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Taming a
Minsky Cycle
Iván Werning with Emmanuel Farhi
MIT

11. March 2021 Markus Brunnermeier

 Extrapolative Expectations & Bubbles
 Extrapolative expectations (adapted expectations in growth)
 E.g. Gennaioli & Shleifer book
 (distorted beliefs)
Potential
 Momentum Price path

 Bubbles
Bubble
starts
Fundamental
innovation Fundamental
value

𝑡𝑡

2
Good vs. bad bubbles
 New technologies and R&D investments (1998-2000)
 Overcoming QWERTY (chicken-egg) problems

 Safe Asset as a bubble (government debt 𝑟𝑟 < 𝑔𝑔)

 Serves as precautionary savings tool
 Asset Price = E[PV(cash flows)] + E[PV(service flows)]
dividends/interest insurance via re-trading
 2 𝛽𝛽s 𝛽𝛽 𝑐𝑐𝑐𝑐 > 0 𝛽𝛽 𝑠𝑠𝑠𝑠 < 0
Debt as Safe Asset
Brunnermeier-Merkel-Sannikov 2020
 Real estate bubbles (2006)
 Financial innovation/liberalization bubbles
 BITCOIN
3
Harmless vs. Dangerous Bubbles – how to fight?
 Equity financed bubbles (1998-2000)
 Credit financed bubbles (2005-2006)
 Minsky’s financing classification
 Hedge borrowing: can pay off whole debt
 Speculative borrowing: can pay off interest due
 Ponzi financing

1. Policy makers should “fight” bubbles by

a. Leaning against during build-up
b. Clean afterwards only
2. Policy makers should “fight” bubbles
a. with monetary policy
b. primarily with macro-prudential tools
c. both

4
Minsky’s bubble phases
Potential
Price path

Bubble
Fundamental starts
innovation
Fundamental
value

𝑡𝑡
Displacement Boom Euphoria Profit-taking Panic
phase phase phase phase

5
Why do rational investor ride rather than attack bubbles?
 Co-opetition among rational investors Sequential awareness/learning + critical mass
 Competition: exit bubble before it bursts Kills backwards induction argument
 Cooperation: ride as long as other ride it common knowledge of bubble

Potential
Price path

Bubble
Fundamental starts
innovation
Fundamental
value
Mutual knowledge
1. order 2. order 3. order ….

𝑡𝑡 6
Poll Questions
1. Policy makers should “fight” bubbles by
a. Leaning against during build-up
b. Clean afterwards only

2. Policy makers should “fight” bubbles

a. with monetary policy
b. primarily with macro-prudential tools
c. both

3. Policy makers’ belief distortions and exuberance are

a. smaller than the markets’
b. about the same
c. Larger than the markets’

7
 Taming a Minsky Cycle

Emmanuel Farh
Iván Werning

March 202
Markus Academy, Princeton
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 Macroprudential Policy
Macroprudential policies motivation
nancial fragilit
aggregate demand stabilizatio
monetary policy constraints or dilemma
Open economy: capital ows, dilemma

Farhi-Werning (2013, 2014, 2016)

Applications: capital controls, scal unions, deleveragin
General model: pecuniary + demand externalitie
Formula: MPCs + Wedges (Econometrica 2016

New Today… “Taming a Minsky Cycle” (2020

Minsky Boom Bust Cycle
Boom: compolacency, rising asset prices and leverag
Bust: “Minsky moment”, risk repricing, deleveragin
Non-rational expectations, extrapolation
fi
y

fl
s

fi
…

 Macroprudential

nancial macro
decisions impact

e.g. credit boom e.g. low return shock

high leverage and risk taking lower future loans
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 Macroprudential
macropru regulation

nancial macro
decisions impact

e.g. credit boom e.g. low return shock

high leverage and risk taking lower future loans
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 Macroprudential
macropru regulation

nancial macro
decisions impact

e.g. credit boom e.g. low return shock

high leverage and risk taking lower future loans
Is there a market failure?
Not necessarily.
Externality needed.
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 Macroprudential
monetary policy?
macropru regulation

nancial macro
decisions impact

e.g. credit boom e.g. low return shock

high leverage and risk taking lower future loans
Is there a market failure?
Not necessarily.
Externality needed.
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 Macroprudential
monetary policy? monetary policy?
macropru regulation

nancial macro
decisions impact

e.g. credit boom e.g. low return shock

high leverage and risk taking lower future loans
Is there a market failure?
Not necessarily.
Externality needed.
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 Macroprudential
nancial macro
decisions impact

