Economic Stability Leads to Instability

It has been said that democracy is the worst form of government, except for all others.  The same  may be true of capitalism as an economic system.  Apparently, achieving steady growth and low inflation -- an enviable environment -- can actually cause market bubbles like we have just experienced.  Or as the economist Hyman Minsky put it, "stability leads to instability."

The problem arises when people believe that the future will be like the recent past.  When the economy is humming along, it is quite easy to be confident that such benign conditions will continue.  Confidence makes people all too ready to take on more risk. 

Initially, this risk taking is amply rewarded.  Success, however, leads to complacency.  The assumption of risk over time begins to appear, well, less risky. 

The recent housing bubble is a perfect example of the three stages of the Minsky process -- stable economic systems break down because they encourage increasingly risky debt financing.  In the first stage, home buyers can cover the principal and interest payments on their loans.  Then some people begin to speculate such that they can only afford the interest payments.  Finally, in the Ponzi phase, borrowers take on excessive debt levels that can only be financed if housing prices continue to rise.

Everything was idyllic for a while as more people piled into the housing market and prices rose ever higher.  It worked until it didn't.  Prices eventually declined and the bubble burst, leading to the massive de-leveraging that we are now experiencing.

We have been clearly chastened.  Let's see if we're wiser as well.

Words of Wisdom

The only function of economic forecasting is to make astrology look respectable.
-- John Kenneth Galbraith, Economist