Guillermo Calvo on Austrian business cycle theory

by on August 21, 2013 at 6:19 am in Economics | Permalink

Don’t worry too much about the failings of the Austrian economists themselves, rather focus on what we can learn from them.  That is the tack taken by Guillermo Calvo in a recent paper (pdf), here is one excerpt:

I will argue that the Austrian School offered valuable insights – disregarded by mainstream macro theory…Over‐extension of credit was at center stage of the Austrian School theory of the trade (or business) cycle, but authors differed as to the factors responsible for excessive credit expansion.  Mises (1952), for instance, attributed excessive expansion to central banks’ propensity to keeping interest rates low in order to ensure full employment at all times.  As inflation flared up, interest rates were raised causing recession. Thus, under his view the cycle is triggered by pro-cyclical monetary policy with a full-employment bias which was not consistent with inflation stability. Hayek (2008), on the other hand, dismissed von Mises explanation, not because it was not a good depiction of historical events, but because he thought that instability is something inherent to the capital market and, in particular, it is related to what might be called the banking money multiplier mirage. His discussion conjures up contemporary issues, like securitized banking, for example. At the risk of oversimplifying, Hayek’s views, a phenomenon that seems central to his trade cycle theory is that credit expansion by bank A induces deposit expansion in bank B who, in turn, has incentives to further expand credit flows, etc. If bank A makes a mistake, the money-multiplier mechanism amplifies it.  This is reminiscent of misperception phenomena stressed in Lucas (1972). Hayek’s discussion does not exhibit the same degree of mathematical sophistication but focuses on a richer set of highly relevant issues.  For example, that credit expansion is not likely to be evenly spread across the economy, partly because of imperfect information or principal-agent problems.  This implies that credit expansion is likely to have effects on relative prices which are not justified by fundamentals. Shocks that impinge on relative prices are hardly discussed in mainstream close-economy macro models. Hayek’s theory is very subtle and shows that even a central bank that follows a stable monetary policy may not be able to prevent business cycles and, occasionally, major boom-bust episodes.  Unfortunately, Hayek does not quantity the impact of perception errors…

That is a bit long-winded, so here is how I would express some related points:

1. Once you cut through the free market (or anti-market rhetoric), the Austrian theory is not as different from Minsky’s as it sounds at first.  And both sides hate it when you say this.

2. There may be a fundamental impossibility in maintaining orderly credit relations over time and the more sophisticated versions of the Austrian theory get at this.  Keynes thought that too, but arguably “the liquidity premium of money itself” is a red herring when trying to understand this issue.  In that sense Keynes may have been a step backwards.

3. The Austrian theory may require a rather “brute” behavioral imperfection concerning naive short-run overreactions to market prices, quantities, and flows.  For reform economies, newly developing economies, and economies coming off a “great moderation,” this postulate may not be entirely unreasonable.

4. That credit booms precede many important busts, and play a causal role in those busts, and shape the nature of those busts, is a deeper point than Keynes let on in the General Theory.

5. One should never use the Austrian theory to dismiss the relevance of other, complementary approaches, most of all those which stress the dangers of deflationary pressures.

6. I don’t exactly agree with Calvo’s Mises vs. Hayek framing as stated.

The paper is interesting throughout and also offers a good discussion of Mexico’s peso crisis, and the point that, while allowing a deflationary contraction is a big mistake, simply trying to reflate won’t set matters right very quickly because there are real, non-monetary problems already baked into the contraction.

The original pointer is from Peter Boettke, who discusses the piece as well.

1 Frederic Mari August 21, 2013 at 8:05 am

I hate to sound like I am simplifying things beyond breaking point but:

1- Does anyone contest the importance of leverage and, more generally, credit into fuelling bubbles?

2- Is not the main failing of the Austrians (the one everyone cares about because it is what sets them apart) to insist that, once the bubble has burst, nothing should be done, except tightening belts and letting the bust cleanse our balance sheets and our souls?

3- I do like the point about sectorial shifts (real estate anyone?)

4- As to your re-inflation comment, it seems to me that, if you are caught in a balance sheet recession/a bust that follows too much credit expansion, you can either try and re-inflate the asset prices to get out of a “bankruptcy”-like state… Not easy as people just got burnt. Or you can run down the debt load. Deleveraging is the long winded way to do that. IMO, debt forgiveness would be faster (and better than above-normal inflation).

Actually, a third way would be to boost the incomes of those most indebted (whether corporations, banks, people or states) to achieve an inordinately fast deleveraging.

