Below is a framework that delineates the ideology and economics of two groups of economic thought that are much talked about in the wake of the Credit Crisis: the Chartalists and the Austrians. These two groups are considered outside of the mainstream and this is important because many economists and market pundits in both camps predicted the global credit crisis while almost no mainstream economists did. The questions are why and what separates them from mainstream Keynesians and Monetarists and from each other?
Let’s talk about ideology first. Almost exactly a year ago, I wrote that:
my goal… is to separate the policy and the politics from the mechanics of how our fiat money system operates. That way it will be clear what is actually happening in our monetary system right now and what is pure political posturing…
…policy decisions are largely political, exogenous decisions about which informed decision-makers can disagree. However, if we aren’t at least informed about the mechanics of how modern money works, it is very difficult to have an intelligent debate about deficits, Social Security, fiscal stimulus or anything else for that matter.
Here’s what I was saying: there are good economic frameworks we can all use to understand the economy. However, two individuals using the same framework can come up with wildly different economic policy prescriptions, depending on one’s political or philosophical predisposition. Much of this has to do with one’s view toward the role of government.
My view is that the most logical way of thinking of government’s role is to differentiate between effective and ineffective policy. I am mostly a pragmatist; so what concerns me is the efficacy of government policy, not its size or scope per se.
Because government must tax to maintain its existence or to ensure its control of the currency and this tax will redistribute monies from some agents to others, what are our priorities as a people as to how that redistribution should take place? Who should we tax, by what means and by how much? And who should receive the benefits of government spending and for what purposes? These are questions actually worthy of debate and are fundamental to democracy.
Yet, that is not the delineation normally used to frame government’s role in most all economic ideology. Instead, we are presented with arguments about the size and scope of government.
When thinking about government and its role and size, there are three camps of thought.
- Big Government. Supporters of big government believe that government can do good. In this view, an increase in the size of government is not just warranted but necessary in a severe economic downturn in order to fill the void left by the private sector’s fragility. The large scale fiscal stimulus enacted in 2001 at the beginning of President Bush’s first term, in 2008 at the tail end of the Bush Administration, and in 2009 during the Obama Administration are examples of Big Government in action.
- Limited Government. People in this camp believe that government must always be held in check – even in times of economic distress. If not, a self-perpetuating bureaucracy develops, with a cadre of individuals dependent on government and wedded to institutions or programs which no longer have great value. In this view, expanding government is like moving to into bigger house; the new space must be filled with stuff, with size justifying the need for possessions rather than the need for space justifying the size.
- Small Government. Individuals in this camp see government as a parasite which, while necessary in small measure, always and everywhere raises the specter of despotism and cronyism. In this view, government must be kept as small (and as local) as possible because it feeds on society and on power to usurp property and wealth for its own use and that of its cronies.
When I look at the economics world, I see four economic thought groups divided by this principal ideological difference. In the mainstream we see the Keynesians and the Monetarists. In the heterodox areas, we see the Chartalists and the Austrians
- Chartalists and Keynesians are ‘pro-government’ meaning "an increase in the size of government is not just warranted but necessary in a severe economic downturn".
- Austrians and Monetarists are ‘anti-government’, meaning they "believe that government must always be held in check – even in times of economic distress" or they see"government as a parasite which, while necessary in small measure, always and everywhere raises the specter of despotism and cronyism"
If I could simplify the Monetarist and Keynesian view of recessions, this is what I would say:
- Keynesians: Market-based economies are more efficient and lead to higher growth than command and control economies, but markets do fail. When they do, aggregate demand collapses. We advocate an activist policy response in both fiscal and monetary policy. This will mitigate the severity of downturns by increasing aggregate demand and lead to higher growth as a result.
- Monetarists: "Inflation is always and everywhere a monetary phenomenon" as Milton Friedman said in 1970. This is a lesson we failed to appreciate during the Great Depression. During recession, lowering the rate of interest will mitigate the severity of downturns by increasing the supply of money and lead to higher growth as a result. Therefore, we advocate an activist policy response only in monetary policy. Government’s fiscal policy must be limited and should not be used to counteract a deflationary threat which is a purely monetary phenomenon.
Paul Samuelson was at the center of creating the neoclassical synthesis that is mainstream economics today. This unites Keynesian and Monetarist thought in a unified but rivalrous body of thought. After the Great Depression, the Keynesians gained sway and their dominance lasted for some 30 years. However, when the U.S. went off the gold standard in 1971 and the world experienced an oil shock in 1973, a painful inflationary period led to the rise of the monetarists, led by Milton Friedman and the Chicago school. See: Freshwater versus saltwater circa 1988. Nevertheless, despite the ideological differences between these groups neither predicted the credit crisis. The Economics discipline failed us at the most crucial moment in the last three quarters of a century in economic history.
