Chapter Nineteen

The Hangover Theory

Hayek vs. Keynes

The Skyscraper Index

The Great Recession presents us with a new mystery to solve: why did investors make such colossal mistakes? Why were housing prices pushed up so high, and why did people place such big bets on those prices never coming down? To get us started down a path of understanding, lets look at an odd coincidence surrounding the tallest building in the world.

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The Singer Building in New York was once the tallest building in the world. It’s 47 floors dwarfed everything before it and it was financed by the head of the Singer Sewing Machine Company. Construction began on the tower in early 1906 and was completed before the end of 1907. Just in time, as it turns out, to witness our famous Panic of 1907. --Surely you are already familiar with the Empire State Building. All 1,250 feet of it were constructed in just 18 months, starting in late 1929, and reaching its top height in 1930. Of course, construction did get delayed a bit by the stock market crash that preceded the Great Depression. When it was done, the lack of business earned it the nickname Empty State Building. Of course, we should also mention the Chrysler Building in New York, which enjoyed a few brief months as the tallest building in the world when it was completed earlier in 1929, ahead of the crash. --The Empire State Building stood as the tallest in the world until it was beaten in 1970 by the North Tower of the World Trade Center, which itself was usurped by the Sears Tower – now called Willis Tower – in Chicago in 1973. And then there was the CN tower in Toronto which surpassed them all in 1976. Each of those was also followed by a dip in the stock market, and the general malaise that was the stagflation of the 1970s. Are you noticing a pattern here? Well, how about this one?--CN Tower’s incredible height was finally surpassed in 2009 by Burj Khalifa in Dubai. This building is monstrously tall, so tall in fact that you could stack the Sears tower on top of the Empire State Building and the Burj Khalifa still beats them by a smidge. Of course, it’s completion was also followed by the worst global recession since the Great Depression.It really seems like every time we get a new Tallest Building in the World, we also experience a horrible economic collapse. And the Kingdom Tower in Jeddah, Saudi Arabia, which is meant to surpass the height of Burj Khalifa, was supposed to be completed by the end of 2019, just prior to the pandemic and subsequent recession, though as of this recording its construction remains halted. --Property Analyst Andrew Lawrence spotted the odd correlation and found that the construction and completion of large structures seems to correlate with recessions going all the way back to 1800 and even connects to recessions which happened elsewhere in the world, like a recession in Asia which followed the completion of the Petronas Twin Towers in Kuala Lumpur. It doesn’t quite hold up though. The problem is that we are cherry picking a lot of data. Including some recessions and some buildings, but there are plenty of recessions without a skyscraper, and plenty of skyscrapers without a recession. Watching out for supertall buildings won’t help you predict the next big downturn in the economy. But that doesn’t mean these are total coincidences. --The economic theory behind skyscrapers is pretty simple. Entrepreneurs will want to locate their businesses in the places where they’re going to get the most business. Proximity to suppliers and customers can make a big difference. These businesses will want to cluster near each other, forming city centers. But you have to balance the benefit of being close to the action with the cost of building upwards. Land in the outskirts might be so cheap that it’s better to expand out rather than up. And so, economists would expect that buildings close to the city center are a little taller than those around them, but not by much. --These days, the Empire State Building has plenty of peers, but when it was built most of these other buildings weren’t around. It towered above the rest. It was abnormally tall for its time. --And Burj Khalifa is abnormally tall for our time. These other buildings around it are massive skyscrapers as tall as anything in New York. But Burj Khalifa dwarfs them. There is really very little doubt that Burj Khalifa was built to astound, and to bolster the reputation of Dubai as a major city of the world. It is, if I may say, a vanity project, and one that makes very little economic sense. It’s just far more expensive to build up this tall instead of just building several shorter towers nearby. --This is a concept of Austrian Business Cycle Theory called malinvestment. Malinvestments are badly allocated business investments due to an artificially low cost of credit. When interest rates are artificially low, they encourage business investments which could not be justified under normal interest rates. If interest rates have been pushed down to 1 or 2%, that might make building one of these supertall buildings possible. The financing is so cheap, that even if the skyscraper is not expected to be profitable for many years, the developer will still come out ahead. But these are also very large projects that take many years, and the money isn’t borrowed all at once but over a series of stages. If, in the middle of those stages, the artificially low interest rate ends and the developers can no longer get such cheap financing, the whole project goes bust. Scale that up across an entire economy of business investment and you might have a problem on your hands.

The Austrian School

Amidst the Great Depression, John Maynard Keynes and his fellow economists at Cambridge wanted to hear alternatives to Keynes' own theory. They invited an Austrian economist named Friedrich Hayek, who presented a very different approach. Hayek became a full professor at the London School of Economics, where he and Keynes continued their intellectual debate.

