Empirical evidence on episodes of financial crises shows firstly, that countries with large amounts of foreign debt, i.e. emerging market countries (as e.g. Thailand, Mexico, Argentina) but also industrial countries (as e.g. Norway, Sweden, Finland), are subject to large variations in the foreign debt stock, and secondly, that these variations cause either large swings in exchange rates or in foreign exchange reserves, implying that the foreign cash flow position is generally different from zero. The most important reason for a nonzero foreign cash flow position in case of variations in the foreign debt stock is the empirical fact that foreign debt is generally used for investment in domestic assets, generating income streams predominantly in domestic currency. Summing up, it is reasonable to assume that changes in the foreign debt stock *DB\*(t)* generally lead to transactions in the foreign exchange market which lead to variations in the exchange rate *s(t)* and in foreign exchange reserves *Z* ( t).

Consequently, in case of flexible exchange rate systems, a reduction/increase in foreign debt *DB\*(t)* by foreign lenders leads to an increasing demand for/supply of foreign currency by domestic agents, causing a rise/fall of the exchange rate *s(t),* as paying back/receiving foreign debt requires that domestic/foreign currency has to be exchanged

30The sum of the domestic cash flow position 2.19 and the foreign cash flow position 2.18 expressed in domestic currency, i.e. multiplied by the exchange rate *s(t),* equals the overall cash flow position defined in equation 2.6 plus nominal earnings in foreign currency in domestic currency *s(t)EA•(t)* which have been neglected for reasons of simplicity in the previous analysis.

into foreign/domestic currency. Thus, it holds formally that

$$s(t) = s(DB^\star(t)),\tag{2.20}$$

stating that a decrease/increase in foreign debt causes an increased demand/supply for foreign currency leading to a rise/fall of the exchange rate. Accordingly, capital outflows/inflows generally lead to a depreciation/ appreciation of the home currency.

In case of fixed exchange rate systems, it seems reasonable to assume that a reduction/increase in foreign debt *DB\*(t)* by foreign lenders leads to an increasing demand for/supply of foreign currency by domestic agents, causing a reduction/increase in foreign exchange reserves *Z(t).* Ergo, the stock of foreign exchange reserves *Z(t)* is formally given by

$$Z(t) = Z(DB^\*\_{\frac{1}{4}}(t)),\tag{2.21}$$

stating that a decrease/increase in foreign debt causes an increased demand/supply for foreign currency leading to a reduction/increase in the stock of foreign reserves. Consequently, capital outflows/inflows generally lead to a decline/rise of foreign exchange reserves. Foreign exchange reserves *Z* ( t) generally have an inverse effect on domestic interest rates i(t) as a rising/declining stock of foreign exchange reserves increases/decreases the amount of high powered money, leading to a decrease/increase in domestic interest rates, i.e. formally it holds that

$$i(t) = i(Z(t)).\tag{2.22}$$

The inclusion of the influence of financial constraints on asset prices, real economic activity, liquidity, profits, and solvency generates cumulative upward and downward processes which are much larger in amplitude than demand-side cumulative processes, as they are reinforced by the financial accelerator effect via improving or deteriorating cash flow and net worth positions. A drop/rise in nominal earnings giving rise to a demandside cumulative downward/upward process, being associated with declining/rising asset prices, cash flows, profits, net worth and deteriorating/improving demand conditions, is amplified firstly, by an increase/decrease in the domestic and in the foreign interest rates on debt *iDa(t)* and *ih8 (t)* by equations 2.14 and 2.15, secondly, by a reduction/increase of available domestic and foreign debt finance *DB(t)* and *DB\*(t)* by equations 2.16 and 2.17, thirdly, in case of flexible exchange rate systems by a rise/fall in the exchange rate by equation 2.20, and fourthly, in case of fixed exchange rate systems, by a decrease/increase in the stock of foreign exchange reserves by equation 2.21 inducing an additional rise/fall in domestic interest rates by equation 2.22, leading to a further drop/rise in asset prices, to a further deterioration/improvement in demand conditions, to a further macroeconomic contraction/expansion, to further deteriorations/improvements in cash flow, profits and net worth, to further interest rate increases/decreases, to further revaluations/devaluations of the exchange rate, and to a further decrease/increase in the stock of foreign exchange reserves.

It is important to note that the inclusion of financial constraint effects does not longer require that cumulative processes are triggered by exogenous events, because interest rates and exchange rates ( and foreign exchange reserves) are endogenous variables as well. Accordingly, there arises the possibility that cumulative processes are *purely endogenous*  in nature, implying that macroeconomic expansions as well as contractions, which are possibly associated with systemic financial crises, are an inherent characteristic of modern economies, being discussed in detail in part II of the book.

**The Emergence of Supply-Side Induced Cumulative Processes. A** further effect, which has been neglected so far, but giving rise to further accelerations of demand-side and financial-accelerator induced cumulative processes, is the impact of supply-side induced cumulative processes through changes in supply conditions *Y'(t),* being induced by alterations in domestic and real asset stocks, *A(t)* and *A\*(t),* according to equation 2.11. It is reasonable to assume that the stocks of domestic and foreign assets *A(t)* and *A\*(t),*  and thereby supply conditions *Y'(t),* are positively dependent on financing conditions, and on the availability of debt finance, since the acquisition of assets generally requires external funds. Hence, formally it holds that

$$A(t) = A(i\_{DB}(t), i\_{DB}^\*(t), DB(t), DB\_{\cdot}^{\bullet}(t))\tag{2.23}$$

$$A^\bullet(t) = A^\bullet(i\_{DB}(t), i\_{DB}^\bullet(t), DB(t), DB^\bullet(t)),\tag{2.24}$$

stating that investment in domestic and foreign assets is negatively dependent on domestic and foreign interest rates, and positively dependent on the availability of domestic and foreign debt. Equations 2.23 and 2.24 imply that an overall macroeconomic contraction/expansion, being associated with falling/rising asset prices, nominal earnings, cash flow, profits, net worth, domestic and foreign debt stocks, and increasing/decreasing domestic interest rates, foreign interest rates, and exchange rates, is further dampened/accelerated by a decrease/increase in potential output, leading to a further reduction/increase in nominal earnings according to equation 2.5, and thereby to a further acceleration of the cumulative downward/upward process.

Changing supply conditions, i.e. changing asset stocks, have an additional accelerating effect on cumulative upward and downward processes by influencing asset prices. This effect is not captured by equations 2.12 and 2.13 as they do not determine asset prices by supply and demand conditions. However, during macroeconomic contractions/expansions, decreasing/increasing asset stocks lead to an additional decrease/increase in domestic and foreign asset prices by an increasing supply/demand of domestic and foreign assets. One important effect arises especially in times of financial distress, being labelled as *distress selling* or *fire-sale of assets,* when a large number of economic units is forced to sell large amounts of their asset stocks at the same time to meet payment obligations, as it has been for example described by condition 2.9, resulting in a collapse of asset prices causing further solvency and liquidity problems.

**An Assessment.** Summing up, there exist various transmission mechanisms causing endogenous upward and downward processes in overall macroeconomic activity, where expansions are associated with "financial health", and contractions with "financial distress". Furthermore, it has been emphasized that contractions, as well as expansions can be purely endogenous phenomena which are not caused by exogenous shocks. However, notwithstanding the fact, that the analysis can provide a deep understanding of cumulative processes, it does not provide an explanation why a process is expansionary

or contractionary, i.e. there is no explanation why an expansionary process, being associated with strong liquidity and solvency positions, can suddenly turn into a systemic financial crisis which leads to a deep depression. Furthermore, the analysis also assumes that *all* liquidity and solvency disturbances are transmitted into the real sector, which would imply that any little disturbance in the liquidity and solvency status would lead either to a dynamically unstable never-ending expansion, or to a dynamically unstable never-ending contraction being associated with systemic financial crises; that is, regarding the analysis of financial crises, the framework does not distinguish between systemic and spurious financial crises. These drawbacks are going to be considered in the following section which studies the determinants of financial stability and allows for a distinction between spurious and systemic financial crises, or why some disturbances lead to the above mentioned cumulative processes and others not. Both the analysis of cumulative processes and financial stability are the necessary ingredients for the theoretical models in part II of the book.

## **2.3 Determinants of Financial Instability**

After having discussed the interdependencies of asset prices, bankruptcy, and real economic activity, giving rise to systemic financial crises in case of adverse financial market disturbances, this section analyzes factors determining whether a given set of financial market disturbances causes either a spurious, or a systemic financial crisis, depending on the overall state of financial instability. Section 2.3.1 starts with a general definition of financial instability, being followed by the analysis of four important determinants of financial instability, where section 2.3.2 discusses the distribution of robust and fragile cash flow positions within an economy, section 2.3.3 the adequacy of refinancing positions, section 2.3.4 the volatility of asset prices and their use in the financial system, and section 2.3.5 the influence of monetary instability.

### **2.3.1 A General Definition of Financial Instability**

Following the general definition of financial crises in section 2.1, spurious and systemic financial crises are subject to the same adverse shocks and drops in asset prices, but differ significantly with respect to their impact on real economic activity. In case of systemic financial crises, asset price drops cause, according to the results of section 2.2.4, widespread illiquidity and insolvency among agents, liquidity crunches, dysfunctions of the payment system, and collapses in aggregate economic activity. By way of contrast, spurious financial crises are characterized by the absence of widespread disruptions in financial market activity, as well as by the absence of collapses in real economic activity. Ergo, whether a given set of adverse disturbances in financial markets causes a disruption of financial markets' capacity to allocate funds efficiently and induces a strong contractive transmission into the real sector or not, is dependent firstly, on factors determining the robustness of aggregate cash flow and solvency positions to remain positive, secondly, on factors determining the robustness of real economic activity and financial market activity not to develop into a cumulative downward spiral. To put it differently, whether a given set of financial market disturbances causes a spurious or a systemic financial crisis depends

on factors determining the degree of aggregate financial instability31 , being defined as follows:

*The degree of aggregate financial instability of an economy is the level of probability that a given set of asset price disturbances, being triggered by actual and/ or expected real and/ or financial shocks, causes widespread illiquidity and insolvency among economic units, as well as a collapse of real economic activity. If, for a given set of disturbances, the probability of widespread failures and real economic downturns is high, then the economy is designated as being financially unstable. If, for the same given set of disturbances, the probability of widespread failures and drops in real economic activity is low, then the economy is called financially stable.*

This general definition implies that in case of financially unstable economies, even very small shocks and financial market disturbances suffice to cause a systemic financial crisis, whereas in case of financially stable economies, only huge shocks associated with very large drops in asset prices give rise to systemic financial crises.

#### **2.3.2 Cash Flow Positions and Present Values**

The first determinant of financial instability is the aggregate proneness to illiquidity and insolvency in case of adverse real and/or financial shocks. Determining the aggregate level of proneness to bankruptcy requires that the economy is disaggregated into single economic units, or into groups or sectors with similar determinants of the liquidity and solvency status in order to obtain a distribution of crisis-prone and financially robust economic entities which allows for the determination of the aggregate level of financial instability.

Assessing the overall financial stability of an economy according to the distribution of robust and fragile cash flow positions goes back on H. P. Minsky's analysis of financial fragility which is going to be set out in sections <IP_ADDRESS> and <IP_ADDRESS>. 32 As Minsky's original concept is restricted to the analysis of financial fragility in closed economies, sections <IP_ADDRESS> and <IP_ADDRESS> enlarge Minsky's theory of financial stability to open economies.

#### **<IP_ADDRESS> Hedge, Speculative and Ponzi-Finance**

In order to get a measure of potential aggregate illiquidity and insolvency in case of adverse shocks, the first step is to classify economic units on a microeconomic level according to their risk to become illiquid and insolvent, where Minsky defines three different states of risk, namely *hedge, speculative* and *"Ponzi" finance.* To distinguish between these different types of economic units, some definitions and theoretical concepts have to be introduced firstly.

31 In the economic literature, financial instability is often labelled synonymously as financial fragility, financial vulnerability, or systemic risk.

