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Edited by Dimitri B. Papadimitriou and L. Randall Wray
Chapter 13: The Psychology of Financial Markets: Keynes, Minsky and Emotional Finance
Sheila Dow* Introduction Hyman Minsky’s Financial Instability Hypothesis (FIH) has provided an influential explanation for the current phase of systemic instability, tying it into a cyclical pattern of asset valuation (Whalen 2007). For Minsky, boom periods result from a growing tendency to reduce expectation of risk and to expect an increasing appreciation of asset values, with consequent growth in credit and thus exposure to risk. This tendency increases the fragility of the financial system and thus its potential for reversals, as expectations are confounded and defaults increase. A key element of the process is that illiquidity problems, through knock-on effects on asset valuation, can create insolvency problems. The boom period is categorized as one of ‘euphoria’, which has a key role in the absence of the necessary conditions for objective quantitative risk assessment. While uncertainty diminishes with the general confidence in low risk during the boom period, the reversal increases uncertainty about future asset values, encouraging a rise in liquidity preference which continues as expectations become more firmly held of asset price deflation. The concept of euphoria, and indeed of uncertainty in the absence of objective quantifiable risk, are redolent of psychology rather than rational economic man. Indeed the expression ‘the psychology of the market’ is often used in this context, and notably by Minsky’s (1975) mentor Keynes. While Keynes explicitly discussed psychology in a variety of ways as an integral part of his economic analysis, Minsky did not actively explore it. Indeed, as Chick (2001, p. 40) has pointed...
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