Learning and Financial Stability

Brown University, Providence RI

Investigators

Abstract

Learning and Financial Stability 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.