Friday, October 29, 2010

Considerations on market stability and the world of finance

David Prychitko has written a very interesting article, just published in the latest issue of the Review of Austrian Economics. It is a timely consideration of the ideas of a prominent Keynesian, Hyman Minsky, on the question of the alleged inherent instability of the financial system (actually all capitalist financial systems).

Minsky was a devoted Keynesian, but an imaginative one. He extends and deepens Keynes’s ideas, making them more plausible and intuitive. His main instrument is a very useful taxonomy of types of finance. There are three types, hedge finance, speculative finance and Ponzi finance. They escalate in degree of risk. When the revenue stream from an investment is confidently expected to pay all expenditure streams at every moment in the future we have hedge finance. With speculative finance there are some holes; near-term expenditures may exceed revenues, the hope being that in the longer term, revenues and capital gains will redress the balance. Ponzi finance is a situation in which in which interest on the debt actually exceeds revenue flows. (In passing we could note that this is a nice framework not only for analyzing the behavior of individuals, but also, even more relevantly, of the state.)

Minsky’s story uses this taxonomy to explain how a cycle is composed of the progression of economic agents from hedge finance to Ponzi finance before an inevitable collapse. He claims that the take off from hedge to speculative finance is inevitable, the Minsky-moment at which the start of the boom occurs. Prychitko, while giving us an appreciation of Minsky’s work, criticizes him for not providing an explanation of the genesis of this progression from tranquil business as usual to escalating speculative positions. Of course the Austrian explanation is the credit cycle ignited by what is so charmingly referred to today as “quantitative easing” by the central bank. For the rest you need to read this wonderful article which provides Austrians with a welcome window into the other world.

I would like to add a note on one aspect of this fundamental debate with the Keynesians. Prychitko claims that Minsky has no explanation of the Minsky-moment and implies, I think, that without such an explanation we are at a loss to understand how any cycle would occur. Why would entrepreneurs ever abandon their commitment to hedge finance? What provokes them to take on more risk to the point of financial meltdown? I think this is basically correct. But I want to guard against the possible conclusion that what is being claimed is that, absent governmental monetary mismanagement, no cycles would ever occur.

Of course Keynes’s explanation (surely implicit in Minsky) is rooted in casual social psychology. Entrepreneurs display “animal spirits” and are susceptible to waves of optimism and pessimism. There is “herding.” Asset values, being inherently subjective, very sensitive to projected future revenues, are subject to large, unpredictable, connected swings. So the explanation of the Minsky-moment is that eventually financial tranquility is bound to be disturbed by a contagion of unrealistic optimistic expectations. And the rest is history.

My own take on this is as follows: I think there is an element of truth in what Keynes says. I think, even in the absence of monetary mismanagement, there would be cycles. In fact, cycles are part of the experimental, evolutionary nature of the market process. All action is based on expectations. The epistemological basis of some expectations is more solid than others. In the realm of business investment, particularly in an environment of innovation and rapid change, the knowledge-base is quite tenuous. Entrepreneurs pit their conflicting expectations against each other. Most of them (and maybe all of them) will be wrong. Hence, where the investment environment invites imaginative visions (for example the late 1800’s and early 1900’s, the 1990s) we are bound to get a clustering of errors. It is inherent in the market process.

There are a number of reasons why the “people should know better” argument doesn’t work against this. Firstly, even though it may be perfectly clear that asset values are unrealistically high, and must eventually be corrected, investors do not know when this correction will come and are anxious to ride the boom as long as they can. There is a kind of brinkmanship. That this occurs is, I think, undeniable. Second, one could argue that memory is fatally selective. We remember the more recent past better than the more distant, especially when the latter belongs to previous generations. So, for example, the discrediting of Keynesian ideas is not remembered as well by the current generation as by those who lived through the 1970’s and early 1980’s. Third, there is the “each episode is unique” syndrome (a kind of pop “historicist” anti-Mengerian approach); this is a “new economy” in which the old rules don’t apply. And there may be other, similar arguments. I think it not implausible to suggest that the “dark forces of time and ignorance” do make for a world of unavoidable turbulence.