Macropru formula: linked to MPCs and wedge

General model: incomplete markets, nancial
constraints with prices etc. (pecuniary externalities)
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 Extrapolative Expectations
Greenwood-Sheifer (2014): survey of investor
expectations
Extrapolation of future stock
is Common: Bothreturns
Boom correlate
& Bust with past
returns and level of stock market
Policies to Tame a Minsky Cycle

Elements today
Monetary with and without macro-pr
Macroeconomic vs. nancial stability
Targets and instruments a la Tinberge
trading off targets with given instrument
assignment of targets to instrument
Key role of endogeneity of beliefs
…

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 Minsky
Unhappy with neoclassical synthesis;
important aspects of Keynes
but missing nancial/investmen
too rosy on stability prospect
Ideas
system is endogenously unstable…
… perfect stabilization with money and scal policy:
impossibl
tranquility, seeds the risk taking, that creates boom/
bus
nancial markets different than real economy; debt
nancing during expansion, turns more speculative
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t

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 Minsky in
“Stabilizing an Unstable Economy”
Boom and role of expectation feedback
“Instability emerges as a “unless the past is being “A rise in the price of
period of relative tranquil validated […] none but nancial instruments or
growth is transformed into a pathological optimists will capital assets may very well
speculative boom […] invest.” increase the quantity
middlemen in nance demanded […] thus breed
change in response to the conditions conductive to
success of the economy.” another such rise.”

Policy implications for nancial controls…

“We need a Theory that “External controls and “It is possible that with other
coordinating mechanisms institutional organizations
makes instability a
may be needed in a and policy systems the
normal result in our capitalist economy. Indeed, susceptibility of our economy
economy and gives us central banking and other to nancial crises can be
handles to control it.” nancial control devices lower than at present”
arose as a response to the
embarrassing incoherence of
nancial markets.”
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…

Related Literature
Monetary Policy: Woodford, Gali, Werning, Eggertson-
Krugman, McKay-Nakamura-Steinsson, Auclert;

Monetary Policy and Expectations: Farhi-Werning;

Angeletos-Lian; Gabaix

Macroprudential Policy: Farhi-Werning, Korinek-

Simsek, Caballero-Simsek, Bianchi-Mendoza

Extrapolative/Diagnostic Expectations: Bordalo-

Gennaioli-Shleifer, Maxted …
…

 Monetary

Monetary
Macropr

Rational
Expectation
+



 Monetary

Monetary
Macropr

Rational
IT
Expectation
+



 Monetary

Monetary
Macropr

IT
Rational
IT +
Expectation
Macropru
+





u



 Monetary

Monetary
Macropr

IT
Rational
IT +
Expectation
Macropru

Extrapolativ
Expectations
+





u



e

 Monetary

Monetary
Macropr

IT
Rational
IT +
Expectation
Macropru

Extrapolativ Lean Against

Expectations Boom
+





u



e

 Monetary

Monetary
Macropr

IT
Rational
IT +
Expectation
Macropru

I
Extrapolativ Lean Against
Expectations Boom
Macropru
+





u



e

 Model Ingredients
He-Krishnamurthy (2013) (Brunnermeier-Sannikov, 2014
asset pricing model
adds nominal rigidities + optimal polic
Incomplete markets
risky asset (Lucas tree
risk-free short-term bon
Two agents
savers: save risk-fre
borrowers
invest in risky asse
borrow risk-fre
Three periods t=0,1,
Consumption good produced 1-to-1 with labor
Rigid wages, no in ation
:

fl
t

 Demand Determined Outpu Endowment

(rigid wage)

t=0 t=1 t=2

borrowin risky retur

ZLB binds realize
& investing
d

Periods, States and Demographics

Three periods t ∈ {0,1,2}

Aggregate state ω ∈ {H, L}
Determines dividend D2,ω of Lucas tree with
D2,H > D2,L
Agents i ∈ {S, B} share ϕ i
Preferences and Technology