32 Sections 2.3.2.l and <IP_ADDRESS> are based on Minsky (1972, 1975, 1977, 1978, 1980a, 1980b, 1982a, 1982b, 1986).

**Basic Concepts.** Consider a single business unit existing for some periods *t* = l, ... , n, which faces a series of contractual cash payment commitments on debts *PCt,* and a series of expected quasi rents, or expected gross nominal profits *GP RL* where both expected gross profits and payment commitments are separated into an income (interest) and into a return of principal components, like in a fully amortized contract. Accordingly, today's payment commitments *PCt,* resulting from the current liability structure are defined as

$$PC\_t = PC\_t(y) + PC\_t(a),\tag{2.25}$$

that is, by interest (income) payments on current debt *PCt(Y),* plus repayment of the principal *PCt(a).* Expected gross nominal profits *GPR{* are defined as

$$GPR\_t^s = GPR\_t^s(y) + GPR\_t^s(a),\tag{2.26}$$

that is, as the expected net income part of cash flow *GPR;f,(y)* representing the "yield" of investment over replacement or acquisition costs, plus wastage or consumption of capital *GPR;f,(a).*

For a business unit to be viable, it is necessary that it holds that

$$\sum\_{t=1}^{n} GPR\_t^\* > 0\tag{2.27}$$

$$\sum\_{t=1}^{n} GPR\_t^t > \sum\_{t=1}^{n} PC\_t,\tag{2.28}$$

that is, that the sum of expected gross profits has to be greater than zero, and that the sum of expected gross profits has to be greater than the sum of payment commitments over the entire economic lifetime.33

The value, or capitalized net worth of a business unit, *E,* is defined by the discounted present value of expected gross profits less payment commitments, formally as

$$E = \sum\_{t=1}^{n} k\_t (GPR\_t^e - PC\_t),\tag{2.29}$$

where *k1* represents the discount factor, reflecting financial market conditions which depend on market interest rates, and on general general risk conditions. 34A tighten-

33This condition is also valid for the viability of a single investment project, where viability is defined, according to conditions 2.27 and 2.28, by the economic lifetime of investment. Note that there is a difference between the economic and the physical lifetime (point in time when the investment good becomes obsolete in a physical sense) of an investment project being analyzed by the vintage approach, discussing the influence of technological progress on inhomogeneous capital stocks. For literature on the

vintage approach, see Johansen (1959), Solow (1962), Phelps (1963), and Solow et al. (1966). 34 It is important to note that the capitalized net worth position *E* of a business unit according to Minsky differs from the standard definition of a firm's value according to perfect capital market theory with respect to the consideration of interest costs, and with respect to the consideration of the financial structure. Following perfect capital market theory, a firm's value is simply determined by discounting expected gross profits. That is, interest costs are *not* subtracted from expected gross profits, because interest costs are only considered by the discount factor, which implies, in accordance with the Modigliani-Miller theorem, that the financial structure is neglected as **a** detenninant of the value of a firm. By way of contrast, Minsky's concept of the capitalized net worth of a business unit *E* explicitly considers interest costs, and thereby the financial structure by subtracting payment commitments *PC,* from expected gross profits *GPRi.*

ing/relaxation in financial market conditions is reflected by a fall/rise in *kt,* indicating an increase/fall in market interest rates and in risk premia.

**Hedge Finance.** A hedge finance unit is characterized by the condition

$$
\hat{G}PR\_t^\epsilon > PC\_t \tag{2.30}
$$

for all periods *t* = 1, ... , *n,* stating that in every period *t,* expected gross profits exceed payment commitments. According to equation 2.29, the present value, or the net worth of a hedge-finance unit *E* is independent of financial market conditions, i.e. a change in interest rates or in overall risk conditions, being reflected in a change of *kt,* does not lead to changes in *E.* Thus, a tightening in financial markets cannot lead to bankruptcy, i.e. to a negative present value *E,* or to illiquidity by a sudden increase in *PCt.* Hedge financing is only possibly in case the balance sheet's debt side contains only equities or long-term debt with maturity date *t* = *n,* and with fixed interest rates. However, negative net worth or illiquidity can arise in case actual cash flows fall short of anticipated cash flows and of the amount of payment commitments, which can be caused e.g. by unexpected increases in labour and material costs, or by unexpected drops in aggregate demand. To avoid such adverse events, hedge-finance units generally are going to hold money and marketable (short-term) financial assets which are not needed for normal operation and which serve only as an insurance against illiquidity and insolvency. Summing up, a hedge-finance unit is not dependent on the "normal" functioning of financial market, but on the "normal" functioning of product and factor markets.

Given that expectations are fulfilled and realized gross profits *GP R1* exceed payment commitments in each period, i.e. if it holds that *GP~* = *GPR,,* > *PCt* for all *t,* a hedge finance unit receives net money inflows in each period. Furthermore, if the income portion of realized gross profits exceeds the income portion of payment commitments (interest rate costs), i.e. if *GPR,,(y)* > *PCt(Y),* then net worth is going to increase in each period. The increase in net worth and in money holdings can be used to finance the acquisition of capital assets without changing the debt-asset ratio, or, in case capital assets are additionally financed by an increase in external debt, financing conditions are not going to deteriorate. Likewise, if net worth consists of equity shares, the fulfillment of expectations of hedge-finance units leads to an increase in share prices and to an increase in the wealth of stock holders.

**Speculative Finance.** For a speculative finance unit, it holds that

$$GPR\_t^\mathbf{c} < PC\_t \tag{2.31} \tag{2.32}$$

$$GPR\_t^t > PC\_t \tag{2.32}$$

stating that near-term payment commitments (periods 1 tom) exceed near term expected gross profits, but that in the longer run (periods *m+* 1 *ton),* expected gross profits exceed payment commitments. Furthermore, for a speculative finance unit, it holds that

$$\sum\_{t=1}^{m} GPR\_t^t(y) > \sum\_{t=1}^{m} PC\_t(y),\tag{2.33}$$

that is, though total payment commitments exceed total expected gross profits over the first m periods, the net income part of cash flow *GP ~(y)* exceeds interest rate costs *PC1(y)* in periods 1 to m. Hence, a speculative finance unit has a share of its principal on debt which falls due in the near term, but whose repayment exceeds the near term debt-repayment funds the unit's assets generate. To meet near-term payment obligations the speculative unit can either run down its money or liquid assets, or, if liquid assets do not suffice, the unit needs to place new debt or to roll over debt, i.e. speculative financing involves a short-term financing of long-term positions. 35 Thus, a prerequisite for speculative finance is that borrowers as well as lenders believe that there exists a market in which cash, being used to bridge liquidity gaps in early periods, can be obtained frictionlessly at required dates. Moreover, liquidity to fulfill payment commitments in early periods is assumed to be available at "normal" financing terms which do not detrimentally affect the probability that future obligations can be fulfilled.

A speculative finance unit's expected net worth or solvency position *E* depends crucially on the level of market interest rates and risk premia, determining the level of the discount rate *kt,* For a set of "low" interest rates and risk premia, implying a "high" value of *kt,* the expected discounted present value *E* is positive. By way of contrast, a tightening in financial market conditions, being associated with "high" market interest rates and risk premia, connoting a "low" value of *kt,* can possibly cause a present value reversal, i.e. *E* < 0, implying insolvency of the business unit. Furthermore, in case the speculative finance unit operates under floating debt interest rates, a present value reversal is accelerated by an increase in payment commitments *PCt* in case of financial market tightening. Accordingly, speculative finance is built on the assumption that interest rates will not move outside some acceptable range. Furthermore, a speculative finance unit can become insolvent, as a hedge finance unit, in case actual gross profits fall short of expected gross profits and of the amount of payment commitments. Summing up, a speculative finance unit is dependent on the "normal" functioning of product and factor markets like a hedge finance unit, but is additionally dependent on the "normal" functioning of financial markets. Thus, a speculative finance unit is exposed to higher risk of illiquidity and insolvency than a hedge finance unit.

Despite the fact that a speculative finance unit has to increase its stock of short-term debt and to decrease its liquid assets in early periods to bridge liquidity gaps, a speculative unit is able to decrease its short-term debt and to increase liquidity in the long-run, and thereby to increase its equity relative to its liabilities in case profit expectations are fulfilled, i.e. if *GP~= GPRt,,* as the income portion of gross profits exceeds the income portion of payment commitments (interest payments) in every period, i.e. because it holds that *GPR1(y)* > *PCt(Y)* for all *t.* Consequently, it is possible to increase net worth for speculative units even if debt is refinanced. However, in case the business unit is financed at least partly by equities, this statement is only valid if payment commitments include conventional payments of dividends, because in this case, the business unit has positive retained earnings. If, on the contrary, dividends are not included in payment commitments, it is possible that the income portion of payment commitments exceeds the income portion of gross profits, i.e. it is possible that *GPRt,(y)* < *PCt(Y),* implying

35 A third possibility is the fire-sale of assets if liquid assets do not suffice, and placing new debt or rolling over debt is not possible. However, this credit or liquidity crunch scenario emerges only if a financial crisis is already in place and is therefore neglected in the further analysis.

that dividends are paid out of current cash flow which reduces the future earning capacity of a business unit and increases the speculative nature of the unit. This kind of dividend policy can mirror unjustifiable optimistic expectations, as well as measures to preserve or to increase the market value of equities.

Banks, other financial institutions, treasuries with floating debt, and business firrns rolling-over bank debt or commercial paper, are typical speculative finance units firstly, as they borrow short-term and invest in long-term projects, and secondly, as they deal very often with floating debt, making them vulnerable to interest rate changes since a business unit that borrows at floating interest rates is engaged in a form of speculative finance even though at current interest rates the unit is classified as a hedge finance unit.

**"Ponzi" Finance.** For a Ponzi finance unit, it holds that

$$GPR\_t^c < PC\_t \tag{2.34}$$

$$GPR\_t^\epsilon \gg PC\_t \tag{2.35}$$

and

$$GPR\_t^c(y) < PC\_t(y) \quad \quad \quad \quad \quad \quad \quad \quad \quad (t = 1, \ldots, n - 1) \tag{2.36}$$
  $GDR\_t^c(y) \approx \quad DC\_t(y)$

$$GPR\_t^\epsilon(y) \gg PC\_t(y) \tag{2.37}$$

stating that in all periods, except in the final period *t* = *n,* expected gross profits are lower than payment commitments, and interest rate costs exceed the net income part of cash flows. Consequently, in order to meet payment commitments in periods *t* = l to *t* = *n* - l, a Ponzi finance unit has to increase its debt stock and to decrease liquidity steadily. Hence, a Ponzi financing scheme is, as a speculative financing scheme, built on the assumption of a "normal" functioning of financial markets, i.e. that debt to meet payment commitments can be placed frictionlessly at required dates and at "normal" financing conditions.

The expected present value *E* of Ponzi units is much more sensitive to interest rate and risk premia changes, as well as to disruptions in product and labour markets, than the present value of speculative finance units, implying that present value reversals can happen very fast if there are only slight interest rate and/or risk premia increases, or only small deteriorations in product and factor markets. Moreover, Ponzi units are vulnerable to changes in market sentiment regarding expected gross profits in the final period *t* = *n,*  since the viability of a Ponzi unit depends on positive expectations regarding to an event far in the future. Only slight reassessments towards a more pessimistic outcome can lead to refusals to obtain liquidity by placing new debt, leading very quickly to bankruptcy and to a stop of the investment project. In contrast to speculative finance units, Ponzi finance units cannot increase their net worth and liquidity in the long run even if gross profit expectations are validated, i.e. even if it holds that *C P* ~ = *C P Rt,* as interest rate costs always exceed the net income part of cash flow except in the final period, implying that a Ponzi finance unit is subject to a steady decrease of net worth. Consequently, a Ponzi finance unit is exposed to much greater risk of illiquidity and insolvency than hedge and speculative finance units. In case of default, debt restructuring including refinancing and recapitalization is often used as an instrument to transform Ponzi units into speculative units and speculative units into hedge units.

