Financial Systems and Economic Crises

The Main Determinants of Financial Instability

by Camelia Oprean Stan (Author) Sebastian-Ilie Dragoe (Author)
©2022 Monographs 256 Pages


This book examines the main causes of financial instability and highlights that,
with the exception of wars and pandemics, the financial system is the source of the
crisis, not just a means of spreading it, as most mainstream experts believe. Based on
the following findings, the innovative sections of this book provide academics and
policymakers with important and practical knowledge: because negative shifts in the
financial system precede recessions, financial indicators can predict the onset of a
crisis much earlier than real variables; the proposed recession forecasting model can
predict the emergence of the crisis a month in advance. When the economy’s sensitivity
to the financial system is reduced, there will be only modest negative economic
growth and no true recessions.

Table Of Contents

  • Cover
  • Title
  • Copyright
  • About the authors
  • About the book
  • This eBook can be cited
  • Preface
  • Table of Contents
  • List of Abbreviations
  • Introduction
  • 1 The Radiography of the Financial System, with a Focus on the United States
  • 1.1. The different aspects of the financial system in general
  • 1.2. Financial – monetary economy fundamentals
  • 1.2.1 Money supply: Money creation by the central and commercial banks
  • 1.2.2 Money creation and “monetary destruction”
  • 1.2.3 Questioning the money multiplier process
  • 1.2.4 Non-neutrality and super non-neutrality of money
  • 1.3. Developments in the current U.S. financial system
  • 1.3.1. Loan and bank credit decoupling from money and nonbanking superfinancialization
  • Credit aggregates: Suitable for nominal GDP targeting?
  • Financial interconnections
  • Securitization, credit origins, and holdings
  • 1.3.2. The Fed’s role in causing the great moderation
  • 1.3.3. The movement of long-term and short-term interest rates
  • 1.4. Preliminary conclusions
  • 2 Historical, Conceptual, and Empirical Approaches to Crises
  • 2.1. The influence of the financial system on economic crises: The historical context
  • 2.1.1. Tulip crisis
  • 2.1.2. The panic of 1907
  • 2.1.3. Great depression of the 1930s
  • 2.1.4. Great stagflation
  • 2.1.5. Dotcom mania
  • 2.1.6. The great recession
  • 2.2. Considerations about equilibrium illusions
  • 2.3. The current status of the literature on economic and financial crises and its critique
  • 2.4. An examination of relevant indicators to forecast the crisis
  • 2.4.1. The omnipresence of a financial indicator, as a proof of the inseparability of business cycle from financial cycle
  • 2.4.2. Instances where inverted yield curve and credit variables may fail to predict crisis
  • 2.4.3. Other suitable indicators for predicting crises
  • 2.4.4. Signals that are too weak or have lost their ability to add information
  • 2.5. Preliminary conclusions
  • 3 Coordinates and Determinants of Financial Instability
  • 3.1. Evidence from the literature
  • 3.2. Main determinants of financial instability
  • 3.2.1. Capital mobility and the size of capital
  • 3.2.2. Decreasing profitability for financial institutions
  • 3.2.3. Economic inequality
  • 3.2.4. Low and stable inflation
  • 3.3. Preliminary conclusions
  • 4 Potential Solutions for Financial Stability
  • 4.1. The advantages of Chicago Plan
  • 4.2. The benefits of a cashless society
  • 4.3. Capital requirements management
  • 4.4. Inflation targeting versus price-level targeting, inflation channel, and nominal GDP
  • 4.5. Yield curve and interest rates management
  • 4.6. Considerations on “helicopter money drop” solution
  • 4.7. Preliminary conclusions
  • 5 Economic Crisis Forecast Model
  • 5.1. The usual recession mechanism
  • 5.2. The model proposal
  • 5.3. Testing the predictive power of the model based on financial indicators of the Great Recession
  • 5.4. Coronavirus recession and its correlation with the proposed model
  • 5.5. Preliminary conclusions
  • References
  • List of Appendixes
  • List of Figures
  • List of Tables

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The major goal of this book is to show that all economic crises (except those caused by pandemics, wars, and supply shocks) originate from negative fluctuations and disturbances in the finance sector. Such a view is crucial not just for understanding the role of finance in the economic cycle but also for predicting recessions. The Holy Grail of macroeconomics has always been the recession forecasting. The ability to predict recession is crucial not only for governments and the financial industry (more specifically, central banks) to ensure employment and quality of life but also for investors to hedge their investments and large businesses to adapt their production and inventories.

