Bolded = Emphasis Mine
There are two problems with the ABCT:
- It’s incomplete
- It puts too much emphasis on the central bank
Let’s start with the first one.
Most of you have probably heard how the theory goes since Austrians tend to recite it non-stop. Essentially it goes like this.
- The Central Bank artificially lowers the interest rate below it’s natural rate causing a boom
- The structure of production is distorted as the excess credit is put towards investment which doesn’t reflect present time consumer demand
- The boom comes to an end once the investments fail to make their returns
- The economy contracts as capital goods have to be liquidated and as the structure of production adjusts itself.
But just to nuance this a bit more, Roger Garrison explains it like this:
The Austrian theory of the business cycle is a theory of the unsustainable boom. Its logic is firmly anchored in the notion that the price system is a communications network. A miscommunication in the form of an interest rate held below its market, or “natural,” level by central-bank policy sets the economy off on a growth path that is inherently unsustainable. Given actual consumer preferences and resource availabilities, such a policy-induced boom contains the seeds of its own undoing. The temporal pattern of resource allocation is inconsistent with the preferred pattern of consumption. In time this inconsistency precipitates a bust.
It is too often forgotten that the ABCT only really describes the boom. Garrison never explains how exactly the bust will play out and neither does he posit that the ABCT can. As far as we know, the bust is caused when malinvest from the boom period turn unprofitable. Steve Horwitz explains:
It shows that if a boom is set in motion by overly expansionary monetary policy, then the apparent growth taking place during that boom will not be sustainable. The artificial boom contains the seeds of its own bust, and the illusory growth will soon be revealed as such… it tells us nothing about exactly when the boom will break or the precise factors that will cause it. The theory claims that eventually costs will rise and make it clear that the longer-term production processes falsely induced by the boom will not be profitable, leading to their abandonment. But it says nothing about which projects will be undertaken in which markets and which costs (other than perhaps the loan rate of interest) will rise, and it tells us nothing about the timing of those events. We know they have to happen, but the where and when are unique to each business cycle.
Once the cycle reaches its turning point, ABCT tells us little to nothing about how the bust will play out. The theory gives us good reason to think that further inflation and interventionist attempts to prevent the necessary reallocation of resources will make matters worse, but that’s about it. The ABCT is not a theory of the causes of the length and depth of recessions or depressions but a theory of the unsustainable boom. It is a theory of why we are in a recession in the first place, not a theory of how long or how deep a particular recession will be.
If the ABCT is a theory of an unsustainable boom generated by an excess supply of money, then a recession caused by other factors — for example, a monetary deflation — would not invalidate the ABCT. Put differently, the ABCT is a sufficient explanation for a recession, but it is not a necessary one. Not every recession requires the ABCT as an explanation, nor can the ABCT explain everything about any particular recession.
The last sentence is particulary important since the ABCT can’t be a true theory of business cycles if it can only explain one kind, unsustainable booms. Even then, it only explains half of the cycle. A business cycle theory must describe the boom and the bust.
But advancements in the Austrian theory have been hindered by zealous hatred of central banking. Too often Austrians (wrongly) put the principal instigator of the ABCT as the central bank. While they can (and very often do) play an important part of it, we’ll have to bring in other factors to center of attention to gain a more comprehensive view of economic fluctations.
To do this, we must look to other theories that complement and supplement the ABCT. Namely; Monetary Disequilibrium Theory, Patterns of Sustainable Specialization and Trade, and Financial Instability Hypothesis.
Yeager and the Austrians
Monetary disequilibrium theorists have probably enjoyed the most fruitful dialogue with Austrians out of this list. Virginian Political Economists like George Selgin, Steve Horwitz, and many more have formulated a theory of free banking by conjoining monetarist and austrian ideas. Mutual amity is further bolstered by the fact that Leland Yeager, the most famous Disequilibrium theorist, was recognized as a Distinguished Professor at the Mises Institute and is now a emeritus professor for them.
MDT is a monetarist theory that states that recessions are caused by “an excess demand for money, in the sense that people want to hold more money than exists” (The Fluttering Veil pg 3). For a more detailed analysis, read my Cash Balance Theory post.
In this example, the central bank increases the money supply (MS) when there’s no increase in the demand for money (MD). Equilibrium (E) first shifts to disequilibrium (E*). People now hold more money than they would rather have. Eventually people will use their excess cash to consume and invest, thereby increasing their prices towards a new equilibrium (E’). Note that as the nominal interest rate for money (i) falls the price level increases.
