Robert Skidelsky: Lecture 1: The Anatomy of the Crisis

Another video of Robert Skidelsky, a British economic historian and the author of the best biography of John Maynard Keynes in existence. Skidelsky’s Keynesian economic ideas have also converged with Post Keynesian economics over the years.

Here he gives lecture 1 of a series at the University of Warwick on economics. This lecture is an analysis of the financial crisis of 2008 and how orthodox neoclassical economics brought the world to this catastrophe.

Austrian Business Cycle Theory: Its Failure to explain the Crisis of 2008

The Austrian business cycle theory (ABCT) is a credit-based explanation of the business cycle used by Austrian economists. ABCT has, however, come in different forms and was developed over many years by Mises, Hayek, Rothbard and more recently by modern Austrians like Roger Garrison. It is not monolithic, and some Austrians like Israel M. Kirzner have even criticised Hayek’s development of ABCT as not entirely consistent with Mises’ exposition in 1912. Here are some of the major works by Austrians where different forms of the ABCT are expounded:

(1) The version of Mises in Human Action: A Treatise on Economics (Auburn, Ala., 1998), pp. 568–583.

(2) Hayek’s first version of ABCT in Prices and Production (London, 1931). After Nicholas Kaldor’s attack on it in “Capital Intensity and the Trade Cycle” (Economica n.s. 6.21 (1939): 40–66), Hayek had to re-write his theory.

(3) Hayek’s second version of ABCT in Profits, Interest and Investment (London, 1939).

(4) M. Skousen’s new interpretation in The Structure of Production (New York, 1990).

(5) Gerald P. O’Driscoll and Mario J. Rizzo in The Economics of Time and Ignorance (Oxford, UK, 1985), pp. 198–213.

(6) More recent developments of ABCT, as in Roger Garrison’s Time and Money: The Macroeconomics of Capital Structure (London and New York, 2000).

It should be noted that ABCT is not monolithic. But the historical essence of the theory is fairly clear:

“ABCT is unique in including real capital goods among its elements in a manner which does not assume away their essential heterogeneity ... The theory demonstrates the connection between this structure of capital and monetary policy by way of Wicksell’s natural rate of interest theory and Mises’s integration of money into general economic theory” (Batemarco 1998: 216)

However, both Ludwig Lachmann and Joseph Schumpeter did not think that Hayek’s business cycle theory could be used to explain all business cycles (Batemarco 1998: 222). More importantly, Israel M. Kirzner has also made the following remarks on Hayek’s theory:

KIRZNER: I've never felt that the Hayekian business cycle theory was essentially Austrian. In fact, Mises, who was the originator of this whole idea in 1912, didn't see it as particularly Austrian either. There are passages where he notes that people call it the Austrian theory, but he says it's not really Austrian. It goes back to the Currency School and Knut Wicksell. It's certainly not historically Austrian. Further, I would claim that, as developed by Hayek, there are many aspects of it that are non-Austrian. I don't believe that to be an Austrian you have to buy into the Hayekian view of business cycles …. I think the way Hayek developed it was not quite consistent with the way Mises laid it out in 1912 (see “An Interview with Israel M. Kirzner,” Austrian Economics Newsletter, vol. 17.1, 1997).

Kirzner believed that Hayek’s own version of ABCT was “not quite consistent” with Mises’ own theory from his 1912 book The Theory of Money and Credit. So clearly we have to careful about which form of ABCT we are criticising.

In this post I will analyse what appears to me to be the most important form of ABCT: the form postulating distortions in the capital goods sector (for a good summary of this form of ABCT, see Garrison 1997: 23–27), and how this simply cannot be invoked as a serious or fundamental explanation of the US housing boom in the 2000s and financial crisis of 2008.

In his popular pamphlet Economic Depressions: Their Cause and Cure written in 1969, Rothbard sets out a form of ABCT which seems typical of the general form of it . He points to malinvestments in capital goods by businesses as the fundamental cause of recessions:

“And there is a third universal fact that a theory of the cycle must account for. Invariably, the booms and busts are much more intense and severe in the “capital goods industries”—the industries making machines and equipment, the ones producing industrial raw materials or constructing industrial plants—than in the industries making consumers’ goods” (Rothbard 2009 [1969]: 32–33).

“But what happens when the rate of interest falls, not because of lower time preferences and higher savings, but from government interference that promotes the expansion of bank credit? …. What happens is trouble. For businessmen, seeing the rate of interest fall, react as they always would and must to such a change of market signals: They invest more in capital and producers’ goods. Investments, particularly in lengthy and time-consuming projects, which previously looked unprofitable now seem profitable, because of the fall of the interest charge. In short, businessmen react as they would react if savings had genuinely increased: They expand their investment in durable equipment, in capital goods, in industrial raw material, in construction as compared to their direct production of consumer goods” (Rothbard 2009 [1969]: 32–33).

