Debt and financial sentiment : early Keynes on balance sheet effects of asset price changes

The paper explores the link between financial sentiment and private debt, using Keynes’s A Treatise on Money as a conceptual backdrop. In responding to his critics after the publication of his General Theory Keynes famously talked about unexpected, violent changes in conventional asset valuations resulting from doubts with a life of their own boiling over onto the surface. Such doubts he argued influenced the size of what he called the bear position, which in his Treatise on Money he took to be an index of financial sentiment. Minsky also drew from Keynes’s earlier work when he famously argued that optimistic future expectations raise asset prices, creating a margin that enables firms to access finance in the present. However, neither asset price speculation nor shifting financial sentiment over the business cycle received in his work the kind of attention they did in Keynes’s Treatise. The focus of this paper is what Minsky left unexplored on financial sentiment and the balance sheet effects of asset price changes in the Treatise, which sheds light on when private debt can become excessive. The central insight is that financial sentiment begins to diverge when economic performance unexpectedly falls short, raising doubts that current asset prices are excessive. While the economy might be debt-led when financial sentiment is strong it tends to become debt-burdened as sentiment weakens.