Saturday, February 22, 2014


5. The issue of the rationality of the agents

The idea of ​​“endogenous” explanation of the crisis is quite problematic for the Austrian paradigm. In the Austrian School’s view the market is a "spontaneous order" and if something is wrong it is due to the “exogenous” intervention of an external agent (either the State or Central Bank). In the market, if there is no intervention, the agents should behave in a “rational” way, or at least constituting a “rational order”. “Human action is always rational”, writes Ludwig von Mises, the great master of the Austrian School (18).

However, there are important paradigms of economic theory that put into question this view. Among them we have to Behavioral Economics, Neuroeconomics and Experimental Economics. According to these approaches economic agents are not rational subjects who make decisions carefully calculated but rather are systematically conditioned by a set of purely subjective perceptions (optimistic or pessimistic), emotions, neurobiological factors, cognitive biases, group behavior, contexts of moral hazard, etc.

Several leading economists have studied the current crisis based on this perspective. One of them is Robert J. Schiller, recently awarded the Nobel Prize in Economics, who in his book Irrational Exuberance gives an interesting explanation of how the financial bubbles are created. He focuses particularly on the behavioral patterns of the agents and their expectations of future asset prices. If asset prices begin to rise, then less sophisticated investors will enter into the speculative scheme and they will believe that prices will continue to rise continuously. Then there comes a time when expectations are not met and the “irrational exuberance of optimism” becomes an “irrational exuberance of pessimism” with the consequent entropic effects on the market that involves this kind of perception.

Thus, one finds in Schiller’s analysis a very interesting “behavioral” correlate of the Minsky’s approaches because, as McCulley says: “Humans are not only momentum investors (…) but also inherent both greedy and suffering from hubris about their own smarts. It’s sometimes called a bigger fools game, with each individual fool thinking he is slightly less foolish than all the other fools” (19). It seems this one, and not the Austrian vision of “spontaneous order”, a better description of what has happened in the financial markets in recent years.

6. Conclusion

Is true that some Austrian economists predicted the crisis, but this is an example of being right for the wrong reasons or at least too simplistic reasons. We do not want to detract Austrian contribution about how central banks can influence the generation process of “financial bubbles” and “fictitious economies” but we want to prevent that this contribution lead us to reach conclusions as extravagant as saying that the “exogenous” state intervention is the only explanatory factor in the crisis and that the crisis in no way put into question the optimality of the free and unregulated market.

In fact, as we have seen, there are very relevant endogenous factors that have much greater explanatory power regarding the generation of the “financial bubble” such as those related to the Minsky’s financial instability hypothesis, the dynamics of the monetary aggregate M3, the complex derivatives, toxic assets, excessive speculation in the housing markets, the role of rating agencies, cognitive biases, the “irrational exuberance” of the agents, deregulation and moral hazard environment generated that should be considered for a coherent and consistent explanation of the crisis and the generation of better judgment elements for its solution.

Thus the current crisis is a highly complex phenomenon that cannot be properly approached from a unidirectional perspective. For this reason this paper has taken into account several paradigms of economics such as Neo-Ricardianism, Post Keynesianism, Behavioral Economics and Experimental Economics. In fact, in order to analyze the phenomenon is not only necessary to do so from a perspective multiparadigmatic but also from a multidisciplinary perspective taking into account the contributions and developments in other social sciences such as Sociology, History and Political Science. Moreover, this problem should be approached even from a transcendent philosophical perspective for a more solid and enduring civilizational reconstruction of the economic system. But that is something that goes beyond the scope of this article and might be a matter for a later one.


18) Ludwig von Mises, La Acción Humana, Unión Editorial, Madrid, 1980, p. 45.
19) Paul McCulley, “The shadow banking system and Hyman Minsky’s economic journey”, Global Bank Central Focus, May 2009.

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Wednesday, February 12, 2014


4. The financial instability hypothesis: "endogenous" explanation of the crisis

Hyman Minsky was a post-Keynesian economist whose ideas were rejected in their time because they were considered “overly radicals” but who currently (posthumously) has become very famous because his “financial instability hypothesis” seems to explain quite well the current crisis.

Specifically, Minsky begins considering that economic agents can basically take three financial positions:

1) Hedge: Investments are financed in a way that they can fulfill all payment obligations regardless of the cash flows generated by the investment. Principal and interest payments on debt are insured for the proper time.

2) Speculative: In this case the agents bet on the future variations of the price of goods. Revenue flows generated by investments are adequate to meet the interest payment but the payment of principal is not guaranteed.

3) Ponzi: In this situation the payment obligations exceed the revenue stream derived from the investments. Agents have to borrow more and more to pay debts, so that the final solution is selling assets to obtain liquidity to afford the payments since the debt renegotiation is increasingly difficult.

