For “new economics,” look to old economists

November 9, 2009

When it comes to managing the business cycle, mainstream economics have failed rather spectacularly, their prescriptions leading to increasingly violent bubbles and busts. For this reason there have been calls for a “new economics.” To get there, perhaps we just need to rediscover forgotten economists like Hyman Minsky and Ludwig von Mises.

I was intrigued by an article by Mark Whitehouse in the Wall Street Journal last week. He described how concepts like “leverage” and “collateral,” crucial to understanding credit and commonly discussed by financial economists, remain foreign to mainstream economics.

These are concepts that Minsky understood as far back as the ’60s. His Financial Instability Hypothesis precisely describes the credit bubble and bust we’ve just been through.

Today Minsky is more frequently discussed in investment circles, but his ideas remain largely ignored by academic economics. And they certainly don’t inform policy.

Then there is Mises, who Mark Spitznagel writes in this weekend’s Wall Street Journal “predicted the depression” yet remains totally ignored by the mainstream: “How curious it is that the guy who wrote the script depicting our never ending story of government-induced credit expansion, inflation and collapse has remained so persistently forgotten. Must we sit through yet another performance of this tragic tale?”

Most likely so, since Mises is generally dismissed as a “sound money” quack.

My favorite forgotten economist is L.M. Holt, who described the debt deflationary theory of depressions in 1897. (For easier reading, I retyped it.)

Irving Fisher, who is credited with that theory thanks to a paper published in 1933, only came to it after being crushed, financially and intellectually, by the Great Crash. (Days before it he declared that stocks had reached “a permanently high plateau.”) Had Fisher read Holt, he might have understood that the market peak was a debt-financed mirage.

Instead of learning from Fisher’s mistake, economists are repeating it, advocating the inflation of a new public debt bubble to replace the private one that just burst.

This is unfortunate. If mainstream economists had the intellectual honesty to admit that their theories don’t properly account for debt, if they gave “fringe” thinkers like Minsky and Mises a fair hearing, we might discover the “new” economics that has been under our noses for a hundred years.


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“I maintain, however, that allegiance to perfectly free markets is misguided. I rest my case on the fact that a number have said Somalia is a model of governance to emulate. I invite those of you who believe that to move to Somalia.”At the very least, I didn’t say that. I just referred to a paper that suggests that Somalia has been doing better without a central government than it did with one. The facts that Powell documents in that paper suggest that: (1) the Somali anarchic system works well for the Somalis, and (2) the system doesn’t work well for non-Somalis. Ultimately, when justice is administered by tribes and relationships between tribes, being without a tribe would likely lead to a lack of justice. So, it would be unwise for me – or anyone else who thinks Somalia’s system is doing a decent job – to move to Somalia. It may be a country that works for Somalis, but it’s not one that expands to include immigrants very well.The only point that I was trying to make is that Somalia gets an unfair “bad rap”, and as such is not a good argument for why unfettered markets are a bad idea.So far, your argument against unfettered markets has relied on:OTC derivatives – which you now agree isn’t actually free because of the Fed’s interest rate interventions.People not using roads without stoplights – which is false because there are European cities that have actually gotten rid of their traffic laws, and have ended up better.An appeal to authority – from Hobbes, a man who believed that your dreams were largely a function of how warm you were when you slept.Somalia – which has improved since it got rid of its government, even if it doesn’t incorporate new members into society very well.I’m sure you don’t mind if I find myself unconvinced.

Mr. Burdell;I invite you to learn more about fractional reserve banking. It seems you have fallen prey to a common, yet very basic, misunderstanding about how it works.A bank cannot lend more money than it has. If you deposit $20, the bank can only lend $18, which is something I could also do without violating any laws.In the end, I agree that full reserve abnking would work. The subsistence farming comment is a bit of hyperbole (and really only applies to those who believe that CDs should be fully reserved as well).However, my contention that the system would still work is based on a confidence that banks would merely work around the restrictions and that effectively nothing would change. Sure, the lower classes and small businesses would probably lose access to low fee deposit accounts, but banks would simply drive all but the most stubborn or ignorant depositors to investment deposits thus evading the reserve requirement.In fact, just during my morning bike ride I created a workable structure that a bank could implement using daily maturity CDs to replace demand accounts. It’d be more expensive for the bank, and therefore more expensive for the depositor and borrower, but it would work.So sure, it would work, but in spite of your attempts to hobble the system.You are also rediculous for attempting to imply that I think hyper inflation is good. As long as the change in currency (inflation or deflation) is moderate and predictable I’m not sure that it matters which way things go. It’s when the movement of money is extreme and/or unpredictable that damage occurs.

