Austrian business cycle theory refuses to die

There is a new paper from Princeton by Matthew Baron and Wei Xiong (pdf), preliminary draft but the results are striking:

This paper examines financial instability associated with bank credit expansion in a set of 23 developed countries over the years 1920-2012. We find that credit expansion, measured by the three-year change in bank credit to GDP ratio, predicts a significantly increased crash risk in the returns of the bank equity index and equity market index in the subsequent one to eight quarters. Despite the increased crash risk, credit expansion predicts both lower mean and median returns of these indices in the subsequent quarters, even after controlling for a host of variables known to predict the equity premium. Furthermore, conditional on credit expansion of a country exceeding a modest threshold of 1.5 standard deviations, the predicted excess return for the bank equity index in the subsequent four quarters is significantly negative, with a magnitude of nearly -20%, while the positive predicted excess return subsequent to a credit contraction of the same size is substantially more modest. These findings present a challenge to the views that credit expansions are simply caused by either banks acting against the will of shareholders or by elevated risk appetite of shareholders, and instead suggest a role for optimism of bankers and stock investors.

The pointer is from Hyun Song Shin.  I would continue to stress, however, that Austrian approaches still need more Hyman Minsky and should cease putting all of the “blame” — causal, moral, or otherwise — on the monetary expansion of the central bank.  Don’t forget my banana point:

Let’s say that the government subsidized the price of bananas, you bought so many bananas, put them on your roof, and then the roof collapsed.  Is that government failure or market failure?  The price was distorted, but I still say this is mostly market failure.  No one made you put so many bananas on your roof.


Would the banana point change if we changed the banana analogy thus:

The gov't subsidizes bananas, you bought so many bananas that farmers reduce food crops to grow bananas, and the cost of non-banana foods increase.

Market failure or government failure?

If the market are the citizens. And if the government are our representatives. Then both have failed.

To state the obvious, this results in an inefficient allocation of resources but not necessarily a recession/depression. What you describe is no different from the government imposing a burdensome tax on non-bananas. But a full scale recession/depression/crash and fluctuating business cycles require a separate macro transmission mechanism. Inefficiency should just lead to lower growth which needs no separate Austrian explanation.

The macro transmission mechanism is loans that are not matched for maturity, loans that depend, in the aggregate, on monetary "expansion." Either this expansion is a Free Lunch™ or else the ensuing crash is inevitable. We all just watched this happen a few years ago and we're still making a big show of scratching our heads over it.

Hard currency: a felicitous intersection of common sense, moral intuition, and truth in practice. Those things don't always line up, but this time they do.

That doesn't seem to fit the observations of the recent past very well. We had long term loans (mortgages) that when they turned over the market didn't want to lend again. So that would seem like a problem of mismatched maturity *except* what the market did was lend to the Fed. gov't for 30 year bonds. So long term borrowing matched by long term lending.

What would one expect to see if there's a mismatch between borrowing and lending maturity? Say people want to borrow long term but lend short term. One would expect to see very low short term rates but high long term rates. In a world of mismatched maturity there has to be a large spread between long and short rates since that is where the market will offer the most reward. The financial institution that's willing to help the long term lenders 'create' short term loans to meet demand will use that differential for profit.

Yet rates fell for both the long and short term and the spreads declined. this is not consistent with your macro transmission mechanism hypothesis.

it may be a personal failure for that person with the collapsed roof but we don't have enough information to determine if it is a market or govt. failure. Maybe others became banana tycoons and the program could be deemed a success. We do know beyond a reasonable doubt that solyndra was a government failure because it resulted a net loss. However, if a fledgling business had solyndra as a client and the initial sales were enough to eventually becomes a conglomerate then technically solyndra could be a success. It's hard to quantify these things sometimes

Yes, we have no bananas.

That would be ratex, not ABCT, though.

The farmers who didn't change to bananas would see exceptional profits when the great crash came.

