✐ ✐ ✐ ✐ The Global Financial Crisis and Its Aftermath ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ The Global Financial Crisis and Its Aftermath Hidden Factors in the Meltdown EDITED BY A G MALLIARIS, LESLIE SHAW AND HERSH SHEFRIN ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ Oxford University Press is a department of the University of Oxford It furthers the University’s objective of excellence in research, scholarship, and education by publishing worldwide Oxford is a registered trade mark of Oxford University Press in the UK and certain other countries Published in the United States of America by Oxford University Press 198 Madison Avenue, New York, NY 10016, United States of America © Oxford University Press 2016 All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior permission in writing of Oxford University Press, or as expressly permitted by law, by license, or under terms agreed with the appropriate reproduction rights organization Inquiries concerning reproduction outside the scope of the above should be sent to the Rights Department, Oxford University Press, at the address above You must not circulate this work in any other form and you must impose this same condition on any acquirer Library of Congress Cataloging-in-Publication Data Names: Malliaris, A G., editor Title: The global financial crisis and its aftermath : hidden factors in the meltdown / edited by A G Malliaris, Loyola University Chicago, Leslie Shaw, Chicago Psychoanalytic Society, Hersh Shefrin, Santa Clara University Description: New York : Oxford University Press, 2016 | Includes bibliographical references and index Identifiers: LCCN 2016008338| ISBN 9780199386222 (alk paper) Subjects: LCSH: Financial crises | Global Financial Crisis, 2008–2009 | Economic policy | Social justice Classification: LCC HB3722 G5856 2016 | DDC 330.9/0511–dc23 LC record available at http://lccn.loc.gov/2016008338 Printed by WebCom, Inc., Canada ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ CONTENTS Preface and Acknowledgments xiii Contributors xv PART ONE Introduction The Global Financial Crisis and Its Aftermath A.G Malliaris, Leslie Shaw, and Hersh Shefrin Introduction A Multidisciplinary Methodology Orthodox Economics and Financial Crises A Classic Financial Panic Contributions from Economics Contributions from Psychology 15 Values 18 Epilogue 21 References 21 PART T WO The Global Financial Crisis of 2007–2009 and Economics From Asset Price Bubbles to Liquidity Traps 25 A.G Malliaris Introduction 25 Purpose of This Chapter 26 What Is Financial Instability? 30 Methodology 35 The Recent Global Financial Crisis 38 The Expansion Phase 39 The Upper Turning Period 45 The Great Recession of 2007–2009 48 The Liquidity Trap: The Lower Turning Period 49 Conclusions 52 Notes 53 References 53 A Minsky Meltdown 57 Janet Yellen Minsky and the Current Crisis 57 Bubbles and Monetary Policy 60 ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ CONTENTS vi Another Important Tool for Financial Stability 63 Notes 64 Modeling Financial Instability 67 Steve Keen Introduction 67 Loanable Funds vs Endogenous Money 68 A Monetary Model of Loanable Funds 69 A Monetary Model of Endogenous Money 75 Occam’s Razor Passes Endogenous Money and Fails Loanable Funds 78 Simulating Loanable Funds and Endogenous Money 78 Modeling Financial Instability 81 Empirical Data 86 Conclusion 88 Appendix 89 Loanable Funds Model 89 Endogenous Money Model 89 Goodwin model 91 Minsky Model (New and Modified Equations Only) 92 Common Parameters to Goodwin and Minsky Models 92 Minsky 92 Notes 98 References 100 Assessing the Contribution of Hyman Minsky’s Perspective to Our Understanding of Economic Instability 104 Hersh Shefrin Introduction 104 Eight Elements in Minsky’s Perspective 105 Minsky and FCIC Juxtaposed 108 Psychology in Minsky’s Perspective 123 Excessive Optimism 123 Overconfidence 124 Aspiration-Based Risk Seeking and Aversion to a Sure Loss 125 Confirmation Bias 126 Representativeness 126 Reaction to Minsky’s Work 126 Diverse Perspectives 127 Lack of Contagion, Self-Interest, and Confirmation Bias 130 Conclusion: Self-Interest Colored by Confirmation Bias 133 Appendix 134 Notes 136 References 139 ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ Contents vii Prelude to the Global Financial Credit Crisis 143 John Silvia The Things We Take for Granted—and Their Economic Implications 143 Secular Shifts Masked by Short-Term Economic Prosperity 144 Pushing the Credit Envelope 149 Home Prices Fail to Meet Expectations: The Economic Shock 151 Feedback from the Change: Change Begets Credit Revulsion 152 Feedback from the Change: Impact on the Labor Market 153 Economic Growth without a Labor Market Recovery 153 An Altered Framework for the Labor Market 154 The Reservation Wage Model 156 Legacy of a Disparate Labor Market after the Credit Crisis 158 Duration of Unemployment: No Sign of Recovery for Many Workers 158 A Permanent Drop in the Employment Ratio? 161 Regional Disparities Reflect Industry Concentrations 163 New American Phenomenon: Constrained Worker Mobility 165 The “Mancession,” the “Mancovery,” and Industry Mix 165 Where Race and Ethnicity Matter 167 Participation Rates: Older Workers Stay Longer, Younger Workers Quit? 167 Unequal Education = Unequal Recession 168 Dual Returns to Education: Higher Income and Lower Unemployment 169 Hard Realities: Fewer Jobs for the 20th-Century Worker in the 21st Century 170 Show Me the Money: Wages and Hours 171 Income Growth: Still below Pre-Recession Pace 171 A Monetary Policy Disconnect? 