Friday, May 31, 2013

Minsky versus ABCT

Two posts here attempt to link Minsky’s financial instability hypothesis and the Austrian business cycle theory (ABCT) in terms of their views on credit and business cycles:
Daniel Kuehn, “A Thought on Minsky and Rothbard that Would Probably Make neither Happy,” Facts and Other Stubborn Things, May 29, 2013.

Jonathan Finegold Catalán, “Minsky v. Mises–Hayek,” Economic Thought, 30 May, 2013.
While both were concerned with the destabilising role of endogenous credit money, I remain sceptical about the attempts to link them.

The Austrian business cycle theory is an equilibrium theory whose concern is with (alleged) real distortions in the capital goods sector of the economy caused by the deviation of the bank rate of interest from the imaginary unique Wicksellian natural rate of interest. The theory also requires unrealistic assumptions about the nature of capital. First, it is doubtful whether most capital goods can be usefully categorised into clear higher and lower “orders” at all, and, secondly, heterogeneous capital can also have a significant degree of durability and substitutability. A capital structure in a capitalist economy where we find some important degree of adaptability, versatility and durability in the nature of capital goods means that the “bust” phase of the Austrian business cycle theory is a grossly unrealistic and unconvincing explanation of any real world contraction.

Furthermore, the ABCT is dependent on a tendency to equilibrium by which the bank rate will return to the imaginary natural rate of interest, and thus clear the real capital goods markets. All these things are simply worthless equilibrium theorising, irrelevant to the real world.

But what is even worse is that the ABCT has little concern with financial crises or asset bubbles, the real world economic phenomena associated with credit booms in poorly regulated financial systems.

In contrast, Minsky’s theory takes account of both financial crises and asset bubbles, and is the superior theory without any doubt. Despite some influence from Schumpeter’s equilibrium theories, Minsky’s financial instability hypothesis does not really require general equilibrium assumptions or effects.

Karen I. Vaughn identified the major failing of modern Austrian theory in this respect:
“Mises never discusses the possibility of systematic speculative error except in the context of his trade cycle theory, in which speculators-investors are misled by improper monetary signals emanating from a fractional reserve banking. Yet if the future cannot be predicted, or as Shackle would say, if the future is created out of the actions of the past, why is it not least conceivably possible for speculative activity to be on net incorrect at least some of the time? Certainly, we have the empirical evidence of speculative bubbles that are endogenous to markets as an example of market instability. One would think that the extent and potential limiting factors that affect such endogenous instabilities would be of great importance for fully understanding market orders, yet it is an issue surprisingly missing in the Austrian literature. Hence, although, we can appreciate the force of Mises’ argument as far as it goes, it seems that a crucial part of the case for the effective functioning of a market economy is missing.” (Vaughn. 1994: 87–88).
Finally, I find Jonathan Finegold Catalán statement here to be priceless:
“From what I understand, Minsky’s position is that credit cycles are self-feeding, as continuing credit expansion is needed to maximize profit. Greater credit expansion implies falling lending standards, in turn increasing the risk of banks’ loan portfolio. From a macro perspective, the greater the credit expansion, the greater the risk of a financial shock. The banking system cannot self-regulate, because there’s no incentive to do so, and therefore the government needs to regulate the industry in a way to achieve an optimal amount of risk.

I don’t find the theory, at least framed in that way, very convincing. First, it’s not clear why growing risk (e.g. a growing probability of loss) doesn’t act as an incentive to restrict a loan portfolio. Second, empirically, there is little evidence that banks disregarded risk.
What? Is there really “little evidence that banks disregarded risk” in the most recent housing market bubble?

I can only conclude that the liar’s loans and NINJA (no income, no job or assets) loans slipped his mind.

As for “growing risk (e.g. a growing probability of loss)” acting as “an incentive to restrict a loan portfolio” one wonders why we have numerous financial crises in history in which banks loaded up on bad assets or pumped out loans to speculators without much interest in restricting their loan portfolios. Australia’s property bubble in the 1880s immediately comes to mind.

Vaughn, K. I. 1994. Austrian Economics in America: The Migration of a Tradition. Cambridge University Press, Cambridge and New York.


  1. I recently wrote a paper on this in relation to the "Is Minsky a loanable funds theorist?" debate which I hope to get published soon (its pretty controversial so it might be hard). Here's the argument I've come up with -- which I think is both solid and very important for a number of different reasons.

    In order to function properly the natural rate of interest theory MUST assume that all interest rates in the economy are at their "natural rate" in equilibrium. That means that ALL interest rates -- from that paid on your mortgage (hello!) to the yield on junk bonds -- must be in line with its equilibrium value. If it is not then malinvestment and inflation will occur under the neoclassical/Austrian theory.

    This happens despite what the central bank rate is. Even if the CB is clever enough to get THE natural rate (on overnight deposits) correct, the rest of the interest rates must also line up with this natural rate. This effectively assume the Efficient Market Hypothesis in strong-form. Think about it. It definitely does.

    The Austrians always fall apart on this. On the one hand they claim that they don't believe in perfectly rational agents and that they believe in Knightian uncertainty. But on the other hand the ABCT suggests that if we abolish the CB or the CB gets the overnight rate "correct" then we will have a stable, full employment economy. Well, they want to have it both ways but they cannot. If they believe in the former then they are strong form neoclassicals of the New Classical school and can be dismissed as highly orthodox. If they believe the latter then capitalism may generate its own terminal instability without any so-called "outside" intervention by governments or central banks.

    Anyway... Minsky rejected the natural rate theory. He saw interest rates as being set through pure speculation in the face of uncertainty. Here is Minsky himself from his book "John Maynard Keynes":

    "In the alternative interpretation, the core of Keynes’ system consists of an analysis of capitalist finance in the context of uncertainty, and of how capitalist finance affects the valuation of items in the stock of capital assets and thus the pace of investment. This core of Keynesian economics is fundamentally inconsistent with the static production function and invariant-preference-system constructs which are the basis of the neoclassical synthesis." (Minsky, H. 1976 pp129)

    And that is the main reason why the two theories differ. It is also why Minsky cannot be a loanable funds theorist. Finally -- and I think that this is the real killer point -- if you adhere to behavioral finance, which many neoclassicals do today, then you cannot believe in the natural rate theory, the Taylor Rule, the idea that the central bank can manage the economy through interest rate policy, and so on. See how important this argument is? Ha!

  2. LK,just wanted to tell you,Bob Roddis ramble incoherent once again over at Mike Norman
    about his bloody "calculation",I don´t understand his point and i don´t think he understand what
    he write either, but here is some directed to you:
    "That is why monstrous liars like “Lord Keynes” and Pilkington and DeLong and Krugman always fail to mention that essential central concept in their inept and dishonest critiques of Austrian analysis" !lol! Well you and Phil at least side a long with Nobel awarded a Princeton professor and a esteemed Berkley Prof !I guess our Bob think that, you, Phil,Paul and Brad is involved i some conspiracy of any kind,maybee a new "gang of four "!Take it as an honor LK!

    1. I am surprised anyone takes Roddis seriously: incoherently rambling is what he does best!

  3. Hey LK,

    You might like this...

  4. See also the following paper: