On types of crisis

Posted by Daniel Heymann on 13 February 2009

The current macroeconomic crisis is changing the life of people worldwide. It thus poses urgent demands on economic policies. It is also an exemplary event, raising serious questions for macroeconomic analysis. No obvious outside shock provoked the financial crash or the economic recession (and events like the fall of Lehman Bros would hardly rise to the rank of “sunspots” to coordinate an otherwise avoidable collapse). Policies failed, but under first-world institutions: no eye-catching “emerging economy crisis” antics there. Cheating was part of the picture, but it would take more than some Madoffs (or a high degree of systemic fragility) to shake the world economy. With some license in “stylizing facts”, the question would be how such a crisis did emerge as a self-generated outcome in economies with “best practice institutions” and not abnormally dishonest or gullible agents. More introspectively, one is also led to ask what kind of analytical apparatus would contribute best to understand the current economic circumstances and to discuss alternative policies and reforms.


All crises are different, and almost necessarily so. However, despite its striking particularities, this one belongs to a family of events. Common to them are: large-scale revisions of wealth perceptions, and widespread “broken promises“, especially on financial contracts (Leijonhufvud, 2003, Galiani et al. 2003, Heymann, 2008). These are symptoms of macroeconomically relevant errors in forecasts. In the booms that lead to the crisis one typically finds high expectations of future prosperity due to policy or technological innovations (however, not every economic boom has been a bubble). Falsified beliefs of many economic agents (although not necessarily of all market participants or analysts) are the general feature of crises, apart from the specificities in their emergence and transmission. Accommodating monetary policies, and fancy repackaging of assets as a vehicle for large wealth and risk misjudgments, were certainly important in the buildup of the US bubble, as government deficits were in other episodes. But these features do not seem necessary, or sufficient, conditions for a bubble and crash. Dramatic crises have erupted in economies with passive monetary policies and no-frills financial systems.


Macroeconomic ups and downs come in different shapes and sizes. As in a straightforward second-best problem, when considering anti-crisis policies, it matters to identify the disturbance to be dealt with. Small fluctuations in real activity “around a given trend” do not change wealth by much; macroeconomic policies need not depart from routine procedures. In other instances (assuming that liquidity preference is expressed by demanding more national currency), the appropriate response may be for the central bank to lend to financial operators, if there is a sizeable shock on some asset valuations, but wealth readjustments, credit contractions, and defaults will not propagate unless those operators are forced to liquidate positions. With larger shocks, those policies would be insufficient to maintain aggregate demand if downward wealth revisions have been large and the solvency of many agents is uncertain, or seen as contingent on the absence of a drop in present activity levels.  Assuming that defaults would not become widespread provided current activity levels are sustained, and that liquid agents are willing to lend to the government, this configuration would call for traditional fiscal expansions through public spending and transfers to liquidity- constrained consumers. 



For some particularly deep crises, where the size and the diffusion of wealth misperceptions and the mass of unenforceable debts are too large, remedies may go beyond standard “Keynesian” prescriptions, because the problem goes beyond a “simple” effective demand failure[i]. Suppose a counterfactual scenario where the income flows of all agents, and particularly the “ultimate” debtors, households and businesses, are somehow maintained at their pre- crisis levels, but even so many agents remain insolvent. The set of property rights has become inconsistent. Sustaining aggregate demand for the time being, even if feasible, would leave unsolved the indeterminacy of wealth position and the widespread lack of creditworthiness. That inconsistency must be processed, and property rights redefined so that resources can be mobilized and used again. This scenario is symmetrical to that where property rights are hazy because of unresolved social and political conflicts. Here, a failure in the economic system sends to the political arena the problem of distributing wealth losses when contracts cannot be enforced. There are no simple solutions for that. “Leaving it to the market”, basically to bankruptcy courts, is a possibility, but parties and judges would face the daunting problem of determining fair and feasible payments in a state of deep, systemic uncertainty and, while the mass of cases waits to be settled, propensities to spend and to lend would hardly recover strongly. Reshuffling bad debts, e.g. by transferring the claims from banks to the government, would unburden intermediaries but, apart from distributive considerations, the macroeconomic normalization of credit and real activity would depend on when and how is lifted the shadow of widespread insolvency of non- financial agents (across the world). And any direct government intervention on contracts may cause strong political conflicts. 


The diagnosis in the developed world has been shifting from a not- too- serious, encapsulated disturbance, to a shock that would call for fiscal expansion and some government takeovers of problematic bank assets. Hopefully, but not certainly, this will stop the decline in real activity and prevent a propagation of defaults. Big crises like this one face polities with dramatic decision problems with strong efficiency and distributional consequences. These consequences have a salient international dimension, which should not stay unmentioned when writing from the South. However, their discussion exceeds the scope of these notes.

Daniel Heymann*
ECLAC and University of Buenos Aires.  



Leijonhufvud, A. (2003): “Macroeconomic Crises and the Social Order”, University of Trento.

Galiani, S., D. Heymann and M. Tommasi (2003): “Great Expectations and Hard Times: The Argentine Convertibility Plan”, Economia (LACEA), Spring.

Heymann, D. (2008): “Macroeconomics of Broken Promises”, in R. Farmer, ed. Macroeconomics in the Large and the Small, Elgar.

Koo, R. (2003): Balance Sheet Recession, John Wiley



* All opinions are personal.

[i] Cf. Koo (2003) on Japan. In economies with a limited demand for local money and public debt, the likelihood of a crisis of the worst kind is higher, once the economy’s buffer stocks (like international reserves) have been used up. Accordingly, there may be a corridor effect in the consequences for LDCs of the current international crisis.