A recession would just work in the opposite direction. MS would shift to the left and now people want more cash. So they’ll cut their spending and investment to do so, thus increasing the nominal interest rate. On an aggregate supply/demand graph, this will reflect a negative AD shock and a lower price level.
The similarity between MDT and ABCT couldn’t be clearer. Both give an account of inflationary booms caused by expansion of the money supply from the central bank. Even better, MDT shows us what the economy looks like during a bust. However Garrison believes there are significant differences between the two.
Axel Leijonhufvud has made headway toward our understanding of macromaladies and of competing theories about them by creating a useful taxonomy. Basic categories are defined in terms of (1) the nature of the disturbance and (2) the nature of the failure of the economy to adjust to the disturbance. The two “natures” are then categorized as “n” (for nominal) or “r” (for real).
This approach gives rise to a two-way taxonomy, which can be symbolized as n/n, n/r, r/n, and r/r. To illustrate, suppose that there is a general, but unanticipated, shift of preferences on the part of wealth holders to a higher level of real cash balances. This is a real disturbance. Suppose further that there is some difficulty in the pricing mechanism for both inputs and outputs, which impedes the necessary decrease in the general price level. This is a nominal failure. Until the pricing difficulty is overcome, there will be excess supplies of commodities and factors of production on an economywide basis. This macromalady belongs to the r/n category…
Leland Yeager draws attention to a particular sort of disturbance followed by adjustment failure which, in his judgment, is especially relevant for understanding depressions and hence for devising institutional reform aimed at avoiding them. A decrease in the money supply in the face of an unchanged money demand causes the prices of all commodities and factors of production to be above their market-clearing levels. While the market can eventually bring prices into line with the smaller money supply, it cannot achieve a new monetary equilibrium quickly or painlessly. The theory of “monetary disequilibrium”—a term with which Yeager ties his own ideas to those of Clark Warburton —focuses on the difficulties of achieving economywide price adjustments made necessary by a monetary contraction. Clearly, this focus puts monetary disequilibrium theory in the n/n category of Leijonhufvud’s taxonomy…
In [econo-rhythms] business cycles are an inherent part of the market process; in [monetary disequilibria], they are disruptions of the market process. That is, both the lower turning point (the upturn) and the upper turning point (the downturn) are endogenous for those who conceive of business cycles as econo-rhythms and exogenous for those who think in terms of monetary disequilibrium. Contrasting econo-rhythms and monetary disequilibria in this way suggests another, more conventional taxonomy, in which business-cycle theories are categorized on the basis of the exogeneity (X) or endogeneity (N) of the lower and upper turning points [Hansen, 1951, p. 411ff]. The four categories can be symbolized as X/X, X/N, N/X, and N/N, where X/X is monetary disequilibrium theory and N/N is econo-rhythm theory. It is difficult to identify any simple relationship between this taxonomy and the one devised by Leijonhufvud. However insightful his treatment of market adjustments to monetary disturbances, Leijonhufvud never explains how—or suggests that—a boom engenders a bust or vice versa.
The Austrian theory of the business cycle falls squarely into the X/N category. The exogeneity of the upturn is a clear recognition that the economy wide disturbance is inflicted on the market process and is not an unavoidable feature of market economies. The endogeneity of the downturn gives a cyclical quality to the movements in prices and quantities and to certain macroeconomic magnitudes. The Austrian business cycle, then, is less of a cycle than the supposed econo-rhythms, but more of a cycle than sluggish-price monetary disequilibria.
Further, if the Leijonhufvud taxonomy is applied to the entire sequence of events from the initial upturn to the subsequent downturn, then the Austrian theory would fall into the n/r category. As summarized by Fritz Machlup, “monetary factors cause the cycle but real phenomena constitute it.” For Yeager and Leijonhufvud monetary mismanagement precipitates a bust; for Mises and Hayek monetary expansion engenders a boom, which eventually leads to a bust.
So let’s summarize the important parts:
- MDT believes the “nature of disturbances” and that the failure of the economy to adjust to these disturbances are nominal.
- MDT sees the upturn and downturn of the business cycle as exogenous
- ABCT on the other hand sees nature of disturbances as nominal but the failure to adjust as real
- ABCT posits upturns are exogenous and downturns are endogenous
This essay was written back in 1989 and the face of MDT has changed. Today, it’s most prominent representatives are the market monetarists. In formulating a new ABCT, we should look to insights from the likes of Scott Sumner and Lars Christensen; especially since Market Monetarism has many overlaps with the Free Banking school of George Selgin and Larry White.
