The Hypothesis

The Behavioral Model Hypothesis is a quite simple one. People can’t predict the future, so they project the current situation ahead as far as necessary when making economic decisions. This general decision making rule, when executed by everyone in the economy, creates the necessary dynamics for a cyclical economy. When enough people make bad predictions, the economy reaches a turning point. Too optimistic? That’s a recession Too pessimistic? That’s a recovery.

Structural factors are what keep the economy from experiencing a never-ending boom or death spiral. On the upside, there are increasing economic costs that create a natural speed limit on how fast the economy, or even sectors of the economy can grow. On the downside, businesses can operate profitably at low income levels, consumers have a significant amount of non-discretionary spending, monetary authorities can prevent an implosion of fractional reserve lending, and the same lumpy economy creates investment opportunities even in the deepest recession.

Structural factors also can act as an impediment to recovery. Broken consumers, lenders, creditors, or governments can reduce the quality of a recovery, even if the recovery is still guaranteed to occur. Likewise, fiscal and monetary policies that can reduce the structural impediments to the next recovery are desirable, even though they are unable to prevent or end a recession.

Keynes was the original proponent of the Behavioral Hypothesis in his General Theory, published in 1936. The problem Economics had is that if Keynes’ ideas on uncertainty were implemented into conventional economic theory, most of it would have had to be thrown out. Therefore, the most important feature of Keynesian Economics was thrown out, so that the rest could be seamlessly incorporated into the Classical Model.

Very many economists, most frequently those with Keynesian leanings, complain bitterly about this omission of uncertainty. Very few actually have the ability to complain effectively. One of those that could was Hyman Minsky.

Minsky developed the Financial Instability Hypothesis (officially in 1992, though he had published many papers on this subject prior) based on the application of uncertainty to financial markets. Decision makers in finance are particularly likely to project the current situation out indefinitely, since departures from herd behavior are very costly to them. Bubbles become endogenous to financial markets through this behavior, and always end up with the proverbial bust.

The problem with Minsky’s FIH is it only relates to a relatively modern financial system, and does not explain how the economic cycle is a feature of economies at all times and in any level of development. Clearly, Minsky’s idea should be applied much more broadly than just the modern U.S. financial economy.

The goal of this blog is to flesh out the Behavioral Model Hypothesis and then apply it to financial markets. Ultimately, my goal is to get a book out of this solely for my own edification. However, I think it this type of analysis is both potentially profitable and woefully lacking today. The only way to find this out is to launch it and see what happens.

My first goal is to post basic but useful commentary on the weekdays. On the weekends I’ll post a longer research-oriented thing on Sunday that I’ve worked on during the week. Once I can do this for a month, I’ll start trying to cross-pollinate with other business blogs. Baby steps first. Here we go.