Working Papers | 65 | May

2010

Amit Bhaduri

A Contribution to the Theory

of Financial Fragility and Crisis
wiiw Working Papers published since 2005:
No. 65 A. Bhaduri: A Contribution to the Theory of Financial Fragility and Crisis. May 2010
No. 64 L. Podkaminer: Why Are Goods Cheaper in Rich Countries? Beyond the Balassa-Samuelson Effect. April 2010
No. 63 K. Laski, J. Osiatynski and J. Zieba: The Government Expenditure Multiplier and its Estimates for Poland in 2006-
2009. March 2010
No. 62 A. Bhaduri: The Implications of Financial Asset and Housing Markets on Profit- and Wage-led Growth: Some Results
in Comparative Statics. February 2010
No. 61 N. Foster and R. Stehrer: Preferential Trade Agreements and the Structure of International Trade. January 2010
No. 60 J. Francois and B. Hoekman: Services Trade and Policy. December 2009
No. 59 C. Lennon: Trade in Services: Cross-Border Trade vs. Commercial Presence. Evidence of Complementarity.
November 2009
No. 58 N. Foster and J. Pöschl: The Importance of Labour Mobility for Spillovers across Industries. October 2009
No. 57 J. Crespo-Cuaresma, G. Doppelhofer and M. Feldkircher: The Determinants of Economic Growth in European
Regions. September 2009
No. 56 W. Koller and R. Stehrer: Trade Integration, Outsourcing and Employment in Austria: A Decomposition Approach. July
2009
No. 55 U. Schneider and M. Wagner: Catching Growth Determinants with the Adaptive Lasso. June 2009
No. 54 J. Crespo-Cuaresma, N. Foster and R. Stehrer: The Determinants of Regional Economic Growth by Quantile.
May 2009
No. 53 C. Lennon: Trade in Services and Trade in Goods: Differences and Complementarities. April 2009
No. 52 J. F. Francois and C. R. Shiells: Dynamic Factor Price Equalization and International Convergence. March 2009
No. 51 P. Esposito and R. Stehrer: Effects of High-Tech Capital, FDI and Outsourcing on Demand for Skills in West and East.
March 2009
No. 50 C. Fillat-Castejón, J. F. Francois and J. Wörz: Cross-Border Trade and FDI in Services. February 2009
No. 49 L. Podkaminer: Real Convergence and Inflation: Long-Term Tendency vs. Short-Term Performance. December 2008
No. 48 C. Bellak, M. Leibrecht and R. Stehrer: The Role of Public Policy in Closing Foreign Direct Investment Gaps: An
Empirical Analysis. October 2008
No. 47 N. Foster and R. Stehrer: Sectoral Productivity, Density and Agglomeration in the Wider Europe. September 2008
No. 46 A. Iara: Skill Diffusion by Temporary Migration? Returns to Western European Work Experience in Central and East
European Countries. July 2008
No. 45 K. Laski: Do Increased Private Saving Rates Spur Economic Growth? September 2007
No. 44 R. C. Feenstra: Globalization and Its Impact on Labour. July 2007
No. 43 P. Esposito and R. Stehrer: The Sector Bias of Skill-biased Technical Change and the Rising Skill Premium in
Transition Economies. May 2007
No. 42 A. Bhaduri: On the Dynamics of Profit- and Wage-led Growth. March 2007
No. 41 M. Landesmann and R. Stehrer: Goodwin’s Structural Economic Dynamics: Modelling Schumpeterian and Keynesian
Insights. October 2006
No. 40 E. Christie and M. Holzner: What Explains Tax Evasion? An Empirical Assessment based on European Data. June
2006
No. 39 R. Römisch and M. Leibrecht: An Alternative Formulation of the Devereux-Griffith Effective Average Tax Rates for
International Investment. May 2006
No. 38 C. F. Castejón and J. Wörz: Good or Bad? The Influence of FDI on Output Growth. An industry-level analysis. April
2006
No. 37 J. Francois and J. Wörz: Rags in the High Rent District: The Evolution of Quota Rents in Textiles and Clothing.
January 2006
No. 36 N. Foster and R. Stehrer: Modelling GDP in CEECs Using Smooth Transitions. December 2005
No. 35 R. Stehrer: The Effects of Factor- and Sector-biased Technical Change Revisited. September 2005
No. 34 V. Astrov, Sectoral Productivity, Demand, and Terms of Trade: What Drives the Real Appreciation of the East
European Currencies? April 2005
Amit Bhaduri is Professor Emeritus, Jawaharlal
Nehru University and Visiting Professor, Council for
Social Development, New Delhi, India.
Amit Bhaduri
Financial support from Fonds zur Förderung der
wissenschaftlichen Forschung (FWF), Vienna for this
A Contribution to the
project (No. P18419-G05) at the Vienna Institute for
International Economic Studies (wiiw) is gratefully Theory of Financial
acknowledged. Fragility and Crisis
Contents

