What I'm Reading
By Arnold Kling
Macroeconomic Theory and its Failings, edited by Steven Kates. The publisher, Edward Elgar, prices its hardbacks out of reach for ordinary readers. I assume that their target buyers are libraries. I received a review copy.
The book consists of essays from heterodox economists, including a major camp of Austrians (Pete Boettke and Steven Horwitz stand out) and a major camp of Minsky-ites (Robert E. Prasch stands out). I am in the odd position of agreeing with both of those camps.
Before I get to those, let me quote Martin Ricketts (p. 215).
Mutual governance emerges in situations of great uncertainty and where the dangers of moral hazard and adverse selection are extreme.
He is talking about Coasian transaction-cost issues in the governance structure of financial firms. He is suggesting that when insurance-type risks are involved, a mutual structure works best. I would note that there are pundits who suggest that one of the factors in the financial crisis was the conversion of investment banks from partnerships to public companies.
The downturn in economic activity we associate with the recession is, on the Austrian view, the economy attempting to shed capital and labor from where it is no longer profitable. Because markets are discovery processes that take place through real, historical time, and because human actors have fragmentary knowledge, moving those resources to where they will be more productive cannot happen instantaneously. Entrepreneurs at the earlier stages of production will idle capital and labor as their profitability shrinks. Entrepreneurs at the later stages will now have to consider whether to purchase new capital or hire new labor. They may well have to wait until prices and wages fall sufficiently to make the purchases worthwhile. They may also have to wait until workers can learn where the new opportunities are, and possibly get retrained, much as some capital might have to be refit to be valuable at the later stages.
Now you see where my Recalculation Story comes from.
Prasch writes (p. 191):
Minsky was not simply denying the proposition that markets were able to bring about stability from a position of instability. He was affirming the direct opposite…we could begin with a free market system in a state of stability, this condition would itself…bring about instability…markets were self-destabilizing.
prolonged stability would modify the expectations of underwriters and creditors…Revised expectations, working in conjunction with competitive pressures, would induce profit-seeking firms to engage in ever-more risky financial transactions…during tranquil and relatively prosperous periods firms are pleased to discover that the default rate on risky assets is lower than predicted…they come to believe that transactions or positions that they once perceived to be overly risk should be reclassified as acceptable risks
Thus we have the story of the emergence of subprime mortgage lending.
In Banks and Modigliani-Miller, I talked about financial intermediaries producing misleading signals about the underlying risks they are taking. In that regard, I am telling a Minsky story. We get a tranquil period, and people become less and less wary of the underlying risks that financial firms are taking. Instead, we see misleading signals: a track record of low defaults; banks claiming that they have achieved this with new technology (computer models, innovative securities); and regulatory cheerleading. Make no mistake, the regulators were cheerleading for relaxing mortgage credit standards, securitizing mortgages, and tactics that raised bank leverage. I have plenty of quotes from top regulators in 2005 and 2006 telling us how much safer the system had become, thanks to financial innovation. See Not What They Had in Mind.
In the Austrian view, misleading signals are created by low interest rates set by the central bank. In the Minsky view, misleading signals are endogenous to the financial process. I think that the Minsky story has merit. Otherwise, I see the way that the crisis plays out–the Recalculation Story if you will–as following the Austrian description.