Financial crisis
It is apparent however that a consistent feature of both economic (and other applied finance disciplines) is the obvious inability to predict and avert financial crises.
It has been argued that the assumptions of unique, well-defined causal chains being present in economic thinking, models and data, could, in part, explain why financial crises are often inherent and unavoidable.
[8] One factor that frequently contributes to a bubble is the presence of buyers who purchase an asset based solely on the expectation that they can later resell it at a higher price, rather than calculating the income it will generate in the future.
However, it is difficult to predict whether an asset's price actually equals its fundamental value, so it is hard to detect bubbles reliably.
The subprime mortgage crisis and the bursting of other real estate bubbles around the world also led to recession in the U.S. and a number of other countries in late 2008 and 2009.
In particular, Milton Friedman and Anna Schwartz argued that the initial economic decline associated with the crash of 1929 and the bank panics of the 1930s would not have turned into a prolonged depression if it had not been reinforced by monetary policy mistakes on the part of the Federal Reserve,[13] a position supported by Ben Bernanke.
Reflexivity refers to the circular relationships often evident in social systems between cause and effect – and relates to the property of self-referencing in financial markets.
[18] It has been argued that if people or firms have a sufficiently strong incentive to do the same thing they expect others to do, then self-fulfilling prophecies may occur.
[21] Reflexivity poses a challenge to the epistemic norms typically assumed within financial economics and all of empirical finance.
For example, borrowing to finance investment in the stock market ("margin buying") became increasingly common prior to the Wall Street crash of 1929.
Another factor believed to contribute to financial crises is asset-liability mismatch, a situation in which the risks associated with an institution's debts and assets are not appropriately aligned.
For example, commercial banks offer deposit accounts that can be withdrawn at any time, and they use the proceeds to make long-term loans to businesses and homeowners.
[20] Likewise, Bear Stearns failed in 2007–08 because it was unable to renew the short-term debt it used to finance long-term investments in mortgage securities.
This generates a mismatch between the currency denomination of their liabilities (their bonds) and their assets (their local tax revenues), so that they run a risk of sovereign default due to fluctuations in exchange rates.
[22] Many analyses of financial crises emphasize the role of investment mistakes caused by lack of knowledge or the imperfections of human reasoning.
[28] Unfamiliarity with recent technical and financial innovations may help explain how investors sometimes grossly overestimate asset values.
One major goal of regulation is transparency: making institutions' financial situations publicly known by requiring regular reporting under standardized accounting procedures.
Fraud has played a role in the collapse of some financial institutions, when companies have attracted depositors with misleading claims about their investment strategies, or have embezzled the resulting income.
Many rogue traders that have caused large losses at financial institutions have been accused of acting fraudulently in order to hide their trades.
Developing an economic crisis theory became the central recurring concept throughout Karl Marx's mature work.
In the long-run, however, when one considers the combined economic activity of all successfully-operating business, it is clear that less money (in the form of wages) is being returned to the mass of the population (the workers) than is available to them to buy all of these goods being produced.
The viability of this theory depends upon two main factors: firstly, the degree to which profit is taxed by government and returned to the mass of people in the form of welfare, family benefits and health and education spending; and secondly, the proportion of the population who are workers rather than investors/business owners.
[citation needed] World systems scholars and Kondratiev cycle researchers always implied that Washington Consensus oriented economists never understood the dangers and perils, which leading industrial nations will be facing and are now facing at the end of the long economic cycle which began after the oil crisis of 1973.
To facilitate his analysis, Minsky defines three approaches that financing firms may choose, according to their tolerance of risk.
The Banking School theory of crises describes a continuous cycle driven by varying interest rates.
The capital flows reverse or cease suddenly causing the subject of investment to be starved of funds and the remaining investors (often those who are least knowledgeable) to be left with devalued assets.
[39] Mathematical approaches to modeling financial crises have emphasized that there is often positive feedback[40] between market participants' decisions (see strategic complementarity).
For example, some models of currency crises (including that of Paul Krugman) imply that a fixed exchange rate may be stable for a long period of time, but will collapse suddenly in an avalanche of currency sales in response to a sufficient deterioration of government finances or underlying economic conditions.
[44][45][46][47] Herding models, based on Complexity Science, indicate that it is the internal structure of the market, not external influences, which is primarily responsible for crashes.
Reinhart and Rogoff also class debasement of currency and hyperinflation as being forms of financial crisis, broadly speaking, because they lead to unilateral reduction (repudiation) of debt.