171 Conclusion 174 Notes 175 Mathematical Definition, Mapping, and Detection of (Anti)Fragility 177 Nassim Nicholas Taleb and Raphael Douady Introduction 177 What Is Fragility? 177 Fragility as Separate Risk from Psychological Preferences 179 Detection Heuristic 181 Fragility and Transfer Theorems 182 Tail-Vega Sensitivity 182 Mathematical Expression of Fragility 185 Definition of Fragility: The Intrinsic Case 186 Definition of Fragility: The Inherited Case 186 Implications of a Nonlinear Change of Variable on the Intrinsic Fragility 187 Theorem (Fragility Transfer Theorem) 188 Proof 188 Theorem (Fragility Exacerbation Theorem) 189 Discussion 190 ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ CONTENTS viii Monomodal case 190 Scaling Parameter 190 Fragility Drift 191 Second-Order Fragility 191 Definitions of Robustness and Antifragility 192 Definition of Robustness 192 Example of Robustness (Barbells) 193 Definition of Antifragility 193 Remarks 194 Applications to Model Error 195 Case 1: Application to Deficits 196 Model Error and Semi-Bias as Nonlinearity from Missed Stochasticity of Variables 197 Model Bias, Second-Order Effects, and Fragility 197 The Fragility/Model Error Detection Heuristic (Detecting ωA and ωB when Cogent) 198 The Heuristic 199 Properties of the Heuristic 199 Comparison of the Heuristic to Other Methods 200 Further Applications 200 Acknowledgments 201 References 201 PART THREE The Global Financial Crisis of 2007–2009 and Psychology The Varieties of Incentive Experience 205 Robert W Kolb Introduction 205 The Range of Incentives 206 A Taxonomy of Incentives 210 Conclusion 222 Notes 222 References 223 Goals and the Organization of Choice under Risk in Both the Long Run and the Short Run 226 Lola Lopes The Exceedingly Long (and Mostly Unexamined) History of Thought on Risky Choice 227 Distributional Thinking: Ruin and Safety-First 228 Modeling Distributional Thinking 229 Gambling When You Must: Aspiration and Bold Play 231 Demonstrating Security-Potential and Aspiration Level in the Lab 232 Concluding Thoughts on the Importance of Application 236 References 238 ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ Contents ix 10 The Topology of Greed and Fear 240 Graciela Chichilnisky Introduction 240 Background and Examples 243 Two Approaches to Decision Theory 244 The Topology of Fear and the Value of Life 246 How People Value Their Lives 246 Gerard Debreu and the Invisible Hand 247 The Axiom of Choice and Rare Events 248 Representing a Purely Finitely Additive Measure 248 Appendix 250 Arrow’s Definition of Monotone Continuity (MC) 250 The Dual Space L∗∞ 252 Notes 251 References 254 11 A Sustainable Understanding of Instability in Minds and Markets 257 Leslie Shaw Introduction 257 Part One: The Psychology-Psychoanalysis Divide 261 Part Two: Irrationality as a Psycho-Philosophical Problem 266 Part Three: A Sustainable Understanding of Instability 269 Notes 274 References 277 12 Existence of Monopoly in the Stock Market 279 Viktoria Dalko, Lawrence R Klein, S Prakash Sethi, and Michael H Wang Introduction 279 Existence of Monopolistic Tendencies in the Stock Market 281 Comparison between Monopoly Power in the Financial, and the Goods and Services Markets 282 Market Manipulation is Widespread, Frequent, and Occasionally Rampant 284 A Model of an Information-Based Manipulative Trading Strategy 285 The Set-Up of the Model and Related Literature 285 The Model and Results 287 Discussion of the Results 292 Under What Conditions Can the Strategic Trader Profit from Information-Based Manipulation? 292 Under the Above Conditions, Do the Perception-Guided Investors Realize Gain or Loss? 293 What Is the Source of Thought Contagion, Leading to the Perception-Guided Investors’ Herding? 294 Why Do Positive Returns Reverse after the Announcement of Good News? 294 ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ 486 leaders (Cont.) government, trust in, 320–322, 321f –323f leadership, 17, 302–332 See also authority, crisis of crisis in, 416 key role of, 302 qualities for, 302 “leaning vs cleaning” debate, 11 Lear, Jonathan, 266–269, 271, 275–276nn17–22, 460–461 Lebesgue measure, 245, 250–251, 253n21, 254nn28 legal principles, violation of, as natural tendency, 359 legitimacy, 302, 303 legitimation crisis, 303–304 Lehman Brothers bankruptcy of, 8–9, 45, 46, 153, 297, 413, 462 leverage ratios of, 109t as shadow bank, 31 subprime investment losses of, 2005 forecasts on, 137n6 too big to fail and, 122t lending, structure of New Keynesian model of, 68 Post-Keynesian perspective on, 68 two rival models of, 11–12 lending rate, in endogenous money debt on, 81, 84f GDP as function of, 81, 83f money on, 81, 84f on money velocity, 81, 83f lending rate, in loanable funds, 78, 81, 81f debt on, 81, 82f money on, 81, 82f on money velocity, 78, 81, 82f Leo XIII, Pope, 407 Rerum Novarum of, 402–404, 411n8 lessons for future financial stability, 453–465 See also virtue ethics, on future financial stability leveraging amplification of business cycle swings by, 64 definition of, 342 excessive, 462 INDEX increased, before financial crisis, 344 Minsky and FCIC juxtaposed on, 109t Minsky on, 105–106 regulatory intervention for prevention of, 342 Lew, Jacob, 328 Lewis, Ken, 122t Lewis, L., 242 libertarian paternalism, on incentives, 208–209 lift, 287–288, 299n17 Lincoln, Abraham, 304 Lippman, Walter, 329 liquidity crises of, increasing standards for, 64 liquidity trap, 10 asset bubbles and, 51 behavioral finance on, 52 current hypotheses on, 51–52 definition of, 50 in Japan, 51–52 Keynesian, 50 in lower turning period and, 26, 50–52 modern view of, 50–51 monetary policy in, 52 quantitative easing on, 51 loan delinquencies, start of, 149, 149f loan loss