Theories of Economic Crisis in the Capitalist System (Part-3)

The ‘Financial Instability Hypothesis’ also emphasises that expectations exhibit unsystematic behaviour due to the uncertainty of the future. In his theory, Minsky states that the expansionary periods of the business cycle are not permanent, speculative investments increase in this period and a process of instability in the financial structure will begin. The main elements of Minsky's ‘Financial Instability Model’:

Three Financial Stages:

Minsky states that the financial system consists of three stages: Hedge Finance, Speculative Finance and Ponzi Finance.

Minsky Moment (Minsky Moment):

The Minsky Moment refers to the transition of the financial system from stable to unstable in a period. This moment usually marks the point at which the financial crisis starts at a time when the ‘Speculative Financing’ and ‘Ponzi Financing’ phases increase.

Debt Rollover and Asset Prices:

Minsky argues that economic agents have a cycle in which they tend to borrow more and more over time. In this process, increased borrowing may inflate asset prices, but a fall in asset prices, especially in the case of Ponzi Finance, leads to a financial crisis.

State Intervention:

Minsky argues that the state should intervene to ensure financial stability by regulating and supervising the economic system. The purpose of this intervention is to control excessive fluctuations in financial markets and to maintain the stability of the system.

Financial Innovation and Regulation:

Minsky argues that financial innovations and new financial instruments increase the instability of the system and that regulation plays a preventive role in this regard.

Sustainable Borrowing and Profit Margins:

Minsky emphasises that the long-term borrowing capacity of economic agents is limited and financial instability will increase if profit margins narrow.

Finally, Minsky's ‘Financial Instability Model’ offers a more holistic perspective on the causes of economic cycles and financial crises. This model is considered to be an important tool for understanding the imbalances in financial markets and the instabilities that arise in the process. According to H. Minsky, the instability of the capitalist system stems from the capitalist financial structure. Minsky follows Keynes and includes the banking and financial system in the basis of business cycle theory. Financial fragility depends on the cash flows, payment commitments and balance sheet structures of economic decision-makers.

The increase in the short-term debt structure rather than long-term borrowing, the shift from hedge financing to speculative financing and from speculative financing to Ponzi financing, and thus the shift from long-term borrowing to short-term debt structure are important factors in the transformation of the financial system into a fragile structure. This change in the debt structure will bring along the problem of debt repayability and undermine confidence in financial institutions. While the fact that the realised profits of firms provide the expected return during the development periods stimulates the demand for investment, the fact that banks turn to risky financing methods in order to increase their credit facilities also increases financial fragility. When the ratio of Ponzi and speculative financing in total loans reaches a point that exceeds the firm's payment obligations, the firm will resort to borrowing or asset sales. Therefore, it is inevitable that firms will suffer capital losses.

In the event that the CBRT implements a tight monetary policy, it will be difficult for banks to create a credit channel and liquidity, and sudden increases in short-term interest rates will also increase long-term interest rates. In other words, the crisis process starts with the increasing demand for money by economic decision-makers who are vulnerable to interest rate hikes due to fragility (Dymski, 1997, pp.501-508). The financial fragility hypothesis also envisages government intervention against the crisis as the central bank fulfils its role as the lender of last resort and increases government expenditures to increase the demand for money by economic agents.

Minsky developed his hypothesis in a closed country model and did not add the concept of exogenous financial fragility. For example, when a Post-Keynesian exogenous vulnerability index is constructed for Turkey using the Paula and Alves method, we can say that financial vulnerability has increased in exchange rates, external interest rates and global risk perception, consistent with periodic developments. This is because the Turkish economy needs a high level of external financing due to the chronic current account deficit problem. The ratio of exports to imports and the ratio of the Central Bank's international reserves to short-term debt stock are low. Despite the flexible exchange rate regime, the CBRT has direct and indirect interventions in the market, has a high level of foreign trade deficit and current account deficit, and is significantly sensitive to the ‘sudden stop’ problem of capital flows.

The most criticism of Minsky's hypothesis came from the British economist Garry Dymski. First of all, he considers Minsky's failure to emphasise the importance of current account deficit and foreign capital as a serious deficiency because he only works in a closed economy. He says that he ignores the effect of debt & income and balance sheet inequalities on asset prices. He finds the analysis too general. He attributes the bubble formation in asset prices to the inadequate control of institutional mechanisms that can transform capital flows into investments.

