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The Fed’s “Crazy Train” and the Stability that Breeds Instability

Hyman Minsky’s Financial Instability Hypothesis posited that a capitalist system is unstable at times because it will tend to move from periods of stability, when the illusion of stability leads to irrational risk taking, which then leads to inevitable economic contraction. In the FIH he said:

“The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable, and financing regimes in which it is unstable. The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system. In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance.”

I got to thinking about this as I read the latest shot across the bow from Paul Krugman who criticizes anyone who has criticized the Federal Reserve’s QE program over the years. He cites irrational concerns about inflation. Of course, I haven’t been critical of QE over the years because I think it causes inflation. Quite the contrary. I’ve been critical of it because I don’t think it has a powerful transmission mechanism by which it positively impacts the economy. In addition, I’ve stated that QE could cause the very stability that leads to instability.  That is, it could cause people to bid up stock prices in an irrational manner and borrow funds to finance such purchases which could actually lead to a degree of stability that actually leads to a significant degree of instability.

I think the evidence clearly shows that this has been the case. Not only have we witnessed unprecedented gains in margin debt over the last 5 years, but it’s quite obvious that the stock market has become increasingly unstable every time the Federal Reserve pulls the punch bowl away. The average swings in the S&P 50o since 2008 can be summarized by periods with and without QE:

Average daily change with QE: +0.09%

Average daily change without QE: -0.13%

There’s an argument here that the stability during QE actually leads to a degree of instability. Can this all be attributed to the Federal Reserve? It’s impossible to say. But the data certainly seems to back up the idea that the various iterations of QE create a highly stable positive stock market environment whereas periods without QE tend to result in unstable periods of negative stock market performance. Is this necessarily bad?  And how bad is it? Again, it’s impossible to know.

The debate of course, is about what the potential upside relative to what the downside is. People like Paul Krugman say QE doesn’t hurt so why not try it. But I say there are risks in such programs that encourage a form of Ponzi finance which could actually lead to instability.  In my view, QE is a gigantic distraction to effective policy (like tax cuts or infrastructure spending) that carries substantially more downside risk than some people seem to think.  So, perhaps there’s more merit to this criticism than some people think?