Abstract ................................................................................................................................... i

I Introduction ..................................................................................................................... 1

II A model of fluctuations driven by capital gains and debt-financed consumption .......... 2

III Some modifications of lending behaviour ...................................................................... 6

IV Financial fragility and crisis ............................................................................................. 8

V Summing up: models and reality .................................................................................. 13

Bibliography ......................................................................................................................... 16
Abstract

Three interrelated aspects typical of most financial crisis of domestic origin are brought
together in a model in this paper. The first aspect is debt financed consumption boom
supported by rising asset prices which ultimately leads to credit crunch and debt deflation
as lenders lose confidence in borrowers. This is related to the second aspect tracing
gradual evolution towards Ponzi finance. This is accompanied by fragility of the financial
sector itself and its insolvency as an inevitable outcome of unregulated economic
expansion. The paper concludes with comments on how these three aspects interact in the
real world of possible extensions.

Keywords: capital gains, consumers’ debt, debt-driven fluctuations, effective demand,

financial fragility, liquidity preference

JEL classification: D84, E12, E21, E32, E41, E44, E51, G12, G18, G24, N22

i
Amit Bhaduri*

A contribution to the theory of financial fragility and crisis*

I Introduction
Each financial crisis reminds one of the saying of an ancient Greek philosopher, ‘It is never
possible to step into the same river twice’ (Heraclitus, circa 544 B.C). Yet the ever
changing river has some relatively unchanging attributes that make it possible to recognize
it as the same river. Each financial crisis too has recurring features that remain similar,
along with its historical specificities that make each crisis different. The purpose of theory is
to isolate these necessary characteristics, even if they might not be sufficient to describe
adequately any particular crisis. Formal models are not historically accurate, but try to
isolate the central mechanism that precipitates many financial crises.

At least two features typically recur in a crisis. The first is loss of confidence either in or by
the financial sector. Since the system of credit money and the entire edifice of financial
institutions function largely on the basis of mutual confidence among the players in the
market, this leads to abrupt changes in lenders’ behaviour as the proximate cause of the
crisis. The second feature is the transmission of the crisis from the financial to the real
economy through aggregate demand. In usual Keynesian analysis this operates typically
through a sudden decline in real investment. However, at least in the recent financial crisis
(starting in 2007) it seems more the fragility of private consumption played the more crucial
role. Thus, for simplicity of exposition we focus mostly on greater consumption expenditure
sustained by rising asset prices (including housing) to examine the pattern of interaction
between financial fragility and aggregate demand.1

Section II of the paper outlines a schematized model explains how capital gains might drive
debt financed consumption expenditure resulting in fluctuations in both output and debt.
Section III extends the argument to show how similar fluctuating patterns prevail under
more plausible assumptions about lending behaviour of financial firms and banks which
takes into account borrowers’ ability to meet debt obligations from their current income. A
simplified one period version of Ponzi finance is postulated to set the limit in this case.
Section IV sets the argument in the context of financial fragility arising from increasing
internal liquidity problem faced by the financial system itself. Its ‘fragility’ is an expression of
its inability to cope with the challenges of even relatively small unanticipated defaults by

* Without implicating them in my errors I wish to record my intellectual debt to Ariel Wickerman, Duncan Foley, Dimitri
Papadimitrieu, Joanilio Teixeira, Martin Fitzbein, Massimo Riccottilli, Rune Skarstein and Servaas Storm. An earlier
version of this paper is available in the Working Paper Series (2010) of Levi Institute of Economics, Bard College, USA.
1
Evidence accumulated especially from the United States on how debt financed consumption expenditure becomes
fragile over time, with some commentators sending early warning (Baker, 2006; Campbell and Cocco, 2006; Dayan
and Maki, 2000; Maki and Palumbo, 2001; Godley, 2001; 2002; Gross, 2004).

1
means of the liquidity available within the system leading to a reinterpretation of Keynesian
liquidity preference. In the present context it relates more to financial firms than to the
general public (i.e. households and firms in the real sector). Section V concludes by
bringing together different aspects of the argument. It explains how recurring liquidity
problem and loss of confidence arise as a surface phenomenon of the deeper evolving
relation between the financial to the real sector in developed market economies. To avoid
misunderstanding, it also comments on some additional complications that are important in
many crises, but not treated adequately in the paper.

II A model of fluctuations driven by capital gains and debt-financed

consumption

From the expenditure side, gross national product (GNP) consists of

GNP = Y = C + I + U. (1)

Consumption C is assumed to be partly autonomous, and partly induced by income.

