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date: 25 February 2018

Financial Crises

Summary and Keywords

Numerous crises have occurred since the beginnings of the modern economic system, from the Dutch Tulip Mania of 1636 and the South Sea Bubble of 1720 to the Dollar Crisis and Asian Financial Crisis. Scholars have written about the causes and remedies of financial crisis, resulting in a substantial amount of literature on the subject especially after the Great Depression. The writing on financial crisis declined between the end of World War II and the monetary crises in the early 1970s, but has become vibrant again since the 1980s. Some of the earliest voices that contributed to the intellectual history of studying financial crisis include Adam Smith, Karl Marx, David Ricardo, Walter Bagehot, and John Maynard Keynes. These men provided the foundation for understanding the central issues and questions about financial crisis and influenced the debates and scholarship that followed. One such debate involved monetarists vs. business cycle theorists. The monetarists argue that crises are caused by changes in the money supply, while those favoring a business cycle approach insist that expansions and contractions are part of economic interactions and so the economy will at times experience crises. As crises continue to affect both domestic and global financial markets, more perspectives are added to the discussion, including those that invoke rational expectations and economic models, along with those that draw from international political economy. There are also questions that remain unanswered, such as the issue of crisis response and that of financial fragility.

Keywords: financial crisis, Adam Smith, Karl Marx, John Maynard Keynes, monetarists, business cycle, money supply, financial markets, rational expectations, international political economy

Introduction

In 1873 Walter Bagehot wrote his famed Lombard Street which considers the role of the nineteenth-century London banking community (located on Lombard Street) in addressing a financial panic. In one chapter, entitled “Why Lombard Street is Often Very Dull, and Sometimes Extremely Excited,” Bagehot discusses how the connections between credit markets can spread a crisis throughout the domestic economy. It is, however, the title of this chapter which perhaps provides the best descriptor of the literature on financial crisis; at times it is of great interest and at other times it is quite dull. When a crisis has just emerged, the amount of literature expands greatly, but in the aftermath and when markets calm down and begin to expand again, policy recommendations are ignored and interest in crisis wanes. After the Great Depression the writing on financial crisis was considerable, but between the end of World War II and the monetary crises in the early 1970s, the amount of literature declined, only to grow in the 1980s through present.

This essay considers the literature on financial crisis. Although, in the scholarly and policy community, interest in crisis may ebb and flow, crises are never that far away. Charles Kindleberger (2000:1) described financial crisis as a “hardy perennial,” something that re-emerges on a rather regular basis. Crises have occurred since the beginnings of the modern economic system. Kindleberger (2000) identifies crises back to 1618 and examines many famous episodes such as the Dutch Tulip Mania (1636), the South Sea Bubble (1720), and more recent events like the Dollar Crisis and Asian Financial Crisis. In the nineteenth century significant crises occurred about once a decade, a pattern that seems to be re-emerging since the 1980s. Writings to understand the causes and remedies of financial crisis also have a long and distinguished history as many well-known economists have added their voices to the debates. This essay will begin by considering some of earliest voices that contributed to the intellectual history of studying financial crisis. After that, it will examine the traditional divide between monetarists and business cycle theorists and present their positions on financial crisis. It will then move on to discuss some of the main issues that have been considered from the more recent economics and international political economy literatures. Two significant themes, responses and contagion, will be considered separately. Finally, this essay will conclude with an assessment of the recent subprime crisis and identify future research directions for crisis literature.

The Earliest Voices on Financial Crisis

From its beginnings, it seems that crisis and capitalism have gone hand and hand. Because of this rather unfortunate marriage, it is not uncommon to see many of the most celebrated historical economists lending their voices to the discussions and debates about financial crisis. Over time, the explanations, methodologies for studying, and instruments of crisis may have changed, but the literature continues to focus on four primary questions: Why do crises exist? What causes a crisis? How does a crisis spread? How are crises resolved? Consideration of these questions is evident in the works of Adam Smith, Karl Marx, David Ricardo, Walter Bagehot, and John Maynard Keynes. Although none of these authors presents a specific theory of crisis and they wrote in quite different economic times, their insights provide the foundation for understanding crisis and it is worthwhile to briefly consider their contributions.

Adam Smith lived during a period of relative financial calm. While there were occasional bank runs, England did not begin to experience larger crises until after Smith’s death in 1790, with the crises of 1793 and 1797. Concerned with bank runs, in the Wealth of Nations (Book II, ch. II) Smith cautioned against the excessive creation of paper money by banks or, in more modern terms, he warned against excessive liquidity. Citing the example of failures in the Scottish banking system, he argued that such imprudence with circulating bank notes would lead to crisis. As a solution, Smith advocated prudence and banking oversight to regulate the creation of paper currency. He did not directly speak to crisis beyond this, but his warnings on liquidity and calls for oversight have been reiterated even in the wake of the recent crisis (Mussa 2009).

