Understanding Systemic Risk in Global Financial Markets

CHAPTER 4Systemic Risk, Economic and Behavioral Theories: What Can We Learn?

INTRODUCTION

This chapter explores the issue of systemic events in the context of some longstanding academic theories related to economic cycles and human behavior. By studying the characteristics of the numerous crises that have occurred throughout history, certain common themes emerge related to the economic climate that existed leading up to these events. For example, several theories exist around the impact of monetary policy on the development of asset bubbles. Some argue that so-called “easy credit” conditions have fueled investors' speculative buying of risky assets, which may have artificially inflated prices to unsustainable levels. That said, economic factors alone cannot be blamed for events such as the Great Depression or the Credit Crisis. The occurrence of these catastrophic financial events required the interplay between economic factors and the actions of individual consumers, investors, or corporations. Regarding the latter, this chapter discusses some theories related to human behavior and investment risk taking, speculative borrowing, and even the role that fear and the human brain may have played in contributing to financial crises.

After reading this chapter you will be able to:

• Describe the key components of Hyman Minsky's model of financial crises.
• Define and distinguish between homogeneous and heterogeneous beliefs.
• Describe the Rational Expectations Theory and how its key ...