reserves, reforming policy on, 64 loan pricing vs interest rates, Minsky on, 58 loanable funds of Eggertsson and Krugman, 70 vs endogenous money, 68, 98nn4–5 Minsky simulation of, 78–81, 79f monetary model of, 69–75, 70f, 71f, 72t, 74f, 98–99nn6–17 money velocity as function of lending and repayment rates in, 81, 82f simulating, 78–81, 79f –84f loanable funds model differential equations for, 89 lending and repayment rates on, 78, 81, 81f loans creates deposits, 68 long shot, 229–230, 230f, 231–233, 233f Long-Term Capital Management (LTCM), 348–349 ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ Index Lopes, Lola, 15, 241, 242, 244, 462 loss aversion, 314 lottery, 244 as Arrow’s actions, 253n19 definition of, 253n17 Lovallo, D., 459 lower turning period, 9, 10, 25, 30, 49–52 financial instability hypothesis and, 52 length of, 49–50 liquidity trap and, 26, 50–52 (see also liquidity trap) timing of, 26, 49–50 low-probability, high-impact events, 389, 391, 393 LPL Financial, 399 Lucas, Robert, 6–7, Ludwig, Eugene, 116t Lund, Thomas, 125 Machina, Mark, 179 MacIntyre, Alasdair, 430, 433–435, 441 MacIntyre view, 430, 433, 436–437 macroeconomics aggregate private debt and banks in, 11–12 failure of, risk and financial instability in, 32 macroprudential policies, for financial stability, 11 macro-prudential supervision, 64 macrostability, 31 Madison, James, 304 Madoff, Bernie, 313, 423n6, 424n110 Madouros, Vasileios, 133–134 Madrick, Jeff, 129 Malinvaud, E., 247 Malliaris, A G., 30, 34, 43, 44, 51 “mancession,” 165, 166f, 167f “mancovery,” 165, 166f, 167f mania information-based stock market manipulation in, 280 Keen on, 138n12 Kindleberger on, 280 speculative, Mankiw, Gregory, 377–378 manufacturing sector, production and jobs in, 1980–2012, 146, 147f 487 market efficiency hypothesis, 40, 41 market efficiency paradigm, Fama’s, 40 marketing, persuasion in, 327 Marmot, Richard, 326 Marx, Karl, 19, 324, 359 mathematical models See also specific types nonlinear, role of, 7–8 Matthew’s Gospel, 402 McCloskey, Deirdre, 4, 237, 362 McCulley, Paul, 65n8, 107 McFadden, D., 247 McKinney, Stewart, 122t Meckling, William, 205–207 media, 329 on Minsky’s work, 129–130, 138n14 psychological traits of, 104 megastate, failure of, 328 Meier, Steven, 121t meritocracy, 305, 326–327 Michalek, Richard, 340 micro-prudential supervision, 63 microstability, 31 middle class, disappearing, 307–309 Mill, John Stuart, 3, 364, 366 Miller, R T., 423n8 Milnor, J., 244, 254n30 mind, 260–262, 275nn5–6 minimum wage, increases in, 157 Minsky, 67–68, 69, 92–98, 93f –97f endogenous money model in, 75–77, 76f, 99n18 endogenous money simulation in, 78–81, 80f Godley Tables in, 69–70, 70f, 95–98, 96f, 97f loanable funds simulation in, 78–81, 79f Minsky, Hyman, 4, 7, 10 on aggregate private debt, 67 on asset price bubbles, 10 on booms, 12, 37–38, 40–41, 84, 106–108 business cycles of, 35 on complacency as asset prices rise, 57–58 credit cycle model of, 37–38 ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ 488 Minsky, Hyman (Cont.) on crisis-proof financial systems, 429 on deleveraging paradox, 59 on expansion phase evolution, 44 financial instability hypothesis of (see financial instability hypothesis, Minsky’s) fundamental issues and, 462–464 on Ponzi finance, 242 reforms of, 132 Shefrin on, 13 “The Financial Instability Hypothesis: A Restatement” of, 269–270 Yellen on, 10–11 Minsky, loanable funds model in aggregate demand in, 73–75 banking sector’s perspective in, 71–72, 72t consumption sector’s perspective in, 71–72, 72t four-account view of, 70–73, 72f private debt–aggregate demand relation in, 75 velocity of money in US in, 1960–2013, 73, 74f Minsky, on economic instability understanding, 104–139 eight elements of, 105–108, 136–137n2 financial innovation and asset values in, 106 fringe finance in, 106 leverage in, 105–106 new-era thinking in, 106 Ponzi finance in, 105, 106 regulatory failure in, 106 runs on financial institutions and markets in, 107 too big to fail in, 107 employment policy in, 105 example of, 134–136, 135f, 136f Global Economic Crisis as out-of-sample test of, 104–105 Minsky and FCIC juxtaposed in, 108 on financial innovation and asset values, 111t–114t on fringe finance and shadow banking system, 109t–110t on leverage, 109t INDEX on new-era thinking, 114t–115t on Ponzi finance, vs hedge and speculative finance, 110t–111t on regulatory failure, 115t–119t on runs on financial institutions and markets, 119t–121t on too big to fail, 121t–123t psychology in aspiration-based risk seeking and aversion to sure loss in, 125–126 behavioral vocabulary for, 123, 137n3 confirmation bias in, 126 of economic agents, 104 of economists, politicians, and media, 104 excessive optimism in, 123–124, 137nn4–6 overconfidence in, 124–125 representativeness in, 126 reaction to, 126–132 of academics views, pro and con, 127–128, 137nn9–10 of central bankers, 128–129, 137–138nn11–12 in FCIC report, 129, 138n13 lack of contagion, self-interest, and confirmation bias in, 130–132, 138nn15–21 of media, 129–130, 138n14 overview of, 126, 137n7 of promulgators, 127, 137n8 self-interest on confirmation bias in, 133–134, 138–139nn22–26 Minsky meltdown, 57–66, 462 bubbles and monetary policy in, 60–63 current crisis and, 57–60 global nature of, 59, 60 macro-prudential supervision and, 64 micro-prudential supervision and, 63 risky behaviors in, 58–59 Minsky moment, 107 Minsky-Bagehot-Keynes sequence, 35 Minsky-Kindleberger-Keynes paradigm, 35, 36, 43 Mishkin, F S., 31, 33, 34 ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ Index mobility constrained worker, 156, 165 economic, decline in, 308 modern economic