Explaining Financial Crises A Cyclical Approach H O H E N H E I M E R V O L K S W I R T S C H A F T L I C H E S C H R I F T E N Marc Peter Radke Marc Peter Radke - 978-3-631-75437-5 Downloaded from PubFactory at 01/11/2019 04:53:46AM via free access This book develops a new theoretical approach to the explanation of systemic financial crises in industrial and emerging market countries. In contrast to standard models, the present cyclical approach is consistent with the following three stylized facts. Firstly, systemic financial crises are a recurrent phenomenon generally accompanied by excessive boom-bust cycles. Secondly, the frequency of financial crisis cycles is very irregular. Thirdly, most financial crisis cycles are initiated by positive shocks to profit expectations which induce an unsustainable build-up of financial fragility driven by irrational exuberance. The present approach is based on a sophisticated balance sheet structure with many assets, as well as on an expectation formation scheme which combines the rational expectations hypothesis with Keynes’ Beauty Contest Theory. Marc Peter Radke was born in 1972 in Ludwigsburg. After graduation from grammar school in 1992, he did an apprenticeship as a bank clerk in Stuttgart which he completed in 1994. From 1994 to 1999 he studied economics and business management at the University of Hohenheim. From 1999 to 2005 he was a research and teaching assistant with the Department of Economics at the University of Hohenheim and received his Ph.D. in economics in 2005. He is now working as an economist for the Deutsche Bundesbank in Frankfurt am Main. H O H E N H E I M E R V O L K S W I R T S C H A F T L I C H E S C H R I F T E N Marc Peter Radke Explaining Financial Crises Marc Peter Radke - 978-3-631-75437-5 Downloaded from PubFactory at 01/11/2019 04:53:46AM via free access Explaining Financial Crises Marc Peter Radke - 978-3-631-75437-5 Downloaded from PubFactory at 01/11/2019 04:53:46AM via free access Hohenheimer Volkswirtschaftliche Schriften Herausgegeben van Prof. Dr. Michael Ahlheim, Prof. Dr. Ansgar Belke, Prof. Dr. Rolf Caesar, Prof. Dr. Harald Hagemann, Prof. Dr. Klaus Herdzina, Prof. Dr. waiter Piesch, Prof. Dr. Inga Schmidt, Prof. Dr. Ulrich Schwalbe, Prof. Dr. Peter Spahn, Prof. Dr. Gerhard wagenhals, Band53 £ PETER LANG Frankfurt am Main. Berlin• Bern •Bruxelles, New York• Oxford • Wien Marc Peter Radke - 978-3-631-75437-5 Downloaded from PubFactory at 01/11/2019 04:53:46AM via free access Marc Peter Radke Explaining Financial Crises A cyclical Approach £ PETER LANG Frankfurt am Main• Berlin• Bern• Bruxelles• New York• Oxford• Wien Marc Peter Radke - 978-3-631-75437-5 Downloaded from PubFactory at 01/11/2019 04:53:46AM via free access Open Access: The online version of this publication is published on www.peterlang.com and www.econstor.eu under the interna- tional Creative Commons License CC-BY 4.0. Learn more on how you can use and share this work: http://creativecommons. org/licenses/by/4.0. This book is available Open Access thanks to the kind support of ZBW – Leibniz-Informationszentrum Wirtschaft. ISBN 978-3-631-75437-5 (eBook) Bibllographlc Information published by Die Deutsche Bibliothek Die Deutsche Bibliothek lists this publication in the Deutsche Nationalbibliografie; detailed bibliographic data is available in the internet at <http://dnb.ddb.de>. : $' Zugl.: Hohenheim, Univ., Diss., 2005 D 100 ISSN 0721-3085 ISBN 3-631-54350-6 US-ISBN 0-8204-7777-X © Peter Lang GmbH Europaischer Verlag der