What causes economic crises
Economic crises are complex events with multiple contributing factors. Different theories highlight different aspects, but no theory captures the full picture. There are a few key reasons why no single theory fully explains economic crises:
- Economic crises are complex events with multiple contributing factors. Different theories highlight different aspects, but no theory captures the full picture.
- Theories often focus on proximate causes rather than underlying root causes. For example, many theories explain how financial fragility can trigger crises but don’t fully explain why fragility builds up in the first place.
- Most theories are partial equilibrium models that abstract away important general equilibrium effects. This limits their explanatory power for major macroeconomic events like crises.
- Theories are often based on historical crises that may not generalize well to new types of crises in different institutional contexts. Theories have limited out-of-sample predictive power.
- Political economy factors and social psychology elements are often neglected in purely economic theories of crisis. These non-economic factors likely play an important role.
- Data limitations constrain researchers’ ability to test theories definitively. There are often too few crises to statistically discriminate between competing theories.
- Crises likely stem from a confluence of factors. Interactions between financial fragility, asset bubbles, credit booms, policy mistakes, economic rigidities, and exogenous shocks probably contribute in complex ways.
- Heterogeneity between crises in different countries also limits the generalizability of specific theories tied to historical cases.
There have been two main theories that provide useful frameworks for understanding different dimensions of crises: one put forth by Hyman Minsky and another by Charles Kindleberger.
Minsky’s Model:
- Builds on Keynes’ theory of inherent instability in capitalist economies.
- Emphasizes domestic business cycles driven by investment fluctuations and fragile debt structures. Periods of economic stability lead to more risky lending and investment practices, resulting in financial fragility and higher risk of crisis.
- As a result, crises are a consequence of endogenous dynamics, not external shocks.
- Policy agenda focuses on structural reforms like Big Government, employment strategy, and financial regulation.
Kindleberger’s Model:
- Emphasizes international propagation of crises often triggered by exogenous displacements like war.
- Focuses on asset price fluctuations, monetary expansion, and the need for a lender of last resort.
- Policy agenda advocates for stabilizers in commodity and capital markets and policy coordination.
The differences between Minsky and Kindleberger’s models can be summarized:
- Minsky traces cycles to fiscal policy (investment), Kindleberger to monetary policy (credit)
- Minsky inspired by Simons, Kindleberger by Bagehot
- Minsky was a New Dealer and anti-globalist, Kindleberger a globalist
- Minsky advocates activism and reform, Kindleberger wants stabilizers
- Minsky is concerned with the fragility of financing structures, Kindleberger with manias and panics
- Minsky leaves a legacy of Post-Keynesian economics, Kindleberger of historical narrative
In sum, economic crises are extremely complex events that resist explanation by any single theory. A plurality of perspectives is likely needed, but even then our understanding remains limited.
Theories of Economic Crises
By: Alessandro Roncaglia – La Sapienza University in Rome
Minsky and Kindleberger: Fellow Travelling Theorists of National and International Financial Instability
By: Perry Mehrling – Boston University