By the time David Ricardo was writing, financial crisis was a frequent problem. Ricardo’s contribution more significantly expresses the orthodox liberal view, which is that the market provides equilibrium and crises are due to exogenous shocks. Although Ricardo believed in the power of markets, he clearly favored the Bullionist position that blamed crisis on the overissue of bank notes (Ricardo 1810). He also argued for governmental responses to crisis, and posthumously published writings on the creation of a public national bank in England, suggesting that institutions could play a powerful regulatory role in responding to crisis (Ricardo 1824). Ricardo’s work on crisis fueled a famous intellectual debate in England between what became known as the Currency and Banking Schools. This debate was primarily about how well the British monetary system regulated itself and what oversight was necessary in order to maintain stability. Ricardo’s work on crisis would significantly influence the monetarist position in economics.

Writing later in the nineteenth century, Karl Marx was certainly interested in financial crisis as an ever present threat to the capitalist economic system. He argued that crises were part of an “oscillatory pattern of economic growth” (Howard and King 1985:221). Marx argued that the laws of the capitalist mode of production made the system prone to instability, depressions, and economic fluctuations. He also presented a more cyclical view of the capitalist system which included periods of growth and periods of crisis. Marx argued that crises would become more severe as time went on and eventually lead to systemic failures. Marx offered a host of reasons why capitalism was prone to crisis, including the tendency for the rate of profit to fall and the mismatch between overproduction and underconsumption (Howard and King 1985). Several of these themes have been adopted by Marxists or radical political economists in subsequent writing. The extension of Marxist ideas is probably best seen today in crisis explanations that discuss Kondratieff waves and other cyclical mechanisms that push the capitalist system into crisis (Arrighi 1994; Denemark et al. 2000; Wallerstein 2006).

A lesser known economist, but outspoken journalist and editor of The Economist, Walter Bagehot provided an analysis of crisis response in the 1870s which is still central to writings and thinking about financial crisis. Bagehot is largely credited with articulating the concept of “lender of last resort” in his writings on the Bank of England and its role in a series of crises in the nineteenth century. Bagehot’s famous advice on crisis response, that “banks should lend freely, but dearly,” is still the logic behind policy responses to crisis. Bagehot also provided a detailed discussion about how crisis was likely to spread through the domestic economy (Bagehot 1873).

Finally, in the twentieth century, the writings of John Maynard Keynes have been instrumental to much of the subsequent scholarship on crisis. In one of the final chapters of The General Theory, Keynes promoted a theory of crisis that attributed business cycles and crises to expectations about the value of capital assets. When capital assets were expected to be less valuable due to poor expectations about the future, a crisis would likely occur and cause individuals to seek liquidity (Keynes 1973b:313–32). An activist fiscal and monetary policy was necessary to respond to or counteract a crisis. It is clear from several of his works that Keynes was quite concerned about crisis. He wrote extensively on the English financial crisis of 1914 (Keynes 1914) and on the potential for crisis in the financial system created through the World War I peace settlements (Keynes 1973a), but it would be later authors, writing from a Keynesian perspective, who would extend his work to consider finance and crisis more completely (Minsky 1982; Kindleberger 2000).

These authors, representing the main intellectual history of writing on financial crisis, provided the foundation for understanding the central issues and questions about financial crisis. While none of them provided unambiguous theories about the causes and remedies for crisis, they all influenced the debates and scholarship which was to come.

The Traditional Debate: Monetarist vs. The Business Cycle

Theoretically, the existence of crisis has traditionally been presented as a debate between those favoring a monetarist approach which argues that crises are caused by changes in the money supply, and a business cycle approach which argues that expansions and contractions are part of economic interactions and so the economy will at times experience crises. Monetarist thinking is best exemplified in Friedman and Schwartz’s (1963) well-known Monetary History of the United States 1867–1960 which examines 100 years of US financial history and concludes that contractions in the money supply are a major factor in four of the six serious US crises in that period. Friedman and Schwartz present a model that suggests a small shock can cause a change in the public’s desire for cash and a reduction in the amount of money in the economy. A crisis will ensue, deepen, or spread if there are no policies or institutions to counteract the shrinking money supply. Thus, central bank involvement through monetary policy is required to resolve a crisis. Schwartz (1985) further contended that many events thought of as crises are actually “pseudo-crises,” or simply market corrections of overvalued assets. These corrections are to be expected when assets are hard to value, but they signal nothing about the stability of the economy. While they may cause distress to markets or individual investors, they are not true crises because they do not reduce the money supply.

The monetarist school of thought is based on assumptions consistent with financial orthodoxy and therefore assumes markets work to efficiently distribute goods. Crises are either corrections, as in the case of pseudo-crises, or they are caused by poor governmental policies – particularly policies that do not manage inflation or policies that undermine a free market. Thus, crises can be prevented or circumvented by sound economic policies which privilege free markets. From this logic grew what has become known as “first-generation” crisis models. Paul Krugman (1979) is often attributed with developing this first-generation model in his influential article on balance of payments crises. Krugman argued that if a credit expansion was allowed to exceed a monetary expansion, a state would likely experience a speculative attack on its currency because investors would fear the decline in reserves and the government’s inability to maintain a currency peg. In other words, poor government policies that tried to maintain fiscal imbalances and fixed exchange rates, which were perceived as unsustainable, would lead to an attack on a state’s currency, and thus to a crisis.