Given this scheme, Minsky’s hypothesis is this: that from a position of financial stability (hedge) economies will tend, due to its own dynamic, to positions of financial instability (speculative and ponzi) in which will reach a point of overall insolvency of the economy with consequent bankruptcies of companies and banks that this implies (“Minsky’s moment”). In Minsky’s own words: “The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable, and financing regimes in which it is unstable. The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system”. (17)

To understand why the instability is generalized in the system we must begin by understanding what happens in the boom phase. Firstly, financial stability (predominance of the hedge position) predominates and expectations are optimistic. Because of this economic agents rely on their ability to meet payments (solvency) and that the future returns on their investments will be more than sufficient (optimistic estimate of the marginal efficiency of capital). At the same time, banks, considering the environment of prosperity and the large amount of funds which they have available to lend, are more lax at the moment of establishing restrictions. Although some reluctances may arise on the part of lenders, these are diluted by the economic strength of the boom phase; system robustness makes the agents rely on that this one will not fail and therefore begin to take riskier positions (speculative and ponzi) which contribute, paradoxically, to making more fragile to the system (paradox of debt). Thus, the optimistic expectations lead firms to overestimate the performance of their investments and that banks underestimate the possibility of default on obligations. In this way it will begin to systematically happen that agents cannot meet their payment obligations as these exceed the yields obtained. Initially they will seek to solve this through the debt renegotiation but sooner or later the agents have to sell their assets to obtain liquidity, a process which leads to a deflationary episode that finally leads to the crisis with the subsequent bankruptcy of companies and banks.

Thus, stability creates instability, the robustness the system makes it fragile and optimism leads to pessimism. Here is the great contribution of Minsky facing a discredited Austrian Business Cycle Theory: an “endogenous” explanation of the crisis.


17) Hyman P. Minsky, “The financial instability hypothesis”, The Jerome Levy Economics Institute Working, Paper Nº 74, May 1992.

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Thursday, February 6, 2014


3. The Fed did it?: critique of “exogenous” explanation of the crisis

The other central point of the argumentation that is made from the Austrian Business Cycle Theory in order to sustain that the State caused the crisis refers to the preponderant role of the Federal Reserve (Fed) in the generation of the “credit bubble”. In this manner, the problem is not the free market, deregulation or the dynamics of private banks but rather the distorting action of “central agent”.

Taking into account the important caveat that the Federal Reserve is, in institutional terms, a private organization and not a government organization (as is often believed), one can answer the Austrian's argument in two ways.

First, by demonstrating that the causal process involved is not as simple or straightforward as the Austrians claim. There have been periods of significantly low interest rates in which asset bubbles or substantial recessions have not occurred. Interest rates are merely another cost of companies among many others. In fact, the Federal Reserve began to raise interest rates in a period as early as 2005 but even so the bubble doesn’t burst. Likewise, the economist Nouriel Roubini, internationally promoted as who predicted the crisis, had said in his lecture September 2006 at the International Monetary Fund, that an “imminent” crisis would occur in early 2007 (13). However, the economy seemed to be working perfectly even until early 2008 and the bubble did not burst until September. Therefore, the correlation between economic activity and interest rate is not as simple or straightforward as to try to make a reliable prediction based only on it. (14)

Second, by attending to the distinction between the monetary aggregates and their respective dynamics. Austrian economists tend to illustrate his argument by referring to a Central Bank which manipulates “the” money supply. However, it is widely accepted (from orthodox neoclassicals to the heterodox post-Keynesians) that there is an important distinction between the types of monetary aggregates. The aggregate M0 is a narrow measure of money supply and M3 is the broadest. While M0 is strictly controlled by the Federal Reserve, M3 basically depends on the specific action of individual banks. Thus, if one wants to find evidence that “the Fed did it”, such as the Austrians argue, must be verified that the dynamics of M0 is much more correlated with the crisis than the dynamics of M3.

Is there such evidence? In his article “Debunking Macroeconomics”, heterodox economist Steve Keen gives relevant econometric information in this regard (15). Specifically, he establishes, for the period 1990-2012, the correlation between changes in M0 and M3 and the dynamics of real economy (taking the level of unemployment inversely). In what follows, the graphs presented by Keen:

Graph 1

Graph 2

As shown in Graph 1 the correlation between M0 and economic activity is weak and has the wrong sign, whereas the correlation between M3 and economic activity is strong and has the correct sign. Therefore, according to this, you can consistently say that the dynamics of the crisis is more due to the action of individual banks rather the action of Central Bank (the Fed).

But you could still argue that the initial action of the Fed is what has distorted the dynamics of banks. However, this reply should be dismissed becausethe correlation between changes in M0 and changes in M3 is (…) strongly of the wrong sign for the pre-crisis period from 1990-2008 (-0.55), and only barely positive for the post-crisis period (+0.14)”. (16)

Therefore, there is no solid basis for considering the current crisis as a merely “exogenous” phenomenon regarding the market caused by the arbitrary intervention of a central agent (Fed) in a financial system which would work perfectly without such intervention. You cannot ignore the context of “moral hazard” generated by private banks, the “toxic assets”, the role of “rating agencies” (with the implied corruption) and the specific influence of private agents in the process of deregulation. All this, then, must lead us to an “endogenous” explanation of the crisis.


14) It must be said, however, that the Roubini’s theory, an heterodox and multidisciplinary economist, incorporated many more items than the mere Austrian Business Cycle Theory and therefore is much more plausible.
15) Steve Keen, “Debunking Macroeconomics”, Economic Analysis & Policy, vol. 41, nº 3, December 2011.
16) Steve Keen, Ibídem, p. 160.

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