Though Ponzi-investment projects can be tinged with fraud, there are lots of legal Ponzi finance schemes, generally emerging in case of investment projects with long construction periods, as e.g. investments in real estate or in high technology production. During the construction period, investors generally receive almost no cash income and have to finance current labour, material and interest rate costs by placing new debt. Furthermore, there is uncertainty about the development of costs, as well as about whether the completed investment project can be sold at a reasonable price or whether the project validates gross profit expectations. Thus, the investment project is only profitable if costs do not rise over expected levels, and if the sum of expected gross profits is higher than the sum of payment commitments. Likewise, Ponzi schemes also emerge in case of risky investments in real or financial assets when the costs of holding assets are higher than their general net income (dividends or returns), implying that overall returns are only positive in case asset prices appreciate substantially in the future to expected levels. 36

**Adverse Shocks and Financial Posture "Downgrading".** It has to be emphasized that the classification of hedge, speculative and Ponzi finance units does not only depend on the cash flow position of business units, but also on the size, and on the type of adverse shocks. Thus, adverse shocks are able to transform e.g. a hedge finance unit into a Ponzi finance unit, implying a "downgrading" of liquidity and solvency positions.

Hedge finance units can be only downgraded to speculative and to Ponzi finance units in case of large adverse shocks in product or factor markets, but not by adverse shocks in financial markets. The trigger for the downgrading of a hedge finance unit has to take place somewhere else in the economy and is not caused by the behaviour of hedge finance units. However, this statement is only valid if hedge finance units' activities were not based upon unrealistic, euphoric expectations with respect *to* input costs and market development over time. Accordingly, the fragility of a hedge unit, measured as the probability to become a speculative or a Ponzi unit, can also stem from euphoric expectations with respect to factor and product markets. Speculative units can be downgraded to Ponzi finance units both by adverse shocks in the real and in the financial sector, i.e. by increases in factor costs, increases in interest rates and in risk premia. Ponzi finance units can be only downgraded *to* bankrupt finance units by both adverse real and financial sector shocks. Generally, the size of shocks being necessary to downgrade a business unit *to* the next lower financial posture decreases due to an increasing probability to become illiquid and insolvent for a given set of shocks.

36Investments in "New Economy" shares during the late 1990s are a typical example of Ponzi financing schemes. During the stock market hype in the late 1990s, high market prices of "New Economy" shares could not be justified by their performance, as cash flows were low or even negative for the near-term periods, and dividends were often not paid, so that holding the asset was not profitable in the nearterm. However, investors expected an appreciation of "New Economy" share prices in the future which would have made an investment profitable. But when "New Economy" firms failed to validate investor expectations by actual cash flows and profits, profit expectations collapsed, and led to a worldwide stock market crash and to widespread bankruptcies among "New Economy" firms. A further example is the boom-bust cycle in stock markets during the 1920s having led to the Great Depression, which is a very nice equivalent to the incidents in the late 1990s.

#### **<IP_ADDRESS> Financial Instability in Closed Economies**

**The Weight of Hedge Finance Units in the Financial Structure** of **an Economy.**  Following the analysis of hedge, speculative and Ponzi finance units, a financial system is stable if adverse disturbances in product and factor markets, as well as increases in interest rates and risk premia, implying a decline in capitalization rates *k;,* do not appreciably affect the ability of economic entities to fulfill their financial obligations. By way of contrast, in an unstable or fragile financial system, the same disturbances in financial, product and factor markets can affect adversely the ability of business units to fulfill their payment commitments. Ergo, the overall instability of financial systems increases if the ratio of speculative and Ponzi to hedge finance units increases. Furthermore, if there is an increase in the ratio of Ponzi finance to speculative finance and hedge finance units, the already prevailing fragility of the financial structure deteriorates further and is in danger to evolve into a cumulative downward spiral being associated with debt deflation processes.

**Industry Structure and Economic Development as a Determinant of the Weight**  of Hedge Finance Units in the Financial Structure. The weight of hedge finance units in relation to speculative and Ponzi finance units is not only dependent on profitmaximizing decisions of agents with regard to the optimal liability structure, but also on the kind of industry structure and economic development.

Labour-intensive industry structures without high-tech machinery, being prevalent in low developed countries, are characterized by simple and cheap capital assets whose gestation period is short. A large fraction of external financing relates to financing of goods in commerce. In such systems debt repayment is closely linked to the income generation process because there are no sophisticated long-living investment goods with long construction periods which have to be financed by short-term debt. Hence, in such systems the fraction of speculative and Ponzi units in relation to hedge units is very small.

On the contrary, both in highly industrialized and in emerging market countries, the industry structure is characterized by capital-intensive production with high-tech machinery, implying that capital assets are long-living, complicated and expensive, and that gestation periods of investment goods are very long. In such systems, short-period cash flows yield a gross profit which is only very small in relation to the value of the capital assets. Unless financing is organized in long-term contracts, such economies are not able to generate sufficient cash flow to fulfill payment obligations in early periods of production without the use of short-term debt. As a result, the "normal" way of finance is to combine income cash flows from general operation with portfolio transactions by placing new shortterm debt, or by rolling over debt. Thus, high developed or emerging market economies, using highly sophisticated capital assets, generally tend to have a higher fraction of speculative and Ponzi finance units than less industrialized countries, which can be seen by the fact that the size of the financial system is much smaller in less developed countries than in high developed or emerging market countries. Thus, high developed and emerging countries have a much more unstable financial structure than low developed countries.

These results have two important implications for economic development policies. Firstly, economic development or growth requires a strong development of the domestic financial sector to transform the industry structure from labour-intensive production with low productivity to capital-intensive production with high productivity. This result

implies that domestic and/or international financial market liberalization is a favourable method to boost productivity and to reduce poverty in low developed countries. Secondly, the transition process towards capital-intensive production with a strong domestic financial sector is associated with an increase in financial instability making transition economies more vulnerable to financial crises. Consequently, financial market liberalization leads to an increase in financial instability and in the frequency of financial crises, which can be validated by the stylized facts being outlined in chapter 3. Summing up, financial liberalization is necessary for economic development but requires strong financial market regulation to prevent the overall financial structure from becoming too fragile.

The Size of Different Economic Sectors as a Determinant of the Weight of Hedge Finance Units in the Financial Structure. A further determinant of the weight of hedge finance units in relation to speculative and Ponzi finance units is the size of different economic sectors, as e.g. the firm, the household or the banking sector, in the total financial structure, as well as the composition of their income streams and payment commitments.

*Financial intermediaries* are generally, as aforementioned, speculative finance units as they transform by their very nature short-term debt (deposits) in long-term assets (loans), implying that the ability to fulfill near-term payment obligations (e.g. deposit withdrawals) requires a "normal" functioning of financial markets in order to place new debt, or to roll over debt at "normal" financing conditions. Moreover, as financial intermediaries' gross profits predominantly depend on the liquidity and the solvency status of business firms and households, financial intermediaries also depend on a frictionless functioning of product and factor markets.

*Business firms* can take all three financial postures, where the fraction of speculative and Ponzi finance units increases with the capital/labour ratio, so that the firm sector in industrialized, as well as in emerging market countries is dominated by speculative and Ponzi finance units. Hence, business firms depend on the frictionless functioning of product and factor markets to generate sufficient income streams, as well as on the "normal" functioning of financial markets to prevent an increase in financing costs.

*Households'* financial posture can be subdivided in two broad categories, namely in households' financial posture of consumption, and in households' financial posture of asset ownership. Households' financial posture of consumption, referring to households' consumption expenditures (housing included), is dominated by hedge finance units as debt contracts for consumption and mortgage finance are generally designed as fully amortized contracts, i.e. as series of (constant) payment commitments which are defined over the entire term of the debt contract, excluding a final extra repayment of a remaining part of the principal.37 Ergo, as households' income streams mainly consist of wage income, households can only become speculative or Ponzi finance units if actual wage income falls short of expected wage income and other sources of disposable income, like e.g. unemployment insurance. Regarding mortgage debt, households can additionally get into liquidity and solvency problems in case the market value of the hypothecated asset falls short of the face value of outstanding debt as already discussed in section 2.2.4. However,

37 A partially amortized contract includes a final payment at the end of the contract's lifetime which contains a part of the principal. An unamortized contract involves repayment of the entire principal at the end of the contract's lifetime. For this classification, see Minsky (1982b), p. 30.

a "downgrading" of households, or even a failure of households, can only occur if there has taken place a substantial decline in income and employment, i.e. consumer debt can amplify an economic downturn and a route to financial crises, as outlined in section <IP_ADDRESS>, but it does not generate financial instability. Furthermore, financial market tightening by increasing interest rates and risk premia has no influence on financial stability of households' consumption financial posture.

By way of contrast, households' financial posture of asset ownership, referring to households' investment activities into financial assets, can generate financial instability as it is dominated by speculative and Ponzi finance. Households often engage, and especially during speculative boom phases, in debt finance of securities, as e.g. equities, options, or bonds. As income streams consist mainly of dividends or interest payments, which in most cases do not suffice to meet due payment commitments of debt contracts, and as the profitability of investment projects depends heavily on selling out the position at an appreciated price, households' portfolio is speculative if the interest rate on debt is lower than the portfolio's internal rate of return (e.g. the dividend/price ratio), and Ponzi, if the interest rate on debt is higher than than the portfolio's internal rate. Consequently, as income streams and payment commitments of households' asset ownership depend mainly on financial market conditions, increases in interest rates, as well as in risk premia can lead very quickly to a move from speculative to Ponzi finance or even to bankruptcy. However, since asset prices are also determined by income streams from product and factor markets, households can be downgraded additionally by adverse disturbances in the real sphere of the economy.

*Governments* are very often speculative finance units as income streams generally consist of tax revenues and new borrowing, i.e. government expenditures depend crucially on the ability to roll over short-term debt. As long as the sum of expected income streams exceeds the sum of future payment commitments on debts outstanding, there arise no liquidity and solvency problems for governments. However, if expected tax revenues fall short of payment commitments, e.g. due to an economic downturn, or if current running expenses increase, e.g. owing to a general interest rate increase, governments can become very quickly Ponzi units or even bankrupt since rolling over debt can become impossible. Generally, governments' incentives to engage in speculative or Ponzi finance are not aimed at generating financial instability wilfully. However, there are often distorting incentives which lead governments to engage in "unsound" fiscal policies by increasing short-term debt. Especially governments engaging in large floating short-term debt run the risk of becoming Ponzi or even bankrupt.

Summing up, financial instability increases in case of growing financial intermediation, in case of a growing government sector and increasing government expenditures, in case of a growing capital/labour ratio, and in case of growing investments of households in financial assets. Accordingly, financial stability depends heavily on the relative size of households' financial posture of consumption.

#### **<IP_ADDRESS> Foreign Hedge, Foreign Speculative, and Foreign Ponzi Finance**

Minsky's original concept of hedge, speculative and Ponzi finance can be only applied to closed economies as it refers solely to money flows in domestic currency, as well as solely to domestic product, factor and financial market conditions. Financial crises in the 1990s however demonstrated, that systemic financial crises, both in emerging market and in industrialized countries, were influenced by asset and debt positions in foreign currency. Consequently, in order to get a correct measure of overall financial instability in open economies, cash flow positions resulting from transactions in foreign currency have to be considered explicitly. In order to be consistent with the degree of internal financial fragility, having been discussed in the two previous sections, this section enlarges Minsky's original concept by explicitly considering cash flow positions in foreign currency.

However, the classification of business units in hedge, speculative, and Ponzi units by taking into account cash flows in foreign currency is not as easy as Minsky's original concept for closed economies. For example, cash flow positions in domestic currency can be used to compensate cash flow positions in foreign currency and vice versa, making it very difficult to assess a business unit's financial posture. Moreover, cash flow positions in foreign currency can involve payment commitments in foreign currency, but income streams in domestic currency which have to be exchanged in the foreign exchange market to pay debt, exposing the business unit additionally to currency risk. Accordingly, to get a useful measure for financial instability, internal fragility, stemming from cash flow positions in domestic currency, i.e. from the distribution of hedge, speculative and Ponzi finance as defined in section <IP_ADDRESS>, has to be separated from external fragility stemming from cash flow positions in foreign currency. To distinguish internal from external financial instability, external cash flow positions are labelled analogously to Minsky's original terminology as foreign hedge, foreign speculative, and foreign Ponzi finance. After having discussed the determinants of external financial fragility, section <IP_ADDRESS> is going to combine internal and external financial fragility to determine the overall degree of financial fragility of single units and of an entire economies.

