12.2 Financial instability: bubbles and crises

In section 6.5, we referred to more recent events such as the dot.com bubble of the

late 1990s. However, other approaches have been taken. One such approach has been

to argue that much trading in nancial markets is based upon ‘noise’ rather than

‘news’ – where ‘noise’ indicates irrelevant information coming to the market and

‘news’ information about market fundamentals. The existence of a great deal of noise

in markets results in excessive volatility in prices.

This is the basis of the well-known ‘noise trader’ model which was rst developed

in relation to stock markets in an attempt to explain the world-wide bull market

in stocks in the 1980s and the subsequent collapse in 1987. The noise-trader model

suggests that stock prices result from market psychology unrelated to fundamentals.

It follows the form of a number of models that had aimed to explain price bubbles

as the outcome of rational behaviour – there are two groups of market agents

both of whom act rationally but interaction between them produces bubbles. In

noise-trader models, the ‘smart money’ agents act rationally, basing their actions

largely, but not entirely, on fundamentals. The second group, the noise traders, acts

irrationally. The interaction of the two groups pushes asset prices far away from their

fundamental values.

In section 8.4, for example, we looked briey at the application of the noise-

trader model to foreign exchange rates in which Frankel and Froot (1990) sought

to explain the large real appreciation of the US dollar over the period 1981–85 and

its subsequent depreciation. They argued that there was evidence that investors

had heterogeneous expectations. Surveys of the forecasts of participants in the forex

market showed wide dispersion at any point in time. Thus, Frankel and Froot pro-

posed a model of speculative bubbles in which exchange rates were determined by

the roles of three groups of actors (fundamentalist forecasters, chartists and portfolio

managers). Fundamentalists forecast a depreciation of the dollar which would have

been rational if there had been no chartists. Chartists extrapolated recent trends based

on an information set that included no fundamentals. Portfolio managers took posi-

tions in the market and thus determined the exchange rate based on expectations

that were a weighted average of the forecasts of the other two groups. The rst stage

of the dollar appreciation after 1980 was explained by increases in real interest-rate

differentials. The second stage was explained by the endogenous take off of the

speculative bubble. As fundamentalists’ forecasts of depreciation proved incorrect

month after month, the portfolio managers decreased the weight they assigned to

those forecasts and increased the weight they assigned to those of the chartists. In

doing so, they reduced their weighted-average expectations of depreciation, raised

their demands for the dollar and thus brought about the continued appreciation

of the dollar. In 1985, the dollar entered a third stage in which an ever-worsening

current account decit reversed the overvaluation caused by the bubble. They thus

showed how (non-rational but) sensible behaviour could generate not simply short-run

volatility in exchange rates but also, and more importantly, large and cumulative

exchange rate misalignments.

All of the views we have looked at so far are concerned with particular events or

individual behaviour. A different approach, the nancial instability hypothesis of the

American economist Hyman Minsky, sees excessive market volatility as an inherent

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Chapter 12 • Financial market failure and nancial crises

part of the capitalist economic system. This begins with a distinction important in

many interpretations of the work of J M Keynes – the distinction between risk

and uncertainty. Everyone accepts that information about the future is not perfect

but it is possible to argue that past experience is a sufciently good guide to the

future that we can specify all potential outcomes and express the likelihood of

their occurring in terms of probabilities. For more information on the meaning of

risk in nancial economics see Appendix I: Portfolio theory where risk is dened as

the probability that an outturn differs from what was expected, and is measured by

the standard deviation or variance of past returns. This means that decisions can be

made mathematically on the same basis as would be the case if there were perfect

information. People might, of course, make incorrect assessments of probabilities

in the sense that the future may turn out differently from that expected, but if the

sample of cases we are dealing with is sufciently large, decisions will be correct on

average. It follows from this that the future can be insured against.

Further, if all the available information relevant to future decisions is available

equally to everyone then everyone will make the same assessment of probabilities and

will respond rationally to these. This is what is known as ‘risk’. If nancial decisions

were made under risk, there should be no problem of instability. Keynes, however,

believed that the uncertainty facing decision makers in nancial markets is much

more profound than indicated by the notion of ‘risk’ and that it could neither be

treated mathematically nor insured against. In making decisions about the imperfectly

known future, market agents need to anticipate how other market agents are going to

behave and that, in turn, requires them to know how they are likely to assess future

possibilities. We looked at an example of this from Keynes in section 6.5. Any mistakes

made in such predictions might lead to a failure of co-ordination and instability. In

other words, people face a future that is so uncertain that agents are in no position

to attach probabilities to likely future outcomes. They are more likely to make deci-

sions on some conventional basis – some rule of thumb that seems to have worked

reasonably well for them in the past. This situation is referred to as ‘uncertainty’.

According to Keynes, decision making in nancial and investment decisions

takes place under uncertainty, leading naturally to instability if shocks cause rapid

and fundamental reappraisals of expectations concerning future events. Investment

decisions are the key determinant of aggregate economic activity and must be studied

within the context of capitalist nancial practices. However, disequilibrating forces

operate in nancial markets where investors must raise nance. These affect the price

ratio between capital assets and current output which, along with nancial market

conditions, determine investment. The two sets of prices in the ratio are determined in

separate markets and are inuenced by different forces, explaining why the economy

is prone to uctuations. Shocks emanate from nancial markets and are spread by way

of investment decisions. Because both sets of decisions are made under uncertainty,

they can change rapidly, affecting not only the price ratio between capital assets and

current output but also the prices of various capital and nancial assets.

Minsky accepted the existence of regular nancial crises in capitalist economies,

but in his later work, argued that they are systemic, endogenously generated events

rather than accidents. He focuses on business debts. To service these, rms must

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