However, increase in wealth and the stock of inherited debt also influence the level of
consumption, captured by
C = c 1 Y + c 2 (dW/dt) -c 3 ρ D + K 1 , (2)

with arbitrary constants c 1 , c 2 , c 3 > 0, K 1 = autonomous part of consumption, W = wealth

of the private consumers. Note that the wealth effect is shown as operating through rising
asset values, and capital gains rather than the stock of wealth.2 While the conventional real
balance effect depends on the stock wealth, the emphasis here is on the increase in
wealth on the assumption (substantiated by recent experience) that both higher borrowing
as well as lending are particularly facilitated by rising asset prices. Borrowers can meet
their debt repayment obligations without difficulty from their capital gains, while the lenders
too lend more leniently with a more comfortable balance sheet caused by rising asset
prices. The increase in wealth (dW/dt) occurs mostly through higher prices of assets
(including housing and real estates). In a macroeconomic sense, this is notional increase in
so far as it cannot be realised on a macro scale without setting off strong bearish
tendencies in the market. However, on the micro scale higher wealth makes each
individual wealth owner more credit worthy in the eyes of the lending institutions, while
expanding simultaneously the credit base of individual lending institutions through increase

2
The assumption of continued capital gains based on information provided by an ‘efficient’ capital market was indeed the
essence of the model of ‘great moderation’. On this basis the Federal Reserve System (FED) refused to intervene in a
situation of continuously rising asset (housing) prices and consumption led boom financed by rising indebtedness of
households, until the very end marked by financial meltdown ( staring around September, 2007). This story is not
unfamiliar. ‘.. in the 1920s, convinced that skilled monetary management at the Federal Reserve and the rise of new
professionally run investment trusts had reduced the riskiness of markets, Irving Fisher declared on 15 October that
stock prices have reached ‘what looks like a permanently high plateau’’. This was just before the Great Crash leading to
the severest depression of the last century (Fox, 2009; also Time, 2009, pp. 44-45).

2
in the value of their assets on balance sheets. This results in expansion of actual credit
against notional capital gains. Nevertheless, the stock of inherited debt D exerts a negative
influence on consumption through the repayment burden. With ρ as the repayment
coefficient, this explains its negative sign in equation (2).

Persistent current account deficit (U) is covered by increased foreign debt (D F ) as

liabilities to foreigners denominated in the same, assumed to be stable domestic currency.
For simplicity of exposition we assume current account deficit is partly autonomous (K 2 ),
and the rest induced by net import as a function of GNP, i.e.
U = (dD F /dt) = n 1 Y+K 2 , (3)

where n 1 > 0 is the net import propensity.

Similarly, keeping the exposition simple investment (I)is assumed to have an autonomous
part (K 3 ) and the rest induced by income,

I = n 2 Y + K 3 , n 2 >0. (4)

The critical feature of the debt driven economy is a positive relation between increasing
(notional) wealth and increasing (actual) debt financed consumption. We assume for
expositional simplicity strict proportionality,

(dW/dt) = w(dD/dt), w > 0, a positive constant. (5)

Using (2), (3), (4) and (5) in (1), we obtain the time behaviour of Y governed solely by the
dynamics of the flow and the stock of debt and an autonomous term K, i.e.

Y = a(dD/dt) – mrD + mK, (6)

where a = mc 2 w > 0, r = c 3 ρ , and m = (1-c 1 - n 1 - n 2 ) −1 > 0; K = (K 1 +K 2 +K 3 ) = an
autonomous term, assumed for simplicity to be a time independent positive constant.

The transmission mechanism from debt to income generation in the real economy through
effective demand is outlined by focusing first on a highly simplified case of lending
behaviour by financial institutions. We postulate that there is an arbitrarily given ceiling E to
the stock of debt such that

(dD/dt) = A > 0 for D < E, and, (dD/dt) = 0 for D = E. (7)

On these assumptions, with positive borrowing supported by a steady flow of debt at the
constant rate A > 0, Y would be at its maximum value when debt repayment burden is at its
minimum D=0, to yield from (6)
Y max = aA + mK and D min = 0 (8)

3
A minimum value of Y is reached on the other hand when debt repayment burden is at its
maximum,
Y min = aA + mK - mr.E and D max = E (9)

Under these assumptions the economy fluctuates abruptly between the maximum and the
minimum value of Y in a two dimensional plane of the stock of debt (D) and income(Y).
With the stock of debt initially assumed to be at zero, D min = 0, Y starts at its maximum,
Y max with no repayment burden of debt in (8). However, as the flow of debt continues at a
steady rate A, the stock of debt accumulates over time to reach the ceiling D max = E over
t 1 = (E/A) periods. At that maximum debt repayment burden with debt at its ceiling E, Y is
reduced to its minimum value Y min in (9) with an abrupt switching off of all lending
according to (7).

