An Austro-Austrian business cycle theory

Remove the Austrian judgments about government vs. market and here is what you’ve got:

1. When the euro starts, in essence a bunch of unreliable countries write an irresponsible naked put, pledging that “a euro in a Greek bank is equal in value to a euro in a German bank.”  It isn’t.  They bust their fiscal futures, though few people see this up front.

2. At first markets believe these pledges and perceive expanded gains from trade, including from lending.

3. Trade and lending across Europe expand, and this includes housing bubbles in some of the countries.  Some of this expansion is sustainable, but some of it isn’t.  Eventually the parts which are not sustainable become manifest.  The PIIGS are not up to the standards they set for themselves and ultimately they can’t credibly make good on those naked puts they wrote.

4. Eventual debt troubles induce (some would say require) fiscal austerity, rightly or wrongly.  This brings about the original Prices and Production result that “the consumer demand simply isn’t there to support the new commitments.”

5. More fundamentally, at some point the bank deposits (yikes) are no longer there to see through the new projects and commitments at various local levels.  That’s scary.

6. A Hayekian contraction ensues, compounded by Keynesian AD negative shock problems.  The imposition of tougher capital standards on the banks, combined with bank attempts to unload the crummy bonds, speeds the downward path.

7. It also becomes revealed that the expansion of the German export sector isn’t quite as permanent as it seemed at the time.  Periphery demands for German goods are down and if the eurozone splinters the new “deutschmark” could have quite a high value.  Eventually a Hayekian contraction will ensue for Germany as well, although this is just starting.

8. What about the USandA?  This is the least certain part of the story, but here goes.  The creation of the eurozone financialized Europe to a much greater degree and U.S. borrowers assumed this financialization was permanent, more or less.  It isn’t!  Our shadow banking system could see a very significant whiplash from all of this turmoil, possibly culminating in (shadow) bank runs over here too.  We are trying to gently unwind our shadow banking system connections with Europe but we may not have the time.  By the way, trying to unwind those ties just causes Europe to unravel more quickly, so we are like a dog trying to chase our own tail.

Here is a new piece on Deutsche Bank and Taunus.

And so ends my Austro-Austrian tract.

Addendum: For extra reading, see this recent paper by Claudio Borio and Piti Disyatat, “Global Imbalances and the Financial Crisis,” which is remarkably Austrian (cites Wicksell only, but just look at the names of the sections in the paper).  p.15 gives some numbers on why European banks (rather than developing nations such as China) drove a “liquidity glut.”  Here is Borio’s overall “macroprudential” framework.  Here is Borio’s 2004 paper which more or less predicted the financial crisis, and got some key mechanisms right in a deep ways.  Here is an audio interview with him.  File Claudio Borio under Underrated Economists.


Wait till this happens for China. :-(

so cool ~

Here is a new piece on Deutsche Bank and Taunus.

Yet another business writer who doesn't understand (or care) that it's misleading to compare an IFRS leverage ratio to a USGAAP leverage ratio. Oh, it's Simon Johnson? He really should know better. Shame.

Is that you Mistadobalina?

The question is what to do now.

I've yet to see a plausible story that austerity will help Greece, Italy, etc. Austerity leads to lower growth leads to higher debt/GDP ratios leads to higher rates, etc. making debt repayment a worse problem. Fear of credit issues leads to a run on the bank, which no one (or at least no one without their own currency) can survive.

That in turn hits the world economy, or at least those parts of the world which trade with those counties or whose financial institutions lend to those countries to any significant degree.

The alternatives seem to be the breakup of the Euro, the end of austerity (such as ECB guaranteeing debt), the worldwide economy taking a severe turn for the worse, or some combination.

Either the current level of spending is ideal, or the ideal level is lower, or the ideal level is higher. Which is it?

I've yet to see a plausible story that ANYTHING will help Greece, Italy, etc.

This is your problem:

the end of austerity (such as ECB guaranteeing debt),

Your view of what "austerity" is is far, far too narrow. Debts must be paid by someone.

Maybe you have to distinguish countries--Italy is different than Greece, for example, and you also need to distinguish a country's risk from the risk of the overall EU financial risk. So, for example, you've seen Finland and other northern European bonds being infected by the Euro risk. Thus, you need to separate out components of risk. When you do that, Italy seems manageable. They, like Greece, have rampant tax avoidance and if they just go after those who are not paying, while others are, they will improve their situation.

