*** Financial Crisis

Theories of financial crises

World systems theory

Recurrent major depressions in the world economy at the pace of 20 and 50 years have been the subject of empirical and econometric research especially in the world systems theory and in the debate about Nikolai Kondratiev and the so-called 50-years Kondratiev waves. Major figures of world systems theory, like Andre Gunder Frank and Immanuel Wallerstein, consistently warned about the crash that the world economy is now facing. World systems scholars and Kondratiev cycle researchers always implied that Washington Consensus oriented economists never understood the dangers and perils, which leading industrial nations will be facing and are now facing at the end of the long economic cycle which began after the oil crisis of 1973.

Minsky's theory

Hyman Minsky has proposed a post-Keynesian explanation that is most applicable to a closed economy. He theorized that financial fragility is a typical feature of any capitalist economy. High fragility leads to a higher risk of a financial crisis. To facilitate his analysis, Minsky defines three approaches to financing firms may choose, according to their tolerance of risk. They are hedge finance, speculative finance, and Ponzi finance. Ponzi finance leads to the most fragility.

for hedge finance, income flows are expected to meet financial obligations in every period, including both the principal and the interest on loans.

for speculative finance, a firm must roll over debt because income flows are expected to only cover interest costs. None of the principal is paid off.

for Ponzi finance, expected income flows will not even cover interest cost, so the firm must borrow more or sell off assets simply to service its debt. The hope is that either the market value of assets or income will rise enough to pay off interest and principle.

Financial fragility levels move together with the business cycle. After a recession, firms have lost much financing and choose only hedge, the safest. As the economy grows and expected profits rise, firms tend to believe that they can allow themselves to take on speculative financing. In this case, they know that profits will not cover all the interest all the time. Firms, however, believe that profits will rise and the loans will eventually be repaid without much trouble. More loans lead to more investment, and the economy grows further. Then lenders also start believing that they will get back all the money they lend. Therefore, they are ready to lend to firms without full guarantees of success. Lenders know that such firms will have problems repaying. Still, they believe these firms will refinance from elsewhere as their expected profits rise. This is Ponzi financing. In this way, the economy has taken on much risky credit. Now it is only a question of time before some big firm actually defaults. Lenders understand the actual risks in the economy and stop giving credit so easily. Refinancing becomes impossible for many, and more firms default. If no new money comes into the economy to allow the refinancing process, a real economic crisis begins. During the recession, firms start to hedge again, and the cycle is closed.

Coordination games

Mathematical approaches to modeling financial crises have emphasized that there is often positive feedback between market participants' decisions (see strategic complementarity). Positive feedback implies that there may be dramatic changes in asset values in response to small changes in economic fundamentals. For example, some models of currency crises (including that of Paul Krugman) imply that a fixed exchange rate may be stable for a long period of time, but will collapse suddenly in an avalanche of currency sales in response to a sufficient deterioration of government finances or underlying economic conditions.

According to some theories, positive feedback implies that the economy can have more than one equilibrium. There may be an equilibrium in which market participants invest heavily in asset markets because they expect assets to be valuable, but there may be another equilibrium where participants flee asset markets because they expect others to flee too. This is the type of argument underlying Diamond and Dybvig's model of bank runs, in which savers withdraw their assets from the bank because they expect others to withdraw too. Likewise, in Obstfeld's model of currency crises, when economic conditions are neither too bad nor too good, there are two possible outcomes: speculators may or may not decide to attack the currency depending on what they expect other speculators to do.

Herding models and learning models

A variety of models have been developed in which asset values may spiral excessively up or down as investors learn from each other. In these models, asset purchases by a few agents encourage others to buy too, not because the true value of the asset increases when many buy (which is called "strategic complementarity"), but because investors come to believe the true asset value is high when they observe others buying.

In "herding" models, it is assumed that investors are fully rational, but only have partial information about the economy. In these models, when a few investors buy some type of asset, this reveals that they have some positive information about that asset, which increases the rational incentive of others to buy the asset too. Even though this is a fully rational decision, it may sometimes lead to mistakenly high asset values (implying, eventually, a crash) since the first investors may, by chance, have been mistaken.

In "adaptive learning" or "adaptive expectations" models, investors are assumed to be imperfectly rational, basing their reasoning only on recent experience. In such models, if the price of a given asset rises for some period of time, investors may begin to believe that its price always rises, which increases their tendency to buy and thus drives the price up further. Likewise, observing a few price decreases may give rise to a downward price spiral, so in models of this type large fluctuations in asset prices may occur. Agent-based models of financial markets often assume investors act on the basis of adaptive learning or adaptive expectations.

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