What Charles Kindleberger calls the Minsky model or theory of financial instability of the capitalist economy, proposed by Hyman Minsky in 1975, remains perhaps the best theory for analyzing financial crises. While it cannot be used to predict a crisis, the model at least gives ample warning of the conditions that likely lead to one.
Minsky labels three types of finance in the economy (hedge, speculative, and Ponzi). Hedge units can service interest and principal repayment out of cash flow, speculative units can pay interest but have to roll over principal, and Ponzi units have to sell assets or attract new financing in order to remain in business. Minsky then theorizes that with a protracted period of stability and “good times,” the actors in the economy move toward the riskier speculative and Ponzi financing. Usually, such movement is accompanied by inflation, and when the monetary authorities decide to tighten monetary policy to contain inflation, the speculative units “become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units … will be forced to try to make position by selling out position. This is likely to lead to a collapse of asset values” (Minsky, 1992).
This is not to say that there has been no progress in macroeconomics since the 1960s. In particular, economists working in a field called the new macroeconomic theory now claim that they have a “better mousetrap” than the earlier Keynesian models because their theory can incorporate “dynamic stochastic general equilibrium,” rational and/or endogenous expectations, real disturbances (or technology and other shocks), and varying degrees of speed-of-adjustment of wages and prices. They claim that they have “empirically relevant” evidence in support of new macro, but at the same time admit that “there is little certainty about how best to specify an empirically adequate model” (Woodford, 2008).
One critique of the new macro is simple: that it is “a bunch of mathematical modeling utterly divorced from reality” (Kling, 2008). Such criticism can be brought to an empirical test. For example, why have none of the economists working in this field at least warned about the 2008 crisis? The question here is perhaps no different from Deirdre McCloskey’s famous challenge to those who make a living predicting the stock or bond markets. That question was: If you’re so smart, why aren’t you rich? The point is that if there is a profit opportunity from the working of an economic model, such opportunity would not be observed in a world of efficient markets. But that also means that economics cannot predict such things as interest rates, stock market prices, etc.
It would be no surprise if those who applied the thinking of Minsky to their investment portfolios did well during the meltdown of financial markets in 2008. Nonetheless, for reasons I can’t surmise, the followers of Minsky seem to have had a lonely presence among the great body of economists.