Wednesday, June 20, 2012

Prychitko on Minsky’s Financial Instability Hypothesis (FIH)

Prychitko has an important article here analysing Minsky’s Financial Instability Hypothesis (FIH) from the Austrian perspective:
Prychitko, D. 2010. “Competing Explanations of the Minsky Moment: The Financial Instability Hypothesis in Light of Austrian Theory,” The Review of Austrian Economics 23: 199–221.
There is some merit in the article, and it is not entirely negative. I have actually enjoyed some of Prychitko’s work in the past (such as Prychitko 1993).

But Prychitko’s own arguments against Minsky have problems as well, some of which I list here:
(1) On p. 218, Prychitko misses the point that effective and careful regulation of the financial markets – the policy actions that stop reckless lending to speculators and that prevent serious asset bubbles before they happen – was already a fundamental Post Keynesian policy prescription long before the 1990s.

Thus Wray’s interpretation of the origins of the 2000s financial crash is in no sense some sudden change in the Post Keynesian explanation of what happened or “post hoc ergo propter hoc reasoning” (Prychitko, p. 218).

Prychitko accuses Wray of misinterpreting “the past decade as a return toward an unhampered market economy.” That is just a straw man: nobody says that the 1980s–2000s saw a creation of some Austrian fantasy world of anarcho-capitalism or Misesian classical liberalism. The point is that the economic system that existed from the 1940s to the late 1970s was modified and attacked by New Classical, monetarist and neoliberal ideologues after about 1980, and was made deeply dysfunctional.

The system was made relatively more laissez faire than what preceded it – not made an “unhampered market economy.”

As for financial deregulation that occurred in these years, the acts that changed the Post-WWII system are easy to list:
Depository Institutions Deregulation and Monetary Control Act (1980)

Garn–St. Germain Depository Institutions Act (1982)
These two acts were major contributors to the Savings and Loan crisis.

Riegle-Neal Interstate Banking and Branching Efficiency Act (1994)

Financial Services Modernization Act of (1999), also called the Gramm-Leach-Bliley Act

Commodity Futures Modernization Act (2000).

The SEC’s Voluntary Regulation Regime for Investment Banks (2004).
(2) It is strange to see Prychitko complain that the FIH is not a general theory of business cycles (p. 220), when even prominent Austrians like Kirzner and Lachmann never thought that the ABCT was a universal theory of cycles either. E.g., here is the opinion of Lachmann:
The Trade Cycle cannot be appropriately described by means of one theoretical model. We need a number of models each showing what happens when certain potential causes become operative. The many models that have been constructed by economists in the past are therefore not necessarily incompatible with each other. Overinvestment and underconsumption theories, for instance, are not mutually exclusive. None of them of course is the true theory of the Trade Cycle; each is probably an unduly broad generalization of certain historical facts. Once we admit the dissimilarity of different historical fluctuations we can no longer look for an identical explanation. In dealing with industrial and financial fluctuations eclecticism is the proper attitude to take. There is little reason to believe that the causes of the crisis of 1929 were the same as those of the crisis of 1873.” (Lachmann 1978:100–101).
Under the sensible viewpoint of Lachmann that the “many models that have been constructed by economists in the past are therefore not necessarily incompatible with each other,” it would seem that Austrians could accept Irving Fisher’s debt deflation theory of depressions or even Hyman Minsky’s development of that theory in the financial instability hypothesis.

See my post here.

(3) Needless to say, Prychitko’s attempt to defend the ABCT (pp. 212–217) doesn’t convince me.

Time preference theory of interest rates is false. Prychitko even uses the imaginary, non-existent natural rate of interest (“To Mises, borrowing from Wicksell, the so-called natural rate of interest has fallen,” p. 213), when even a number of his fellow Austrians (e.g., the later Mises, Hülsmann, and Robert Murphy) are well aware that the Wicksellian unique natural rate does not exist and attempts to found the Austrian business cycle theory on it are flawed:
“Hülsmann on Mises’s Business Cycle Theory,” February 11, 2012.
The US economy already had enormous slack in the early 2000s and the ability to import goods, and there is no reason why credit infusions would cause an unsustainable and serious distortion of the capital structure.

Prychitko also manages to commit the most astonishing distortion of what happened in the 2000s:
“During those years [sc. 2000s], credit-induced demands for new homes caused a doubling of their values—an historically unprecedented event. The housing industry, of course, is a latticework of timely production projects and draws a wide variety of specific (yet complementary) higher-ordered inputs into the housing market.” (p. 215).
But the new housing component of the boom is greatly exaggerated: many of the mortgages in the 2000s were merely refinancing and home equity loans, and the money obtained from the debt not used for new housing construction at all, but to pay credit card debt down or purchase more consumer goods.

Even a Austrian like Robert Blumen understands this:
Robert Blumen, “Fannie Mae Distorts Markets,” Mises Daily, June 17, 2002.
In the 2000s the economic effect of the subprime loans (such as liar’s loans or NINJA loans), where people used their houses as ATMs, was an asset bubble in housing, from which exotic CDOs were created.

The economic effects – essentially caused by consumer loans – are clearly very different from the alleged distortions of capital structure imagined in the ABCT. Even if we assume that alleged unsustainable capital structure distortions occurred, they would have been swamped by effects coming from consumer credit expansion to asset bubble speculation, the financial effects of banks loading up on CDOs, MBSs, and CDSs, and then the financial crisis and debt deflation.

(4) Prychitko complains that the FIH “emphasizes uncertainty, but assumes that interventions designed to reduce systemic risk can actually do so.” In response to this, I would say that well-designed government interventions can reduce economic uncertainty:
“How Can Government Overcome Uncertainty?,” October 4, 2011.