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The Sub-Prime Mortgage Crisis in 2008 and the subsequent recession had many people scratching their heads about economic theory. The Freshwater economists had proselytized about efficient markets which coordinated economic activity rationally. They literally did not believe bubbles like the one seen in the housing prices could even happen. Prices always reflect the fundamental value of the asset, they thought. But the Saltwater economists had believed that those imperfections could be smoothed over with competent monetary policy that prevented mistakes from becoming monetary shocks that disrupt the whole economy. With mainstream economists left with a lot of explaining to do, some economists on the fringes got a little more oxygen and attention. These heterodox economic theories – as opposed to the orthodox theories of the mainstream – had been dismissed by the wider body of academic economists, but they offered some powerful narratives about the most recent crisis. Our heterodox subject here is the Austrian Business Cycle Theory, which is so named because the economists who pioneered it back in the early 20th century – Ludwig von Mises and F.A. Hayek – where both Austrians. But their theory doesn’t have any more connection to Austria than that. Their claim was that recessions were caused by expansions in the money supply which artificially lowered interest rates and encourage malinvestments like the building of giant skyscrapers. For the Austrian’s the original sin that leads to recession is when the Federal Reserve prints more money, flooding credit markets with cash and pushing interest rates down, distorting the economy and pushing it into an unsustainable boom which must be paid for eventually by a painful crash. --The Austrian’s thought Keynes took economists in the wrong direction by aggregating spending and production into aggregate demand and aggregate supply. By summing everything together, you lost the important details in how market economies and the price system coordinate production through its many stages. Hayek explained this with a triangle. Each one of these bars represents a stage of production along the way to producing a final good or service for people to consume. The shortest bars on the left represent the earliest stages such as research and development. These are capital intensive stages and require some risk-taking and some borrowing to get started. But along things go through different stages, being modified and molded until the value of what can be created with our resources is maximized at the final stage where the consumable product is made. The stages at the end require less capital than those at the beginning, and less financing. Because different parts of the economy can have different stages, Hayek represented this process with a simple triangle, showing the increasing value of what is produced as it moves through the production process over time. --What Hayek wanted to convey was that changes in the level of consumption lead to structural changes in the economy. When people consume less, that means they are saving more, which provides more money to be lent out as investment. The reduction in consumption changes the structure of the triangle to favor the earlier, more capital-intensive stages of the production process. This isn’t particularly controversial. What Hayek is pointing out with this triangle is that the more we save, the more we forgo consumption today to invest in new ventures which will pay off with even more consumption later. That is, the more we save the more our economy will grow. That’s the same conclusion the Solow Model would make too. --We can get a better look at this change by adding our production possibilities frontier. We talked about this all the way back in Chapter 3 and if you don’t remember I would recommend going back to watch that video again. The Production Possibilities Frontier shows how scarcity means we face a trade-off in production, and the curve represents the limit of what our resources are able to do. If we use all of our resources – land, labor, capital, and entrepreneurship – only for current consumption, there will be nothing left to devote to investment or the creation of new capital. Likewise, if we go all in on investment, then we get no consumption. We want something in between, and the curve shows us what combinations are possible. The Hayekian Triangle can show us where we will land based on the structure of our economy, and how many resources we devote to different stages of production. With this economy, this will be our level of consumption, and this will be our level of investment. Of course, innovation allows us to expand our production possibilities, and grow the economy to previously unseen levels. When that happens, our production possibilities frontier shifts out and the Hayekian triangle expands along with the economy, setting our new level of consumption and investment. --But other changes can occur too, and this model gives us a little insight into what those changes mean for the economy. Society might choose to increase their savings and invest more in the future, consuming less now. That change would mean we are giving up some consumption for more investment, moving us along the PPF to our new desired location. But what does it mean for society to start investing more in the future? It means more R&D, more investment in these early stages of production where the innovation is really happening that leads to economic growth. Our societal shift changes the structure of the economy to favor those early stages more, transforming the economy to match our movement along the PPF. And of course, the hope is that greater investment will lead to greater economic growth and higher prosperity in the future. --So, what does any of this have to do with the business cycle, or the ups-and-downs in the economy? To see the connection, we are going to need the Market for Loanable Funds, which coordinates