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Behavioural Finance
Lecture 11 Part 1
Financial Instability Hypothesis
The Global Financial Crisis
The Exam
• Structure
– 20 Multiple Choice
• 1 mark each (no negative marks)
• Based on lectures: study lecture notes for this section
– 5 short answer questions (4 marks each): Write a summary and
your own assessment of 5 papers
– 1 essay (20 marks)
• Requires understanding of Circuit theory and tabular approach
to building models of credit dynamics
• Use QED program to build models prior to exam
• Closed book
Short answer questions: summarise & evaluate
• Kirman, AP 1992, 'Whom or what does the representative
individual represent?', The Journal of Economic
Perspectives, vol. 6, no. 2, pp. 117-36.
• Sharpe, WF 1964, 'Capital asset prices: a theory of
market equilibrium under conditions of risk', The Journal
of Finance, vol. 19, no. 3, pp. 425-42.
• Fama, EF & French, KR 2004, 'The Capital asset pricing
model: theory and evidence', The Journal of Economic
Perspectives, vol. 18, no. 3, pp. 25-46.
• Minsky, HP 1977, 'The Financial instability hypothesis: an
interpretation of Keynes and an alternative to ‘standard’
theory', Nebraska Journal of Economics & Business, vol.
16, no. 1, pp. 5-16.
• Graziani, A. 2003, The monetary theory of production,
Cambridge University Press, Cambridge, UK, pp. 1-32.
Essay question
• Does the repayment of debt destroy money?
• Consider the verbal arguments for and against this
proposition.
• Construct two pure credit economy models with constant
output (no economic growth), one in which debt
repayment destroys money, and one in which it does not.
Discuss the dynamics of the two models.
Recap
• Circuit model still skeletal
– But already reaches different economic policy results
to standard models
– Model extended to multiple commodities
– Will be extended to include fixed capital, government,
and Financial Instability Hypothesis
• This week
– The Financial Instability Hypothesis
The Financial Instability Hypothesis
• Developed by Hyman Minsky on simple proposition:
– Capitalism has suffered several Depressions
• Depression every 20 or so years in 19th century
• “Great Depression” of 1930s merely biggest
– So since market economies can have Depressions…
• “it is necessary to have an economic theory which
makes great depressions one of the possible states
in which our type of capitalist economy can find
itself.” (Can "It” Happen Again? A Reprise)
• Theory combined insights from Marx, Schumpeter,
Keynes & Irving Fisher
– Key foundation Fisher’s “Debt-Deflation Theory of
Great Depressions”…
Fisher & Debt Deflation
• Irving Fisher the “Paul Krugman” of his time
– Famous (neoclassical) economist
• Developed early 1900 precursor to “Efficient
Markets Hypothesis”
– Wealthy as inventor of “Rolodex” card system
– Columnist on New York Times
– Stock Market “Bull”
• Believed Market in 1920 reflected growth
prospects for US economy
– Heavily invested in market
– Huge margin loans
– Supported financial position with theory of finance
Fisher & Debt Deflation
• Theory extended standard neoclassical “supply and
demand” model to finance
• Rate of interest as “price in the exchange between
present and future goods.” (Fisher 1930: 61),
– Three forces determine price
1. Subjective preferences of individuals for present
goods over future goods determines supply of
funds
2. Objective possibilities for profitable investment
determines demand for funds
3. Market mechanism brings these into equilibrium
Fisher & Debt Deflation
• Twist compared to standard supply & demand theory
– In market for apples, supply is objective, demand
subjective
• Objective conditions of production determine
supply curve for apples
• Subjective preferences of consumers detemines
demand curve for apples
– But in finance
• Objective factor determines demand
• Subjective factor determines supply
– Reverse of relationship for standard markets
Fisher & Debt Deflation
• Subjective preferences of individuals for present goods
over future goods determines supply of funds
– a low time preference
• prefers to lend now rather than consume
– most likely a lender
– high time preference
• prefers to consume now rather than later
– most likely a borrower.
– Borrowing how those with a high preference for
present goods
• acquire the funds they need now
– at the expense of later income.
