On Instability

1. The economy in which we live – the capitalist market economy – is a formidable, incomparable growth machine (Baumol).
Since its birth with the Industrial Revolution in Britain modern capitalism has been capable of multiplying the material welfare of humanity, which had remained practically unchanged during the preceding “malthusian” millennia. Per capita world GDP in real terms (PPP) today is ten times the level of 1820 (Maddison). In 1820 it was no more than 40 per cent higher than at the time of the first Roman emperors. It is remarkable that this extraordinary average per capita increase coincided with the explosion of world population, from 1 billion people in 1820 to more than 6 billion nowadays. It is no less remarkable that two thirds of the 60-fold increase in world GDP was due to knowledge, innovation, technical progress, higher productivity. Only the remaining third was due to additional quantities of labour, capital, and the other inputs employed in the production of goods and services.
The potential growth of output and productivity – “Modern Economic Growth” (Kuznets) – apparently outweighs the negative features of the capitalist system. This explains the prevalence of the market economy over other “modes of production” and its diffusion wordwide, especially after the failure of the planned economies since the 1970’s.
Besides being unfriendly towards the environment – provoking pollution, warming of the earth, melting of the ice surface, rise of the sea level, etc. – the capitalist system is inegalitarian, and increasingly so, in the distribution of income and wealth. Even the poorest section of world population is economically better off today than two centuries ago. Nonetheless, the disparity between the rich and the poor is presently enormously wider. It is so both within each economy – among the citizens of single nations – and when we consider the distribution of income within the entire population of the world. Considering the latter, the Gini index was 0.50 in 1820; it is near 0.70 today (Bourguignon and Morrisson). The richest 1% of world population (60 million people or so, gets a share of world income equal to that recevied by the poorest half of humanity (3 billion people) (Milanovic).
No less worrisome is the third drawback which afflicts the market system: instability in economic activity and finance.
Since we evoked world GDP in real terms, its fluctuations around the trend can convey a first, impressionistic, idea of the systemic nature of the instability of capitalism. Specifically, dramatic negative deviations from trend – -5% or more – took place for shorter periods in the XIXth century and for longer periods in the aftermath of the two World Wars, in 1929-33 during the last century, and again in 2009. Overall, over the last two centuries we find at least seven major contractions in global economic activity (GDP, but also investment, employment, consumption, social welfare).

2. It has to be emphasized that instability can be not only “real” but monetary and financial as well. Inflation and deflation of consumer prices and of asset prices, currencies appreciation and depreciation, financial manias, panics and crashes, failures of banks and other intermediaries: the frequent occurrence of such phenomena adds another dimension to the instability of capitalism. Monetary and financial disorders are particularly relevant for their random but pervasive repercussions on the distribution of income and wealth, as well as for the sense of uncertainty and the social tensions they generate.
It should already be clear that I am not referring to the recurrent bad harvests in the mainly agricultural economies of the XIXth century. Similarly, I am not referring to the quasi periodical “business cycle” nor to the minor fluctuations in the rate of growth of production which have been experienced mainly in the second half of the last century.
We shall concentrate our attention on the most serious, albeit less frequent, real and/or financial crises.

3. As to the present crisis, the most recent estimates and projections of the IMF for 2009-2010, made under the supervision of Olivier Blanchard, depict one of the deepest contractions in the history of modern capitalism.
Before the crisis, in 2007 the growth rate of world GDP was 5%. The IMF forecasts that in 2009 GDP will fall, by more than 1%, for the first time since 1950. A six percentage points deceleration implies an irreplaceable loss of four thousand billion dollars in world potential output. Vis a vis 2008, the contraction of GDP (- 4%) is concentrated in Western economies and Japan, while China is still growing at the rate of 9% per annum.
After 70 years of inflation, consumer prices will be stable, or slowly falling, this year. The value wasted on “subprime” loans, “toxic” financial assets and stock exchanges could imply for banks and other financial intermediaries four thousand billion dollars of overall losses, equivalent to nearly 1/3 of US GDP and to another 6% of world GDP (bank losses would amount to 2.7 thousand billion dollars (4% of world GDP).
The disaster started in the U.S. and U.K. financial markets, then spread to Europe, Japan and other parts of the world. It happened in spite of the fact that central banks injected huge amounts of monetary base in the money markets (even more than doubling their balance sheet) and governments widened their budgetary deficits, offered guarantees to weak financial institutions, and recapitalized quasi insolvent banks with huge amounts of public money.
According to the IMF, assuming that monetary and fiscal policy continue to support aggregate demand, 2010 should be a year of moderate recovery of production (not of employment). Price deflation will be avoided. The financial industry would return to profit. Several banks could be re-privatised.

