On the Keynesian "Bankers Gone Wild" Hypothesis of Credit Bubbles: Deregulation of Financial Markets, Financial Fragility, Too Much Bad Debt, a "Minsky Meltdown," the Market Failure, and the Credit Crisis

There are two main theories of why we had a credit bubble, and we might as well call them 'Keynesian' and 'Austrian'. In the Keynesian story, there is an irrational expansion of credit, perhaps because creditors under-estimate the risks they are taking. Paul Krugman represents this view rather well. In good economic times 'debt looks safe' and 'the memory of the bad things debt can do fades into the mists of history. Over time, the perception that debt is safe leads to more relaxed lending standards'. Eventually, bankers will become complacent and forgetful, at which point they start making a lot of bad loans. With all that bad debt, there must come a moment of crisis, which Paul McCulley has dubbed the 'Minsky moment'. Such a moment is 'the point at which excess leverage cannot be sustained and the system unravels'. It is called the 'Minsky moment' because the idea of such 'financial fragility' comes from the Keynesian economist Hyman Minsky, whom Krugman cites. Janet Yellen tells a similar tale when she calls the crisis a 'Minsky meltdown', although she admits that 'Fed monetary policy may also have contributed to the U.S. credit boom'.

Krugman, Yellen and others have used the terms such as 'Minsky moment' and 'Minsky meltdown' to suggest that the crisis is an example of market failure. The basic idea is that we had deregulation of financial markets in the US and elsewhere, which led to a lot of irresponsible lending and, ultimately, a credit crisis.  The 'combination of deregulation and failure to keep regulations updated', Krugman explains, 'was a big factor in the debt surge and the crisis that followed'. It is true that there was a kind of selective deregulation before the crisis. But the idea that excess lending was somehow a market failure overlooks a big important fact: too big to fail. The bankers were gambling with other people's money. As I discuss below, they had plenty of incentive to lower their lending standards. And if the bottom falls out? Well, we will get a bailout.

--Roger Koppl, introduction to From Crisis to Confidence: Macroeconomics after the Crash, Hobart Paper 175 (London: The Institute of Economic Affairs, 2014), 7-8.