Intellectual Merit The aim is to provide a parsimonious general equilibrium account of Hyman Minsky's financial fragility hypothesis. Instead of dealing with institutional detail it focuses on the elementary economics of leverage and learning. The PI constructs and analyze a simple general equilibrium model with an active credit market in which borrowers and lenders form expectations adaptively. Except for expectation formation the model is a small open economy variant of the standard Lucas (1978) tree model. To abstract from institutional detail there is just a representative investor/borrower and a representative lender )rest of the world), both of whom are learning from experience. The point is to show that even in this fairly standard model financial crises can occur, and to examine the conditions, with respect to policy, institutions and other aspects of the environment, that affect the likelihood of crises in the model. Financial crises can occur in the model because leverage and expectations combine to form a positive feedback loop. That is, a high rate of return experienced by the investor will induce both him and the lender to become more optimistic and hence to extend leverage. With increased leverage, asset prices will be driven up even further, which reinforces optimism and results in even higher leverage. Likewise, a low experienced rate of return will result in cumulative pessimism and a cumulative fall in asset prices. A crisis can occur when a period of cumulative optimism is followed by a period of cumulative pessimism. The high debt left over from the former period, combined with the low asset prices produced by the latter, leaves the representative investor insolvent. Broader Impacts The work is motivated by the global financial crises that broke out in 2008. instead of dealing with it as a product of modern financial arrangements the PI is trying to see how much we can understand by seeing it as the latest of a long series of recurrent crises that have been occurring for hundreds of years. A rational policy response to this crisis will no doubt have to take much institutional detail into account. But it is more likely to be effective if it is also based on a deeper understanding of the root causes of the crisis. By helping to shed light on those root causes the present proposal thus aims to help policy makers deal with the major economic issue of our time.
The project consists of a theoretical investigation of the causes of financial crises. The work is motivated by the global financial crisis that broke out in 2008. It starts from the observation that financial crises like this have been recurrent phenomena throughout the history of capitalist economies. Historians have shown that there is a strong pattern followed by all such crises, which start with increased leverage and asset price bubbles, followed by a crash of asset prices, and then followed by widespread bankrupcy. The most recent crisis conforms quite closely to this pattern. Such historical continuity suggests that the root cause of crises lies not in modern financial arrangements but in fundamental features of capitalist economies that have existed for centuries. In particular, the research has shown that under quite general conditions crises that follow this historical pattern can result from the interaction between the availability of credit and the processes by which rational economic actors attempt to predict future rates of return in an uncertain environment. In such an environment, leverage and deleverage are fragile processes that will inevitably produce such crises from time to time, depending on certain key features. Previous theorists have speculated that this characteristic pattern can occur only in the presence of irrational behavior, in the form of manias and panics. What the theoretical work shows is that no such irrational elements are needed when the right conditions prevail. Those conditions involve low global interest rates, a preceeding period in which asset return are justifiably high because of some productivity-enhancing innovations, and the presence of well developed markets in which people can rapidly selling off assets when their expected returns are low. Ongoing work is aimed at verifying these and other empirical implications of the theory.
