Reality Intrusion

Rob Parenteau, CFA, serves as an economic and investment strategy consultant at MacroStrategy Edge, and edits the monthly Richebacher Letter. He also serves as a research associate at the Levy Economics Institute.

The Austrian School works with a world where money and finance can have repercussions on the real economy, primarily through the effects of financial signals and credit flows on the allocation of productive resources. So too did J.M. Keynes and Hy Minsky, and so too did Dr. Kurt Richebacher. It is a world most of us would recognize as part of our actual experience in the economy.

Contemporary macroeconomics has little room for money and finance to matter. General equilibrium theory, the intellectual pinnacle of the profession, has no room for money. Real business cycle theory has no room for finance – negative shocks to productivity, virtually from out of the blue, are the stated source of recessions. The Taylor rule, which ostensibly guides central bank policy rate setting, has an interest rate but no room for either money or finance, unless it is packed away in the error terms of the canonical equations. Recently, the Henry Kaufman Professor of Financial Institutions at Columbia University and his co-authors concluded the US housing bubble had little effect on consumer spending patterns. Huh?

Investors clobbered repeatedly by financial crises have good reason to search beyond conventional economic analysis. Much of the mainstream approach to economics has made itself irrelevant or at least foreign to our actual experience. Indeed, there is an argument to be made that the representation of human behavior in mainstream economics has approached qualities that would more likely be associated with people struggling with various degrees of autism (you will find this notion, which actually deserves to be taken more seriously, developed in greater detail at a quick glance at the quotes from contemporary economists in the left column will convince you that some members of the profession know there is a problem).

Apparently, repeated episodes of financial instability may also be getting through to not just investors, but policy makers as well. Much to our surprise, the latest World Economic Outlook published by the IMF reveals a macro framework that we believe those pursuing the unconventional insights of the Austrian School, Keynes, Fisher, Minsky, Dr. Richebacher and many others would largely recognize. In discussing the distinct characteristics of business cycles that involve a major financial crisis, the IMF staff discovered the following:

“…expansions associated with financial crises may be driven by overly optimistic expectations for growth in income and wealth. The result is overvalued goods,
services, and, in particular, asset prices. For a period, this overheating appears to confirm the optimistic expectations, but when expectations are eventually disappointed, restoring household balance sheets and adjusting prices downward toward something approaching fair value require sharp adjustments in private behavior. Not surprisingly, a key reason recessions associated with financial crises are so much worse is the decline in private consumption.”

While not as precise as the models developed by heterodox economists over the decades here the IMF recognizes the end of an expansion has something to do with falsified income expectations and mispriced financial assets. When financial signals promote misallocation of productive resources, profit income expectations are likely to be falsified as malinvestment or overinvestment is revealed. With earnings expectations falsified, equity and corporate bond prices are likely to fall toward “fair” or intrinsic value. As product and financial markets react to profit disappointments, households face layoffs leading to further income disappointments, as well as falling wealth, and consumer spending growth contracts. All of this should sound very familiar.

What about the recovery profile from recessions accompanied by major financial crises? Here, summarizing the results of the “Big Five” financial crisis episodes identified by economists Reinhart and Rogoff – which include Finland (1990–93), Japan (1993), Norway (1988), Spain (1978–79), and Sweden (1990–93) – the IMF has found some notable differences from the typical recovery trajectory.

“What do these observations tell us about the dynamics of recovery after a financial crisis? First, households and firms either perceive a stronger need to restore their balance sheets after a period of overleveraging or are constrained to do so by sharp reductions in credit supply. Private consumption growth is likely to be weak until households are comfortable that they are more financially secure. It would be a mistake to think of recovery from such episodes as a process in which an economy simply reverts to its previous state.

Second, expenditures with long planning horizons—notably real estate and capital investment—suffer particularly from the after-effects of financial crises. This appears to be strongly associated with weak credit growth. The nature of these financial crises and the lack of credit growth during recovery indicate that this is a supply issue. Further…industries that conventionally rely heavily on external credit recover much more slowly after these recessions.

Third, given the below-average trajectory of private demand, an important issue is how much public and external demand can contribute to growth. In many of the recoveries following financial crises examined in this section, an important condition was robust world growth. This raises the question of what happens when world growth is weak or nonexistent.”

Again, these are themes which should sound familiar to you. Professional equity investors were, up until the past month, very eager to count the green shoots sprouting from the monthly flow of economic statistics. Policy makers are eager to get banks to revive loan activity. Both of these constituencies appear to be ignoring that the way out of a recession that was triggered in no small part by an overleveraged US consumer may not be the same as the way in. The IMF staff, in contrast, may be starting to get the joke.

