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Instability of Financial Assets and Effective Policy Response - SAMPLE RESEARCH PAPER

01 Mar 2023,12:31 PM

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Keynes wrote the General Theory of Employment, Interest, and Money in the aftermath of the 1929 financial crisis. This financial collapse caused him to construe markets as unstable and characterized by dramatic changes in the prices of financial assets. Keynes' work spotlighted conditions that generate undesirable levels of instability in financial markets, which compromise the price of financial assets. This analysis examines the economist's proposals about the implications of uncertainty for the performance of financial assets and some policy responses the government can consider to assuage this explosive relationship.

When analyzing Keynes' work, a good starting point is examining the neoclassical financial markets theory he contradicted. Keynes' work opposes the efficient market hypothesis, which posits that self-corrections can ensure stable and favorable pricing. This position hinges on two assumptions: perfect informational efficiency and optimal equilibrium prices (Crotty, 2011). In an ideal financial market, prices are set by objective utility-maximizing actors who possess perfect information regarding cash flows from all securities (Crotty, 2011). The implication here would be that all pertinent details are leveraged during pricing. This high level of certainty when pricing financial assets are what Keynes deemed impossible.

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The Keynesian world works differently from the models of market equilibrium. Keynes urges economists at the beginning of The General Theory to critically evaluate their basic assumptions (Keynes, 1954). He posited that neoclassical theory is erroneous because its postulations do not reflect trends in "the economic society in which we live" (Keynes, 1954). To Keynes, markets are rife with uncertainties that make it impossible to make accurate predictions of the future based on all relevant information. Keynes' theory is a model espousing the lack of market equilibrium, which makes markets inefficient. Rational agents can purport to possess the information needed to shape their expectations, but they do not have any assurance that their projections are accurate (Crotty, 2011). This is an imperfect financial market paradigm in which optimal pricing that accounts for all risk and returns related to financial assets is elusive. The implication here is that agents cannot arrive at the accurate expectation of the future status of the economy.

The key plank in General Theory is the chief role aggregate demand plays. The crux of Keynes' theory is that aggregate demand – referring to the sum of spending by enterprises, the government, and households – is the main driving factor in an economy (Jahan, Mahmud, & Papageorgiou, 2014). That means free markets lack self-balancing mechanisms that generate full employment (Jahan, Mahmud, & Papageorgiou, 2014). Insufficient demand can result in protracted unemployment (Jahan, Mahmud, & Papageorgiou, 2014). An economy's output comprises the following components: consumption, purchases made by the government, investment and net exports (Jahan, Mahmud, & Papageorgiou, 2014). A demand spike needs to stem from one of them (Jahan, Mahmud, & Papageorgiou, 2014). The problem is that crises can lead to strong forces that reduce demand (Jahan, Mahmud, & Papageorgiou, 2014). Downturns such as what happened during the pandemic or the 2007/8 crisis hurt consumer confidence and cause people to limit their spending, particularly when it comes to discretionary items like a car (Jahan, Mahmud, & Papageorgiou, 2014). Less spending generates limited investment by enterprises as they react to diminished demand for their goods and services (Jahan, Mahmud, & Papageorgiou, 2014). It is this feedback loop among the different components that have an impact on the prices of financial assets.

The next material area is how Keynes tackled the implications of disequilibrium. Keynes put forward a theory of what happens in the capital process showing that financial and output instability is attributable to market behavior (Keynes, 1954). The central propositions in the General Theory focus on the disequilibrating forces that happen in financial markets. These influences directly impact how capital assets are valued relative to the prices set for current output. It is the price ratio, in addition to financial market factors, that influence investment activity. Therefore, the General Theory focuses on how two different sets unfold in various markets and face distinct economic forces. On one end of the spectrum, there are capital and financial assets, whereas the other has current output and wages (Keynes, 1954). These sets are amenable to the fluctuations happening in the economy.

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In this type of environment, agents have to make financial decisions about the future. Keynes' idea was that people's outlook on the future could impact the level of employment (Keynes, 1954). The current variables likely to absorb the direct effects of shifting opinions about the future include the prices set for financial assets, the valuation of capital assets, and how business people and their bankers consider liability structures (Keynes, 1954). Taking a financial perspective makes it difficult to see time as an element that leads to the generation of additional commodities. Keynes construes time as calendar time and believes that the future brings uncertainty. The implication is that individuals make investment and financing choices amid significant uncertainty. Such precariousness means that perspectives about what the future holds undergo dramatic shifts within short durations. The problem is that the short-lived perspectives of the future impact the prices of different financial instruments and capital assets. The fact that the future is unknowable means that the price of financial assets can fluctuate without agents having enough foresight. It means "there is no scientific basis on which to form any calculable probability" (Keynes, 1954). The inability to decipher the future states is a central aspect of Keynes' theory, and it has profound implications for the performance of financial assets.