Another thing to note is that Garrison describes MDT theory as “monetary mismanagement precipitat[ing] a bust” and puts this in contrast to the Austrian theory. But in the aforementioned essay that was written in 2002, he describes the ABCT the same way as MDT. “A miscommunication in the form of an interest rate held below its market, or ‘natural,’ level by central-bank policy sets the economy off on a growth path that is inherently unsustainable… In time this inconsistency precipitates a bust.” So to reiterate, both basically give the same narrative of inflationary booms.
A third issue has to do with the exogeneity of the ABCT. Garrison, as a Hayekian Austrian, inaccurately states that the upturn is exogenous and that business cycles’ aren’t inherent in the market economy. This may come to a shocker to most since Austrians almost always describe the market as being perfect and that government meddling is the cause of all ills. To a great extent the latter is true, however someone with a good understanding of Hayek knows that the former is not. I’ll nuance this more when we discuss Financial Instability Hypothesis (FIH) as this provides an excellent bridge between the two fluctual accounts.
The Importance of Sustainability and Recalculation
Arnold Kling’s business cycle theory is known as Patterns of Sustainable Specialization and Trade (PSST). Kling rejects almost all modern orthodox thinking. Supply and demand, Walrasian equilibrium, production functions, GDP, etc., all go out the window as Kling see’s nothing useful in describing the economy within the modern macroeconomic framework.
Kling instead goes back to the classical economists, namely Adam Smith and David Ricardo:
An important feature of both the Walrasian system and the Keynesian
macroeconomics that followed is that patterns of sustainable specialization
and trade (PSST) are taken as given. The most efficient division of labour for
producing a particular good or service is understood. Everyone’s comparative
advantage is known.
The PSST approach drops the assumption that production technology is known.
Instead, the Smithian division of labour and Ricardian comparative advantage
are constantly being developed and improved. Entrepreneurs, through a process
of trial and error, figure out how best to configure production. In this process of
ongoing discovery, there can be periods in which workers are unemployed, while
the market mechanism tries to figure out how to utilize them
The gist of it all is that the economy is one complex, evolving organism. Workers and capital goods are traded and specialized for certain patterns of production; and these production process can be disrupted by things such as technological innovation, thus causing some labor and capital to be put obsolete and in need of reallocation.
Each year, tens of thousands of new workers enter the labour force. In addition, each month, millions of workers separate from their current jobs. All of these workers need to find jobs. Otherwise, they will just mill around aimlessly, like the workers at a leaderless construction site.
The organization of these millions of workers is undertaken not by a single
general contractor but by the decentralized decisions of entrepreneurs. As they
develop new businesses and expand existing firms, entrepreneurs create new
forms of specialization and comparative advantage. These in turn provide roles
that employ workers…
Ongoing innovation constantly shifts the patterns of specialization and
comparative advantage. Smith’s pin factory has been subjected to waves of
Schumpeterian creative destruction. Ricardo’s simple pattern of comparative
advantage in wine and cloth has given way to far more complex patterns in
which comparative advantage is subtle and sophisticated.
The PSST invokes Hayek’s theory of spontaneous order. The view here is that the marketplace is an ever changing construct of shifting tastes and preferences made by individuals and can’t possibly be efficiently administered by one central body. The latter is the crux of the knowledge problem. As Hayek states:
If we can agree that the economic problem of society is mainly one of rapid adaptation to changes in the particular circumstances of time and place, it would seem to follow that the ultimate decisions must be left to the people who are familiar with these circumstances, who know directly of the relevant changes and of the resources immediately available to meet them. We cannot expect that this problem will be solved by first communicating all this knowledge to a central board which, after integrating all knowledge, issues its orders. We must solve it by some form of decentralization. But this answers only part of our problem. We need decentralization because only thus can we insure that the knowledge of the particular circumstances of time and place will be promptly used.
A second Austrian connection can be made when we examine PSST’s description of entrepreneurial decision making:
If entrepreneurs had to start each day from scratch trying to figure out how
to engage in profitable production, the task would be impossible. What makes
business manageable today is the ability to use yesterday’s configuration as a
baseline. Entrepreneurs assume that what worked yesterday will be approximately what works today…
Experimenting with new patterns of specialization and trade is relatively easy.
Discovering patterns of sustainable specialization and trade is much harder. Our economic well-being depends on the ability of entrepreneurs to make these
PSST states that the entrepreneurs have no clue what to expect the next day. They only assume that has worked thus far will continue to work in the future. In other words, the future is entirely unknowable and totally uncertain. In other words, economic actors have subjective expectations.