Since Krugman’s articulation of the first-generation model of balance of payments crises, much work has been done that fits less comfortably into a monetarist conception of why crises happen. Some have argued that first-generation models no longer reflect the reality of most crises since often there are no fiscal imbalances prior to the emergence of problems (Chang and Velasco 2001). These inconsistencies forced scholars to consider a wider range of factors in their explanations of financial instability. Thus, more attention has been paid to such causes as the connections between trade and financial markets, increased globalization, and the role of speculation. We will return to some of these issues below.

The second traditional school of thought regarding financial crisis is business cycle theories. While monetarists seem to be less able to explain the reasons for many contemporary crises, it seems the business cycle model is making a comeback in terms of its efficacy and popularity. Often attributed to the ideas of John Maynard Keynes, but advanced mostly by his students, the main assumptions of business cycle theories are that crises are a necessary counterpart of an expansion and that they are tied to real economic factors and not just monetary forces. These theories argue crises have a cyclical character and tend to emerge at some time after an economic expansion when perceptions of profits can become detached from the value of real assets. Crisis is treated as a sort of stage in capitalist development that is endemic to the system. To a greater degree than their monetarist counterparts, the business cycle theorists pay attention to issues in the real economy affecting the chances that the financial system will fall into crisis. Irving Fisher, though perhaps better known for his earlier monetarist writings, is more consistent with the business cycle school in his work on crisis. He was a strong proponent of the thesis that real factors must be taken into account during a crisis. His debt–deflation theory attributed crises to a series of stages sparked by over-indebtedness (Fisher 1932). According to Fisher, when capital becomes spread too thin (i.e., when there is too much debt) markets respond by falling into crisis and this leads to a deflationary spiral (Fisher 1933).

Business cycle theorists are most interested in understanding what moves the process toward crisis and how the crisis can be resolved. For Fisher, the issue was debt. Charles Kindleberger (2000) argued that crises emerge because an event changes expectations, increases capital and investment, and sends capital seeking greater profits. The event can be almost anything, large or small, but the important part is that it creates new expectations in the market. Eventually, those expectations transform into a “euphoria” where investing and profit seeking becomes detached from the sustainable value of the investments (Kindleberger 2000:16). At some point, Kindleberger argues, a “revulsion” will occur that changes expectations and creates a retreat from the market or a flight to safety. Market actors react simultaneously, leading to a crisis. Kindleberger suggests that the various stages he outlines are consistent throughout history, regardless of the object of speculation, and regardless of the kind of crisis (e.g., currency, banking, asset bubble). The reason for crisis is constant. A change in expectations, often brought about by an innovation, will create fertile ground for an expansion, then an overextension, of credit. Expectations will inevitably moderate, investors’ perceptions will change, and crisis will follow.

Kindleberger’s work also emphasizes the theme of irrationality, which is common in the business cycle literature that monetarists criticize (Crockett 1997:4). Kindleberger suggests that crises are essentially born of irrational or speculative behavior and he emphasizes systemic disequilibrium. This is in contrast to monetarist theories that privilege the self-equilibrating stability of the system instead of its disequilibrating and cyclical nature. Of particular concern to many business cycle theorists, and Kindleberger in particular, is the stage or moment when credit expands since this is when the system becomes highly unstable and the cycle is moved toward crisis (Kindleberger 2000: ch. 4).

Kindleberger’s model is not new. Much of it is based on the work of Hyman Minsky. While Kindleberger may be the more recognizable name, Minsky’s work is garnering renewed interest because of the applicability of his theories to current financial crises (Bellofiore and Ferri 2001; Nesvetailova 2007; Davidson 2008). Minsky’s ideas are even popping up in the popular press as a way to explain the subprime crisis (Cassidy 2008). Minsky is often classified as a post-Keynesian and credited with furthering and articulating theories of “financial Keynesianism” (Nesvetailova 2007:57). Since Minsky was a student of Schumpeter, his work reflects several Schumpeterian themes such as the importance of innovation in driving investment and the business cycle. Minsky’s Financial Instability Hypothesis (1982) is his best-known contribution because it ties together the themes of uncertainty, the business cycle, and finance (Wolfson 1994). Minsky explains instability in the financial system as a “result of the normal functioning of a capitalist economy,” that is characterized by six stages that include financial crisis, intervention, and expansion (Minsky 1984:92).

Minsky is particularly interested in how the finance can make the economic system fragile, especially during an expansion. He coined the term “financial fragility,” which has become a common theme in crisis literature. Financial fragility is created by three dynamics: the type of finance (hedge, Ponzi, or speculative), the amount of liquidity, and the amount of debt (Minsky 1982; Wolfson 1994). It is the composition of the finance, coupled with debt and liquidity that creates a robust or fragile financial system. He also explains that financial innovation is a natural occurrence in a capitalist system and is central to creating an economic expansion (and expanding credit). Economic expansions are the most dangerous and fertile ground for crisis (Minsky 1982; Nesvetailova 2007). But as a business cycle theorist, Minsky accepts that both stability and instability are transitory and that subsequent stages of the cycle will unfold.