4. Assuming the IMF forecast will be borne out by the facts of 2009-2010, the present contraction can be statistically inscribed in the “map” of the crises which punctuated the last two hundred years.
The “map” is, unfortunately, very rich and extremely varied.
Nowadays, the countries adopting the market system are a bit less than 200. Few of these economies, if any, have not experienced crises in their history. This common destiny contrasts with their profound structural differences. Several economies have gone through more than one episode of severe financial and real instability. For instance Italy, wars apart, has suffered six serious contractions since its political unification in 1861: in 1873, 1889, 1921, 1929, 1992, and in 2009 (-5% in GDP).
Consequently, we can estimate an order of magnitude of several hundred crises of individual economies during the last two centuries.
Apart from war periods, the heaviest real, monetary and financial crises which can be labeled “international” – if not “global” – since they hit many economies at the same time have been at least four: 1833-1842, the 1870s, 1929-33, and the present day. The 2009 crisis looks less severe in terms of GNP contraction and price deflation, and similar as to the fall of the stock exchanges. At the same time, possibly it involves bigger in terms of the losses suffered by banks and financial intermediaries. In 1929-32 world GDP fell by 17%, wholesale price deflation reached 40%, bank losses amounted to 5% of GDP in the U.S., 9% in Austria, 10% in Italy, but did not reach, overall, the 4% of world GDP estimated by IMF in the present crisis.
1847-48 and 1973-75 were two other phases of serious and quite widespread real and financial instability.
Indeed, in the heaviest episodes instability in the real sector of the economy coincided, and interacted, with monetary and financial instability. The contraction of aggregate demand and sales determined negative profits, shrinking cash-flows, and bankruptcies of non financial firms, which met increasing difficulties in servicing their debts vis a vis creditors. The latter, in turn, plunged into non performing loans, illiquidity, losses, negative net worth, failures. The vicious circle was aggravated when price deflation, and deflationary expectations, raised real interest rates (Fisher) and the increase of the cost of capital was exacerbated by the fall of stock prices. Credit crunch, higher interest rates, pessimism reduced the capacity and propensity to invest of non-financial firms, renewing the recessionary spiral.
Not surprisingly, deep contractions in demand and production have been always associated – not only correlated – with financial instability. The contrary, however, is not always true. In a number of cases, a financial crisis has been stopped, or simply endogenously ended, before evolving into a “real” crisis. This is of special interest in the light of the present recession, which was instead ignited by financial turmoil, especially in the U.S.
I will quote three cases of crisis “abortion”, i.e. of financial crises not generating a “real” contraction: the first two – 200 years apart – were halted by public intervention, the third autonomously lost momentum without  provoking a recession in economic activity.
In 1793, at the dawn of modern capitalism, the first serious financial crisis hit the City. Rumours stemming from difficulties of the British country banks caused a drain of liquidity that extended to London, where the demand for money soared. Nonetheless, the chain of bank failures was broken, and confidence restored, by an orientation of monetary policy made public by the Exchequer. In the words of a brilliant observer and protagonist – Henry Thornton – “The very expectation of a supply of exchequer bills, that is, of a supply of an article which almost any trader might obtain, and which it was known that he might then sell, and thus turn into bank notes, and after turning into bank notes might also convert into guineas, created an idea of general solvency.” (p. 50).
In October 1987 a rise of short and long term interest rates was followed by a 25% fall of Wall Street – a record decline in two days, even worse than the one in October 1929 – with contagion spreading rapidly to the major stock exchanges in other countries. The crash was halted by the immediate reversal of monetary policy, from restrictive to expansionary, enacted by the Fed headed by Alan Greenspan. In this occasion, as well as in several others during his Chairmanship of the Board of Governors – the Mexican, Asian, Russian, LTCM crises in the 1990’s – Greenspan succeeded in restoring confidence in financial and exchange rates markets, avoiding negative spillovers on real economic activity.
The third case is 1857. In that year a serious, fully fledged financial crisis started in the U.S. (railway securities), and spread to London (with the Bank Act suspended), Frankfurt, Paris. Nonetheless, both in the U.S. and in Europe real GDP did not fall.

5. The variety of forms and features which crises have assumed in history goes beyond the link between their real and financial dimensions.
Among other aspects, each crisis is unique in the main object of speculation and overtrading; in the incident which saps the confidence, reverses expectations and precipitates distress selling of commodities and assets; in the sequence and timing of the fall in the latter’s prices; in the international ramification of the bust.
For instance, speculation concentrated on buildings in the U.S. in 2009, country banks in England in 1793, railroad shares in Britain in 1836 and 1847 as well as in the U.S. and France in 1857, companies already listed in the stock exchange, going public, and merged in the U.S. in 1928-29, foreign exchanges in many occasions, as in Italy in 1992.
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).

