Foxhole conversions

There are no atheists in foxholes is an old saying meant to express what crisis will do to one's thinking. The recent crisis has encouraged many mainstream economists to look at what is wrong with their theories that prevented them from seeing the crisis coming. As a result, prominent mainstream economists have begun incorporating at least parts of the Austrian business cycle theory in their work.

 Coordination Problem discussed a recently published paper by Guillermo Calvo of Columbia University and the National Bureau of Economic Research, “Puzzling over the Anatomy of Crises: Liquidity and the Veil of Finance.” Calvo wrote the following:

“Critical Puzzle 1. There is a growing empirical literature purporting to show that financial crises are preceded by credit booms (Mendoza and Terrones (2008), Schularik and Taylor (2012), Agosin and Huaita (2012), Borio (2012)). This was a central theme in the Austrian School of Economics (see Hayek (2008), Mises (1952))...”

“I will argue that the Austrian School offered valuable insights – disregarded by mainstream macro theory – that help to rationalize Puzzle 1 without resorting to irrationality. Over‐extension of credit was at center stage of the Austrian School theory of the trade (or business) cycle, but authors differed as to the factors responsible for excessive credit expansion. Mises (1952), for instance, attributed excessive expansion to central banks’ propensity to keeping interest rates low in order to ensure full employment at all times. As inflation flared up, interest rates were raised causing recession. Thus, under his view the cycle is triggered by pro‐cyclical monetary policy with a full‐employment bias which was not consistent with inflation stability. Hayek (2008), on the other hand, dismissed von Mises explanation, not because it was not a good depiction of historical events, but because he thought that instability is something inherent to the capital market and, in particular, it is related to what might be called the banking money multiplier mirage.”

Calvo is wrong that Hayek “dismissed” Mises’ views. Mises wrote about central banks because they dominate modern economics. Hayek was more theoretical and emphasized the role of fractional reserve banking in creating monetary expansion. Hayek had been a student of Mises and had few differences with him on theory while, being younger, emphasized different things.

Later in the paper Calvo refers to Claudio Borio and William White at the Bureau of International Settlements: "Borio and associates are carrying forward a research program that contains several elements akin to the Hayek/Mises mix.”

Claudio Borio of the BIS echoed Austrian monetary theory in Working Papers No 395, “The financial cycle and macroeconomics: What have we learnt?” with the following:

“More importantly, the banking system does not simply transfer real resources, more or less efficiently, from one sector to another; it generates (nominal) purchasing power. Deposits are not endowments that precede loan formation; it is loans that create deposits. Money is not a “friction” but a necessary ingredient that improves over barter. And while the generation of purchasing power acts as oil for the economic machine, it can, in the process, open the door to instability, when combined with some of the previous elements. Working with better representations of monetary economies should help cast further light on the aggregate and sectoral distortions that arise in the real economy when credit creation becomes unanchored, poorly pinned down by loose perceptions of value and risks.¹⁸ Only then will it be possible to fully understand the role that monetary policy plays in the macroeconomy. And in all probability, this will require us to move away from the heavy focus on equilibrium concepts and methods to analyse business fluctuations and to rediscover the merits of disequilibrium analysis, such as that stressed by Wicksell (1898) (Borio and Disyatat (2011)).

^“18 Building on the work of Wicksell (1898), such distortions played a key role in the work of economists such as von Mises (1912) and Hayek (1933).”

William White, also at the BIS, wrote the following in BIS Papers No 45, “Whither monetary policy? Monetary policy challenges in the decade ahead:”

“I will then go on to argue... that, with each increase of the unemployment rate in relation to the medium-term natural unemployment rate, the Taylor rule is unconvincing in calling for a cut in the current real expected interest rate in relation to the natural real interest rate. The basic difficulty is that the Taylor rule is incomplete without some model of the natural real interest rate – the moving anchor in relation to which the Taylor equation would have the central bank set the expected real interest rate. The natural real interest rate could go up or down after the shock that underlies an increase in the unemployment rate. Which way it jumps depends on what households plan to do with regard to the level and subsequent growth of their consumption. A policy of this kind harkens back to Friedrich Hayek and the notion of ‘neutral money’...”

Ricardo J. Caballero of MIT, admonished his colleagues in “Macroeconomics after the Crisis:  Time to Deal with the Pretense-of-Knowledge Syndrome” to heed Hayek’s warning in his Nobel Prize acceptance speech about pseudo knowledge :

The abstract says, “In this paper I argue that the current core of macroeconomics—by which I mainly mean the so-called dynamic stochastic general equilibrium approach—has become so mesmerized with its own internal logic that it has begun to confuse the precision it has achieved about its own world with the precision that it has about the real one. This is dangerous for both methodological and policy reasons. On the methodology front, macroeconomic research has been in “fine-tuning” mode within the local-maximum of the dynamic stochastic general equilibrium world, when we should be in “broad-exploration” mode. We are too far from absolute truth to be so specialized and to make the kind of confident quantitative claims that often emerge from the core. On the policy front, this confused precision creates the illusion that a minor adjustment in the standard policy framework will prevent future crises, and by doing so it leaves us overly exposed to the new and unexpected.”

Later in the paper he wrote, “Hayek writes: “Of course, compared with the precise predictions we have learnt to expect in the physical sciences, this sort of mere pattern predictions is a second best with which one does not like to have to be content. Yet the danger of which I want to warn is precisely the belief that in order to have a claim to be accepted as scientific it is necessary to achieve more. This way lies charlatanism and worse. To act on the belief that we possess the knowledge and the power which enable us to shape the process of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm” (von Hayek, 1974).”

Finally, a concise description and endorsement of the Austrian business cycle theory appears in Boombustology: Spotting Financial Bubbles Before They Burst by Harvard professor Vikram Mansharamani.