Naturally, then there have been many attempts to understand why. In September of 2009, Paul Krugman asked "How Did Economists Get It So Wrong?"in a long piece on this in the New York Times. This past week, Brad DeLong wrote another widely-read piece in reference to comments by Larry Summers, a former Treasury Secretary and the Chief Economic Advisor to President Obama, questioning the same problem. In it, he acknowledged that mainstream economics got it wrong:
Here is the most interesting part of Summers’ long answer: “There is a lot in [Walter] Bagehot that is about the crisis we just went through. There is more in [Hyman] Minsky, and perhaps more still in [Charles] Kindleberger.” That may sound obscure to a non-economist, but it was a devastating indictment…
It is the scale of the catastrophe that astonishes me. But what astonishes me even more is the apparent failure of academic economics to take steps to prepare itself for the future. “We need to change our hiring patterns,” I expected to hear economics departments around the world say in the wake of the crisis.
The fact is that we need fewer efficient-markets theorists and more people who work on microstructure, limits to arbitrage, and cognitive biases. We need fewer equilibrium business-cycle theorists and more old-fashioned Keynesians and monetarists.
I have drawn a different conclusion from the crisis to Brad DeLong actually: We need fewer equilibrium business-cycle theorists and fewer old-fashioned Keynesians and monetarists. We need more Austrians and Post-Keynesians (Chartalists).
As I wrote in January 2010 on "Why economists failed to anticipate the financial crisis":
Paul Krugman is a Keynesian. So, his prescription is fiscal stimulus. Have the government pump money into the economy and it will alleviate some of the pressure for the private sector. There is some merit to this argument on stimulus. Many Freshwater economists say monetary stimulus is what is needed. If the Federal Reserve increases the supply of money, eventually the economy will respond. This is what Ben Bernanke was saying in his famous 2002 Helicopter speech at the National Economists Club.
Yet, I couldn’t help but notice that Krugman mentioned the word debt only twice in 6,000 words. In fact, it is in the very passage above where Krugman uses the term for the only time in the entire article. And here Krugman refers to government debt; no mention of private sector debt whatsoever…
The reason economists failed to anticipate the crisis is because they were fixated on avoiding downturns and driving the economy to unsustainable growth rates by using debt to consume today what will be earned in the future. Debt is the central problem.
What Keynesians and monetarists have in common is a fixation with mitigating the downturn without any sense of the importance of secular forces like debt accumulation. Commenting on former BIS head William White’s comments on this matter, I wrote:
When aggregate debt levels build up across business cycles, economists focused on managing within business cycles miss the key ingredient that leads to systemic crisis. It should be expected that politicians or private sector participants worried about the day-to-day exhibit short-termism. But White says it is particularly troubling that economists and their models exhibit the same tendency because it means there is no long-term oriented systemic counterweight guiding the economy.
This short-termism that White refers to is what I call the asset-based economic model. And, quite frankly, it works – especially when interest rates are declining as they have over the past quarter century. The problem, however, is that you reach a critical state when the accumulation of debt and the misallocation of resources is so large that the same old policies just don’t work anymore. And that’s when the next crisis occurs.
And so we should look to other schools of economic thought for answers. The two schools I want to concentrate on are the Austrians and the Post-Keynesians. Both schools predicted the crisis because they understand the importance of debt accumulation as a secular force in depressions.
The Austrian School of Economics is one of two principal heterodox schools of thought that foresaw the credit crisis. That makes them worthy of attention.
I like the Austrian framework for how business cycles proceed. Ludwig von Mises, an early 20th century economist, spelled it out in 1936 in the midst of the Great Depression:
- "The lowering of the rate of interest stimulates economic activity. Projects which would not have been thought "profitable" if the rate of interest had not been influenced by the manipulations of the banks, and which, therefore, would not have been undertaken, are nevertheless found "profitable" and can be initiated. The more active state of business leads to increased demand for production and the wages of labor rise, and the increase in wages leads, in turn, to an increase in prices of consumption goods. If the banks were to refrain from any further extension of credit and limited themselves to what they had already done, the boom would rapidly halt. But the banks do not deflect from their course of action; they continue to expand credit on a larger and larger scale, and prices and wages correspondingly continue to rise."
