Financial Recessions – they really are different

The blogosphere and press have recently been energised by a discussion about financial recessions. There is more evidence that recessions really are different after a financial crisis. With this apparent truth, what are needed are theoretical models that capture these effects and the work of Hyman Minsky could prove useful in this regard.

What is a financial recession and why does it matter?

The term ‘financial recession’ refers to type of recession that follows a financial crisis. It is an important concept to grasp, especially for policymakers and theorists, as it says that things will be different in these recessions. This means that the policy response and the theoretical explanation of these recessions need to be tailored to fit the circumstance.

More evidence, over and above that from Reinhart and Rogoff

Reinhart and Rogoff told of this notion is a masterful book titled ‘This Time is Different’. Interested readers should turn to this book, but more recent evidence has also come to light that financial recessions are indeed different.

Moritz Schularick and Alan Taylor (hereafter S&T) have written two pieces on Vox (www.voxeu.org) highlighting their recent empirical work. S&T looked at 14 advanced economies over the last 140 years and found that large credit booms during expansions were associated with more severe and prolonged slumps. In short, they claim “credit bites back.” Compared to historical benchmarks, the US has had a reasonably good recovery, but the UK has not – the analysis of the UK recovery is highly interesting, especially in light of the IMF’s work on fiscal multipliers . The concept of a financial recession has beenchallenged in some quarters, but I will leave a response to Reinhart and Rogoff .

The increasingly important role of Hyman Minksy

The fact that recessions that follow financial crises are different in nature to those other recessions emphasises the point that economic theory needs to catch up with reality. A lot of progress has already been made on the link between an imperfect financial sector and the real economy, but many economists are also turning to the work of Hyman Minksy. According to Wray & Tymoigne (2008)[1], the most important contribution of Minksy was to add his ‘financial theory of investment’ to Keynes’ ‘investment theory of the cycle.’ The key aspects of Minsky’s approach are the notion of a two-price system as well as lender’s and borrower’s risk. These concepts combine to show how the financial theory of investment converges to instability.

The two price system refers to current output and assets. Referring to investment goods, the output price is the supply price of capital, in other words, the price that is just sufficient to induce a supplier to supply new capital (PI). Crucially, however, this curve is flat only where internal funds are used to finance new purchases of capital. Once external funds are needed, the price becomes influenced by lender’s risk. Thus, the supply price curve heads up, which is unusual as one usually assigns an increasing supply with declining prices.

The other price in this two-price system is that for assets, which in the case of investment goods, refers to the current capital stock. This price of current stock provides the starting point for this price, but at some point, external finance will be required, which is the point at which the line becomes curved. In this case, it is the borrower’s risk that leads to the unusual situation of price declining as demand increases. This curiosity is due to the borrower facing insolvency risk with external finance, so they are less willing to pay as more external financing is required. Where these two curves meet determines the level of investment in the economy.

These prices include margins of safety that both the lender and borrower build in to their demand and supply of external finance. At the beginning of a recovery, these margins of safety are high as agents are pessimistic about the future. As the recovery proceeds, projects will begin to return over and above what they were expected to and pessimism will turn to optimism. This optimism lowers the margins of safety (lowers perceived risk) and flattens both curves, resulting in a greater level of investment.

This increased investment leads to multiplier effects akin to Keynes, so this positive feedback loop feeds the optimism. In an investment boom, therefore, these profits validate the more optimistic expectations of investment projects. This cycle is the core of Minsky’s theory, as the cycle of optimism feeds itself but it is always moving towards instability.

Minsky’s theory emphasised the notion of expected future profitability. If this profitability reduced significantly, then the demand price will fall below the supply price. This reduces current investment, which causes the economy to sink deeper. Both from a conceptual and theoretical standpoint, Minky’s view sits interestingly next to models of deleveraging, such as the Cubic IS curve and Mian & Sufi . In the recovery phase of a financial recession, where deleveraging is the order of the day, expected future profits will be lowered and investment will suffer as a result. This points to interesting areas for future research, but for policy, it highlights the importance of attempting unconventional monetary policy and debt restructuring focusing on principle reductions.

Wray & Tymoigne draw attention to the convention approach to individual behaviour, an approach that ties in closely with the views of both Minsky and Keynes. Rather than assuming individuals are rational or irrational, individuals form their view from mass psychology due to the uncertainties about the future. As individual views are formed from mass psychology, they have a tendency to provide a self fulfilling process. This ties in with a speech by George Akerlof[2] in which he notes the importance of norms in guiding economic behaviour. Akerlof believes these norms should be part of utility functions in the economic modelling process. As we try to advance theories that explore the link between financial markets and the real economy, the views of Akerlof and Minsky are becoming increasingly relevant.


[1] Wray, L, R & Tymoigne, E. (2008). Macroeconomics meets Hyman P. Minksy. The Levy Economics Institute of Bard College. Working Paper 543.

[2] Akerlof, G. A. (2007). The Missing motivation in Macroeconomics. Presidential Address of the American Economic Association.

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5 responses to “Financial Recessions – they really are different

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