J. Schumpeter

At the beginning of the 20th century, Joseph Alois Schumpeter, who brought a different perspective to the science of economics with his different and interesting views, emphasised how to define the process of economic development and drew attention to the importance of innovations and entrepreneurs. Schumpeter's analyses on the birth, functioning and development of capitalism are the most important approaches to understand the dynamism of the capitalist system. In a way, he brought a new dimension to the concept of both innovation and entrepreneurship. With the views he put forward, he has become the economist whose name is most frequently mentioned with the economic crisis in the world today.

Schumpeter explained the ‘Development Theory Model’ with three basic stages: creating innovation, creating purchasing power and implementing innovations with the help of entrepreneurs, and analysed how the concepts of innovation and entrepreneurship affect the development process. However, before this explanation, it would be appropriate to examine the points where Schumpeter's Development Theory differs from the neo-classical Theory. Schumpeter's Development Theory and Neo-classical Development Theory differ fundamentally. Schumpeter revealed the difference between the concepts of development and growth, which is one of the important points overlooked by the Neo-classical Theory, by reshaping the production function. Neo-classical theory, which equates development with growth, explains the production function only with capital (K) and labour (L), takes technical knowledge and organisation as given and is based on constant returns to scale. Accordingly, the neo-classical production function is shown in the following equation.

Y=F(K, L) (1)

According to Schumpeter, whose name is mentioned together with the concepts of innovation and entrepreneurship in the literature on development, the production process consists partly of material and partly of immaterial elements. In terms of material elements, capital (K), labour (L) and land (N), which are the basic factors of production, were taken into consideration. Technology (T) and socio-economic elements (U) were included in the intangible field, which is the point where he differed from the neo-classicals. Schumpeter attached great importance to technological and social factors within the framework of a dynamic analysis. Schumpeter's production function is shown in the following equation.

Y = f (K, L, N, T, U) (2)

Schumpeter thought that it would be useful to divide the factors affecting the dynamic development of an economy into two groups. In this way, the difference between the concepts of growth and development was also brought to light.

The first three elements in the equation, namely capital, labour and land, symbolise the effects of the change in factor availability. These three elements were named as growth factors by Schumpeter.

The last two elements in the production function, technology and socio-economic elements, are defined by Schumpeter as the elements of development and progress. In addition to all these, Schumpeter did not adopt the neo-classical view that development is a continuous process, on the contrary, he argued that development will depend on innovations and will pause frequently. He claimed that economic evolution and therefore development occurs spontaneously and discontinuously in the flow channels in the form of shaking, shifting and re-establishing the balance at another point.

Development Theory and Innovations

The concept of innovation, which is an important force in economic life, is one of the main topics of interest to J.A. Schumpeter. As a result of his analysis, innovation has begun to be associated with the change in the handling of the idea and the introduction of new goods and resource combinations into the economic process. Schumpeter defined innovation as technical progress or the discovery of new resources. In more general terms, any change in the production function that increases the output generated by existing factors of production (including those not yet discovered) is considered innovation. In his classical and most important book, Economic Development Theory, he categorised innovation and mentioned five different innovations:

1. Bringing a new good or a new type or quality of an existing good to the market,

2. The use of a new production technique (it is not necessary that this new technique has not yet been discovered. What is important here is that this technique is newly applied),

3. Opening of a new market,

4. The discovery of a new source of raw materials or semi-finished products,

5. a change in the organisation of any sector.

Schumpeter recognised that innovations are not created by existing firms but by using existing resources. What is important here is that the difference between innovations and discoveries and inventions should not be overlooked. Innovations refer to the application of any discovery or invention in the commercial field.

Development Theory and Entrepreneur

There are two ways to provide the credit needed by the firm to create innovation. The first way is for the owner of the capital to fund the innovation directly by himself/herself; this type of capitalist is called adventurous capitalist. The second way is for the firm to apply to financial institutions for the necessary resources. Schumpeter calls economic actors who undertake the management of innovation in this way entrepreneurs. The entrepreneur, who is a person who undertakes a task rather than a certain profession, has to implement innovations, make the necessary investments and bear the risks arising from these investments.