Uncertainty does not happen during crises alone. Indeed, booms also present circumstances that engender precariousness. When a boom begins, it causes a spike in optimism and confidence, making people less risk-averse (Crotty, 2011). That increases the propensity to purchase financial assets and leads to an endogenous spike in liquidity (Crotty, 2011). Ultimately, everyone gets a favorable price for their financial assets, generating advantageous outcomes like more credit use, additional business and consumer wealth, greater demand, lower interest rates, increased jobs, and higher spending (Crotty, 2011). If the boom persists, then agents develop a new belief that the economy is now in a new era in which the drivers that led to the end of previous booms are not at play (Crotty, 2011). This leads to the conviction that the boom is permanent. This faith alone is not a testament to the economy's health. Keynes emphasizes that market ebullience does not last forever (Crotty, 2011). As the boom matures, then the economy starts to experience financial fragility (Crotty, 2011). At saturation, the economy becomes incapable of generating the amount of cash flows required "to sustain euphoria-inflated financial asset prices" (Crotty, 2011). The moment this happens, skepticism sets in against the backdrop of reducing profit and stagnating household income, both leading to lower investment and consumption (Crotty, 2011). The drop in aggregate demand growth and jobs causes agents to realize that they were over-optimistic when they projected future cash flows (Crotty, 2011). As a result, they adjust their expectations and have less faith in the accuracy of forecasts, which leads to a reduction in prices (Crotty, 2011). These trends are accompanied by higher interest rates, defaults, and risk aversion (Crotty, 2011). Thus, even economic booms entail uncertainty and eventually lead to a drop in the prices of financial assets.

An effective policy response can moderate the uncertainty affecting financial assets can be helpful. Keynesian economics posits that active government intervention is necessary to ensure the economy runs well. Keynes wrote his theory following the 1929 stock market crisis that led to the Great Depression, which led him to conclude that unchecked free-market capitalism is inherently defective. The 1929 financial collapse shifted thinking about the stability of relying on free markets. The crisis showed that unregulated markets are amenable to instability, insider manipulation, and insider fraud (Crotty, 2011). They could also precipitate a serious economic downturn and unrest (Crotty, 2011). The 1929 financial crisis and ensuing downturns, such as the one that happened in 2007/8, affirmed Keynes' propositions about endogenous financial instability (Crotty, 2011). There was no self-correction in these examples. Nobel Laureate Joseph Stiglitz lent his mind to this issue and stated that the economics profession has been wrong for assuring "regulators that markets could be self-regulated; that they were efficient and self-correcting" (Crotty, 2011). Thus, Keynes supported government intervention as a means of tackling unpredictable issues like unemployment and economic recession. This school of thought prompted the US government to engender a stringent regulatory system.

The basis for government intervention stems from Keynesian thinking that demand drives an economy rather than market supply. The total amount of spending influences all economic outcomes, including the production of products and services and the level of employment. Uncertainty, like what happens during a recession, leads to a drop in demand. To resolve this debacle, the government has to step in by infusing additional capital into the economy. This step will drive consumption and generate economic stability or recovery.

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One of the applicable interventions is monetary policy. Monetary policy can be a tool for economic stimulation (Jahan, Mahmud, & Papageorgiou, 2014). Government fiscal and monetary policies can impact aggregate demand. Monetary policy can lead to real changes in output and jobs when certain prices remain constant such as nominal wages. Injecting additional money into the economy would not work if there is an instantaneous price change. This explains the Keynesian position that prices tend to be rigid. Price rigidity means that fluctuations in any aspect of spending – investment, consumption and government spending – can lead to output fluctuation. When expenditure from the government goes up, and the others remain constant, this will raise output. The output rises by a multiple of the initial shift in expenditure that generated it. That would mean that an additional $10 million in government expenditure will cause the output to go up by $15 million (representing a 1.5 multiplier effect) or $5 million, which would be a 0.5 multiplier. Keynes hypothesized that governments must resolve issues in the short run instead of waiting until market forces correct things in the long run (Jahan, Mahmud, & Papageorgiou, 2014). To be succinct, "in the long run, we are all dead" (Keynes, 2014). Intervention is the key to ensuring the prices of financial assets do not crumble to the point of no recovery.

Keynes applied his mind to dismissing claims of certainty and market self-balancing. To the theorist, the economy is rife with uncertainties that impact the prices of financial assets. This means exposure to the risk of price fluctuation in a way that agents cannot predict or that market forces alone cannot correct. Both booms and downturns engender processes that generate uncertainty, hence the need for an effective policy response. The government can use monetary policy that brings additional money and spending to the economy to ensure price stability.

 

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Bibliography

CROTTY, J. 2011, May. The realism of assumptions does matter: Why Keynes-Minsky theory must replace efficient market theory as the guide to financial regulation policy [online]. The University of Massachusetts Amherst. [viewed 28 October 2022]. Available from: https://www.umass.edu/economics/publications/2011-05.pdf.

JAHAN, S., MAHMUD, A. S. & PAPAGEORGIOU, C. 2014. What is Keynesian economics? International Monetary Fund51(3), pp.53-54.

KEYNES, J. M. 1954. The general theory of employment, interest, and money. London: Macmillan.

 

 

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