Financial Crisis- I

1. Financial Crisis- I

2. Pre-Capitalist Finance “Money lenders” loaned their own money From ancient times Money was loaned to: Individuals for consumption The state, governments, for roads, wars, exploration Merchants for trade Rise of Banking Loans from deposited monies Renaissance Italy in 14th Century See: Shakespeare’s Merchant of Venice

3. Capitalist Finance • Commercial credit: finances trade • Just as before, money borrowed to buy cheap and sell dear • Industrial credit: finances real investment • Money borrowed to build plants, buy machinery and raw materials and hire workers • Consumer credit: finances personal consumption • From pawnbrokers through installment plans to credit cards • Mortgages to buy homes • State credit: Governments borrow and lend • Borrows to finance expendiures > tax revenues • Lends at home and abroad, e.g., foreign aid

4. Financial Institutions - 1 • Banks • Private banks • Lend to consumers, business & governments • Objective: profit • National banks • Central Banks: regulate money supply, oversee private banking sector • Development Banks: fund investment, consumption, buy political support • Supranational Banks • International private banks • World Bank

5. Financial Institutions - 2 • Stock markets • Buy & sell stocks • Stocks are ownership shares, of various sorts • e.g., some pay dividends, some don’t • Commodity Markets • Buy & sell commodies, e.g., metals, soy beans, pork bellies, spot sales & futures contracts (that can be bought and sold • Foreign exchange markets • Buy & sell currencies • Bond Markets • Buy & sell bonds

6. Crises & Financial Crises • Many kinds of crises: • Commercial crises • Industrial crises • Financial crises • All are Interrelated • Remember discussion of growth & what has to happen: • M-C(MP,L) . . . P . . . C’-M’ • Or, to be more complete:

7. Interrelationships L - M - C(MS)...P(2)...L * . L - M - C(MS) M - L M - L . . . P(1)... C’ - M’ . . . . P . . . M - MP M - MP A rupture at one point circulates to others, e.g., if money (M) can’t be had for investment, then M-L and M-MP can’t take place, then no P(1), etc.

8. Circulation of Crisisin Industrial Circuit - 1 • Crisis of Industrial credit means no M • No M (no bank credit, no stock sales, etc.), then no M-L, M-MP, …P…, C’, M’ • No L (refusal of labor market), or no MP (trade disruption), then no …P…C’, M’ • No …P…, then no C’, M’ • No C’-M’, then no revenue, no profit, no beginning again in new period

9. Circulation of Crisisin Industrial Circuit - 2 • Crisis of Commerical Credit means breakdown in C’-M’ • Expand C’-M’…. • C’ sold to wholesalers (who need credit) • C’ sold by wholesalers to retailers (who need credit) • Breakdown in C’-M’ circulates

10. Circulation of Crisisin Reproduction of Labor - 1 • No L-M (refusal to enter labor market), then no wage), more …P(2) …, Life but no L. (assuming ability to produce consumer goods) • E.g., frontier, unsubordinated colonials • No L-M (no jobs), then no wage, less C(MS), more …P(2) …, less L. (assuming some MS purchased with savings) • E.g., downturn, rising unemployment • In other words: a breakdown in the subordination of life to labor, or in the reproduction of labor.

11. Circulation of Crisisin Reproduction of Labor - 2 • Crisis of Consumer Credit • E.g., default on consumer debt  repo’s • E.g., defaults on mortgages  foreclosures • Surge in Consumer defaults •  collapse in consumer demand for durables and housing • Collapse in consumer demand •  drop in aggregate demand, drop in both C’-M’ and in M – C(MS) which provokes fall in investment, employment etc. • Collapse in market for consumer debt • E.g., mortgages and mortgage-based securities

12. Finance & Keynesian Models - 1 • All the major components of aggregate demand: C, I, G, X and M depend on finance • C = consumer demand, depends on consumer credit • I = investment demand, depends on capital markets (loans, stocks, bonds, etc.) • G = government expenditures, depend upon borrowing, e.g., in US Treasury Bills • X = exports, depend upon commercial credit • M = imports, depend upon commercial credit

13. Finance & Keynesian Models - 2 • Two-way relationship: • Healthy credit  growth in C,I,G,X,M. • Healthy growth  confident credit markets, but…. • Breakdown in credit  breakdown in C,I,G,X,M • Breakdown in C,I,G,X,M  breakdown in credit markets. • Monetary Policy • Central bank affects finance through interest rates and handling of government debt • Via reserve requirements, discount rate, open market operations • Regulation of finance part of monetary policy

14. Financial Crises & Regulation - 1 • Regulations were created because: • the “free market” was subject to manipulation and abuse and regularly produced crises that undermined part or all of the economy. • Examples: • Tulip Mania (1634-1637) • Bank Panics and Crises of: 1792, 1796-1797,1819,1825,1837,1847,1857,1866, 1873, 1884, 1893, 1896, 1907 • Wall Street Crash of 1929.

15. Financial Crises & Regulation - 2 • Primary purposes of regulation: • To create and maintain confidence in various financial institutions and their operations • In order to create and maintain useful flows of money to finance consumption, investment, trade and government expenditures • To protect those who depend upon credit from misconduct and exploitation

16. Financial Crises & Regulation - 3 • Financial regulation includes: • Specification of what actions are legal and which ones are illegal and… • Specification of what institutions can do what • Broadly this involves laws passed by congress • Supervision to enforce laws, prosecute violations of laws • Institutions to supervise, to check to see if regulations are being adhered to, investigate violations and prosecute them.

17. Financial Crises & Regulation - 4 • Regulatory institutions in the US include: • Federal Reserve System (Fed) • Regulates member banks reserves, etc. • Federal Deposit Insurance Corporation (FDIC) • Insures deposits, regulates bank deposit behavior • US Securities and Exchange Commission (SEC) • Regulates securities markets (stock, bonds, etc.) • National Credit Union Administration (NCUA) • Licences, supervises and regulates credit federal credit unions • Commodity Futures Trading Commission (CFTC) • Oversee and regulate commodities markets, futures & options

18. Great Depression & Financial Regulation • Stock Market Crash of 1929 • October 29, 1929 “Black Tuesday” • Financial collapse contributed to collapse of economy more generally • Despite Federal Reserve Act of 1913 • New financial regulations in 1930s: • Farm Credit Administration, • Federal Securities Act, Glass-Steagall Act (creates FDIC, lets Fed set max interest rates on S&L, splits commercial and investment banking), • Export-Import Bank created, • Exchange Stabilization Fund created, Federal Farm Mortgage Corporation, SEC created, etc.

19. Keynesian Era & financial Crises • Comprehensive financial regulation at home meant virtually no domestic financial crises • Bretton Woods agreement on fixed exchange rates with IMF as overseer and lender of last resort • UNTIL: accelerating inflation and growing gov. debt, trade deficits and speculative attacks on the dollar lead to abandonment of Bretton Woods, volitile flexible exchange rates and negative interest rates.

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