Wissenschaften Frankfurt am Main 2005 All rights reserved. All parts of this publication are protected by copyright. Any utilisation outside the strict limits of the copyright law, without the permission of the publisher, is forbidden and liable to prosecution. This applies in particular to reproductions, translations, microfilming, and storage and processing in electronic retrieval systems. Printed in Germany 1 2 4 5 6 7 www.peterlang.de Marc Peter Radke - 978-3-631-75437-5 Downloaded from PubFactory at 01/11/2019 04:53:46AM via free access To My Family Barbara and Jan-Luca Marc Peter Radke - 978-3-631-75437-5 Downloaded from PubFactory at 01/11/2019 04:53:46AM via free access Marc Peter Radke - 978-3-631-75437-5 Downloaded from PubFactory at 01/11/2019 04:53:46AM via free access All economic events, by their very nature, are motivated by crowd psychology ... Men think in herds; ... they go mad in herds, while they only recover their senses slowly, and one by one. - Charles Mackay, Preface to the second edition of Memoirs of Ex- traordinary Popular Delusions and the Madness of Crowds, 1852, cited in Agenor (2004), p. 292. Marc Peter Radke - 978-3-631-75437-5 Downloaded from PubFactory at 01/11/2019 04:53:46AM via free access Marc Peter Radke - 978-3-631-75437-5 Downloaded from PubFactory at 01/11/2019 04:53:46AM via free access Preface After having completed my doctoral thesis which was approved by the Faculty of Business, Economics and Social Sciences at the University of Hohenheim in June 2005, I would like to express my gratitude to a number of persons and institutions without whose help this "novel" never could have been written. Firstly, I would like to thank my wife Barbara Radke for her wonderful, heartfelt emo- tional support, for her patience, and for her understanding for all those late night and weekend working sessions throughout the creation of this book. Moreover, I am deeply indebted to our son Jan-Luca Radke who had to do lots of playground sessions without his father. A special thanks belongs to my parents Renate and Dietrich Radke who helped us a lot during one of the hardest parts of our life. Furthermore, I am grateful to Ela and Jens Friderichs who have given lectures to me and to my family, and hopefully will give us further lectures in the future on the mysteries of life and how to cope with them. I would like to thank my supervisor Prof. Dr. Harald Hagemann for his professional sup- port. He provided me a very friendly, liberal, and stimulating environment for research. Furthermore, I am deeply indebted to his personal support, and to his ever-human be- haviour which motivated me in very difficult circumstances to finish my doctoral thesis. I am also very grateful to my second supervisor Prof. Dr. Hans-Michael Trautwein who supported my work with valuable suggestions and comments at our meetings in Hohen- heim and Oldenburg. Moreover, I am deeply indebted to his personal assistance and to his loyalty. I am also indebted to Prof. Joaquim Pinto de Andrade for his encourag- ing comments and useful hints at our meetings in Hohenheim, Oldenburg and Brasilia. Furthermore, I am very thankful to Prof. Dr. Heinz-Peter Spahn for assisting in the examination and administration procedure. Many thanks go to my former and current colleagues for their emotional support and for the nice work atmosphere they provided at the Department of Economics at the Uni- versity of Hohenheim. Particularly, I would like to thank (in alphabetical order) Dr. Tone Arnold, Andreja