Noah Smith had an interesting post on inflation-as-debt-reduction-mechanism and my reply on that is here: http://theredbanker.blogspot.com/2013/08/noahpinions-latest-on-loving-inflation.html

2 The Anti-Gnostic August 21, 2013 at 8:34 am

I think a good insight from Austrian theory is that ultimately the only effective regulation of financial activity is bankruptcy. It disturbs me that we are drifting toward an economy where the rich are protected from becoming poor.

3 Andrew' August 21, 2013 at 8:54 am

2- What is this “should” you speak of?

4 david August 21, 2013 at 8:55 am

1. The main dispute would be whether you take financial dynamics as the core part of your model, or whether you would take an intertemporal consumption function as central and then add financial frictions. This is important because this is where proponents get to ‘burn in’ the political and policy implications of their models. Hence, even though Hayekian and Minskyite endogenous credit bubbles have the same dynamics, their counterfactuals (of what would happen if a policymaker did something else) are all different, and those counterfactuals follow heavily from motivating assumptions that don’t actually play a large role in constructing the explanations. “Knightian uncertainty” used to motivate stylized facts in Austrian capital theory will never imply the possibility of socially-rewarding individually-unattractive intervention, and “fundamental uncertainty” in post-Keynesian capital theory will never favour market liberalization, even if they are invoked to justify very similar-looking stylized facts!

Which brings us neatly to:

2. See 1.

5 Frederic Mari August 21, 2013 at 10:56 am

@Anti-gnostic: So do I but I think the problem with too-big-to-fail is real and, while it grates, I’d rather save some undeserving banksters than see the economy implodes. I wasn’t against the rescue/banks bailout. I was against pretty much everything that followed.

@Andrew’: You’ll have to clarify your witticism. “should” seems correct in that sentence. Or is it “nothing ought to be done” in proper English?

@david: Fair enough, I see what you’re saying and I was indeed being over-simplistic. If I was to venture a guess as to how I would model things, I think I would definitely want something with ‘regimes’ i.e. the ability to move from a state of ‘business as usual, people consume/invest etc’ to a state of ‘bubble-mood, primacy of finance over consumption/production, people speculate, credit is driven by rising prices, not discounted cash flows”…

6 Z August 21, 2013 at 11:09 am

I think the heart of the issue, one that drags down economics as a respectable profession, is the assertion that the choice is between “saving some undeserving banks” and “seeing the economy implode.” The causal relationship between government policy and the severity of recessions is hardly scientific fact, outside of the extremes. The Great Depression was not a replay of the Long Depression because of WW2, hardly the recommended policy of economists.

7 Al August 21, 2013 at 5:39 pm

The Too Big To Fail concept seems more relevant to reducing systemic risk rather than to properly matching full consequences to actions. If a systematic crisis occurs despite shrunken banks, the government will probably step in to forestall the full unraveling of the imbalance. You can’t talk about market based incentives unless you assume that government agencies will ignore or reject arguments based on recursive disruptions to the economy.

8 derek August 21, 2013 at 9:33 pm

Indeed. Most economists and policy makers consider that a feature not a bug. The Krugman extraterrestrial threat is the desire for a bubble.

9 Lord August 22, 2013 at 1:04 pm

Austrians focus on malinvestment and point the finger at low interest rates, central banks, and government. Minskyites focus on debt and (ir)rational exuberance of markets. For Austrians, we are poorer for it and can’t afford to do anything about it and must wallow in it, while for Minskyites bad debts chain us but debts as monetary, yet restarting the next bubble as problematic so employment as preferable to more debt. .Rather than two sides of the same coin, more orthogonal, one edge and one face.

10 Wonks Anonymous August 21, 2013 at 9:51 am

“That credit booms precede many important busts, and play a causal role in those busts, and shape the nature of those busts, is a deeper point than Keynes let on in the General Theory.”
Is that actually the case empirically? Friedman’s “plucking model” is based on the stylized fact that booms do not correlate with subsequent busts, but busts correlate with subsequent booms.

11 Greg G August 21, 2013 at 10:12 am

Great post Tyler. This kind of eclectic and open minded analysis is what sets MR apart from other blogs. I especially enjoyed the point about the similarities between Minsky and the Austrians.

12 Z August 21, 2013 at 11:00 am

Huzza. This is what has made me a fan of the site. The comments are almost always thought provoking.

13 James Oswald August 21, 2013 at 12:26 pm

I’ve also thought of Minsky and the Austrians as being relatively close in terms of analytical framework. The other side of the spectrum would be someone like Sumner who focuses on macro aggregates without looking at all at the banking sector. I think both approaches are useful, despite their dissimilarities.

