The Financial Instability Hypothesis and the Financial Crisis in Eastern European Emerging Economies

Abstract

The present paper applies the financial instability hypothesis in order to explain the financial crises of 2008-2010 in eleven emerging Eastern European economies Also, it seeks to map if institutional frameworks of these countries enabled them to stand against the factors leading into the financial crisis.

The paper maps cycles of three macroeconomic indicators representing the real economy, and four indicators representing financial markets. A cycle analysis is conducted with the help of a Hoderick-Prescott filter, made to isolate cycles from trends in time series. The paper concludes that there were substantial positive financial cycles previous to the financial crisis mirrored by similar cycles in the real economy.

Similarly, the results show negative cycles in the same parameters during the years of crisis. It seems as an uncontrolled increase in money and credit caused the economy to overheat and thereafter contract in both substantial financial and real economy crises.

Also, the paper compiles twelve different indices of institutional development. These are standardized and presented in an institutional development matrix, showing that the institutional framework for the eleven economies was weak previous to and under the melt down of the economy.

The construction of an integrated institutional development index on the basis of the same twelve parameters confirm institutional shortcomings, which may have made the economies less able to guard themselves from a crisis initiated by both domestically and internationally financial instability.