Benkovic, Isabell Benignus, Anand Chopra, Christine Eisenbraun, Andreas Findeis, PD Dr. Bjorn Frank, Oliver Fror, Dr. Daniel Hartmann, Michael Knit- tel, Oliver Kreh, Dr. Peter Kuhn!, Ulrike Lehr, Dr. Jorg Naeve, Dr. Matthias Rosch, Ralf Rukwid, Oliver Schelling, Rosemarie Schlecht, Dr. Olaf Schneider, Deborah Schemer Markus Schreyer, Prof. Dr. Ulrich Schwalbe, Dr. Stephan Seiter, Sybille Sobczak, Dr. Udo Vullhorst, and Carsten Wander. Especially, I am indebted to my colleague and friend Dr. Karin Knottenbauer for her emotional and professional support. ix Marc Peter Radke - 978-3-631-75437-5 Downloaded from PubFactory at 01/11/2019 04:53:46AM via free access I would like to thank the "Landesgrad uiertenforderung des Landes Baden-W iirttemberg" for having been granted a generous scholarship for two and a half years. I am also grateful to the "Stiftung Ausbildung, Fort- und Weiterbildung der Landesbank Baden- Wiirttemberg" for having been granted a generous financial support for the publication of this book. Mit UnterstUtzung der Stiftung Landesbank Baden-WOrttemberg LB=BW Let me finally mention that this book has been typed with ME)( 2e. I would like to express my thanks to all those people who have created and continuously updated this nice and reliable software. Marc Peter Radke Stuttgart-Hohenheim, August 2005 X Marc Peter Radke - 978-3-631-75437-5 Downloaded from PubFactory at 01/11/2019 04:53:46AM via free access Contents Preface. List of Figures . List of Tables ix xvii xix 1 Introduction and Overview 1.1 History vs. Theory 1.2 Outline of the Book .... I Theoretical and Empirical Foundations 1 1 7 11 2 Financial Crises and Financial Instability: Definitions and Principles 13 2.1 A General Definition of Financial Crises . . . . . . . . . . 13 2.2 Asset Price Fluctuations and Aggregate Economic Activity 15 2.2.1 Determinants of Asset Prices . . . . . . 17 2.2.2 Asset Prices and Financial Constraints . . 19 2.2.2.1 Perfect Capital Market Theory 19 2.2.2.2 Imperfect Capital Market Theory 20 2.2.2.3 A Comparison with Real World Financial Constraints 23 2.2.3 Asset Prices and Aggregate Demand . . . . . . . . . . . . . . . 25 2.2.4 Asset Prices, Liquidity, Solvency and the Emergence of Cumu- lative Processes . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 2.2.4.1 Liquidity, Solvency, and Profits: Definitions and Inter- dependencies . . . . . . . . . . . . . . . . 27 2.2.4.2 Determinants of Bankruptcy . . . . . . . . 31 2.2.4.3 Cumulative Expansions and Contractions 33 2.3 Determinants of Financial Instability . . . . . . . . 39 2.3.1 A General Definition of Financial Instability . . 39 2.3.2 Cash Flow Positions and Present Values . . . . 40 2.3.2.1 Hedge, Speculative and Ponzi-Finance 40 2.3.2.2 Financial Instability in Closed Economies 46 2.3.2.3 Foreign Hedge, Foreign Speculative, and Foreign Ponzi Finance . . . . . . . . . . . . . . . . . . 48 2.3.2.4 Financial Instability in Open Economies 51 2.3.3 Adequacy of Refinancing Possibilities . . 54 2.3.4 Excess Volatility in Asset Prices . . . . . 56 2.3.5 Monetary Instability and Debt Deflation 64 2.4 Exogenous and Endogenous Financial Crises . . 67 xi Marc Peter Radke - 978-3-631-75437-5 Downloaded from PubFactory at 01/11/2019 04:53:46AM via free access 3 Stylized Facts and Standard Theory of Financial Crises 71 71 71 73 74 74 75 77 80 80 82 3.1 Defining and Identifying Financial Crises 3.1.1 Currency Crises . 3.1.2 Banking Crises . . . . . . . . . . 3.1.3 Twin Crises ........... 