Theories of Economic Crisis in the Capitalist System (Part-2)

Capitalist Crisis Theories in the Imperialist Age

With regard to the imperialist epoch, bourgeois crisis theories generally reflect the capitalist understanding of crisis in this epoch. In the following, while concretising some crisis theories, we will also mention the bourgeois crisis theorists in this field.

Kondratieff: Long Conjuncture Waves

In the 1790s, statistics on the behaviour of price and output series in the US and the UK suggested to Kondratieff the existence of long waves. According to Kondratieff, the capitalist world was evolving and self-repairing, and therefore Kondratieff was opposed to the Marxist view that the collapse of capitalism was imminent. However, Kondratieff was not the discoverer of the long business cycle wave, and in some respects the fact that it bears his name may be considered a mistake. This idea is more likely to be attributed to the Dutch Marxist Van Gelderen, who, in 1913, made it explicit. In the same period, a group of economists, including Pareto, drew attention to long-term fluctuations in price movements, interest rates and trade volumes over a period of half a century.

Long Conjuncture Waves and Their Characteristics

Long business cycle waves are mainly used to explain long-run fluctuations in series such as prices and output. While these fluctuations indicate the beginning of new periods in the economic cycle and the decline in the years following this beginning, the end of one wave and the beginning of another witnesses important technological revolutions, wars and social transformations. The main characteristics of Kondratieff waves can be listed as follows:

-Kondratieff waves are a behaviour of the world economy and are observed in international output data rather than in the output data of individual national economies.

-It deals with outputs rather than prices.

-They occur on average in periods of 50-60 years.

-They arise when innovations that create technological revolutions create new leading industries and business sectors. In other words, Kondratieff waves arise from the demand for solutions to new problems and the supply of such solutions by innovative firms.

-Each Kondratieff wave is unique in terms of the time and place of its emergence.

-Each Kondratieff wave changes the world economy. In other words, they lead to structural transformations.

Kondratieff also drew attention to the relationship between long cyclical waves and wars. According to Kondratieff, wars and revolutions occur at the beginning of waves or in the transition periods between waves. The most powerful example of this is the Great Depression of the 1930s, which occurred between the two world wars and between two long business cycle waves, the pre-1914 and the post-1945 expansions.

Kondratieff's Analysis of Long Business Cycles

Kondratieff tried to show the existence of long business cycle waves by analysing the price and output series of the UK, USA and France. In his analysis, he first analyses the commodity price indices of the USA, the UK and France. The French price index covers a 25-year period from the late 1850s to the rise of the first long wave in the period 1789-1814. The period of decline starts in 1814 and lasts until 1849. In other words, the decline period covers a period of 35 years. As a result, the cycle is completed in 60 years. The 2nd wave starts in 1849 and ends 24 years later in 1873. On the other hand, the turning point of the wave is different in the USA than in the UK and France. The peak of the wave in the USA was reached in 1866 with the civil war. The decline of the 2nd wave begins in 1873 and ends 23 years later in 1896. The 2nd wave thus lasted 47 years. The 3rd wave's upward movement starts in 1896 and ends in 1920, lasting a total of 24 years. In all data, the decline of the wave starts in 1920. All in all, there have been 3 major fluctuations in price indices since the late 1780s.

Kondratieff Waves in the World Economy

The definition of the world economy according to Kondratieff cyclical waves has been made from time to time according to different perspectives and definitions in the literature. Those who try to define Kondratieff waves in the context of technological innovations and inventions are quite numerous in the literature and each definition contains high subjectivity. In the first Kondratieff wave, which corresponds to the first period of the Industrial Revolution, mechanisation is largely based on water power and textile fabrication is a common industrial activity. The second Kondratieff wave, on the other hand, was based on the rapid spread of steam power, which led to the mechanisation of other industries and the development of new railway infrastructure. With the emergence of the electricity industry and technological changes in the chemical industry, research and development (R&D) activities also became very important, thus defining a new long wave. The importance of R&D units was further enhanced during the fourth business cycle wave, with the advent of the era of mass production of automobiles and synthetic materials, i.e. Fordism. Finally, the last quarter of the twentieth century was characterised by the computerisation of the economy on the basis of cheap microelectronic materials, and there is no definite general view as to when this fifth wave will end.

