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June 17, 2009

Is there inherent financial instability?

There are many questions being raised about the causes and implications of the current recession. One focus is on our financial system, and whether there are natural forces within that system that will lead to periodic problems in our economy. Please explain this.

Dr. Mike Walden, North Carolina Cooperative Extension economist in the College of Agriculture and Life Sciences at N.C. State University, responds:

"Well, the essential idea is that stability ultimately leads to instability. Now actually this is from an economist who is now deceased, whose name was Minsky. Minsky's idea, in a nutshell, was this: When things are going right, people become increasingly optimistic about the future. That leads to more risk taking. That leads to lenders like banks willing to loan money to more people on more risky loans. But as the greater risks are taken, eventually some of those risks won't pan out. Some of those investments will fail. That leads, eventually, to a turnaround in investment psychology. People go from being very optimistic now to being pessimistic, and that can lead to a panic selling of investments, which leads to a financial crash. So obviously, Minksy's ideas have been applied to today's situation, and many are calling this the 'Minsky moment.' But it does lead to a very important policy question, and that is should the government put some kind of limits on investor behavior to prevent this extreme optimism and risk taking potentially leading to a downturn? That's a very, very controversial topic. It would be very hard to implement, yet it's one that's being asked right now."

Posted by Dave at June 17, 2009 08:37 AM