society, 361–362 monetary model, of loanable funds, 69–75, 70f, 71f, 72t, 74f, 98–99nn6–17 monetary policy after dot-com bubble, 62 aggregate demand and, 61 asset price bubbles and, 29, 60–63 bubbles and, in Minsky meltdown, 60–63 effectiveness of, pre-Global Financial Crisis assumptions on, 143 in Europe, incorrect assumptions in, 143, 414 expansionary, FOMC, 39–40 financial instability on, 33 in financial regulation, 13 in Great Moderation, 33 history of, 32 in housing bubble, 58, 414 in housing bubble, Bernanke on, 43 labor market disconnect in, 171–174, 173f lax, pre-2007, 414 in liquidity trap, 52 on lower turning period, 52 money, on lending and repayment rates in endogenous money, 81, 84f in loanable funds, 81, 82f money market funds, money supply blinders, 129 money velocity, 73 lending and repayment rates in, in endogenous money, 81, 83f lending and repayment rates in, in loanable funds, 78, 81, 82f in US, 1960–2013, 73, 74f monomodal case, 190 monopolistic access to information, 17 monopoly, stock market, 297–299 See also stock market monopoly monopoly power in asset price bubbles, 17 in financial markets, 17 489 in financial vs goods and services markets, 282–284 monotone decreasing sequence of events, 253n18 Moody’s Investors Service, 218–219, 340 Moore, Geoff, 431, 437, 441 Moore-Keat view, 431, 433, 437–440 financial crises and VPI model in, 440–443 moral agency, social structure and, 343–344 moral benefits, of financial crises, 429–448 financial crisis history and, 429–430 financial institutions and, 445–446 global financial crisis and, 431–433 Goldman Sachs example of, 446–448 MacIntyre view on, 430, 433, 436–437 Moore-Keat view on, 431, 433, 437–440 primary and secondary virtues in, 440–441, 443–444 theory of the firm in, 430 virtue ethics in, 430 virtue-practice-institution model in, 430, 433–436 virtue-practice-institution model in, financial crises and, 440–443 moral cleansing, 442 moral contagion, 416 moral hazard problem, 415, 424n16 moral relativism, 419 Morgenson, Gretchen, 18, 139n24 Morse, Charles F., mortgage broker incentives, 211f, 214 mortgage debt, in US household leverage, 59, 109t mortgage originator incentives, 211f, 214–215 mortgage servicer incentives, 211f, 216 mortgages automated processing of, 390 ethical issues in lending policies for, 386–387 relaxed lending in, before Global Financial Crisis, 144 ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ 490 mortgages, adjustable rate, 110t–112t, 137n5 delinquency rates of, 2nd quarter 2006, 150, 151f delinquency rates of, 2nd quarter 2006, prime and subprime, 150–151, 151t motivated irrationality, 455, 456, 457 motivational effects, 258, 274n2, 455 multidisciplinary methodology, 5–6, Mumford, Lewis, 324 narcissism, 367, 369 National Homeownership Strategy, 220, 221 nationally recognized statistical-rating organizations (NRSROs), 218–219 natural incentives, 210, 222 nearby, 241–242 Chichilnisky on, 244 classic theory on, 244 negative amortization, 111t New Classical approach, 463 New Keynesians on banks, 67 on credit creation and bank lending accounting, 67 New York Clearing House, new-era thinking Minsky and FCIC juxtaposed on, 114t–115t Minsky on, 106 Nietzsche, Friedrich, 364 Nocera, Joe, 389 Nohria, Nitin, 432 nonlinear growth models, instability of, norms, fundamental Catholic, 404 Norris, Floyd, 129, 138n12 nutrition assistance, supplemental, 157 Nye, Joseph, 281 Obama, Barack, 329, 381 obedience constructive, 302–303 crimes of, 302 object relations school of psychoanalytic thought, British, 272 Occam’s razor INDEX on endogenous money and loanable funds, 78, 99nn19–21 principle of, 68 Occupy Wall Street, 17, 19 Oden, Gregg, 232 Ohanian, L., 48–49, 48t Olen, Helaine, 308 optimism, 455 excessive, 123–124, 137nn4–6 organizational ethics, 416–418 organized uncertainty, 390–392 organizing good and productive work, 407–408 out-of-sample test, of Minsky Asian currency crisis of 1997 as, 133 Global Economic Crisis as, 104–105 overconfidence, 124–125 about future, 459 overconfidence bias, 143, 462–463 over-inducement, 291, 292f, 293f over-optimism, about future, 459 Ozdaglar, A., 34 Pacem in Terris, 409 Page, Benjamin, 329 panic, 280 panics, financial, 28, 28f on asset price bubbles, 28 Bernanke on, classic, 8–9 classic, 1907, classic, weakening economies in, liquidity crises in, on markets, 462 Papademos, L., 32, 33 Papadimitriou, Dimitri, 137n9 Partnoy, Frank, 223n9 Patterson, Mark, 346 Payne, John, 236 peaks, in asset price bubbles, 26, 27 Pecci, Vincent Joachim, 403 Pederson, Lasse, 285, 286 Penn Square Bank failure, 107–108 Peralta-Alva, A., 49 perception See also information-based market manipulation manipulation of, about stock value, 286 perception-guided investors, 287, 298n12 ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ Index Pérez-Soba, J J., 419, 420, 425n20 Perkins, Tom, 378 personal ethics, 415–416 personal finances, self-assessment of, 312, 313f persuasion, in marketing, 327 perverse effects, 421 perverse incentives, 417, 424n16 Pettis, Michael, 441, 445–446 Pezzuto, I., 424–425n18 phantastic objects, 458 Philippon, Thomas, 380–381 Phillips, Bill, 94–95, 95f Pickett, Kate, 326 Pickwickian sense, 344 Pius XI, Pope, 407 Plato, 454–455 pleasure, pursuit of, 363 pleasure principle, 262, 459–461 Plosser, C I., 32 pole of ambitions, 368 policy, fiscal on asset price bubbles, 29 effectiveness of, assumptions before Global Financial Crisis on, 143 policy, monetary See monetary policy political malfunctions, 328–329 politicians, psychological traits of, 104 Polo, L., 413, 420, 421 Ponzi finance, 13, 59, 244 bubbles induced by, 111t–114t definition of, 105 vs