**Basic Concepts.** The analysis of external cash flow positions follows the terminology and the basic concepts of section <IP_ADDRESS>. The first step to determine the external cash flow position from the overall cash flow position of a business unit is to separate total payment commitments into "external" payment commitments in foreign currency, and into payment commitments in domestic currency. The second step is to single out "external" expected gross profits which are used to fulfill external payment commitments in foreign currency from total expected gross profits; it has to be emphasized, that external expected gross profits being used to pay foreign debt can be denominated both in domestic and in foreign currency. Then, in the third and last step, external expected gross profits, which are used to fulfill external payment commitments in foreign currency, and external payment obligations in foreign currency have to be compared, determining the external cash flow position.

In order to account for foreign exchange risk, evolving in case external expected gross profits are denominated partly, or entirely in domestic currency, the external cash flow position has to be separated further in external cash flow positions containing only money flows in foreign currency, and in external cash flow positions containing money flows in domestic currency as well which have to be exchanged in the foreign exchange market to fulfill external payment commitments.

In case all expected gross profits are denominated in foreign currency, and assuming that in this case income streams only result from transactions with foreigners, the external cash flow position consists only of money flows in foreign currency, implying that only foreign product, factor and financial market conditions are relevant for possible changes

in the external financial posture. Accordingly, the external expected present value of a business unit *E\** in foreign currency, being formally defined as

$$E^\bullet = \sum\_{t=1}^n k\_t^\bullet (GPR\_t^{\bullet \epsilon} - PC\_t^\bullet),\tag{2.38}$$

is determined by discounting external expected gross profits *GP R;•* less external payment commitments *PC;,* where the external discount factor *k;* only consists of foreign interest rates and risk premia as financing costs need not to be "earned" in domestic currency.

By way of contrast, in case external expected gross profits contain at least partly income streams which are denominated in domestic currency, and assuming that these income streams only stem from transactions with domestic residents, the external cash flow position is additionally exposed to currency risk, implying that foreign product, factor, and financial market conditions, as well as domestic product and factor market conditions38 are relevant for possible changes in the business unit's financial posture. Thus, in this case, the external discount rate *ki* consists of foreign interest rates and risk premia, as well as of the expected rate of change of the exchange rate, as financing costs have to be "earned" in domestic currency, being subject to foreign exchange risk.

**Foreign Hedge Finance.** A prerequisite for a business unit to be classified as a foreign hedge finance unit, is that the external cash flow position has to be denominated in foreign currency in each period, i.e. external expected gross profits have to be denominated completely in foreign currency, implying that there arises no currency risk. Given that all net money flows are denominated in foreign currency, a foreign hedge finance unit's external expected gross profits exceed in all periods external payment commitments. Accordingly, a foreign hedge finance unit can be only downgraded, and external present value reversals can only happen in case of adverse shocks in foreign product and factor markets, as e.g. a decline in foreign GDP, or an adverse terms of trade shocks reducing domestic net exports. Foreign financial market disturbances cannot lead to downgrading or to external present value reversals.

On the contrary, a unit whose external expected gross profits exceed external payment commitments for all periods, but whose external expected gross profits are partly or entirely denominated in domestic currency, *cannot* be classified as a foreign hedge finance unit. Rather, such a unit engages in a form of speculative, or even Ponzi finance, due to considerable exchange rate risk, as devaluations of the home currency can lead very quickly to an external present value reversal, even in case of fixed exchange rates, since exchange rates are not invariable in the long-run.

38Business units are assumed not to depend on domestic financial market conditions because changes in domestic interest rates, as well as in domestic risk premia do not change payment commitments in foreign currency. It has to be emphasized however, that domestic financial market conditions do have an influence on a business unit's net worth via the impact on the external discount factor *k;* in case external expected gross profits are partly or entirely denominated in domestic currency, and in case these gross profits are "earned" at home. In this case, the external discount factor should be weighted average of domestic and foreign financial market conditions including currency risk, where the weighting factor of domestic financial conditions should be determined by the proportion of external expected gross profits in domestic currency to total payment commitments in foreign currency. Yet, for reasons of simplicity, the influence of domestic financial market conditions on the external discount factor is neglected in the following.

**Foreign Speculative and Foreign Super Speculative Finance. A** *foreign speculative finance unit* is defined by four characteristics. Firstly, ca.sh flow positions in all periods are denominated in foreign currency, implying that there arises no currency risk. Secondly, external payment commitments in early periods exceed external expected gross profits. Thirdly, in later periods, external expected gross profits exceed external payment commitments. Fourthly, in early periods interest payments on foreign debt are smaller than the net income part of external ca.sh flow. Accordingly, a foreign speculative finance unit is dependent on the "normal" functioning of foreign financial markets in order to place foreign short-term debt, or to roll-over foreign debt at "normal" foreign financing conditions. Such a unit is vulnerable to adverse shocks in foreign product, factor and financial markets.

A *foreign super speculative finance unit* is defined by the same characteristics as a foreign speculative finance unit except for the fact that external expected gross profits are partly or entirely denominated in domestic currency, exposing the unit additionally to currency risk, and to adverse disturbances in domestic product and factor markets.

**Foreign Ponzi and Foreign Super Ponzi Finance.** A *foreign Ponzi finance unit* is defined by the following four characteristics. Firstly, ca.sh flow positions in all periods are denominated in foreign currency. Secondly, in all periods except for the final period, external expected gross profits fall short of external payment commitments. Thirdly, only in the final period external expected gross profits exceed external payment commitments. Fourthly, in all periods except for the final period, interest rate costs on foreign debt exceed the net income part of external ca.sh flow. As a result, a foreign Ponzi finance unit has to increase its foreign debt stock steadily and is dependent on a normal functioning of foreign financial markets to place steadily new foreign short-term debt, and to roll-over debt at "normal" foreign financing conditions. A foreign Ponzi finance unit is vulnerable to adverse disturbances in foreign product, factor, and financial markets.

A *foreign super Ponzi finance* is defined by the same characteristics as a foreign Ponzi finance except for the fact, that external expected gross profits are partly or entirely denominated in domestic currency, making the business unit additionally vulnerable to devaluations of the home currency and to adverse disturbances in domestic product and factor markets.

#### **<IP_ADDRESS> Financial Instability in Open Economies**

This section studies in a first step determinants of external financial fragility according to the classification of the previous chapter, and enlarges in a second step the concept of internal financial fragility to an open economy context in order to combine finally both results to derive determinants of overall financial instability in open economies.

**Determinants of External Financial Instability.** Like internal financial instability, external financial instability increases if the ratio of foreign hedge finance units to all other external financial postures decreases, where the weight of foreign hedge finance units in the aggregate external position depends heavily on the stage of development of an economy.

*Low developed countries* with a low capital/labour ratio, low productivity, and an underdeveloped and often financially repressed39 domestic financial system, tend to have almost no foreign debt as well as no income streams in foreign currency due to three reasons. Firstly domestic financial market regulation often prohibits to get into foreign debt. Secondly, foreign investors are not willing to invest in countries and industries with low productivity and low yields, and thirdly, low productivity implies low export performance and thereby low income streams in foreign currency. Consequently, as there arise almost no transactions in foreign currency, external financial instability in low developed countries is low.

*High developed countries,* being characterized by a high capital/labour ratio, average productivity, and well-developed domestic financial systems, tends to exhibit generally also a low degree of external financial instability, as the aggregate external cash flow position is dominated by foreign hedge finance units. An overall foreign hedge finance position develops from a low share of foreign debt in total debt, and from external income streams which are mostly denominated in domestic currency, or in foreign currencies with low exchange rate risk. 40

*Emerging market or transition economies* are generally subject to a high degree of external financial fragility as the aggregate external cash flow position is dominated by foreign (super) speculative and foreign (super) Ponzi finance units. Emerging market or transition economies are subject to a very fast increasing capital/labour ratio, and to huge productivity increases. Yet, the increase in highly sophisticated capital assets with long gestation periods cannot be financed entirely by the domestic financial system, firstly as domestic savings are very often too low, and secondly, as emerging market and transition economies cannot issue domestic debt due to the "original sin" hypothesis41 , stating that due to past misbehaviour there is no possibility to borrow in domestic currency, leading to high share of debt denominated in foreign currency. Accordingly, emerging market and transition economies very often engage in heavy short-term foreign borrowing, where income streams are very often earned at home in domestic currency making them extremely vulnerable to foreign exchange risk.

A further determinant of the weight of foreign hedge finance units in the aggregate external finance position is the relative size of different economic sectors, as already outlined in section <IP_ADDRESS> for the case of internal financial instability. As external financial instability appears predominantly in emerging market and transition economies, the following description concentrates exclusively on external financial postures of different sectors in emerging market and transition economies.

39 Accoring to McKinnon (1973), Shaw (1973), and Williamson and Mahar (1998}, a financially repressed system is defined as a system in which government regulations determine the amount, the price, and the distribution of credit. These regulations are often reinforced by state-owned banks, by licensing and regulating private financial institutions with respect to their general management, and by controlling international capital movements.

40It has to be emphasized that there are exceptions, especially in the case of small high developed countries with a high degree of openness. For example, Norway, Sweden, and Finland borrowed heavily in foreign currency after domestic financial sector liberalization in the late 1980s, which caused high external financial instability and evolved into systemic financial crises in all three countries at the beginning of the 1990s.

41See e.g. Eichengreen and Hausmann (1999}, and Velasco (2001}.

*Banks and financial intermediaries* in emerging market and transition economies play a dominant role for domestic finance as information asymmetries do not allow business firms or households to take foreign debt directly abroad, implying that foreign funds are generally allocated via the domestic financial sector. Hence, financial intermediaries in emerging market and transition economies are generally foreign super speculative, or even foreign super Ponzi units (as well as domestic speculative finance units), as they transform domestic short-term debt (deposits in domestic currency) and foreign shortterm debt ( deposits or short-term loans in foreign currency) with floating interest rates, in long-term assets which are denominated in domestic currency (long-term domestic loans). This financial posture implies that the financial sector in emerging and transition economies is subject to high financial instability as it is vulnerable to disturbances in domestic and foreign product, factor and financial markets, as well as to disturbances in foreign exchange markets.

*Business firms* in emerging market and transition economies are generally subject to low external financial fragility as they are not able to borrow in foreign currency as mentioned above. It must be noted however, that very large business firms, or even conglomerates with international creditworthiness can take foreign debt, and very often engage in foreign short-term borrowing to finance domestic long-term assets generating predominantly income streams in domestic currency. Accordingly, if the industry structure is dominated by such conglomerates, the business firm sector contributes considerably to the emergence of external financial stability, as the external finance position is dominated by foreign super speculative and foreign super Ponzi units.

*Households* in emerging market and transition economies exhibit in general no external financial instability as they cannot engage in foreign debt finance, firstly, due to lacking creditworthiness, and secondly, due to lacking wealth.

*Governments* in emerging market and transition economies very often engage in heavy foreign short-term borrowing at flexible interest rates to finance domestic government expenditures as domestic tax revenues are not sufficient. As tax revenues are denominated in domestic currency, governments in emerging market and transition economies are in most cases foreign super speculative, or even foreign super Ponzi units. Accordingly, governments are highly vulnerable to disturbances in domestic and foreign product, factor, and financial markets, as well as to disturbances in foreign exchange markets.42 It has to be emphasized however, that "unsound" external fiscal policies, which prevailed in the late 1970s and 1980s, have reduced enormously as international financial market liberalization has imposed fiscal discipline on governments.43

Summing up, external financial fragility in emerging market and transition economies increases with growing capital inflows which are allocated by the domestic financial system, as well as with increasing government expenditures which are financed by increasing short-term foreign debt.

42For example, Argentina's latest government debt default, as well as the international debt crisis in the 1980s were predominantly caused by external financial fragility which stemmed from heavy foreign short-term borrowing at flexible interest rates, having led to bankruptcy after international interest rates rose considerably and tax revenues dropped due to domestic recessions. 43For example, government policies in East Asia before the Asian crisis in 1997 /1998 were sound and

not subject to large amounts of short-term foreign debt.

