Economic Crises

Endogenous Cycles

There is an alternative understanding of economic crisis, which runs parallel to the conventional wisdom but which supports very different assumptions about how the economy operates. Hyman Minsky's work offers a good illustration. According to his financial instability hypothesis, economic crises are endogenous to the psychology of market participants, particularly in the financial sector. During periods of consolidation, these market actors are conservative and risk averse. They are content to accept low returns on their investments in order to avoid the possibility of losing the principal (which is the money they invest). Over time, however, these actors become more competitive and more self-confident. Through experimentation with risk and financial innovation, they discover the potential rewards available from higher (and compounded) rates of return. They also learn that the cost of risk aversion is relative failure even if profits remain stable in absolute terms. As then Citibank chairman Chuck Prince put it shortly before the crisis struck in 2007, “so long as the music is playing, you have to get up and dance” (quoted in Nakamoto & Wighton, 2007, para. 4).

Over time, Minsky argues, this combination of competitiveness and self-confidence leads to a significant underpricing of risk—not just by a single actor, but across the financial system as a whole. Meanwhile, ever increasing numbers of actors in the real economy have been given access to, and so become dependent on, substantial volumes of credit (or leverage). The fragility of the system increases as a result. At a certain point this system simply tips over, as the underlying risk of the assets takes its toll on investment returns and financial actors wake up to the realization that their positions are undervalued. At this point, however, it is difficult to unwind individual positions without undermining the system as a whole. Financial institutions begin a scramble to consolidate their balance sheets only to spark a massive contraction in credit markets. Lending standards move sharply higher even as lending volumes fall. Nonfinancial firms and households are forced to pay down their debts (de-leverage), and activity in the real economy grinds to a halt.

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