As a whole, writers like Fisher, Kindleberger, and Minsky who hail from the Keynesian side of the theorists are particularly interested in the role of financial institutions and arrangements to provide lender of last resort duties. The role of government in ameliorating a crisis once it emerges is a central theme. Fisher argued that a lender of last resort could thwart the debt–deflation spiral. Kindleberger argued the lack of a lender of last resort after the crises of 1931 was a contributing factor in the crisis not being resolved (Kindleberger 1973), and Minsky discussed the role of the Federal Reserve and other institutions acting in this capacity.

While not influenced by Keynesian or post-Keynesian economics, there is another branch of writings on the cyclical nature of crisis that deserves mention. Scholars such as Immanuel Wallerstein (1974) and Giovanni Arrighi (1994), writing from a world-systems perspective, are interested in the expression of long cycles and Kondratieff waves which include crisis periods as well as calm and expansive periods. This Marxist-inspired literature also sees crisis as endemic to the capitalist system, but is more concerned about longer-term changes in the capitalist mode of production than Keynesians are. Recent scholarship on crisis from this perspective has included many radical critiques of how the capitalist system breeds crisis through over-accumulation and how current crises suggest the system is in transition (Bello 2006; Wallerstein 2006; Thompson 2009).

Crisis in an Era of Globalized Financial Markets

The debate between monetarist and business cycle theorists is a traditional way to view the literature on financial crisis. While there are elements of these schools in much of the contemporary literature, the scholarship on financial crisis now encompasses dozens of new issues and perspectives. This proliferation has been driven by the growing incidence of crisis since the 1970s, the reemergence of unregulated global capital, and the complexities of a highly integrated globalized political economic system. As crises continue to affect domestic markets and the global financial system, more perspectives are added to the discussion. What follows is an attempt to organize and discuss the main areas of research on financial crisis. While the methods, the specific research questions, the variables, and even the global economic systems may continue to change, it is important to recognize that the main questions surrounding financial crisis remain: Why do crises exist? What causes a crisis? How does a crisis spread? and How are crises resolved?

Rational Expectations and Economic Models

From an orthodox economic perspective, the issues of irrationality and instability suggested by the business cycle school are difficult to reconcile with the belief that the market actors are rational and the market tends toward equilibrium. In addition, by the 1990s it seemed that Krugman’s “first generation” model, which blamed crisis on persistent fiscal imbalances and pegged exchange rates, explained fewer of the crises that emerged. Thus, authors developed models to explain contemporary crises and address the issue of whether speculation and crisis could be considered rational behavior.

Explaining crises that did not follow Krugman’s original analysis led to the emergence of “second generation” crisis models. These models rest on the existence of multiple equilibriums and consider the policy choices of governments which may balance several economic priorities instead of only considering the maintenance of a currency peg (Krugman 1996). In addition, second generation models give particular attention to the idea that crises are based on self-fulfilling expectations (Flood and Garber 1984; Sachs et al. 1996; Radlet and Sachs 1998). Obstfeld (1986) argued that crises emerged not from misguided currency valuations or bad macroeconomic policies, but from speculative attacks designed to force policy changes.

First generation models focus on how crises inevitably come from problematic macroeconomic policies, while second generation models suggest that crises are more unpredictable, can emerge anywhere, and may be created by the coordinated movement of market actors speculating and anticipating a new equilibrium. The actors engaging in the speculation are rational because they are anticipating new economic circumstances and reacting in an expected manner. These models have been used to explain how recent crises have self-fulfilling characteristics. Sachs et al. (1996) examined crises in 28 emerging markets in the 1990s and determined that the crises were more often caused by self-fulfilling expectations than by poor fundamentals. Radlet and Sachs (2000) further extended a second generation crisis model to the Asian Financial Crisis of 1997 and argued that liberal reforms in East Asian economies led to fragility in these financial systems. This made them particularly vulnerable to reversals in capital flows. When market actors observed others withdrawing capital, they followed suit, creating a self-fulfilling panic and ultimately a currency crisis. This was a rational action for individual investors, but a financial disaster for investors as a group, as well as for the East Asian states.

First generation models were also narrow in their focus. They only considered currency or balance of payments crises. Second generation models have been used to examine other kinds of crisis. For example, Flood and Garber (1994) explained rationality and self-fulfilling expectations in speculative bubbles. Kaminsky and Reinhart (1999) were interested in the role of banking crises and their relationship to currency crises. They argued that banking and currency crises were “twin crises.” Currency crises often were preceded by problems in the banking sector which had been caused by earlier financial liberalization.

More recently there has been an emphasis on “third generation” crisis models. These models “assign a key role to financial structure and financial institutions, especially the domestic banking system,” in causing a crisis (Chang and Velasco 2001:490). The goal of the third generation model is to understand how the financial structure may be influencing domestic financial institutions. Chang and Velasco (2001) is representative of third generation models since they argue that international illiquidity must be considered as a central factor in causing crises. Thus, third generation models have moved beyond a focus on macroeconomic policies and toward an examination of the domestic institutions and their relationship with global capital markets. Second and third generation approaches moved the crisis literature beyond mechanistic predictions and toward models that incorporate more variables into their analyses and consider more issues relevant to the globalized financial system. While this is a major advance, many questions remain unanswered, particularly those that focus on the issues of politics. Those studying crisis from a political economy perspective attempt to fill some of these gaps.

