A Reconsideration of Minsky’s Financial Instability Hypothesis

Abstract

The worst and longest depressions have tended to occur after periods of prolonged, and reasonably stable, prosperity. This results in part from agents rationally updating their expectations during good times and hence becoming more optimistic about future economic prospects. Investors then increase their leverage and shift their portfolios towards projects that would previously have been considered too risky. So, when a downturn does eventually occur, the financial crisis, and the extent of default, become more severe. Whereas a general appreciation of this syndrome dates back to Minsky [1992, Jerome Levy Economics Institute, WP 74] and even beyond, to Irving Fisher [1933, Econometrica 1, 337-357], we model it formally. In addition, endogenous default introduces a pecuniary externality, since investors do not factor in the impact of their decision to take risk and default on the borrowing cost. We explore the relative advantages of alternative regulations in reducing financial fragility, and suggest a novel criterion for improvement of aggregate welfare.