Financial instability

Since the 1980s, advanced and emerging economies have undergone recurrent bouts of financial instability, which in some cases have culminated in extreme periods of financial distress - that is, financial crises. In light of the extraordinarily high macroeconomic and fiscal costs imposed by these crises, preventing the emergence (or containing the materi- alization) of financial instability has become a key objective of central banks around the world. In addition to their mandate to foster price stability (that is, ensuring the stability of the purchasing power of money) and promote sustainable economic growth, central banks have been increasingly monitoring financial sector developments in order to ensure a smooth functioning of the three pillars that make up the financial system, to wit, financial institutions, markets, and infrastructures. The regular publication of Financial Stability Reports aiming at identifying threats to financial stability is nothing but a reflec- tion of the increased attention devoted by central banks and multilateral institutions to financial instability issues.

As Crockett (1997, p. 2) puts it, financial instability can be defined "as a situation in which economic performance is potentially impaired by fluctuations in the price of financial assets or in the ability of financial intermediaries to meet their contractual obli- gations." Episodes of financial instability are thus intimately related to the "real side" of the economy, impacting adversely the level of economic activity through various chan- nels (asset prices and credit flows, just to mention the most relevant ones). Nonetheless, unlike price stability, which has a clear definition and can be measured, the same degree of intellectual clarity has not yet emerged as regards financial instability. As a matter of fact, both financial instability and its positive counterpart, financial stability, lack widely accepted definitions and measurement techniques, although a growing literature has tried to fill this void after the inception of the 2008-09 global financial crisis (Borio and Drehmann, 2009, review the literature on this subject matter). These deficiencies partly reflect the lack of a unified analytical framework underpinning financial instability and partly the multi-faceted nature of the latter.

Specifically, as far as the former rationale is concerned, if one analyses financial instability through the lens of the (still dominant) New Keynesian paradigm for policy making - whose underlying general-equilibrium framework relegates monetary and financial considerations to the sidelines and treats time in a deterministic fashion - financial instability cannot but be interpreted as an exogenous phenomenon occurring outside the realm of the economy because of shocks hitting the economy randomly or improper government policies (Schroeder, 2009, p. 292; Tymoigne, 2010, p. 2). Thus, any distinction between financial fragility and financial instability remains blurred within the settings of the New Keynesian framework, up to a point where the two concepts conflate into one (Aspachs et al., 2007, p. 41, for instance, define financial fragility as a combi- nation of high probability of defaults and low bank profitability). The interpretation of financial instability as a random, exogenous event and its conflation with financial fragility both bear important implications from a policy perspective, notably as they limit policy makers' ability to detect the onset of financial instability at early stages of its development and to mitigate it through appropriate pre-emptive (corrective) measures.

On the other hand, drawing on Minsky's (1982a) financial instability hypothesis (FIH), the Post-Keynesian School rather accounts for financial instability in an endogenous fashion, as an endemic pathology of the working of market-based capitalist economies. These economies are inherently unstable by virtue of their propensity to migrate endog- enously from periods of prolonged stability to periods dominated by financial instability. By putting money, finance and uncertainty at the core of the analysis, not only does the Post-Keynesian School conceive of financial instability as a natural by-product of the inner working of capitalist economies, but it also devotes special attention to financial fragility as a harbinger of financial instability. To put it into a nutshell, prolonged periods of economic stability breed over-optimism among economic agents, mainly firms and banks, which increasingly rely on debt to finance investment and positions in capital assets. The excessive reliance on debt increases the fragility of the economy as a whole, as epitomized by the shift from conservative "hedge" to speculative "Ponzi" financial structures, nurturing the seeds of future instability down the road. Financial instability eventually manifests itself through a Fisherian debt-deflation process, jeopardizing eco- nomic activity (see Minsky, 1982b, p. 67).

Accordingly, an implication of Minsky's FIH is that preventing the emergence of financial instability (or, at worst, limiting its severity) requires policy actions aimed at constraining the build-up of fragility during periods of stability and economic expan- sion. These policy actions may elicit direct central bank intervention, either through a tightening of the monetary policy stance and/or the implementation of appropriate micro-prudential and macro-prudential policies. Their goal is to prevent the build-up of systemic risk before its materialization impairs the working of the financial system and imposes costs on the whole economy.

See also:

Asset price inflation; Debt deflation; Financial crisis; Financial instability hypothesis; Macro-prudential policies; Minsky, Hyman Philip.