Perspectives from International Political Economy

Modern International Political Economy (IPE) was born in the 1970s and became concerned about the issue of financial crisis in the 1980s, when the Third World Debt Crisis emerged. This crisis brought attention to the uneven power relationship between the developed and underdeveloped worlds, the expanding and controversial power of international financial institutions, and the connections between private market actors and sovereign states. Only a few influential voices such as Susan Strange and Benjamin J. Cohen were calling for scholars to pay attention to the increasing power of global capital prior to the 1980s. Since then, particularly since the dismantling of capital controls in favor of neoliberal economic policies, more attention has been paid to the issue of financial crises. The scholarly interest in crisis has gone hand and hand with the study of the “resurrection of global finance” as a potentially destabilizing force (Cohen 1996). There is no overarching theory of financial crisis that emerges from the IPE tradition; instead there are a host of methodologies and perspectives that demonstrate the wide variety of topics that have been considered in this literature. This section presents the various debates that have emerged. First it considers the literature on the debt crisis, and then considers the role of domestic political systems on crisis, and finally examines some of the literature that has been focused on systemic risks caused by the expansion of global finance.

The Debt Crisis

By the 1970s the recycling of petrodollars, the growth of private loans in the less developed world, and the oil shocks set the stage for the 1982 Mexican announcement that it could no longer service its debt. In domino-like fashion, over two dozen other states followed with similar announcements. In the economics literature, the causes of the debt crisis seemed to focus on exogenous shocks that exacerbated already existing borrowing country economic problems (Cline 1983), or on banks which were flush with capital and seeking borrowers, regardless of their ability to repay (Darrity and Horn 1988).

The IPE literature added several explanations and perspectives to these debates, and most importantly, brought more political variables into the explanations for crisis and its resolution. First came explanations that defaulting countries exhibited weakness in their political systems which contributed to poor economic policy making. For example, Snider argued that the politically weak governments and excessively politicized economic policies caused countries to be far more likely to default on their loans. He argued that weak political capacity was an important predictor of default (Snider 1990). The role of politics in other phases of the debt crisis was also explored. Kahler (1986) considered how domestic politics affected cooperation in providing stabilization after the debt crisis emerged (Kahler 1986), and was particularly concerned with the role that politics would play in the tasks of providing stability, regulating private businesses and managing reform. In a similar vein, Haggard (1985) argued that political characteristics of a state were likely to influence the success of economic reforms and stabilization/adjustment policies (Haggard 1985). Politics, according to Haggard, would affect how the crisis was managed and how or if adjustment would take place. In total, the addition of political variables to understanding crisis provided new avenues for research which would become particularly relevant for future crises.

A lesser known contribution from the debt crisis comes from theorists writing from the Braudelian tradition or world-systems school which tied the crisis to long-term cyclical behavior of debt. An exemplary study was published by Christian Suter (1992) who examined debt cycles from 1820 onward and correlated peripheral debt to both secular trends and long waves. He theorized that the accumulation of debt in peripheral states was related to Kondratieff growth cycles, Kuznets cycles, and world leadership cycles. Core boom phases led to capital exports, which correlated to upswings in the cycles. Default was correlated with contraction phases (Suter 1992). These sorts of analyses about the debt crisis suggested that it was not just mainstream IPE theories that considered crises. This is a theme that continues to be considered in scholarly work on crisis (Bello 2006; Wallerstein 2006; Thompson 2009).

Expanding Political Explanations and Crony Capitalism

As a logical extension of the political variables adopted to understand the 1982 debt crisis, the role of domestic politics in causing or contributing to financial crisis has become a well-studied theme. This is particularly true of the Asian Financial Crisis in 1997. This literature addresses three main questions. First, what domestic political factors may make a country more or less vulnerable to crisis; second, which domestic political factors make a country more able to manage financial crisis; and finally, what is the relationship between government and business and how does this relationship affect financial stability? While these are interrelated themes, they also present distinct issues for understanding the influence of politics on crisis.

Many authors have written on the role that politics plays in creating or encouraging the conditions for a crisis. A wide range of political variables have been considered in these studies including regime type, ideology, political party strength, interest group power over establishing economic policies, political events such as elections, and the strength of a government to enact or change policies and create regulations (Mei 1999; Pempel 1999; Haggard 2000a; Leblang and Bernhard 2000; Nobel and Ravenhill 2000; Horowitz and Heo 2001; Leblang 2002). By examining these sorts of issues, this literature brings into focus the connections between political systems and the incidence of crisis.