In the modern context, it is not that credit has expanded but rather that the rate of interest has allowed credit to expand and projects to be undertaken that are not profitable at a higher rate of interest. Low interest rates change the structure of the economy. For example, low interest rates made housing more affordable in the prior decade, drastically increasing the flow of credit to the housing sector and fuelling a credit bubble.
- "This upward movement could not, however, continue indefinitely. The material means of production and the labor available have not increased; all that has increased is the quantity of the fiduciary media which can play the same role as money in the circulation of goods. The means of production and labor which have been diverted to the new enterprises have had to be taken away from other enterprises. Society is not sufficiently rich to permit the creation of new enterprises without taking anything away from other enterprises. As long as the expansion of credit is continued this will not be noticed, but this extension cannot be pushed indefinitely. For if an attempt were made to prevent the sudden halt of the upward movement (and the collapse of prices which would result) by creating more and more credit, a continuous and even more rapid increase of prices would result. But the inflation and the boom can continue smoothly only as long as the public thinks that the upward movement of prices will stop in the near future. As soon as public opinion becomes aware that there is no reason to expect an end to the inflation, and that prices will continue to rise, panic sets in."
In the modern context, it is not consumer price inflation but rather asset price inflation which cannot continue indefinitely. As soon as credit stops flowing to the sector where the asset bubble has formed, prices drop and revulsion steps in. That is what we saw during the tech bust and the housing bust as well.
- "Some enterprises cut back their scale of operation, others close down or fail. Prices collapse;crisis and depression follow the boom. The crisis and ensuing period of depression are the culmination of the period of unjustified investment brought about by the extension of credit. The projects which owe their existence to the fact that they once appeared "profitable" in the artificial conditions created on the market by the extension of credit and the increase in prices which resulted from it, have ceased to be "profitable." The capital invested in these enterprises is lost to the extent that it is locked in. The economy must adapt itself to these losses and to the situation that they bring about. In is case the thing to do, first of all, is to curtail consumption and, by economizing, to build up new capital funds in order to make the productive apparatus conform to the actual wants, not to artificial wants which could never be manifested and considered real except as a consequence of the false calculation of "profitability" based on the extension of credit."
Isn’t this what is happening right now? Again, when Mises refers to prices, you should be thinking about asset prices in the modern context. Mises also says curtailing consumption to build up new capital funds is vital. In the modern context, that is called deleveraging.
But here is the key section that is controversial, the policy prescription:
- It has often been suggested to "stimulate" economic activity and to "prime the pump" by recourse to a new extension of credit which would allow the depression to be ended and bring about a recovery or at least a return to normal conditions; the advocates of this method forget, however, that even though it might overcome the difficulties of the moment, it will certainly produce a worse situation in a not too distant future.
Mises is essentially saying let the chips fall where they may. This is the crucial part that other economic schools of thought reject. I would say this prescription works in a garden variety recession. If you build up debt across business cycles and allow the system to collapse, what would the political consequences be? Would civil unrest lead to failed states and the rise of demagogues and authoritarian leaders? And would the friction from a collapse in demand create trade and currency disputes that led to military confrontation?
Hyman Minsky is the main economist celebrated from the Post-Keynesian school, although Wynne Godley and Abba Lerner often get top billing as well . This school of thought is now being dubbed Modern Monetary Theory or MMT because of its explanation of the fiat currency monetary system that came into being after 1971. At its core, the theory rests on just a few planks:
- Fiat money has no intrinsic value. It simply represents a liability of government, an IOU. The only promise government makes is to repay the holder of that liability with another IOU of equivalent nominal amount in whatever money form the government decides: it could be coins, bonds, paper currency or electronic credits.
- Because money is created by government, this means government faces no solvency constraints in its own currency since it could always fulfil its IOU liability by creating more money. Government could default on its fiat currency obligation only as a political decision out of a desire not to manufacture more money.
- In a fiat currency system, when government is the monopoly issuer of currency, money derives its value from the government’s ability to tax and is entrenched by its use as the money of legal tender. Government is the only entity in society that can coerce any and everyone in its jurisdiction to accept a liability.No transaction between private parties can be coerced under penalty of law. However, taxes are coercive, meaning they are not a voluntary arrangement between two parties. This coercive power means you need government’s money to expunge your tax liability.
- Wynne Godley promoted the accounting identity which showed that government deficits are exactly equal to non-government sector surpluses. That is to say, in an open economy like the U.S., the private sector balance plus the current account balance is exactly offset by the government sector’s balance. Any movement in one balance necessarily moves the others. Government budget deficits are the result of this ex-post accounting identity, meaning attempts to reduce deficits will actually have unintended consequences due to the accounting identity. An attempt to reduce deficits in the face of the private sector’s desire to net save after a large build up of debt will fail and lower aggregate demand.