savings with investment, balancing that trade-off between consumption and investment with the interest rate. You can remind yourself about the Market for Loanable Funds in Chapter 11. The interest rate is what coordinates society’s preferences between consumption now and investment in consumption later. The equilibrium in this market is what is really driving our choice along the PPF and crafting the structure of the economy represented by our Hayekian triangle. When people start saving more, that increases the supply of loanable funds and pushes down the interest rate. At this higher level of savings and investment, the structure of the economy changes to balance the level of consumption with that level of investment, putting us at our new point on the PPF. This still isn’t very controversial either and is consistent with what we learned in those previous chapters. But where Hayek and von Mises disagreed with what became the mainstream was that when real people in the economy choose to save more, its different from when the Federal Reserve just prints more money to be used for investment. --They felt that when the Federal Reserve increases the money supply, it distorts the market for loanable funds and artificially reduces interest rates. Those increases don’t cost us anything, they try to get around the trade-off forced on us by scarcity. But there is no getting around it. The extra money in the money supply drives down the interest rate, but it also drives private savings down, because a lower interest rate reduces the incentive to save. And so, the economy sees a boost in both consumption and investment, which pushes the economy beyond the production possibilities frontier. But this is impossible! The frontier is the limit of our production, so what’s happening here? Every stage of production is reaching for more resources, driven by the artificial incentives of the loanable funds market, but there aren’t enough resources to actually go around. It’s like the Fed convinced a dozen people to go for seconds on pizza, but there are only a couple slices left. Everyone reaches for a slice, but not everyone can have one, and some people’s hopes are going to go bust. In the economy, that’s malinvestment. Projects pushed forward by low interest rates which are going to run into a production nightmare when they can’t get the resources they need to finish the job. According to the Austrian model, the economy is destined to collapse to the level of investment supported by the real sacrifices in consumption represented by private savings. --The only answer for economic recessions then is austerity, or a pullback in excess spending. Hayek did this work alongside Keynes’ work amidst the Great Depression, and he and his fellow adherents called for the opposite of the Keynesian prescription. They said governments should cut back on spending and get their budgets in order. The Depression was the price paid for the monetary excesses of the 1920s, and all we could do was endure the pain while the malinvestments got sorted out. This work was revived by many in the wake of the 2008 financial crisis. They pointed to the loose monetary policy in the early 2000s, where the effective federal funds rate the Fed targeted was well below what even the New Keynesians recommended with the Taylor Rule. The Fed was printing too much money and keeping interest rates too low. That led to bad investments in the housing market, and inevitably as resources dried up, a subsequent collapse. The Federal Reserve, the Austrians say, should be replaced by the Gold Standard again, backing all money by a fixed amount of gold. But of course, that isn’t enough, because the money supply can fluctuate just due to bank lending. So, many adherents to the Austrian school back full reserve banking, prohibiting banks from lending out any of your deposits. Investment, they believe, should be done by the saver themselves, not by an intermediary like a bank whose incentives might be distorted. --The Nobel Prize winning economist Paul Krugman calls this The Hangover Theory because it says that recessions are the consequence of an economy that is partying too hard on easy credit. He writes, “It turns the wiggles on our charts into a morality play, a tale of hubris and downfall. And it offers adherents the special pleasure of dispensing painful advice with a clear conscience, secure in the belief that they are not heartless but merely practicing tough love. Powerful as these seductions may be, they must be resisted—for the hangover theory is disastrously wrongheaded.”Why do Krugman and other mainstream economists find the Austrian model so unconvincing? Most think it is missing the details it needs to be coherent, and those details are the ones that lead to you a Keynesian conclusion. How are bad investments translating into an economy-wide recession? It’s easy to see why a collapse in the housing market might lead to unemployed real estate agents, but why would it lead to unemployed auto workers? Without the negative monetary shock and a fall in aggregate demand, this is hard to explain. And the Austrian model is very high on markets and their ability to coordinate economic behavior, but without inefficiencies like sticky prices it is hard to explain why those same markets are falling for what the Federal Reserve is selling. Don’t businesses know that the interest rates are artificially low, and their investment projects aren’t really going to work? It doesn’t quite hold up to scrutiny. And ultimately it is a theory that lays the blame of recessions on the doorstep of consumption, essentially saying that buying too many overcoats will lead to more unemployment, a peculiar claim Hayek himself admitted to. Nevertheless, if the Keynesian school emphasized the dangers of letting an economy slip into an economic depression, the Austrian school emphasizes the dangers of letting and economy overheat and burn through its resources too quickly. So perhaps both underrate the narrative on the other side.

The Debt Cycle

During and after the Great Depression, many economists worked on theories which incorporated the financial system into their understanding of the business cycle. If you look all the way back from the Classical school on through to our current point in the course, you'll find that every theory we have examined pretty much ignores the financial system. It's all about spending and productivity. Many economists have gone a different route, trying to incorporate instability in the financial system into their model of overall economic instability.

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Credit has the power to build a modern economy. By taking out a loan, an entrepreneur is able to purchase the capital they need to start creating new wealth, growing the economy. Existing businesses can take out loans to finance innovative new ideas or to smooth out the ups and downs in their revenue and operate consistently. When people go into debt for these reasons it pays off, because their incomes grow by more than the interest they have to pay on the loan. It’s a little different when people take out loans to buy a car or a house or something else. In that case, a person is just moving future consumption to the present. They can’t afford to pay the full price of a car right now, and so they take out a loan to buy it now, reducing their future consumption in order to pay the interest on the loan. There isn’t anything bad about this, but the purpose of the loan is a little different than a loan made for investment. --It also isn’t surprising that in the many decades leading up to the financial crisis in 2008, household debt was increasing. After all, incomes were also rising over this time period, and rising household debt levels are not a problem if these increases are in proportion to those income increases. But just prior to the financial crisis, this trend reversed. People started to pay down their household debt, and the total load of household debt declined significantly through the Great Recession. --For the first time since the Great Depression, household debt actually declined from 2009 to 2012 after slowing significantly in 2007 and 2008. The graph on the right shows household debt payments as a percentage of disposable income, which is something we would want to see holding steady. Overall debt levels could rise, but if they rose in proportion to people’s after-tax income then this graph on the right would show a flat line. But we can see that in the early 2000s, people were taking on more debts, with bigger payments, until 2007, when people started to reduce their debt loads. --Of course, it is no surprise that this reduction in debt was driven largely by changes in mortgage debt. After a few years of taking on a lot more debt, many Americans decided it was time to start paying it back. They bought less and devoted more of their cash to making payments. This, more than anything, explains the changes in housing prices over the same period. That boom was driven by easy credit, which led to a lot of buying, driving prices up. But when more and more people slowed their buying, prices had to come down back to earth. But how does that turn into an economic recession? Maybe it meant some bad times for real estate agents and mortgage brokers, but certainly the rest of the economy could carry on as normal, right? --One theory that was resurrected after the financial crisis was initially put forward by Irving Fisher to explain the Great Depression. Yep, this is the same Irving Fisher who said stock prices had reached a permanently high plateau shortly before those same stock prices came tumbling down. Fisher saw the problem of the Great Depression as being a problem of debt-deflation. In his formulation, people in the 1920s had become over-indebted, and with debt payments eating into their budgets many decided it was time to make some sacrifices and pay those debts down before incurring any new debts. They started saying no to the salesman offering them financing on the new radio or new car, and since fewer loans were being made with the repaid money, the money supply contracted. The monetary shock led to deflation, and prices fell and profits shrank. Firms pulled back on production, output declined, and unemployment rose. I’m sure a lot of this is starting to rhyme with our other theories, and there are a lot of similarities. What puzzled Fisher and other economists enough to get them to drop this explanation for a while was why the decline would persist. Why don’t lenders make new loans as the debts are being paid off? Shouldn’t this just drive interest rates down to encourage more lending, bringing the economy back to normal? Not if the deleveraging also pushes down asset prices, as it did in the financial crisis. --Picking up on Fisher’s Debt-Deflation hypothesis, none other than Federal Reserve Chairman Ben Bernanke, back when he was working as an academic economist, proposed financial accelerators as an explanation. When households paid back their debts prior to the Great Depression, they led to a fall in sales which crashed the stock market. In the financial crisis of 2008, they pushed housing prices down which reduced the value of mortgage-backed securities. People are able to get credit based on the value of their assets. They put these assets up as collateral which could be sold in the event that the borrower can’t repay the loan. The amount a person or company can borrow depends on the value of their assets, and that means the value of these assets can impact the amount of money which is used for investment. If the value of these assets crashes in a financial crisis, then the amount people and companies can borrow for investment shrinks too, and it won’t increase unless the value of those assets goes back up. The collapse in asset prices accelerates the crash, and without painful deflation throughout the economy or a reinflation of those asset prices, we could get stuck at a low level of investment spending which holds the economy down indefinitely. --A mark in favor of this theory is that it works as an explanation around the world, where many countries all experienced a rise in household debt due to increased mortgage lending fueling a boom in housing prices which eventually crashed when people began paying down their debts. It’s hard to believe that the Real Business Cycle Theory could find reasons for labor productivity to drop in each of these economies, or for the Austrian school to find excessive money creation. But importantly, not all of these economies experienced a bad recession. Australia, in particular, fared well, with only a minor blip showing up in their GDP. --But the theory here, nonetheless, is that some of these economic recessions were being led by a cycle of debt. In the 1920s, people overindebted themselves buying things like refrigerators, radios, and cars all on easy-to-get credit. This isn’t investment, it doesn’t increase production and wages. Instead, it’s paying for more consumption now with less consumption later, and the Depression – in this story – was brought on by that reduction in consumption as people paid off debts. And then in the early 2000s, people started buying houses with easy-to-get mortgages and taking out home equity loans on the increased values of their homes. Home equity loans allow a homeowner to borrow money based on the part of the value of their house that they’ve already paid off. You get a big chunk of cash now, and just make bigger monthly payments. Lots of people did this to remodel their home, go on vacation, retire early, or just enjoy the extra money. But eventually, those payments got too big, and people decided it was time to pay them down. This is a compelling narrative, and it does seem to offer a lot of power in explaining the housing bubble. But it is still a bit incomplete, and really needs to be paired with the Keynesian story to make any sense, which is indeed what its proponents do. However, one critical question is why this reversal in household debt is leading to a crazy collapse in financial markets that brings down the financial system. Why did the financial system allow itself to be so vulnerable to a change in consumer behavior like this?

