Destabilizing stability

The problem of risk accumulating during periods of calm, through the process of debt accumulation and the gradual intensification of the speculative character of financial markets, was aptly described by Minsky (1977) in the formula "stability is destabilizing." Periods of calm, of prosperity — viewed, from the statistician's perspective, as periods of low volatility — lead, once they persist for a sufficient length of time, to a growing appetite for risk, manifested in an expansion of lending activity (which, in its final phase, may be termed a credit boom), as well as in rising leverage within the financial sector.

These tendencies, often speculative in nature, ultimately lead to a deterioration in portfolio quality, and, in the end, to a financial crisis. Such a course of events may stem from a certain important property that the risk phenomenon possesses — it is invisible. Market participants do not see its rising level. What they do see is the low empirical volatility observed in financial markets — and this suggests that the world is safe, encouraging an increase in the scale of risky activity. Reinhart and Rogoff (2009), however, argue that many of the standard indicators for the United States, shortly before the 2008 crisis, already displayed precisely this moment of accumulated crisis potential. The world stood on the brink of a serious crisis, and this was visible. What matters here, however, is that these were not statistical indicators — such as the various measures of the dispersion of market variables — but "hard" financial indicators, ones capable of capturing precisely this accumulation of crisis potential (before the 2008 crisis, one observed asset price inflation, rising financial leverage, large current account deficits, and a slowing pace of economic growth).

Empirical Studies Confirm 'Destabilizing Stability'

The problem of a system's growing vulnerability to crisis has already been studied. Schularick and Taylor (2012) examined the thesis that credit booms contribute to the emergence of financial crises, and confirmed it. Adrian and Shin (2010) examined the procyclical effect of rising leverage precisely during boom periods — and rising leverage of this kind is, as is well known, rising risk. Danielsson, Valenzuela, and Zer (2018), for their part, tested — almost literally — Minsky's hypothesis that "stability is destabilizing." Drawing on the map of real crisis events, they tested the thesis that prolonged periods of stabilization — that is, periods of low volatility — may serve as a predictor of financial crises. Their findings confirmed Minsky's conjecture. Low market volatility possesses strong predictive power; crises occur precisely following such long periods of stabilization. At the same time, the authors found no grounds for confirming the truth of the reverse hypothesis — that high volatility causes financial crises. Danielsson, Valenzuela, and Zer (2018) likewise examined the operation of the aforementioned destabilizing mechanisms, and found that prolonged periods of low volatility bring about, first, an increase in lending activity — that is, greater indebtedness — and, second, a rise, during such periods, in financial leverage — that is, in the degree of risk undertaken in financial markets.