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I’ve long believed that markets and economies trend towards disequilibrium (aka a loss of stability). And this is contrary to what we learned in economics – that a system tends towards equilibrium.
And while equilibrium may sound good in theory; it doesn’t hold up in reality.
Why?
Because markets and the economy are complex and dynamic social systems. Meaning they constantly change over time and have ripple effects.
There are eight billion people in the world – both rational and irrational – that are driven by their own biases. Thus, influencing everything around them.
Two key theories explain why markets don’t stay in balance and why boom-and-bust cycles are inevitable:
- Hyman Minsky’s Financial Instability Hypothesis (a.k.a. the “Minsky Moment”)
- George Soros’ Theory of Reflexivity
Let’s break down how these ideas help us understand financial bubbles, market crashes, instability, and economic crises.
So, let me explain why they’re so important. . .
The Minsky Moment: Why Stability Creates Instability
Hyman Minsky was a post-Keynesian economist who did most of his work in the mid-to-late 1900s. But more than that, he was a brilliant thinker and wrote the groundbreaking book ‘Stabilizing an Unstable Economy’ (1986) – a book I highly recommend reading.
Now, unfortunately, most of Minsky’s work was ignored by mainstream economists and he received very little recognition.
In fact, very few even knew who he was.
But that all changed after the 2008 Great Financial Crisis (GFC). . .
Many dusted off Minsky’s work and realized that he may have effectively written the playbook on what would happen between 2001-2009. Hence the “Minsky Moment” was born.
Minsky wrote about the inherent instability in markets and economies through feedback loops between risk tolerance and credit.
But most importantly, how periods of calm are the seeds for future volatility; and vice versa.
He called this the Financial Instability Hypothesis (FIH)1 – which is now known as the Minsky Moment.
How Minsky Moments Happen
- During stable times, investors become more confident and take on more debt & risk
- Over time, debt levels rise too high, making the system fragile
- Eventually, a trigger (external or internal) sparks panic
- Investors rush to sell & deleverage, causing a market collapse
- The crisis ends, stability returns - and the cycle repeats
This is the Minsky Moment—the tipping point where overconfidence turns into panic and markets collapse under their own weight.
Now, second – there are three stages of financial regimes2 in the private economy that trend towards instability all on their own.
The Three Stages of Financial Instability
Minsky outlined three financial regimes that determine how stable or fragile a market is:
- Hedge Finance → Safe: borrowers can repay principal & interest
- Speculative Finance → Risky: borrowers can only cover interest, not principal
- Ponzi Finance → Dangerous: borrowers rely on new debt to cover old debt
When markets shift from Hedge Finance to Ponzi Finance, they become fragile and vulnerable to collapse - which is exactly what happened in 2008.
As you can see – both parts of the financial instability hypothesis feed off each other.
Thus, according to Minsky, financial crises occur when the economy moves from the hedge finance stage to the speculative or Ponzi finance stages, as increasing levels of debt and risk tolerance lead to a buildup of financial fragility and vulnerability. When a shock or disruption occurs – such as a decline in asset prices or a slowdown in economic growth – borrowers may become unable to meet their obligations, triggering a wave of fear, defaults, and a breakdown in the financial system.
And this tipping point into collapse is the infamous “Minsky Moment”.
So, it appears from this perspective – and history if history means anything (I believe it does) – that markets trend toward disequilibrium more often than not.
And that’s what makes Minsky and his financial instability hypothesis so important.
George Soros’ Reflexivity: Why Markets Overshoot Up & Down
George Soros (you may have heard of him) is a Hungarian-born investor who’s best known for ‘breaking the Bank of England3’ (the BoE) in 1992.
How did he do that?
In short, he believed that the British currency – the pound sterling – was too strong and strangling the economy. Making matters worse, the pound was effectively pegged to the German currency in the Exchange Rate Mechanism (ERM – which was essentially the first step in what would later become the Euro).
Thus, Soros saw an opportunity to force the BoE to devalue their currency sooner than later.
Or rather, push the BoE to fall on their face instead of limping along.
Soros made huge short bets on the pound (i.e. selling the pound), thus putting pressure on it.
As others saw what he was doing, more shorts piled in. This forced the BoE to cut interest rates and break their peg – devaluing the pound.
Soros made out like a bandit – netting over $1 billion in a single day (remember a billion was worth much more in 1992).
Now – say what you will about Soros (he’s a very divisive character) – but the thesis he used to determine this opportunity was brilliant.
He called this the Theory of Reflexivity.
How Reflexivity Creates Boom & Bust Cycles
Soros argues that market prices don’t just reflect reality - they influence it.
- Investor sentiment & fundamentals feed off each other in a self-reinforcing loop
- When markets are rising, optimism fuels more buying, pushing prices too high
- When markets are falling, pessimism fuels more selling, pushing prices too low
This is how bubbles and crashes happen - not because of rational decision-making, but because of feedback loops that drive extreme market moves.
And while Soros didn’t invent the term reflexivity (he got the inspiration from philosopher Karl Popper), he applied it in financial markets – or at least was the one who became famous for it.
Example: The 2000s Tech Bubble
- Investors were bullish on tech stocks → they bought more
- Prices kept rising, reinforcing confidence → more buying
- Valuations skyrocketed beyond fundamentals
- Eventually, reality caught up, triggering a crash
- Fear took over, and markets overcorrected too far down
Thus, Soros showed that the reflexive process is particularly relevant in financial markets, where investors’ perceptions and actions can have a significant impact on asset prices and market conditions.
He made the point that financial bubbles and crashes aren’t caused solely by external factors – such as economic fundamentals – but also by the reflexive feedback loop between investors’ perceptions and their buying/selling actions.
Why This Matters for Investors
I believe it’s important to keep these two concepts in mind – the financial instability hypothesis and the theory of reflexivity – when navigating markets.
Gauging sentiment and understanding the causal link it has to fundamentals is critical as well as the inherent feedback loops that propel markets both irrationally high and low.
So, while many cling to equilibrium theories and rational markets, we will know better.
And next time you hear someone preaching about how investors and markets are efficient – keep Minsky and Soros in mind. . .
Sources:
1. https://economicsociology.org/2015/08/24/chinas-minsky-moment-stability-leads-to-instability/
2. https://www.wallstreetmojo.com/minsky-moment/
3. https://www.investopedia.com/ask/answers/08/george-soros-bank-of-england.asp
4. https://www.ft.com/content/0ca06172-bfe9-11de-aed2-00144feab49a
Disclosure:
This communication is general in nature and provided for educational and informational purposes only. It should not be considered or relied upon as legal, tax, or investment advice or an investment recommendation, or as a substitute for legal counsel. Any investment products or services named herein are for illustrative purposes only and should not be considered an offer to buy or sell, or an investment recommendation for, any specific security, strategy, or investment product or service. Always consult a qualified professional or your own independent financial professional for personalized advice or investment recommendations tailored to your specific goals, individual situation, and risk tolerance.