The parallel here is to Ludwig Lachmann’s “radical subjectivism.” Lachmann extends the notion of subjective value to say that the re-emergence of a similar set of conditions in the future doesn’t mean that the the same set of prices will re-emerge the way did as in the past. Therefore there is no deterministic relationship between the past and present. Instead, the future is inherently unknown. In the aftermath of the Cambridge Capital Controversy, Lachmann wrote in Reflections on Hayekian Capital Theory that:
Everybody seems to agree today that the stock of capital cannot be measured outside equilibrium, viz. outside entirely artificial conditions. But there are two reasons for it of which we may call one the ‘Ricardian’ or ‘objectivist’, the other the ‘Austrian’ or ‘subjectivist’ reason. We may also say that the one is ‘backward looking’, the other ‘forward looking’. The former rests on the fact that any change in the mode of income distribution, in rate of profit or wage rate, will affect relative prices and thus deprive us of any solid yardstick. It is particularly germane to any view of capital which links the present value of capital resources to their current cost of reproduction, a ‘backward looking’ view…
The second reason rests on the fact that the purpose of all capital, hence also of the current maintenance of existing capital goods, is to secure a future income stream. But the future is unknowable, though not unimaginable, and men have to use knowledge substitutes in order to evaluate future income streams, viz. expectations. Experience shows that different persons will typically hold different expectations about the future income to be expected from the same resource, and that the same person may hold different expectations about the same future event at different points of time. The inevitably subjective nature of all ‘forward looking’ views renders the measurement of capital impossible…
Meanwhile an impious legend has grown up that our inability to measure the stock of capital in the real world was discovered in the Cambridge of the 1950s.
Interestingly enough, Lachmann developed his theory of radical subjectivism by applying Keynes’ theory of subjective expectations.
The highwater mark in Keynesian subjectivism came in Keynes’ 1937 article in which he attempted to explain what his 1936 book, The General Theory, actually meant. Keynes explains, in effect, that the demand for money in the present derives from the uncertainty of our knowledge about the future. And the kind of uncertainty that Keynes is referring to is the kind that Lachmann calls radical uncertainty and associates with radical subjectivism. According to Keynes, as quoted by Lachmann, “We simply do not know”
From the Keynes camp, I accept the view that financial market psychology is variable (animal spirits and all that) and that market economies are unstable.
The Recalculation story can be thought of as an Austro-Keynesian model. It is Austrian in that it emphasizes the role of markets in processing information. During a Recalculation, there is too much information to be processed in too little time. The story is Keynesian in that during the Recalculation there are multiplier effects. Unemployed people cut back on their spending, and that in turn requires further adjustment, including more temporary unemployment.
The Keynesian connection will also be more thoroughly nuanced when we discuss FIH. Turning our attention back to PSST and ABCT, we find a theory that wholly complements each other. Art Carden uses PSST to describe the recalculation process in the Austrian theory:
If the economy is left to its own devices, miscalculations will be corrected and malinvestments will be corrected by a process of recalculation. Firms and households fix their mistakes, and resources are reallocated. Prices that are consistent with the economy’s underlying fundamentals of tastes, technology, and resource availability emerge and guide people toward what Arnold Kling has called “patterns of sustainable specialization and trade.” In other words, physical capital, human capital, and social capital are invested in lines of production that do not compromise a society’s ability to provide for its future wants.
Kling calls his own view a “Recalculation Story” explanation of recessions. According to Kling, after an unsustainable boom period, the economy needs to “recalculate” and figure out where the excess workers (from the bloated sectors) need to go so that the economy can resume a stable, sustainable growth. This is very similar to the Misesian view of the “cleansing” role of recessions. Although not an Austrian himself, Kling does acknowledge that his theory is complementary to the Austrian view…
Kling (and the Austrians) are arguing that this recession is not simply about a lack of generic “spending” but rather is tied to the preceding housing boom. In particular, during the boom, workers were sucked into construction (and other related occupations). Once the housing bubble collapsed, these excess workers needed to go someplace else. That’s why unemployment started rising, and “the recession” set in.
In terms of government policy, Kling (and the Austrians) argue that this is a real misallocation of resources: too much lumber, glass, and yes, labor went into housing during the boom years. In order for the economy to readjust to the new situation, it takes time for workers to leave the housing sector and to match up their skills with the desires of consumers in a more sustainable pattern.
