Ognjen Radonjić and Srdjan Kokotović UNIVERSITY OF BELGRADE FACULTY OF PHILOSOPHY OgnjenRadonjić andSrdjanKokotović Keynes, Minsky and Financial Crises in Emerging Markets UNIVERSITY OF BELGRADE FACULTY OF PHILOSOPHY One of the most important, yet perhaps still under‐appreciated lessons of the global financialcrisisof2007 ‐09concernstherolethatacademiceconomicsplaysintoday’ssocietyand politics.Alongwiththerevelationsabouttheskewedincentivestructureinthefinancialindustry, short‐termism in national economic policies, dogmatic thinking at the levels of international economicsinstitutionsandcontroversialprocessesof financialinnovation, thecrisis hasexposed mainstream academic economicsas a closed‐mindedenterprise,worryinglynarrow in itsscope and mission, and increasingly detached fromthe analysis of economic realities. As part of this transformation in academic economics, studying economic history and learning from the rich historyoftheprofession,hasbeencrowdedouttothemarginsofeconomics. Keynes, Minsky and Financial Crises in Emerging Markets represents a long‐needed attempt by economists to depart from this sad trend. Radonjić and Kokotović focus on the evolutionoffinancialstructuresandthewaythisprocesshasbeen analysedby , ontheonehand, economicorthodoxy, andheterodoxscholarssuch asJohn Maynard Keynes and Hyman Minsky, on the other. At the very centre of the book’s critique is the relationship between privately createdcredit instrumentsandpublic, or official monetarysupport to the economy. Focusingin depth of the anatomy offinancial instability and crises, the authors chart the evolution of key conceptual approaches to financial crisis, and examine in dept h thekey cases of fragility, crises and crashes of the past threedeca des. Their rigorous,reflexive and well‐documented empirical analysisillustratestheeffectsofkeyprocessesofendogenouscreditatworkindifferentpolitical‐ economycontexts:emergingeconomiesinLatinAmerica,EastAsia andEasternEurope,and the advancedeconomiesof Anglo‐Saxon capitalism. Carefully tracing the development ofacademic thoughton finance over thepast few decades the authorspresent adynamic, critical and well‐ informedportrayalofthefinancialsystemdrivenbyprivatefinancialinnovationyetdependanton public liquidity provisionin times of crises. Their analysisof this c ontroversy makes this text a must‐readforallstudentsoffinancialcapitalismpost‐2008,andavaluableresourcetothosewho aimtolessentheeconomicburdenoffinancialcrisesinthefuture. AnastasiaNesvetailova CityUniversityLondon Keynes, Minsky and Financial Crises in Emerging Markets Филозофски факултет, Универзитет у Београду │ 2014 K eynes, Minsky and Financial Crises in Emerging Markets K Ognjen Radonjić Srdjan Kokotović Ognjen Radonjić Srdjan Kokotović Keynes, Minsky and Financial Crises in Emerging Markets First edition, Belgrade 2014. Publisher: Faculty of Philosophy, University of Belgrade Čika Ljubina 18-20, Belgrade 11000, Serbia www.f.bg.ac.yu For the publisher: Miloš Arsenijević Dean of the Faculty of Philosophy Reviewers Miodrag Zec (University of Belgrade) Boško Živković (University of Belgrade) Marc Lavoie (University of Ottawa) Anastasia Nesvetailova (City University London) Proof reading: Charles Robertson Printing: „Službeni glasnik“, Belgrade Print run: 300 ISBN 978-86-88803-55-7 Publishing of this book was supported by the Ministry of Education, Science and Technological Development of the Republic of Serbia Acknowledgements We are sincerely thankful for valuable comments and suggestions to professors Miodrag Zec, Boško Živković, Pavle Petrović, Marc Lavoie and Anastasia Nesvetailova. The analysis, findings, and conclusions expressed in this book are en- tirely those of the authors and do not represent the views of either the University of Belgrade or the National Bank of Serbia. Any error remains an exclusive responsibility of the authors. To my friend and mentor, professor Miodrag Zec Ognjen Radonjić To Milica, Dunja and Nadja, my beloved three princesses Srdjan Kokotović Even if you are a minority of one, the truth is the truth. Mahatma Gandhi Measure, value, that which endures in the transient world– all disappear. They are replaced by nihilism, the cult of worthlessness. Truth is reduced to an empirical or mathematical reality and is no longer the ideal to which reality should aspire. The truth sets us free because it has power over us; it gives us instructions, not the other way around. Rob Riemen, Nobility of Spirit. A Forgotten Ideal | 9 Table of contents 13 | Foreword by Professor Marc Lavoie 15 | Introduction 23 | I Exegesis of the Conventional Wisdom: Efficient Markets, Rational Expectations and Exogenously Generated Financial Crises 24 | 1. Vanguards to the Efficient Markets Hypothesis 25 | 2. The Efficient Financial Markets Theory: Birth and Implications 28 | 3. Exogenously Generated Speculative Bubbles and Financial Crises 31 | 4. Orthodox Views on International Financial Crises 35 | 5. Assumptions of the EMH: Ab Absurdo 36 | 5.1. Risky and immutable future 40 | 5.2. The degree of risk-aversion and expectations of rational agents are exogenous 41 | 5.3. Expectations of rational agents are homogenous 42 | 5.4. Uncorrelated trades of irrational investors 43 | 5.5. Correlated trades of irrational investors and stabilizing actions of rational arbitrageurs 44 | 5.6. Any security has always-available perfect or almost perfect substitute and agents have unrestricted, ready available access to credit 44 | 5.7. Neutrality of money 50 | II Keynes’ U-turn: Endogenous Expectations, Speculative Financial Markets and Instability of Investment Demand 51 | 1. Probability, the Weight of Argument and Fundamental Uncertainty 53 | 2. Non-neutrality of Money, Liquidity Preference and Keynes’ Rejection of Saw’s Law [...]