3.2 Frequency and Severity of Financial Crises 3.2.1 Incidence of Financial Crises .... 3.2.2 Duration and Costs of Financial Crises 3.3 Business Cycles, Financial Liberalization, and Financial Crises 3.4 3.5 3.3.1 Basic Links ....................... 3.3.2 Financial Liberalization in the Post Bretton Woods Era Stylized Behaviour of Macroeconomic Variables During Episodes of Fi- nancial Crises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4.1 Financial Market Variables .................... 3.4.2 3.4.3 3.4.4 3.4.5 3.4.1.1 Monetary Aggregates and Foreign Exchange Reserves . 3.4.1.2 Deposits and Domestic Credit . 3.4.1.3 Interest Rates ......... 3.4.1.4 Equity and Real Estate Prices . Current Account Variables . Capital Account Variables Real Sector Variables . . . . Balance Sheet Variables .. 3.4.5.1 Liquidity and Profit Variables 3.4.5.2 Market Valuation and Solvency Variables 3.4.6 An Assessment . . . . . . . . . . . . . . . . . . . . Standard Theory of Financial Crises and its Correspondence with the Stylized Facts . . . . . . . . . . . . . . . . . . . . . 3.5.1 Inconsistent Macroeconomic Policy Models . 3.5.2 Self-Fulfilling Expectations Models .... 3.5.3 Asymmetric Information Models ...... 3.5.4 Credit Constraint and Balance Sheet Models . 3.5.5 Endogenous Financial Crisis Models. 3.5.6 An Assessment ................ 87 89 89 90 90 91 91 92 93 94 94 95 96 98 99 100 101 102 104 104 II A Cyclical Theory of Financial Crises 111 4 A Model of Financial Crises and Endogenous Fluctuations in In- dustrial Countries 113 4.1 The Real Side . . . . . . . . . . . . . . 113 4.2 The Financial Side . . . . . . . . . . . 115 4.2.1 A Stylized Financial Structure . 115 4.2.2 Financial Market Equilibria . . 118 4.3 Short-Run Comparative-Static Analysis . 127 4.3.1 General Results . . . . . . . . . . 127 4.3.2 A Comparative-Static View of Financial Crises . 133 xii Marc Peter Radke - 978-3-631-75437-5 Downloaded from PubFactory at 01/11/2019 04:53:46AM via free access 4.4 Long-Run Dynamic Analysis . . . . . . . . . . . . . . . . . . . . 139 4.4.1 Finance, Investment and Long-Run Profit Expectations . 139 4.4.2 The Local Dynamics of the System 149 4.4.3 Phase Diagram Analysis . . . . . . . . . . . . . . . . . . 152 4.4.4 The Global Dynamics of the System . . . . . . . . . . . 159 4.4.5 A Dynamic View of Financial Crises and Macroeconomic Fluc- tuations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168 4.4.5.1 The Emergence of Endogenous Long-Run Equilibrium Business Cycles . . . . . . . . . . . . 169 4.4.5.2 The Emergence of Financial Crises . . . 173 4.4.6 A Keynesian Perspective on Global Dynamics . . 176 4.5 A Comparison with Standard Theory of Financial Crises 179 4.5.1 Inconsistent Macroeconomic Policy Models . 180 4.5.2 Self-Fulfilling Expectations Models . . . . . . 183 4.5.3 Asymmetric Information Models. . . . . . . . 186 4.5.4 Credit Constraint and Balance Sheet Models . 189 4.5.5 Endogenous Financial Crisis Models . . 192 4.5.6 An Assessment . . . . . . . . . . . . . 194 4.6 A Comparison with Standard Business Cycle Theory . . . . . . . . . . . . . . . . . . . . . . 198 4.6.1 Theories of Endogenous Business Cycles 199 4.6.2 Theories of Exogenous Shock-Driven Business Cycles 202 4.6.3 An Assessment . . . 204 4. 7 Mathematical Supplements . . . . . . . . . . . . . . . . . . . 207 5 A Model of Financial Crises and Endogenous Fluctuations in Emerg- ing Market Countries 213 5.1 The Real Side . . . . . . . . . . . . . . 214 5.2 The Financial Side . . . . . . . . . . . 217 5.2.1 A Stylized Financial Structure . 