Financial instability, institutional development and economic crisis in Eastern Europe

Abstract

This paper sheds light on the financial crisis of 2008–2010 in eleven emerging Eastern European economies (EE11): Armenia, Azerbaijan, Belarus, Bulgaria, Georgia, Kazakhstan, the Kyrgyz Republic, Moldova, Romania, Tajikistan and Ukraine. The aim is twofold. In the first place it seeks to find out if the financial instability hypothesis, as put forward by Minsky and Kindleberger, is a valid explanatory factor for the crisis. Secondly, it tries to map if general institutional frameworks of these countries were developed in order to stand against the factors leading into the financial crisis.To answer these research problems the paper maps cycles of three parameters representing the real economy, i.e. gross domestic product, manufacturing output and unemployment and four parameters representing the financial markets, i.e. money supply, credit volumes, inflation and government debt. The cycle approach is carried out with the help of a structural time series analysis to isolate cycles 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 that an uncontrolled increase in money and credit caused the economy to overheat and thereafter contract into 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 general institutional framework for the eleven economies was weak previous to and under the meltdown of the economies. The construction of an integrated institutional development index on the basis of the same twelve parameters confirms institutional shortcomings, which may have made the economies less able to guard themselves from a crisis initiated by both domestically and internationally financial instability.