The Financial Instability Hypothesis

The intellectual legacy of F.A. Hayek eventually spurred economists like Milton Friedman to challenge Keynesian orthodoxy with monetarism, rational expectations, and eventually real business cycle theory. They all concluded the same thing as Hayek: the government should keep its hands off the economy. But some carried forward with the intellectual legacy of J.M. Keynes, and warned that without safeguards, market economies were inherently unstable.

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We saw in previous chapters how after Keynes died, his theory was taken up by others who sought to connect it to the broader theories of economics. First came the Neoclassical Synthesis which connected Keynes’ short run description to the classical long run theory. Then the monetarists emphasized the importance of monetary shocks, the new classical school emphasized the importance of expectations, and the New Keynesians looked for nominal rigidities which would hold the economy at a short run equilibrium. Not everyone agreed with this intellectual path. The British economist Joan Robinson, who worked directly with Keynes as he developed his theories, thought that the new generation of economists were missing the point. Keynesian theory wasn’t meant to describe some full employment equilibrium which is the usual case that we occasionally deviate from. Keynes was trying to get away from the notion that such an equilibrium is the default state of the economy, but rather a rare special case with no magical properties that attract the economy to it. In the 1970s, as rational expectations was taking hold and Keynesian theory was being tossed out, Robinson pushed for a new intellectual project which would focus on what she saw as the central problem, that uncertainty about the future makes a market economy inherently unstable. --This intellectual project is often called post-Keynesian, but there isn’t really a unifying idea which ties it together as a school of thought like the others. But one Post Keynesian thinker, Hyman Minsky, has gotten significant attention for his model of financial markets, and how uncertainty makes them inherently unstable. Minsky breaks debt down into three types of borrowers. --The typical case with debt is that you have what Minsky calls a Hedge Borrower. This would be a person or a company who has a flow of income sufficient to pay down their debts. So, say a company has a decent profit margin, earning good and consistent revenues each year, and they want to expand with a new office in another location. The company projects that the new location will earn similar revenues and profits, and so they take out a $1 million loan to finance the expansion with a 3% interest rate that they intend to pay back in full over the course of three years. At the end of the first year, the balance on their loan is $1,030,000 after adding the 3% interest. They make their annual payment, which if they want to pay off the loan in three years works out to just over $350,000. The remaining balance then accrues 3% interest over the next year, and at the end of year two the company makes another payment, paying that interest but also further paying down the principle. By the end of the third year, their balance is the same as their payment, and they pay off the loan entirely. Hedge borrowers have the income to pay off both the principle and the interest over the life of the loan. Again, this is the typical case. But Keynes himself pointed out a particular feature of a market economy that complicated this picture. --Interest rates tend to be lower if you plan to pay back the loan quickly. This is the spread of treasury yields in 2022, which shows this phenomenon. If you want to borrow money for 1 month, the annualized interest rate is only 0.05%, almost nothing. But if you want to borrow money and pay it back in 20 years, the annualized interest rate is 2.18%. Lenders want to lend for a short period of time, because there is less uncertainty about how things will be in a month compared to how they will be in 20 years. But borrowers want to pay back loans over a long period of time. It’s easy to pay back the loan if you have 20 years to do it rather than one month. But, there is a way for borrowers to get the low short term interest rate but pay it back over a long period of time. --Minksy calls this speculative borrowing. Our firm would take out the million-dollar loan, but with a term of one year instead of three so that they get the lower interest rate. At the end of that first year, the firm has to pay back the full balance of $1,005,000. You can see how the lower interest rate saves them a lot of money, but they might not have enough income to pay off this full balance after just one year. So, instead, they only pay the interest, the $5,000. Then they go to another bank and they borrow $1 million again, which they should have an easy time doing. Their assets and cash flow were enough to convince a bank to give them a million dollars a year prior, so as long as things are going as planned this new bank will be willing to do the same. The firm gets the new million-dollar loan, and then pays off the old one with it. Then, at the end of year 2, they are in the same situation again, owing $1,005,000. They pay the interest out-of-pocket themselves but take out a new loan at the nice low yearly interest rates and roll their balance forward. And then they just keep doing this, basically forever. This kind of speculative borrowing is extremely common, and to get the very best rates many thousands of firms are rolling their debt forward every day. It’s rarely in these firms’ interest to pay off their entire balances because the interest rates are so low that they can get a better return by using their