Internal Financial Instability Revisited. To assess the overall degree of financial instability in open economies, the degree of internal financial stability, having been discussed in section <IP_ADDRESS>, has to be modified to fit into an open economy context, *as* the degree of internal financial stability does not depend solely on domestic disturbances due to current account and capital account transactions. Regarding current account transactions, an initially internal financially stable economy with no external financial instability can be downgraded, e.g. by a drop in foreign GDP, or by a terms of trade shock reducing domestic net exports and thereby domestic expected gross profits which are used to pay back domestic debt. Regarding capital account transactions, in fully liberalized domestic and international capital markets interest parity can be assumed to hold, implying that an economy with no external financial instability, but with a low share of domestic hedge finance units, can be downgraded by a foreign interest rate increase, or by an expected devaluation of the home currency leading to rising domestic payment commitments.

Summing up, in *case* an economy is characterized by internal financial stability, and exhibits no external financial instability, disturbances in foreign product and factor markets can induce an increase in internal financial fragility, whereas foreign financial market disturbances do not have any considerable effects. In *case* an economy is characterized by no external, but by internal financial instability, disturbances in foreign product and factor markets, *as* well *as* disturbances in foreign financial markets can induce an increase in internal financial fragility.

**Overall Financial Instability in Open Economies.** Financial instability in open economies increases if internal financial instability increases and/or if external financial fragility increases. That is, overall financial instability increases if the ratio of hedge finance units to speculative and Ponzi finance units decreases, and/or if the ratio of foreign hedge finance units to foreign (super) speculative and foreign (super) Ponzi units decreases. Consequently, emerging market and transition economies are much more fragile than industrial or low developed economies, in *case* their domestic financial system *as* well *as* the capital account are liberalized, *as* they are additionally subject to high external fragility.

### **2.3.3 Adequacy of Refinancing Possibilities**

This section refers to the analysis of internal and external cash flow positions of the previous section, and discusses how a systemic financial crisis can be prevented in *case* an economy is hit by large adverse domestic and/or foreign shocks, normally causing widespread bankruptcies and real economic downturns. The following analysis distinguishes among refinancing possibilities in domestic and in foreign currency, where domestic currency refinancing possibilities determine the degree of internal financial instability, and foreign currency refinancing possibilities determine the degree of external financial fragility. 44

**The Adequacy of Refinancing Possibilities in Domestic Currency.** Large adverse disturbances in domestic and/or foreign product, factor and financial markets normally cause systemic financial crises by inducing an enormous downgrading of hedge finance units, and widespread bankruptcies among speculative and Ponzi finance units, *as*

44The analysis of domestic refinancing possibilities is based on Minsky (1972) and (1986), chapter 3.

payment commitments cannot be fulfilled any longer. However, large adverse shocks need not induce systemic financial crises if there exist possibilities for troubled business units to receive sufficient "emergency" liquidity to bridge short-run liquidity gaps. Thus, financial stability also depends crucially on the availability of refinancing resources providing sufficient short-term liquidity.

A troubled business unit whose income streams from normal operation do not suffice to fulfill payment obligations, generally has three possibilities to obtain short-term liquidity in order to prevent bankruptcy. Firstly, placing new debt or rolling over debt, secondly, running down liquid monetary assets, and thirdly, a fire-sale of financial and/ or real assets.

The ability of households, business firms and governments to *place new debt* and/or to *run down liquid monetary assets* (as e.g. deposits) generally depends on the liquidity status of the financial sector. However, a liquidity crunch among households, firms and the government generally passes to a liquidity crisis of the financial sector due to large deposit withdrawals, and due to a maximum degree of lending, e.g. by an exhaustion of credit lines up to the maximum. That is, a private and government sector liquidity crisis evolving into a financial sector liquidity crisis as defined by condition 2.9 in section <IP_ADDRESS>, passing over definitely into a systemic financial crisis, can be only prevented by an extraordinary provision of central bank credit. 45 Hence, financial instability decreases in case there are effective lender-of-last-resort interventions by central banks.

A widespread *fire-sale of assets* only generates sufficient liquidity by sales revenues in case the relevant *secondary* asset markets are independent of system behaviour. Otherwise, a widespread fire-sale of financial or real assets by households, firms, and banks causes an enormous drop in assets' market prices, causing insolvency and deteriorating liquidity problems as sales revenues drop sharply. Consequently, financial instability increases if the ratio of the value of those assets whose market value is independent of system behaviour to the value of assets which reflect system behaviour decreases. For an asset to be independent of system behaviour, the secondary market for the asset firstly, has to be pegged or rather protected, secondly, has to be very large and deep in order not to result in large price fluctuation if demand and supply conditions change rapidly, and thirdly, must not depend on overall financial conditions. For a secondary market to work effectively and to contribute to financial stability, an asset has to be transformed at any time into cash without a loss of its market value, which requires a set of position takers who buy significant amounts of assets for their own account, and who sell large amounts of assets out of their stock. Position takers in secondary markets in general finance their transactions by borrowing from financial intermediaries, which however does not prevent the occurrence of a systemic liquidity crisis as described above; in case of a widespread fire-sale, the position taker has to increase its bank debt to sell a large amount of assets he generally does not own. Consequently, a position taker contributing to financial stability must have additional sources of emergency or standby liquidity. However, the only source of finance which is truly independent of system behaviour is liquidity support by the central bank. Therefore, financial stability can be considerably increased in case position takers have unlimited access to central bank credit. Furthermore, financial stability can be increased if the central bank takes over the position taker function by itself to

45If central banks are not independent, a liquidity crisis of the government sector need not lead to a liquidity crisis of the financial sector. In this case, the government uses central bank reserves directly to pay outstanding debt which can lead to inflation and, in extreme cases, to hyperinflation.

stabilize assets' market prices, as e.g. the market price for Treasury bills, in case of large fluctuations in demand and supply conditions.

**The Adequacy of Refinancing Possibilities in Foreign Currency.** Troubled business units which cannot fulfill payment commitments in foreign currency, generally have three options to prevent bankruptcy. Firstly, a unit can engage in all activities described above to obtain liquidity in domestic currency and to sale revenues in the foreign exchange market. However, this strategy is subject to foreign exchange risk, as a large and sudden increase in demand for foreign currency leads either to a sharp devaluation of the home currency in case of flexible exchange rates, or to a large depletion of central bank foreign reserves in case of a fixed exchange rate system which can possibly lead to a suspension of the peg (and to a devaluation of the home currency) in case foreign reserves are not sufficient. Consequently, external financial instability is negatively dependent on the stock of central bank foreign reserves, and increases in case the foreign exchange market is highly volatile in case of sudden changes in demand and supply conditions.

Secondly, in case the business unit possesses foreign assets, the unit can sell these assets in a fire-sale action in foreign financial markets. This action is not subject to exchange rate risk, but depends on the liquidity of foreign financial markets. Consequently, external financial instability increases if the share of the market value of foreign assets which are independent of foreign system behaviour decreases.

Thirdly, the business unit can increase foreign debt, depending on the liquidity status of foreign financial intermediaries. That is, external financial instability decreases if there are effective lender-of-last-resort interventions by foreign central banks.

#### **2.3.4 Excess Volatility in Asset Prices**

This section studies the impact of asset price fluctuations on financial stability by asset prices' influence on long-run debt-asset ratios, as well as on long-run cash flow positions. Furthermore, this section analyzes the impact of asset price and debt-asset ratio swings on real economic activity, causing excessive and expectations-led boom-bust cycles **in** goods and in financial markets, and possibly giving rise to systemic financial crises during the bust phase.

**A General Definition of Excess Volatility.** Asset prices are subject to fluctuations if there is a change in asset prices' determinants. Using a simplified version of equation 2.3, an asset's market price *PA* is given formally by

$$P\_A = \frac{CF^\bullet}{i\_r} = \frac{CF\_r^\bullet}{i - \hat{p}^\bullet},\tag{2.39}$$

that is, by expected nominal cash flows *CF'* which are discounted by a real risk-adjusted interest rate *ir* representing real finance costs. Expected nominal cash flows are defined as expected real cash flows *CF;* valued at the expected price level *P',* i.e. as *CF•= CF; P•,*  whereas the real interest rate is defined as the difference between the risk-adjusted nominal interest rate *i* and the price level's *P* expected growth rate *p•* = *P•* / *P,* i.e. as *ir* = *i* - *p•.*

In order to distinguish asset price volatility stemming from (expected or unexpected) price level effects, which are going to be discussed in section 2.3.5, from asset price volatility stemming from changes in expected real cash flows and from changes in nominal interest rates, it is assumed in the following, that there is no change in the actual and in the expected price level, implying that *P, p•* and *p•* remain constant. Accordingly, volatility in asset prices can be caused only by changes in expected real flows *CF:,* and by changes in the nominal risk-adjusted interest rate i.

If expectations are formed according to the rational expectations hypothesis, i.e. if it holds that expected real cash flows are equal to actual real cash flows *CFr* in case exogenous shocks are absent, formally if *CF:* = *CFr,* then a change in asset prices simply reflects changes in economic fundamentals. 46 This kind of asset price volatility, being consistent with actual changes in economic fundamentals, is labelled as *"normal"*  or *"correct" asset price volatility,* as asset price changes indicate correctly fluctuations in economic fundamentals.

By way of contrast, *excess volatility in asset prices* emerges if expectations, and thereby asset prices, fluctuate with a much higher amplitude than changes in economic fundamentals, implying that expectations do mostly not coincide with actual economic fundamentals. By equation 2.39, excess volatility emerges in case changes in expected real cash flows are larger than changes in actual real cash flows in absolute terms, i.e. if it holds that *jdCF:I* > *jdCFrl,* implying that expected real cash flows are usually not equal to actual real cash flows, i.e. formally it usually holds that *CF: =/= CFr.* Consequently, excess volatility in asset prices does not indicate changes in fundamentals correctly, but reflects expected changes in fundamentals which are much larger than actual changes in fundamentals.

**Excess Volatility and Extensive Boom-Bust Cycles in Financial and Goods Markets.** The existence of excess volatility implies that in boom phases, asset prices generally reflect overly optimistic, or even euphoric expectations as to future growth of real cash flows, though actual growth of real cash flows is much lower. Formally, excess volatility in boom phases is defined by *dCF:* > *dCFr* and *CF:* > *CFr,* implying the existence of an *asset price bubble* as an asset's actual market price, i.e. *PA* = *CF•* /i, = *(CF: P•)/(i* - *p•),* is much higher than its fundamental value *PX= CF/ir* = *CF, P/(ip•).* Accordingly, an asset price bubble grows with an increasing difference between market prices and fundamental values, i.e. with a growing difference *PA* - *PX* = *((CF: P•)* - *(CF, P))/(i* - *p•).*

Asset price bubbles generally cause a large acceleration in economic growth, being caused by demand-side, financial accelerator-induced and supply-side induced cumulative upward processes as described in section <IP_ADDRESS>. Largely rising expenditures during excessive boom phases are financed by an increase in indebtedness leading to a significant rise in debt-asset ratios and to fall in net worth, as the actual growth in profits and cash flows is smaller than the growth in expenditures which are based on expected profits and cash flows. If domestic financial markets' capacity does not suffice to meet the increasing demand for credit, economies generally start to take foreign debt. Especially emerging market or transition economies, having very often an underdeveloped domestic financial system as outlined in section <IP_ADDRESS>, depend on foreign financial markets' supply of credit in case of a domestic macroeconomic expansion. But also small industrialized countries,

46For a general description of the rational expectations hypothesis and its impact on formal solutions to general dynamic economic models, see appendix D.

whose domestic financial system cannot meet rising demand for credit often engage in foreign debt finance (as e.g. Norway, Sweden, and Finland in the late 1980s). As costs of taking foreign debt measured in domestic currency terms, as well as default risk, depend crucially on exchange rate risk, the build-up of foreign debt tends to be much higher in fixed and credible exchange rate systems than in flexible ones.

An increasing indebtedness both in domestic and in foreign currency, generally induces a build-up of aggregate financial instability, being outlined in more detail below, because future domestic and/or foreign interest payments, as well as repayment of domestic and/or foreign debt, can be only met in case future actual cash flows or income streams, both in domestic and in foreign currency, rise to expected levels. Consequently, there is a general increase in the risk of becoming illiquid or insolvent, as business units' future liquidity and solvency status depends increasingly on the validation of euphoric expectations by actual cash flows. If actual cash flows do not grow to expected levels, many business units are going to become illiquid or insolvent in the future.

