Systemic Characteristics of Financial Instability

I describe how in the new paradigm of a Competitive, Efficient, and Frictionless Economy (CEFE), introduced in Falahati (2019), macroeconomic imbalances with fluctuating levels of liquidity emerge endogenously. This provides a solid foundation for studying Minsky’s views on financial instability in an economy with a banking and risk-underwriting system. I identify an inverse relationship between liquidity premia and risk premia, which leads to endogenous risk-premium rating cycles, including credit-risk-premium rating cycles, and macroeconomic swings. Ceteris paribus, lower liquidity increases the prices of contracts covering risks (e.g., credit default swaps), whist it decreases prices of all other assets. The opposite occurs with higher liquidity. I analyze operations of banks, risk-underwriters, and the State/Central Bank, and present a new theory of banking which improves current understandings. This theory explains how a banking system uses the floating capital of the economy more efficiently, while it also generates greater systemic risks, compared to an economy without banks. I show how the banking system can induce macroeconomic booms and busts and generate endogenous asset price bubbles and bursts. I highlight other systemic problems of the economy and derive their implications for improving the financial management of the economy and its institutions.