Daniel Detzer and Hansjoerg Herr deliver a superb summary of timeless economic theories of financial crisis. The main focus is on (i) escalatory inflation and deflation dynamics caused by monetary policy, (ii) boom and bust investment cycles caused by herding and inefficient expectation formation, and (iii) speculative bubbles related to cognitive behaviour that is inconsistent with efficient markets.

“Theories of financial crises: An overview”, by Detzer, Daniel; Herr, Hansjörg
Working Paper, Institute for International Political Economy Berlin, No. 32/2014
http://econstor.eu/bitstream/10419/92912/1/778558266.pdf

The below are excerpts from the paper. Emphasis and cursive text has been added.

Neoclassical paradigm: monetary policy creates inflation and deflation distortions

“The neoclassical paradigm…[postulates] that the monetary sphere in one way or another can for a certain period of time develop independently of the real sphere. As…the real sphere in the end dominates economic development, the monetary sphere sooner or later has to adjust. The general idea is that the monetary sphere in the short- and medium-term can become a disturbing factor for the real sphere…In extreme cases developments in the monetary sphere can lead to financial crises with far reaching repercussions for the real sphere.”

“Knut Wicksell (1898, 1906)…explained…the interaction of two rates of return, the so-called natural rate of interest and the money interest rate. The natural rate of interest is the interest rate… which would be realized if…savings and investment would directly interact and there would be no money…The money interest rate…is determined in the monetary sphere mainly by the central bank…As soon as the money interest rate is lower than the natural interest rate a cumulative investment process is triggered…The resulting expansion leads to an inflationary process…As soon as the money interest rate is above the natural interest rate a deflationary contraction process results…It is important to point out that as soon as the two interest rates are not the same a cumulative process develops which has no endogenous tendency to tend towards equilibrium. For example, if the money rate is below the natural rate the economy will come into a situation of overheating which has no tendency to be corrected…An expansion will lead to increasing instability and fragility and must sooner or later come to an end. It makes place for a cumulative contraction phase. A sharp enough contraction will lead to systemic problems in the financial system.”

“Irving Fisher’s (1933) famous debt-deflation theory… argues that overoptimistic expectations lead to periods of expansion including asset price bubbles. Herding and speculative behaviour trigger asset price inflations, which are usually combined with huge credit expansion. These are also phases of high GDP growth and high employment. When the asset price inflation comes to an end an asset price deflation is the ultimate result…Asset price deflations lead to the destruction of wealth as well as to problems for speculators and other economic units in paying back their debt. Non-performing loans start to grow. Distress selling of assets to be able to service debt and panic leads to sharply falling asset prices…The difference between a normal crisis and a disaster leading to a systemic financial crisis with deep repercussions for production and employment is a goods market deflation. A constellation of high debt and goods market deflation leads to an increase of the real debt burden by all debtors in the domestic currency. The nonperforming loan problem explodes, the coherence of financial markets erodes and the economic boat capsizes.”

Keynes and Minsky: behavioural patterns leading to asset price booms and busts

“John Maynard Keynes…proposed a model of a monetary production economy. In such an approach money plays a key role and penetrates all spheres of the economy. Instabilities and financial crises all develop within the framework of a monetary production economy…It was Hyman Minsky who developed an explicit model of financial crises in the tradition of Keynesian thinking after World War II.”

“Uncertainty leads to certain techniques or behaviour by economic agents to cope with uncertainty. Keynes gives three examples of such a behaviour: ‘Agents assume that the present is a much more serviceable guide to the future than a candid examination of past experiences would show … We assume that the existing state of opinion as expressed in prices and the character of existing output is based on a correct summing up of future prospects … Knowing that our own individual judgement is worthless, we endeavour to fall back on the judgement of the rest of the world … The psychology of a society of individuals each of whom is endeavouring to copy the others lead to what we may strictly term a conventional judgment.’… the tendency towards a conventional judgment or ‘state of confidence’ leads to herding behaviour. Herding is one of the most powerful feedback mechanisms leading to unsustainable expansions and financial crises. Keynes is very close here to some ideas later developed within behavioural economics and especially behavioural finance.”