Y min in (9) marks the beginning of a recession when positive wealth effect also ceases due
to switching off of all credit flows to the private consumers. However, the situation can get
worse; because all lending stops at D = E, but the obligation for repayment on
accumulated debt with its depressing effect on consumption continues. Repayment
obligation would generally be met largely through forced sale of assets under distress. A
gradual reduction of debt begins as (dD/dt) turns negative. This is the classic case of debt
deflation as the economy slides into a deepening recession (Fisher, 1933). Y falls even
below its minimum level (Y min ) given in (9), as the flow of debt (dD/dt), and its associated
wealth effect on consumption turn negative. However, the inherited stock of debt (D) also
begins to decrease, and the repayment burden on debt begins to falls gradually. This
process continues until debt reaches a sufficiently low value for lending to start again, and
recovery begins.3

The possibility of debt deflation is incorporated in the formal analysis by assuming that the
economy switches instantly to a debt retirement mode at the rate B as soon as all flow of
debt stops at the debt ceiling, i.e.

(dD/dt) = - B, B > 0 at D = E. (10)

Combining (6) and (10) it is easy to see that Y falls even below its earlier specified
minimum value in (9) due to the operation of a negative wealth effect to yield an even lower
minimum value, which lies below Y min in (9), and is given by,

Y Ext min = mK - aB - mrE. (11)

3
With forced sale asset prices might continue to fall making the debt repayment burden increasingly heavier, and
recovery more difficult. In more extreme cases recovery becomes impossible without government intervention. This
point is discussed at length in section 4 on financial fragility.

4
However, as the stock of debt also begins to fall at the rate B, and the repayment burden
gradually eases, and income begins to rise from that lowest level given by (11).

Diagram 1

Income Y

Ymax

Ymin

Y Ext min

E D(Debt)
Notes on Diagram 1

Y max from (8) ; Y min from (9) Y

ext. Min is from (11); tan Z = ‐ mn from (16)

The argument can be summed up algebraically. Using (7) and (10) we represent the
increasing and decreasing phases in the stock of debt over time as
D = tA, for t ≤ t 1 , where t 1 = E/A, (12)
D = (E-tB) = for t ≥ t 1 . (13)

From (6) we depict the time paths of Y as

Y(t) = aA - mr(tA) + mK , for t ≤ t 1 (14)
Y(t) = mK - mr(E-tB) - aB , for t ≥ t 1 , with an instantaneous switch between the two modes
at time t = t 1 at D = E. (15)

5
Since from (12) and (14), (dD/dt) =A and (dY/dt) = - mrA, whereas from(13) and (15),
(dD/dt) = -B and (dY/dt) = + mrB, it follows from the chain rule of differentiation that both in
the increasing and decreasing phase of the stock of debt, the same slope z obtains
between D and Y, i.e.

(dY/dD)= z = - mr. (16)

The stock of debt increases for (E/A) = t 1 periods, and then it decreases for the next
(E/B) = t 2 periods. Since in general, A ≠ B, it follows t 1 ≠ t 2 , implying the duration of the
two phases of increasing and decreasing in debt might differ.

Geometrically the analysis is summarized in Diagram 1. Starting initially at zero debt, the
behaviour of debt and income over time can be seen by moving along the direction of the
arrow on a two dimensional plane in D and Y.

III Some modifications of lending behaviour

Without pretence to realism the above model schematises a simple mechanism of

fluctuations in debt and income based on a stock-flow approach. Higher positive flow of
credit driven by capital gains stimulates consumption and income through higher
aggregate demand, but at the same time exerts a depressing influence on demand
through the repayment obligations on a higher stock of accumulated debt. This results in
sustained oscillations similar to some earlier Keynesian models of endogenous business
cycles, with the important difference that the present model emphases a mechanism
working through consumption rather than of investment (cf. Kalecki, 1971; Kaldor, 1960;
Goodwin, 1951; 1982).4

The model postulates a crisis of confidence of the lenders as borrowers become over
indebted reaching a debt ceiling. However, a most obvious flaw of the model lies in
assuming that this ceiling to the stock of debt is arbitrarily given (at E) without any
reference to either the ability of the borrowers to repay or the risk faced by financial
institutions which leads to such crisis of confidence. More plausibly the ceiling might be
related to the ability of the borrowers to repay in relation to their income. In that case, the
lenders face the risk of being caught in a debt trap, as the lending institutions fear that the
borrowers can only service debt with further loans. When reduced to a single period

4
In business cycle models in the tradition of Kalecki and Keynes, the positive impact on aggregate demand of the flow of
investment through the multiplier mechanism is counteracted by the depressing effect of capital stock on investment.
Mathematically they generate limit cycles (Arrowsmith and Place, 1982, ch. 5) or fluctuations from delayed response
through mixed difference differential equations (Minorsky,1969, ch. 34). It might be mentioned in this context Lavorie
and Godley (2000) made an interesting distinction between debt burdened and debt financed effective demand. A
similar distinction operates here with the flow of new debt contributing positively while the stock of inherited debt
contributing negatively to aggregate demand.

