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On Instability

di - 22 Dicembre 2009
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Again, anything can become the spark which ignites the rush to liquidate commodities, stocks, real estate, bills, foreign exchange, and represents the causa proxima of the crash. As Kindleberger says “in itself causa proxima is trivial: a bankruptcy, a suicide, a flight, a revelation, a refusal of credit to some borrower, some change of view which leads a significant actor to unload” (p. 107). Nonetheless, the repercussions are dramatic. Prices fall. Expectations are reversed. The movement picks up speed. The supply of credit dries up, even for creditworthy clients. In September 2008 the news which put the slide into motion was the decision of the U.S. government not to bail out Lehman Brothers, a big broker-dealer mostly involved in “toxic” bonds, speculative derivatives, and other risky assets.
I will not go on with endless exemplification. Kindleberger surveys a large sample of cases.
Given its specific features, each crisis is a topic for economic history. The literature is indeed vast. In particular, the analysis of the psychological determinants of changes in expectations is necessarily historical. Vilfredo Pareto, the great neoclassical mathematical economist, relies on his skills as a sociologist when he tries to explain the recurrence of crises: “After a crisis, people are highly pessimistic. But attitudes gradually change. A new generation, which did not experience the last crisis, gets into business. The social body accumulates a stock of new excitable material” (vol. II, p. 311).

6. We can ask whether such historical variety is amenable to a general theory, of instability if not to a single model.
Why is capitalism inherently unstable?
Economic theory does have an answer. Several strands of instability theory are available, since Henry Thornton, dissenting in 1802 from Adam Smith as well as from his friend David Ricardo, first linked together waves of business confidence and pessimism, ease and scarcity of mercantile credit, and liquidity preference. In a monetary economy investment decisions are highly decentralized, atomistic, anarchic, based on – as Keynes said – “very precarious expectations in an economy of individualistic capitalism”, always exposed to “a sudden collapse in the marginal efficiency of capital” (pp. 315-317 of the General Theory). Business choices are motivated by expected return and risk. They are guided by market prices, and by demand and price expectations, in an uncoordinated and uncertain context. Business fluctuations, real and financial crises, as well as manias, panics and crashes, constitute an integral part of such an economic system. Prices are unable to signal in every circumstance that an excess is developing: an excess of confidence, indebtedness, and investment in the search for profit and innovation, the engine of the capitalist economy as a growth machine.
Crises can be seen as the way – an extremely costly way – the system corrects imbalances and overshootings.
It is not a question of irrationality of investors (as Akerlof and Shiller have recently wrongly said). Investors are “rational”, in the sense that they try to maximise returns making the best use of available information. Nonetheless – as Keynes has clarified since his “Treatise on Probability” of 1921 – probabilities are not always commensurable and quantifiable, and ultimately reflected in asset prices. The myriad individual agents must make investment decisions even when probabilities cannot be calculated, given the poor state of knowledge and the high degree of uncertainty. In those circumstances, choices are made on what Keynes calls a conventional basis. Because of uncertainty and market imperfections price signals can be inadequate. “Animal spirits”, as a kind of bounded rationality, by necessity integrate calculus and price signals in motivating the decisions to invest which cannot be postponed. The critical notion, here, is the Keynesian category of convention:  “We are assuming, in effect, that the existing market valuation, however arrived at, is uniquely correct in relation to our existing knowledge of the facts which will influence the yield of the investment, and that it will only change in proportion to changes in this knowledge: though, it cannot be uniquely correct, since our existing knowledge does not provide a sufficient basis for a calculated mathematical expectation” (p. 152 of the “General Theory”).
Keynes has definitely and definitively clarified why capital expenditures are the most volatile component of aggregate demand and why even rational investment plans can prove wrong, giving way to fluctuations and crises: the instability of capitalism.
Specifically, the anatomy of a typical crisis has been gradually evolved in a single, simple model. The model builds on the contributions of economists like Thornton, Marx, Bagehot, Schumpeter, Wicksell, Fisher, Keynes, Minsky.Charles Kindleberger best exposed the model in plain words: “By no means is every upswing in business excessive, leading inevitably to mania and panic. But the pattern occurs sufficiently frequently and with sufficient uniformity. What happens, basically, is that some event changes the economic outlook. New opportunities for profits are seized, and overdone, in ways so closely resembling irrationality as to constitute a mania. Once the excessive character of the upswing is realized, the financial system experiences a sort of ‘distress’, in the course of which the rush to reverse the expansion process may become so precipitous as to resemble panic. In the manic phase, people of wealth or credit switch out of money or borrow to buy real or illiquid financial assets. In panic, the reverse movement takes place, from real or financial assets to money, or repayment of debt, with a crash in the prices of commodities, houses, buildings, land, stocks, bonds – in short, in whatever has been the subject of the mania” (p. 5).

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