hedge and speculative finance, 106 Minsky and FCIC juxtaposed on, 110t–111t Minsky on, 134, 135, 136f, 241, 242, 464 regulatory approaches on, 134 relative size of, balancing and, 139n24 positive price drift, 291, 292f, 293f post-capitalist society, 324 post-distribution, 291 potential-minded, 230, 230f, 231 power in financialized system, 345 in financialized world, 344–345 Power, Michael, 390–392, 394 Power Distance Index, 377 491 practical rationality, 415 practice–institution balance, 21 practices, 434, 438 institutional corruption from, 21 internal goods in, 434–435 moral grounds for, 442 primary and secondary, 441 symbiotic institutions and, 439–440 predatory pricing, 283 preferential option for poor, Catholic’s, 406 prelude, to Global Financial Crisis, 143–176, 153 assumptions on fiscal and monetary policy action effectiveness in, 143 credit envelope in, pushing, 149–151, 150f, 151f, 151t credit expansion in, 143 credit revulsion in, 152–153 education in, higher income and lower unemployment from, 169–170, 169f education inequalities in, recession inequalities from, 168–169, 169f employment ratio in, permanence of drop in, 161–162, 162f, 163f home prices in, economic shock from, 151–152, 152f housing lending in, 144 income growth in, pre-recession pace of, 171, 173f job prospects for 20th century workers in 21st century in, 170–171, 170f labor market in, 153, 154f labor market in, altered framework for, 154–157 labor market in, disparate, legacy after credit crisis, 158 labor market in, economic growth without recovery of, 153–154, 154f, 154t, 155f labor market in, reservation wage model of, 156–157, 158f “mancession,” “mancovery,” and industry mix in, 165, 166f, 167f monetary policy disconnect in, 171–174, 173f participation rates by age in, 167–168, 168f ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ INDEX 492 prelude, to Global Financial Crisis (Cont.) race and ethnicity in, 167 regional disparities and industry concentrations in, 163, 164f secular shifts masked by short-term economic prosperity in, 144–149, 145f, 147f –149f student loan debts in, current instabilities in, 144 unemployment duration vs recovery in, 158–161, 159f –161f wages and hours in, 171, 171f worker mobility in, constrained, 156, 165 prices direct influences on, 17 stability of, financial stability and, 29, 32–33 price-sensitive information., 285 pricing risk, nonlinearity in, 177 primary practices, 441 primary thought process, 263–265, 264f primary virtues, 440–441, 443–444 Prince, Charles, 423 principal–principal’s agent relationship, 15, 206–207 private debts Eggertsson and Krugman on, 69 in loanable funds tradition, 68 neglect of dynamics of, erroneous, 89 probability waves, 262, 275n10 process-product differentiation, 263 procrustean bed, 391 Procrustes, 391 production, in manufacturing sector, 1980–2012, 146, 148f professionalism, in virtue ethics, 446–447 professionals, financial See financial professionals professions See also specific types trust in, 318–320, 319f progress paradox, 330 prospect theory, 457 prosperity, vs social justice, 305 prosperity phase, 9–10, 25, 26 prudence, 415 prudential judgment, 404 psyche, 369 psychoanalytic self psychology, 360 psychodynamic dual approach, 263–265, 264f psychodynamic psychology, 458 psychological preferences avoidance of, 179 fragility risk from, 179–180 psychology, Fisher and Keynes on, 137n3 psychology, Minsky on, 4, 15–18 See also specific topics aspiration-based risk seeking and aversion to sure loss in, 125–126 confirmation bias in, 126 of economic agents, 104 of economists, politicians, and media, 104 excessive optimism in, 123–124, 137nn4–6 in financial crises, 13 overconfidence in, 124–125 representativeness in, 126 psychology–psychoanalysis divide, 260–266, 264f, 275nn5–6, 10, 13, 16 public choice, on incentives, 207–208 public ethics, 419 public institutions, trust in, 317–318, 317f Pugh, Alexander, 95 purely finitely additive, 244 purely finitely additive measures, 254n27 representing, 248–250 quantitative easing, 51, 60, 65n8 race, on unemployment, 167 Radner, Joshua, 18 Rajan, Raghuram, 33, 388, 394 rare events axiom of choice and, 248 insensitivity to, 241–244 rating agencies, conflicts of interests in, 417 rational agents, as amoral, 418 rational behavior, broad definition of, 242 rational choice model, Fisher and, 455 rationality agents violating, 36 deviations from, 36 ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ Index practical, 415 Rawls, John, 365, 410n2 real GDP vs equities, relationship of, 29 growth since 1999 of, 306–307, 307f long-term growth of, 27, 28f, 29 recession See also Great Recession of 2007–2009 2001, 39 crash of the tech bubble in, 39 definition of, 27 inequalities in, from education inequalities, 168–169, 169f recession phase, 9, 10, 25, 26 reflection, 231, 234–235 reflexive breakdown, 266, 275n18 regulation and control mechanisms See also monetary policy enforced self-regulation, 395 failure of, 417–418 regulators, government finance profession conflict of interest of, 346 incentives for, 211f, 220–221 regulatory arbitrage, 417 regulatory capture, 220 regulatory failure, 417–418 Minskey vs FCIC on, 115t–119t Minsky on, 106 Reinhart, Carmen, 6, 38, 48, 128, 341, 465 REITs 1974 crisis of, 107 Minsky on, 119t–120t relativism, cultural and moral, 419 repayment rate, in endogenous money debt on, 81, 84f GDP as function of, 81, 83f money on, 81, 84f on money velocity, 81, 83f repayment rate, in loanable funds, 78, 81, 81f debt on, 81, 82f money on, 81, 82f on money velocity, 78, 81, 82f representativeness, 126 Rerum Novarum, 402–404, 411n8 reservation wage model, 156–157, 158f 493 