money to make other investments, so they only pay off the interest. If you’ve been going through these chapters wondering why it is that credit markets are so critical to the economy, this is why. If credit markets go even one day where trust fails and businesses can’t get new loans to pay off these old ones, and those firms suddenly have to pay off huge balances all at once, those firms will literally be bankrupted even though their fundamentals are strong and they have enough income to make this debt structure work to their advantage. But Minsky’s big contribution is in describing how that trust fails. --The problem, Minsky said, were Ponzi borrowers. If the economy experiences a long period of stability, these firms start to take on too much risk, increasing their debt burden a lot because the past few years have been good enough to justify it. They get too comfortable and think the good times will keep on coming. But then, if something unexpected happens, and a firm’s revenue drops, they might not have the cashflow to make those interest payments. That means their new loan needs to be bigger so that they can use it to pay the principle and the interest. And since times have been good, banks might be willing to lower their lending criteria to allow these firms to take out bigger and bigger debts. But as soon as the assets of this firm decline in value or they fail to rise fast enough to keep up with their growing pile of debt, they won’t have the collateral to keep this Ponzi scheme going, and they’ll have to default. That default will reverberate through the deeply interconnected system, and if it causes a panic, credit markets might freeze, and we’ll have a full-blown financial crisis on our hands. --The 2008 financial crisis played out a little differently, but this theory which Minsky put forward in the 70s and 80s describes the sub-prime mortgage crisis eerily well. In that crisis, the Ponzi borrowers weren’t the firms, they were the people taking out those adjustable-rate mortgages with big balloon payments they planned to avoid by refinancing their home, leveraging the increasing home prices to their advantage. But as soon as their asset, the home, stopped growing in value, they couldn’t get a new mortgage big enough to pay off the old one and they defaulted. And the reason they were able to do this was because the prosperity had lasted so long everyone was willing to relax their lending criteria and take on more risk. --Minksy calls this the Financial Instability Hypothesis. He says that periods of prolonged prosperity and high optimism lead financial institutions to invest in even riskier assets. Bad news, such as a bad quarter for revenues in a major sector of the economy or a sudden rise in mortgage defaults, can set off a chain reaction of falling asset prices and a collapse in the economy. The financial markets link the economy together in a web of credit, and Minksy, in agreement with Keynes’ General Theory, sees the problem as human nature. People are just prone to optimism in good times, and they are myopic about the past. If the economy goes years without a bump, lending practices which were once considered prudent start to get relaxed and the economic boom continues with the expansion of credit to riskier borrowers. Sometimes its loans to stock traders in the 1920s, sometimes its loans to home buyers in the early 2000s. But eventually the asset prices used as collateral for these loans can’t go up anymore, and their collapse leads to debt-deflation, financial panic, and a collapse. --The policy prescriptions of the Financial Instability Hypothesis are not dissimilar to the actual policies implemented after the financial crisis in 2008. Debt relief, such as expansionary monetary policy which pushes down interest rates and creates some inflation that makes it easier to pay off debts, or just direct debt relief like the TARP program, can help the financial system get its house in order. But add to that financial regulations which restrict Ponzi borrowing and put checks on the system so that it does not relax lending criteria and take on too much risk. In 2010 the Congress passed a bill known as Dodd-Frank, which overhauled financial regulation to bring pieces of shadow banking out into the light, eliminated some regulatory loopholes for big banks, and created a system to encourage financial professionals to whistleblow on illegal practices. A fair bit of those regulations were repealed in 2018. --Minksy’s theories were largely ignored until the financial crisis in 2008, but their compelling narrative which seems to describe the fundamental problems that led to that crisis has brought them into the mainstream. This description of financial instability, when combined with debt-deflation and other aspects of Keynesian theory gives us a coherent understanding of recessions. But it isn’t a complete one. The Minsky hypothesis would have us predicting recessions when the debt burden is rising over a period of stability. This chart shows total U.S. debt, both public and private, as a percentage of GDP. Note that this big spike during the Great Depression is the result of collapsing GDP, not of skyrocketing debt. But here’s the other thing to note, after the Depression, the debt burden fell and remained pretty low, and indeed that period saw fewer and milder recessions. But since Minsky formulated his hypothesis, debt has genuinely taken off to heights never-before-seen. You’d think that period would be littered with recessions, but instead it was the calmest period of stable economic growth in human history. My own take is that Minsky offers incredible and important insight to how financial crises happen, and how they collapse the economy, but it doesn’t quite get us to a complete theory of the business cycle.