Bill is the intellectual equivalent of a dirty sanchez.

Jesse, You keep changing your name from one gross personna to another, but you are still what you are.

You can find an analysis along the comment I made at Roubini's site:

No one gives half a shit.

Tyler, this is addressed at you specifically.

The Euro isn't working out for Europe. Is the Dollar working out for the USA?

We have abandoned areas like Detroit and parts of Baltimore. There's also West Virginia and Kentucky. Is the American Currency Union causing problems similar to Europe?

Sorry I can't phrase this more intelligently.

Like with the eurozone, the problem isn't the money the problem is the local governments.

True. But large economic unions tend to diffuse consequences and responsibilities.

the problem is both. Fiat money is a simulacrum, meaning it means nothing

Depends on what the alternative is. If Detroit were an independent nation, would there be tariffs on the goods produced there? Would unions have overwhelming power in such a small polity, or none at all?

If Detroit were its own nation, at least it could fail on its efforts.

Right now, no one is responsible for Detroit's successes and failures.

"We have abandoned areas like Detroit and parts of Baltimore. There’s also West Virginia and Kentucky."

No we haven't abandoned Detroit. Detroit is downsizing to fit a changed economy. No one can promise everlasting growth in every city of a very large country. And West Virginia and Kentucky are both growing, so what's your point about them? Granted, they both started poor, but they are both getting richer. Have you been to Kentucky this century? It's a pretty prosperous state outside of the rural mountain areas. And the rural mountain areas haven't gotten worse, just not as rich as the plains.

Honestly, you'd be better off asking about California and Illinois. Both of those states have very serious long term financial problems and their plight is closer to Greece or one of the other PIIGS.

Aren't most US states required to run balanced budgets?

Many of them are, though in Colorado's case we often balance shortfalls with injections from the Federal government.

West Virginia and Kentucky suffer, to a considerable degree, from the natural resources curse. For a number of reasons, it's difficult to build a diverse resilient economy when the "best" local decisions are always "invest in coal".

Detroit was a "Big 3" company town, and the Big 3 did all of (1) make bad decisions about the product, (2) downsize, and (3) outsource. There's plenty of blame to put on the local government there, but much of the problem can be laid at the hands of the private sector.

Kentucky's economy has very little to do with coal production. Indeed, Kentucky has a pretty diverse economy. For reference, roughly 3% of Kentucky GDP is based on auto manufacturing. Twice the percentage coal represents.

"In 2009, mining accounted for 1.6 percent of the state’s GDP compared to manufacturing’s 17.4 percent of GDP."

Yep, that's pretty much the Austrian School story of it, alright, with one important addition: the ECB's inflationary policy is at the heart of all these bubbles and collapsed export sectors. Maybe even the "negative AD shock," if Austrians felt that using Keynesian language were useful.

Just curious: why do you call it a "Hayekian contraction" instead of a "Misesian contraction?"

'the ECB’s inflationary policy'
Best satirical comment today.

Austrians define inflation in the pre-keynesian style. They mean growth in the money supply. Under that definition the ECB was in fact inflationary over the last 10 years.

Ok - and here I thought that the ECB's much deplored restrictive interest rate policy of the last 10 years was the problem. That the ECB was explicitly following German ideas of ensuring that inflation did not take hold, while many other central banks continued to plead for the Bundesbank - oops, the ECB - to follow policies designed to combat the lack of inflation.

I'll admit that the term inflation is a very slippery one, especially when so many people want to define it to their own needs. Germans are pretty simplistic that way - and Germans tend to shy away from anything with an Austrian overtone. They prefer their Soziale Marktwirtschaft - which seems to have worked quite well over two generations, actually. But then, part of the framework in which the idea of Soziale Marktwirtschaft exists is based on the idea that 'property entails obligations.' (German Grundgesetz, Artikel 14 -
(2) Eigentum verpflichtet. Sein Gebrauch soll zugleich dem Wohle der Allgemeinheit dienen. 'Property entails obligations. Its use should also serve the public interest.')