More importantly, the IMF staff seems to understand the unique nature of the challenge this time around. In the five prior recessions they studied with significant financial crises, the way out was not through releveraging of the private sector, but rather through improved trade balances, as global growth successfully floated all boats. If private sector spending is dampened by balance sheet repair and lender caution, then economic recovery prospects become more dependent on fiscal stimulus or foreign demand. This time around, the latter exit, the one the IMF identifies as most frequently employed in such situations, is somewhat blocked as the countries running the largest current account deficits wrestle with the most severe recession in many decades.

Calls for a second round of fiscal stimulus have begun to crop up around the US in recent weeks as fears the green shoots will fade to brown have been fed by a weaker than expected employment result, more signs of debt distress, and the continued ravages of home price deflation. That such calls are arising just weeks after investors were debating the prospects for hyperinflation dynamics taking hold, and bidding up commodity prices while selling Treasury bonds, tells you something about the deep uncertainty that still prevails. We are indeed in uncharted waters. What remains missing is any serious investigation of a new global growth model. The old one, based on consumer debt binges fueled by serial asset bubbles on the one hand, and headlong expansion of productive capacity in low labor cost countries that prefer to accumulate foreign currency reserves in part to manage currency pegs, is impaired enough that even the IMF realizes the scope of the challenges ahead.

On the US side, we know issues of private sector deleveraging, energy independence, water infrastructure, education and health care need to be addressed. Entrepreneurs, investors, policy makers, and economists best train their efforts in these directions to craft a plausible way forward from what is clearly not a garden variety recession with a conventional monetary or fiscal policy fix. If public/private collaboration is required to execute solutions in these areas because investors and creditors remain too short term oriented or too risk averse, then so be it. Reality has intruded on a global growth model that has proven itself unsustainable. Time to drop the delusions and move forward.

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  1. "DoctoRx"

    The US, for example, has always had a public-private collaboration: 40 acres and a mule; westward ho!; infrastructure. Nothing new at the end of this otherwise fine post.

    The pressing question is how to resolve the general overindebtedness.
    I favor the Govt forcing principal reductions. Proof that such has worked would be a normal level of interest rates. Overpaying on the cost of something and underpaying on the finance charges, which is the current model, is ridiculous.

  2. Mike Sankowski

    Macro has been infected by micro methods that willfully do not see the important flows to the economy.

    Glad to see that a person from the Levy institute is here – I am a big fan. If you get the chance, take a look at Warren Mosler's money ideas. They have changed my entire view of economics.

    There are few people who consider the impact of money on the economic environment. Because of this, most people (not just economists) are mystified at how bad things are right now for the economy. As long as our major economists don't understand that net money is necessary for savings, we are doomed to face a lost generation like Japan has over the last 18 years.

  3. donna

    Me in graduate level econ class to professor:

    "Are we going to talk about Austrian economics?"

    Professor: "No."

    Me, turning off brain for the rest of the semester, "Oh, alright…"

    Got an A of course, but was bored the entire time…

  4. RTD

    The same criticisms of mainstream neoclassical economics apply in spades to Austrian economics. The Austrian model, while perhaps more dynamic than the neoclassical model, is still largely a model of a barter economy. Likewise, Austrian capital theory is only half of a capital theory – all of the focus is on the asset side and the liabilities used to fund the creation of those assets are completely ignored by the Austrians. When you cut to the chase, the Austrian world is still one where savings automatically represent purchases of new capital goods, the economy is always operating at or near capacity, and money and finance are largely irrelevant (except when the government interferes somehow, the standard Austrian meme).

    Austrian economics is just as much a dead end as neoclassical economics.

    The author is correct, Hyman Minsky gave us the closest thing we have to a realistic model of the economy.


  5. MacroStrategy Edge


    I agree that anyone who knows ther history recognizes the public/private collaboration element is as American as apple pie. I am not ignorant of the abuses that can arise in such arrangements, but I am always surprised by the belief that markets left unfettered will always get us where we need to go.

    Regarding reducing general overindebtedness, I agree in part. Considering the difficulty of the monopoly issuer of currency (the federal government) going bankrupt, best to focus on reducing domestic private sector overindebtedness.

    That requires foreigners reducing net saving (thereby reducing US trade deficit) and government increasing its budget deficit.
    Or you can go for debt default or debt renegotiation. The latter has proven difficult given securitization. The former we may get anyway as more households go upside down on their mortgages and cannot refi.

    Mike – Agree mainstream economists have forgotten about the fallacy of composition in their 3 decade or so project to introduce micro foundations for macro. Macro is not just aggregated micro optimization problems.

    Am quite familiar with Mosler's revival of the chartalist and functional finance work, have found it quite useful, and tried to bring some of his points out in comments yesterday on this site.

    I do differ in several places, mostly having to do with practical considerations. Biggest hang ups I have are with their treatment of tax and loan accounts, the sidestepping of private portfolio preferences, and the focus on net financial assets rather than money creation per se, which like Minsky, I believe still has a lot to do with bank portfolio preferences (bank loans and security purchases create deposits, deposits can be used as a means of final settlement, i.e. money.

