In the seemingly never-ending aftermath to the economic crisis that began in 2007, there is little disagreement that financial markets are characterized by instability rather than stability. Even Eugene Fama, the most influential proponent of the Capital Assets Pricing Model (CAPM; Fama 1970), now acknowledges that CAPM is strongly contradicted by the data:
The attraction of the CAPM is that it offers powerful and intuitively pleasing predictions about how to measure risk and the relation between expected return and risk. Unfortunately, the empirical record of the model is poor—poor enough to invalidate the way it is used in applications… whether the model's problems reflect weaknesses in the theory or in its empirical implementation, the failure of the CAPM in empirical tests implies that most applications of the model are invalid. (Fama and French 2004, p. 25)
CAPM’s empirical demise as a theory of finance has been accompanied by the rise of behavioural finance, which attributes much of the instability of finance markets to the limited and heuristically oriented cognitive capacities of actual traders (Kahneman and Tversky 1979; Kahneman 2003). While this is clearly an important aspect of instability, I will take a different tack and situate my explanation in the integrated macro-financial vision of Hyman Minsky’s Financial Instability Hypothesis (FIH). Previous papers have applied Minsky’s vision to macroeconomics (Keen 1995; Keen 1997; Keen 2000; Keen 2011); in this paper I will focus on the implications of Minsky’s analysis for the behaviour of financial markets.
A lengthy prelude is necessary before I consider Minsky’s analysis of financial markets, since past experience has shown that a neoclassical perspective on economics (which the vast majority of policy makers have, as well as most economists) obstructs comprehension of the link Minsky postulates between debt and asset prices.