Fisher & Debt Deflation
• Objective side of the equation
– Marginal productivity of investment or “marginal
return over cost” (1930: 182)
– Determines demand for funds
• High return means high demand for funds
• Low return means low demand
– Willingness to borrow/lend not enough
• must be opportunities for borrowed money to be
invested and earn a rate of return
Fisher & Debt Deflation
• Market equates subjective and objective forces
– Supply: High rate of interest
• even those with high time preference will lend
– supply of funds will be quite high
– Low rate of interest
• only those with low time preference will lend
• supply of funds will be small
– Demand: High rate of interest
– most investments will be unviable
– demand for funds will be low
• Low rate of interest
– most investments have positive net present value
– demand for funds will be high
Fisher & Debt Deflation
• So far sounds just like standard supply & demand:
– Supply & demand set equilibrium interest rate
• But still one curly problem:
– Standard market model ignores time
– However time explicitly part of exchanges in finance
• Borrow money now, repay later
• So Fisher extended standard timeless supply & demand
model with two assumptions:
– “(A) The market must be cleared—and cleared with
respect to every interval of time.
– (B) The debts must be paid.” (1930: p. 495)
• Great assumptions to make in 1930—Not!
Fisher & Debt Deflation
• As well as one of world’s most prominent economists,
Fisher was also a newspaper columnist (a risky business...)
• On Wednesday, October 15, 1929, Fisher comments
“Stock prices have reached what looks like a permanently
high plateau.
– I do not feel that there will soon, if ever, be a fifty or
sixty point break below present levels, such as Mr.
Babson has predicted.
– I expect to see the stock market a good deal higher
than it is today within a few months.”
• On October 23rd, 1929, Black Wednesday: Dow Jones
loses almost 10% in a single day
• 4 years later, the broad market was 1/6th of its peak,
and Irving Fisher had lost over $10 million.
The Wall Street Crash
Dow Jones 1914-Now
5
110
From 382 at its peak
To below 42
at its trough
4
110
1000
100
10
1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
DJIA 1929-1933
With rallies that implied
“the worst is over…”
in less than 3 years
400
300
By the final end,
market was down 89%
from its peak
25 years to recover
200
100
0
1929
1929.5
1930
1930.5
1931
1931.5
1932
1932.5
1933
From Sage to Laughing Stock…
• Fisher’s reputation destroyed by wrong predictions
• In aftermath, developed theory to explain the crash
– “The Debt Deflation Theory of Great Depressions”
• based on rejection of conditions (A) and (B) above
– Previous theory assumed equilibrium
• but real world equilibrium short-lived since
– “New disturbances are, humanly speaking, sure
to occur, so that, in actual fact, any variable is
almost always above or below the ideal
equilibrium.” (1933: 339)
– Disequilibrium the rule in economy & finance markets
• Fisher realised a disequilibrium theory needed too
Debt Deflation Theory of Great Depressions
• Key disequilibrium forces are debt and prices
– The “two dominant factors” which cause depressions
are “over-indebtedness to start with and deflation
following soon after”
• “Thus over-investment and over-speculation are
often important; but they would have far less
serious results were they not conducted with
borrowed money.
• That is, over-indebtedness may lend importance to
over-investment or to over-speculation. The same is
true as to over-confidence.
• I fancy that over-confidence seldom does any
great harm except when, as, and if, it beguiles
its victims into debt.” (Fisher 1933: 341; emphasis
added!)
Debt Deflation Theory of Great Depressions
• When overconfidence leads to overindebtedness, a chain
reaction ensues:
• “(1) Debt liquidation leads to distress selling and to
• (2) Contraction of deposit currency, as bank loans are
paid off, and to a slowing down of velocity of circulation.