More oddly, if the gov't was subsidizing bananas the result would not be a banana bubble, the price would probably be falling. Perhaps there would be a bubble in land prices that are ideal for growing bananas. But again when the crash comes from the gov't pulling back on banana subsidies those who invested in non-banana industries would enjoy higher profits.

It's not failure at all. It's stimulus. Now there is demand for roofers.

Broken window fallacy awaaaaaaaaaay!

What we clearly need here is more: a) building inspectors and b) banana storage regulations.

I just skimmed through the paper, but I didn't see any robustness checks with changing the date of the analysis. I think in this case that's really important. 1920-2012 just barely picks up two of the biggest global stock market crashes. If huge crashes are on 80 year cycles (or have a say 3% chance in an expanding debt scenario), then picking a 90 year band with both crashes could be overestimating the negative return of a credit run up. But if 1920-1997, 1935-1970, etc show a similar effect that shows a pretty impressive robustness.

Only two veritable minsky moments in the US in the past 100 years

Wouldn't it be weird if you couldn't have gotten these results in 2005? A concerned Austrian runs the 1920-2005 data set in 2005, sees no negative return effect, and then stays in the market. If this methodology is good, shouldn't it have picked up on the risk of a crash without that crash being in the data set?

I'm not saying that it would happen that way, it's much more interesting if it doesn't. But I think that's the main oversight.

What if the government subsidized the cost of bananas. You bought a whole lot of bananas and then drove your car through your living room wall. Is this goverment failure or market failure?

If you think it's all mostly market failure then why have the Government in this business of subsidizing bananas at all? If you think monetary policy is effective at changing behaviour, why absolve it of blame when the roof collapses?

Why play a blame game at all?

My (miserably blog-based) understanding Austrian business cycle theory is: recessions are caused by mis-allocation of goods and effort, e.g. people being in the wrong jobs. Authorities can make this worse by conjuring enough money to temporarily hide mistakes.

If that story is true, you can blame the market or the government it doesn't change the predictions that the recession will end only when effort is re-allocated better and that stimulus can hinder as much as help that. But if that story is wrong, then stimulus might to a great deal of good. Either way the blame doesn't change the policy prescription.

The problem is that the 'wrong jobs' seem to be supposedly caused by low interest rates. Low interest rates cause misallocation which cause people to go into 'wrong jobs' (say real estate broker rather than pizzaria owner).

The result, though, should be increased interest rates as there's a huge demand for the 'right jobs' but not enough people to go into them. In the above example, low interest rates 'caused' people to bid up home prices and become brokers rather than pizza makers. When the crash comes the brokers get laid off but there's no easy way to convert real estate offices into pizza shops and ovens. So the brokers will experience prolonged unemployment. So far that model fits BUT the pizza makers should see excellent wages since they have the market all to themselves for a while as competition is locked out.

That we don't see nor would we see any collapse in demand.

Wouldn't it be a whole lot easier to end the banana subsidies than to launch a roof inspection program to prevent collapses? Plus trying to prevent whatever other crazy things people are doing with bananas? If so, it is best to call this a government failure, since that points us to the easiest solution of the problem.

Adding to DB’s comment (I agree), one might point out that the central bank monitors usage of the bananas it helps to create. Moreover, central bankers such as McChesney Martin sometimes attributed policy actions to the view that there was too much credit growth - too many bananas being placed on roofs. Martin saw the number of roof bananas as part of his mandate, with a view to keeping them at safe amounts. Today’s Fed still monitors the roof bananas but with a different philosophy, and one that’s moved further away from not just the Austrian school but also Minsky (one would think).

Also, some Austrian theorists – namely, those who take issue with fractional reserve banking, with or without a central bank – are closer to Minsky than others. They’ve articulated a different mechanism than Minsky’s for the kind of results claimed in this paper, but it need not include a central bank.

The odd assertion is that the market can't see an obvious source of profit in shorting bank stocks.

Shorting requires more precise timing, and generally carries greater risk, making it harder to land risk adjusted gains.

