Review of theoretical and historical analyses
WP3 – Causes and Consequences of the crisis
In addition to the work focusing specifically on the recent financial crisis, the researchers reviewed theoretical work on financial crisis and conducted case studies for selected other important historic crises. An overview of these developments can be found here.
Eckhard Hein and Nina Dodig (WP no 23) review the empirical and theoretical literature on the effects of changes in the relationship between the financial sector and the non-financial sectors of the economy associated with ‘financialisation’ on distribution, growth, instability and crises. They focus on four channels of transmission of financialisation to the macro-economy: first, the effect on income distribution; second, the effects on investment in the capital stock; third, the effects on household debt and consumption; and fourth, the effects on net exports and current account balances.
For each of these channels some empirical and econometric literature supporting the presumed channels was surveyed, some theoretical and modelling literature examining the macroeconomic effects via these channels were reviewed, and finally, small analytical stock-flow consistent models generating the most important macroeconomic effects were presented. The authors show that, against the background of redistribution of income at the expense of the labour income share and depressed investment in capital stock, each a major feature of financialisation, short- to medium-run dynamic ‘profits without investment’ regimes may emerge, which can be driven by flourishing consumption demand or by rising export surpluses, compensating for low or falling investment in capital stock. However, each of these regimes, the ‘debt-led consumption boom’ type and the ‘export-led mercantilist’ type, contains internal contradictions, with respect to household debt in the first regime and with respect to foreign debt of the counterpart current account deficit countries in the second regime, which finally undermine the sustainability of these regimes and lead to financial and economic crises. The authors concluded that neither the ‘debt-led consumption’ nor the ‘export-led mercantilist’ regime should serve as a role model for the post-crisis development. The latter should rather focus on generating wage/income-led or domestic demand-led types of development by means of redistributing income towards labour and low income households, re-regulating financial sector to serve the non-financial sectors, re-creating the incentives for real investment in the capital stock, and stabilising macroeconomic policies coordinated at the international level.
Daniel Detzer and Hansjörg Herr (WP no 25) review and compare systematically different schools of economic thought regarding the analyses of financial crises. First, approaches that consider financial crises as a disturbing factor of a generally stable real economy (Wicksell, Hayek, Schumpeter, Fisher, and the early Keynes) were reviewed. Then, approaches in which the dichotomy between the monetary and the real sphere is lifted were considered (the later works of Keynes and Minsky). Lastly, behavioural finance approaches were covered. After having reviewed the different approaches, similarities and potentials for syntheses were examined. The authors developed a theoretical framework, which is methodologically based on a Wicksellian cumulative process, while overcoming the neoclassical dichotomy. These aspects were combined with some ideas taken from John Maynard Keynes’s analysis of uncertainty, expectations and herding, Hyman Minsky’s analysis of debt ratios and changing leverages, Irving Fisher’s analysis of goods market and debt deflation, and different ideas stemming from behavioural finance. In this approach, a range of feedback mechanisms serve to explain a long-lasting expansion, after an initial positive trigger. However, in this phase vulnerabilities are built up, finally depressing the economy, with the feedback factors working in reverse as soon as the upswing ends. The paper ended with some policy recommendations based on the developed theoretical framework. In particular, it was recommended to use financial regulation measures to prevent the build-up of vulnerabilities in the expansion period and to reduce some of the feedback mechanisms which exacerbate the booms and busts, in particular purely financial speculation. In the bust, deflation was identified as one of the most important negative feedback mechanism. Therefore it was argued that economic policy efforts should focus on avoiding deflation by means of wage and demand policies, in particular.
Nina Dodig and Hansjörg Herr (WP no 24) review the literature on previous financial crises leading to stagnation including comparative case studies of the Great Depression of the late 1920s/early 1930s in the US, the Latin American debt crisis of the 1980s, and the Japanese crisis of the 1990s and 2000s. It focuses on the following guiding questions: What triggered big financial crises? Which factors intensified financial crises? And most importantly, which factors contributed most to preventing a rapid return to prosperity? The aim was thus to identify the stylised facts of previous crises, both in terms of the causes of the crises and of the difficulties in recovering from such crises.
The main conclusion from this paper is that stagnation after big financial crises becomes likely when the balance sheets of economic units are not quickly cleaned, when the nominal wage anchor breaks, and when there is no big and longer demand stimulus by the government. Some tentative conclusions for the recent financial crisis and the ongoing Euro crisis were drawn as well. The authors argued that, in particular, bail-out packages should have been combined with debt reliefs for households rather than focusing only on the stabilisation of big financial institutions. Labour market reforms and austerity policies in Southern European countries bear strong resemblance to those imposed on Latin American countries in the 1980s, worsening the downturn and leading to stagflationary tendencies. There is thus a risk of repeating Japan’s deflationary experience as several Euro area countries, most notably Greece, have been experiencing or are in danger of deflation due to one-sided focus on internal devaluation. Instead, nominal stabilisation and demand enhancing policies would have been needed if a long period of stagnation were to be avoided. For the Euro area, this should have been accompanied with a more symmetric approach towards dealing with current account imbalances, with more expansionary policies of the surplus countries, in particular.