Kindleberger and the Minsky model

18 Dec, 2014 at 11:25 | Posted in Economics | 1 Comment

In an often cynical world, standard financial and macroeconomic quantitative models give people the benefi t of the doubt. Fundamental economic theory assumes the best of us, supposing that human beings are perfectly rational, know all the facts of a given situation, understand the risks, and optimize our behavior and portfolios accordingly. Reality, of course, is quite different. While a significant portion of individual and market behavior can be modeled reasonably well, the human emotions that drive cycles of fear and greed are not predictable and can often defy historical precedent. As a result, quantitative models sometimes fail to anticipate major macroeconomic turning points. The ongoing debt crisis in Europe is the most recent example of an extreme event shattering historical norms.

Once an extreme event occurs, standard models offer limited insight as to how the ensuing crisis could play out and how it should be managed, which is why policy responses can seem disjointed. The latest policy responses to the European crisis have been no exception. To understand and respond to a crisis like the one in Europe, perhaps we need to consider some new models that include the “human factor.” Economic historian Charles Kindleberger can offer some insight. In his book Manias, Panics, and Crashes, Kindleberger explores the anatomy of a typical financial crisis and provides a framework that considers the impact of the powerful human dynamics of fear and greed. Kindleberger’s descriptive process of the boom and bust liquidity cycle can help shed light on the current European sovereign debt saga, and perhaps illuminate whether we have in fact turned the corner on this financial crisis.

Kindleberger analyzed hundreds of financial crises dating back centuries and found them to share a common sequence of events, one that followed monetary theorist Hyman Minsky’s model of the instability of a credit system. Fundamentally, the more stable and prosperous an economic structure appears, the more leverage and speculative financing will build within the system, eventually making it highly vulnerable to a surprising, extreme collapse. Kindleberger provided the qualitative (as opposed to quantitative!) description of the Minsky Model, shown below, which is a useful snapshot of the liquidity cycle. It can be applied to Europe and any potential boom/bust candidate, including Chinese real estate, commodity prices, or investors’ recent love affair with emerging markets. Kindleberger famously dubbed this sequence a “hardy perennial,” probably because the galvanizing human conditions of fear and greed are more often than not prone to overshoot fundamental values compared to the behavior of a rational individual, which exists only in macroeconomic theory.

Loomis Sayles

For more on Minsky, listen to BBC 4 where Duncan Weldon tries to explain in what way Hyman Minsky’s thoughts on banking and finance offer a radical challenge to mainstream economic theory.

As a young research stipendiate in the U.S. thirty years ago, yours truly had the great pleasure and privelege of having Hyman Minsky as teacher. He was a great inspiration at the time. He still is.