reserves, loan loss, reforming policy on, 64 respect fairness and, 19 status and, 19 reverse Minsky journey, 65n8 rhetoric, 303 Ridgeway, Cecilia, 376 Riker, John, 18–19, 458, 463 risk managerialization of, 390–392 transfer of, 392–393 underestimation of, 124–125 risk aversion, 179 utility function and, 227 risk management, 19–20, 384–396, 416–417 acceptable level of risk in, 393 basic means for, 392 confirmation bias on, 388 criticism of, 386–387 false sense of confidence from, 393 in financial crisis, 384–385 for formulating vs implementing strategy, 388–389 framing effect in, 388 Greenspan’s policy of, 58 history of, 384 human behavior in, 386 vs individual judgment, 390 for low-probability, high-impact events, 389, 391, 393 as managerial smokescreen, 20, 393–394 managerialization of risk in, 390–392 maximizing firm’s value for shareholders in, 392 misuse of, 393–394 organizational implementation of, 20 purposes of, 393–395 in recent financial crisis, 385 for regulatory compliance vs management control, 394–395 social impacts of, 392–393 tools of, 384 transfer of risk in, 392–393 unknown unknowns in, 386 use of, 20, 387–390 ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ 494 risk management (Cont.) value at risk (VaR) in, 200, 385, 386, 395 risk seeking for loss, 231–232 risk theory, 15–16 risk-taking under uncertainty, 15 risky behaviors, 416–417 in Minsky meltdown, 58–59 risky choice, 16, 226–238 application in, importance of, 236–237 aspiration and bold play in, 231–232 distributional thinking in, 228–229 distributional thinking in, modeling, 229–231, 230f history of thought on, 227 reflection in, 231–232 risk seeking for loss in, 231 security potential and aspiration level in, laboratory demonstration of, 232–236, 233f –236f short shot vs long shot in, 229–233, 230f, 233f robustness, in fragility, 192–193 Rogoff, Kenneth, 6, 38, 48, 128, 341, 465 rogue practice, 431, 445–446, 447 Roman Empire Christians on, 402 Saint Cyprian on, 411n4 Rosengren, Eric S., 33, 34 Rothkopf, David, 326 Rothschild, Michael, 179 Rowe, Nick, 72t, 74f, 98–99nn6–17, 21 Rubin, Robert, 346, 347 runs on financial institutions and markets Minsky and FCIC juxtaposed on, 119t–121t Minsky on, 107 Sachs, Jeffrey, 327 safety-first, 228–229, 230, 237 Salter, Malcolm, 328 Samuelson, Paul, 127, 346 Sanchez, J., 49 Sarbanes-Oxley Act of 2002, 342 Sargent, Thomas J., satisfaction with status quo, lack of, 309–312, 310f –313f scaling parameter, 190–191 INDEX Schiller, Robert, 131 Schinasi, Garry J., 31 Schlefer, Jonathan, 131 Schneider, Sandra, 236 Schrodinger’s equation, 262, 275n10 Schumpeter, Joseph, 67, 324 Schwab, Klaus, 313 secondary practices, 441 secondary thought process, 263–265, 264f secondary virtues, 440–441, 443–444 second-order fragility, 191–192 secular shifts, short-term economic prosperity masking of, 144–149, 145f, 147f –149f securitization, ethical issues in, 386–387 securitized credit instruments See also specific types in Minsky meltdown, 58–59 securitizer incentives, 211f, 217–218 security potential, laboratory demonstration of, 232–236, 233f –236f security-minded, 229, 230f, 231 segmentation, 421 self injured, 369–370 traumas to, 360–361 self objects, 368 self-actualization, 360 self-control, imperfect, 455 self-interest, 363 confirmation bias and, 133–134, 138–139nn22–26 confirmation bias and, in Minsky’s work, 131–132, 138nn15–21 selfish heedlessness, 340, 342 self-psychology, 360, 367–370, 375n2 economic world and, 371–373 ethics, economics, and, 359–375 (see also ethics, self-psychology and economics) self-regulation, enforced, 395 Sennett, Richard, 324 sentiment, 455 separation thesis, 418 sexualization, of workplace, 373 ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ Index shadow banking, 31 McCulley on, 107 Minsky and FCIC juxtaposed on, 109t–110t Yellen on, 58–59 Sharfstein, David, 381 Shaw, Leslie, 16–17, 238, 364 Shefrin, Hersh, 12–13 on behavioral portfolio theory, 237 on credit cards, 381 on distributional thinking, 242 economic theory of self-control of, 457 fairness rights of, 380 on fear and financial markets, 241 on Minsky’s math skills, 270, 276n25 on Ponzi schemes, 242, 244 on rational responses to extreme events, 242 Sherman Act of 1890, 281 Shiller, Robert, 36, 42, 127–128, 137n10, 458 Shin, Hyun Song, 31, 62 short shot, 229–233, 230f, 233f short-sellers, stock market manipulation on, 296, 299n19 short-term economic prosperity, secular shift masking by, 144–149, 145f, 147f –149f Silver-Greenberg, Jessica, 139n25 Silvia, John, 13, 462–463 Simon, Herbert, 133 Simulink, 94 Slovic, Paul, 457 Smith, Adam, 4, 363, 429 invisible hand theorem of, 242, 247 on principal–agent incentives, misalignment of, 206–207 on state-mandated power, 115t two-system model for moral choices of, 454–455 Smith, Frederick, 232 Snow, John, 117t social cohesion, 326–328 social entropy, 421 social justice, 399–412 Catholic social doctrine and, 400 global solution to, 409–410 495 historical foundation of, 402–404 LPL Financial abuse and, 399 vs prosperity, 305 regulatory actions against brokerage firms and, 399 run-up to global financial crisis and, 404–406 scriptural foundations of, 400–402 social ethics and justice in, loss of, 399 virtuous business leadership and, ethic of, 406–409 social movements, new, 420 social standing, on health, 326 social structure, power, and financial fraud, 340–350 continuing fundamental instabilities in, 349–350 criminogenic environment in, 341 financialized capitalism in, 341 fraud and power in financialized world in, 344–345 IBGYBG (“I’ll be gone, you’ll be gone”) in, 340, 341, 396 international capital flows and “too complex to