH for governments is to avoid the
debt- deflation through policies and institutions, which should sustain financial society,
where the speculative finance is restrained. The inflation of the commodity prices should
also be regulated during a period of deflation. Misnky and Keen consider that during a
crisis, the interest rate should be driven to very low levels, in order to avoid the increase
of the debt.They suggest that the low interest rates would prevent the inflation increase
during the economic boom. In fact, this statement contradicts with the bubble theory,
suggesting that the bubble starts with low interest rates and credit expansion.
Keen, S. “ Economic Growth and Financial Instability”, PhD Thesis, University of New South Wales
School of Economics, 1997, pp. 205, 209
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