To Buy or Not to Buy, That’s Not the Question: A Simple Model of Credit Expansion

NRU Higher School of Economics , 2012. No. 05.

Smirnov A. D.

The proposed model is aimed to reveal important patterns in the behavior of a simplified financial system. The patterns could be detected as regular cycles consisting of debt bubbles and crises. Financial cycles have a well defined structure and form periodic sequences along the axis of credit expansion while retaining stochastic nature in terms of time. Bubbles are defined as “large asset price deviations” from their fundamental value, and crises, if would represent huge losses of financial wealth. Regular sequences of bubbles and crises in the model are explained via behavior of market participants whose collective actions facilitate either emergence or  postponement of crises due to events as investors’ self-imposed restrictions upon debt accumulation. The paraphrase of famous Hamlet’s dilemma exposes the illusory character of investors’ attempt to avoid crises: financial catastrophes, even being postponed, are inevitable under the regime of credit expansion. It was shown, in particular, that the probability of default grows in coherence with the increasing money issuance, and at the point of a total collapse it reaches the unit value.  The model clearly discerns phases of normal investing, speculation and a Ponzi game which have the same meaning as in the “financial instability hypothesis” elaborated by H. Minsky. The model while supporting the assessment of crises inevitability under regime of a credit expansion, does not share the  Austrian School doomsday predictions regarding the exact dates of such events.

Keywords: financial bubble, modelling of complex systems, credit meltdown