Banking regulation, behavioural finance and the financial crisis in Europe: Looking to the Kindleberger-Minsky paradigm

Abstract

Post-Keynesian analysis, such as that of Charles Kindleberger and Hyman P. Minsky, describes the kind of decision making that affects the state of the macroeconomy and examines the financial innovations that facilitated the recent real-estate boom and bust. According to a Minsky process of sustained increasing financial fragility, the subprime crisis is responsible for a full-scale bout of systemic instability and debt deflation. The present paper builds on the Kindleberger-Minsky paradigm by showing how the present period of financial distress in Europe is due to stochastic asset price dynamics with herding and financial constraints in the decisions of heterogeneous agents. Using simulations, the paper shows that the crisis is due to agents' wealth distribution dynamics, selling because of financial constraints after the bubble has peaked due to the switching behaviour of agents. It suggests that central banks, notably the European Central Bank, could act in response to asset price movements only in the presence of sharp financial market corrections. The paper concludes by suggesting short-term solutions to the current crisis, as well as longer-term policy to prevent a recurrence of its destabilising effects.