In his Development Theory, Schumpeter argued that the factor that creates capital is the new purchasing power and identified the creation of new purchasing power as the second stage of his model. In the last stage of the model, the innovator creates a new production technique with all the credits and resources it provides and incorporates this technique into the production process. In this sense, the decision process of the entrepreneur differs from the profit maximisation-oriented Neo-Classical decision process. For Schumpeter's entrepreneur, what will emerge as a result of ‘new’ is only imaginable. Coming up with a new plan and practice and acting with the customary method are as different from each other as building a road and walking on the road. At this point, Schumpeter questioned how the entrepreneur could create a new product or technique by borrowing money and still make a profit and found the answer within the system. The new purchasing power created by borrowing from the bank or investing money by the adventurous capitalist, i.e. credit, affects the economic system. Above all, the new purchasing power injected into the market affects the price level. Technological innovation, on the other hand, provides the entrepreneur with a cost advantage. The profit of the entrepreneur consists of the part above the costs and is expressed as the difference between expenditures and sales amounts for the entrepreneur. Schumpeter argued that this situation does not exist in the equilibrium in Walras' circular flow. In the circular flow, total sales are barely enough to cover costs and in equilibrium producers neither make a profit nor incur a loss. However, according to Schumpeter, if the entrepreneur is successful, he uses innovations such as technology that are superior to the elements in the circular flow, and his total income is always higher than his total costs. As a result, the net credit created in the economy is due to development.

The destabilisation of the equilibrium, net entrepreneurial profit, net credit, directed the economy towards a new equilibrium. In the following period, the attractiveness of the profits generated in the new business field will attract other firms to this field. This formation, which will cause the restructuring of the industry, will prevail over the outdated business fields and will lead to their extinction and possibly unemployment. As a result of these developments, the economy will reach a new equilibrium. Schumpeter called this process the process of creative destruction in his book Capitalism, Socialism and Democracy. The creative destruction process, which is vital for capitalism, is summarised as follows:

1. The new product in the market will steal from the demand of already existing products.

2. The new product can be priced higher than its old competitors.

3. The first imitators of the product will be ready to accept any price.

4. As the product becomes standardised and ordinary, prices will fall significantly.

5. Continuous development is necessary to maintain market shares. The initially new product will always be replaced by another, more advanced product. In this way the process of creative destruction will work.

Schumpeter, following Kondratieff, defined development periods of about fifty years as cycles or circuits. He labelled the sum of the waves of technological change that encompass research and innovation in all these cycles as ‘successive industrial revolutions’. Schumpeter explained his theory of business cycles in his book Economic Cycles published in 1939. According to this theory, without innovations, economic life would remain in a state of stagnant equilibrium, and cyclical flows would continue to be experienced in the same way and with the same magnitude every year. As a result, the phenomena of profit and interest would disappear and wealth accumulation would stagnate. However, since the entrepreneur is driven by the profit motive, he/she will transform this stagnant situation into a dynamic process of economic development by creating innovation. In this regard, it will change the traditional circular flow and direct labour and land to investment. Moreover, since the amount of savings created in this process is not sufficient, it will resort to credit sources. Thus, a resource will emerge in the economic system that will create a dynamic movement.

In Schumpeter's business cycle theory, fluctuations are no longer circular but cyclical. Fluctuations in the economy are analysed in four different phases as prosperity, stagnation, depression and revival. Within this process, investments mainly refer to the transition to the prosperity phase. At the high conjuncture point, i.e. in the prosperity phase, the economy faces, on the one hand, the increase in factor prices as a result of innovations financed by credit and, on the other hand, the decrease in commodity prices as a result of production coming to the market due to technical innovations. Since there will be no new demands for financing in this period, the relationship between goods prices and factor prices makes innovations unstable. At this stage, losses will occur in the economy and the economy will enter a period of stagnation until the cost-price balance is restored. After all this, a completely different wave of innovation will emerge, the economy will revive and the cyclical fluctuation will start again. According to Schumpeter, each business cycle is different from each other both because of the technological differences in that period and the differences in historical events. Schumpeter analysed the unique movement of each wave and at the same time tried to examine the characteristics of the system that created these fluctuations. Unlike Kondratieff, he developed a theory for long waves. Schumpeter argued that innovations in a sector reduce the costs of the sector, leading to a fall in prices and a rise in real wages. Therefore, he stated that the engine of capitalist growth is technological innovations. According to Schumpeter, an innovation-based prosperity process will lead to stagnation. The stagnation will be followed by a depression period and then a revival will begin. Schumpeter also analysed the fluctuations in the capitalist system in terms of their length and stated that there are 3 different types of fluctuations in this system:

1. Kitchin Waves: They are short cyclical fluctuations usually lasting 3-4 years.

2. Juglar Waves: They are cyclical fluctuations lasting 7-11 years.

3. Kondratieff Waves: 50 -60 years long cyclical fluctuations.

According to Schumpeter, there may be six separate fluctuations of 10 years within the long waves. He defines these waves as Juglar Waves. In addition, there may be 3 separate fluctuations of 40 months within the Juglar Waves, which he called ‘40 Month Fluctuations’.

(To be continued)