This contraction of deposits and of their velocity,
precipitated by distress selling, causes
• (3) A fall in the level of prices, in other words, a swelling
of the dollar. Assuming, as above stated, that this fall of
prices is not interfered with by reflation or otherwise,
there must be
• (4) A still greater fall in the net worths of business,
precipitating bankruptcies and
Debt Deflation Theory of Great Depressions
• (5) A like fall in profits, which in a "capitalistic," that is, a
private-profit society, leads the concerns which are
running at a loss to make
• (6) A reduction in output, in trade and in employment of
labor. These losses, bankruptcies, & unemployment, lead to
• (7) Pessimism and loss of confidence, which in turn lead to
• (8) Hoarding and slowing down still more the velocity of
circulation. The above eight changes cause
• (9) Complicated disturbances in the rates of interest, in
particular, a fall in the nominal, or money, rates and a rise
in the real, or commodity, rates of interest.” (1933: 342)
Debt Deflation Theory of Great Depressions
• Theory fundamentally nonequilibrium in nature
• Fisher’s statement is a powerful argument for
disequilibrium analysis in macroeconomics and finance:
– “9. We may tentatively assume that, ordinarily and
within wide limits, all, or almost all, economic
variables tend, in a general way, toward a stable
equilibrium…
– 10. Under such assumptions … it follows that,
unless some outside force intervenes, any "free"
oscillations about equilibrium must tend
progressively to grow smaller and smaller, just as a
rocking chair set in motion tends to stop…
– 11. But the exact equilibrium thus sought is seldom
reached and never long maintained.
Debt Deflation Theory of Great Depressions
• New disturbances are, humanly speaking, sure to
occur, so that, in actual fact, any variable is almost
always above or below the ideal equilibrium…
– Theoretically there may be—in fact, at most times
there must be—over-or under-production, over-or
under-consumption, over-or under-spending, overor under-saving, over-or under-investment, and
over or under everything else.
– It is as absurd to assume that, for any long period
of time, the variables in the economic organization,
or any part of them, will “stay put,” in perfect
equilibrium, as to assume that the Atlantic Ocean
can ever be without a wave.” (Fisher 1933, p. 339;
emphases added)
Debt Deflation Theory of Great Depressions
• Two classes of far from equilibrium events explained
– Ordinary cycles
• Deflation or debt but not both
– Depressions
• Both debt and deflation…
Debt Deflation Theory of Great Depressions
• Cycles, when one occurs without the other
– with only overindebtedness or deflation, growth
eventually corrects problem; it is …
• “more analogous to stable equilibrium: the more the
boat rocks the more it will tend to right itself. In
that case, we have a truer example of a cycle”
(Fisher 1933: 344-345)
• Great Depression: overindebtedness and deflation
– with deflation on top of excessive debt, “the more
debtors pay, the more they owe. The more the
economic boat tips, the more it tends to tip. It is not
tending to right itself, but is capsizing” (Fisher 1933:
344).
Debt Deflation Theory of Great Depressions
•
•
•
•
Fisher’s new theory ignored
Old theory made basis of modern finance theory
Debt deflation theory revived in modern form by Minsky
Fisher’s macroeconomic contribution (which emphasised
the need for reflation and “100% money” during the
Depression) overshadowed by Keynes’s “General Theory”
• Many similarities and synergies in Keynes and Fisher, but
different countries meant one largely unaware of others
work
Keynes and Debt-deflation
• Some discussion of debt-deflation when discussing
reduction in money wages (neoclassical proposal):
– “Since a special reduction of money-wages is always
advantageous to an individual entrepreneur ...
– a general reduction … may break through a vicious
circle of unduly pessimistic estimates of the marginal
efficiency of capital …
– On the other hand, the depressing influence on
entrepreneurs of their greater burden of debt may
partially offset any cheerful reactions from the
reductions of wages.
– Indeed if the fall of wages and prices goes far, the
embarrassment of those entrepreneurs who are heavily
indebted may soon reach the point of insolvency—with
severe adverse effects on investment.” (Keynes 1936:
264)
Keynes and Debt-deflation
– “The method of increasing the quantity of money in
terms of wage-units by decreasing the wage-unit
increases proportionately the burden of debt; whereas
the method of producing the same result by increasing
the quantity of money whilst leaving the wage-unit
unchanged has the opposite effect.