217 5.2.2 Financial Market Equilibria . . 220 5.3 Short-Run Comparative-Static Analysis . 223 5.3.1 General Results . . . . . . . . . . 223 5.3.2 A Comparative-Static View of Financial Crises . 228 5.4 Long-Run Dynamic Analysis . . . . . . . . . . . . . . . 235 5.4.1 Finance, Investment and Long-Run Profit Expectations . 235 5.4.2 The Local Dynamics of the System 240 5.4.3 Phase Diagram Analysis . . . . . . . . . . . . . . . . . . 243 5.4.4 The Global Dynamics of the System . . . . . . . . . . . 249 5.4.5 A Dynamic View of Financial Crises and Macroeconomic Fluc- tuations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 254 5.4.5.1 The Emergence of Endogenous Long-Run Equilibrium Business Cycles . . . . . . . . . . . . . . . . . . . . 255 5.4.5.2 Domestic Financial Crisis without Currency Crisis 259 5.4.5.3 The Occurrence of a Twin Crisis . . 262 5.4.6 A Keynesian Perspective on Global Dynamics . . . . . . . . 266 xiii Marc Peter Radke - 978-3-631-75437-5 Downloaded from PubFactory at 01/11/2019 04:53:46AM via free access 5.5 A Comparison with Standard Theory of Financial Crises 5.5.1 Inconsistent Macroeconomic Policy Models . 5.5.2 Self-Fulfilling Expectations Models ..... 5.5.3 Asymmetric Information Models ....... 5.5.4 Credit Constraint and Balance Sheet Models . 5.5.5 Endogenous Financial Crisis Models ..... 5.5.6 An Assessment . . . . . . . . . . . . . . . . . 5.6 A Comparison with Standard Business Cycle Theory 5. 7 Mathematical Supplements . . . . . . . . . . . . . . . 269 270 272 277 282 284 286 286 287 6 A Calibration Model of Financial Crises in Emerging Markets 295 6.1 The Nature of Calibration Models . . . . . . . . . . . . . . . . . . 295 6.1.1 Solution Procedures to Dynamic General Function Models, Lim- itations, and Simulation Methods . . . . . . . . . . . . . . 295 6.1.2 Simulation of Financial Crises with Calibration Techniques . 297 6.2 The Real Side . . . . . . . . . . . . . . 301 6.3 The Financial Side . . . . . . . . . . . 303 6.3.1 A Stylized Financial Structure . 303 6.3.2 Financial Market Equilibria 307 6.4 The Balance of Payments . . . . . . 313 6.5 Monetary and Exchange Rate Policy 314 6.6 Analytical Solution of the Model . . 317 6. 7 Simulation Classifications and Assumptions 318 6.7.1 Financial Crises as a Cyclical Phenomenon . 318 6.7.2 Financial Crises as an Adverse Exogenous Shock Phenomenon 321 6.8 Sensitivity Analysis and Method of Graphical Representation . 322 6.9 Simulation of Financial Crises as a Cyclical Phenomenon . . . . 324 6.9.1 The Boom Phase . . . . . . . . . . . . . . . . . . . . . . 324 6.9.2 The Overborrowing Phase and the Upper Turning Point 327 6.9.3 The Bust Phase . . . . . . . . . . . . . . . . . . . . . . . 331 6.10 Simulation of Financial Crises Caused by an Adverse Foreign Interest Rate Shock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335 7 Conclusion 353 7.1 New Perspectives for Economic Theory 353 7.2 Policy Recommendations . . . . 355 A Tobin's q-Theory of Investment 361 B Financial Constraints in Perfect Capital Markets 365 C An Example of Off-Balance Sheet Transactions 369 D Forward vs. Backward Looking Variables and Solutions of General Dynamic Rational Expectations Models 373 D.l Forward and Backward Solutions of Linear Differential Equations 373 D.2 The Leibnitz Rule: Differentiating a Definite Integral 375 D.3 Backward and Forward Looking Variables . . . . . . . . . . . . . 