In the 1950s, economist Hyman Minsky introduced his Financial Instability Hypothesis, emphasizing a troubling paradox: economic stability can actually breed instability. How does this phenomenon occur?
Minsky observed that financial crises typically follow periods of economic prosperity. Such prosperity encourages both borrowers and lenders to adopt increasingly reckless behaviors. As credit and debt levels rise, asset prices become artificially inflated.
Eventually, the overabundance of optimism births instability; lending and debt reach unsustainable heights, leading to the inevitable bursting of financial bubbles. As a result, asset prices plummet, correcting the missteps made during the preceding boom.
The housing boom and subsequent bust of the last decade illustrate Minsky’s theory perfectly. A flood of inexpensive credit from the Federal Reserve aimed to alleviate the impact of the dot-com crash, but much of it funneled into the housing market.
Early investors enjoyed substantial returns, prompting banks to issue increasingly risky loans, fueled by the belief that “house prices always go up.” By the time the bubble burst, the entire economy had been distorted into a tragicomic farce. Naturally, it all ended in despair.
All Calm, No Storms
In the wake of the mortgage crisis, the Fed’s remedy—an influx of cheap credit—has created a stock market that appears devoid of risk. Over the last five years, stock prices have surged with little interruption, leading investors to fall into a dangerous complacency just as they should be on high alert.
Both stock and bond investors are seemingly convinced of a risk-free environment. It feels as if potential market turmoil has been entirely eradicated.
As the Wall Street Journal notes, “The volatility index (VIX), which measures expected stock-market fluctuations based on options trading, has spent 74 consecutive weeks below its long-term average—a stability streak not witnessed since 2006 and 2007.”
“Additionally,” they report, “the extra return that bond investors require on investment-grade corporate debt over low-risk Treasury bonds has reached just one percentage point, a rate not seen since July 2007. The smaller this ‘spread’ becomes, the less risk-averse bond investors appear.”
It’s worth remembering that 2007 marked the beginning of a significant market downturn, which ignited a catastrophic financial crisis. Should the current period of market calm alarm investors? Here at the Economic Prism, we believe it should—and many others share this sentiment.
Monetary Activism
Interestingly, some at the Federal Reserve are expressing their concerns. Do they not understand that their policies of zero interest rates and quantitative easing contribute significantly to the market’s extended stability?
Earlier this week, Richard Fisher, president of the Federal Reserve Bank of Dallas, remarked, “This indicates a great deal of complacency,” referring to last year’s unprecedented issuance of $366 billion in junk bonds—more than double the volume seen before the 2008 crisis. “When complacency sets in, surprises are inevitable.”
Fisher seems fully aware of the dynamics at play and the Fed’s role in this scenario. It’s common knowledge, after all.
Most people recognize that maintaining a zero federal funds rate for six consecutive years inevitably inflates asset prices and encourages excessive risk-taking. Yet, this is precisely what the Fed has been doing.
The extreme policies of monetary activism have yielded a seemingly stable market, in which stock prices keep climbing. This artificial environment disproportionately rewards the most leveraged investors—those willing to borrow at low rates to make bold bets on stocks.
This risky gamble continues to work beautifully—until it doesn’t. At that moment, market instability will return, leading to a swift and severe downturn. The inevitable crash will likely be more rapid and destructive than the last, prompting the government to devise plans for any savings you might have left under the pretense of helping you.
Sincerely,
MN Gordon
for Economic Prism
