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.


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