... that financial markets are the heart of modern capitalist economies, which are prone to fragility, thanks to the non-neutrality of money, division of ownership and management in big corporations and financial institutions, the ever-growing and massive debt financing of uncertain investment projects over the business cycle, continual financial innovation and fundamental uncertainty In a word, dynamic financial. .. 77 | Keynes, Minsky and Financial Crises in Emerging Markets 3 The Nonergodic Economic System and the Short and Long-Term Expectations of Entrepreneurs 4 Dual Price Investment Theory, Conventional DecisionMaking and Speculative Financial Markets 5 Flimsy Expectations, Propensity to Hoard and Instability of Investments 6 Speculative Bubbles, Busts and Business Cycles 7 Destabilizing Arbitrage and Speculative... are equalized, and since according to the EMH marginal cost of acquiring new publicly available information is zero then marginal income earned on the basis of publicly available information is also equal to zero 28 | Keynes, Minsky and Financial Crises in Emerging Markets 3 Exogenously Generated Speculative Bubbles and Financial Crises Between the lines, the theory of efficient markets is based on... financial markets: why and how the expectations of agents and thus the prices of financial instruments change and in what way the dynamics of financial markets inevitably lead towards equilibrium in the short and long run Namely, until the 1960s, economists did not explore the dynamics of financial markets and did not attempt to frame theoretically continuous, seemingly irrational and unexplainable price changes... have been reissued, and the annual Minsky conference is now being held in New York City, at the Ford Foundation, with hundreds of participants, including many presidents of the US Federal Reserve Banks 14 | Keynes, Minsky and Financial Crises in Emerging Markets Ognjen Radonjić and Srdjan Kokotović do a marvelous job of recalling the standard view of financial markets – the efficient market hypothesis... those stock market gains.” (Greenspan 2005, p 5) 4 Orthodox Views on International Financial Crises In parallel, at the international level, mainstream orthodox (efficient markets) crisis models have been created in order to explain recurrent financial boom-bust episodes in mainly developing countries So-called “first generation” crisis models depart from conflicting internal policies and a fixed exchange... generates efficient functioning of financial markets, i.e instantaneous elimination or elimination in the very short run of possible discrepancies between the actual and intrinsic value of securities In a word, guided by Smith’s “invisible hand”, individual agents aiming at maximizing their own gain, unintentionally simultaneously maximize the benefits to the society If, on the other hand, if no one but you... Credit for the soft landing goes to large-scale and unprecedented financial assistance provided by the developed world and international financial institutions We finish with a conclusion and policy recommendations | 23 I Exegesis of the Conventional Wisdom: Efficient Markets, Rational Expectations and Exogenously Generated Financial Crises The Efficient Markets Hypothesis is certainly one of theories... of the value of global financial assets to the value of world investments in 2010 was equal to 1385% (IMF, WEO database; Lim Mah-Hui 2008; The Economic Times) In 2010, the turnover in traditional foreign exchange markets (spot, forward, and swaps) was equal to nearly 4 trillion US$ a day and the value of annual world exports 16 | Keynes, Minsky and Financial Crises in Emerging Markets balances are of... As Minsky says: “Although the full force of Keynes’s insights into the workings of a capitalist economy has not been absorbed into the ruling economic theory and policy analysis, 20 | Keynes, Minsky and Financial Crises in Emerging Markets enough of his message – that our economic destiny is controllable – has come through to make conscious management of the economy ” (Ibid, p 8) If, on the other hand, . 2014 K eynes, Minsky and Financial Crises in Emerging Markets K Ognjen Radonjić Srdjan Kokotović Ognjen Radonjić Srdjan Kokotović Keynes, Minsky and Financial Crises in Emerging Markets First. ownership and management in big corporations and financial institutions, the ever-growing and mas- sive debt financing of uncertain investment projects over the business cycle, continual financial innovation. Minsky and Financial Crises in Emerging Markets Ognjen Radonjić and Srdjan Kokotović do a marvelous job of recall- ing the standard view of financial markets – the efficient market hypoth- esis –