"I’ll admit that the term inflation is a very slippery one, especially when so many people want to define it to their own needs. Germans are pretty simplistic that way – and Germans tend to shy away from anything with an Austrian overtone."

The definition of inflation as any increase in the money supply isn't an Austrian one, it was the standard one during the 1800's. Its just that now people think of it as increases in the price level.

Also, interest rates in europe were well below what they should have been.

Interest rates should capture relative risk, and at the time they didn't. They treated Greek, spanish, and Italian bonds as very similar to German bonds. They didn't take into account the default risks that we are seeing now.

Especially in Spain and Ireland, there wasn't a small credit and money expansion, was it?

From what I read the ECB in the early 2000's set the interest to a level that was appropriate for Germany to get out of a slump but far too low for periphery countries. That caused monetary expansion in these countries but wasn't reflected in overall European inflation figures which is why people were so surprised when the whole thing collapsed. If people had looked at national figures and included rising asset-prices in measuring inflation alarm bells could have been rung much earlier.

Wait, so do you really just think it's doomed? I guess the part of this that I understand the least and would maybe help me get your whole analysis better is this:
Why is a euro in a German Bank not the same as a Euro in a Greek bank?

Is it just because a Euro in a Greek Bank just isn't as safe, and if it isn't safe, from a broader economic sense, it's not worth as much?

Like, how a lottery ticket is worth EITHER a million dollars or it's worth nothing... but if there a million of them out there then they are ALL worth $1 until the one that's worth a million dollars is found and they that one is worth $1M and the rest are worth $0. Is it like that?

You can answer your own question. Which would you rather have right now: A savings account with 100Euro in a Greek bank or a savings account with 100Euro in a German bank?

Second question: how much more would have to be in the Greek account before you'd accept the risk (or hassle of withdrawing the money from the Greek account and depositing in a German account)?

'A savings account with 100 Euro in a Greek bank or a savings account with 100 Euro in a German bank?'
Man, it is as if no one grasps the idea that there one can have 100 euros in a Spanish bank, and yet the deposit is in Germany, or one can have a deposit in a direct bank like ING-DiBa and live in Italy (or in the case of ING-DiBa, have an account in euros in non-euro countries like Canada or Australia).

There are any number of problems in the eurozone, but the idea that banking isn't eurozone wide is just amazingly ignorant - the Greeks are pulling money out of banks to keep it from being taxed (or recognized as being from proceeds of things the state would not have approved of - like, oh, bribes for building permits). They aren't pulling money out of 'Greek' banks any more than they are pulling money out of Spanish or Dutch/German or German banks - the Greeks (and to a certain extent, the Italians) are pulling money out to hide it.

Remember WaMu? Remember WaMu suffered a massive bank run, customers pulling out $16.7 billion in deposits in a ten-day span? Remember anybody writing about how a dollar in a Vermont bank was worth more than a dollar in a Washington State bank? Don't remember it? Not at all? Maybe because it was absurd to talk about WaMu as a Washington State bank?

This isn't to deny valid assessment of what is happening in the eurozone - which, from one perspective, looks like the creation of a single currency zone addressing a number of currently recognized flaws. Such as states having the authority to create debt without much fear of penalty. Or states living beyond their means.

A while ago, many of my dollars, and a decent number of my euros were sitting in an American bank located in Frankfurt (through a hundred percent owned 'German' subsidiary) - I'm curious how commenters here would feel about the safety of my euro deposits in an American bank, or the safety of my dollar deposits in a German bank. Or whether to call such a multinational company (with branches quite literally spanning the globe) 'American' or 'German' even makes sense.

Reality disagrees. See, e.g.,

The FDIC covers banks in Vermont was well as Washington State, and there is no credible chance that Washington State will secede in the near future and go off the dollar (or that Vermont will leave the other 49 states, leaving to dollar weakened). //assuming your meant to hypothetically equate Vermont ~ Germany and Washington State ~ one of the PIIGS//

Which part of reality? The one that has Greeks fleeing with cash, in the same country that has more registered Porsche Cayennes than people earning 50,000 euros in taxable income (which was also cited here)?

