What is Needed? Less Confidence in Stability

by Dirk Ehnts

What is a crisis? The Merriam-Webster dictionary offers the following three definitions:

a : the turning point for better or worse in an acute disease or fever

b : a paroxysmal attack of pain, distress, or disordered function

c : an emotionally significant event or radical change of status in a person’s life

Explanations a and b offer us two different views of the state of things. Either, the crisis is suffered during a period of sickness, or the crisis is the result of a sudden increase of pain where before the patient was healthy.

The economic crisis that started in 2007 with the sub-prime crisis can be approached from two theoretical views that oppose each other like the explanations above. The dominant theory is expressed by the efficient market hypothesis by Eugene Fama (1970). It comes in different forms, but even in its weakest form it assumes that all publicly available information is already reflected in stock prices. It should therefore be impossible to beat the market since today’s prices reflect all available information. The message of this theory is that markets are stable. Prices are formed by market participants, and these collectively do not make mistakes. Therefore, the efficient market hypothesis argues that markets should be freed from regulation and would generate the best of all worlds if left to themselves.

The rival to the efficient market hypothesis had been developed by Hyman Minsky (1992) and is called the financial instability hypothesis. As a student of Schumpeter, he researched the financial side of the former’s creative destruction. Firms innovate, and in order to do so move into debt. Minsky opened the financial black box of firms and tried to expose the modes of financing that would enable firms in the real sector to finance innovative investment. This is the crucial aspect of capitalism since according to Minsky investment drives economic growth.

Minsky’s main insights are twofold. First, financial markets are unstable by themselves. Firms speculate when they take out a loan, then invest in the real economy and repay only later when revenues come in. This is process must involve risk on two counts. There is lender’s risk in the sense that the borrower does not repay. There is also borrower’s risk because exposure to external debt increases the chance of bankruptcy. Firms that borrow from external sources and repay both principal and interest are engaging in what Minsky terms hedge finance. Given optimistic expectations, firms might engage inspeculative finance, so that they can only pay the interest rate but not the principal. They must roll over existing loans. The next step would be to engage in Ponzi finance, in which they can neither repay interest nor principal. The two last types of finance make firms dependent on the financial market.

The second insight is that stability of financial markets over time lead to instability. The reason is that lessons of the past will be forgotten and financial firms will finally remove the regulation that was once put in place. When this happens, firms move their balance sheets from hedge to speculative and then to Ponzi financing positions.

The efficient market hypothesis and the financial instability hypothesis are mutually incompatible. Either markets are stable and in equilibrium, or they are unstable and out of equilibrium. Or, returning to the definition of a crisis above, either a crisis is a ‘turning point for … worse in an acute disease’ (Minsky) or ‘a paroxysmal attack of pain’ (Fama). The recent economic crisis has shown that the ideas of Minsky are closer to reality than those of Fama. Regulation of financial markets has been eroded since the end of the Bretton Woods system, and the repeal of the Glass-Steagall act and other reforms have led us closer to the theoretical world of Fama. However, it was in these conditions that financial crises made a return to the developed world.

In a world of perfect competition, firms that make bad investments exit the market. They go bankrupt if their investments yield no or not sufficient return. However, in the financial sector we have a problem. This sector combines two functions that are important for capitalism to work.

The first function is that of a payment system. We all use banks to transfer money, and without this function life would not be the same. Paying bills, paying for purchases or getting a wage would be quite difficult if there were no banks.

The second function fulfilled by the financial sector is that of the credit system. The most simple payment system that can be dreamt up is one were each of us gets credits for selling things and debits for buying things. To ensure that nobody can spend more money than she has, the amount of debits cannot be larger than the amount of credits. There is a hence a budget constraint imposed on all users of the payments system. This creates a major problem: there is no first sale. Since at the beginning everybody starts with zero credits, nobody is able to purchase things. It is the task of the financial system to determine who is allowed to break these budget constraints and by how much.

The problem in the real world is that because the financial system fulfills both functions – payment and credit system – it is too important to let it go down. Hence, historically central banks have acted as lender of last resort in case of financial distress. They thereby validated past investments and bailed out the financial firms. The European Central Bank is the first modern central bank which is not allowed to bail out governments and – via those governments – the financial sector firms.

Economics and finance came to a fork in the road by the middle of the 20^th century. Both disciplines embraced the efficient market hypothesis and discarded the financial instability hypothesis. With hindsight this was a mistake. It is time for these disciplines to correct this mistake. There are many important issues that young researchers can tackle. However, they must be willing and able to go off the beaten track. Intellectual curiosity and a willingness to assume responsibility are crucial for the disciplines to be transformed. Only then will confidence in economics and finance return.

• Fama, Eugene F, 1970. “Efficient Capital Markets: A Review of Theory and Empirical Work,” Journal of Finance, vol. 25(2), pages 383-417

• Minsky, Hyman P. 1992. “The Financial Instability Hypothesis,” Economics Working Paper Archive wp_74, Levy Economics Institute

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About the Author

Dr. Dirk Ehnts is a research assistant at the Carl-von-Ossietzky University of Oldenburg (Germany). His focus is on economic integration and economic geography, covering trade, macro and development. He is working at the chair for international economics since 2006 and has recently co-authored a book on Innovation and International Economic Relations (in German). Ehnts has written at his own blog since 2007: Econblog 101. Curriculum Vitae.