Financial instability passes over into actual financial distress when agents realize that expectations were too optimistic, i.e. when actual income streams fall short of expected levels and of payment commitments, causing widespread illiquidity and insolvency. Business failures of especially highly leveraged business units act as triggering events for a sharp downward revision of expectations inducing a "burst" of the asset price bubble. Formally, the burst of an asset's market price *PA* is induced, according to equation 2.39, by a sharp decline in expected real cash flows *CF;* (and by an increase in the risk-adjusted nominal interest rate i due to increased default risk), as agents realize that actual real cash flows cannot grow up to expected levels in the future, i.e. agents realize that *CFr* « *CF;.*

The burst of asset price bubbles and beginning failures of highly leveraged business units are generally accompanied by a large increase in real domestic and/or foreign interest rates on debt, as well as by large domestic and/or foreign debt withdrawals due to a sharp increase in overall default risk. In case business units are highly indebted in foreign currency, large debt withdrawals cause, in case of fixed exchange rate SYStems, a large reduction in foreign exchange reserves according to results of section <IP_ADDRESS>, which very often causes to a currency crisis, i.e. a large devaluation of the home currency, as foreign exchange reserves do not suffice to meet capital outflows. After a devaluation has taken place, the remaining stock of foreign debt is subject to a large increase domestic currency terms, deteriorating further the liquidity and solvency position of business units. In case of flexible exchange rate systems, large debt withdrawals lead to a devaluation of the home currency, also inducing a rise in the foreign debt stock in domestic currency terms.

Collapsing asset prices, rising interest rates, and increasing failures among business units induce a cumulative downward process according to the mechanisms described in section <IP_ADDRESS>. Bust periods are also subject to excess volatility when asset prices reflect overly pessimistic expectations as to future declines in real cash flows, i.e. if expected declines in real cash flows are larger than actual declines. Formally, excess volatility in bust periods is characterized by *-dCF;* < *-dCFr,* and *CF;* < *CFr.* This "undershooting" of expectations aggravates the downswing more than necessary, as lenders expect default risk to be much higher than actual default risk, leading to higher real interest rates, to much larger drops in asset prices, to much stronger withdrawals of debt, and to much larger devaluations of the home currency, or to much larger declines in foreign exchange reserves, inducing more bankruptcies and a much deeper downswing. Excessive bust periods come to an end when agents realize that expectations had been too pessimistic, and when debt-asset ratios in balance sheets have declined to "sound" levels.

**Excess Volatility, Self-Fulfilling Expectations, and Expectations-Led Cumulative Upward and Downward Processes.** Excessive boom-bust cycles, leading to a build-up of financial instability by "overindebtedness", and possibly causing systemic financial crises, have their roots in *irreducible* uncertainty about the future. If uncertainty is not irreducible, as it is assumed in standard economic theory, rational expectations provide a powerful tool to forecast the future development without error in case exogenous shocks are absent, implying, as aforementioned, that excess volatility cannot arise. In a real-world environment however, uncertainty is not completely irreducible, connoting that expectations cannot be formed solely according to the rational expectations hypothesis. Rather, to assess future developments which are subject to irreducible uncertainty, expectations tend to be formed by reassessing the actual or past development into the future, implying an adaptive or even extrapolative expectation formation scheme which is compatible with excess volatility, as an increasing reliance can lead to a widening gap of expectations and fundamentals. As a result, real-world expectations tend to be subject to a mixed expectation formation scheme which varies over the business cycle, as boom and bust phases, giving rise to excess volatility, tend to be dominated by adaptive and extrapolative expectations, whereas at the turning points, when agents realize that past expectations have been unrealistic, the expectation formation scheme switches quickly from adaptive and extrapolative to a rational expectation formation scheme, i.e. back to economic fundamentals. Hence, the emergence of excess volatility, financial instability, and systemic financial crises depends crucially on different and varying expectation formation schemes over the business cycle. The degree of financial instability and the severity of the subsequent financial crises is determined firstly, by the strength of adaptive and extrapolative expectations during the upswing and the downswing relative to the influence of rational expectations, determining also the length of the expansion and the contraction phase, and secondly, by the velocity with which "unrealistic" adaptive and extrapolative expectations are transformed into a rational expectation formation scheme, determining the amplitude of asset price swings at the turning points.

The existence of excess volatility implies that the upswing and the downswing of extensive boom-bust cycles are mainly driven by cumulative processes in expectations, giving rise to *expectations-led cumulative upward and downward processes* in goods and financial markets, which are much larger in amplitude than standard cumulative processes described in section <IP_ADDRESS>. Expectations-led cumulative upward/downward processes are characterized by a self-reinforcing expectation formation scheme, as a past increase/decrease in expected values leads to a further increase/decrease in expectations. However, expectations-led cumulative upward/downward processes may not be misunderstood in the sense that they are completely detached from the actual development of economic fundamentals. Rather, cumulative upward/downward processes induced by adaptive and extrapolative expectations are generally associated with an actual improvement/ deterioration of fundamentals up to a certain boundary, justifying a further rise/fall in expectations. As a result, expectations during upswings and downswings are *selffulfilling* up to a certain boundary, i.e. optimistic/pessimistic expectations about the

future development generate an actual boom/contraction up to a certain limit by cumulative demand-side and financial accelerator-induced upward/downward processes.

Demand-side cumulative processes, as outlined in section <IP_ADDRESS>, are accelerated by self-fulfilling expectations, as an increase/decrease in expectations causes a rise/drop in asset prices, leading to an improvement/deterioration of demand conditions and to an actual increase/decrease in nominal earnings, cash flows, and net worth, justifying ex post the initial increase/ decrease in expectations. If this process was able to be continued, then this cumulative upward/downward process would be *no* example of excess volatility, but an example of *rational behaviour,* because in this case expectations would simply reflect correctly, and rationally ex ante the actual behaviour of fundamentals in the future, which would validate expectations ex post, and which would justify a further ex ante increase/decrease in expectations. However, the self-fulfilling character of expectations has a "natural limit" both in boom and in bust periods, which is going to be discussed in the following paragraph, implying that from a certain point on, expectations do not longer "predict" correctly future actual developments, but simply become unrealistic as expectations are not longer formed rationally; thus, expectations become increasingly adaptive and extrapolative, implying a widening gap between actual and expected values, i.e. expectations become overly optimistic in boom periods, and overly pessimistic in bust periods.

Financial-accelerator induced cumulative processes, as outlined in section <IP_ADDRESS>, are amplified by self-fulfilling expectations, as self-fulfilling demand-side cumulative upward/downward processes induce an improvment/deterioration of the aggregate cash flow and solvency position, which justifies an increase/decrease in domestic and foreign indebtedness as well as a decrease/increase in domestic and foreign interest rates on debt, leading to a further improvement in cash flows and net worth, and justifying a further increase in indebtedness. A general rise in indebtedness in boom phases would be *no* example of an increase in financial instability caused by excess volatility, but also an example of rational behaviour, if actual income streams would rise to expected levels, because in this case, future cash flows would suffice to meet future interest payments and repayment of debt. The build-up of financial instability is about to begin if rising indebtedness is increasingly based on unrealistic adaptive and extrapolative expectations about future income streams, resulting in widespread bankruptcies in the future, as future payment commitments cannot be met. Likewise, debt withdrawals and increases in interest rates on debt during bust periods would be *no* example of "expectation undershooting" in case default risk was assessed by actual cash flow and net worth positions, and not by expected ones which are overly pessimistic.

Summing up, if there emerges large excess volatility in asset prices, business cycles tend to have a much larger amplitude than business cycles without serious excess volatility. Furthermore, excess volatility and excessive boom-bust cycles are generally associated with a large build-up of financial instability which very often induces systemic financial crises, whereas "tranquil" business cycles without heavy excess volatility tend to exhibit no, or only a slight build-up of financial instability which does not pass over into systemic financial crises. These boom-bust cycles driven by excessive volatility in expectations, and their interaction with the financial accelerator, are going to be discussed and modelled formally in detail in part II of the book, as they are one of the most important determinants of systemic financial crises.

**"Natural" Limits of Self-Fulfilling Expectations and Expectations-Led Cumu**lative Processes. It has been argued that both boom and bust phases are not subject to excess volatility in case expectations are self-fulfilling, i.e. if an increase/decrease in expectations leads to an actual macroeconomic expansion/contraction. If there was no limit to the self-fulfilling nature of expectations, positive economic growth based on rational behaviour could be sustained forever without any increase in financial instability if there were no negative exogenous shocks. However, self-fulfilling expectations are subject to "natural" limits in the real and in the financial sphere of modern capitalist economies which prevent never-ending expansions/contractions by disappointing overly optimistic/pessimistic expectations through an actual deterioration/improvement in cash flow and solvency positions, inducing a downward/upward revision of expectations to actual fundamentals.

In the real sphere of modern capitalist economies there are three main factors preventing a never-ending boom/bust driven by self-fulfilling expectations. Firstly, regarding boom periods, aggregate demand cannot increase unboundedly, as it is limited by maximum production capacity and subject to saturation effects. Respecting bust periods, aggregate demand cannot fall to zero, as there exists a minimum of demand. Secondly, in boom periods, aggregate supply cannot increase limitless due to an upper bound of capacity utilization in a static environment. In a dynamic environment, an increase in production capacity is subject to long gestation periods, implying that output cannot grow as fast as expected output. Regarding bust phases, aggregate supply cannot fall to zero, as there is a minimum of aggregate demand which has to be satisfied, and as a reduction in production capacity is also subject to a long time horizon in comparison with fluctuations in expected output. Thirdly, in boom phases, output cannot be expanded at expected costs as there arise labour and material shortages, connoting an increase in input costs and a deterioration of cash flow and net worth positions. In open economies with fixed exchange rates, rising input costs lead to a deterioration of international competitiveness and to real revaluation of the home currency. In bust phases, a reduction in output leads to lower input costs and to an improvement in international competitiveness, implying an improvement in cash flow and net worth positions.

In the financial sphere of modern capitalist economies there are three factors preventing unbounded expansions/contractions. Firstly, regarding boom periods, rising input costs imply rising actual and/or expected inflation, leading to monetary tightening by central banks. A general increase in interest rates connotes a deterioration of cash flows and net worth positions due to rising payment commitments. In bust periods, lowering input costs causing disinflation lead to monetary expansions and to an improvement in cash flow and net worth positions. Secondly, in boom periods, which are subject to rising debt-asset ratios and rising interest rates, it is possible that there arises a sudden change in overall risk perception by market participants, assessing current indebtedness and cash flow positions as not sustainable. This increase in overall risk perception leads to rising domestic and foreign interest rates on debt due to rising risk premia independently of monetary tightening, to a general tightening of liquidity conditions in domestic and international financial markets, and to rising foreign exchange reserve outflows ( especially in the case of fixed exchange rate systems) implying higher domestic interest rates. In bust periods, being subject to falling debt-asset ratios and lowering interest rates, it is possible that there is a relaxation in overall risk perception by market participants, assessing cur-

rent indebtedness and cash flow positions *as* sustainable. This relaxation in overall risk perception leads to a fall in risk premia, to a decrease in domestic and foreign interest rates on debt independently of monetary policy, to a relaxation in the overall liquidity condition in domestic and international financial markets, and to increasing foreign exchange reserves inflows (especially in *case* of fixed exchange rate systems) implying lower domestic interest rates. Thirdly, in boom periods, deteriorating cash flow and net worth positions of financial institutions, *as* well *as* rising foreign exchange reserves outflows, can cause government authorities to suspend government guarantees in the form of deposit insurance, and bail-out guarantees of troubled banks, *as* well *as* to give up a fixed exchange rate regime, *as* future losses are unavoidable and would lead to an increase in government indebtedness which is not sustainable, e.g. due to rising domestic inflation. A suspension of government guarantees, *as* well *as* a suspension of a fixed exchange rate system causes contingent losses to become actual losses leading to a rise in risk premia, to an increase in interest rates, and to a deterioration of financial markets' liquidity. In bust periods, the existence of government guarantees, *as* well *as* the stability of a fixed exchange rate regime can induce an increase in credibility, leading to lower risk prernia, lower interest rates and to a relaxation of liquidity conditions in financial markets.

