Hyman Minsky and behavioral finance

Abstract

Hyman Minsky is best known for his analysis of the instability of capitalism stemming from human psychological propensities. When optimism prevails, financial institutions make risky loans. As these loans get repaid, this generates greater optimism and more risk taking. Herd behavior reinforces this. Also, in good times financial institutions demand deregulation so they might make even riskier loans. At some point, the economic system cannot support the growing debt levels; unable to repay their loans, firms have to borrow money just to pay the interest on their debt. A financial crisis begins when loans are not repaid, financial institutions are in jeopardy of failure, and lending ends. For Minsky, the government can reduce the probability of financial crises by strictly regulating financial institutions; however, the government cannot prevent financial crises because it cannot control human psychology. The paper concludes with some remarks on Minsky and contemporary work in behavioral finance.