The authors claim an increased crash risk within 1-8 quarters, and "predicted excess return for the bank equity index in the subsequent four quarters of nearly -20%." So, it seems like they are claiming that the timing is not that difficult to nail down (about 1 yr). They also argue that their findings "suggest a role for optimism of bankers and stock investors" so they do seem to be claiming that investors' optimism blinds them from seeing the short opportunity.

On the other hand, the authors published their results instead of starting a hedge fund, so that may be one indicator of their confidence in the future out-of-sample replicability of their findings.

Pretty sure that is a fallacious analogy. I may be mistaken, but isn't the Austrian view that excess money leads to malinvestment. Bananas are a consumption good, not an investment. Market's would understandably respond differently to incentives on investment goods than on consumption goods.

I've always thought of it in terms of selection pressures. If the government artificially suppresses interest rates, the market will, in the short term, select for firms that take advantage of this. Firms which take a longer-term view of things, they'll lose market share in the short term, and thus the market will come to be dominated by firms that exploit the temporarily lowered interest rates.

That's just my pet theory, though, and I don't really know what I'm talking about.

The Austrians place too much blame on the central bankers. Unless there was a system that outlawed all credit, there will be credit booms and busts based on the social mood cycle swinging from optimism to pessimism. Simple reforms, such as making bankers personally liable for losses, would go a long way to taking the excesses out of the system.

They're still right about the central bank misbehaving though. It seems the only thing the central bank has done is extend the credit cycle by smoothing out the depressions (turning them into recessions), but if you believe in the fractal nature of the markets, this is setting up a crash an order of magnitude larger than the 1930s.

Substitute "outlawed all credit not financed by bank deposits" for "outlawed all credit" and many Austrian theorists agree that there would still be credit booms and busts. They may oppose the policies and theories favored by central bankers, but they see fractional reserve banking as the original source of financial instability, and this can occur with or without central banking.

"fractional reserve banking as the original source of financial instability, and this can occur with or without central banking"

We had financial instability before we had a modern banking system (see the South Sea Bubble). Introduction of modern banking just introduced a new place for the failure to take place.

I don't doubt that bubbles may have occurred without fractional reserve banking, but the South Sea Bubble wasn't one of them - the Bank of England was lending against deposits at the time. The tulip bubble may be a better example? But it didn't predate fractional reserve banking, which popped up in various times and places before it became the norm in the last few centuries. Jesus Huerta de Soto has written a good history in Money, Bank Credit and Economic Cycles, and he may be the best example of an Austrian who I believe it can be said sees fractional reserve as the original source of financial instability.

Go to a chiropractor and you will be diagnosed with a subluxation.

Go to an Austrian economist and you will be diagnosed with a bad case of central banking.

Go to a Keynesian and you will told you didn't stimulate the economy enough.

Just because chiropractors' theory is nonsense doesn't mean that chiropractors don't help people. And if the ABCT is true, well, then yes, you WILL be diagnosed with a bad case of central banking. Comparing that to chiropractice doesn't even begin to make sense.

I find everything here convincing. I have decided to start putting bananas on my roof.

I don't think the banana example is particularly relevant.

Two basic categories of entities are entering into market transactions: governments and private entities.

Governments tend not to consider fundamental economic realities in making their decisions, whereas private entities do. For example, the government will set an interest rate target and typically enter into open market transactions to get there. If the government is trying to reduce interest rates, it will buy treasury securities at higher prices than currently exist in the market without considering whether it is a good investment. If the market tries to adjust, it can't, because the government won't let it. It will just keep buying treasury securities without regard to the fundamental value of the these securities. The goal isn't to earn a good return on investment. It is to increase the value of these securities and reduce interest rates.

There is no way for the market to correct imbalances until it reaches a tipping point, and everything comes crashing down like a game of Jenga, which we are supposed to believe is a "market failure." Yeah, the market failed to correct imbalances created by government intervention.