6
criterion for lending, the debt adjustment equation (7) can be reformulated defining a single
period condition for Ponzi finance as the credit ceiling, i.e.5
(dD/dt) = θ (Y- ρ D), θ >0. (17)

In this simple one-period specification, the flow of credit continues to be positive, and
adjusted to the extent of the gap between income and debt servicing obligation of each
period, i.e. (Y – rD) > 0. However, when this gap dwindles to zero, credit reaches its ceiling.
Accordingly, the flow of credit stops, and retirement of debt governed by the equation,
(dD/dt) = θ [Y − ρ {D max − (dD / dt )}] (18)

From (6) and (17) setting (dD/dt) =0, it can be seen that the maximum stock of debt is
determined endogenously as
D = D max =mK/( ρ + rm). (19)

Assuming that the initial stock of debt is minimum at zero, there is no repayment obligation.
Consequently, the inflow of credit is maximum at that point, and (6) implies income is
maximum at
Y = Y max = mK/(1- θ a),

when D = D min = 0 at t = 0. For an economically meaningful solution,

Y max > 0, implying (1 - θ a) > 0. (20)

Inserting (6) in (17), the phase of increasing debt is seen to be governed by a first order
differential equation,
(1- θ a) (dD/dt) = - θ (rm + ρ )D + θ mK , having a solution (21)
D = D max (1-e − λt
), where λ = θ ( rm + ρ ) / (1 − θ a ) . (22)

Since in view of (20), λ >0 it follows that at t =0, D= 0, but as t → ∞ , D → D max .

Similarly inserting (6) in (18) the phase of decreasing debt is guided by the differential
equation,
(1- θ a - θρ ) (dD/dt) = - θ rm D- θρ Dmax + θ mK , (23)

which reduces on simplification to

5
Minsky (1975; 1986) introduced a perceptive distinction among three stages in the evolution of the financial structure of
a firm, as it transits from hedge to speculative to finally Ponzi finance. Hedge finance allows firms to meet their
repayment obligations from expected regular flow of anticipated revenue; in speculative finance, firms still meet their
obligations mostly from anticipated revenue flows, but may need occasional injection of ‘bridge finance’ in some
periods. In Ponzi finance, continuous outside financial injections would needed to meet obligations (Taylor, 2004,
pp. 261-263). Note the distinction between speculative and Ponzi finance has been blurred in our one period
formulation.

7
(dD/dt) = µ D − µ Dmax , µ = θ mr / [θ (a + ρ ) − 1] (24)

Theoretically debt approaches asymptotically it maximum governed by (22). We

approximate by assuming that for a sufficiently large value of t = t 1 debt is arbitrarily close
to its maximum level, and the system then goes into its debt repayment mode according to
(24), until at t=t 2 debt again reaches its initial minimum value D= 0. In this case the
particular solution to (24) can be written as,
D= D max [1- e µ ( t −t2 ) ], t 2 ≥ t >t 1 . (25)

As t increases to t 2 , the stock of debt D gradually decreases from its maximum to its
minimum value of 0 at t = t 2 provided µ > 0, implying

θ (a+ ρ ) > 1. (26)

Thus starting initially(t=0) at D=0, debt approaches asymptotically its maximum level D max ,
coming sufficiently close to it as t becomes arbitrarily large at t = t 1 when the phase of
reduction in debt commences in conformity with (24) to return ultimately to the zero debt
situation at t = t 2 . Therefore, despite the postulated modifications in lending behaviour the
qualitative the nature of the debt cycle remains similar to the simpler case depicted in
Diagram 1 provided inequalities (20) and (26) are satisfied.6

These inequalities can be economically interpreted within the Keynesian framework of

demand determined output. Given the magnitude of the multiplier (m), the parameter a
(=c 2 w) captures the wealth effect operating through capital gains and increase in debt
financed consumption, while θ governs the speed with which debt increases.
Consequently the product term θ a governs the increase in debt and consumption which
has to be less than unity for the income generation process to be stable (condition 20).
Similarly inequality (26), θ ρ > (1- θ a) ensures that repayment has to exceed saving from
the wealth effect on output for the process of debt reduction to be effective.

IV Financial fragility and crisis

During the alternating phases of expansion and contraction in economic activity depicted in
the preceding sections, the financial institutions providing credit also undergoes
simultaneous changes in their asset structures and balance sheets. Paradoxically, the
fragility of the financial system tends to increase during the phase of expanding income
and debt of the real sector paving the way to its contraction.