And I'm sure you are familiar with this -
'Directive 94/19/EC of the European Parliament and of the Council of 30 May 1994 on deposit-guarantee schemes requires all member states to have a deposit guarantee scheme for at least 90% of the deposited amount, up to at least 20,000 euro per person. On October 7, 2008, the Ecofin meeting of EU's ministers of finance agreed to increase the minimum amount to 50,000. Timelines and details on procedures for the implementation, which is likely to be a national matter for the member states, was not immediately available.'
Most interestingly, in a country with fewer people earning 50,000 euros in taxable than a single model of Porsche (the Cayenne might be more suited than the sporty 911 or the inexpensive Boxster in Greece, admittedly), the insured amount, 100,000 euros, and coverage to that amount, 100%, is identical to Germany's.

I will be interested to read about bank runs when the money starts flowing from France, the Netherlands, or Germany - because at that point, the eurozone will be over. Money flowing from a case of fraud and manipulation is roughly the same as what happened when Austria lost its truly anonymous banking for non-citizens, or Luxembourg lost its status as the EU tax avoidance (OK, evasion) preferred haven (There was even a Swiss 'bank run' after the Swiss signed a tax agreement with the EU - though in that case, the money just hopped a bit to Vaduz.) To come from a slightly different direction - ever wonder why the ECB prints 500 euro notes? It isn't to help tax collectors, after all.

Here is a little secret - Europeans hide as much money from being taxed as they can get away with. The Greeks are true masters of the art, though the Spanish have this cute dodge using artificially low real estate prices - with the published price being roughly 50% of the real price - the other half being paid, generally, in what some people would call untraceable financial instruments. (In other words, much of the Spanish boom was actually off the books - which suited UK and German investors with their own off the books income just fine.)

Prior_approval, if you are correct then this can all be fixed with a flattening and major cut of the income tax.

prior_approval, as you said yourself, the EU member states are required to have a deposit guarantee scheme.

Compare to USA, where Vermont and Washington State are not. Instead, the FDIC covers all 50 states.

The Euro *is* over. It was doomed to fail from the start because the member states failed to give up enough sovereignty to a central government -- one with, inter alia, the independent power to tax its citizens directly to fund an FDIC-like institution.

Good points, prior_approval. Regarding flat rates, deductions are not the issue. Its reporting and hiding income, and that won't change in a volutary system even if rates are lower. What does change things is collecting taxes via electricity bills, or property tax, or bank transaction reporting.

And what of the banking accounts with more than the Deposit guarantee? Are people as willing to keep more than 100K Euros in a Greek bank as they are Germany? Does anybody have a source that would indicate what is actually happening with bank deposits?

I'm still not quite understanding whats the nature of the "shadow" banking system between US and the eurozone. It seem to plain to me. They buy our investment asset security, and we sell it to them---a lot of these are the infamous real estate backed asset the cause the 2008 financial crisis. If there's a bank run in the eurozone, I don't see the contagion to our banks unless our banks partially own or in business with these eurozone banks.

One conclusion that can be drawn from this paper and the one from Shin---the "global saving glut" has nothing to do with the financial crisis. This meme should die right here and now. Krugman and more importantly Bernanke should retract their past statements regarding Asian crountries, esp. China, flooded the world with liquidity, somehow caused the financial crisis due to their high saving.....

Small steps toward a much worse world...

It's almost as if Tyler is starting to read & understand Hayek -- instead of falsely assuming that Murray Rothbard is "Hayek".

Greg, please go fuck yourself.

That's helpful.

Yes, it is.

I rarely endorse random insults but in this case I found that helpful.

These BIS economists know their Hayek well .. and used Hayek & Minsky to foretell the U.S. parhological boom & inevitable financial crash & economic discoordination / bust, from around 2003.

William White then led the BIS reseach team & presented his work at Jackson hole to Greenspan, Bernanke and the rest.

"in essence a bunch of unreliable countries write an irresponsible naked put"

Could someone elaborate on this? I'm afraid I don't follow the analogy.

They are betting that EU countries mashed together will be more fiscally responsible in toto than they were individually prior to the union. Kind of like mortgage backed securities.

Sort of. What they don't realize is that aggregating risks only trades variance in normal times for increased tail risk.