H. Minsky's Financial Instability Model

Hyman Minsky's ‘Financial Instability Model’ provides a theoretical framework for understanding financial instability in the economic system and the causes of financial crises. Minsky argues that the financial system is inherently unstable and that this instability increases over time. In his Hypothesis, Minsky analysed the developmental periods of capitalism. Because according to him, as in the case of other economists, the ‘New Deal Rules’ for the exit from the ‘Great Depression of 1929’ are defined as the period of protectionist capitalism since there was full state intervention in the labour and industrial sectors. Thus, the profitability and assets of the private sector increased. The control of money also passed to financial capitalists. These were individuals or institutions that took excessive risks in pursuit of high profits. In fact, capitalist states are countries with the risk of debt deflation and high inflation.

Minsky uses two price systems in his ‘Theory of Financial Instability’. The first one is for the current product and the other is the asset price system. In the first one, there are prices for consumption, investment, government expenditures and export goods and services. In the second, asset price system, investments and realised profits are determined. According to Minsky, borrowing to finance investments increases the fragility of the economy.

Furthermore, Minsky argues that capitalism can be seen in many different forms and that the type that emerged in the post-war developed countries fits the characteristics of financial capitalism. According to him, the reason why the large states of the capitalist world did not experience major shocks after World War II, such as the crises experienced between 1929 and 1933, is that the Big State prevented asset prices and profits from falling below a certain level. In Minsky's words, Big Government and Big Bank are trying to prevent instability in the system. Their aim is to establish and implement a ‘good financial society’ in which the tendency of business and bankers to engage in speculative finance is restricted.

To this end, the big government tries to limit the volatility of demand by putting floors and ceilings on commodity prices, while the big bank tries to prevent instability in the financial system by putting floors and ceilings on asset prices. Nevertheless, the economy is inherently unstable. This instability has been tried to be restricted by applying floor and ceiling prices. The inherent instability of the system is due to the interaction between investment and financing.

On the other hand, Minsky's contribution is the theory of financing of investments and the realisation of cyclical movements. In order to stabilise the instability of the system, big government seeks to increase the share of the public sector in economic life. In the United States, for example, the public sector's share of GDP rose from three per cent before World War II to 25 per cent after the war. A public sector of this proportion can eliminate fluctuations in private sector spending and stabilise the level of income and employment. Moreover, according to Minsky, high levels of public deficits have 3 effects:

1. Income and employment effect - simple multiplier effect

2. Cash flow effect - Borrowing created by public deficits

3. Portfolio effect - ‘public borrowing is realised through government securities, which are considered as safe assets’

Moreover, H.Minsky developed the Fisher approach within the framework of the financial fragility hypothesis. According to this approach, the fragile structure resulting from the problems in the financial system in fulfilling its functions during the expansionary periods of the business cycle leads to the onset of financial crises with the fall in asset prices and asset sales. The amount of investment is determined by the demand and supply prices of assets.

Chart 1: Minsky Investment Pattern

According to Minsky, the most important issue is how investments will be financed. Investments are realised with owned assets or external financing. In this case, there is a risk for the borrower and the lender. This risk brings up the idea of the inherent instability of investments. Financing of investments can be hedge, speculation or Ponzi. In hedge financing, expected cash flows are higher than future cash commitments. Since cash flows are uncertain, each firm needs to define a variance, i.e. variability, for these flows. The variability of cash flows should not depend on financial market conditions. These variables should depend on the normal functioning of goods and labour markets. In speculation financing, cash commitments in some periods are higher than cash flows. Firms cover the difference between cash commitments and cash flows by borrowing. Moreover, speculative financing depends on the functioning of money markets. An increase in the weight of speculative finance in the economy increases the upward pressure on interest rates.

