Wall Street, Markets Show We're on the Road (Again)

Last Updated Jan 4, 2010 2:30 PM EST

The late, great economist Hyman Minsky famously theorized that nothing so destabilizes the financial system as stability.

What he meant was that periods of economic and corporate prosperity sow the seeds for future downturns. In good times, people spend and borrow, banks lend, investors invest. Risk takes an extended holiday. As the boom continues, financial institutions swollen with cheap money compete to make more loans, while levering up their own assets to get in on the fun. Profits flow, leading to more of the same. Credit begets credit.

Yet competitive pressures eventually force financial firms to expand their markets, which requires embracing riskier customers. Investors swing away. Companies also get ever more creative in developing financial products that can squeeze profits from diminishing returns.

Everyone is still partying, but by now things are starting to spin out of control. The ice cream social, where everyone gets a taste, winds up as speculation-fueled bender. And the hangover is a doozy.

If Minsky's correct, what's interesting here is that the cycle isn't triggered by, say, a world-changing technological innovation. Nor is it a function of low interest rates or other external factors. Rather, the pattern is encoded within the very structure of the financial system. And the same road that leads to the promised land also leads to perdition. As he wrote in expounding his "financial instability hypothesis":

". . . . over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system."
Today, we're on the road again. The question, as ever, is where it leads and what lies ahead.

Back to the future, if left-wing rags like the WSJ are to be believed. Wall Street is already up to its old tricks, the paper notes. Banks are bigger than ever. Among large firms, financial compensation as a percentage of total revenue is climbing. Hedge funds are reacquainting themselves with the felicities of leverage. While under more scrutiny, credit rating firms continue to cash checks from companies they're ostensibly supposed to rate. The markets are jumping for joy.

Four days into the new year, service has been restored to normal. Whatever that is.

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    Alain Sherter covers business and economic affairs for CBSNews.com.