Then you have companies like Fannie Mae and Freddie Mac that have politically-motivated goals of improving "affordable housing." How did they do it? These organizations bought more crappy sub-prime and Alt-A loans than the economic fundamentals would have suggested would be appropriate. A prudent investor would not have made the same decisions based on the returns and risks associated with these investments, but when your goal is not to earn an adequate return for a given risk but rather to achieve other goals, you shouldn't be surprised when large losses are the result.

Tyler's right in that we shouldn't lay most of the blame on the central bank. Instead, we should blame widespread belief in the efficient market hypothesis. People believe nominal market prices are the word of god and cannot be wrong. This really means that the majority of people cannot be wrong. Well the truth is majorities are sometimes wrong.

But wouldn't there be a opportunity for profit betting against the majority? Yes and this is exactly what some people did with the housing bubble, but they were in the minority and did not command enough funds to prevent the bubble. They were in the minority because most people believe in the efficient market hypothesis and therefore believe there is no possible profit in betting against a bubble.

It is a government failure. It isn't just the crash. Think of that first erroneous banana.

The banana point is a straw man. Yes, if policy subsidized an obviously foolish behavior like stacking bananas on one's roof, then the fools who would do so are also largely to blame. Borrowing newly created credit to invest in business ventures that are, at least on paper,profitable while the boom lasts is not obviously foolish. Rather than a stack of useless bananas yielding no profit or consumption value, during the boom people are investing in things that do appear to be profitable and who's increasing market value supports higher current consumption via the wealth effect.

What if the bananas are stacked on my roof, and it collapses?

If you pare away all the layers, Austrians are saying that a free market will have ups and downs, where everyone else says that we must smooth out the business cycle. Blame is not an issue because the sole purpose of a free and competitive market is to make errors obvious. A healthy market imposes corrections all the time, and fools who don't pay attention get put out of business.

What the central banks have done is guarantee an even greater collapse. Price fixing always fails eventually.

"Austrians are saying that a free market will have ups and downs, where everyone else says that we must smooth out the business cycle"

No, they claim that business cycles are due to credit and money expansion by the banking sector/central bank, and without that there would be no business cycle.

They are delusional.

The Austrian theory of the business cycle has not died because there have been no counter theories presented that have been capable of refuting it.

Your banana example misses the mark. In your banana example, bananas are not the medium of exchange. The price distortions in the banana example are not caused by a calculation distorting monetary system. They are caused by subsidies of bananas, which people can opt out of.

ABCT on the other hand concerns price distortions caused by socialist, non-market medium of exchange which people cannot opt out of without being kidnapped and thrown into a cage. Their choice to avoid prison for tax evasion has played a role in the use of a universal price distorting monetary system. This is not mostly the fault of the hapless citizenry. It is the fault of government thugs and their ideological propagandists.

The price distortions CAUSED by absence of profit and loss in money production, is the cause for why malinvestments take place according to ABCT. Your bananas example doesn't address this.

When you go outside in the summer, does your tinfoil hat burn your scalp?


When you see pathetic and bad 7th grade stuff like this, are you as encouraged as I am?

Nope, I think you're an idiot, and this hat really burns.

Cowen's point is misleading at best. Banks within the central banking system are allowed to make loans with money created out of nothing. This distorts not only interest rates but the prices of assets that are purchased with the new money. Further, those spending the new money first are stealing purchasing power from those holding the existing money. Consumers are given credit cards to buy finished goods which they otherwise could not afford. The entire price structure is thus distorted by a process which amounts to an unsustainable and temporary subsidy derived from other people's purchasing power. The Minskyites (like all of the other statist and funny money "schools") completely ignore and suppress the nature of this process and dishonestly label the whole thing "capitalism".

Review the first paragraph of Minsky's paper "The Financial Instability Crisis" which completely ignores the aforementioned price distortions:

The financial instability hypothesis has both empirical and theoretical aspects. The readily observed empirical aspect is that, from time to time, capitalist economies exhibit inflations and debt deflations which seem to have the potential to spin out of control. In such processes the economic system's reactions to a movement of the economy amplify the movement--inflation feeds upon inflation and debt-deflation feeds upon debt-deflation. Government interventions aimed to contain the deterioration seem to have been inept in some of the historical crises. These historical episodes are evidence supporting the view that the economy does not always conform to the classic precepts of Smith and Walras: they implied that the economy can best be understood by assuming that it is constantly an equilibrium seeking and sustaining system.