regulate” in, 347–349 moral agency and, 343–344 post-financial crisis fraud in, 349 selfish heedlessness in, 340, 342 sociological perspective on, 341–343 state power and financial fraud in, 345–347 structure and moral agency in, 343–344 tax havens in, 348–349 social trust, 313–314 social utilitarians, 420 socially emergent incentives, 212, 217–218, 219, 222 society fundamental components of, 361 modern economic, 361–362 sociological perspective, on fraud and financial crisis, 341–343 Socrates, 266–267, 268, 410 South Sea Company, 40 ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ 496 sovereign debt crisis, 414 in Europe, 3, 143, 146, 147f, 175n3, 310, 414 spread narrowing between issuers of, 146, 147f S&P 500 index cyclical behavior of, 28, 28f, 29 vs real GDP, relationship of, 29 SP/A theory, 232–236, 233f –236f specialists, 17 Spence, Michael, 285 Spillenkothen, Richard, 116t spin, 303 Spitznagel, Mark, 389 spreads bank increases in, 144, 145f of corporate bonds vs cash market, 149, 150f of mortgage-backed securities current coupon yields vs costs of funds, 150, 151f St Petersburg paradox, 15, 227, 228, 252n6, 253n18 Allais on, 228 Bernoulli on, 227–228 Buffon on, 228 Lopes on, 228 stability See also instability definition of, 34 Fechner on, 262 financial sector, definition of, 31–32 technical concept of, and economics, 34 stability, financial, 29 asset price bubbles and, 29 central banks in, 33–34 definition of, 31–32 economic policies in, 32 endogenous and exogenous variables in, and random shocks, 34 global, domestic financial instability on, 33 macroprudential policies for, 34 price stability and, 29, 32 real economic, 32 shocks and recessions in, 34 stagnation, fear or, as self-fulfilling, 17 Standard and Poor’s, 218–219 INDEX Stanton, Tom, 129, 138n13 state See also government financial fraud and power of, 345–347 first-order importance of, 306 Statman, Meir, 19, 237, 377, 378, 380, 381, 463 status, 376–377 life satisfaction and, 330 market for, 19, 377–378 stewardship, good, 408 Stewart, John, 330 Stiglitz, Joseph, 285 stimulus programs, government, 414 stock market, housing bubble and, 43, 44f stock market manipulation action-based, 298n7 prosecution rates for, low, 284, 298n8 SEC on, 298n4 trade-based and information-based, 282 in U.S., illegal, 298n5 stock market monopoly, 279–299 definition of, 281 efficient market hypothesis and, 279–280, 297n1 financial instability hypothesis and, 279, 280 financial markets in, 279 future research on, 296–297 information-based manipulative trading strategy model in, 285–296 (see also information-based market manipulation, trading strategy model) information-based market manipulation in, 280–299 (see also information-based market manipulation) monopolistic tendencies in, 281–284 monopoly power in financial vs goods and services markets and, 282–284 players and key terms in, 281–282 as widespread, frequent, and occasionally rampant, 284 Stokes, Bruce, 379 Stokey, Nancy L., strategic traders, 281 goal of, 287 ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ Index as indirect price-setter or monopolist, 286 strictly speaking incentives, 209, 210, 212, 222 student loan debts, current instabilities in, 144 subprime loans, as Ponzi finance, 59 success, integrity and, 304 Sunstein, Cass, 208–209, 213 supervisory and regulatory policies, 63 synthetic collateralized debt obligations, 385 synthetic credit spreads, 149–150, 150f systems-dynamic program See also Minsky core paradigm in, 95, 95f Taffler, Richard, 458–459 Tahbaz-Salehi, A., 34 tail risks, silent accumulation of, 177 tail-vega sensitivity, 182–185, 186f of fragility, 178, 178f Taleb, Nassim Nicholas, 10, 14–15, 199 on black swan events, 462 on concave and convex transition periods, 47, 53 on forcing reality to fit preconceived forms, 391 on fragility and antifragility, 177, 462 on low-probability, high-impact events, 389, 393 tax havens, 348–349 tax rate, increased effective, 157 Taylor, Frederick, 206 Taylor, John B., 32, 43 Taylor rule, 36 Tcherneva, P., 49 tech bubble central bank policy after, 62 crash of, 39 Federal Open Market Committee response to, 39–40 irrational exuberance in, 39 technological change, 324–325 temperance, 415 Thaler, Richard, 208–209, 213, 457 theory of general equilibrium, 31 theory of self, 19 497 thinking, fast and slow, 16–17 Thinking Fast and Slow (Kahneman), 257, 275n17, 454, 457 thoughts, 263 Tirole, Jean, Titmuss, Richard, 207, 222n3 Tone, Andrea, 326 too big to fail, 327, 348 Minsky and FCIC juxtaposed on, 121t–123t Minsky on, 107 “too complex to regulate” industry, international capital flows and, 347–349 trade, free, 325 trade-based manipulation, 282 transfer function, 179 transfer of risk, 392–393 transfer theorems, fragility and, 182, 183t transparency, lack of, 111t, 304, 417 triggers, 47 Troeltsch, Ernst, 411n6 Troubled Asset Relief Program (TARP), 49 bonuses for top employees from, 347 troughs, in asset price bubbles, 26, 27 Trumpism, 331 trust in key players in economics, loss of, 19 loss of, 425n21 in people vs institutions, 312–314 social, 313–314 trust, loss of, 303 economic consequences of, 305 in financial markets, 359, 360 political, social, and moral consequences of, 305 psychological consequences of, 305 public, 312–313 trust and distrust, 303, 312–323 in banks, 315–317, 316f in business vs government, 315, 315f in government, 315–317, 316f in government leaders, 320–322, 321f –323f multicountry evidence of, 314–317 in professions, 318–320, 319f ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ 498 trust and distrust (Cont.) in public institutions, US and UK, 317–318, 317f Tuckett, David, 458–459 