Economics of Crisis

Abstract

According to Semmler (2019), for speculations, currency and financial crises, the economic literature can be divided into three generations of models: (1) Focus on macroeconomic fundamentals (such as differences in economic growth rates, productivity and price levels, short-term interest rates as well as monetary policy actions) causing exchange rate movements. (2) Speculative forces – such as self-fulfilling expectations, which destabilize exchange rates without deterioration of fundamentals. (3) Following the theory of imperfect capital markets, self-fulfilling expectations depend on some fundamentals, for example, the strength and weakness of the balance of sheets of the economic units such as households, firms, banks and governments. The financial instability literature discussed is not formally developed to the point of rigorous testing that is common for the aforementioned models. These are the Minskyan models that rely on empirical and qualitative investigations of financial crises as case studies (e.g. Kindleberger, 1978). Such approaches, unfortunately, receive comparatively little treatment in economic discussions, yet they rely on psychological, behavioral and social factors that are becoming increasingly important in interdisciplinary approaches. In particular, Minsky and Kindleberger emphasize the collective euphoria – emboldened by myopia – that drives the boom, which no participant wants to miss out on. According to Semmler (2019), the offset of a crisis tends to feature the following: (1) A deterioration of the balance sheets of economic units (households, firms, banks, the government and the country) (2) Before the crisis the current account deficit to GDP ratio rises (3) Preceding the currency crisis, the external debt to reserve ratio rises (after the crisis the current account recovers) (4) There is a sudden reversal of capital flows and unexpected depreciation of the currency (5) Domestic interest rates jump up (partly initiated by central bank policies) - subsequently stock prices fall (6) The banking crisis occurs with large loan losses by banks and subsequent contraction of credit (sometimes moderated by a bail out of failing banks by the government) (7) The financial crisis entails a large output loss due to large scale bankruptcies of firms and financial institutions.