Of course, private citizens are fools to be continuously misled by distorted and unsustainable prices induced by the central banking system. But how does that help the Minskyites who join in with suppressing any discussion of the true cause of the problem in the first place? In fact, the Keynesians and other statist schools have been relentless in pursuing the same suppression of any notion of central bank induced price distortions.

I fail to see how the Austrians have been refuted because their analysis has been so effectively suppressed and obscured from public understanding. I fail to see how the Minskyites are vindicated since their vision is based upon their continuous suppression of Austrian analysis.

Well said. The banana analogy is lame because it places the blame for the recession (roofs collapsing) on the stupidity of market participants. People would really have to be unbelievably stupid to pile so many bananas on their car roofs. The ABCT in no way claims that borrowers in the market are just plain stupid.

The ABCT states that prices are the primary guides for market participants. When the government distorts prices in the way central banks do, the pricing signals persuade rational people to make mistakes in planning. They don't learn from those mistakes because mainstream economists like Cowen have convince them that the ABCT is wrong. No one causes recessions; they are random events like tornadoes. Mainstream business cycle theory is @#$% happens!

Plenty of research has shown that people take greater risks when interest rates are low. The lower the rates the greater risks they take. The Fed depends on that behavior because if it didn't exist their loose monetary policy would not work. The Fed will reduce real rates below zero if necessary to lure someone into borrowing. The obvious fact that their policies have failed miserably for the past five years is some evidence that people are catching on to the ABCT.

For more non-Austrian evidence for the ABCT, see the work of Bario at the BIS.

"They don't learn from those mistakes because mainstream economists ... have convince [sic] them than ABCT is wrong."

But won't a few entrepreneurs figure this out and exploit it for a profit? And then won't the others follow? I thought the main criticism of ABCT is that it's just too implausible to believe that entrepreneurs all make exactly the same mistake at the same time.

Minsky, while personally on the Left, raised issues that apply to any analysis of macro phenomena and that have been incorporated by many economists who favor a market economy. Look at the references in the Baron and Xiong paper.

Amateur Austrians like to think that you can make meaningful statements about economics by saying the words "distort" and "artificial" a lot.

Take some random words, arrange them into some sort of sentence, then add the words "distort and "artificial" at regular intervals. You now have your own amateur Austrian theory of booms and busts. Now copy this sentence and paste it all over the internet, repeating this as many times as you feel like. If anyone points out that your sentence doesn't mean anything, just ignore them and keep pasting. For an authentic amateur Austrian experience you should also be feeling constantly angry, self-righteous and confused whilst doing this.

"The lower the rates the greater risks they take."

Are you aware that this is not the ABCT?

If lots of people buy stuff with newly created funny money, they will bid up the price of that stuff. In fact, THAT'S THE EXPLICITLY STATED PURPOSE OF THE ENDEAVOR BY THE KEYNESIANS THEMSELVES, smart guy. The result will be sales and prices that would not exist but for the government managed cartelized central bank system and which will only continue to exist so long as additional new funny money emissions continue to temporarily maintain those false prices. Further, it is this simple explanation of self-evident phenomena that is completely ignored and suppressed by all Keynesian analysis, including Minsky.

Some anti-Austrians are better than others at obfuscation of simple and self-evident facts. Philippe and Mr. Cowen are worse than others.

You seem unaware that the process also allows for and facilitates the mass transfer of wealth to the 1%:

David Stockman: In the case of progressive Democrats, the betrayal is even more insidious. Hooked on the non-sensical Keynesian doctrine that borrowing is good and saving is bad, the so-called progressives have been a sucker for the Fed’s regime of lower interest rates, forever longer. That this regime leads to financial repression and preposterously low “cap rates” throughout financial markets seems to escape their grasp entirely; and that rock-bottom cap rates cause drastic over-valuation of financial assets and massive windfalls to the capital owning speculative classes—does not even remotely register.

