The Great Recession, which started in 2007 in the US as a financial crisis, was a landmark event. Not merely for its magnitude, representing the largest post WWII global economic downturn, but also for the embarrassment it caused to the great majority of professional economists dealing with macroeconomics. To say it was unexpected would be an understatement – it simply did not fit into any of the mainstream models.
The mainstream consensus (the macroeconomics of the major schools of the new neoclassical synthesis) would predict the economy’s overheating to be signaled by rising labor and resource scarcity, reflected in rising aggregate price levels. The steering wheel of the central bank would react to such overheating by tightening the money supply, avoiding the overheating that could result in a significant bust. As it had, the narrative would go, in the preceding period of The Great Moderation from 1983 to 2007, during which the US economy experienced a period of relative stability with low levels of unemployment, and only short shallow recessions.
However, the US aggregate price levels in the period preceding the financial crisis were oscillating around the target 2 percent. And while in the housing sector prices did increase by an incredible 81 percent from 2000 to 2005, and total value of household mortgage debt rose even faster (Kling 2009, p. 13), “the conventional wisdom was that because monetary authorities could mitigate the effects of financial crashes, there was no need for monetary policy to focus on identifying or stopping financial bubbles in order to prevent such crashes.” (ibid., p. 38)
The role of money in the business cycle was seen as that of an exogenous factor. A tool to be used to smooth the cycle, not an endogenous factor of the cycle. The response to financial crises in the 1980s and 1990s as well the dot com crash in 2000 was monetary expansion. Each time it seemed this recipe from the mainstream macroeconomist’s cookbook was able to mitigate the slowdown and prevent a significant fall of employment and consequent sustained drop of aggregate demand associated with a large crash. Here came the truly embarrassing part for the representatives of the mainstream consensus: this time round the recipe did not work. Even coupled with a massive fiscal stimulus the economy nonetheless suffered a severe recession. The mainstream thus first failed to predict the bust, and then failed to contain it.
Both failures suggest the mainstream models and the theory, upon which they are built, are seriously lacking. Bubbles clearly are important, and if we are to understand them financial institutions (institutions both in the colloquial and neoinstitutional sense) are a necessary part of the puzzle. This recognition has prompted returned attention to schools of thought, which include financial institutions, money, and credit as endogenous rather than exogenous factors in their theorizing about the business cycle. Namely, the post-Keynesians (following the footsteps of Hyman Minsky) and the Austrians (following the Mises-Hayek theory of the business cycle). Both of these schools of thought explain the bust through overly speculative investment during the period of the boom. Yet they also differ substantially.
The post-Keynesians seem to have received significantly more attention. Their theory of over optimism leading first to speculative then to Ponzi-finance (in their mind, under a market system a natural tendency of financial institutions to take on excessive risk) conveniently lends itself to another phenomenon brought about by returned attention to financial institutions: a popular narrative that the crisis was a market failure resulting from deregulation of the financial industry in recent decades.
However, this popular narrative is flawed. In fact, a serious case can be made for the exact opposite – that the crisis was caused by misguided government intervention. First, by changes to the reserve requirements of banks, which incentivized more risk-taking (coupled with federal deposit insurance, this encouraged gambling with other people’s money) (Kling 2009) (Roberts 2010); second, through low interest rates which distorted price signals and fueled overinvestment (ibid.); third, through the regulatory privilege enjoyed by the rating agencies who gave highly risky securities AAA and AA grades misleading investors (White 2009). Thus, the main reason the post-Keynesian theory has received more popular attention in recent times is probably a rather poor one.
Indeed, the post-Keynesian theory is less a theory, which explains the business cycle, and more an assertion that happens to get some of the resulting problems right. The assertion being that the business cycle was caused by financial instability, which is itself a product of changes in financial practices and investor confidence/optimism. That is a reasonable hypothesis; the financial crisis may very well have been caused by over optimism about rising prices of (real-estate) assets. Though the reverse causality – that rising prices of assets caused over optimism for investors in various financial instruments – is also plausible. The problem of the assertion, though, is not solely that it overlooks competing interpretations. More crucially, its problem is that even if it is correct, it is not helpful if it does not explain why and how the over optimism comes about.
If there are – as Minsky admits – periods of “tranquility”, when levels of optimism are on average appropriate to the underlying real conditions in the economy, then what makes investors suddenly go into a frenzy of overly risky investments? The post-Keynesians do not offer an answer; they assume that part of the problem away. As Prychitko notes:
Caught up in aggregate models, the [post-Keynesian financial instability] hypothesis—like mainstream macroeconomics as a whole—does not examine and appreciate money’s influence on the relative prices of consumer goods and especially those further up the line in the capital structure. The hypothesis emphasizes uncertainty, but assumes that interventions designed to reduce systemic risk can actually do so. It calls for Big Players, but it does not understand their unintended consequences. While criticizing the best laid plans of “deregulation,” it embraces the best laid intentions of further regulation. (Prychitko 2010, p. 220)
The Austrians on the other hand do offer an explanation as to why the behavior of investors would change in such an unfavorable way. According to the Austrian theory:
Capital is a sequence of stages of production; its temporal structure is a key macroeconomic variable. Interest rates that reflect people’s preferred tradeoff between consuming now and consuming later guide capital creation and allow for sustainable growth. Almost as a corollary, interest rates that are distorted by central-bank policy misguide capital creation and give rise to unsustainable growth. (Garisson 2009)
Additionally, (Cachanosky and Salter 2017) report on a growing body of empirical literature, which suggests that financial crises are typically preceded by a credit boom. Which is exactly what the Austrian theory would predict. They integrate this recent literature with the Austrian canon and note that its authors “turn to [Austrian Business Cycle Theory] due at least in part to dissatisfaction with the way mainstream models handle money.” They conclude that:
[..] since business cycles result in turbulence in all of an economy’s markets, then that which is common to all markets ought to be examined as a potential transmission mechanism. Money, as one half of all exchanges, is the missing link. Monetary distortions result in distortions in the price system itself, setting the stage for the boom-bust dynamics to follow. (ibid., p. 179)
[t]here is no reason to consider ABCT and other business cycle theories as always incompatible with each other. Nor is there reason to think a choice has to be made between the ABCT and other business cycle theories. A business cycle theory may apply in some crises but not on others, and different phases of a crisis might be explained with different business cycle theories. (ibid., p. 183)
Perhaps that can be a useful takeaway from the embarrassment the majority of the economics profession faced during the financial crisis. Perhaps different schools of thought can learn from each other and approach the study of business cycles in a more holistic way, which includes money and financial institutions as relevant, and – at least for some crises – endogenous factors. Perhaps. Alternatively, the lessons of the Great Recession might remain unlearned, and those behind “the steering wheel” again trusted to smooth the cycle as if the financial crisis exposing their inability to do so had never happened. Janet Yellen seems to believe we can and should go back to that state of discourse. For now, I hold on to hope that at least a large chunk of the profession will choose not to follow this head-in-the-sand strategy.
For the reader’s convenience I’ve added two graphics to the text that are not my own. The generic depiction of the Minsky moment I borrow from the economicsociology.org blog, and the graphs depicting the Austrian business cycle theory from Frank Shostak who himself adapts it from (Garrison 2001).