– Having regard to the excessive burden of many types
of debt, it can only be an inexperienced person who
would prefer the former.” (1936: 268-69)
– Keynes’s focus here more physical and macro (impact
on investment) than Fisher; Keynes’s main
contributions on finance relate to
• Dual Price Level hypothesis
• Analysis of expectations and behaviour of finance
markets
Keynes and the Dual Price Level Hypothesis
• In most of General Theory, Keynes argued that
investment motivated by relationship between marginal
efficiency of investment schedule (MEI) and the rate of
interest
• In Chapter 17 of General Theory, “The General Theory of
Employment” and “Alternative theories of the rate of
interest” (1937), instead spoke in terms of two price
levels: commodities (cost price) & assets (speculative)
– investment motivated by the desire to produce “those
assets of which the normal supply-price is less than
the demand price” (Keynes 1936: 228)
• Demand price determined by prospective yields,
depreciation and liquidity preference.
• Supply price determined by costs of production
Keynes and the Dual Price Level Hypothesis
• Two price level analysis becomes more dominant
subsequent to General Theory:
– The scale of production of capital assets “depends, of
course, on the relation between their costs of
production and the prices which they are expected to
realise in the market.” (Keynes 1937a: 217)
– MEI analysis akin to view that uncertainty can be
reduced “to the same calculable status as that of
certainty itself” via a “Benthamite calculus”
– whereas the kind of uncertainty that matters in
investment is that about which “there is no scientific
basis on which to form any calculable probability
whatever. We simply do not know.” (Keynes 1937a: 213,
214)
• So how do investors form expectations?
Keynes and the Dual Price Level Hypothesis
• Given incalculable uncertainty, investors form fragile
expectations about the future
• These are crystallised in the prices they place upon
capital asset
• Given fragile basis for expecations, asset prices are
subject to sudden and violent change
– with equally sudden and violent consequences for the
propensity to invest
• Seen in this light, the marginal efficiency of capital is
simply the ratio of the yield from an asset to its current
demand price, and therefore there is a different
“marginal efficiency of capital” for every different level
of asset prices (Keynes 1937a: 222)
Keynes on Uncertainty and Expectations
• Three aspects to expectations formation under true
uncertainty
– Presumption that “the present is a much more
serviceable guide to the future than a candid
examination of past experience would show it to have
been hitherto”
– Belief that “the existing state of opinion as expressed
in prices and the character of existing output is based
on a correct summing up of future prospects”
– Reliance on mass sentiment: “we endeavour to fall back
on the judgment of the rest of the world which is
perhaps better informed.” (Keynes 1936: 214)
• Fragile basis for expectations formation thus affects
prices of financial assets
Schumpeter on Cycles & Credit
• Joseph Schumpeter leading “Evolutionary Economist”
– Applying theory of evolution to economics
• His “Theory of Economic Development” emphasised
cyclical nature of capitalism
– Credit played important role in cycle
• Supervised Minsky’s PhD
– direct influence on Minsky’s thought
• Rejected neoclassical view of money
– “veil over barter”
– “Money neutrality: Double all prices & incomes, no-one
better or worse off”
• Nonsense assumption in a world with debt…
Schumpeter’s model: money has real effects
• Schumpeter accepts neoclassical view as true for existing
products, production techniques, etc., in general
equilibrium
• But new products, new methods, disturb “the circular
flow”. Money plays essential role in this disequilibrium
phenomenon
– Affects the price level and output
– Doubling all prices & incomes would make some better
off, some worse
• Those with debts would be better off
– Including entrepreneurs…
Schumpeter’s model: money has real effects
• Conventional theory suffers from “barter illusion”
– Existing producers using existing production methods
exchanging existing products
• “Walras’ Law” applies
• Major role of finance is initiating new products /
production methods etc.;
• For these equilibrium-disturbing events, classic “money a
veil over barter” concept cannot apply.
– “From this it follows, therefore, that in real life total
credit must be greater than it could be if there
were only fully covered credit. The credit structure
projects not only beyond the existing gold basis, but
also beyond the existing commodity basis.” (101)
• “Walras’ Law” false for growing economy…
Schumpeter’s model: credit has real effects
• “[T]he entrepreneur needs credit …
• [T]his purchasing power does not flow towards him
automatically, as to the producer in the circular flow, by
the sale of what he produced in preceding periods.
