Tuesday, January 13, 2009

Nature of the Financial Crisis

Axel Leijonhufvud has a very insightful article on the causes of the financial crisis. The basic point of departure is the difference between positive and negative feedback systems. Typically markets display negative feedback: when demand exceeds supply price tends to rise. This restores equilibrium. A thermostat is a negative feedback system, it stabilizes the temperature in your house. Positive feedback systems can lead to bubbles. Leijonhufvud explains how the monetary system and the financial system took on features of positive feedback.

Leijonhufvud also has important things to say about the process of deleveraging. His conclusion is not rosy:
American households are also fairly highly levered at this time and virtually the only way for them to reduce debt is to increase their saving. The fall in business investment combined with the increase in attempted saving by households will, under present financial conditions, produce the kind of recession that John Maynard Keynes theorised about. The automatic adjustment tendencies of free markets are peculiarly ineffective in producing a recovery from a recession of this type.

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