1. 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…

2. Confidence and Effective Demand in Keynes’ Economics
UNCERTAINTY
Rush to liquidity in a crisis only reduces prices of securities
 i UP
“Quasi – rents”
Yields/Profits
Interest Rate
Price of Capital Asset, Pk
(What it’s worth)
vs.
Price of Investment, PI
(What it costs to build)
Investment Spending
Multiplier
Effective Demand, Output and Employment

3. Stabilizing an Unstable Economy
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.
Hyman Minsky
Student of Simons/
Schumpeter
A Minsky Cycle
Displacement (invention, easy money)
Boom…successful speculation
Euphoria…financial innovation
Profit taking
Panic PK
Borrower’s Risk
Price of capital assets
Lender’s Risk PI
Internal funds Io I1
Investment
When expectations are disappointed, investment collapses … but debts remain

5. 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.

6. 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