As president-elect Barack Obama contemplates coping with our financial crisis, he should realize that no matter what he does America's financial markets will remain inherently unstable and prone to future crises. When I say our financial sector is unstable, I do not mean that it never functions well. On the contrary, most of the time it is innovative, flexible, and encourages the development of new businesses. But the financial sector also contains seeds of repeated crises, almost all grounded in basic aspects of human nature.

Herman Minsky, a U.S. economist who developed a psychological theory of financial crises, described the first seed. Minsky said all types of firms in a capitalist system must borrow money to operate, but their borrowing can take three forms: (1) hedged borrowers earn enough profits each quarter to pay their debts for that quarter; (2) speculative borrowers must continue borrowing along the way to repay their debts; (3) Ponzi borrowers never earn enough to repay until their production process is over, when they sell their finally finished products and repay debts.

Ponzi borrowing occurs when firms producing investment goods — products made to help manufacture other goods sold to consumers — create big products with long-term payoffs. During any extended period of prosperity, such as the late 1990s, both borrowers and lenders become increasingly optimistic that prosperity will continue. Hence, they gradually shift toward more borrowing to increase their returns on equity. But then some unexpected negative event occurs that makes lenders want to collect on their loans quickly.

That forces many borrowers — especially those heavily leveraged — to repay before they are ready. Their ensuing scramble to find money causes a sharp increase in the demand for credit, and many become bankrupt. This leads to a downward spiral in credit markets, similar to what is occurring now.

The second ingredient is the sudden appearance of unexpected negative events, what author Nassim Nicholas Taleb calls “black swans.” These events are not accounted for in the models used by stock traders, who think such events highly improbable. But a review of the past 40 years shows that black swans occur quite often, initiating credit crises.

It's human nature to think success has been caused by an individual's brilliance, not favorable circumstances beyond his control. This thinking causes successful investors in periods of prolonged prosperity to underestimate the likelihood of unexpected disaster.

The third ingredient is the human trait of self-interest. That is, you weigh your own welfare and that of your family and close friends more than the welfare of other people in decisions. Self-interest has many social virtues: it is the chief motive of most people in a free enterprise system; it underlies the idea that governments should be chosen by the governed; and it explains why democracies have so many checks and balances.

But self-interest can also lead to greed, or deliberately exploiting others unfairly to benefit oneself. Such greed becomes prominent in financial markets during periods of prosperity. It is exemplified by mortgage brokers who sold subprime loans to people who couldn't afford to buy homes, or by bankers who sold hard-to-understand mortgage-backed securities like collateralized-debt obligations to investors globally.

The fourth ingredient is the complex and tightly interlocked operation of financial markets and derivatives, which causes a malfunction in any one part of the financial system to spread quickly to many other parts of that system.

Problems manifest

One way any financial contagion can spread like wildfire is through automated stock trading run by computers programmed to buy or sell under certain market conditions. Those programs can cause a massive downward pressure on stocks, as in the case of “Black Monday” in 1987 when the Dow Jones Industrial Average fell 500 points in one day.

The credit rating agencies also play a crucial role in a global financial system. Today financial markets use money from all over the world, so foreign investors need some way of judging the quality of investments far away from where they live. They rely on the opinion of experts, such as credit rating agencies, to evaluate specific investment opportunities. If those rating agencies do a poor job, foreign investors lose all confidence in their ability to judge securitized offerings. So, they just stop buying securities, as in our present worldwide credit freeze.

Another factor is the cyclical nature of U.S. politics. The American historian Arthur Schlesinger argued that control over the federal government passes back and forth among two different views. Conservatives want small governments, minimal regulation, and maximum freedom for individuals and firms. Liberals want more active government, more regulation of markets, and greater constraints on businesses to benefit workers.

When one group gains control of the federal government in an election, its views are put into practice. But neither view is without flaws, since there is no perfect way to run a democracy, or any other form of government. After one group has been dominant for about 15 years, the citizenry gets tired of the flaws in its approach and elects the other group. This tension creates a constant shift from strong regulation to almost no regulation, creating fundamental instability in the rules of financial markets.

Central banks lose clout

Globalization is the final factor contributing to financial instability. The expansion of financial markets across the world has weakened the power of central banks to control their own monetary conditions. This trend became clear during the flood of capital that entered real estate markets after the stock market crash of 2000-2002. So much money shifted into real estate from all over the globe that central banks' ability to control their own money supplies and interest rates was severely diminished.

The end result of all these factors is that credit crises are likely to arise periodically, and central banks have less power to stop them. Minsky thought that major credit crises could be overcome by massive government spending to restore credit, similar to what the U.S. Treasury and Federal Reserve are doing.

Unfortunately, such spending creates government deficits that will eventually generate inflation, which can only be stopped by the Fed using high interest rates to create an offsetting recession, as Paul Volcker did in 1980.

The inherent destabilizing forces of a capitalistic system cannot be eliminated without ruining the benefits of an innovative financial system. Hence, we'd better get used to periodic financial crises, and develop some means of minimizing the financial disruptions they produce.

FINANCIAL CRISES PAST AND PRESENT

1973

First Oil Price Shock

1973 - 1975

U.S. Recession

1980 - 1982

U.S. Recession

1981

Home Mortgage Rates Hit 18.45%

1987

Black Monday Stock Drop

1990

Junk Bond Crisis
Real Estate Prices Collapse

1997

Asian Financial Crisis

1998

Long Term Capital Management Fails

2000 - 2002

Global Credit Crunch

2007 - 2008

Global Stock Crash

Anthony Downs is a senior fellow at the Brookings Institution. He can be reached at tonydowns3254@gmail.com.