Bank for central bankers confirms ABCT

The popular press blames Wall Street shenanigans and banker greed for the most recent recession as the movie The Big Short demonstrates. Politicians digest the economics of the mainstream media and that is the reason Congress passed the Frank-Dodd Act increasing regulation of banks. It was punishment for what politicians perceived as banker sins.

Congress passed the act in spite of the fact that no mainstream economist I know of has blamed Wall Street or banks for the crisis. In the minds of mainstream economists, recessions are random events. The economy naturally spins in equilibrium like a top until an unforeseen “shock” slams into it, makes it wobble and sling thousands of people out of work. I like to call it the “crap happens” theory of business cycles.

A much better explanation of recessions come from the Austrian school of economics in which credit expansion causes misallocations of capital that accumulate during an expansion. The weight of those misallocations eventually crushes the expansion and a recession follows. The most robust explanation of the mechanism is Hayek’s Ricardo Effect [link] in which nominal profits guide the allocation of capital.


The Bank for International Settlements, the central bankers’ bank, has once again added to the already immense empirical support for the Ricardo effect in a recent paper “Labor reallocation and productivity dynamics: financial causes, real consequences.” Even the title echoes the Austrian theory, which is often summarized by saying that monetary policy ignites the expansion while the real economy ends it.

The authors of the BIS paper labored to determine if credit expansion that leads to an economic boom has any impact on labor productivity. They concluded that it does by shifting labor from highly productive sectors such as manufacturing to the least productive sectors such as real estate. The authors divided productivity into common (within industry) and allocative (between industries.) They discovered that credit booms have the greatest impact on allocated productivity. Here are some of the most valuable quotes, among many, from the paper:

...inflation correlates negatively and significantly with the allocation component of productivity growth... 

Aggregate productivity slows down during credit booms primarily because employment expands more rapidly in the construction sector, which structurally features low productivity growth. And employment expands more slowly or contracts in manufacturing, which is structurally a high productivity growth sector. 

...financial crises have persistent direct negative effects on the subsequent path of aggregate labour productivity.

... the occurrence of a crisis greatly amplifies the impact of previous misallocations.

...credit growth during the boom does not appear to have any additional effects on subsequent productivity growth. The statistical insignificance of the various coefficients suggests that the impact operates through misallocations during the boom and the incidence of a crisis.

The bottom line is clear. The occurrence of a financial crisis amplifies the impact of pre-peak productivity growth and its components.

...the drag on productivity due to a financial crisis is much larger when these labour misallocations have been large during the expansion, ie the allocation component prior to the recession is low.

the slow recovery after the Great Financial Crisis is the result of a major financial boom and bust, which has left long-lasting scars on the economic tissue.

...it is not reasonable to think of money as neutral over long-term policy horizons.

..loose monetary policy is a blunt tool to correct the resource misallocations that developed during the previous expansion, as it was a factor contributing to them in the first place.

So how do these points relate to Hayek’s Ricardo Effect? Changes in productivity lie at the heart of the Effect. Hayek observed that in a credit expansion the prices of capital goods, as in manufacturing, will rise first and induce greater investment there, including in labor. But with the increased employment of labor, the prices of consumer goods will rise as well because laborers will use their new income to buy more consumer goods.

The higher prices of consumer goods will inflate nominal profits for consumer goods makers. Higher profits mean wages are lower in comparison to the profits, so managers will hire more labor and use less labor-saving equipment. That reduces productivity within industries. What the paper adds to the Ricardo Effect is that credit expansion also reallocates labor from the highly productive sector of manufacturing to the low productivity sector of real estate construction.

The shift in labor to low productivity businesses spells death for the manufacturing sector as profits fall due to increased prices for labor and material inputs as sales collapse. We have witnessed that process playing out on the international stage as manufacturing, mining and energy have suffered from a recession for months. It’s only a matter of time before the retail sector (GDP) follows.

Some newcomers to Austrian economics from the mainstream have argued that the ABCT merely describes the turning point in the cycle and does not predict the severity of the downturn. But the authors of this paper disagree:

...recessions associated with financial crises are particularly deep and recoveries after downturns associated with credit booms particularly shallow.

In other words, the depth of the recession is proportional to the height of credit expansion. Also, the authors land a blow on one of the favorite punching bags of Austrian economists – math models:

In policy formulation, all too often the conclusions are based on the standard “one-good” benchmark model – or on models that behave as if there was only one good.

If you told the average person on the street that the Fed used models with only one good in it they would call you a liar. They would find it hard to believe that educated people would deliberately stray so far from reality. After all, if they lived in such a fantasy world a relative would have them locked up and subjected to psychological analysis.