Lachmann, L. M. 1978. Capital and its Structure, S. Andrews and McMeel, Kansas City.

Prychitko, D. 1993. “After Davidson, Who needs the Austrians: Reply to Davidson,” Critical Review 7.2–3: 371–380.

Prychitko, D. 2010. “Competing Explanations of the Minsky Moment: The Financial Instability Hypothesis in Light of Austrian Theory,” The Review of Austrian Economics 23: 199–221.


  1. Yeah thanks LK... This paper, if summarized in one sentence, is basically looking at the FIH through the scope of the ABCT. How unfortunate, but I do think point 4 is key, though I haven't read your post on this, I will when I have time.

    But simply put: how can you say that Government reduces uncertainty if you admit to 1) ontological uncertainty 2) non ergodicity and 3) transmutability?

    I have written on this here:

    Uncertainty and How it Works in Economics
    Uncertainty…Round 2

  2. (1) would you agree that not all systems face uncertainty in the Knightian sense? For example, playing roulette involves risk, not uncertainty. Therefore what we talking about is: how does government reduce uncertainty in that specific system we call the economy.

    (2) The economy might be conceived, as Paul Davidson does, as a nonergodic stochastic system.

    But when you introduce an intervention to influence the state of a nonergodic stochastic system, that process and outcome is not in the same ontological category as the future of that system, without intervention.

    For example, the value of shares of a company is uncertain. But what if the Treasury bought up a considerable part of the stock of a certain promising company, making the shares scarce, announcing it will even support the value of the shares into the future, promising a floor below which the price will not fall. It has reduced uncertainty.

    So too when aggregate demand is expanded by means of fiscal policy, and companies see the volume of sales orders rising, their uncertainty about future sales has been reduced - and they engage in employment hiring decisions and capital investments.

    Think of long term climate, as a more different category. It may well be a nonergodic stochastic system. Yet into the future, it is entirely possible that - with advanced enough technology - we could use technology to control weather or climate - preventing an ice age, for example.

  3. Just to turn your attention to my comment on Isaac's second post on uncertainty - I think it's relevant to discussions of how 'governments' can reduce uncertainty and the faulty framing this discussion often suffers from.

  4. I'll respond to you next week LK, I am busy at the moment.

    But yes, uncertainty does not apply to everything. A game of roulette is a game of risk because there is a fixed number of solutions and the data is the same. But the game turns into a game of uncertainty if the data constantly changed, in which the data is not so straight forward which in turn suggests different interpretations of the same data.

    " Yet into the future, it is entirely possible that - with advanced enough technology - we could use technology to control weather or climate - preventing an ice age, for example."

    This is a key analogy I think because it sets the differences in our way of looking at uncertainty. Sure technology of this kind may fix some problems we have presently but this does not mean it reduced uncertainty, what of the change of data? Can it not be at least equally possible that this solution leads to even further problems, and maybe bring more problems than we had before? This is what essentially Shackle's point when he states that uncertainty "goes beyond the reach of legislation or improvement of organization and technology "

  5. Shackle on the article Keynes wrote in the Quarter Journal of Economics:

    "Something immeasurably more fundamental, more general, more completely beyond the reach of legislation or improvements of organization and technology, had emerged from his work and raised itself above the mists like a mountain from which we have retired. This was the existence of an uncertain, an unknown future."

    G. L. S. Shackle, The Years of High Theory: Invention and Tradition in économic Thought 1926-1939, p. 135.

    I have to say I do not think by these words Shackle was condemning government intervention to stabilise an economy: for throughout his life he was clear that he did support Keynesianism:

    AEN: If one takes that position, then a question could be asked of you: Given what you have said, what should economists do?

    SHACKLE: I think they should give up giving advice, except on the most hesitant, the most broad grounds. I think they should introduce an ethical element, a more than ethical element. If a man is asked whether public expenditure should be cut or not, he perhaps should say, “Well, if we cut it, we shall cause a great deal of misery; if we don’t cut it, we don’t know what the consequences will be, but we can’t at least have this misery on our consciences”. This sort of argument is not an economic argument, it’s an argument with one’s conscience.

    For very many years I’ve not believed in welfare economics as a scientific construction. My idea of welfare economics is that you choose an administrator, a man with a conscience himself, and broad sympathy, with a generous mind and then you say, “Leave it to him!” I don’t believe you can do any better.

    original interview:

  6. I think it Is reasonable to conclude that the passage was talking about radical uncertainty. That's how I make sense of that passage. Also I am not condemning intervention in itself, all i am saying is that there is uncertainty everywhere. This is something that needs to be recognized by both free and mixed marketeers

    1. (1) yes, of course it is talking about "radical uncertainty." I am not disputing that.

      (2) What I am saying is that nevertheless Shackle thought that Keynesian intervention was morally justified:

      “Well, if we cut it [public expenditure ], we shall cause a great deal of misery; if we don’t cut it, we don’t know what the consequences will be, but we can’t at least have this misery on our consciences”.

      I would depart from Shackle by saying that I think there are also (1) economic arguments for Keynesianism, and (2) arguments for how the government can lessen uncertainty too.

      (3) Also, even Lachmann said "The future is unknowable but not unimaginable". Economies do exhibit regularities. Do we really, for example, have no good reason for thinking businesses will continue to chase profits?

      Do we have no reason for thinking that businesses won't suddenly stop all capital goods investment forever?

      That consumers won't suddenly stop buying all consumers goods tomororw?

  7. The Lachmann quote is a sentence of ontological uncertainty. The "unimaginable" part had to do with people's creativity, expectations, and human action. In other words, this is the "transmutable reality" portion of uncertainty.

  8. LK,
    I did another uncertainty post responding to some of your comments :