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, P k vs. Price of Investment, P I Investment Spending Effective Demand, Output and Employment Multiplier Rush to liquidity in a crisis only reduces prices of securities  i U P (What it’s worth) (What it costs to build) Confidence and Effective Demand in Keynes’ Economics

Stabilizing an Unstable Economy Hyman Minsky 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 Price of capital assets PKPK PIPI Internal funds Borrower’s Risk Lender’s Risk IoIo I1I1

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 (P k ) falls Supply price of investment goods (P i ) 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