Technolog
t = 0,1

t=2

Preference
Borrower

Savers
s

Nominal Rigidities

Sticky wages normalized to on

Zero Lower Bound (ZLB) binds at t=1, not at
t=0 e

 Budget Constraints

Savers

Borrowers
Labor Wedges and Output Gaps

Labor Wedge

Positive wedges iff negative output ga

“Macroeconomic Stability”
s

Debt as a State Variable

Savings of savers b1S (debt of borrowers) state
variable at t=
Asset price and output…
1

Debt as a State Variable

Savings of savers b1S (debt of borrowers) state
variable at t=
Asset price and output…

Financial Fragility: two intuitions

higher debt lower risk-taking capacity
higher risk premia lower asset price
lower consumptio
higher debt higher precautionary motive
lower natural rate lower consumptio
Risk always key here; without it, no effect.
1



n





Value Functions and AD Externality
S
Allocation pinned down by b1
S S B S
Value functions V (b1 ) and V (b1 )
Aggregate demand externality if recession at t=1
(compare MRS of planner to agents’)

Externality

Social Marginal Utilities ≠ Private Marginal Utilities



 Monetary Policy
Focus on Pareto weights that neutralize
distributive objectives (λ S /λ B = c0S /c0B)
Optimal monetary policy targeting rul

Lean against boom (μ0 < 0) iff borrowers initially

S
levered (b0 > 0
S
Benchmark with b0 = 0 gives standard “in ation
targeting” (IT)
)

fl
 Monetary

Monetary
Macropr

Rational
IT
Expectation

Extrapolativ
Expectations
+



e

 Monetary Policy an Macropru

Optimal monetary policy targeting rul

Macroprudential tax on borrower leverag

Assignment of targets to instruments:

macro stability to monetary polic
nancial stability to macroprudential policy
fi
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 Monetary

Monetary
Macropr

IT
Rational
IT +
Expectation
Macropru

Extrapolativ
Expectations
+





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Extrapolative Expectations
Introduce extrapolative expectations by
borrower

Modeled by either
wedge in investor Euler equation o
subjective probabilities
s

AD and Belief Externality

AD and Belief Externalit

Belief externality reinforces AD externality as

B,e B
long as borrowers optimistic (c1 > c1 ) in
equilibriu
This will be the case.
m

 Monetary Policy
Optimal Monetary Policy targeting rul

Lean against boom (μ0 < 0) if extrapolative

expectations
e

 Intuition
“Take the punch bowl away when the party is
still going”
Contractionary Monetary Policy
cools economy during boo
cools expectations of return
cools borrowin
low borrowing bene cial in future

Extrapolative expectations important

fi
m



 Monetary

Monetary
Macropr

IT
Rational
IT +
Expectation
Macropru

Extrapolativ Lean against

Expectations Boom ?
+





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e

 Monetary+Macropru
Optimal monetary policy again

Macropru tax borrower leverag

Assignment of targets to instrument

monetary: macro stability
nancial stability: macropru
fi

 Monetary

Monetary
Macropr

IT
Rational
IT +
Expectation
Macropru

I
Extrapolativ Lean Against
Expectations Boom
Macropru
+





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e

Extrapolative Expectations During Bust

Before: only extrapolative during t = 0;

rationality kicks in at t = 1 (“Minsky moment”
Now: extrapolative also during bus

Two state variables

leverage (as before
beliefs affected by past asset prices (new
Two-dimensional nancial stabilit
monetary policy alone: additional reason to lean
against the wind at t = 0…
…remains true with macropru policy
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)



)

 Monetary

Monetary
Macropr

IT
Rational
IT +
Expectation
Macropru

I Extrapolation

Extrapolativ Lean Against during Bust
Expectations Boom
Macropru Lean Against

Boom
+





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:

 Conclusion
General theory of macropru + monetary polic
workhorse for many applications
general formula: MPCs and wedge

Minksy Cycles with non-Rational Expectations

expectation management: interventions attempt to
mitigate nancial crashes in price
dilemma: may affect monetary polic
modi es optimal policy responses (targets and
instruments)
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