6
The abruptness is still present at the switch point t = t 1 from increasing to decreasing mode of debt.

8
The expansionary phase encourages a general state of economic optimism, as
‘conventions’ (Keynes, 1937) gain ground that this is going to be the normal state of the
economy that can be extrapolated into the future. Consequently actors in the economy
become inclined to borrow and lend more freely. This tendency is strengthened further by
rising asset prices accompanying economic expansion. During this process, not merely the
financial position of firms and households in the real sector but even that of firms in the
financial sector undergoes change, particularly because it becomes a wide spread practice
to rely on sustained capital gains both for the expansion of credit and, for its repayment .7
When unregulated, it might become in effect a process of transition towards Ponzi finance
for many players in both the real and the financial sector (Minsky, 1986).8 This evolution
towards Ponzi finance involves both borrowers and lenders. Borrowers tend to over borrow
in relation to their regular income because they hope to meet repayment obligations more
easily out of capital gains. Financial firms too feel more solvent due to the rising value of
assets on their balance sheet, and become more inclined to lend liberally by relaxing the
standards of scrutiny. Interestingly, this process is sustained on a macro scale so long as
most of the notional capital gains quoted in the market are not actually realized, but
generate sufficient economic optimism for both borrowers and lenders to take increasingly
fragile financial positions characterized by increased volume of lending on the one hand
and indebtedness on the other.9

As the optimistic view of ‘business as usual’ continues, the fear of adverse negative shock
in an uncertain future tends to recede to the background. In general less liquidity is held,
and in particular financial firms hold less in reserve as precaution. This amounts to a
downward shift of the (Keynesian) liquidity preference schedule, as less liquidity is
demanded by financial firms themselves. It is this weakening preference for liquidity of
financial firms, rather than that of the firms and households in the real sector that begins to
make the financial system fragile at its core.

Financial firms unregulated by the monetary authority substitute liquidity typically with
assets floated by other financial firms through various innovative arrangements. This leads
7
As already stated (see note 2) the model of ‘great moderation’ of the FED was based on this assumption. For a critical
summary view of this received wisdom see also Foster and Magdoff (2008). In a complex financial system, particularly
non-bank financial firms like mutual funds, mortgage banks may increase leverage ratio, and hold securities issued by
of other financial firms, guaranteed by credit rating agencies and insurance companies, in the capital base as close
substitute for liquidity. At the end of 2007 Fannie Mae and Freddie Mac has astoundingly high leverage ratios of 65
times and 79 times respectively, while the leverage ratio of all the five big investment banks in the US (Merrill Lynch,
Lehman Brothers, Bear Stearns,, Morgan Stanley and Goldman Sachs) hovered anywhere between 33 and 26 times
(Chitale, 2008, p. 22).
8
Minsky’s explanation on this point runs mostly in terms of investment behaviour of firms in the real sector, and many
formal modelling exercises followed similar routes (e.g. Taylor and O’Connell, 1985). However, the recent crisis made
clear once more a pattern familiar from several past experiences. Financial crisis often precedes a crisis of the real
sector suggesting that the fragility of financial firms might evolve faster than that of households and firms in the real
sector. Chiarella and Flaschel (2000) in their otherwise sophisticated and disaggregate theoretical modelling of the
financial sector ignores this particular aspect.
9
Bhaduri, Laski and Riese (2006) emphasized this aspect in their model.

9
to increasingly interlocked assets and capital structures among financial firms
characterized by mutual guarantees and various forms of private insurances without
sufficient liquidity in reserve.10 At the same time borrowers in the real sector become
increasingly indebted in an easy credit regime in which innovative credit instruments are
used as substitutes, while the probability of default on these loan arrangements increase in
proportion. And the possibility of sudden financial collapse looms large below the surface
of an expanding economy.

This state of affairs is driven by a growing divergence in the perception of risk. Each
individual financial firm might feel safer, as they share or transfer risk to other financial
firms through interlocking of insured asset structures, but the systemic risk tends to
increase also on that very count. The failure to recognize or ignore this externality of
systemic risk by private financial firms in pursuit of higher immediate profit paves the way
to a crisis. It might get triggered off by even a relatively small unexpected default in relation
to the total volume of credit advanced.

An unexpected default in such situations would force the concerned financial institutions
which became less liquid during the phase of expansion to raise liquidity immediately,
particularly to sustain the scheme of interlocked mutual guarantees with other financial
firms. Paradoxically, a high degree of homogeneity of expectations among financial firms
forged during good times tends to worsen the problem in bad times. Since most other firms
with convergent expectations are similarly over-extended in terms of credit advanced in
relation to liquidity held, there is a general unwillingness to part with liquidity. Thus the
concerned financial firm trying to cover its obligations on defaulted loans is forced to sell
assets immediately under distress in a market with relatively few takers.