The Asian Financial Crisis of 1997 provides the main case studies and evidence for this line of inquiry. In the Nobel and Ravenhill (2000) edited volume, the various authors examine how domestic and international institutions express interest group preferences and limit policy choices. Specific chapters address the particular political conditions that lead to vulnerability in individual countries. In total, the collection of essays shows that the diversity of political configurations within Asian states was a factor in making any specific states more or less vulnerable to crisis. An edited volume by Horowitz and Heo (2001) is concerned with the role that organized interests play in creating policy and influencing domestic political institutions. The book examines economic policy making in eleven countries and uses these case studies to create an overall picture of the role that politics can play in causing a state to be more or less vulnerable to a financial crisis. Individual cases suggest a variety of ways that political systems can affect stability. In a more focused study, Leblang (2002) looks at the incidence of speculative attacks. He argues that political events such as election or dissolution of a cabinet may cause concern that a new government will change policies. He has shown that the likelihood of a speculative attack increases around elections since they generate political and policy uncertainty (2002). These representative works move the debate on the causes of financial crisis within a country away from solely economic issues and toward how economic policies are created in highly politicized environments.

A second line of inquiry has been concerned with how political variables affect the response or post-crisis environment. Much of the research discussed above that looks at how politics can cause vulnerability to crisis also assesses the role that various political systems and political configurations will have on the ability of a country to mount a response to crisis and ultimately recover. This line of inquiry owes much to Stephan Haggard’s (1985) earlier work on the politics of adjustment. In fact, Haggard remains a dominant voice in assessing the role that politics plays in response and recovery. His work on the Asian Crisis examined how types of government (e.g., democracy, dictatorship) influenced response. He argued that while the democratic political system in Korea and Thailand had some problems managing the crisis, these democratic political systems brought accountability to leaders, and individuals to power who could implement reforms. At the same time, the far more authoritarian Malaysian and Indonesian systems faced difficulty due to “erratic policies which increased market uncertainty” (Haggard 2000b:135). Thus, more authoritarian/nondemocratic governments did not face any significant advantages over democratic ones (Haggard 2000a). Haggard and MacIntyre (1998) argued that the main political issue in resolving the crisis was how institutions generate credibility and decisiveness. They concluded that while both democratic and nondemocratic systems had some problems with these issues, the nondemocratic system in Indonesia seemed to respond least well.

Finally, the relationship between government and business has been an important theme in understanding financial crisis. The basic argument is that the closer intertwined and less transparent the relationship between government and business, the more likely market actors will respond negatively and increase instability. In addition, the closer the business–government relationship is, the less likely it is that business will be regulated by the state. Studies on the business–government relationship have argued that specific relationships such as the Korean chaebols (Woo-Cumings 1999) and the unregulated banking sector in Thailand (MacIntyre 1999) have helped contribute to crises. Another literature identifies “crony capitalism” as a contributing factor to a state falling into crisis (Dooley 2000; Wei 2001; Wei and Wu 2001). Crony capitalism was a common theme in understanding the business–government relationship in many Asian countries that fell into crisis in the 1990s. Rather than just suggesting a strong business–government relationship, crony capitalism implies an extremely tight-knit group that controls both government and business to a degree that transparency is lacking and decisions are made based on personal connections, not on good business practices.

All three of these themes have increased the scholarship that tests the relationship between crisis and political variables and therefore forwarded a truly IPE understanding of the reasons for and responses to financial crisis.

Uncontrolled and Growing: Financial Markets and Crisis

Since the 1990s, there has also been a strong interest in the IPE literature to assess the deregulation of financial markets and encouragement of liberalization in the post-Bretton Woods period. Many authors have suggested that states (on purpose or not) have either lost or are losing control over financial interactions in favor of market actors (Cerny 1993; Helleiner 1994; Strange 1996, 1998) and that financial interactions are increasingly detached from the global productive or real economy (Binswanger 1999, 2004). These trends identify another branch of IPE thinking about crisis – one that focuses on more systemic issues than looking into domestic economic systems. Thus, there has been growing attention to whether financial crises are more likely in an era of high capital mobility and globalized finance. Certainly the historical record gives some indication that there may be a connection since the incidence of financial crisis has increased since the collapse of the Bretton Woods regime in the 1970s.

While many authors speak to these issues, Susan Strange deserves very early credit for suggesting these relationships needed to be examined and she made significant contributions to understanding the destabilizing role of global portfolio capital. In Casino Capitalism (1986), she focused on the dangerous and gambling-like nature of global capital movements and argued that risk and uncertainty in the financial sector had historically been responsible for economic crisis. She followed up this theme in subsequent works including Retreat of the State (1996) and Mad Money (1998). Strange was not tentative in her predictions; she argued that the unfettered and expanding capital movements, facilitated by technological innovation, would cause instability since the system had expanded beyond the control of an effective governing body (Strange 1998). She also emphasized the need to create better regulatory structures in order to combat these systemic trends. Examination of the role that capital movements play in financial crisis continues to drive a portion of the IPE literature on crisis (Pauly 1995; Eichengreen and Fishlow 1998; Kahler 1998; Griffith-Jones et al. 2001; Helleiner 2001).