PSST and ABCT share the same essential elements. Unsustainable patterns of production occur during boom years which lead to an eventual bust that causes production to reorganize itself into a more sustainable pattern. The difference is that PSST doesn’t put monetary expansion as the only cause of these fluctuations. PSST can thus gives Austrian theory a more wider picture of the effects of changes in production due to things like trade and technology.
And Now, a Moment for Minsky
Hyman Minsky was a post-keynesian economist who put forth the Financial Instability Hypothesis which argues that financial crises are inherent in capitalism because periods of economic prosperity encouraged borrowers and lender to be be progressively reckless. This excess optimism creates financial bubbles and the later busts. Therefore, capitalism is prone to move from periods of financial stability to instability. His famous quote is:
The more stable things become and the longer things are stable, the more unstable they will be when the crisis hits.
Tejvan Pettinger summarizes the cycle:
- Traditionally, bank lending is secured against assets. The lending is hedged against default. For example, banks lend mortgages if people can raise a deposit and can maintain mortgage payments to repay both the capital and interest. Typically banks would also check strict lending criteria to make sure the mortgage is affordable.
- However, if house prices rise and there is economic growth, both lenders are borrowers become more optimistic and willing to take on greater risks.
- Banks insist on smaller deposits and are willing to lend bigger multiples of income.
- Lending becomes more leveraged.
- The greater lending itself causes asset prices to rise and this increases confidence even further. People keep expecting rising prices – the past becomes the guide to the future.
- We could term these sentiments as ‘Irrational exuberance‘ There is a feeling that the crowd can’t be wrong. If everyone expects asset prices to keep rising, it’s easy to jump on the bandwagon.
- Rather than hedge borrowing (safe secured lending) we see a growth of speculative lending and even ‘ponzi borrowing’. This means banks and financial institutions lend money in the hope that asset prices keep rising to enable repayment. However, the loans of a ponzi nature are unsustainable in the long term.
- Regulatory capture. Regulators who should be insisting on safe lending levels also get caught up in the irrational exuberance. Credit rating agencies make mistakes in allowing speculative and ponzi borrowing.
- However, this asset bubble and speculative lending cannot be maintained for ever. It is based on the unreasonable expectation that asset prices keep rising beyond their real value. When asset prices stop rising, borrowers and lenders realise their position has left them short – they don’t have enough cash to meet their repayments. Everyone tries liquidity their assets to meet their borrowing requirements. This leads to a loss of confidence and credit crunch.
The Minsky moment refers to the point where the financial system moves from stability to instability. It is that point where over-indebted borrowers start to sell off their assets to meet other repayment demands. This causes a fall in asset prices and loss of confidence. It can cause financial institutions to become illiquid – they can’t meet the demand for cash. It may cause a run on the banks as people seek to withdraw their money. Usually, the Minksy moment comes when lending and debt levels have built up to unsustainable levels. It can lead to a balance sheet recession
Post keynesian economics is often lead to policy conclusions that are relatively far left on the spectrum. Principally due to the fact Post Keynesians see the market as too chaotic and in needed of central control (ironically, the same reason why Austrians don’t support central control). Among the CATO Institute economists however, Minsky has always been viewed with much sympathy.
Tyler Cowen, for instance, had this to say:
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.
In the aforementioned excerpt where Kling refers himself as an Austro-Keynesian, he went on to say:
I am comfortable with a Minsky-Kindleberger view. Thus, I reject what I see as the common Austrian view that the only source of instability in the economy is central bank money-printing.
From the Austrian camp, I accept the view that there is not much that government can do about downturns. I view a downturn as a sudden, widespread realization that certain patterns of specialization and trade are unsustainable. We just have to wait for entrepreneurs to sort things out.
Critical things to note about FIH is that:
- The money supply is considered endogenous
- Economic actors have subjective expectations
The latter point has already been elaborated so we’ll return to it later. The former is the most important reason why I wanted to include Minsky.
First let’s define what an endogenous and an exogenous money supply are for those who don’t know.
- Exo- means “external”. When something is exogenous, that means it’s caused by external forces. In the case of the money supply, this would mean that via the money multiplier, the money supply is created by an external monetary institution i.e., the central bank. More specifically, the money supply is a function of the interest set by the central bank, on a graph it is represented as a vertical line just as the one used in the MDT section
- An endogenous view of the money supply is the opposite. The central bank cannot directly control the money supply, only short term rates. Instead, control comes from something inside the market, money demand. Therefore the money supply is actually a function of money demand or in other words, money demand creates money supply.
