One of my favourite frameworks for thinking about investing and the economy is the simple but profound concept of stability being destabilising. This comes from the ideas of the late economist Hyman Minsky.
When he was alive, Minsky wasn’t well known. His views on why an economy goes through boom-bust cycles only gained prominence after the 2008-2009 financial crisis. In essence, Minsky theorised that for an economy, stability itself is destabilising. I first learnt about him – and how his ideas can be extended to investing – years ago after coming across a Motley Fool article written by Morgan Housel. Here’s how Housel describes Minsky’s framework:
“Whether it’s stocks not crashing or the economy going a long time without a recession, stability makes people feel safe. And when people feel safe, they take more risk, like going into debt or buying more stocks.
It pretty much has to be this way. If there was no volatility, and we knew stocks went up 8% every year [the long-run average annual return for the U.S. stock market], the only rational response would be to pay more for them, until they were expensive enough to return less than 8%. It would be crazy for this not to happen, because no rational person would hold cash in the bank if they were guaranteed a higher return in stocks. If we had a 100% guarantee that stocks would return 8% a year, people would bid prices up until they returned the same amount as FDIC-insured savings accounts, which is about 0%.
But there are no guarantees—only the perception of guarantees. Bad stuff happens, and when stocks are priced for perfection, a mere sniff of bad news will send them plunging.”
In other words, great fundamentals in business (stability) can cause investors to take risky actions, such as pushing valuations toward the sky or using plenty of leverage. This plants the seeds for a future downturn to come (the creation of instability).
I recently came across a wonderful July 2010 blog post, titled A Batesian Mimicry Explanation of Business Cycles, from economist Eric Falkenstein that shared historical real-life examples of how instability was created in the economy because of stability. Here are the relevant passages from Falkenstein’s blog post (emphases are mine):
“…the housing bubble of 2008 was based on the idea that the borrower’s credit was irrelevant because the underlying collateral, nationwide, had never fallen significantly in nominal terms. This was undoubtedly true. The economics profession, based on what got published in top-tier journals, suggested that uneconomical racial discrimination in mortgage lending was rampant, lending criteria was excessively prudent (underwriting criteria explicitly do not note borrowers race, so presumably lenders were picking up correlated signals). Well-known economists Joe Stiglitz and Peter Orzag wrote a paper for Fannie Mae arguing the expected loss on its $2 trillion in mortgage guarantees of only $2 million dollars, 0.0001%. Moody’s did not consider it important to analyze the collateral within mortgage CDOs, as if the borrower or collateral characteristics were irrelevant. In short, lots of smart people thought housing was an area with extremely low risk.
Each major bust has its peculiar excesses centered on previously prudent and successful sectors. After the Panic of 1837, many American states defaulted quite to the surprise of European investors, who were mistakenly comforted by their strong performance in the Panic of 1819 (perhaps the first world-wide recession). The Panic of 1893 centered on railroads, which had for a half century experienced solid growth, and seemed tested by their performance in the short-lived Panic of 1873.”
It turns out that it were the “prudent and successful sectors” – the stable ones – that were the epicenters of the panics of old. It was their stability that led to investor excesses, exemplifying Minsky’s idea of how stability is destabilising.
The world of investing is full of paradoxes. Minsky’s valuable contribution to the world of economic and investment thinking is one such example.
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