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Note: Can policymakers prevent a cycle of deleveraging from producing debt deflation and depression?
A year or so ago, the work of the late economist Hyman Minsky was known to only a small band of devoted followers. All that has changed since the onset of the current financial crisis. Today, Minsky's financial instability hypothesis , the notion that economic stability encourages behavior on Wall Street and beyond that renders the financial system increasingly fragile , is attracting far more attention. Yet Minsky was interested not only in the buildup to a crisis but also in how depressions could be avoided and what measures were necessary to prevent future crises from occurring.
Most economists believe that the economy tends to be self-equilibrating and that crises occur only because of outside (or "exogenous" in econospeak) shocks to the system. In his book Stabilizing an Unstable Economy (1986), Minsky, however, argued that Wall Street and other financial players "generate destabilizing forces, and from time to time the financial processes of our economy lead to threats to financial and economic stability, that is, the behavior of the economy becomes incoherent." The dramatic upheavals in the financial system over the past year can be seen as a vindication of Minsky's assertion that "stability is destabilizing."
In Stabilizing an Unstable Economy, Minsky pointed out that during periods of tranquility, banks innovate to escape regulatory shackles. At the same time, they boost profits by increasingly mismatching their assets and liabilities, borrowing short at cheap rates and lending for longer periods. This exposes them to danger should lenders suddenly become reluctant to roll over loans. Minsky noted that bankers, who are rewarded with stock options, will seek to grow assets rapidly and leverage their asset bases to enhance their company's share price. In good times banks are prepared to lend more readily, even to those who are...