So what? Well the power of the Austrian argument derives not from asserting that without government mismanagement cycles could be avoided; it comes rather from the anti-utopian argument that this world is not perfect. It is extremely complex, it churns, it surges, and it progresses. The trick is to allow it to play out and not think you can achieve smooth sailing by interfering with it. Striving for the impossible produces highly exaggerated cycles and messes up the ability of the process to filter information, to sift the viable projects from the others. Absent government mismanagement, the boom comes to a natural end because the waves of optimistic investment put an increasing strain on the supply of loanable funds and push up interest rates. The most insane thing you can do is attempt to prolong the boom by trying to keep down the cost of increasingly scarce credit.

But this is the view of someone who believes that the market process is inherently stable. Cycles will occur, but the financial markets, if unencumbered, can accommodate them. Cycles are mitigated by the homeostatic properties of the market, which work fast enough to correct any run-away waves of optimism and pessimism, to prevent social dysfunction or collapse.

The Keynesians quite simply do not believe this. They believe that the market system is inherently unstable, that herding behaviors, if not checked by enlightened leadership, could result in financial and social collapse, in disaster and catastrophe.

[At least that is the story. It’s hard to know how sincere this is and to what extent it is just a pretext for the desire to engage in large scale Robin-Hood-type income distribution. In addition, it totally ignores the unrealism of assuming that government leadership has the ability (knowledge) to, and can be trusted to, do the job. That is, it ignores the incentive and knowledge problems that economic policy must face. It asserts market failure but ignores government failure.]

As a theoretical matter, the stability of the market system cannot be proved. Stability (and convergence) rests (among other things) on the speed with which the undeniable homeostatic forces (like price flexibility) work relative to the speed of other changes. We have no robust theory of behavior in disequilibrium and without one we cannot prove the stability of a system of interconnected markets. The confident assertion that the market system is not inherently unstable (which I do firmly believe) derives from a particular understanding of how markets work plus a particular reading of history. Theoretically the world need not work the way it does. It could be closer to the one envisioned by Keynes, but it isn’t.

The absence of a knock-down argument (theoretical or empirical – history does not speak with one voice) is the reason I even have to write something like this; it is the reason discredited ideas get recycled. It makes our jobs much more difficult. But I guess there is an upside to that.


Troy Camplin said...

I learned a lot from Prychitko's paper (of course, I suppose that's easier for someone like me, who's not an economist). I agree with you -- to a certain extent -- that there would be cycles without government intervention. However, I do not think they would be the kinds of events as the current depression or the Great Depression without such outside intervention. I base this on the other major heterogeneous network process most people are familiar with: the world ecosystem. If we look at species as equivalent to firms, we can see cycles of proliferation and extinction. However, every major extinction event was precipitated by an external event. The dinosaur mass extinction event was caused by a massive meteorite. So were other similar mass extinction events. Much more typically are smaller, more local extinction events (occuring in a power law distribution of extinction events). Perhaps we need a more complex understanding of these kinds of cycles.

Prof J said...

Prof. Lewin,

I didn't realize you had a blog otherwise I would have stopped in sooner. Just finished your paper "The Capital-Based View of the Firm" with Baetjer. Very nice. Important for someone like me who is a neoclassical-trained financial economist doing corporate finance.

Anyway, to this post. I largely agree with you. Absent intervention, including (or especially) monetary monopoly, there would still be "cycles." But, like Troy above, I don't think they would be economy-wide. Here I think the RBC model overstates the impact of industry shocks. Without a monetary monopoly to carry such "shocks" through the entire economy, they'd largely be localized.

Also, thanks for your writings on Israel.

Peter Lewin said...

No disagreement with either of you. I believe the magnitudes of the cycles are greatly exaggerated by corrective government action. The point is, it is the onset of the cycle that produces pressure for government action. The Fed does not want to allow interest rates to rise. Its an interesting discussion as to whether we should call that exogenous or endogenous.

Welcome to my blog Prof J.

Troy Camplin said...