“Since the 1960s Hyman Minsky developed his Financial Instability Hypothesis…A financial system can be described as robust if small changes in cash flows, capitalization rates or in payment commitments will not inhibit the ability of most units to meet their financial commitments. The opposite is true for fragile systems. Here, small changes in the above mentioned variables will have detrimental effects so that many units fail to meet their financial commitments…Therefore, the economy becomes more fragile, when the relative weight of [robust] hedge units to speculative and Ponzi units declines.”

“Minsky is…able to model how an economic system can create a boom and how it moves during the boom from financial stability to financial fragility, which then can turn into a bust…During an investment boom the margins of safety are reduced and expected receipts exceed payment commitments only slightly and not throughout the whole project. Also, more short-term lending will take place. Therefore, the relative weight of Ponzi and speculative units increases during the boom…In Minsky’s theory the boom is turned into a bust by an increase in interest rates…The increase in the interest rate leads to a negative net-worth of some Ponzi units. Also, net worth of speculative and hedge units decrease…Therefore, investment declines…Actual cash flows of banks fall below expected cash flows, so that these also need to raise new finance or sell assets. Furthermore, other units in the system will try to fulfil their commitments by selling assets. Therefore, asset values fall and the demand price for investment declines…Borrowers’ and lenders’ risk increases and lead to an overall collapse of investment.”

Behavioural finance: inefficient markets and speculative bubbles

“Increasing empirical findings that raised doubts about the validity of some key ideas in finance – the efficient market hypothesis and the capital asset pricing model…It was found that in many instances the behaviour and decisions of market participants did not fit the assumptions of standard theories. There is a vast and growing amount of literature in this field. Baker and Nofsinger (2010) identified four prevalent key themes: heuristics, framing, emotions and market impact.

  • Heuristics are means of reducing the cognitive resources necessary to find solutions to certain problems. They can be described as mental shortcuts and are often referred to as rules of thumb. They help individuals to make decisions under uncertainty with a limited ability to quantify the likelihood of outcomes…
  • Framing means that the decisions taken by people, who have different options, are strongly influenced by how their choices are framed. That means people confronted with exactly the same problem, may chose different alternatives depending on how the problem is presented to them
  • Emotions and associated human unconscious needs, fantasies and fears drive decisions. The underlying idea is that emotions and feelings influence psychic reality in manifold ways and areas. They may explain sudden changes in expectations and abrupt breakdowns of markets. Some of the research in this category investigates relations between investors’ moods that depend on factors like, sunshine, weather, or sporting events and their investment decisions…
  • Market impact…investigates whether and how cognitive errors and biases of individuals or groups affect market outcomes and prices and prevent financial markets to be efficient. In efficient markets agents use all information about the value of an asset available to them…Shleifer (2000: 24) stated that ‘market efficiency only emerges as an extreme special case unlikely to hold under plausible circumstances’. He named two key conditions in the theory that explain the deviations from efficient market outcomes – limits to arbitrage and investors’ sentiment. Limited arbitrage prevents the informed investors to trade away price deviations caused by irrational investors. Investors’ sentiment is responsible for disturbance of efficient prices in the first place.”

“Shiller defined a speculative bubble as ‘a situation in which news of price increases spur investors’ enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases and bringing in a larger and larger class of investors, who despite doubts about the real value of an investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.’… He described the development of a bubble as follows: [1] There are some initial price increases (precipitating factors). [2] These are supported by certain feedback loops, which lead to further price increases.[3] The price increases draw the attention of the media and the general public towards some stories, which explain the increases. Here, particularly new era stories are of relevance. A new era story implies the general perception that the future is brighter and less uncertain than it was in the past. [4] Those stories justify the price increases. [5] This draws more people into the market to buy, which in turn increases prices even more.”