The Financial Instability Hypothesis

The Financial Instability Hypothesis suggests that the financial system is inherently prone to cycles of stability and crisis. During stable periods, excessive borrowing and risky investments build up, creating vulnerabilities. Eventually, these imbalances lead to sudden shocks or crashes when confidence falters, causing rapid declines in asset prices and financial distress. This cycle then resets, with stability returning until the next buildup of risks. Essentially, the hypothesis argues that financial markets are naturally prone to boom-and-bust patterns due to human behavior and the interconnectedness of financial institutions, rather than being perfectly efficient or stable on their own.