Minsky takes the latter view. Accordingly, commercial banks are the ones that create money out of thin air (Wray pg. 8; 15):
A commercial bank lends by crediting the borrower with a demand deposit and it invests either by crediting the seller of the security with a demand deposit or by writing a check on itself in favor of the seller of the security. The bank expects that the borrower or the seller of the security credited with a deposit will use their deposit very soon after it is created. This will result in checks being drawn on the initiating bank.
In a banking system with many banks, such as the American Banking System, the expectation is that the checks drawn on any particular bank will be deposited in another bank. The bank upon which the check is drawn must pay the bank in which the check is deposited the face amount of the check. This payment takes place by transferring reserves or banker’s money. In an active trading community offsetting claims for payments arise among the banks. Bankers are sophisticated enough to set up a clearing arrangement so that only the difference between payments from a bank and payments to a bank are made in the form of reserve money. (if a check drawn upon a bank is deposited in the same bank, the entire transaction is internal to the bank: the writer’s account is decreased and the depositor’s account is increased.)
The liquidity obligation of a banker is peculiar. Whereas an ordinary business has dated debts, debts which are not due until a specified date, the essential attribute of a bank is that its liabilities, aside from the owner’s investment, are demand liabilities. The initiative in making a bank’s liabilities current lies with the depositor, the owner of the bank’s liabilities. As a result the banker must always keep sufficient [base money] on hand to meet whatever clearing losses result from depositors’ actions and in case of unexpectedly large clearing losses a banker must be able to replenish his stock of banker’s cash.
The solvency constraint on a banker is more demanding than is true for nonfinancial businesses. A bank has a much greater ratio of assets and hence liabilities to net worth than is true for a nonfinancial business. As the acquisition of most of the banker’s assets is financed by the issuance of the bank’s own debt, demand deposits, a relatively small drop in the value of the bank’s assets will result in the value of the bank’s assets being less than the value of the bank’s demand deposits. This means that banks cannot survive as large a fall in the value of its asset as ordinary business firms can. The only assets a banker will willingly acquire are those that he believes will not fall in market value. A banker’s business makes him conservative. He is willing to give up possible gains from the appreciation of the assets he owns to avoid the losses that would occur if his assets fell in value. As a result banks, a thin equity business, will hold only assets which are believed to be well protected against declines in their value.
The bolded statement shows Minsky clearest statement on money’s endogeneity. He states that banks neither lend their deposits or reserves from the central bank. Instead, new deposits are created as loans and other assets are be acquired. “However, the liquidity of their asset portfolio is substantially less than that of their liabilities—creating a potential liquidity problem—and their leverage ratio is very high because net worth is small relative to assets. In both of these respects, banks are different from other entities that issue liabilities to take positions in assets.”
Recall that Garrison describes the Austrian business cycle as being exogenous/endogenous. This is not the case for Hayek. (Friedrich A. Hayek, Volume 2, pg. 205)
[Robert] Lucas’s monetary business cycle theory contains a refined version of the classical dichotomy. The source of fluctuations is not inherent in his market model, in which money is basically exogenous and neutral. Only erratic changes (shocks) in the money supply have temporary real effects… Hayek, on the other hand, looked for a fully endogenous explanation of the cycle. In his Wicksellian approach, the creation of credit money is a market process that both generates and reverses booms. Endogenous changes in the money supply are a source of impulses to real activity and also a part of the propagation mechanism that annihilates the positive real effects
Allin Cottrell (pg. 4) also states:
Hayek counts his own monetary theory of the cycle as an endogenous theory: the claim is that shifts in expected profitability… inevitable in the development of a capitalist economy, while the money rate of interest necessarily (under the current arrangements) fails to act as an adequate shock absorber in the face of these shifts…
His basic argument is that even in the absence of central bank accommodation,
the private banks will generally be in a position to extend their lending (and hence create deposits) at an unchanged rate of interest, in the face of increased loan demand from optimistic entrepreneurs.
In his words Hayek has the follow to say in his Monetary Theory and the Trade Cycle:
Professor Mises himself… has, in his latest work, afforded ample justification for this view of his theory by attributing the periodic recurrence of the trade cycle to the general tendency of central banks to depress the money rate of interest below the natural rate. Both the protagonists and the opponents of the monetary theory of the trade cycle thus agree in regarding these explanations as falling ultimately within the exogenous and not the endogenous group… It seems to me that this classification of monetary trade cycle theory depends exclusively on the fact that a single especially striking case is treated as the normal, while in fact it is quite unnecessary to adduce interference on the part of the banks in order to bring about a situation of alternating boom and crisis. By disregarding those divergences between the natural and money rate of interest that arise automatically in the course of economic development, and by emphasizing those caused by an artificial lowering of the money rate, the monetary theory of the trade cycle deprives itself of one of its strongest arguments; namely, the fact that the process it describes must always recur under the existing credit organization, and that it thus represents a tendency inherent in the economic system, and is in the fullest sense of the word an endogenous theory.