In order to achieve the main goal, the following secondary objectives were set: examination and testing of the financial-monetary economy’s fundamentals; a series of econometric research to demonstrate the significance of money and finance in the actual economy; from a historical perspective, examining the impact of the financial system on economic crises; constructing an argument against equilibrium theory; studying the most important recession predictors and demonstrating that almost all recessions have financial foundations; a study of the primary causes of financial instability; investigate possible methods for guaranteeing financial stability and a resilient financial system; presenting an econometric model for predicting recessions based mostly on financial data and demonstrating that such a model may have predicted the Great Recession; after the Great Recession, predicting the next recession in the United States; an examination of Romania’s recession lag; and an examination of how the Coronavirus recession differs from other recessions.

This study tests hypotheses and applies analytical tools and procedures that are often employed in the study of the financial-monetary economy and financial instability. Several econometric research and analyses have been conducted that show the importance of money and finance in the actual economy. Secondary data could be obtained in databases released by important organizations such as the World Bank, the International Monetary Fund, the National Bureau of Economic Research, Eurostat, and the Bureau of Economic Analysis, among others. They are analyzed with well-known econometric tools and used in the financial area, such as EViews. The findings of this research are provided in the book as studies, analyses, and recommendations and are summarized in the major chapter conclusions.←13 | 14→

The book can give academics and policymakers important and practical insights since the presumed impact of this study on literature and practice is underscored by the following key original contributions and results which demonstrate that, because negative shifts in the financial system precede recessions, financial variables can report a crisis much earlier than real variables, as early as two months before a potential crisis; that financial variables can better predict recessions and industrial performance indicators can better predict negative GDP fluctuations; and that is possible indeed to develop a model that can predict recessions and negative GDP fluctuations.

There are a few terms and phrases that will be used more frequently in this study and are explained in the sections that follow.

The nonfinancial sector is referred to as the “real economy.” For example, the phrase “credit for the real economy” actually means “credit to nonfinancial sectors” (e.g., households, businesses, and government).

The entire value of final products and services generated at the national level over a period of time (typically quarterly or annually) is reflected in the gross domestic product (GDP).

The nominal GDP is adjusted with the GDP deflator to produce real GDP. Economic growth is measured in terms of real GDP.

Potential GDP reflects the economy’s productive capacity by reflecting the “full employment” GDP, which is the amount of GDP that can be achieved when the economy uses a high resource rate and follows a stable inflation path. A mix of factor inputs – labor, capital, and total factor productivity – is used to calculate potential GDP (Moisa, Necula, & Bobeica, 2010). To begin with, GDP is regressed on labor and capital with constant substitution elasticity. The Solow residual is the resultant residual, which is supposed to reflect technical developments. To extract the technical trends, the residual is filtered. After that, the efficiency-level trend is incorporated into the regression. This tool is used by policymakers to assess output gaps and evaluate which instruments can be utilized and to what extent, in order to bring actual GDP closer to potential GDP.

The liquidity trap defined by Krugman is a situation in which monetary policy loses control because the nominal interest rate is 0 or near-0% and monetary policy is unable to encourage investment and consumption since cash and bonds are perfect substitutes (Krugman, 1998).


ISBN (Softcover)
Publication date
2022 (July)
Berlin, Bern, Bruxelles, New York, Oxford, Warszawa, Wien, 2022. 256 pp., 7 fig. col., 163 fig. b/w, 15 tables.

Biographical notes

Camelia Oprean Stan (Author) Sebastian-Ilie Dragoe (Author)

Sebastian-Ilie Dragoe is an economist at the Lucian Blaga University of Sibiu who specializes in macrofinance. Financial markets, money theory, banking and finance institutions, and econometrics are among his other research interests. Camelia Oprean-Stan teaches and researches in the areas of finance in the Department of Finance and Accounting, Lucian Blaga University of Sibiu. Her research interests also include capital markets, portfolio administration, and financial management.


Title: Financial Systems and Economic Crises