It feels great when the economy is healthy: when unemployment is low, the economy is growing, debt is easy to acquire and the stock market is doing well. Yet “all stable economies sow the seeds of their own destruction.” This is because stability induces risk-taking behavior that creates financial instability that eventually causes panic and crisis.
This is the gist of Hyman Minsky’s “Financial Instability Hypothesis”. Minsky, who died in 1996, was a professor of economics who spent much of his academic career at Washington University in St. Louis. The Financial Instability Hypothesis seems quite obvious having experienced the great recession. During his lifetime, however, neither he nor his theory were taken seriously. Too bad he died before the financial crisis, because now his theory is widely accepted and he is quite famous in economic circles.
Overall, the Financial Instability Hypothesis states that stability breeds instability because stability itself is destabilizing. Minsky wrote: “A fundamental characteristic of our economy is that the financial system swings between robustness and fragility and these swings are an integral part of the process that generates business cycles.” During times of economic stability healthy investment leads to speculative euphoria, increasing financial leverage and over-extension of debt. A “Minsky Moment” occurs when insiders begin taking profits, panic ensues and prices collapse which creates a recession or financial crisis.
Thus, it is economic stability itself induces the erosion of margins of safety, reduction of liquidity, increases in leverage, rising cash flow commitments, and rising prices of risky assets relative to safe assets. All this induces fragility into the economy so that it has trouble withstanding even modest shocks.
Where are we in this cycle? Probably somewhere between boom/expansion and euphoria. But who knows? It is very difficult to determine where we are in economic cycles except in retrospect. Each cycle has it’s own characteristics and length.