It is an apparently unimportant difference in exposition that leads one to this view that the monetary theory can lay claim to an endogenous position. The situation in which the money rate of interest is below the natural rate need not, by any means, originate in a deliberate lowering of the rate of interest by the banks. The same effect can be obviously produced by an improvement in the expectations of profit or by a diminution in the rate of saving, which may drive the “natural rate” (at which the demand for and the supply of savings are equal) above its previous level; while the banks refrain from raising their rate of interest to a proportionate extent, but continue to lend at the previous rate, and thus enable a greater demand for loans to be satisfied than would be possible by the exclusive use of the available supply of savings. The decisive significance of the case quoted is not, in my view, due to the fact that it is probably the commonest in practice, but to the fact that it must inevitably recur under the existing credit organization.
It is best to begin our investigation by considering once again the situation of a single bank, and asking how the manager will react when the credit requirements of the customer’s increase in consequence of an all-around improvement in the business situation… Among the factors that determine the volume of loans granted by the bank, only one has changed; whereas previously, at the same rate of interest and with the same security, no new borrowers came forward, now, under the same conditions of borrowing, more loans can be placed. On the other hand, the cash holdings of the bank remain unchanged…
While expansion by a single bank will soon confront it with a clearinghouse deficit of practically the same magnitude as the original new credit, a general expansion carried on at about the same rate by all banks will give rise to clearing-house claims which, although larger, mainly compensate one another and so induce only a relatively unimportant cash drain. If a bank does not at first keep pace with the expansion it will, sooner or later, be induced to do so, since it will continue to receive cash at the clearing house as long as it does not adjust itself to the new standard of liquidity…
By creating additional credit in response to an increased demand, and thus opening up new possibilities of improving and extending production, the banks ensure that impulses towards expansion of the productive apparatus shall not be so immediately and insuperably balked by a rise of interest rates as they would be if progress were limited by the slow increase in the flow of savings. But this same policy stultifies the automatic mechanism of adjustment that keeps the various parts of the system in equilibrium and makes possible disproportionate developments that must, sooner or later, bring about a reaction.
Hayek criticizes Mises (and other exogenous theorists) for putting most of the blame on central banking. He further explains that market competition between bankers can lead to inflationary booms. When demand for loans increases because views of economic prospects brighten, banks make more loans — out of thin air. Despite the increased demand, bankers won’t raise their interest rates due to competition with other banks and because of the fact that the supply of loans to borrowers is almost limitless.
Furthermore, Hayek says that a money rate of interest below the natural rate does not have to be due to a deliberate lowering of the interest rate by the banks. The same result can be achieved by an improvement in the expectations of profit or by a diminution in the rate of saving, which may drive the natural rate (at which the demand for and the supply of savings are equal) above its previous level. If the banks refrain from raising their rate of interest to a proportionate extent, this will enable a greater demand for loans, a demand not backed by an available supply of savings. Unlike most Austrian economists (especially Misesian-Rothbardians), Hayek put more emphasis on profits than on interest rates.
And as the blogger, Lord Keynes shared an excerpt from Prices and Production showing that Hayek has been arguing an endogenous theory in his earliest formulation of the ABCT (emphasis his):
“There can be no doubt that besides the regular types of the circulating medium, such as coin, bank notes and bank deposits, which are generally recognised to be money or currency, and the quantity of which is regulated by some central authority or can at least be imagined to be so regulated, there exist still other forms of media of exchange which occasionally or permanently do the service of money. Now while for certain practical purposes we are accustomed to distinguish these forms of media of exchange from money proper as being mere substitutes for money, it is clear that, ceteris paribus, any increase or decrease of these money substitutes will have exactly the same effects as an increase or decrease of the quantity of money proper, and should therefore, for the purposes of theoretical analysis, be counted as money.
In particular, it is necessary to take account of certain forms of credit not connected with banks which help, as is commonly said, to economise money, or to do the work for which, if they did not exist, money in the narrower sense of the word would be required. The criterion by which we may distinguish these circulating credits from other forms of credit which do not act as substitutes for money is that they give to somebody the means of purchasing goods without at the same time diminishing the money spending power of somebody else. This is most obviously the case when the creditor receives a bill of exchange which he may pass on in payment for other goods. It applies also to a number of other forms of commercial credit, as, for example, when book credit is simultaneously introduced in a number of successive stages of production in the place of cash payments, and so on. The characteristic peculiarity of these forms of credit is that they spring up without being subject to any central control, but once they have come into existence their convertibility into other forms of money must be possible if a collapse of credit is to be avoided.” (Hayek 2008: 289–290).