The New International Financial Architecture (NIFA) literature that emerged after the Asian Financial Crisis was largely based on the idea that the cause of the Asian Crisis had something to do with ineffective global rules and institutions. While the original NIFA project has long lost its momentum, the idea that liberal markets and ineffective capital regulations can lead the system into crisis is once again becoming a prominent theme in the literature. In general terms, the literature suggests the need for global institutions and regulatory structures that would better manage capital and therefore better prevent and address financial crisis (Armijo 2002). In terms of real reforms, the post-Asian Crisis Bank for International Settlements’ capital adequacy reforms suggest the potential for global regulations, although the effectiveness and appropriateness of these reforms has been a subject of debate (Bank for International Settlements 1999; Kahler 2000; King and Sinclair 2003).

It is likely that the greater incidence of financial crisis will drive more people in IPE to study these events and also to study how the international system can best cope with crisis. The 1997 Asian Crisis, the smaller domestic crises that occurred in developing countries after that, and the new subprime crisis have certainly brought more attention to the issues of global capital and finance, and undoubtedly new themes and scholarship will follow.

Responses: Lenders of Last Resort, Bailouts, and Moral Hazard

Both IPE and economic explanations of crisis consider the role of response, or, simply, how do markets get calmed once a crisis emerges? Most popular in considering response is the idea of a lender of last resort (LOLR). The concept of a LOLR is at least as old as the nineteenth-century writings of Walter Bagehot (1873). A LOLR is a capable institution (or actor) that can lend to firms, or even to sovereign states, in order for them to manage their liabilities when they are unable to get credit elsewhere. The goal is to calm markets by providing liquidity. The need for a LOLR has been emphasized by many scholars writing on financial crisis, but there has also been increasing controversy about the provision of liquidity by governments and what this might mean for increased risky behavior in financial markets. Thus, two issues are prominent in the scholarship surrounding the LOLR. First, what institution should act in this capacity? Should it be domestic or international? Public or private? Second, does the existence of a lender of last resort cause moral hazard and thus more risky business behavior?

In considering what should act as LOLR, next to Walter Bagehot, probably the biggest proponent of having a LOLR is Charles Kindleberger. Kindleberger identifies a variety of public and private institutions and even individuals who have acted as LOLR throughout history, and thus for him the function is more important than the structure. As long as whatever acts as LOLR has the capacity to calm markets, it seems that it has the capacity to be effective. He cites many cases where varying forms of LOLR created stability and resolved a financial crisis, and conversely, he notes many crises where the lack of a LOLR deepened the crisis and stalled financial recovery (Kindleberger 2000). Perhaps his best-known case is the lack of a LOLR during the 1931 financial crises. Kindleberger saw this failure as leading to the severity and length of the Great Depression (Kindleberger 1973).

After the Mexican and Asian Crises in the 1990s, the issue of a LOLR became prominent in the literature once again, but this time with a renewed interest in who should perform this function. The IMF was considered by several authors, but with significant reforms that create greater capacity for the institution (Fischer 1999; Kenen 2001). The creation of new international financial institutions or bankruptcy provisions was suggested by several scholars as a way to provide a quasi-LOLR function (Krueger 2001; Rogoff and Zellelmeyer 2002). In addition, the role of the private sector in providing LOLR functions has been a popular theme since the Asian Crisis (Eichengreen 1999; Kenen 2001; Roubini and Setser 2004).

The second, and perhaps most controversial, issue regarding the LOLR is the issue of moral hazard. Does a LOLR encourage more risky behavior from investors since they know that they will be rescued if their investments fail? On one side, there were many studies that suggested a LOLR would successfully manage crisis, and recommendations for the creation of an international institution with LOLR capabilities (Fischer 1999; Jeanne and Wyploz 2001; Corsetti et al. 2004). However, the position that a LOLR could create an unacceptable level of moral hazard also continues to be articulated (Calomiris 1998; Giannini 1999; Mishkin 1999).

In the 2008 subprime/credit crisis, the issue has changed somewhat from one of whether a LOLR creates a moral hazard to whether it is ethical or appropriate for taxpayers to “bail out” companies and banks that are at risk of failing. The use of the term “bail out” is indicative of the disdain with which the idea is being received. Individual citizens have expressed outrage that companies who were tied to too many risky investments or operated businesses in imprudent manners were able to be rescued from bankruptcy (Stolberg 2008). Regardless of public outrage, the US Federal Reserve and Treasury, as well as the IMF and various financial authorities, did provide LOLR functions throughout 2008 and into 2009. Because of this, it is likely that these actions will be the subject of future study as the consequences of these policies become more evident over time.

Contagion

In the crisis literature, many authors have expressed concern about contagion. Kindleberger considered contagion as a possible stage in his crisis model (Kindleberger 2000), and the experiences of the Asian Crisis and the subprime/credit crisis of 2008 seem to confirm that contagion is a possibility. In the IPE literature, the issue of why a crisis spreads seems to be of less interest than the role that institutions can play to manage a crisis and keep it from spreading (Strange 1998; Bryant 2002). In the economics literature, there has been far more work to prove contagion effects and to determine their cause. Eichengreen et al. (1996) examined the contagion effects of currency crises and determined that a speculative attack in one part of the world is significantly linked to the chance of an attack in another. While they were unable to determine the reasons for this linkage, later studies have addressed this issue with varying explanations. Some have suggested that crises spread through financial connections (Van Rijckeghem and Weder 2001) while others contend it is through trade connections (Glick and Rose 1999).

