T HEORY

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41 accurate. Validity measures the level of interconnectedness of the chosen theory and empirical data and the relevancy of the empirical data to the research questions in our problem statement.⁸

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42 relation of the two theories many refer to these as the Minsky-Kindleberger theory.

The Minsky-Kindleberger theory will form the foundation of our analysis because we consider this theory to be highly useful in analyzing the SCC. Furthermore, as opposed to monetary theory the Minsky-Kindleberger model to a larger extent takes the factors leading up the crisis in regard.

The Minsky-Kindleberger model will be supported by the Debt-Deflation theory of Irving Fisher (1933). It is important to include Fisher’s theory because, compared to the Minsky-Kindleberger model, it is more detailed in its explanation of the mechanisms leading up to a crisis. Furthermore, Fisher has important points that are of relevance to the current financial crisis. The inclusion of the Debt-Deflation theory will thus add to the broader understanding of the SCC.

On the micro level we have chosen to select the theories of Hamilton and Mickletwaith (2006) and Lai (1993) because of their relevance to explain the behavior and failure of subprime mortgage lenders whilst the theory on “Bubble Psychology” by De Bondt (2003) is included because it is highly useful in analyzing the behavior of both participants. De Bondt is relevant because of his inclusion of several aspects of individual behavior, such as the theory of Tversky and Kahneman

“Judgment under Uncertainty: Heuristics and Biases” (1974). By including these theories on the micro level we add a new dimension to the understanding of the SCC.

We established earlier that the subject of LOLR is one characterized by controversies. Several viewpoints are represented in the text by Bordo (1990). This text will form the basis of our analysis on the issue of the Fed as LOLR.

As the theories on the subject is not a framework for an analysis but more of a set of ideas, representing the four schools on this topic, it is not a straight forward action to pinpoint a specific viewpoint that will be utilized throughout the paper. Instead we shall draw on knowledge from all four which in unison shall lead to a discussion of important main themes as to the SCC and the Fed as the lender of last resort.

The only view-point we find to be rather unnecessary for the purposes of this thesis is the school of free banking. This is due to the irrelevant and improbable nature of the idea in relation to the SCC as the mere existence of a central banks and regulation in the US market makes any discussion based on this viewpoint superfluous.

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43 6.2.2 Use of Theory

The Minsky-Kindleberger model contains six points; displacement, euphoria, financial distress, panic, contagion and the lender of last resort. These points are, according to Kindleberger, crucial factors that play a vital role in relations to the occurrence of a financial crisis. The main part of the analysis of this thesis will be divided into six sections thus using the Minsky-Kindleberger model as a framework. This chronological approach allows us to analyze the SCC thoroughly – on a macro level – and carry the reader through the different crucial phases of the crisis. We will try and follow the model as much as possible by following the course of events. However, some events might be explained at an earlier stage compared to their occurrence in reality because it gives the reader a

“flowing” understanding of the SCC and our analysis. A model is rarely perfectly compatible with reality.

It is important to emphasize that the analysis will not have the purpose of examining whether or not the Minsky-Kindleberger model is suitable in explaining financial crises in general but rather in analyzing the SCC through the use of the chosen theory.

Relevant insights from the Debt-Deflation theory will be included in different parts of the analysis on the macro level when appropriate.

Important arguments from the theories of Hamilton and Micklethwait and Lai will be used to analyze the behavior of the subprime mortgage lenders. “Bubble Psychology” will serve as the theoretical foundation of the psychological aspects of the behavior of subprime mortgage lenders and borrowers.

We will conduct our analysis on the LOLR actions of the Fed by applying a study in retrospect. An understanding of the responses of the Fed when faced with the challenges that the SCC has posed will form the basis of a discussion on the essential themes within the theory of the lender of last resort.

6.2.3 Critique on Theory

The Minsky-Kindleberger model is criticized by not operating with a clear cut definition of financial crises (Per H. Hansen, p. 17). Furthermore, the model operates on a macro level, thus not

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44 including relevant aspects such as the psychology of financial market participants during a bubble or corporate failures etc.

Fisher’s theory is founded on the assumption that over-indebtedness leads to price deflation.

However it is evidenced that debt-deflations in the US have been avoided via the assistance from the Fed to the financial system (Martin H. Wolfson, 1996, p. 315). This diminishes its relevance to the SCC but does not write off its ability to analyze the factors leading up to the crisis.

Theories on the micro level can be characterized as operating too narrowly, thus not providing the tools to analyze an extensive event, such as the SCC, independently.

The diverse opinions that characterize the theory on the LOLR are perhaps the most important points of critique on the subject. The ambiguous viewpoints presented by Bordo (1990), thus doesn’t present a unified theory but multiple with various beliefs and conclusions on the topic.

Therefore it is not possible for us to reach a single conclusion on the topic and we must therefore contend with a discussion of the responses of the Fed with the different schools of thought.

Another point of critique is the closed mindset of the different schools. Due to the assumptions of the authors as to the market and consequences of LOLR responses the recommended actions are inhibited. Therefore the models all do not consider a new model which is a hybrid depending on the situation.

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