Question

Explain Minsky’s financial instability hypothesis and discuss the proposition that Minsky can be regarded as a behavioural finance theorist.

Answer 1

Minsky argued that an economy can easily move from stable to an instable economy when there is debt accumulation by the non-government sector. This factor of debt accumulation by the private sector can be said to be a major reason for economic crisis. Minsky says that banks when they start lending to people with less collateral or even people with very little creditworthiness that creates excess demand and it increases the price of goods and services and eventually this will circle of giving out loan by banks will continue to increase until the bubble that is formed burst suddenly and economy moves in instability. For example if take the case of housing bubble in US in around 2007, the major reason for this was banks were lending loans to people to buy houses because the house prices were increasing and they were sure that they will recover the loan by selling the house, loan was given to people even whose ability to pay back was not there and people were buying house not just for living but for speculative purposes and eventually the housing crisis became so big that it engulfed the banks also. Here the behavior is the herd mentality, the number of people who were taking loans and buying houses were increasing and it was more because the other person had bought and sold the home and had gains, this is an example of herd mentality.