Hitherto, the discussion referred only to factors leading to an actual boundedness of cumulative processes driven by self-fulfilling expectations. However, expectations *as* to the factors mentioned above can have the same effect due to their self-fulfilling nature. For example, an increase in expected inflation due to expected rising factor costs leads to an expected increase in interest rates, which can lead to an actual interest rate increase in *case* expected inflation leads to an actual increase in factor costs. Consequently, selffulfilling expansions and contractions are limited by *actual and expected* bounds.

Summing up, excess volatility in expectations and in *asset* prices is caused by agents not considering natural bounds of expectations-led cumulative processes, leading to an adaptive or extrapolative expectation formation scheme, and to a widening gap of expectations and fundamentals. Despite the fact that the limits mentioned above represent no new information for economic agents, *as* they are prevalent during each business cycle, overly optimistic expectations during boom phases generally abstract from the boundaries of expansion, predominantly due to the belief that "natural" limits of *past* business cycles have disappeared, e.g. by the introduction of new technology regimes *(as* e.g. the introduction of new continuous process technologies after World War I having contributed to the stock market bubble in the late 1920s, or the introduction of information and communication technologies having given rise to the "New Economy" bubble during the late 1990s), or by fundamental changes in the order of domestic and international financial markets *(as* e.g. large-scale financial liberalization policies in the post Bretton Woods era). By way of contrast, in bust periods agents generally tend to expectation undershooting *as* overly pessimistic expectations are stronger than the belief in a natural lower limit.

**Excess Volatility and Financial Instability.** It has been argued that financial instability is generally built up during boom phases by excessively rising *asset* prices and sharply increasing debt-asset ratios. However, *as* rising *asset* prices and increasing debt-

asset ratios are a common stylized fact of business cycles' boom periods47 which do not all cause financial fragility and financial crises, an increase in financial instability cannot be simply detected by a rising debt-asset ratio. Rather, whether an increase in the debt-asset ratio indicates a rise in financial instability or not, depends on the question whether the initial increase in indebtedness is sustainable or not.

Generally, an increase in debt-finance is *sustainable* if there is no long-run drop in the aggregate liquidity and in the aggregate solvency position of an economy. Consequently, a sustainable increase in debt finance is accompanied by a constant or increasing longrun cash flow position, by a constant or decreasing long-run debt-asset ratio, implying a constant or increasing long-run net worth position. For an increase in debt-finance to be sustainable, the rise in the sum of long-run profits has to be equal or larger than the increase in indebtedness, which can be seen formally by equations 2.6 and 2.8. It has to be emphasized that a sustainable debt increase can be subject to a decrease in the net worth and in the cash flow position, but only in the *short-run,* stemming e.g. from long gestation periods. Consequently, a sustainable increase in indebtedness requires that expectations as to future income streams, on which the initial increase in debt-finance is based, are going to be validated by the actual development of future income streams, i.e. that the formation of expectations has been rational or realistic.

By way of contrast, an *unsustainable* increase in indebtedness is characterized by a long-run deterioration of the aggregate liquidity and solvency status of an economy, implying possibly widespread illiquidity and insolvency in the long-run. Accordingly, an unsustainable increase in indebtedness is accompanied by a decreasing long-run cash flow position, by an increasing long-run debt-asset ratio, reflecting a decline in the long-run net worth position. For an increase in the debt-asset ratio to be unsustainable, the initial increase in indebtedness has to be larger than the sum of long-run profits by equations 2.6 and 2.8. If the sum of long-run profits is negative, there is a further rise **in** the longrun debt-asset ratio. Furthermore, an unsustainable increase in indebtedness has to be based on unrealistic euphoric expectations as to future income streams which cannot be validated, implying either that the initial increase in indebtedness can be repaid only with deteriorating liquidity and solvency positions, or that the debt increase cannot be repaid as income streams fall short of payment commitments, leading to systemic financial crises.

Summing up, a growing positive divergence between expected and actual real cash flows causes steadily increasing asset prices which reflect a growing divergence between expected and actual economic fundamentals. This growing positive divergence between expected and actual fundamentals induces an increasing degree of financial instability *if*  the steadily rising overall debt-asset ratio is increasingly based on irrational or unrealistic expectations about the future, implying that the increasing debt stock both in domestic and in foreign currency becomes more and more unsustainable. On the contrary, in case expectations are formed rationally, there is *no* increase in financial instability, as increasing short-run indebtedness is sustainable owing to realistic and rational expectations. However, if expectations become more and more irrational, i.e. more and more overly optimistic, a growing degree of financial instability causes an increasing drop **in** asset prices when agents realize that actual income streams fall short of payment commitments. The larger the drop in asset prices, and the larger the impact of widespread bankruptcies on

47For **an** overview of the stylized time patterns of major economic indicators of empirical business cycle analysis, see Moore (1983), chapter 6, and Zarnowitz (1992), pp. 23-28.

real economic activity, the higher is the probability that expectations tend to undershoot, i.e. to be overly pessimistic, which induces a much longer bust period than necessary by high real interest rates, by excessive debt withdrawals, and by collapsing exchange rates, leading to further bankruptcies and to a further decline in real economic activity.

Empirical studies of excess volatility and its impact on financial instability and aggregate economic activity48 conclude that especially stock and real property prices tend to be subject to excess volatility, giving rise to a build-up of financial instability by a significant increase in debt-asset ratios of business firms, households and financial intermediaries. Though bond markets are generally subject to much less volatility than stock and real property prices, bond prices too can exhibit excess volatility if actual or expected changes in macroeconomic fundamentals cause investors to change abruptly their expectations for inflation and real interest rates. Excess volatility in bond prices and in real interest rates can adversely affect real economic activity via the interest rate channel as the volume of investment financed by bonds (and by long-term borrowing) is typically much larger than the volume financed by equities (Crockett 1997).

#### **2.3.5 Monetary Instability and Debt Deflation**

This section studies the impact of price level fluctuations on financial instability by their influence on asset prices and real economic activity via volatility in real interest rates, real borrowing costs, and real debt burdens.

**Price Level Instability, Excess Volatility, Extensive Boom-Bust Cycles and Financial Instability.** According to the "Schwartz" hypothesis, named after A. Schwartz (1981, 1986, 1995, 1997), and according to I. Fisher's (1932, 1933) business cycle theory, price level instability can aggravate, or even cause financial instability by inducing uncertainties and unrealistic expectations of borrowers and lenders about potential real returns of investment projects. The Schwartz hypothesis, as well as I. Fisher's business cycles theory are very similar to the asset price excess volatility hypothesis, having been outlined in the previous section 2.3.4, as they also claim that financial instability and subsequent financial crises are caused by unrealistic and highly volatile expectations of agents inducing excessive boom-bust cycles in goods and financial markets. Both theories differ however with respect to the "driving" variable of the system, as they claim that excessive boom-bust cycles, financial instability and excess volatility in asset prices are not mainly caused by unrealistic expectations as to real cash flows, but by unrealistic expectations as to the price level's growth rate, resulting in unrealistic expectations concerning real interest rates, real borrowing costs, and real returns. 49

The emergence of excess volatility in asset prices by excess volatility in the expected price level and in the price level's expected growth rate can be formally outlined by a modified version of equation 2.3, which corresponds to equation 2.39, determining an

48For studies of the nexus between excess volatility and financial instability, see e.g. Bank for International Settlements (1998), International Monetary Fund (2000, 2003a, 2003b) Bordo and Jeanne (2002), Borio and Lowe (2002). For the empirical nexus of financial stability and economic growth, see e.g. Levine (1997).

49For empirical tests, as well as for a review of the literature on the link between price stability and financial stability, see e.g. Bordo and Wheelock (1998), Bordo, Dueker and Wheelock (2000, 2001a).

asset's market price *PA as*

$$P\_A = \frac{CF\_r^\bullet \, P^\bullet}{i - \hat{p}^\bullet},\tag{2.40}$$

that is, *as* the discounted present value of expected nominal cash flows, where *p•* denotes the expected price level, *CF;* expected real cash flows, *CF•* = *CF; p•* expected nominal cash flows, i the nominal risk-adjusted interest rate, *p•* = *P•* / *P* the price level's expected growth rate, and i - *p•* the expected risk-adjusted real interest rate.

In order to study the emergence of excess volatility in asset prices due to excess volatility in expected future prices, it is assumed in the following that expected real cash flows *CF;* are constant, implying that volatility in asset prices is caused by fluctuations in the expected price level, in the price level's expected growth rate, and in the nominal interest rate. Consequently, excess volatility emerges in case price expectations are subject to larger fluctuations than the actual price level, implying that price expectations are not formed rationally. Formally, excess volatility emerges if ldP•I > Id Pl and ldfi•I > ldfil, implying that it usually holds that *pe # P.*

The existence of excess volatility in expectations regarding the future price level implies that boom phases, which are generally associated with inflationary pressures, lead to overly optimistic expectations of real returns and asset prices by overly optimistic expectations *as* to real interest rates and nominal cash flows via actually rising inflation, and via an expected accelerating inflation rate for the future. These overly optimistic expectations give rise to the emergence of an asset price bubble, *as* expected cash flows are much higher than actual, and *as* expected real interest rates are much lower than actual. Formally, excess volatility in asset prices due to expected inflation being much higher than actual inflation is defined, according to equation 2.40, *as d p•* > *d P* and *dp•* > *dp•,* implying *p•* > *P.*

The asset price bubble induces a cumulative upward process in goods and financial markets via expectations-led demand-side and financial accelerator-induced processes *as*  described in sections <IP_ADDRESS> and 2.3.4. A growing difference between the expected and the actual inflation rate by an increasing reliance on adaptive and extrapolative expectation formation schemes, induces a build-up of financial instability by increasing debt-asset ratios, *as* the future liquidity and solvency status depend increasingly on the validation of euphoric inflation expectations. If the actual inflation rate does not rise to expected levels due to disinflation or even deflation, asset prices are going to collapse inducing widespread failures among firms and financial institutions.

As outlined in section 2.3.4, the boom phase comes to a halt and passes over into actual financial distress, when agents realize that inflation expectations had been unrealistic due to an actual deterioration of cash flow and liquidity positions, being induced generally by *disinflation* or even *deflation,* resulting from tightening monetary policy, from an overall increase in the assessment of risk, and from a reduction in growth. Deflation, disinflation and rising nominal interest rates lead to an increase in actual and expected real interest rates, causing failures of especially highly leveraged business units and triggering the asset price bubble's burst. Formally, according to equation 2.40, the collapse of asset prices *PA*  can be induced by a rise in the nominal interest rate i, by a fall in the expected price level *p•,* and by a fall in the price level's expected growth rate *p•.*

The burst of the asset price bubble, *as* well *as* failures of business firms and financial institutions induce an expectations-led cumulative downward process which tends to exhibit excess volatility if expected future changes of the price level are smaller than the actual change of the price level, and if the price level's expected future growth rate is smaller than the price level's actual growth rate.5° Formally, according to equation 2.40, excess volatility in bust phases is characterized by *d pe* < *d P* and *d fl* < *d p* implying *pe* < *P.* This "expectation undershooting" comes to an end when agents realize that expectations had been too pessimistic, and that cash flow and solvency positions, as well as debt-asset ratios have returned to sustainable levels.

Summing up, financial instability increases/decreases with increasing/decreasing monetary instability, implying that financial instability is reduced by monetary policy aiming at a stabilization of the price level's actual and expected growth rate, and increases if monetary authorities cause unexpected changes in the price level's growth rate by unexpected and discretionary shifts in monetary policy leading to excess volatility in price expectations.