We assume that a certain unanticipated fraction q of loan is defaulted resulting in

immediate additional demand for liquidity L which is larger the greater is the extent of
default (q) and the higher is the leverage of the firm (x). Given the state of uncertainty, a
lower price of financial asset p helps to induce substitution in its favour against liquidity and
strengthens interlocking and illiquidity among firms so that in case of default the amount of
liquidity required tends to be inversely related to asset price in an interlocked system of
finance. This is summarized as
+ + −
L = ψ (q , x , p ) , (27)

where sign over the relevant variable indicates the sign of its partial derivative .

10
For instance an elaborate system of shadow banking populated by mutual funds, mortgage banks, brokerage
institutions etc developed in the United States which provided credit substitutes without intermediation of banks. This
shadow banking system has been described as having the characteristics of ‘complexity’ and ‘tight coupling’
(Bookstaber, 2007). The former relates to the mutual interlocking of balance sheets and assets, and the latter
resembles production on an assembly line where little time is left for correction or slow adjustment of portfolios and
capital structures, mainly because of the interlocked nature of the assets.

10
Assuming a composite asset for simplicity, the volume of that composite asset to be
supplied to the market for sale is (L/p) where p = the price level of the composite asset. As
a result of default the additional supply of assets(A S ) in the market for sale is given by

∆ A S = L/ p. (28)

A stylized representation of the demand for asset (A D ) in the market would typically
include two types of traders —the ‘value traders’ who consider the current price level of
asset (p) in relation to its long term value guided by ‘fundamentals’( π ), and the ‘trend
traders’ who focus on the short term trend in the of price assets (dp/dt). Thus, if (p- π )>0,
value traders consider assets to be over valued, and tend to be bearish. However, despite
value traders’ bearishness, price might continue to rise, if their bearishness is outweighed
by the trend traders bullish sentiment that price would continue to rise in the near future.11
When most value as well as trend traders share similar bullish or bearish sentiment,
market sentiments appear relatively homogeneous; when divided, guessing the ‘average’
sentiment that prevails in the market becomes the central concern of traders in the stock
exchange (Keynes, 1930; Keynes, 1964, ch. 12.).12

The demand for assets in the stock exchange is represented by the equation
A D =F [(p- π ), (dp/dt) ], (29)

where for reasons explained above the partial derivative of the first argument pertaining to
value traders, F 1 < 0, and that of the second argument relating to trend traders F 2 > 0.

For simplicity of exposition we postulate (unrealistically) that the system has an equilibrium
at p= π ( a constant) implying, A D = AS at p= π . Thus, in the equilibrium state so defined,
trend traders are inactive, and the value traders’ demand price π for assets at discounted
future profits equals the supply of assets A S .Thus, in equilibrium the market trades without
expectations of capital gains of losses at price π determined exclusively by fundamentals.

The movement in asset price around equilibrium depends on the excess demand and
supply of assets created by default depicted by the asset price adjustment equation,
(dp/dt) = - γ [ ∆ A D - ∆ A S ], γ > 0. (30)

Inserting (27), (28) and (29) in (30), and totally differentiating, we obtain
d(dp/dt)/dp = γ {[F 1 ] + [L(1-η )/p 2 ]} /(1- γ F 2 ), (31)

11
Friedman (1953) ignored the role of trend traders in the market to claim that profitable speculation is always stabilizing.
12
The averaging procedure followed by players in a market of divided expectations (according to Keynes) is analogous to
guessing the winner of a ‘beauty competition’. Each player chooses the prettiest face, not according to his own
criterion, but by guessing what the ‘average’ voter would consider to be the prettiest face, and then, as further
refinement guessing the average of this average and so on. Taylor (2004, pp. 152-159) provides a lucid account.

11
where η = ( p / L)(∂L / ∂p ) < 0.

From the one variable phase diagram in (dp/dt) and p in Diagram 2 it is seen that stability
requires expression (31) to be negative. Its slope on the left hand side measures the rate
of change of price (dp/dt) in response to increase in the price level (p). Therefore, stability
requires the rate of price rise to become more sluggish with increase in the level of price.

Diagram 2

Rate of asset price

increase, (dp/dt)

p* Asset price level (p)

Note on Diagram 2

The system is (locally) stable (unstable) at p* provided the slope at p* given by (31) or (35)
is negative (positive)

It is plausible to assume that the speed of asset price adjustment γ in a modern stock
market for assets is sufficiently high to make the denominator in the expression on the right
hand side of (31) negative, i.e. (1- γ F 2 )< 0. Consequently the asset market would be

12
stable around the postulated equilibrium at π provided the numerator of that expression is
positive, i.e.
[F 1 ] + [L(1-η )/p 2 ] > 0 (32)

Thus the necessary and sufficient condition for stability boils down to,
1 - η > - (F 1 p 2 /L). (33)