Posted by Andrew | Report as abusive

Andrew:You forgot that in lending the $18 the bank still owes me $20 and only has $2 in reserve to give me. To make good on its contract with me, if I decide to withdraw my $20 before the loan is due, it must, in effect, counterfeit $18, which it does via the Federal Reserve Bank. The contracts I refer to are checking and savings accounts which I can withdraw from at anytime vs. instruments like CDs which stipulate a specific time in the future when I’m able to access that money.

Posted by Art Thomas | Report as abusive

Art:And yet fractional reserve banking worked across the globe for well over a century without a federal reserve.That’s because every bank has a hundred thousand people depositing money and they don’t all want their money out at once. Taking advantage of this goes back well before formalized fractional reserve banking.

Posted by Andrew | Report as abusive

I think the concept of perfection has made a lot of danger and this because of the current mainstream math-economics models which draw and calculate this supposed perfect state of the world. There’s no perfection in every human activity, so there’s no such a thing like an ideal of perfect market (and the need of the government to act when the market fails to reach this perfect state).And there’s no such a thing like a perfect free market. There’s only the market: the whole of voluntary exchanges. It’s free in his own definition. And what Mises theory shows us is that a free market is better if we want to avoid the business cycle.Don’t you like bailouts? So you shouldn’t like the central bank and the current global financial system: central banks are only there to help banks when they have problems and they can do it because of their monopolistic status. And if only the central bank can produce money, well that’s not really “free” like it should be. End of story.

Posted by Lorenzo B. | Report as abusive

@Andrew”I invite you to learn more about fractional reserve banking.”I am always trying to learn more, including about banking. I absolutely muddled up my whole analogy. You are right that banks can not loan out more money than is originally deposited with them. The point I was trying to get at; however, and I am sure you would agree, is that, if only for a short time, banks are creating money (in the form of credited deposits) by, per the example, loaning out $18 of my deposit, while still telling my that they have $20 sitting in my account (when in reality there are only $2 “sitting” there). Art points this out in his post. Now, if you repeated this behavior, you would be committing fraud, since you really do not have my $20 sitting safely away in your vault or wherever.

Posted by George P. Burdell | Report as abusive

Ok, so we have a difference on what your account represents and what the bank has promised you.You think your account should be like a safety deposit box, representing money present, so that the bank’s only job is to pay guards to stand watch.It actually represents how much money you have a right to demand from the bank.Claiming that the bank is undertaking a fraud because they don’t have all $20 of “your” dollars on hand is like saying you are being fraudulent if you tell someone you have $20 after you deposited the money.You DO have a right to $20, so you do “have” $20. Of course, what you really have is a cash equivalent receivable of $20. In fact, its so close to being like cash in your pocket (especially with debit cards) that there is nearly no distinction these days.So long as the bank can meet its obligation to pay you the amount you have a claim to at the time of your demand it has met the promises it made. Any other promises you imagined were made to you are not binding on the other party.I would like to see you, or anyone, put together a business plan for a full reserve bank. For the sake of discussion, let’s say its a not-for-profit bank. Put pencil to paper and figure out the fee revenue that your bank would have to generate from the depositor’s accounts just to break even while still providing the transaction services that a banking customer expects today.If you do that, I believe you’ll realize why there are no full reserve banks in business. No one would be willing to pay the fees that would be required.

Posted by Andrew | Report as abusive

It seems obvious to me now, Mr. Winkler, that you\’re not actually interested in rational discussion. As far as I can tell, no commenter claimed that \”Somalia is a model of governance to emulate\”. For you to claim that multiple commenters have done so is a first-rate example of the straw-man fallacy. Something tells me that this was, in fact, deliberate on your part; hence you seem to be only interested in spreading propaganda.Perhaps your goals would be better served by disabling the comment feature on your blog, if that is allowed by the parent website.

Posted by Autolykos | Report as abusive

Andrew,It all depends on the contract between the bank and the depositor. If the bank says it will pay you upon demand (and they make the same claim to all other depositors) then they are committing fraud because they obviously cannot pay all depositors on demand (and during a bank run they would actually default). Banks should be honest in their contract language, otherwise depositors will not have the correct information to make the best decision with their property (and mis-allocate it).Of course if people wished to put their property at greater risk (short or long term deposits or whatever else) they will be compensated for the risk (lower fees and greater returns).All I believe the Austrians are trying to say is that the warehousing contracts banks enter should be separated from any investment aspect.

Posted by John Deal | Report as abusive