The Financial Instability Hypothesis
The possibility that the financial system might be a source of instability leading to crises was frequently discussed in pre-Keynesian business cycle literature, which is reviewed briefly in the next section. The main focus of the chapter is the revival of interest in the financial instability hypothesis (FIH) in the 1970s and 1980s. The FIH does not attempt to provide a complete theory of business cycles but concentrates instead on explaining speculative booms and subsequent crises. In most versions the speculative boom and the financial crisis that terminates it are both triggered by shocks; consequently it is implied that we should not look for too much regularity in the periodicity and amplitude of cycles in which such crises occur and that crises may not occur in all cycles. They are essentially individual events with certain common features but the economy's reaction to them may be cyclical and basically similar in the sense that the comovements of various macroeconomic time series will be similar.
As noted in the previous chapters, the role of the banking and the wider financial system has been largely neglected in mainstream post-war business cycle literature except to the extent that a role is attributed to the money supply1 or monetary shocks (e.g. Lucas 1975) in cycle generation. This is not the case in the historical literature.2 The main issue to be resolved is whether the banking system itself is a major source of instability, as postulated by the FIH, or whether its importance lies in its tendency to spread the effects of shocks hitting some sectors of the economy to others. The following review of the theoretical literature does not resolve this issue. Empirical investigations need to be undertaken that are more rigorous than the existing historical analyses (such as that of Kindleberger 1978).
Although the post-war business cycle literature, particularly that inspired by Keynes's 'General Theory' (GT) (Keynes 1936), largely ignored the role of the banking system in the business cycle, the FIH can in fact be regarded as being a descendant of the GT. Minsky, its main proponent, certainly sees it as such (e.g. Minsky 1982a, b and 1986). Keynes did not progress to a full theory of the cycle. Instead he attempted to identify and explain the behaviour of variables which he regarded as essential components of cyclical movements. It was never absolutely clear which sectors and which variables were the prime movers and how they interrelated in cycles. Consequently various interpretations are possible. Nevertheless, Keynes did emphasise the role of uncertainty, as opposed to risk, in the sense of Knight.3 Areas in which Keynes stressed decision-making under uncertainty, such as financial and investment decisions, should therefore feature strongly in a truly Keynesian theory of the cycle. Uncertainty is, however, more difficult to model than risk and leads naturally to instability if shocks or extraneous events cause rapid and fundamental reappraisals of the expectations concerning future events held by economic agents. It is perhaps because of the difficulty of analysing economic decisions under uncertainty4 that it was essentially ignored in the multiplier-accelerator modelling of the cycle. As noted in the previous chapter, more recent cycle literature concentrates mainly on risk rather than uncertainty, again probably because analysis of stochastic models is more tractable in this case and normally assumes that the distributions of real and monetary stocks are known to the economic agents.
Following the brief review of the pre-Keynesian cycle literature in which financial instability played a part, the FIH is discussed. The FIH does not fit well with modern analysis incorporating rational expectations (RE) but the latter has also been developed to provide models in which speculative bubbles can occur. Some of this work will be reviewed in section 3.4. The final section of the chapter will draw some conclusions concerning the implications of financial instability for economic policy designed to attenuate the business cycle, which may well need to encompass the regulation of the banking and perhaps the wider financial system.