The Crisis of 2008

It is still too soon to draw conclusions about the current global financial crisis. What we know is that overheated real estate markets and easy access to credit caused an enormous amount of debt. Much of this debt was securitized and held by financial intermediaries as part of their assets, but as the prices of US homes began to decline, the value of the loans became suspect. This led to the greater problem that the assets that banks and investment corporations held were not able to be valued. With no market to sell these assets, declining prices meant that banks (and other investment-linked corporations) had to report losses which led many companies to have more liabilities than assets, to conservative lending behavior, and ultimately to the tightening of lending practices that caused a credit contraction. The effects of this contraction have been felt globally. Domestic central banks and financial authorities, along with international financial institutions such as the IMF, have attempted to bring some confidence and relief back to the markets through various measures to get liquidity back into the system.

This brief synopsis of what occurred leaves out many of the more interesting facets of the crisis – such as speculative behavior, stock market crashes, the role of credit rating agencies, unethical mortgage brokers, swaps and derivatives, deregulation of financial institutions, bank runs, Ponzi schemes, and Galbraith’s “bezzle” – and the list goes on. It is also likely that there are other problems that have yet to manifest themselves, such as a crisis in the unsecured debt market (credit cards) and commercial real estate markets. The causes and ramifications of the crisis will undoubtedly be studied for decades and lead to many new insights. Unfortunately, at this point in time, it is difficult to do more than identify a few issues that are likely to be central to future studies on financial crisis. The issues that are most salient in the current crisis are really not new. Anyone who knew some of the details of the current crisis while reading through the theories presented above would probably be able to draw many parallels. There is particular concern about three issues related to the current crisis and these are likely to drive future research: the regulation of global capital, crisis response (bailouts and institutions), and the fragility of financial markets.

In many parts of the world, the current crisis has highlighted the failures of policies that favored liberalism and free capital markets. These issues have been of concern at two levels. First, within the regulatory system of domestic governments, there is a concern that government has done too much to reduce its oversight of financial markets. Second, a more global question is the level of exposure states have had to foreign assets and how unregulated this process is. Certainly domestic political systems will reevaluate the role of regulatory agencies that manage their economic systems in future months and years. The more difficult issue to resolve, and one likely to drive significant research on crises, will be the issue of global regulation, which will have to be tied to state coordination of financial policies. Forums like the G8 (G20) are likely to be arenas where coordinated policies will be considered and perhaps pursued. To some degree there has already been an attempt to do this through various summits and meetings of the G8, G20, and EU. The main issue related to this will be how states will manage, in some coordinated fashion, the financial innovations that have emerged in the last few decades, such as hedge funds, securitized mortgages, swaps, and other derivatives. Clearly, politics will have much to do with how regulations get designed and whether policy coordination happens or is even possible.

A second issue that has already garnered an enormous amount of attention is the issue of crisis response. Should any firms be allowed to fail? Is there such a thing as “too big to fail”? Again, this is in many ways a domestic issue that harkens back to LOLR policies. However, the crisis has already involved global financial institutions such as the IMF in crisis response and LOLR activity, and issues of global responses and global “bailouts” should be considered. The US Treasury and Federal Reserve have worked to stabilize the US economic system, but there certainly are questions about how globalized markets might need to be stabilized from these large American financial actors too; particularly since there is no other financial institution that has enough capacity to manage the global economy. Of course, there have also been political responses to LOLR actions, including legislation tied to the Troubled Asset Reduction Program that promotes “Buy American” policies in order for firms to get assistance. While the pro-domestic language of these proposals was lessened in the final drafts, the question of how domestic political interests will affect the LOLR role and activity is one that should garner the attention of those studying crises.

Finally, there is the issue of financial fragility. How prone to crisis is the current global economic system? One of the more interesting financial crisis books to have come out recently is Anastasia Nevestailova’s Fragile Finance (2007). In this book she presents a Minskyan perspective of financial crisis that focuses on innovation in capital markets and the expansion of debt and credit. Her analysis is a model of how the credit systems have created financing that is causing the financial system to be unstable. While these themes are not particularly new, they are ones that need to be studied in more depth. Keynesian perspectives are likely to experience a new acceptance as liberalized financial markets are seen as the culprit in creating the current crisis. The linkages between unregulated financial capital and serious crisis should be examined with new vigor, a theme that will not surprise any student of the late Susan Strange. Moreover, it is worth asking whether the increase in the incidence of crisis can be reversed in a globalized economic system that is constantly innovating to generate profit, and what policy paths might be available to manage the flow of capital while still benefiting from it.

These three themes appear to be the most relevant for understanding the current crisis and it is likely that the events of the current crisis will drive research on financial crisis in the future. Crises are, indeed, a hardy perennial and are likely to persist. The insights gained from the scholarship on financial crisis to date should provide clues to policy makers about how to manage these events in the future.

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