• If he does not happen to possess it … he must borrow it…
He can only become an entrepreneur by previously
becoming a debtor…
• his becoming a debtor arises from the necessity of the
case and is not something abnormal, an accidental event
to be explained by particular circumstances. What he
first wants is credit.
• Before he requires any goods whatever, he requires
purchasing power. He is the typical debtor in capitalist
society.” (102)
Schumpeter’s model: credit has real effects
• In normal productive cycle, income from production
finances purchases; credit can be used, but not essential
– “[T]he decisive point is that we can, without
overlooking anything essential, represent the process
within the circular flow as if production were currently
financed by receipts.” (104)
• Effectively, Say’s Law applies: “supply creates its
own demand”
• Aggregate demand equals aggregate supply (with
maybe some sectors above, some sectors below)
– But credit-financed entrepreneurs very different
• Expenditure (demand) not financed by current
receipts (supply) but by credit
• Aggregate Demand exceeds Aggregate Supply
Schumpeter’s model: credit has real effects
• Credit finance for entrepreneurs thus endogenous: not
“deposits create loans” but “loans create deposits”:
– “[I]n so far as credit cannot be given out of the
results of past enterprise …
– it can only consist of credit means of payment created
ad hoc, which can be backed neither by money in the
strict sense nor by products already in existence...
– It provides us with the connection between lending and
credit means of payment, and leads us to what I
regard as the nature of the credit phenomenon.” (106)
Schumpeter’s model: credit has real effects
• Say’s Law & Walras’ Law apply in circular flow, but not
entrepreneurial credit-financed activity:
– “In the circular flow, from which we always start, the
same products are produced every year in the same way.
– For every supply there waits somewhere in the
economic system a corresponding demand, for every
demand the corresponding supply.
– All goods are dealt in at determined prices with only
insignificant oscillations, so that every unit of money
may be considered as going the same way in every
period.
– A given quantity of purchasing power is available at any
moment to purchase the existing quantity of original
productive services, in order then to pass into the hands
of their owners and then again to be spent on
consumption goods.” (108)
Aside: “Marx with different adjectives”
• Schumpeter here similar to Marx’s “Circuits of Capital”
• Commodity—Money—Commodity
– Equivalent to Schumpeter’s “circular flow”
– Essentially Say’s Law applies
• Sellers only sell in order to buy
• Money—Commodity—Money
•Same as
– Equivalent to Schumpeter’s entrepreneurial function
Schumpeter’s
– Say’s Law doesn’t apply: “The capitalist throws less
point:
value in the form of money into the circulation than
•Capitalist
he draws out of it...
“throws in”
– Since he functions ... as an industrial capitalist, his
borrowed
supply of commodity-value is always greater than his
money
•Succeeds if demand for it. If his supply and demand in this
respect covered each other it would mean that his
can repay
capital had not produced any surplus-value...
debt and
pocket some – His aim is not to equalize his supply and demand, but
to make the inequality between them ... as great as
of the gap
possible.” (Marx 1885: 120-121)
Schumpeter’s model: credit has real effects
• So Schumpeter’s dynamic view of economy
– Overturns “money doesn’t have real effects” bias of
neoclassicals/monetarists
– Breaches “supply creates its own demand” Say’s Law
view of self-equilibrating economy
– Breaches Walras’ Law “if n-1 markets in equilibrium, nth
also in equilibrium” general equilibrium analysis
– Links finance and economics: without finance there
would not be economic growth, but
– Finance can affect economic growth negatively as well
as positively (if entrepreneurial expectations fail)…
Integration: Financial Instability Hypothesis
• Minsky combined concepts of
– Fisher: debt deflationary mechanism,
– Role of commodity price inflation
– Schumpeter: entrepreneurial role of credit
– Keynes & “2 price levels” analysis
• Expectations formation under uncertainty
• Behaviour of financial markets
• Finance  Investment  Savings causal loop
– (Also Kalecki: Finance as limit on investment)
– Marx: Tendency to cycles & crisis in capitalism
• To produce Financial Instability Hypothesis