Keynes vs. Hayek

The intellectual battle between Keynes and Hayek rages on, and has even produced this wonderful rap battle. Put it on repeat, and absorb the lyrical expression of everything we've covered for the past nine chapters!

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>>CLERK: Lord Keynes! Welcome, sir. It's a pleasure.>>KEYNES: The pleasure's all mine. >>CLERK: Your agenda-->>KEYNES: That won't be necessary. I am the agenda. >>CLERK: [laughs]>>KEYNES: Tell them I've arrived-- >>HAYEK: And then tell them I've arrived.>>CLERK: And, your name is?>>HAYEK: Hayek. F.A. Hayek. With an "H".
>>KEYNES: Freddy. (yeah) Keynes. Hey, listen, party at the Fed.>>HAYEK: Already? >>KEYNES: Twenty minutes. Lobby.
John Maynard Keynes. F.A. Hayek.>>KEYNES: Yeah, we're opposed >>HAYEK: We oppose each other philosophically>>KEYNES: In the same studio
We've been going back and forth for a centuryI want to steer marketsI want them set freeThere's a boom and bust cycle, and good reason to fear itBlame low interest rates No... it's the animal spirits
>>KEYNES: John Maynard Keynes wrote the book on modern macro The man you need when the economy's off trackDepression, recession, Now your question's in sessionHave a seat and I'll school you in one simple lessonBoom! 1929: the big crash, We didn't bounce back, economy's in the trashPersistent unemployment, the result of sticky wages, Waiting for recovery? (Seriously?) That's outrageousI had a real plan any fool can understand, The advice real simple: boost aggregate demand!C, I, G, altogether gets to Y, Keep that total growing, watch the economy fly
We've been going back and forth for a centuryI want to steer marketsI want them set freeThere's a boom and bust cycle, and good reason to fear itBlame low interest rates No... it's the animal spirits
>>KEYNES: You see it's all about spending, Hear the register cha-chingCircular flow, The dough is everythingSo if that flow is getting low, It doesn't matter the reasonWe need more government spending, Now it's stimulus seasonSo forget about saving, Get it straight out of your headLike I said, "In the long run, we're all dead"Savings is destruction, that's the paradox of thrift, Don't keep money in your pocket or that growth will never lift, becauseBusiness is driven by the animal spirits, The bull and the bear and there's reasons to fearIt's effects on capital investment, income, and growth That's why the state should fill the gap, with stimulus bothThe monetary and the fiscal, they're equally correct Public works, digging ditches, war has the same effectEven a broken window helps the glass man have some wealth The multiplier driving higher the economy’s healthAnd if the Central Bank’s interest rate policy tanks A liquidity trap, that new money’s stuck in the banks!Deficits could be the cure, you been looking for Let the spending soar, now that you know the scoreMy General Theory’s made quite an impression [a revolution] I transformed the econ professionYou know me, modesty, still I’m taking a bow Say it loud, say it proud, we’re all Keynesians now
We've been going back and forth for a centuryI want to steer marketsI want them set freeThere's a boom and bust cycle, and good reason to fear it>>KEYNES: I made my case, Freddie H Listen up , Can you hear it?
>>HAYEK: I’ll begin in broad strokes, just like my friend Keynes His theory conceals the mechanics of changeThat simple equation, too much aggregation Ignores human action and motivationAnd yet it continues as a justification For bailouts and payoffs by pols with machinationsYou provide them with cover to sell us a free lunch Then all that we’re left with is debt, and a bunchIf you’re living high on that cheap credit hog Don’t look for cure from the hair of the dogReal savings come first if you want to invest The market coordinates time with interestYour focus on spending is pushing on thread In the long run, my friend, it’s your theory that’s deadSo sorry there, buddy, if that sounds like invective Prepare to get schooled in my Austrian perspective
We've been going back and forth for a centuryI want to steer marketsI want them set freeThere's a boom and bust cycle, and good reason to fear itBlame low interest rates No... it's the animal spirits
>>HAYEK: The place you should study isn’t the bust It’s the boom that should make you feel leery, that’s the thrustOf my theory, the capital structure is key. Malinvestments wreck the economyThe boom gets started with an expansion of credit The Fed sets rates low, are you starting to get it?That new money is confused for real loanable funds But it’s just inflation that’s driving the onesWho invest in new projects like housing construction The boom plants the seeds for its future destructionThe savings aren’t real, consumption’s up too And the grasping for resources reveals there’s too fewSo the boom turns to bust as the interest rates rise With the costs of production, price signals were liesThe boom was a binge that’s a matter of fact Now its devalued capital that makes up the slack.Whether it’s the late twenties or two thousand and five Booming bad investments, seems like they’d thriveYou must save to invest, don’t use the printing press Or a bust will surely follow, an economy depressedYour so-called “stimulus” will make things even worse It’s just more of the same, more incentives perversedAnd that credit crunch ain’t a liquidity trap Just a broke banking system, I’m done, that’s a wrap.
We've been going back and forth for a centuryI want to steer marketsI want them set freeThere's a boom and bust cycle, and good reason to fear itBlame low interest rates No... it's the animal spirits

The Moss-Bartlet Synthesis

And so it is time to wrap up our quest to understand the business cycle. We have explored many different theories, all clumped together into "schools of thought". Let's take a look back.

