by The recurring pattern in financial crises is more or less the same. For some reason, a shift occurs in the economic cycle (such as war, innovations, new regulations, etc.) that leads to changes in the profit opportunities for banks and companies. Demand and prices rise, pulling more and more parts of the economy into a state of euphoria. Speculative mania, whether it pertains to tulip bulbs, real estate, or mortgages, becomes a reality. Sooner or later, someone sells to cash in their profits, triggering a rush for liquidity. It is time to get off the carousel and convert securities and assets into cash. A financial emergency emerges and spreads. Prices begin to decline, bankruptcies increase, and the crisis intensifies and turns into panic. To prevent a complete crash,
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Lars Pålsson Syll considers the following as important: Economics
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The recurring pattern in financial crises is more or less the same. For some reason, a shift occurs in the economic cycle (such as war, innovations, new regulations, etc.) that leads to changes in the profit opportunities for banks and companies. Demand and prices rise, pulling more and more parts of the economy into a state of euphoria. Speculative mania, whether it pertains to tulip bulbs, real estate, or mortgages, becomes a reality. Sooner or later, someone sells to cash in their profits, triggering a rush for liquidity. It is time to get off the carousel and convert securities and assets into cash. A financial emergency emerges and spreads. Prices begin to decline, bankruptcies increase, and the crisis intensifies and turns into panic. To prevent a complete crash, credit tightens, and calls for a lender of last resort who can guarantee the availability of demanded cash and restore confidence arise. If this fails, the crash becomes inevitable.
Financial markets essentially function as information centres. Since market participants do not have complete information, they tend to gather information about the fundamentals of the economy simply by observing each other’s actions. Herd instinct leads market participants to think in unison and contributes to the development often resembling a byproduct of casino activities. With new technology and instruments, there is an inherent compulsion to trade quickly, further fueling herd behaviour. Information does not have time to be fully digested but must be immediately translated into action based on guesses about how “others” will react when the information becomes public. This, in turn, leads to increased risk exposure.
Our era’s foremost financial crisis theorist, Hyman Minsky, had as a central idea in his work that crises are endogenous (systemic) phenomena where stability creates instability and reduced safety margins for financial transactions with excessively high leverage effects. During the expansion phase of financial bubbles, safety margins decrease, and even the slightest setback can lead to unmet expectations, forcing companies and investors to revise their plans in order to meet their cash-flow commitments. As a result, asset liquidation may be necessary, contributing to a debt-deflation process with increasingly burdensome real debt and difficulties in solving liquidity problems through asset disposal.
Although the obvious flaw in capitalism centers around its inability to maintain a close approximation to full employment, its deeper flaw centers around the way the financial system affects the prices and demands of outputs and assets, so that from time to time debt and debt servicing rise relative to income so that conditions conducive to financial crises are endogenously generated. Such a crisis is, if not contained by a combination of Central Bank lender of last resort interventions, which sustain profits, leads first to a collapse of investment and then to a long lasting depression accompanied by mass unemployment.
According to Minsky, these were inevitable processes. Stability creates instability even without euphoria and excessive optimism. During the expansion phase, banks’ lending practices are confirmed and even riskier projects are validated. In line with the cascading information theory, we have a logic where what initially appeared risky is ultimately perceived as completely risk-free. Banks become more and more confident.
Securitization has resulted in traditional credit assessment being replaced by credit ratings performed by rating agencies without firsthand knowledge of borrowers. This is based on a kind of stochastic assessment, where instead of considering each individual borrower’s credit history, borrowers are treated as random realizations of a “representative” borrower with risks following a normal distribution curve with a given mean and variation. However, if real borrowers do not exhibit the level of homogeneity that such a statistical approach assumes, the flaws in model construction become evident. When the risk proves to have ‘fat tails,’ the intention to reduce and distribute the risks turns into the opposite. The catch is that this is not really apparent until the crisis is in full bloom and the ‘representative’ borrower is on the ropes. Assets that banks have tried to move off their balance sheets through securitization reappear when the off-balance sheet institutions they created are forced to seek help in resolving acute liquidity problems.
The recurring crises demonstrate how systematically inadequate credit ratings are in today’s financial system. One of the fundamental reasons is that those who take the risks are no longer responsible for evaluating borrowers’ ability to bear their costs. The instruments that are said by representatives of the financial market to be created to optimally distribute risk among different actors fail to fulfil their task when there is no credible mechanism for assessing risks. Not even on capitalism’s flagship, the financial markets, can they manage to reduce the genuine uncertainty of the economy to manageable stochastic risks (stochastic processes are like flipping a coin, where we know with certainty that the outcomes are either heads or tails, and the randomness means that with repeated coin flips, we have an equal chance of getting heads or tails). If securities and other assets are priced based on risks estimated using assumptions that apply to stochastic normal distribution models, these prices can never be better than the model assumptions they are based on. In normal times, they might provide decent approximations, but when bubbles grow and the future definitely does not resemble the past (economies are not ergodic systems in statistical terms, where processes remain unchanged over time), the result is a crisis.
The crises stem from a financial system that systematically undervalues risks and overvalues creditworthiness. The financial instability that Minsky believed permeated the financial markets cannot be completely eliminated. However, we can ensure the implementation of regulations and institutions that minimize the damage. Bubbles are an inevitably recurring element in an economy with free rein for essentially unregulated markets. But our contemporary reevaluation of work and wealth also plays a role. Over the decades, people’s perception of their role in the economy has undergone a decisive transformation. From viewing work as the foundation of our well-being, the idea that we should expect to make money from investments has spread to an increasing extent. Today, the hero is not the hardworking industrial worker but the clever investor, for whom money is no longer a means but an end in itself. This rethinking is one of the deep underlying causes of the recurrent crises during the last decades. Here lies the heart of darkness.