There are a lot of books on the topic of financial crises but this one, written in 2008, stand the test of time. At the very least, it offers a useful introduction to Minsky’s Financial Instability Hypothesis. There is also an interesting discussion of the alternative approaches adopted by central banks to the problem of financial stability.
George Cooper argues that our financial system is inherently unstable and that this tendency is accentuated by a combination of factors
- The belief that market forces will tend to produce optimal allocations of capital, and
- Monetary policy that seeks to smooth (and ideally eliminate) business cycle fluctuations in economic activity
Cooper draws heavily on Hyman Minsky’s Financial Instability Hypothesis (FIH) which he argues offers much better insight into the operation of the financial system than the the Efficient Market Hypothesis (EMH) which tended to be the more influential driver of economic policy in the years preceding the Global Financial Crisis.
Cooper uses these competing theories to explore what makes prices within financial markets move. The EMH maintains that the forces of supply and demand will cause markets to move towards equilibrium and hence that we must look to external forces to understand unexpected shocks and crises. Minsky’s FIH, in contrast, argues that financial markets can be driven by internal forces into cycles of credit expansion and asset inflation followed by credit contraction and asset deflation.
Cooper identifies the following ways in which financial systems can become unstable
- Markets characterised by supply constraints tend to experience price inflation which for a period of time can drive further increases in demand
- Monetary policy which is oriented towards mitigating (and in some cases pre-empting) economic downturns can also amplify market instability (i.e. the Greenspan put makes the market less resilient in the long run)
- Credit creation by private sector banks contributes to money supply growth; this in turn can facilitate growth in demand but there is no mechanism that automatically makes this growth consistent with the economy’s sustainable growth path
The point about some asset markets being prone to instability is particularly pertinent for banks that focus on residential property lending. Classical economic theory holds that increased prices should lead to increased supply and reduced demand but this simple equilibrium model does not necessarily work for property markets. Property buyers more often reason that they need to meet the market because it will only get more expensive if they wait. Many of them will have already seen this happen and regret not meeting the market price previously as they contemplate paying more to get a property that is not as nice as ones they underbid on. The capacity of home builders to respond to the price signal is frequently constrained by a myriad of factors and there is a long lead time when they do respond.
The argument Cooper makes rings very true for Australia and is very similar to the one that Adair Turner made in his book titled ”Between debt and the devil”. Cooper’s (and Minsky’s) argument that the pursuit of stability is not a desirable objective and that the system benefits from a modest amount of stress is similar to the argument made by Nassim Taleb in “Antifragility”.
Cooper also discusses the different philosophies that central banks bring to the challenge of managing financial stability. The dominant view is one that focuses on the risk that sees the management of inflation risk as a dominant concern while placing greater trust in the capacity of the market to self correct any instability. The European Central Bank, in contrast, seems to have placed less faith in the market and perhaps been closer to Minsky.
Some quotes from the book will give a sense of the ideas being discussed:
“Through its role in asset price cycles and profit generation, credit formation (borrowing money for either consumption or investment) lies at the heart of the financial market’s fundamental instability”.
“Hyman Minsky said that “stability creates instability” referring to our tendency to build up an unsustainable stock of debt in times of plenty only for that debt to then destroy the times of plenty”
“For a system as inherently unstable as the financial markets, we should not seek to achieve perfect stability; arguably it is this objective that has led to today’s problems. A more sustainable strategy would involve permitting, and at times encouraging, greater short-term cyclicality, using smaller, more-frequent downturns to purge the system of excesses”
“Credit creation is the foundation of the wealth-generation process; it is also the cause of financial instability. We should not let the merits of the former blind us to the risks of the latter.”
I have made some more detailed notes on the book here.