Open Video Transcript

Advanced economies come with tremendous rewards in the form of better standards of living, longer lives, and greater opportunity for self-determination. But from time to time, they are afflicted by bouts of recession from those rewards. We’ve charted the progression of economic thinking. Every time a new crisis came, so did a new theory to explain it, and each time economists thought that they had finally solved the problem for good only to find a new breed of recession to stump them again. The classical school thought that economies would manage themselves through markets and the price system. “Leave it alone,” they said each panic, “the economy will find the best path through.” John Maynard Keynes disagreed, and the Great Depression was a crisis large enough to force economists to rethink their doctrines. Keynes saw recessions as being caused by a shortfall in aggregate demand that follows a change in sentiments among consumers and investors. People get spooked, they stop spending, and sticky prices and wages mean the fall in demand will cause unemployment. And if we let things get bad, sentiments will worsen, and the recession will become a depression. Instead, Keynes recommended that if people weren’t going to spend money, and no one was going to borrow and invest in the economy, then the government might as well take up the mantle and fill the void with deficit spending. At the time, the only ones with an alternative to Keynes were the Austrians. They saw the problem as being one of government intervention, and therefore more government intervention could not possibly be the solution. For the Austrians, recessions were the inevitable consequence of economic booms brought on by the printing of too much money driving interest rates to artificially low levels. The low interest rates discourage savings and encourage investment, but scarcity means we cannot have both. As consumers and investors both reach for more, they come up empty handed, and the economy collapses when people’s disillusionment is set right. That Austrian narrative left too much unexplained, but some agreed that more government intervention wasn’t the answer. The Monetarists identified the cause of recessions to be monetary shocks, not animal spirits. When the money supply shrinks, or even if it just slows in its growth, people suddenly can’t satisfy their liquidity preferences, and that is what causes aggregate demand to fall. The answer, then, is not government spending, but a credible commitment to stable growth in the money supply. But the New Classical school took issue with that. With their application of rational expectations, they did not believe the public would be consistently fooled by stable inflation. Expectations for inflation would be baked into the process, and monetary shocks which were unpredictable would still lead to recessions. But unfortunately, the actions of the Federal Reserve are too easy to account for and will therefore be rendered inert by changes in consumer and investor behavior. And any attempt by the government to smooth things out with fiscal policy will just crowd out the spending of consumers and businesses. Another dollar spent by the government will be met with a dollar's reduction in private spending.But that was still a theory based on the idea that markets were not able to reach equilibrium quickly. Real Business Cycle Theory completely changed the script with an entirely new model of recessions. For them, the problem wasn’t aggregate demand, it was aggregate supply. Events out of our control effect the productivity of labor, and negative supply shocks would lead people to wisely exit the labor force and work less, reducing overall production and giving the appearance of a recession. For Real Business Cycle Theory, recessions weren’t a deviation from some “trend”, they were the trend, representing an economy still at its highest potential. If you want to increase that potential, then cut taxes, they said. Rather than accept that recessions were nothing more than people choosing to take more vacation time, the New Keynesians got to work identifying the rational reasons markets might not always be at equilibrium. For the New Keynesians, the problem is frictions in the economy, which slow changes in nominal wages and prices down. These “nominal rigities” mean that the Monetarists were right about the causes of recessions, but the New Classical folks were wrong to think there was nothing we could do. The Federal Reserve could use monetary policy to stabilize the business cycle, transitioning between easy money and tight money policies to counter the swings in the economy. And yet, the Post Keynesians still warned about hubris. According to the Financial Instability Hypothesis, people had short memories, with long periods of economic stability they would forget to take the prudent measures needed to properly manage investment risk. Lending rules would be relaxed, and businesses would take on too much debt, rolling it over from one period to the next. As soon as something goes wrong and they can’t make their interest payments, those speculative borrowers become Ponzi borrowers, and a debt bubble rises and then pops, taking the financial system down with it. For Post Keynesians, the business cycle is driven in part by this inherent instability in a market system. --So, whose right? Who should we listen to? With history as our guide, I think we can draw two conclusions. First is to notice that recessions today are milder, less frequent, and much shorter than they used to be, and that change started to happen after the Great Depression spurred us to take some action to moderate the business cycle. The second is to note that most theories were formed and accepted along two criteria: how well do they explain the Great Depression, and how well do they explain the most recent crisis? And so, we’ve ended up with a hodgepodge of theories that each tells us something a little different. In the early-2000s television show The West Wing, an episode showed staffers at the White House devising plans in the facing of coming economic recession. The character Donna Moss, aid to the Deputy Chief of Staff, offers the following advice. --[Transcript not available]--Donna’s advice is just right. Each theory gives us a little insight into the problems an economy might face. I think there are certain facts about the economy that we should accept. Wages and prices are sticky, which means monetary shocks really can impact production and employment. The cold fronts are listening, and government policies will always be less effective than we hope. High marginal tax rates do reduce the labor supply. And sometimes it is a supply problem and not a demand problem. Different problems call for different solutions, and since it is hard to tell what problem we might be facing in the moment, you want to lean a little on every theory. And fictional President Josiah Bartlet agrees. --[Transcript not available]

Quick Quiz

Now is the time to test yourself on these concepts! This quick quiz is a great way to see what has clicked and what needs more attention. It is also a good time to reach out to your instructor with questions.

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