Why Minsky matters

26 January, 2017 at 20:11 | Posted in Economics | 5 Comments

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.

kindleOnce 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.

ScreenShot2012-03-28at3_24_51PM

Loomis Sayles

hymanFor more on Minsky, listen to BBC 4 where Duncan Weldon explains 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.

Advertisements

5 Comments

  1. Thanks for this. Wonderful resource.

  2. This diagram and model is only some of the story. It was first better presented by Henry George in 1879 in his seminal book “Progress and Poverty”. Minsky’s explanation does not allow for, or properly explain, the relationship between land values and rising prices. The word “property” is too general and insufficiently clear if it refers to land or buildings or both. The actual problem is to do only with the land values, which behave differently to buildings and other durable capital items.

    It is due to the land owners greed that he/she chooses to speculate in land values with help from the banks. They loan the money, knowing that its interest will be forthcoming as that land becomes more valuable with population rise, infrastructure increase (from tax payers money) and site developments .

    A parallel action of these speculators withholding development sites from use, causes the land value to grow even faster, due to the competition for its right of access and use. As this process continues, the cost of producing goods and providing residence on the increasingly expensive land results not only in homelessness but unemployment and poverty, due to a limitation in demand for the more costly goods. Finally when mortgaged land payments begin to fail, the banks find themselves with “toxic loans” and the card-house collapses.

  3. You can model Minskys ideas using agent based models. The human factor could then be empirical modeled and results used for predicting crisis.

  4. How do “agent-based models”, “the human factor” and “empirical[ly] modelled” all fit into the same sentence?

  5. […] via Why Minsky matters — LARS P. SYLL […]


Sorry, the comment form is closed at this time.

Blog at WordPress.com.
Entries and comments feeds.