Brad DeLong offers a neat little model of speculative fluctuations in asset prices, based on the idea that investors gradually switch strategies based on what seems to work for other people: if people buying stocks seem to be doing well, more people move into stocks, driving up prices and making stocks look even more attractive...
What's missing, as Brad himself points out, is the asymmetry of booms and crashes. What he doesn't say is that what we really need is a model that can produce a Minsky moment -- the point at which margin calls force deleveraging.
I have to say that the Platonic ideal of Minsky is a lot better than the reality.
Indeed. As Robert Solow once said of Schumpeter, he was all problems with one big idea. Minsky's actual macro analysis consists of holding everything in the national income accounting identity constant except for the budget deficit and corporate profits, thereby making them the mirror image of one another. Not promising.
Where I would suggest that DeLong and Krugman start differently is to focus on financial intermediation. Investor beliefs can differ, but I think the main issue is what they believe about financial intermediaries, which I think can be described in terms of the signals that intermediaries send to induce people to invest.
My story is this:
1. Ordinary folks in the nonfinancial sector want to issue risky liabilities (shares of investments in fruit trees, mortgages on houses) and wants to hold riskless assets (demand deposits, money market fund shares).
2. The financial sector obliges by having a balance sheet with risky assets and supposedly riskless liabilities. The bigger the financial sector gets, the more euphoric the investment climate, because nonfinancial folks get to hold more riskless assets and issue more risky liabilities.
3. The financial sector's expansion is based in part on signaling. That is, banks signal that their liabilities are low risk. Signals include fancy buildings, the "FDIC insured" sticker, balance sheets filled with AAA-rated assets, and so on.
4. Financial expansions are gradual, because it takes a while to come up with new signaling mechanisms and to get the credibility of those mechanisms established with investors.
5. Financial crashes are sudden, because once investors lose a little bit of their confidence in financial institutions, their natural instinct is to ask for safer assets (they withdraw money from uninsured banks, or they ask AIG to post collateral). This behavior weakens the financial institutions further, leading to a rapid downward spiral. Today, we are seeing that all sorts of signals are discredited.
So, my advice to Paul and Brad is this: don't start with a model that focuses on investor beliefs about real economic variables. Instead, start with a model in which financial firms use signaling to expand, and the credibility of those signals increases over time as long as nothing adverse happens. It should be easy to develop a model in which signaling devices gain credibility slowly but lose credibility suddenly. That will (a) produce the asymmetry between euphorias and crashes and (b) tell a story that puts the fragility of the financial sector in the middle, where it belongs.
Incidentally, one thing I got from reading Galbraith's book on financial euphoria is that you can fit the late 1920's into this model. Holding companies bought stocks, and the holding companies were bought by other holding companies, and so on. You get the spectacular leverage, and on the way up people think that the assets of the holding companies are pretty low risk. Then when people get a little nervous...