376 xiv Marc Peter Radke - 978-3-631-75437-5 Downloaded from PubFactory at 01/11/2019 04:53:46AM via free access D.4 Forward Looking Variables, Rational Expectations and Dynamic Stability 379 D.5 Solutions to General Dynamic Rational Expectations Models . . . . . . . 383 E Kalecki's Theory of Profits 385 Symbol Glossary 389 Bibliography 393 xv Marc Peter Radke - 978-3-631-75437-5 Downloaded from PubFactory at 01/11/2019 04:53:46AM via free access Marc Peter Radke - 978-3-631-75437-5 Downloaded from PubFactory at 01/11/2019 04:53:46AM via free access List of Figures 2.1 Stylized Financial Structure of a Representative Economic Sector 28 4.1 Stylized Financial Structure in Industrial Countries . . . . . . . . 116 4.2 Graphical Representation of Function p = f (p, ct,>.). . . . . . . . . 147 4.3 Possible Demarcation Curves p = 0 Depending on Investors' Sensitivity as to Changes in p . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154 4.4 Phase Diagram in Case of Hypersensitively Reacting Investors Within the Normal Range of p . . . . . . . . . . . . . . . . . . . . . . . . . . . 156 4.5 Phase Diagram in Case of Normally Reacting Investors Within the Nor- mal Range of p 158 4.6 The Emergence of a Limit Cycle . . . . . . . . . . . . . . . . . . . . . 162 4. 7 A Dynamic Description of Financial Crises in Industrial Countries . . 171 4.8 Global Keynesian Dynamics with Hypersensitively Reacting Investors 177 4.9 Global Keynesian Dynamics with Normally Reacting Investors 178 5.1 Stylized Financial Structure in Emerging Market Countries . . 217 5.2 Graphical Representation of Function p = z(p, ci•, .\;j). . . . . . 239 5.3 Different Demarcation Curves for p = 0 Depending on Investors' Sensi- tivity as to Changes in p . . . . . . 245 5.4 Phase Diagram in Case of Hypersensitively Reacting Investors within the Normal Range of p . . . . . . 246 5.5 Phase Diagram for "Normally" Reacting Investors Within the Normal Range of p. . . . . . . . . . . . . . . 248 5.6 The Existence of a Limit Cycle . . . . . . . . . . . . . . . . . . . . . 250 5. 7 Financial Crisis I: Domestic Financial Crisis without Currency Crisis 256 5.8 Financial Crisis II: Twin Crisis . . . . . . . . . . . . . . . . . . . . . 265 5.9 Financial Crises in a Pure Keynesian World with Normally Reacting Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267 6.1 Stylized Financial Structure in Emerging Markets with a "Developed" Domestic Banking System . . . . . . . . . . . . . . . . . . . . . . . . . 304 6.2 Loan Demand, Elasticities and the State of Confidence During Different Stages of the Boom-Bust Cycle . . . . . . 312 6.3 Simulation of the Boom Phase . . . . . . . 341 6.3 Simulation of the Boom Phase (continued) 342 6.3 Simulation of the Boom Phase (continued) 343 6.4 Simulation of the Overborrowing Phase and the Upper Turning Point 344 xvii Marc Peter Radke - 978-3-631-75437-5 Downloaded from PubFactory at 01/11/2019 04:53:46AM via free access 6.4 Simulation of the Overborrowing Phase and the Upper Turning Point (continued) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345 6.4 Simulation of the Overborrowing Phase and the Upper Turning Point (continued) . . . . . . . . . . . . . . . . . 346 6.5 Simulation of the Bust Phase . . . . . . . 347 6.5 Simulation of the Bust Phase (continued) . 348 6.5 Simulation of the Bust Phase (continued) . 349 6.6 Simulation of a Foreign Interest Rate Increase 350 6.6 Simulation of a Foreign Interest Rate Increase (continued) 351 6.6 Simulation of a Foreign Interest Rate Increase (continued) 352 xviii Marc Peter Radke - 978-3-631-75437-5 Downloaded from PubFactory at 01/11/2019 04:53:46AM via free access