Tullock, Gordon, 207–208 turning periods, 25, 26, 27, 29–30 modeling and validation of, 29–30 Tversky, Amos, 179, 258, 457–458 on aversion to sure loss, 125 on hot hand effect, 124 on rationality, 240 on reflection, 231 type errors, 62 uncertainty, 244 microeconomic decision-making under, 15 organized, 390–392 risk-taking under, 15 unconscious processing, 459 unemployment See also labor market benefits for, extension of, 157 change in debt times velocity and, 86–87, 87f, 100n26 credit acceleration and, 88, 88f cycles of, U.S., 153, 154f downward wages on, 157 education on, 165, 169–170, 169f, 170, 170f education on rate of, 157, 158f in Europe, 153–154, 155f vs Federal funds rate, 171, 172f gender on, 165, 166f long duration vs recovery of, 158–161, 159f –161f mancession and mancovery in, 165, 166f negative home equity and, 163, 164f by occupation, 165, 166f poverty with, 309 race and ethnicity on, 167 seasonally adjusted, 153, 155f since 2008, 308 in U.S by state, 152t, 153 unemployment insurance, on replacement rate, 157 Unger, Roberto, 364 unknown unknowns, 386 INDEX upper turning period, 9, 10, 25, 30, 45–47 concave and convex periods in, 47 disutility of losses vs utility of equivalent gains in, 46 financial amplification in, 47 financial instability hypothesis and, 47 hypotheses about, 46 instability of, 30 relevant events in, 45–47 timing of, 26, 45 triggers of crisis in, 47 upward mobility, lack of faith in, 310 Useem, Michael, 346 Ustuner,Tuba, 377 utilitarian ethics, 422 utilitarians, 364–365 social, 420 utilities, bounded, 252n6 valuation risk, in financial instability, 32 value at risk (VaR), 200, 385, 386, 395 value of life, topology of fear and, 246–247 values, ethical See also ethics cheating and, 18 violation of, as natural human tendency, 18–19 values, personal, 18 vanishing sequence, 244 Veblen, Thorstein, 344, 345, 365 vega sensitivity, nonlinearity of exposure as detection of, 180 Villegas, C., 254n30 virtue ethics, on future financial stability, 453–465 Akerlof, Shiller, and Kranton on, 458 animal spirits in, 456–458, 463, 464 behavioral finance in, 457 cognitive heuristics and biases in, 457 economics and psychology history in, 454–462 Fechner in, 457–458 Fisher in, 455 Freud in, 455, 456, 464 Freud in, Glymour on, 459–460 Freud in, Lear on, 460–461 ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ Index Gladwell on, 458 hidden factors in, 459 Kahneman and Tversky on, 454, 457–458 Keynes in, 455–457 main conclusions on, 464–465 Minsky and fundamental issues in, 462–465 pleasure principle in, 460–461 psychodynamic psychology on, 458–459 Shefrin and Thaler in, 457 Slovic in, 457 Smith’s economics-psychology in, 454–455 Taffler and Tucket in, 458–459 two-system moral choice system in, 454–455 unconscious processing in, 459 virtue ethics theory, 21, 429–448 See also moral benefits, of financial crises financial institutions and, 445–446 Goldman Sachs example of, 446–448 primary and secondary virtues in, 440–441, 443–444 professionalism in, 446–447 theory of the firm in, 430 virtue-practice-institution model in, 430, 433–436 virtue-practice-institution model in, financial crises and, 440–443 virtue-practice-institution (VPI) model, 430, 433–436 financial crises and, 440–443 virtues balance of, 435–436 civic, 326–328 financial institutions and, 445–446 institutional, 435–436, 444 primary and secondary, 440–441, 443–444 social, 441 in VPI model, 434–435 virtuous business leadership, ethic of, 406–409 virtuous corporate character, 439–440 “Vocation of the Business Leader,” 406 von Bismarck, Otto, 324 499 Von Bommel, Jos, 285, 286 voter cynicism, 330 wages See also income downward, on unemployment, 157 economic expansions and recession on, 156 hourly earnings changes in, 171, 171f hours and, 171, 171f minimum, increases in, 157 real, countercyclical, 156 reservation wage model of, 156–157, 158f Walker, Henri, 376 Wallison, Peter, 223n16 Wallstreet Reform and Consumer Protection Act of 2010 See Dodd-Frank Act Walrasian equilibrium models, 132 Walrasian model, 94 Wang, Michael H., 284 Wargo, Donald, 432–433 wealth inequalities in, 17, 326 just creation and distribution of, 408–409 selfish pursuit of, 327–328 Weber, Max, 324 Welch, Ivo, 289 Werning, Ivan, 50 Whalen, Charles, 135n1 White, W., 32, 33 Wildavsky, Aaron, 394 Wilkinson, Richard, 326 Willen, Paul, 124, 137n6 Wilmott, P., 199 Winnicott, D W., 367 Winterich, Karen, 377 Wolf, Martin, 129, 331 Woodford, M., 50 work, organizing good and productive, 407–408 worker mobility, constrained, 156, 165 workers, low- and semi-skilled, 157, 158f working, opportunity cost of, 156–157 work/leisure decisions, 156 workplace, sexualization of, 373 ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ INDEX 500 worry, 309–312, 310f –313f Wray, L Randall, 127, 135n1, 137n9 on Minsky meltdown, 57–66 (see also Minsky meltdown) Xcos, 94 Yeats, William Butler, 305 Yellen, Janet, 10–11, 33–34, 128, 462 on asset price bubbles, 10–11 Zandi, M., 49 Zell, Sam, 378 Zhang, Yinlong, 377 Zingales, Luigi, 305 ✐ ✐ ✐ ✐ ...✐ ✐ ✐ ✐ The Global Financial Crisis and Its Aftermath ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ The Global Financial Crisis and Its Aftermath Hidden Factors in the Meltdown EDITED BY A G MALLIARIS, LESLIE... risks to financial markets and preventing financial crisis The other is on how financial crisis influences the well-being of people In particular, she has studied worldwide financial crises and one... major financial panics occurred during the Great Depression of the early 1930s and the recent global financial crisis of 2007–2009 During these two financial panics, a bursting of a financial bubble