Why was the Great Depression so deep?Why did it last so long?• Friedman and Schwartz: M-contraction.

• Bernanke: true, but there’s more.

Financial crisis bank failures reduced borrower net worth

Increased Cost of Credit Intermediation (CCI)

(A “rational” credit squeeze)• Opposed to Keynes, Minsky, Kindleberger,

Shiller:Animal spirits/Irrational exuberance Inherent instability of financial

capitalism• Bernanke: “push rationality postulate as far

as it will go.”But lets not ignore animal spirits…

UNCERTAINTY

“Quasi – rents”Yields/Profits Interest Rate

Price of Capital Asset, Pk

vs.Price of Investment, PI

Investment Spending

Effective Demand, Output and Employment

Multiplier

Rush to liquidity in a crisis only reduces prices of securities

i UP

(What it’s worth)

(What it costs to build)

Confidence and Effective Demand in Keynes’ Economics

Stabilizing an Unstable Economy

Hyman Minsky1919 - 1996

Financial Instability Hypothesis:•Hedge finance•Speculative finance•Ponzi finance

Two types of risk affect the volume of investment. …The first is the entrepreneur's or borrower's risk and arises out of doubts in his own mind as to the probability of his actually earning the prospective yield for which he hopes. If a man is venturing his own money, this is the only risk which is relevant.…But where a system of borrowing and lending exists, a second type of risk is relevant which we may call the lender's risk. GT, Chapter 11.

When expectations are disappointed, investment collapses … but debts remain

A Minsky Cycle•Displacement (invention, easy money)•Boom…successful speculation•Euphoria…financial innovation•Profit taking

•Panic

Student of Simons/Schumpeter

Investment

Pric

e of

cap

ital a

sset

s

PK

PI

Internal funds

Borrower’s Risk

Lender’s Risk

Io I1

Mehrling on Minsky• Periods of tight liquidity short rates rise (incentive for

stretching liquidity)– Value of today’s cash flows rises relative to cash flows in

the future. • Demand price of capital assets (Pk) falls• Supply price of investment goods (Pi) rises

(interest is a cost of production).

– The incentive to invest is reduced. • The greater danger:

» collapse of investment spending » reduced aggregate income » cash flows elsewhere in the economy fall

short of expected levels» hedge finance units speculative units» speculative units Ponzi units, » the fragility of the system increases.

– An investment slump might amplify the financial problems of a few units and bring the whole system down in a cascade of debt deflation.

Akerlof and Shiller, Animal Spirits

• Confidence – Keynes-Minsky• Hopes, Exuberance, Fears• Waves of optimism and pessimism

• Corruption - Bad Faith Loss of Trust

» S&Ls – Enron – Sub-prime• Fairness

• Punish cheaters, even at own expense• Focus on relative position

• Money illusion• “Illusion” is real in view of nominal

contracts/accounts• Stories

• New eras – Irrational exuberance

Downward wage rigidity