**Monetary Instability and Real Debt Burdens** - **Debt Inflation and Debt Deflation.** Hitherto, the discussion referred mainly to the impact of price level instability on real interest rates, real borrowing costs and asset prices, and neglected the impact of changing real debt burdens via debt inflation and debt deflation on financial instability, having been originally emphasized by I. Fisher (1932, 1933). Debt inflation and debt deflation are commonly defined by the real value of net debt, which is defined as the real value of the sum of debts less the real value of the sum of assets. 51 Applying this definition to the stylized balance sheet in figure 2.1, the real value of net debt, *N DBr,* is given as

$$NDB\_r = \frac{NDB}{P} = \frac{DB + s\, DB^\bullet - (P\_A A + s P\_A^\bullet A^\bullet + LMA)}{P},\tag{2.41}$$

where *N DB* denotes the nominal value of net debt, and *P* the general price level. It has to be emphasized that the real value of net debt can be only used to define debt inflation and debt inflation by identifying their determinants, but cannot be applied to "measure" changes in the real debt burden via changing values in *N DBr* which has a negative sign in case of solvency, and a positive sign in case of insolvency. For example, in case of solvency, a fall in *PA* and *P,4,* both engendering debt deflation being outlined below, cause a rise of *NDBr,* whereas a fall in *P,* also causing debt deflation, leads to a fall in *NDBr.*

The term "debt inflation", designating a fall in the real debt burden, and the term "debt deflation", labelling a rise in the real debt burden, are not uniformly defined in the economic literature. While some authors associate debt inflation/debt deflation with a rise/fall in the aggregate price level, other authors have emphasized asset price inflation/deflation. Common to all definitions is the neglect of open-economy effects, as e.g. the influence of a changing external value of a currency, or the influence of foreign asset prices. In order to overcome existing inconsistencies and to enlarge existing definitions, the present contribution defines debt inflation/debt deflation following equation 2.41, firstly, as a rise/fall in prices of domestic and foreign assets *PA* and *P,4,* secondly, as a rise/fall in the general price level *P,* thirdly, as a fall/rise in the exchange rate *s* in case the balance sheet exhibits a foreign net debtor position *(DB\** > *P,4A\*),* and as a

50Note that this statements is valid both in the case of deflation and in the case of disinflation.

51 For the definition of the real value of net debt, as well as for an overview of the literature on the influence of changing real debt burdens on financial stability, see e.g. Eichengreen and Grossman {1997).

rise/fall in the exchange rate *s* in case the balance sheet exhibits a foreign net creditor position *(DB\** < *P.4A\*).* Among debt inflation/debt deflation, the real debt burden decreases/increases in case of a fall/rise in domestic debt and/or foreign debt *DB* and *DB\*,*  as well as in case of a rise/fall in domestic and/or foreign asset stocks *LMA,A* and *A•,*  implying a fall/rise in the debt-asset ratio.

Financial instability increases/ decreases if there is debt deflation/ debt inflation, as the amount of debt repayment in real terms increases/decreases. Combining the results of the previous paragraph and of section 2.3.4, boom phases driven by excess volatility are able to lower financial instability due to debt inflation, being caused by a rise in domestic, and possibly foreign asset prices *PA* and *P.4,* by a rise in the domestic price level *P,*  and in case of flexible exchange rates combined with a foreign net debtor position by a fall in the exchange rate *s.* It has to emphasized however, that the fall in the real debt burden is dampened, or can be even overcompensated by an increase in the debt-asset ratio. Consequently, in case there is excessive overborrowing during boom phases which overcompensates the reduction in the real debt burden via inflation, rising asset prices and declining exchange rates, being characteristic of the period just before the upper turning point, financial instability increases.

Bust periods are generally associated with an increase in financial instability due to debt deflation, causing a rise in the real debt burden via declining domestic, and possibly foreign asset prices, deflation, and via an increase in the exchange rate in case of a foreign net debtor position. It has to be emphasized as well, that the rise in the real debt burden can be dampened, or even overcompensated by a general decrease in the debt-asset ratio during the late bust phase. As a result, in case of large reductions in the debt-asset ratio which overcompensate the rise in the real debt burden by deflation, declining asset prices, and rising exchange rates, being characteristic of the period just before the lower turning point, financial instability decreases.

### **2.4 Exogenous and Endogenous Financial Crises**

This section discusses briefly different theoretical views of the fundamental causes of financial crises by applying the present analysis of financial instability and financial crises of sections 2.1 to 2.3 to current approaches to financial crises, which are discussed in much more detail in sections 4.5 and 5.5. Standard theory of financial crises, which is going to be discussed in detail in sections 3.5, 4.5, and 5.5, can be classified into two broad categories, namely in theories of endogenously caused financial crises, and in theories of exogenously caused financial crises, as already outlined briefly in section 1.1. The largest part of the existing literature on the causes of financial distress is dominated by standard or mainstream economic theory, assuming that modern capitalist economies are inherently stable and that financial crises can be only caused by adverse exogenous shocks to economic fundamentals, or by an exogenous shift from optimistic towards pessimistic (rational) expectations which become self-fulfilling. By way of contrast, models stressing the endogenous character of financial instability and financial crises, representing the minority in the financial crises literature, assume that modern capitalist economies are inherently unstable, as there are interactions between the real and the financial sphere of modern economies which cause an endogenous build-up of financial instability, leading finally to financial crises.

The following discussion analyzes the propagation mechanisms of exogenous shockdriven and endogenous financial crises, being followed by a short description of mixed approaches. The sections ends with an outlook on an alternative mixed perspective on financial crises which is going to be developed formally in part II of the book.

**Exogenous Shock-Driven Financial Crises.** Models of exogenous shock-driven financial crises generally abstract from financial instability as defined in section 2.3, as they assume that modern capitalist economies are inherently stable and that agents are subject to rational behaviour. Consequently, financial instability cannot arise as excess volatility in asset prices and in the price level, leading to overindebtedness according to unrealistic expectations, are not possible. Thus, the only possibility for financial crises to occur are large random exogenous shocks to economic fundamentals, or random exogenous shifts in (rational) expectations which become self-fulfilling. Moreover, exogenous-shock driven models are not characterized by extensive boom-bust cycles, but describe only the contractionary effect on real economic activity in case of large exogenous shocks, as the build-up of financial instability during expansionary phases is excluded by the existence of rational expectations.

Following the general definition of financial crises in section 2.3.1, the logic of financial crises driven by exogenous shocks to economic fundamentals runs from random exogenous real sector shocks, as e.g. adverse terms of trade or technology shocks, and/or random exogenous financial sector shocks, as e.g. domestic or foreign interest rate increases, to collapses in asset prices whose effects on general financial market conditions and real economic activity depend on the size of the initial exogenous shock, determining whether a crisis is systemic or spurious. Consequently, large/small adverse exogenous real and/or financial shocks lead to large/small drops in asset prices causing a systemic/spurious financial crises.

Respecting the propagation mechanism of financial crises driven by random shifts in (rational) expectations, the logic runs from an exogenous deterioration of ex ante expectations regarding real sector or financial sector variables, to actions by agents which lead to an actual deterioration of real sector of financial variables and to a collapse of asset prices, so that expectations are validated ex post, i.e. expectations are self-fulfilling. For example, an expected depreciation of the home currency, and an expected rise in domestic interest rates being associated with an expected drop in asset prices, leads to actual large capital outflows, an actual rise in domestic interest rates, an actual collapse of asset prices and, if foreign exchange reserves do not suffice, to an actual devaluation of the home currency. The size of the asset price drop, as well as the impact on real economic activity and financial market conditions, depends on the size of the shift in expectations. Accordingly, a small/large deterioration of expectations leads to an actual small/large drop in asset prices inducing a spurious/systemic financial crisis.

Endogenous Financial Crises. Models of endogenous financial crises contend that financial distress is caused by an *endogenous* build-up of financial instability as described in section 2.3 in boom phases, passing over finally into financial crises, and real economic contractions due to expectations-led overindebtedness. Accordingly, models of endogenous financial crises assume that modern capitalist economies are inherently unstable due to unrealistic and irrational expectations giving rise to extensive boom-bust cycles, and that financial crises are a "normal" outcome of economic development.

Following the general definition of financial crises according to section 2.1, and the financial instability analysis owing to section 2.3, the logic of endogenous financial crisis models runs from an endogenous increase in indebtedness, asset prices, inflation, and real economic activity to an unavoidable deterioration of real and financial market activity as described in section 2.3.4 due to the existence of natural limits. Consequently, the endogenous increase in financial instability causes *endogenous* deteriorations in the real and/or in the financial sector, as e.g. rising input costs, a terms of trade deterioration, domestic and foreign interest rate increases, increases in overall risk perception, etc., which lead endogenously to a drop in asset prices and to systemic financial crises as financial instability is high. In contrast to exogenous-shock driven models, even very small "shocks", i.e. small endogenous deteriorations in the real and/or in the financial sector, suffice to cause systemic financial crises. Consequently, according to the theory of endogenous financial crises, spurious financial crises are a very rare event.

**Mixed Approaches.** There are only few models of financial crises arguing that financial distress is caused by the combination of exogenous and endogenous factors. Regarding standard theory of financial crises, only asymmetric information models stressing the importance of moral hazard driven financial distress provide a mixed approach. According to these models, moral hazard induces a large endogenous build-up of financial instability by an immoral increase in indebtedness due to distorted risk perceptions resulting from government guarantees. For example, if there is a general government guarantee to bailout troubled banks, investment decisions by bankers are more risky than without the existence of these guarantees, as the government takes over losses in case of default. Notwithstanding the fact that moral hazard driven financial crisis models explain the build-up of financial instability by endogenous mechanisms, they argue that financial crises only occur in case of exogenous shocks. Consequently, the endogenous build-up of financial instability is sustainable as long as there are no exogenous shocks. Moreover, the reason for an endogenous build-up of financial fragility is the existence of exogenously given government guarantees. Thus, if there were no government guarantees, there would be no endogenous build-up of financial fragility at all.

An Outlook on a Synthetic View of Financial Crises. A detailed analysis of the stylized facts of financial crises, which is going to be set out in the following chapter, shows that financial crises are neither purely exogenous nor purely endogenous events, and that it is unrealistic to assume that a large endogenous build-up of financial instability evolves into a systemic financial crisis only if there arise exogenous shocks. Hence, as the next chapter is going to point out, current approaches to financial crises are too polarized to provide a full understanding of the propagation mechanisms of financial crises.

The present approach, formally outlined in part II of the book, tries to overcome the existing polarization by developing a synthetic view of financial crises which argues, based on stylized facts of business cycles and financial crises, that modern capitalist economies are generally subject to cyclical fluctuations in goods and financial markets, being driven by *endogenous* fluctuations in expectations and indebtedness. These endogenous business cycles are characterized by cumulative upward and downward processes which are inher-

ently stable in the absence of exogenous shocks. Hence, a "normal" functioning implies an endogenous build-up of a low degree of financial instability during the boom phase, which however does not cause a systemic financial crisis but only a mild recession giving rise to the next business cycle. By way of contrast, systemic financial crises can be caused only by positive exogenous shocks to expectations leading to an unsustainable increase in financial instability and to extensive boom-bust cycles, or by exogenous adverse real or financial sector shocks resulting in a large contraction.

## **Chapter 3**

## **Stylized Facts and Standard Theory of Financial Crises**

## **3.1 Defining and Identifying Financial Crises**

Hitherto, financial crises have been defined and categorized, according to the general definition set out in section 2.1, by asset price drops and by the strength of the transmission mechanism of financial sector disturbances into the real sphere of an economy. Notwithstanding the fact that this general definition provides deep theoretical insights into the explanation of financial crises and financial instability, it cannot be applied to identify and to "measure" financial crises empirically due to a limited capacity to observe and to process relevant variables. If financial crises were identified and measured according to the general definition set out in section 2.1, an empirical study would have to observe asset price and interest rate behaviour of a large number of different financial and real assets, as well as a huge number of microeconomic cash flow and balance sheet data of a large number of financial and nonfinancial firms, being not feasible from an empirical perspective.

In order to bridge the gap between the necessity of a multidimensional approach to identify and to measure financial crises, and a limited capacity and number of wellobservable macroeconomic variables and indicators, the empirical literature generally distinguishes among three types of financial crises, namely, currency crises, banking crises and twin crises (being defined as the simultaneous occurrence of currency and banking crises within a certain time period), whose identification and measurement is not trivial, but feasible from an empirical perspective. The following three subsections 3.1.1 to 3.1.3 are going to describe both the empirical definition as well the identification of currency, banking and twin crises, serving as a basis for the following sections of this chapter.

#### **3.1.1 Currency Crises**

Following the empirical literature on financial crises, currency crises are generally defined as follows:

*A currency crisis is a situation in which a speculative attack on the exchange value of a currency causes a devaluation, or a sharp depreciation of the currency, or forces authorities (central banks or governments) to defend the cur-*

*rency by raising sharply short-term interest rates, or by selling large volumes of foreign exchange reserves.*