- The U.S. dollar’s role as a reserve currency creates pressure on the capital account, causing a capital account surplus and a current account deficit. Combined with the private sector’s desire to net save, this entrenches federal government deficits.
- Excess credit builds up across cycles such that there is a secular life cycle of an economy. Depressionary booms and busts are thus endogenous to credit-based capitalist systems. The robustness of the financial system encourages greater risk and creates the build up of credit from hedge borrowers to speculative borrowers to Ponzi borrowers, inducing the fragility that leads to crisis and depression.
The principal policy tool in the MMT framework is government’s role in regulating the flow and accumulation of net financial assets in the private sector.
The government creates private sector assets by issuing money or bonds in exchange for current goods or services, or else for nothing at all via simple transfers. Governments destroy private sector financial assets via taxation. MMT-ers tend to view financial asset swaps, whereunder the government issues money or debt to buy financial assets already held by the private sector (“conventional monetary policy”) as second order and less effective, although they might acknowledge some impact.
The controversial aspect of this comes from Irving Fisher‘s Theory of debt deflation, which suggests that economies are not self-equilibrating. Not arresting the fall in aggregate demand and preventing the collapse in employment leads to a permanent loss of output. MMTers suggest government intervention to support aggregate demand and bring the economy back to full employment.
First of all, I have really done some heavy reductionism in explaining these four groups of economic thought. So I apologize if I oversimplified. But, on the whole I use a Austrian-Chartalist blend. I do not see the two schools of thought as incompatible.
The economics of Austrians is predicated on the inherent instability of the credit mechanism, something very much aligned with Minsky’s view of the instability of stability. The idea is that credit growth becomes divorced from the underlying economics of business ventures (for whatever reason) and this leads to a boom-bust. Where ideology and politics enter is in assessing the phrase "for whatever reason". Is it the Government (the central bank), is it fractional reserve banking or is it the inherent instability of capitalism because of reflexivity? Ludwig von Miss says it is fractional reserve banking when he writes:
In issuing fiduciary media, by which I mean bank notes without gold backing or current accounts which are not entirely backed by gold reserves, the banks are in a position to expand credit considerably. The creation of these additional fiduciary media permits them to extend credit well beyond the limit set by their own assets and by the funds entrusted to them by their clients. They intervene on the market in this case as "suppliers" of additional credit, created by themselves
That may be true – in a gold standard – but I agree with Minsky that the capitalist system is inherently prone to the build-up of excess credit due to animal spirits – and I believe this is true irrespective of fractional reserve banking. That is why I wrote last week on why markets fail, saying the inherent instability of capitalism came from a reflexivity that cannot be modelled using existing mathematical economic models. The Soros piece which spurred that post identified this very well using Friedrich von Hayek as an example. Soros is astute in saying the flaw with Hayek comes here:
Hayek also recognized that decisions based on an imperfect understanding of reality are bound to have unintended consequences. But Hayek and I drew diametrically opposed inferences from this insight…
Hayek subordinated his methodological arguments to his political bias. That is the source of his inconsistency. In the Economica, he attacked scientism. But after World War II, when the communist threat became more acute, he overcame his methodological qualms and became the apostle of market fundamentalism — with only a mild rebuke for the excessive use of quantitative methods in his Nobel Prize acceptance speech.
In all economic schools there is no monolithic way of thinking. The ‘Austrianism’ of today is not the Austrianism of Mises, but more that of latter day Hayek and Rothbard. For example, nowhere does Mises mention the efficient market hypothesis or rational expectations theory. Why? Because those theorems didn’t exist when he lived. They were added to Austrian school thinking by latter day Libertarians after the Samuelson-led neoclassical synthesis made market fundamentalism the mainstream economic doctrine.
Just as Samuelson united mainstream economics in the neoclassical synthesis, I believe Modern Monetary Theory and Austrian Economics have underpinnings which can be united. First and foremost, it is about the build up of credit, leading to an unstable and crisis-ridden period. The point is that if you strip away the politics and ideology and look at the economics, MMT and Austrian economics are not incompatible.
And because the neoclassical tradition has proved inadequate in addressing this crisis, I believe we should look ever more to these two schools of thoughts for a framework to develop solutions.
The Austrian Theory of the Trade Cycle, Ludwig von Mises, Gottfried Haberler, Murray Rothbard, Friedrich von Hayek