Minsky’s Financial Instability Hypothesis and the Leverage Cycle

London School of Economics FMG Special Paper

44 Pages Posted: 2 Mar 2011 Last revised: 6 Dec 2011

See all articles by Sudipto Bhattacharya

Sudipto Bhattacharya

London School of Economics; Centre for Economic Policy Research (CEPR)

Dimitrios P. Tsomocos

University of Oxford - Said Business School and St. Edmund Hall

Charles Goodhart

London School of Economics & Political Science (LSE) - Financial Markets Group

Alexandros Vardoulakis

Board of Governors of the Federal Reserve System

Date Written: September 2011

Abstract

Busts after periods of prolonged prosperity have been found to be catastrophic. Financial institutions increase their leverage and shift their portfolios towards projects that were previously considered too risky. This results from institutions rationally updating their expectations and becoming more optimistic about the future prospects of the economy. Default is inevitably harsher when a bad shock occurs after periods of good news. Commonly used measures to forecast risk in the system, such as VIX, fail to capture this phenomenon, as they are also biased by optimistic expectations. Competition among financial institutions for better relative performance exacerbates the boom-bust cycle. We explore the relative advantages of alternative regulations in reducing financial fragility, and suggest a novel criterion for improvement of aggregate welfare.

Keywords: Financial Instability, Minsky, Leverage, Optimism, Relative Performance

JEL Classification: D83, E44, G01, G21

Suggested Citation

Bhattacharya, Sudipto and Tsomocos, Dimitrios P. and Goodhart, Charles A.E. and Vardoulakis, Alexandros, Minsky’s Financial Instability Hypothesis and the Leverage Cycle (September 2011). London School of Economics FMG Special Paper. Available at SSRN: https://ssrn.com/abstract=1773946 or http://dx.doi.org/10.2139/ssrn.1773946

Sudipto Bhattacharya

London School of Economics ( email )

Houghton Street
London WC2A 2AE
United Kingdom
44 171 955 7320 (Phone)
44 171 955 7420 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Dimitrios P. Tsomocos (Contact Author)

University of Oxford - Said Business School and St. Edmund Hall ( email )

Park End Street
Oxford, OX1 1HP
Great Britain
+44 1865 288 932 (Phone)
+44 1865 288 805 (Fax)

Charles A.E. Goodhart

London School of Economics & Political Science (LSE) - Financial Markets Group ( email )

Houghton Street
London WC2A 2AE
United Kingdom
0207 955 7555 (Phone)
0207 242 1006 (Fax)

Alexandros Vardoulakis

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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