Instability and Crisis in Financial Complex Systems

Abstract

This paper contrasts the Efficient Markets Hypothesis with Hyman Minsky's Financial Instability Hypothesis (FIH), taking into account the dynamic complexity of financial markets. This approach offers analytical tools that can account for crisis through processes endogenous to contemporary economies. Recent work, notably by J. Barkley Rosser, has suggested that complex dynamics is a strong foundations for Keynesian models and results. Group dynamics enter into the analysis in at least two ways: they provide an independent source of fundamental uncertainty which, as discussed by Keynes himself, can lead to speculative bubbles in asset markets, and they can cause overreactions in both lenders' and borrowers' attitudes toward risk. These aspects can lead to financial fragility and instability following a variety of complex dynamics. I shall argue that a financially complex system is, according to the FIH, inherently flawed and unstable: in the absence of adequate economic policy boom and bust phenomena, in financial markets which are fuelled by credit booms and busts, may generate endogenous instability and systemic crisis, such as the recent sub-prime mortgage crisis. [O]ur economic leadership does not seem to be aware that the normal functioning of our economy leads to financial trauma and crisis, inflation, currency depreciations, unemployment, and poverty in the midst of what could be virtually universal affluence—in short, that financially complex capitalism is inherently flawed. (Minsky, 1986, p. 287; our emphasis)

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