12/25/2012

Anatomy of a typical crisis

A model developed by Hyman Minsky is used to interpret the financial crises in the United States, Great Britain, and other market economies. The pro-cyclical changes in the supply of credit. During the expansion phase investors became more optimistic about the future and they revised upward their estimates of the profitability of a wide range of investments and so they became more eager to borrow. At the same time, both the lenders' assessments of the risk of individual investments and their risk averseness declined and so they became more willing to make loans, including some for investments that previously had seemed too risky.

When the economic conditions slowed, the investors became less optimistic and more cautious. At the same time, the loan losses of the lenders increased and they became much more cautious.

Minsky believed that the pro-cyclical increases in the supply of credit in good times and the decline in the supply of credit in less buoyant economic times led to fragility in financial arrangements and increased the likelihood of financial crisis. The instability in the supply of credit.

Minsky argued that the events that lead to a crisis start with a "displacement", some exogenous, outside shock to the macro system. The boom in the Minsky model is fueled by an expansion of credit.

The nature of the shock varies from one speculative boom to another. If the shock is sufficiently large and pervasive, the anticipated profit opportunities improve in at least one important industry sector.

The boom in the Minsky model is fueled by an expansion of credit. He argued that the growth of bank credit has been very unstable. One central policy issue centers on the control of credit from banks and from other suppliers of credit.

Three types of finance---hedge finance, speculative finance, Ponzi scheme. Hedge finance: anticipated operating income is more than sufficient to pay both the interest and scheduled reduction in its indebtedness.

Speculative finance: anticipated operating income is sufficient so it is abe to pay the interest; but the firm has to use cash from new loans to repay part or all of the amount due on maturing loans.

Ponzi finance: its anticipated operating income is not likely to be sufficient enough to pay the interest on its indebtedness on the scheduled due date; to get the cash the firm must either increase its indebtedness or sell its assets.  

When the economy slows, the original hedge finance firms may be in speculative finance group, and the initial speculative finance firms may fall into the Ponzi finance category.

The term Ponzi scheme now is a generic term for the non-sustainable finance patterns.


12/22/2012

Financial crisis-a hardy perennial

Most of the bank failures in the 1980s and 1990s were systemic and involved all or most of the banks and financial institutions in a country. These crisis and bank failures resulted from the implosion of the asset price bubbles or from the sharp depreciation of national currencies in the foreign exchange market. They happened in three different waves: 1980s, beginning of 1990s and second half of 1990s.

Cycle of manias and panics results from the pro-cyclical changes in the supply of credit; the credit supply increases relatively rapidly in good times, and then when economic growth slackens, the rate of growth of credit has often declined sharply.

Non-sustainable patterns of financial behavior: asset prices today are not consistent with asset prices at distant future dates.

Bubble involves the purchase of an asset, usually real estate or a security, not because of the rate of return on the investment but in anticipation that the asset or security can be sold to someone else at an even higher price.

The term mania describes the frenzied patterns of purchases, often an increase in prices accompanied by an increase in trading volumes, individuals are eager to buy before the prices go further.

The dilemma of government intervention upon smoothing out mania and bubbles is moral hazard. That is, if central banks function as the last resort of lender, investors may be less cautious in investing.

The monetarist view is that the mania would not occur if the rate of growth of the money supply were stabilized or constant.

12/18/2012

Analysis on The price of inequality

The failure of the market stems from lack of institution to protect the property right.

I don't agree with Professor Stiglitz's argument that "unemployment is the worst failure of the market, the greatest source of inefficiency, and a major course of inequality." Just think about the cost and benefit of looking for jobs. People spend time and effort looking for jobs that match them better, and this is the cost them would like to bear for expectation of future well-being. (This is the so called frictional unemployment)  Besides, the technology is ever-changing and thus relative sectoral significance changes as society moves on. Structural unemployment as a result is inevitable because it is the implication of a ever evolving society. So a normal rate of unemployment is not only acceptable but also healthy. A mere focus on elimination of unemployment rate can lead to stagflation. (Short run and long run Philip curve)'

I have doubts on Professor Stiglitz's opinion that protests delivers the message that market once again need to be tamed and tempered. Stiglitz argued that minimum wage law, competition law passed in Progressive Era were good for people because they guided market toward better equilibrium, but I argue the contrast. Now people have a reverence of government policy and whenever there is problem in the market, they call for another law to eliminate the problem and protect their interest. The market fails because it is bound by rules and red tapes rather because it is free and amoral.

Professor Stiglitz said that markets, even when they are stable, often lead to high level of inequality. I have a question here on the definition of "inequality" Does that mean every person should get the same amount of money? Or does it mean that cronyism is eroding the justice system? For me, equality implies equal access to chance and fair process of gaining success, not equal ending. 

A good point Stiglitz made is that part of the reason for big magnitude of inequality in America is the market distortion, with incentive directed not at creating new wealth but at taking it from others. (patent war can be an example)

In the mid-2000s, before the onset of the Great Recession, people in the bottom 80 percent were spending around 110 percent of their income. (This resulted from government's stimulation in housing and a loosen rule of loan. Ricardian equivalence failed because many people are on credit constraint. Tax distortion exists.)

I don't deny that government can ameliorate poverty among a certain group of people, like the old, what I doubt is that government can ameliorate poverty among all groups. (Broken window fallacy)