Since η is negative, the left hand side of (33) is unambiguously positive, and so is the right
hand side because F 1 <0. However, other things held constant, the right hand side
decreases as L becomes larger, i.e. higher demand for liquidity tends to destabilize the
market. Since (1/η ) = ( (∂p / p ) / (δ L / L) , this elasticity of asset price with respect to the
volume of liquidity raised through distress sale of assets by financial firms provides an
indication of the extent of interlocking as well as homogeneity of asset structures of
financial firms. The stronger is such interlocking, the larger is the larger is the percent
decrease in asset price due to a higher demand for liquidity, and greater is the absolute
value of (1/η ), i.e. the smaller is the absolute value ofη . Since a smaller absolute value of
η makes the satisfaction of inequality (31) more difficult, stronger interlocking of assets
would have a tendency to destabilize the market for financial assets.

V Summing up: models and reality

It was pointed out at the outset of this paper that loss of confidence of the financial sector
almost invariably appears as the as the proximate cause of most financial crisis.13 This is
hardly surprising because trust and confidence are public goods essential for a smooth
functioning of any modern financial system. This paper is an attempt to probe deeper into
this general idea by investigating how loss of confidence might arise. We suggest this
might take place along two analytically distinct routes. The simple model constructed in
Sections II and III depict in some formal details how the financial sector might lose
confidence in an over-indebted public’s ability to repay debt. This indeed has been the
generally received wisdom about how sudden tightening of credit by cautious financial
institutions precipitates a crisis.

In contrast, the argument of Section IV of this paper proceeds along a different route which
is probably more relevant for understanding how financial fragility develops in a modern
and sophisticated but largely unregulated private financial system driven by the lure of
short term profit. Paradoxically, its fragility has its root in economic prosperity that ultimately
paves the way to a financial meltdown. The collapse of confidence takes place within

13
This experience of collapse of confidence has repeated itself many times in different episodes (Rogoff and Reinhart,
2008).

13
rather than without a ‘fragile’ financial sector itself. Its interlocked asset structure and
resulting illiquidity becomes increasingly incapable of coping with sudden requirements of
liquidity due to default. In reality, these two routes (of Sections II and III on the one hand
and Section IV on the other) are usually intertwined because over lending through various
financial innovations of credit substitutes heightens the probability of default on the one
hand while strengthening on the other hand the interlocking of assets among financial
firms. Nevertheless for expositional clarity we considered it useful to separate analytically
these two aspects.

It should be emphasized that within the narrow confines of the present paper we
deliberately do not deal with loss of financial confidence in a currency which might arises
from growing international indebtedness. Although in some ways the country concerned
resembles an over indebted borrower (discussed in Sections II and III) to whom foreign
credit might suddenly denied, it has several other dimensions lying beyond the scope of
this paper. Even abstracting from various complications due to exchange rate speculation,
international power relations etc, our argument would be affected by the fact that inflow
and outflow of foreign portfolio capital would influence the behaviour of asset prices which
plays a central role especially in the argument of Section IV.

By focusing only on the stimulating wealth effect of increase in credit, and the depressing
debt servicing effect, the paper abstracts deliberately from complete discussions of other
the economic forces governing aggregate demand and income. The limited debt financed
consumption model developed here accommodates income growth mostly through the
expansion of aggregate demand caused by credit expansion linked to capital gains
moderated by the repayment obligation. For reasons of exposition, it abstracts from the
role of credit, and the possible impact of the ‘wealth effect’ on investment. In so far as
investment is influenced by changing asset values and expected capital gains or losses,
the model is incomplete. Extension in this direction might be crucial for characterizing a
financial crisis even of exclusive domestic origin. Because, over indebtedness has to
defined in relation to his income, as barely hinted at in the discussion of Ponzi finance in
Section III.. The model is inadequate without incorporating at least the impact of the wealth
effect on investment which affects in turn income growth and ability to repay over time.14
The list of issues left out of this model could no doubt be lengthened. Never the less, the
usefulness of a limited model of this kind should perhaps be judged somewhat differently.
As said at the outset, its intention is not to represent reality of particular even imperfectly,
but to isolate analytically the working of some crucial mechanisms. The mechanism
highlighted in this paper suggests that the fragility of the financial system emerges for the

14
Valuation of real as well as financial assets influence investors’ decision of acquisition versus physical investment in
new capacity. This original suggestion by Keynes’ ‘two price theory of investment’ was reformulated subsequently by
Tobin (1969) but without complications arising from capital gains. Minsky (1975, 1986) reinterpreted it by
accommodating the possibility of capital gains and changing expectations which in turn affect investment. The present
analysis does not try to model investment behaviour in any serious way.

14
very prosperity of the real economy placing the real and the financial system of an
unregulated market economy in a difficult relation. Financial collapse from time to time is a
reminder of this deeper problem.

15
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17
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