Finally, investments can be made through Ponzi financing. In Ponzi financing, cash commitments are always higher than expected cash flows. In this case, firms meet the principal and interest of their cash commitments by borrowing. In this type of financing, units are highly dependent on debt sales. Again according to Minsky, financial markets are demand-weighted. In case of an increase in demand, private banks borrow from the Central Bank or domestic and foreign money markets while lending. Due to endogenous money supply, monetary policy has no effective control over financial markets. At this stage, high-interest borrowing and Ponzi financing increase and this leads to over-inflated bubbles, which are the harbingers of financial crises. For example, during the high-growth period, the current account deficit, the ratio of loans to GDP and the investment-savings imbalance also increased in the US between 2003 and 2006.

The proliferation of speculative and Ponzi financing options for financing investments also increases the fragility of the economy. This fragility has two components. As the shock absorption rate of economies declines and the risks of borrowers and lenders increase, debt-based financial activities become more dependent on the system. This leads to financial crises and increases debt. Meanwhile, whether the financing of investments will be hedge or Ponzi and the degree of fragility are answered by expectations. According to Minsky, the capitalist financial system will pass from one crisis to another within periods in line with its functioning. This situation arises as a result of the change in expectations during cyclical movements.

Furthermore, in Minsky`s analysis, financing and uncertainty are the basic elements of the analysis. At the bottom of the cyclical movement, expectations of profits and profits are low and investments are financed by Ponzi finance. As the economy moves upwards from the bottom, profit rates increase, but profit expectations are low. As time progresses, as the realised profits exceed the expected profit rates, expectations move upwards and with the profit instinct, firms want to borrow more for profit. According to Minsky, periods of full employment are not natural equilibrium points for capitalist economies. Financial fragility increases with the transition from one cyclical movement to another. In other words, the increase in Ponzi financing also increases financial fragility. The fragility of domestic markets depends on whether interest rates rise or the currency depreciates. Euphoric expectations are realised when full employment is reached. Under overly favourable expectations and given profit and wage sharing, the growth rate of debt is larger than that of profits. This model requires answers to two questions.

How will banks and corporations be affected by overly positive expectations and why borrowing cannot be controlled by monetary policy instruments. According to Minsky, the answer to these questions is the endogeneity of money supply. According to H. Minsky, financial markets are demand-weighted. If private banks do not have sufficient reserves to meet the credit demands, then banks have two options: Borrowing from the Central Bank or money markets. Due to borrowing, liability management of banks gains importance. Banks' liabilities will be covered by government securities, funds and foreign exchange instead of deposits, and liability management will increase interest rates. The increase in interest rates will increase speculative capital movements.

H.Minsky stated that institutional innovations contribute to the expansion of economic activity without leading to an increase in bank reserves. He stated that there will be an increase in interest rates as a result of tight monetary policy, but there will not be an immediate decrease in credit demand, those who want to make a profit with the rise in interest rates will dispose of their liquid assets, and a higher money circulation rate will be realised with innovations. He stated that each financial innovation will reduce the liquidity of the economy, yet more expenditures can be financed with the available liquidity, and that illiquid assets will be replaced by more easily convertible commodities such as cash treasury bills or bonds, which will cause ‘liquid assets to grow like a pyramid’. Thus, the system would become more unstable and crises would occur, and the CBRT could prevent crises by buying illiquid assets to rescue financial institutions that would be in a difficult situation due to falling assets. In this respect, he stated that there is a limit to the increase in banks' operational leverage ratios, i.e. the ratio of liabilities to liquid assets, that this ratio will decrease when the financial situation worsens, that during periods of economic recession, assets will lose their value in the process of liquidation, and that the Central Bank can only prevent systemic crises through monetary expansion.

In H.Minsky`s analysis, monetary policy cannot effectively control financial markets due to the endogeneity of money supply. Monetary policy is especially ineffective in controlling speculative finance. According to Minsky's theory of financial instability, financial fluctuations are generally observed in market economies before recession and decline. In an economy in a period of rapid growth, weaker financing units emerge. According to Minsky, hedge financing, which is more robust at first, dominates the situation, while speculative financing comes to the fore later. Finally, Ponzi finance becomes dominant.

(To be continued)