Question

Real Business Cycle theory and the financial instability hypothesis of Hyman Minsky represent two distinct schools of thought regarding the causes of recessions. What are the major differences between the two theories of recessions and what are their implications for real estate investors?

Answer 1

Real business cycle theory and the financial instability hypothesis of Hyman Minsky have two different thoughts on the factors causing recession.
According to Real Business Cycle theory technological change is the main factor causing recession .According to this theory the real variables are not affected by the nominal variables.According to this theory while economy tries to turn their inputs into outputs the economy will experience certain technological fluctuations and as a result recession will occur.During Recession there is an economic decline in the economy .According to this these theory the exogenous factors that cause changes in the economy will lead to recession.

According to the theory of financial instability the stability in the economy itself causes instability or in other words when there is economic stability in the economy there is over confidence and optimism among the borrowers.Due to this over confidence they will start to borrow more and a stage will reach where this borrowers will not be able to pay back the loans and this will cause instability in the economy.According to this theory there are mainly three stages of debt.They are i) hedge ii) speculative iii)ponzi

During the first stage the borrowers are not so optimistic .They are cautious about the loans and the borrowers will not borrow excessively.At this stage the borrowers are able to repay back both the interest and initial principal amount.
In the second stage there is economic prosperity and more stability in the economy compared to the hedge stage.At this stage borrowers are more confident than the first stage and will start more than the hedge stage.At this period the borrowers are able to pay the interest.
In the last ponzi stage the borrowers are over confident and over optimistic .During this period the borrowers will borrow huge amounts and this is the stage where recession will hit the economy as the borrowers are not able to repay both the interest and the principal amount.At this stage there is excess debt among the borrowers.During this stage the is financial instability.Thus economy from a stage of financial stability to financial instability.

Theory of financial instability is well applicable in real estate business.During the period of financial stability there is optimistm and the market demand for the assets will increase and will cause a real estate bubble.But over optimism will lead to financial instability and at this stage the price of the assets starts declining and investors in real estate gets negatively impacted.