Financial crises: conventions, speculation and instability

The  recent  American financial crisis is an example of how the financial institutions encouraged speculation dependent on future housing prices, the future price of securitized assets and the renewal of lending operations. This behaviour was sustainable until housing prices began dropping and the previous risky lending led to a great number of foreclosures. As housing prices decreased, profits fell, and marginal home buyers, who invested in speculative mortgages could not pay, were subject to foreclosure.

While the price of mortgages declined, housing prices increased steadily from 1991 to 2005. Lending requirements were liberalized and banks managed the capital requirements adjusted to risk by means of enhancing further securitized operations.  In other words, the banking system was encouraging speculative and Ponzi portfolios that mainly depended on the future prices of houses, future prices of the securitized assets and the renewals of lending operations.   As a matter of fact, under a post-Keynesian approach, the recent financial crisis has shown sources of endogenous fragility associated with the narrow interconnections between credit and capital markets.

These questions have long been ignored in the market paradigm of neoclassical economics. From the mainstream perspective, the financial crises would be the result of wrong economic policy options. As a result, it does not consider the active role of money and financial institutions and their speculative and destabilizing behaviors.  Under the neoclassical approach  to finance, financial market imperfections might be avoided and, eventually, corrected, since adequate monetary and financial policies would be implemented. Mainstream economists assume that financial markets efficaciously transfer funds and, furthermore, that financial deregulation has been necessary to increase market efficiency and the supply of loanable funds.

From the Keynesian tradition, financial crises are explained in a context of uncertainty where global investors’ portfolio decisions are not submitted to stochastic behavior, that is to say, they are not predictable. The role of both expectations and private speculative strategies is decisive in Keynes´ analysis. The principle of uncertainty is based on the idea that the past is irrevocable and the future is unknown. In the capitalist economy, money means the representation of wealth, the link between present and future. Money has a non-neutral nature, or yet, it affects spending and portfolio decisions.

Global investors’ decisions are based, as John Maynard Keynes warned, on precarious conventions. Considering this scenario, the evolution of investment, consumption, output and employment, is not independent of the global financial cycle that strongly relies on conventional market opinions. Our understanding is that  financial crises  are, as Minsky  warned, an endogenous process.  Indeed, the current financial crisis has revealed that  global financial integration has augmented the possibilities of destabilizing  the evolution of the levels of spending, output, income and employment all around the world.  Hence, current social challenges are not  independent of  global financial cycles.


 

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