It's a tough call, since what would otherwise be endogenous to the economy -- money, interest rates, etc. -- are given exogenous characteristics due to Fed/government control/influence. It thus becomes difficult to tease apart "endogenous" and "exogenous." Of course, this ambiguity is only a feature for Austrian economics -- as Krizner points out (in "How Markets Work," which I am now reading), in neoclassical economics, everything except existing firms and consumers are "exogenous" to the economy. This, of course, is an absurd assumption. How can entrepreneurial activity, for example, be exogenous to the economy?

Prof J said...

Endo/exo is a good question. I would tend towards categorizing any interest rate manipulation by a central bank as endogenous, though. Interest rate manipulation is a type of government intervention and ACBT can be considered to be a special case within the framework of Austrian political economy and interventionism.

The propensity to intervene generally is a function of how much the state is already intervening (we are quite used to the Fed conducting its shenanigans) and the prevalent ideology regarding interventionism (this appears to be changing right now). The ideology of our political leaders is interventionism, and the framework of macroeconomists generally, is that of central banking.

Totally not QED, but that's how I work out the endogeneity.

Greg Ransom said...

This was Hayek's view also, see _Monetary Theory and the Trade Cycle_, Book IV.

Peter wrote,

"I think, even in the absence of monetary mismanagement, there would be cycles."

Hayek describes something like a Minsky cycle in Book IV, without the detail and helpful distinctions.

Greg Ransom said...

Note well, this is NOT the Hayekian argument.

Peter writes,

"the Austrian argument derives not from asserting that without government mismanagement cycles could be avoided."

In Hayek's _Monetary Theory and the Trade Cycle_ Hayek argues the opposite, i.e. Hayek argues that even without government mismanagement, cycles are inevitable."

Ashwin said...

"cycles are part of the experimental, evolutionary nature of the market process." Well put - Austrians and free market proponents have a much stronger case if they accept this fact. Although I would suggest that the right assertion in the light of this is that markets are frequently unstable but mostly resilient - I use resilience in the "ecological" meaning .

I haven't read the paper but the assertion that Minsky's theory has no explanation of the Minsky moment is not really fair to Minsky. The core assertion of the Financial Instability Hypothesis that "stability breeds instability" or as I would put it, stability breeds loss of resilience is well-founded in many complex adaptive systems. I explored the analogy between the ecological concept of the resilience-stability tradeoff in a post on my blog here .

Correspondingly, stabilising policies can make the system increasingly fragile and susceptible to collapse in the long run - again ecologists have learnt this the hard way over the last century in situations as varied as forest fires and river floods .

Greg Ransom said...

Note well, BIS chief economist William White used the work of Hayek, Selgin and Minsky -- along with the empirical work of his research team -- to identify the malinvestment pathologies of the 00s. White direct told Greenspan and the central banking community of the problem beginning in 2003, and every year there after in a series of BIS reports.

Josh said...


You wrote: "So, for example, the discrediting of Keynesian ideas is not remembered as well by the current generation as by those who lived through the 1970’s and early 1980’s."

I am not sure this necessarily true. Or, to clarify, I don't think that the reason that we keep seeing these ideas spring up is because we have forgotten the past. On the contrary, I would note that many of the public advocates of these ideas are prominent economists who lived through that period -- one of them was on the CEA in the early 1980s.

Peter Lewin said...

@Josh: You may be right. Those public advocates who lived through it and are repeated it are reading history differently from me. But, there are many, my students among them, who find Keynesianism appealing and just don't believe, or relate to, the historical story I tell.

@Greg: Thanks for this information. I am sure that many if not all "Austrians" would not deny my point about the existence of fluctuations even in the absence of money mismanagement. And the quotations provided by Greg convince me that certainly Hayek does not. (I expect similar quotations could be found in Mises.) Non-Austrians, especially critics, (conveniently) misunderstand the "Austrian position" on this; and shorthand characterizations like, "a properly functioning banking system should adjust the market rate to match the changing natural rate" encourage this kind of interpretation.

@Ashwin: Thank you I think an ecological dimension adds much to this discussion.

Peter Lewin said...

Some interesting comments to this blog post appear at the link below.