14 Lee A. Arnold August 21, 2013 at 12:30 pm

The problem for me is that both Hayek and Minsky attempted to create general theories, and others appear to be hoping to use them to understand the crisis, what should be done about it, and how to prevent it in the future. This consistently leads to mental spinning at a general level, instead of looking at specifics. It is one step simpler than that: look instead at what actually happened. There were bubbles in TWO markets, mortgage derivatives and housing prices, and they pumped each other up through incomplete information and intermediary fraud. A flow-chart explanation starts here:
http://www.youtube.com/watch?v=wHoRYAv1wg8&list=PLT-vY3f9uw3ADgyYqUVo2R8kxM4Agc3aw

15 Sunset Shazz August 21, 2013 at 1:29 pm

As Greg G notes above, this is a great post. The parallel between Minsky and Hayek’s theories (regardless of their divergent policy prescriptions) is notable. For many of us, Kindleberger-Minsky and Hayek were the two guys who helped us understand both the boom in 06-07 and the ensuing bust.

16 Greg Ransom August 21, 2013 at 2:20 pm

Well, I’ve been saying this for years … “Once you cut through the free market (or anti-market rhetoric), the Austrian theory is not as different from Minsky’s as it sounds at first.”

Note well, I pointed out this difference between Mises and Hayek in the Q & A portion of a paper Tyler Cowen presented over 15 years ago, when Tyler was presenting a version of Mises as “The Austrian Theory”.

17 Greg Ransom August 21, 2013 at 2:28 pm

I’ve been pointing this out for years … “Once you cut through the free market (or anti-market rhetoric), the Austrian theory is not as different from Minsky’s as it sounds at first.”

18 Al August 21, 2013 at 5:47 pm

The Too Big To Fail concept seems more relevant to reducing systemic risk rather than to properly matching full consequences to actions. If a systematic crisis occurs despite shrunken banks, the government will probably step in to forestall the full unraveling of the imbalance. You can’t talk about market based incentives unless you assume that government agencies will ignore or reject arguments based on recursive disruptions to the economy.

19 Tom August 21, 2013 at 6:11 pm

I think a lot of us have been pointing to the common points in Austrian and post-Keynesian theory for a long time. I don’t think the Austrians are ashamed it of either. They see Minsky as a brilliant but peculiar character with a leftist blind spot that kept him from seeing more than half the light.

The basic core common theses are endogenous money and the credit cycle as the main driver of the trade cycle. They’re right on both counts. The stubborn resistance to those theses shown by policy makers and mainstream academia has been very costly.

20 Tom August 21, 2013 at 7:02 pm

PS – I acknowledge of course that Austrians and post-Keynesians are partly to blame for their wing-nut reputations. The libertarian and leftist ideologies do grate for most people.

But we should be careful about blaming the contemporary mistakes of Austrian-theory followers such as the Pauls, Schiff and Durden on Mises or Hayek. The hyperinflation scare story has more to do with attracting certain types of readers, voters and investors than with Austrian theory.

21 Roger McKinney August 21, 2013 at 8:10 pm

I tend to think that the Austrian theory provides the framework while the other theories flesh out the details. All of them are correct at some point in the cycle.

It’s good to see more economists following the monetary theory of business cycles. Some of the comments to the Boettke article offer lists of them. I particularly like the work of Borio at the BIS.

I take issue with Calvo’s depiction of the bank run as a random event or accident. If Gorton is correct in his description of the run, there was nothing accidental about it.

rdmckinney.blogspot.com

22 errorr August 21, 2013 at 8:47 pm

The moment I see anything about the money multiplier I lose interest. I still don’t see how this relic of classic economics has any meaningful purpose in a modern economy. Before floating fiat money maybe it mattered but when there is inflation targeting it is meaningless. Do economists have to take modern finance courses?

23 o. nate August 22, 2013 at 11:14 am

The Hayekian/Minskyite story about the self-reinforcing nature of booms and busts is also very similar to George Soros’s concept of reflexivity in economic markets.

24 Majorajam August 22, 2013 at 1:45 pm

2 helps to account for why you are wrong about 1, which is to say I do not agree that the variable demand for liquid balances is a red herring with respect to the inherent fragility of credit relationships, and neither did Minsky. Indeed, Fischer’s observation and Keynes theory is effectively the reciprocal of boom time credit’s ‘moneyness’ and the laying of financial system trip wires, wherein all manner of over/’mal’ investment is facilitated.

This dynamic indisputably lies at the core of boom and bust, Schumpeter’s beating heart of the market ‘equilibrium’ orthodox economists have since Walras done so little to clarify.

5 as I read it likewise gives the lie to 1, given that Minksy could be found with that number.

As to 4, Keynes insights are not at all inconsistent with this observation and its related dynamics. The relevance of that renders your point here irrelevant.

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