My best guess is, "in essence a bunch of unreliable countries write an irresponsible naked put" refers to people depositing euros in Greek banks. "The market believed these claims" means that people believed that their deposits in high-interest yielding Greek bank accounts were less risky than in fact they were.

If I write a naked put, then I promise to sell an asset for a pre-specified price without owning the asset. Now I think that in this analogy, the naked put is a deposit in a Greek bank, and the asset is €1. (The pre-specified price is €0.) When I deposit one euro in a Greek bank, I'm essentially buying from the bank a put option. The bank promises to sell one euro cash plus interest in the future (for free). The put is naked because the Greek banks' assets is Greek sovereign debt. One "euro" of Greek sovereign debt is essentially worthless...

Is this right?

I think that's close. My confusion lies in the put analogy. If Greece is the writer of the put, who holds the other side?

I guess he's saying that when Greece adopted the Euro, it was betting that its economy could pay back its liabilities denominated in Euros. This was the naked put. The value of Greece's economic output fell, but the Euro did not devalue. So Greece cannot pay back its creditors - the owners of the put. Now Greece needs a loan from Germany to pay off its creditors.

From the Borio paper:

"“And while Wicksell saw inflation as the inevitable outcome, others, such as Hayek (1933), argued that the distortion would be reflected in relative prices, in this case between consumer and investment goods. This suggests that it would be important to develop formal analytical models in which such a gap is reflected also in unsustainable asset price booms.”"

Here's Claudio Borio discussing asset prices, financial instability, the trade cycle - and Hayek - in 2002:

The BIS economists are also heavily influenced by George Selgin.

Hayek was a liquidationist.

Yes, he was. Liquidation is the only sensible solution to insolvency, and failure to liquidate just results in stagnation.

Hayek later admitted he was wrong about the proper course of action in the U.S.

So, you're saying it's a bad thing to be a liquidationist?

Bluffers who don't know their back pocket from their elbow need to stop fouling the public square.

You're a shit-for-brains, Greg.

So the southern European states are roughly equal to low income Americans borrowing $200K to buy a house in Las Vegas.
Not to worry. Our financial gurus have figured out a way to minimize the risk of default by "packaging" mortgages into AAA bonds and selling the tranches to investors with different risk profiles. Everyone knows property only appreciates.

What's the excuse of the Euro bond buyers? No nation state has ever gone bankrupt? A 2% spread between German bonds and Greek bonds represented the wisdom of the crowd?

The financial professionals always manage to get paid up front.

"No nation state has ever gone bankrupt?" That's not quite right. Certainly, a nation state has drastically changed it's government and standard of living due to default on debt. That's pretty much a bankruptcy.

if un named countries (I assume greece, spain, etc) are , quote, irresponsible, why do you not apply the same strong, loaded language to the banks ? You characterize the bankers as ,quote, markets believe these pledges, where these pledges are made by irresponsible countries.
but aren't bankers paid absurd salarys precisely because they are suppose to be safeguarding our money ?
I guess I feel that you are sort of biased; the people who took out loans they couldn't pay are "irresponsible" , while the bankers who made these loans dissapear in passive voice clouds

Added degree of difficulty: the various nations' regulators force banks to hold sovereign debt.

Well, force is too strong a word. Sovereign debt counts the most with respect to regulators' capital requirements. So "strongly encourage" is probably better, but in light of fiscal realities...

Anon, I don't believe that's true. EU and Basel specifiy risk grades, not nationalities.

Bill, I could be wrong, but as I understand it, Basel II relies on external credit rating of sovereign debts -- all levels of AAA and AA were given a free pass. So Spain, for example, is AA- => 100% weighting (0% risk).

Anon, You seem to contradicting yourself. First you say national governments require national banks to buy their bonds. I say, no, EU and Basel go by risk standards, and then you post a reply saying the same thing.

And, by the way, country ratings change, and that's why premia change as well. A AAA today doesn't mean an AAA tomorrow.

Agreed. They loaded up on Greek and other debt because they could purchase it cheaper relative to other sovereign debt after the EU currency union. Later, you saw the risk premiums converge, based on the faulty assumption that there would be a backstop.

The more I think about this the more I agree. To buy a bond or make a loan is to make an investment. In my world of startup tech companies, a lot of investments fail, but no one calls the VC or the company "irresponsible." They just failed.

