Modeling Financial Crises: A Schematic Approach

John T. Harvey

Professor of Economics

Texas Christian University

Book Idea:

A Post Keynesian Analysis of Exchange Rates in the Post-

Bretton Woods Era

Revised Book Idea:

Currencies and Capital Flows: A Post Keynesian Analysis of Exchange Rate Determination

Currencies, Capital Flows,and Crises: A Post Keynesian Analysis of

Exchange Rate Determination

Mexican Financial Crisis: 1994

Asian Financial Crisis: 1997

•Minsky crises (debt default)

•Currency crises (catastrophic depreciation/devaluation)

•Asset-market crises (catastrophic depreciation)

Goals of Paper

1. Show that all financial crises are manifestations of the same phenomenon

2. Highlight an often overlooked factor

3. Model the economy in a way that allows us to see “everything” at once

4. Compare the model to various historical incidents

Where we are headed…

1. All financial crises are manifestations of the same

phenomenon

the development of increasingly optimistic forecasts alongside

economic forces that cannot justify those expectations

Stages of Crisis:shock => negative repercussions => contagion

Types of Crises

Crisis type

focus of expectations

negative repercussion

initial contagion secondary effects

Minsky manageable debt load

default chain default credit crunch

asset market asset price collapse in asset price

downward revision of related price forecasts

fall in expectation of profit from investment, fall in aggregate expenditures, fall in mpc

flexible exchange rate

currency price currency depreciation

capital flight inflation, FX loan default, fall in aggregate expenditures

fixed exchange rate

currency price currency devaluation

capital flight inflation, FX loan default, fall in aggregate expenditures

2. An overlooked factor

The Investment-Capital Cycle

3. Seeing Everything at Once

Minsky Crisis

Asset-Market Crisis

Currency-Market Crisis

Complete Model

Conclusions

The root cause of financial crisis is the initially gradual and eventually rapid separation of expected returns from what the real economy can actually generate. Ultimately, evidence of the relative under performance of the nonfinancial sector will become known. Shock, negative repercussions, and contagion result. Depending on the magnitude, the economic impact can be significant and even catastrophic. This phenomenon is, given the current structure of market economies throughout the world, systemic. It does not require “crony capitalism,” unique events, or government “interference” with the market mechanism–it is, in fact, the market mechanism itself that causes this outcome.