Guillermo Calvo on Austrian business cycle theory

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.


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