The Destabilizing Effect of Stability
Hyman Minsky’s “Financial Instability Hypothesis” (1992) is often summarized as “stability breeds instability.” As Lawrence H. Meyer observed in Lessons from the Asian Crisis (1999): “a period of stability induces behavioral responses that erode margins of safety, reduce liquidity, raise cash flow commitments relative to income and profits, and raise the price of risky relative to safe assets-all combining to weaken the ability of the economy to withstand even modest adverse shocks.” In the case of the Asian Crisis, it was pegged currencies which allowed Asian banks and corporations to raise cheap USD financing. Financial imbalances built up, but did not register in the artificial low volatility of pegged currencies. When the first FX tremors started in Thailand in May 1997, it was only a matter of time before devaluation. Within days chain reaction spread to Indonesia, and the rest of South East Asia. Corporations defaulted, bank NPL’s skyrocketed, and economic growth plummeted. The Euro offers similar lessons. With the introduction of the common currency, borrowing costs converged for vastly different economies. Greece and Italy which traditionally ran at high inflation and borrowed at high rates suddenly had access to the same rates as Germany. Unfortunately, it’s not possible to legislate risk away. Rather, the artificial suppression of volatility allows imbalances to build under the surface, resulting in hidden fragility. When cracks emerge, the system is threatened with sudden collapse.
This destabilizing effect of stability has also been observed by ecologists: “When the range of natural variation in a system is reduced, the system loses resilience” (Holling and Meffe 1995). And conversely, “the very fact of low stability seems to produce high resilience” (Parameswaran 2009). This theme is the focus of Nassim Taleb’s latest book, “Antifragile: Things That Gain from Disorder” (2012).
The implication for risk management is to be contrarian. While we must attend to emerging visible risk first, we should not be lulled into complacency by periods of calm. Steady trends with low volatility often points to a lack of diversity in opinion and crowded trades. The most severe reversals come as everyone is forced to exit at the same time. Exceptionally low volatility (e. g., from pegged currencies to tapered bond yields) should ring alarm bells and motivate us to seek out hidden risks.