“The problem comes as soon as the workers … begin to spend the new bank money that they have received in the form of higher wages. For the time-preferences of the public have not really gotten lower; the public doesn’t want to save more than it has. So the workers set about to consume most of their new income, in short to reestablish the old consumer/saving proportions. This means that they redirect the spending back to the consumer goods industries, and they don’t save and invest enough to buy the newly-produced machines, capital equipment, industrial raw materials, etc. This all reveals itself as a sudden sharp and continuing depression in the producers’ goods industries. Once the consumers reestablished their desired consumption/investment proportions, it is thus revealed that business had invested too much in capital goods and had underinvested in consumer goods” (Rothbard 2009 [1969]: 34–35).

In this short book, Rothbard says nothing about reckless lending by banks to people for mortgages, nothing about asset bubbles, and nothing about financial crises. The crisis that Rothbard postulates begins with a bust in “producers’ goods industries.” Rothbard also discussed ABCT in Man, Economy, and State (2004 [1962]: 994–1008). In a most extraordinary passage in Man, Economy, and State, Rothbard says this:

“What happens, however, when the increase in investment is not due to a change in time preference and saving, but to credit expansion by the commercial banks? …. What are the consequences? The new money is loaned to businesses.¹¹⁰ These businesses, now able to acquire the money at a lower rate of interest, enter the capital goods’ and original factors’ market to bid resources away from the other firms. At any given time, the stock of goods is fixed, and the [new money is] … therefore employed in raising the prices of producers’ goods. The rise in prices of capital goods will be imputed to rises in original factors. The credit expansion reduces the market rate of interest. This means that price differentials are lowered, and … lower price differentials raise prices in the highest stages of production, shifting resources to these stages and also increasing the number of stages. As a result, the production structure is lengthened. The borrowing firms are led to believe that enough funds are available to permit them to embark on projects formerly unprofitable.

[footnote]
¹¹⁰ To the extent that the new money is loaned to consumers rather than businesses, the cycle effects discussed in this section do not occur. (Rothbard 2004 [1962]: 995–996).

After this, Rothbard (2004 [1962]: 996–1004) expounds ABCT in its usual form. But his footnote has profound significance: “[to] the extent that the new money is loaned to consumers rather than businesses, the cycle effects discussed in this section do not occur.” In other words, the mechanisms causing recession or depression as postulated by his version of ABCT did not occur if the money is mainly loaned to consumers! ABCT assumes that newly created credit money is mainly loaned out to businesses (causing malinvestments in capital goods), and not to consumers to a significant degree.

In this case, we can already see that Rothbard’s version of ABCT cannot be a serious explanation of the housing bubble in the 2000s and the financial crisis of 2008.

It is claimed by some that Austrians economists predicted the crisis, and while it is true that some Austrians correctly identified the housing bubble, they were hardly alone. J. Tempelman in the Quarterly Journal of Austrian Economics states

“[to] be sure, a financial crisis of sorts had also been forecast by many non-Austrian economists, such as Nouriel Roubini and Stephen Roach ... [William R. White] and other Austrians, on the other hand, were more precise in predicting that a crisis would be triggered by a collapse of an asset bubble, specifically the real estate bubble” (Tempelman 2010: 5).

The idea that Austrians were the only ones holding a “more precise” view just isn’t true. There were also heterodox and Post Keynesian economists who were just as “precise” as some Austrians in predicting a financial crisis caused by a housing bubble and excessive debt. The most obvious example is the Post Keynesian Steve Keen of the University of Western Sydney (Australia), who from 2006 was predicting a major financial crisis (see Steve Keen, “‘No-one saw this coming’ Balderdash!” July 15th, 2009, Debtwatch.com).

Moreover, Dirk Bezemer, Professor of Economics at the University of Groningen (Netherlands), has also done a survey of economists and economic commentators trying to establish who predicted the crisis by looking at those with (1) a serious economic model that was used in analysis, (2) predictions that went beyond identifying the property bubble to the implications for the real economy, (3) predictions on the public record, and (4) correct estimates of the timing of the crisis (see Dirk Bezemer, “‘No One Saw This Coming’: Understanding Financial Crisis Through Accounting Models,” Groningen University, 16 June 2009). Here is Bezemer’s list:

Forecast date: 2005
Fred Harrison, UK, Economic commentator

Forecast date: 2006
Dean Baker, US, Co-director, Center for Economic and Policy Research (in August 2002, he also appears to have predicted the housing bubble);

Michael Hudson, US, Professor, University of Missouri;

Steve Keen, Australia, Associate professor, University of Western Sydney;

Jakob Brøchner Madsen, Denmark, Professor, Copenhagen University;

Robert Shiller, US, Professor, Yale University;

Nouriel Roubini, US, Professor, New York University;

Kurt Richebächer, US, Private consultant and investment newsletter writer;

Forecast date: 2007
Wynne Godley, US, Distinguished scholar, Levy Economics Institute of Bard College;

Eric Janszen, US, Investor and iTulip commentator;

Peter Schiff, US, Stock broker, investment adviser and commentator.

Now of these eleven commentators and economists:

(1) Five (45%) are Post Keynesians (Baker, Godley, Hudson, Keen, Sorenson);

(2) Two (18%) are basically maverick neoclassicals (Roubini and Shiller);

(3) Two (18%) are in the Austrian tradition (Richebächer and Schiff).

