a.) What were the main causes within the financial system of the financial crisis that erupted in the US in 2008 and quickly spread around the globe?
New Financial Architecture
special investment vehicles and financial innovation (including MBS and CDOs)
merge of investment and commercial banking
too big to fail institutions, lender of last resort policies
assumptions of NFA: efficient market hypothesis, risk is price accurately, risk is distributed to those who can best bear it, government intervention is unnecessary and harmful
Perverse Incentives and "Rainmakers"
Bonus-pay structure for "rainmakers"
Asymmetric and perverse incentives
Marc Jarsulic argues that at least one reason for the 2007/8 meltdown had to do with bank size, leverage, and the rise of shadow banking. He also argues that the rise of brokers, who are intermediaries in these financial relationships but themselves do not supply the loan, also contributed to the crisis because they were lightly supervised, and had asymmetric risk due to the fact that they were not the originators. He highlights that leading up to the crisis saw a mass concentration of mortgage originators. These mortgages, concentrated mainly in just 10 banks with 60% of the market share, were then packaged (and repackaged) into securities such as Mortgage Backed Securities (and then Collatoralized Debt Obligations). This mass availability of credit, funded through shadow banks, sold by brokers, and repackaged by investment banks, fed into the housing price bubble. Upon the housing markets collapse, the collapse of credit triggered the greater financial crisis (especially due to the role of expectations). For Jarsulic, the origins of the crisis starts, in part, with sophisticated new financial market intermediaries, such as shadow banks and brokers, who funneled money for credit to credulous homebuyers and in doing so created a credit bubble. He understands their willingness to do so is due to the asymmetric risk and short-term financial gain associated with the structure of many of these relationships.
b.) A major financial crisis cannot be endogenously generated in mainstream financial market theory or in the dominant mainstream macro theory, but endogenous financial crises are almost inevitable in Keynes-Minsky financial market theory. Which of the causes of the crisis discussed in your answer to part a.) are adequately theorized in Keynes-Minsky theory and which are not, Explain your answer.
Because mainstream theory relies on the efficient market hypothesis, the theory does not allow for endogenously generated financial crises. It assumes that risk is accurately priced and distributed to those who can best bear it. If that were the case though, financial institutions would not have been interested in receiving bailouts or having those troubled assets removed from their balance sheets.
That considered, Keynes-Minsky theory does allow for crises to be endogenously generated stemming from the structure of the economy and financial system itself. Both Keynes and Minsky argued that instead of reliance on neoclassical/classical theory and the efficient market hypothesis, a realistic set of assumptions and theories about the economy and financial markets should be derived. Crotty shows in his 2011 paper "The Realism of Assumptions Does Matter" that Keynes-Minsky theory would embody the assumptions that:
1. The future in inherently unknowable. The world is characterized by uncertainty rather than calculable risk.
2. Expectations are endogenous and pro-cyclical. They become more optimistic in booms, and more pessimistic in downturns, and wildly unstable in panics.
3. The degree of agent risk aversion is endogenous. Agents become less risk-averse in a bubble and more risk-averse in a downturn.
4. Agents are heterogenous: they have different expectations, degrees of aversion. This is why there's massive daily and hourly trading on security markets.
5. Financial market decisions affect real-sector outcomes and conversely in an interactive, dynamic, and path-dependent process. Future cash flows impact agent decisions.
6. There is no stable financial market equilibrium, though there are periods of relative stasis. Financial market centers of gravity are always being altered by endogenous change in expectations and risk aversion, as well as by the creation and spread of real and financial innovations.
7. The degree of liquidity changes over time. There is excessive liquidity in the boom that pushes security prices to unsustainable levels, but liquidity evaporates in a crisis, making the crisis worse.
8. Agents cannot borrow without limit at a risk free interest rate.
9. Defaults (and therefore counter party risk) exist and are important. Defaults are highly counter-cyclical. Fear of default is a major source of downward price pressure in a collapse.
10. Financial institutions strongly affect the performance of financial markets. They are complex agents whose incentives, information sets, objectives and constraints different from individual agents.
That said, Keynes-Minsky theory adequately addresses the following issues that led to the financial crisis:
1. The Role of Expectations: both Keynes and Minsky theorized the role of expectations in creating bubble/bust cycles. Keynes first wrote that our expectations are merely heuristic guesses based on information about the present, while the future is actually fundamentally uncertain. That considered, Keynes and Minsky apply the nature of expectations, which are pessimistic in downturns and optimistic in upturns, to how this creates and amplifies the massive swings in a capitalist economy. These expectations, rather than certain and calculable knowledge about the future, are what lead to the development of overly optimistic and complex securities, the overextension of credit (credit bubble), and fed into the price bubble for the housing market.
2. Credit boom/crunch and the role of liquidity: Keynes's theory of liquidity accurately understood that liquidity preference changes over time. In the pre-2008 boom, there was excessive liquidity and credit that pushed security prices and housing prices to unsustainable levels. After the "Minsky moment", or the sudden collapse in asset prices associated with increasing financial fragility, then liquidity evaporates and credit dried up, worsening the crisis especially for individuals and the real-sector.
3. Creation of special investment vehicles and complex derivatives: Keynes and Minsky's theory show that the basis for these complex securities is virtually non-sense. MBS, CDO, CMBS, and other types of securities, in order to accurately package, require knowledge of known, and certain, risk probability distributions. But, under conditions of fundamental uncertainty, this is impossible.
4. Fragility & Instability: Keynes-Minsky theory also theorizes that the growth and concentration of the financial sector necessarily leads to increasing financial fragility and instability, leading to crises. For both, capitalist economies are inherently unstable, so the 2008 financial crisis would have been no surprise. For Minsky, part of this is due to the fact that in a capitalist market system, prices are unstable.
Minsky argued that a key mechanism that pushes an economy towards a crisis is the accumulation of debt by the non-government sector. He identified three types of borrowers that contribute to the accumulation of insolvent debt: hedge borrowers, speculative borrowers, and Ponzi borrowers.
The "hedge borrower" can make debt payments (covering interest and principal) from current cash flows from investments. For the "speculative borrower", the cash flow from investments can service the debt, i.e., cover the interest due, but the borrower must regularly roll over, or re-borrow, the principal. The "Ponzi borrower" (named for Charles Ponzi, see also Ponzi scheme) borrows based on the belief that the appreciation of the value of the asset will be sufficient to refinance the debt but could not make sufficient payments on interest or principal with the cash flow from investments; only the appreciating asset value can keep the Ponzi borrower afloat.
If the use of Ponzi finance is general enough in the financial system, then the inevitable disillusionment of the Ponzi borrower can cause the system to seize up: when the bubble pops, i.e., when the asset prices stop increasing, the speculative borrower can no longer refinance (roll over) the principal even if able to cover interest payments. As with a line of dominoes, collapse of the speculative borrowers can then bring down even hedge borrowers, who are unable to find loans despite the apparent soundness of the underlying investments.
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