A mutual fund manager who makes poor investments eventually gets fired. S/he doesn't go before a committee and complain about irresponsible companies or municipalities or what have you.

Could someone explain what the "shadow banking system" consists of and how it functions?

And does the name imply that we(the regulators, bankers, and authorities in general) are totally ignorant of how it works, or are the underlying mechanisms pretty well understood despite the scary sounding name? Thanks.

The shadow banking system, is the connection of institutions that transmit money and act as financial intermediates but are not banks.

This includes: car companies, hedge, funds, furniture companies, pop-desks, some mortgage companies, money market funds, REITS, SIVs, pension funds, sovereign wealth funds etc etc.

They are as well understood as anything else financial.

He'll still be virtually stationary compared to Adam Smith.

I see my witty response to somebody no longer makes sense.


And guess what, despite the talk, there is no legal provision about an EU country leaving. Are the Germans going to sit around and wait for 17 or 27 countries to re-negotiate an EU treaty? It seems that they are only forced to do so, including the restrictions of their own Supreme Court.

Either way, a long slow legal process of "fiscal union" or "fiscal breakup" will occur. The status quo will ensue and things will only get worse (i.e. US Supercommittee, hopefully automatic cuts will hold).

If a country is determined to leave the EU, why would they wait on a long slow legal process? You need to reach an agreement to form a Union, you don't need to bother to breakup a Union. For example, look at the Soviet Union. It took decades of effort to turn Russia into the Soviet Union, but the whole affair broke up within 2 to 3 years.

I think the business cycle theory works here because it is doing what it is designed to do: explain why governments make the same mistakes all the time in fiscal crises.

The "This Time Is Different" analysis of Reinhart and Rogoff was partially based on the empirical data of fiscal crises that had occurred in the past that Austrians were also attempting to describe. They concluded governments, never do what it takes. The Austrian view is governments shouldn't do what it takes. Calling monetary union an investment makes the cycle more clear.

Matthew Yglesias is annoyed at current leaders for taking the R&R view as explanation/excuse for their own fecklessness instead of motivation to do something about it. Austrians are taking advantage of the past failings of human nature to put their ideas in practice which are in fact those same past failings of human nature. Everyone becomes naturally more conservative in a crisis and that is the problem.

We will eventually start growing again which Austrians will take as vindication. It's like saying look at this newly fixed car we brought you after they crashed it in the first place.

When they follow Keynesian prescriptions you end up with decades of stagnation instead.

I'm guessing your definition of Keynesian is so broad as to be meaningless?

Japan followed keynesian presecriptions to the letter.
1) Massive deficit funded fiscal stimulus.
2) Lowered interest rates very low.

They ended up just stagnating.

Point 1 is totally revisionist. The euro was widely derided from day one. That's why half the EU countries did not join it. It's opponents said it was a political project and doomed to end in failure exactly as it is now, its proponents said it was a political project but the politics were righteous so it would triumph in the end.

The southern nations wanted into the euro for the exact reason that they thought they would be able to get money for nothing.

The only thing that surprises me is none of the euro cheerleaders is getting lynched yet.

Apropos of the comments on liquidation, apparently there are two types of liquidationist. First are ones who believe a properly functioning market system is liquid by encouraging prompt competitive entry and exit with rewards for success and penalties for failure at all flexible points in the economic cycle. This allows discontinuous restructuring that prevents a build up of distortions which could intensify capitalist crisis by magnifying the depth of the trough in the down swing (with reasonable exceptions made, of course, during national or global emergencies). Secondly, are spoilers who liquify/addle the important debate about real points in a crisis where liquidation could mutate from cure to cause. I’m not convinced by those who say that the rethink point has been reached based only on evidence that levels of hostility on both sides of the argument are rising exponentially.

"8. What about the USandA? This is the least certain part of the story, but here goes. The creation of the eurozone financialized Europe to a much greater degree and U.S. borrowers assumed this financialization was permanent, more or less. It isn’t! Our shadow banking system could see a very significant whiplash from all of this turmoil, possibly culminating in (shadow) bank runs over here too."

Already happened. The MF global collapse was an example of this as was the AIG bailout.

Comments for this post are closed