And from Hayek’s conceptions of capitalist banking, we reach Minsky’s (1986 pg. 280) conclusion:
In a world with capitalist finance it is simply not true that the pursuit by each unit of its own self-interest will lead an economy to equilibrium. The self-interest of banks, levered investors, and investment producers can lead the economy to inflationary expansion and unemployment creating contractions.
We’ve already noted how some of the theories are similar and complementary with each other but there are two remaining things I would to point out
Starting with MDT, you can already expect that there are still some important differences due to the frequent debates between Kling and Sumner. However in the context of Austrian theory, these squabbles become irrelevant. But first the similarity as explained by Don Boudreaux:
The Austrian theory of the business cycle and the monetary-disequilibrium theory favored by my former teacher Leland Yeager, as well as what EconLog blogger Arnold Kling calls the “recalculation” theory… all look beyond conventional aggregates (such as aggregate demand) and focus instead on the incentives and constraints that confront individuals, households, and firms
The principle issue between PSST (and ABCT) with MDT is, as Garrison stated, the former sees downturns as being real shocks while the latter sees it as being nominal (N/R and N/N respectively). The simple solution here is to view upturns caused by nominal disturbances i.e., an excessive increase in the money supply distorts expenditures on consumption and investment, thus causing an unsustainable pattern of production. Once this unsustainable boom comes to a bust, the recalculation of the economy causes a decrease in money demand. In other words, the increase in money demand is a consequence of real problems and Kling agrees.
However the cause of a secondary downturn, or what Hayek called “a secondary depression,” is the result of the failure of the money supply to re-adjust in order to meet demand in equilibrium. In this way the ABCT can be described as N/R/N in instances of secondary depressions. Zahringrer says that:
Disequilibrium theory can augment Austrian business cycle theory in understanding and explaining secondary depressions, as happened during the Great Depression, brought on by a decrease in the money supply. Second, Horwitz claims that in cases of a change in money demand Austrians should be willing to consider the benefits of a change in the money supply, even without a change in the quantity of the money commodity, as a quicker, less painful adjustment than a change in prices and wages.
A second compatibility I see is with Minsky’s Hypothesis and MDT. Both stress the excess demand for cash in downturns. While Yeager points out that this causes a deficiency in consumption and investment, Minsky puts more emphasis on the fact that people are trying to liquidate financial assets more than what financial institutions can provide. Both these descriptions are in completely consistent with each other.
This was a lot so I’m going to summarize everything we need for a new ABCT into short bullet points:
- Inflationary booms are caused by an excess supply of money.
- These inflationary booms cause production to be distorted towards unsustainable patterns of production
- Money is endogenous. Inflationary booms are caused endogenously by an excessive monetary expansion in which the market rate stands below the natural rate.
- It is not that the banks raise money supply, and so the rate of interest falls; it is divergence between the market and natural rates that drives changes in bank lending and therefore the money supply
- Expectations are subjective. People can behave irrationally. As such, causing investors to speculate on unsustainable booms.
- Eventually the boom leads to a bust causing a painful recalculation of production towards new sustainable patterns
- This real shock causes an excess demand for money. At the aggregate level, we see a deficiency in demand.
I spent a week trying to figure out how to translate this into a model and I couldn’t. In fact I’m not sure that anyone can but if you think you got an idea, go for it.
Anyways here’s a reading list of relevant articles (Some that have already been linked throughout this post) and videos for you guys to research more.
Competing explanations of the Minsky moment: The financial instability hypothesis in light of Austrian theory by David L. Prychitko. The Review of Austrian Economics.
Hayek and Monetary Stabilization by Tom Cloughtery
Minsky as the Glue of an Austrian-Keynesian Synthesis? by Daniel Khuen
Everything’s endogenous by Scott Sumner
Endogenous Money IS-LM Model Calls for Paradigm Shift by H. Publius
Monetary Disequilibrium Theory and Business Cycles: An Austrian Critique
Specialization and Trade by Arnold Kling
Boombustology: Spotting Financial Bubbles Before They Burst by Vikram Mansharaman
Money, Banking and Dynamics: Hayek vs Schumpeter by Agnes Festre