(4) One (Fred Harrison) calls himself as a Georgist (a follower of Henry George)

(5) One is a combination of Austrian and Post Keynesian (Janszen).
(on the classifications, see Barkley Rosser, J. “Did Heterodox Economists Do Better At "Calling It" Than Mainstream Ones? August 28, 2009).

So in other words eight (72%) of the eleven made accurate predictions about the bubble and crisis and were non-Austrians. The largest group (45%) were actually Post Keynesians.

The claim that Austrians were the only ones to predict the crisis of 2008 is pure nonsense. Moreover, just because some Austrians correctly called the housing bubble, it simply does not follow that ABCT has been vindicated. Many other economists from different schools also called the housing bubble and a financial crisis. Are we, for example, to say that because Fred Harrison correctly predicted a housing bubble that his actual Georgist economics is therefore proven right? This simply does not follow, nor does it follow that Austrian economics is correct, merely because some Austrians identified the housing bubble as Harrison did.

In 2001–2008, excessive debt and reckless lending to individuals in a system of ineffective financial regulation was a major factor. This has nothing to do with entrepreneurs making malinvestments in capital goods that shift output into the more remote future, as in ABCT.

In the housing bubble, loans were made to people who clearly were unlikely to pay them back. Debt was used bid up asset prices in property, allowing yet more debt (via refinancing) for purchasing of commodities (whether durable or non-durable). ABCT in the form examined above does not explain this process. Another fundamental factor in the crisis of 2008 was the emergence of exotic financial instruments like collateralised debt obligations (CDOs), including asset backed securities and mortgage backed securities.

When the housing bubble collapsed, defaults on mortgages rose, causing losses to investment banks and other financial institutions holding mortgage backed securities. The financial crisis of 2008 led to a freezing up of interbank lending and a liquidity crisis, which then went global. The resulting effects spread to the real economy severely exacerbating the US recession that had already begun in December 2007. This series of events is best explained by the Keynesian Hyman Minsky’s financial instability hypothesis.

ABCT in the form examined above with its emphasis on malinvestments in the real capital goods sector is not an even remotely relevant explanation of 2000s boom and bust, and the 2008 global financial crisis.

BIBLIOGRAPHY

Batemarco, R. J. 1998. “Austrian Business Cycle Theory,” in P. J. Boettke (ed.), The Elgar Companion to Austrian Economics, Elgar, Cheltenham, UK. 216–336.

Cowen, T. 1997 Risk and Business Cycles: New and Old Austrian Perspectives, Routledge, London.

Garrison, R. W. 1997. “Austrian Theory of Business Cycles,” in D. Glasner and T. F. Cooley (eds), Business Cycles and Depressions: An Encyclopedia, Garland Pub., New York. 23–27.

Garrison, R. W. 2000. Time and Money: The Macroeconomics of Capital Structure, Routledge, London and New York.

Hayek, F. A. von, 1931. Prices and Production, G. Routledge & Sons, Ltd, London.

Hayek, F. A. von, 1935. Prices and Production (2nd edn), Routledge and Kegan Paul.

Hayek, F. A. von, 1939. Profits, Interest and Investment, Routledge and Kegan Paul, London.

Hülsmann, J. G. 2001. “Garrisonian Macroeconomics,” Quarterly Journal of Austrian Economics, 4.3: 33–41.

Kaldor, N. 1939. “Capital Intensity and the Trade Cycle,” Economica n.s. 6.21: 40–66.

Kaldor, N. 1940. “The Trade Cycle and Capital Intensity: A Reply,” Economica n.s. 7.25: 16–22.

Kaldor, N. 1942. “Professor Hayek and the Concertina-Effect,” Economica n.s. 9.36: 359–382.

Kirzner, I. M. 1994. Classics in Austrian Economics: A Sampling in the History of a Tradition, William Pickering, London.

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

Mises, L. von, 1953, The Theory of Money and Credit (trans. H.E. Batson), J. Cape, London.

Mises, L. 1996 [1949]. Human Action: A Treatise on Economics (4th rev. edn), Fox and Wilkes, San Francisco.

Mises, L. 1998 [1949]. Human Action: A Treatise on Economics, Ludwig von Mises Institute, Auburn, Ala.

Rothbard, M. N. 2004 [1962]. Man, Economy, and State: A Treatise on Economic Principles, Ludwig von Mises Institute, Auburn, Ala.

Rothbard, M. 2008 [1985]. What has Government done to our Money? Ludwig von Mises Institute, Auburn, Ala.

Rothbard, M. 2009 [1969]. Economic Depressions: Their Cause and Cure, Ludwig von Mises Institute, Auburn, Ala.

Schumpeter, J. A., 1939. Business Cycles (2 vols), McGraw-Hill, New York.

Skousen, M. 1990. The Structure of Production, New York University Press, New York.

Sraffa, P. 1932. “Dr. Hayek on Money and Capital,” Economic Journal 42: 42–53.

Tempelman, J. 2010. “Austrian Business Cycle Theory and the Global Financial Crisis: Confessions of a Mainstream Economist,” 13.1: 3–15.

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