By the 2012 election this bipartisan farce had reached an extreme. Obama ran against the 1% even though the Fed, now packed with money printers he had appointed, showered the upper strata with the greatest unearned windfall in recorded history. Worse still, his opponent was a certified member of the 1%—yet didn’t have a clue as to how he got there.

I believe Tyler has thrown a golden banana into the room inscribed with the word 'kallisti'.

ABC theory is a lot like AGW theory: a perfectly respectable and valid theory, but proponents promote models with little predictive power because they credit the theory's effects with inappropriate puissance. Missing hyperinflation and missing temperature increases have turned opinion mainly against, but proponents accept little blame for bad predictions.

Seeing that I, for one, did not predict hyperinflation in 2009 and believed the new funny money would go to prop up deflated asset prices, your point is not well taken. Follow the funny money.

Kudos to you, Bob. May your perspicacity be rewarded, and also that of those unheralded climate scientists who haven't been crying doom.

They also didn't predict the stagnant job growth. They predicted a boom followed by a big bust. 6 years later no boom and no bust.

That is nonsense. Back in 2009, Robert P. Murphy for one and many others (and I agreed) that the super low interest rates would lead to years and years of perpetual stagnation. They have. We were right for exactly the right reason.

Ah yes, the no true Scotsman fallacy. Plenty of ABCers predicted inflation in 2009. Everyone from Ron Paul to Peter Schiff:

The best part about you ABC guys is that you think the internet doesn't remember and if you lie enough we will forget just how wrong you are.

Some Austrians predicted more inflation than did others. That is not an indictment of Austrian concepts or analysis which is obviously beyond the scope of your tiny mind. These were nothing more than predictions of what policies would be pursued by the powers-that-be. Few people predicted that the American people would sit around like sheep for five years while it was official policy to forbid funny money loans to "main street". Still, inflation had been much higher than is officially acknowleged and the only result of it has been more theft of purchasing power and more unsustainable price distortions.

That's an interesting notion Bob, but nominal rates do not define the stance of monetary policy. Low nominal rates can also reflect low long-term inflation expectations, something predicted by Fisher and Friedman and observed in Japan since the early 1990s.

Interestingly, the best argument against understated inflation that comes from the left, who have lately been complaining that 1930s minimum wages would be something around $15. This is clearly absurd given any reasonable comparison of living standards, and strongly suggests inflation is vastly overstated.

Hedonics is too much like guesswork, but to the extent a highly subjective multivariate multidimensional concept can be boiled down to one number, the number they're using is probably not too low. Obviously there are political stakeholders who benefit from overstated CPI.

Slightly off topic: Benny talks as if inflation is not going to come eventually. I mean, the supply of money has increased a lot, and inflation has not YET arrived because ---correct me if I am wrong --- demand for money also went up. But do you expect demand to stay this high forever?

How exactly do Austrians justify saying things like 'interest rates are low'? Low compared to what? What *should* interest rates be? If the boom was caused by 'too low' interest rates then why were nominal rates, both short and long term, much higher before the boom than after?

But change "bananas" to "flood insurance" and it is clearly a case of government failure: subsidies lead to building on flood plains, building on flood plains lead to disaster. Won't you reconsider your banana point?

Diaster maybe on the microscale but not the maco one.

Imagine some rich person likes living near the water so much that he insists on building his house there. When the flood comes he drys out and rebuilds because, darnit, it's his money and that's what he likes.

The result of this irrational rich person is that building materials may become a bit more expensive than they otherwise would have been. Houses away from the flood plain are a bit less valuable (since they don't appeal to the rich person to buy). Various other industries that might be a bit larger had the rich person less eccentric tastes are smaller than they otherwise would have been.

We get it, you like Urban Dictionary.

Or perhaps Chicken Brickin'.

Wow, the comments have really gone downhill. Were this my blog, I would be going through the comments with a banhammer.

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