7. On the basis of this theoretical framework it is extremely unlikely that capitalism will be  ever transformed into a stable system, through either legislation or policy. Realistically, the answer to the question whether in each and every circumstance crises can be prevented has to be negative. Real and financial crises will continue to happen in the future. They are rooted in the intrinsically unstable dynamics of the capitalist system.
Less philosophically, crises are like earthquakes, extremely difficult to forecast, nearly impossible to detect before their explosion. It is largely arbitrary to label as “excessive” a certain degree of speculation on specific commodities or assets. This is especially true – as in 2008 – in a non inflationary macroeconomic situation. The same applies to the degree of leverage of financial and non financial firms, whose sustainability depends on a host of other variables, such as interest rates, profitability, cash-flows. Market expectations, and especially their potential change, are hard to interpret and even harder to influence and moderate. The spark which makes the fire burn can be everywhere and nowhere. It can even consist in a warning by the government against speculation and/or in policy measures taken to curb speculation timely.
More generally, the attempt to prevent crises faces the “rules  vs. discretion” issue which is typical of economic policy. Rules – such as disincentives to risk taking, ceilings to leverage, incentivety to transparency, prohibition of certain business practices – can, at best, avoid the repetition of crises similar to the ones experienced in the past. They are unable to prevent instability when it takes new forms and follows unusual sequences. Discretionary measures, on the other hand, are predicated on the assumption that Treasuries, central banks and supervisory bodies can be better informed than market participants, which is not always the case. Besides, discretionary measure by administrative authorities can be, or might appear, highly intrusive. They tend to be refused by the business community, which lobbies against them, and are downplayed by the main body of mainstream neoclassical economics.
It has to be admitted that even today, with the benefit of hindsight, it is arduous to identify the rules and/or the measures which with a reasonable degree of confidence would have avoided the present crisis.
The Financial Stability Forum, founded in 1999, considered the possibility of a serious crisis – sooner or later – but along the following sequence of events: growing foreign indebtness of the U.S., fall of the dollar, interest rates hike, difficulties in the hedge funds industry, recession of the building sector in several countries, losses for the banks more exposed towards this sector. Things went differently. In particular, the dollar strengthened, basic interest rates fell, the hedge funds industry was not involved.

8. If instability cannot be eliminated and “innovative” crises prevented – which is frustrating – very much can be done to circumscribe these phenomena and to limit their negative repercussions.
Experience and keynesian economic theory suggest that policy action should at the same time support the financial system and aggregate demand. Both the financial and the real side of the economy have to be taken care of, in a consistent way. Otherwise, if the financial sector is in a disarray the lack and cost of finance will, sooner or later, provoke a recession; if economic activities stagnate or shrink bad loans and depreciating securities will cause illiquidity and insolvency in the financial industry.
The main ingredients of the recipe are known. Treasuries and central banks should supply liquidity, insure risky assets, channel private capital – and as a last resort public capital – to stabilize the financial system. Monetary policy should be expansionary and aggressive, to the limit of zero nominal interest rates. Budgetary policy ought to accept widening deficits, centered on tax reductions and, preferably, on productive investment expenditure and public works. Minimizing moral hazard in banking and finance, refraining from fueling monetary inflation in the long run, planning credible fiscal consolidation beyond the crisis: these are the constraints which stabilization policies have to respect in order to avoid inefficiencies, instability, and inflation in the future. Needless to say, loopholes in regulation and weaknesses in supervision of the financial sector disclosed by the new crisis ought to be removed. The aim should be to avoid the repetition of similar crises, without pretending that the additional rules can prevent any crisis in the future.

9. We can ask whether the measures taken until now to cope with the present crisis respect the aforementioned criteria.
The financial system has been stabilised. Banks and financial intermediaries are returning to profit. The interbank markets are back to normality. A credit crunch has been avoided, as well runs to convert bank deposits into currency. Perhaps too much public money has been injected into the financial system, but the overdose can be justified by the fact that the policy loss function in a critical situation as the one of 2008-2009 is highly asymmetrical … As to new rules and supervisory methods and bodies, until now no relevant decision has been taken. This is true even in the U.S., where the Treasury has contributed a white paper – “Financial Regulatory Reform, a New Foundation: Financial Supervision and Regulation” – with a long list of proposals. Before introducing new rules and new tools of control it is probably wise to wait for the definitive resolution of the crisis, The financial system is already vastly regulated and  largely supervised. In spite of its pitfalls, during the last two decades it has been capable of sustaining rapid economic growth in  the United States and in other parts of the world.
On the real side, the contraction which started several quarters ago has been halted by expansionary monetary and fiscal policies. On the basis of the more recent indicators a timid recovery seems under way in a world economy whose main engine of growth remains located in Asia, particularly in China (11% of world GNP). Nonetheless, demand policies have not prevented the contraction, especially profound in Japan, Europe, and the U.S. There have been delays, with the ECB still raising interest rates in July last year fearing a non existing inflation. The effects of fiscal policy have been lagged and less than proportional to the 4,5% of GDP average increase in the G-20’s budgetary deficits. Governments relied more an automatic stabilizers than on discretionary measures, more on transfers and tax cuts than on capital expenditures. Lower-than-one multipliers have also been limited by a marginal propensity to consume weaker than econometrically forecast.
Aggregate demand should continue to be supported in 2010, notwithstanding the higher levels of public debt emerging in many countries, especially where huge amounts of public money have been spent to bail out weak financial intermediaries.

10. At least one lesson can be drawn from a crisis which is among the worst, but not the worst, in the history of capitalism. The sheer facts of the crisis are at odds with any idea of laisser faire, of efficient markets, and even of market failures always inferior to the failures of the State. We should not forsake  stabilization policies. The problem is to render those policies more timely and effective, at the same time minimising both their intrusiveness on individual choices and the probability of generating moral hazard.

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