Incentives for debt and the impact on economic stability

Abstract

The global financial crisis came as a surprise for many economists, governments and populations around the world. Most economists relied on models of how the economy functions which did not have the capability to produce or predict breakdowns and crises, because long term stability was taken for granted and short term deviations were expected to largely resolve themselves by the normal functioning of free markets. However, other economists have developed theories and models which predict that excessive economic fluctuations with the potential for breakdowns can occur. This thesis describes and contrasts two of these theories and their associated models; the Financial Instability Hypothesis developed by Hyman Minsky, and later modeled by Steve Keen, and the Leverage Cycle developed by John Geanakoplos. What becomes evident from their analyses is that conditions in financial markets can have a significant impact on the real economy. On this background it is argued that individuals, firms and nations under certain conditions are intrinsically motivated to incur a level of debt, which is sustainable under the tranquil economic conditions that prevailed when it was undertaken, but leaves them vulnerable and sensitive to unexpected negative shocks.