Are Financial Markets Inherently Unstable?

Government's Monetary and Fiscal Policies Create Instability

“There is an urgent need to recognize that financial markets, far from trending towards equilibrium, are inherently unstable.”
—George Soros1

In the aftermath of the collapse of emerging economies in Asia, eastern Europe, and Latin America, many prominent economists and speculators, from Paul Krugman to George Soros, have called for government intervention in financial markets. Recommended policies include monetary inflation and currency controls. The foundation of such state interference is the belief that free markets in general, and financial markets in particular, are inherently unstable and require strict government regulation.

The fathers of this thesis are the British economist John Maynard Keynes and his principal heir, Hyman P. Minsky, who devised a “financial instability hypothesis.” Minsky, a Harvard-taught economist, wrote many books and articles during his academic career of nearly 50 years, most of which he spent at Washington University in St. Louis. He died in 1996.

According to Minsky, Keynes’s general theory of the economy was really a financial theory of uncertainty and expectations. According to this thesis, the capitalist economy is primarily ruled by Wall Street, which is fundamentally fragile and destabilizing owing to excessive debt, lax government rules, and businessmen’s “animal spirits” and “waves of irrational psychology.” (Conservative economist Allan H. Meltzer of Carnegie Mellon University makes the same point.2)

In the Keynes-Minsky model, full employment in an unregulated market economy is not a natural equilibrium point, but a transitory moment in a business cycle. Euphoric expectations lead to an overleveraged condition where the rate of credit expansion exceeds the rate of profit in the economy. Eventually, the boom turns into a debt deflation and depression.

Long-Run Damage by Government Intervention

To stabilize the business cycle, Keynesians favor big-government capitalism where central banks and the International Monetary Fund play major roles as lenders of last resort. Keynes advocated the “socialization of investment” and taxes on short-term trading.3 However, Minsky rightly pointed out that interventionist policies validate the existing fragile financial structure and allow the problems to deepen. He warned that “Once borrowers and lenders recognize that the downside instability of profits has decreased there will be an increase in the willingness and ability of business and bankers to debt-finance.”4 Larger and more frequent interventions become necessary to fend off debt deflations and recessions.

Minsky correctly criticized neo-classical economics for largely minimizing the impact that financial markets can have on economies: “The neo-classical synthesis became the economics of capitalism without capitalists, capital assets, and financial markets.”5

My only problem with Minsky is that he mistakenly blames the market itself for its instability.

Mises’s Non-Neutrality Thesis

To understand the root cause of financial and economic instability, we need to go back to Ludwig von Mises’s “non-neutrality” thesis in his breakthrough work The Theory of Money and Credit. Mises pointed out that monetary intervention (easy money policies and artificial lowering of interest rates) is the principal source of uncertainty, false expectations, and excessive debt-leverage in the economy and on Wall Street. Under a stable monetary system, a laissez-faire economy would suffer occasional financial mishaps, bankruptcies, and down-days on Wall Street, but there would be no systematic “cluster of errors” that currently characterize today’s global economy.6

Fortunately, most economists now recognize that government’s monetary and fiscal policies are the main source of economic and financial instability in the world today. In fact, more and more college textbooks teach up front that the economy is relatively stable at full employment; this is known as the “long-term growth model.” The short-term Keynesian model is taught at the end of the textbooks, where government intervention is recognized as a destabilizing factor in the economy and the chief cause of the boom-bust cycle. See Roy Ruffin and Paul Gregory’s Principles of Economics and N. Gregory Mankiw’s Economics.

Maybe George Soros needs to take a refresher course from these textbooks.


  1. George Soros, remarks before the House Banking Committee Hearing on International Economic Turmoil, September 15, 1998.
  2. Allan H. Meltzer, Keynes’s Monetary Theory: A Different Interpretation (Cambridge: Cambridge University Press, 1968).
  3. John Maynard Keynes, The General Theory of Employment, Money and Interest (London: Macmillan, 1936), chapter 12, “The State of Long-Term Expectation.” See also my article, “Keynes as a Speculator: A Critique of Keynesian Investment Theory,” Dissent on Keynes (New York: Praeger, 1992), pp. 161–69.
  4. Hyman P. Minsky, Stabilizing an Unstable Economy (New Haven: Yale University Press, 1986), p. 213.
  5. Ibid., p. 120. For a favorable review of Minsky’s work, see Robert Pollin, “The Relevance of Hyman Minsky,” Challenge (March/April 1997), pp. 75–94.
  6. Ludwig von Mises, The Theory of Money and Credit (Indianapolis: Liberty Classics, 1981 [1934]). See especially Murray Rothbard’s excellent foreword in this edition.

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