    Would be curious in hearing how you came across Warren's work and what specifically made the lightbulb go off in your head on this approach. It appears especially difficult for many people to understand the nonbank private sector cannot create money (it must get it from transactions with banks and the government), and the government does not need money held by the private sector to finance itself under current arrangements. Yet this is crucial to understand.

  6. MacroStrategy Edge

    Donna – Rather than turning your brain off, consider teaching yourself unorthodox approaches and then bringing them into the classroom by questioning the mainstream approach you teacher is presenting. The time is ripe, as mainstream macroeconomics is not proving very useful these days.

    Rue – I actually find the attempts by the Austrians to bridge between the real and the monetary/financial sides of the economy useful. Minsky and the Post-Keynesians tended to ignore too much of the former while elaborating on the latter.

    Of course, it requires reading the Austrians without falling into the trap of assuming a barter economy (or commodity money imposing its equivalent), the sanctity of Say's Law, perpetual full employment, etc. But this can be done.

    There are distinct parallels between the credit cycle theories of Keynes in the Treatise on Money, and the early Austrian trade cycle work which are useful to excavate and examine. There are also parallels between Minsky's depiction of financial instability and the Austrian credit boom/bust narrative, although I do not agree that all credit dislocations are ultimately to be blamed on the Fed.

    Regardless, my experience is, stripped of ideological biases, there are some veins worth mining in the Austrian literature which can be used to strengthen a Minsky oriented approach to macro in the sense that a more coherent and consistent melding of monetary/financial dynamics and real side dynamics can be accomplished – something Keynes himself sought to complete persuasively in his lifetime.

  7. RTD

    MacroStrategy – IMO, the ONLY things of value within Austrian economics are 1) Schumpeter's depiction of creative destruction and technological progress 2) Hayek's depiction of markets as mechanisms for processing information and 3) Kirner's depiction of entrepreneurs as playing the central role WRT 1 & 2. Virtually everything else can be discarded – their methodology (praxeology as radical a priorism), their business cycle theory (which relies on incoherent concepts like the natural rate of interest and the average period of production), their subjectivist value theory, and most of all their political ideology.

    As far as Minsky goes – IMO, his biggest contribution was NOT the Financial Instability Hypothesis, but rather his basic insight that before production can even take place, real investment must take place and before real investment can take place that investment must be financed, and thus it is the structure of these financial arrangements that determine the state of the economy. This element of financing investment for future production is completely missing from neoclassical models of production as the instantaneous exchange of factors for finished goods. The simplest way of saying this is that mainstream economics is completely focused on the income statement and completely ignorant of the balance sheet. Richard Koo is adding a lot of insight here with his work (though he seems largely ignorant or dismissive of Minsky for some reason).


  8. The Rude One

    Unfortunately the current conjuncture will fail to settle the debate. What's coming will not reconcile the various schools but will likely face condemnation from all: The "public-private solution" is almost inevitable in a politicized economy. The parameters are wide: wage controls, cartelization, rationing, state-mandated investment, exchange controls, etc. Now before you say anything, remember these days such measures are not 'national socialism'. Rather, they are the "Asian model of development." The only limit being the outer limits of sovereign default. Will the situation deteriorate to the point that any of these is tried? Quien sabe? But perhaps the entire ground of the debate will have to change.

  9. Todd Wood

    What is the difference between Austrian economics and wolf-pack mentality? It is good for the young, healthy and strong, but sucks for everyone else.

    It is really just another mental fetish, like all ideologies.

  10. juan

    Short quote from the third volume of Capital:

    The credit system appears as the main lever of over-production and over-speculation in commerce solely because the reproduction process, which is elastic by nature, is here forced to its extreme limits, and is so forced because a large part of the social capital is employed by people who do not own it and who consequently tackle things quite differently than the owner, who anxiously weighs the limitations of his private capital in so far as he handles it himself. This simply demonstrates the fact that the self-expansion of capital based on the contradictory nature of capitalist production permits an actual free development only up to a certain point, so that in fact it constitutes an immanent fetter and barrier to production, which are continually broken through by the credit system.[4] Hence, the credit system accelerates the material development of the productive forces and the establishment of the world-market. It is the historical mission of the capitalist system of production to raise these material foundations of the new mode of production to a certain degree of perfection. At the same time credit accelerates the violent eruptions of this contradiction — crises — and thereby the elements of disintegration of the old mode of production.

    The two characteristics immanent in the credit system are, on the one hand, to develop the incentive of capitalist production, enrichment through exploitation of the labour of others, to the purest and most colossal form of gambling and swindling, and to reduce more and more the number of the few who exploit the social wealth; on the other hand, to constitute the form of transition to a new mode of production. It is this ambiguous nature, which endows the principal spokesmen of credit from Law to Isaac Péreire with the pleasant character mixture of swindler and prophet.
    [Written sometime between 1863 and 1867]

  11. Alon

    I'm sorry, But I cant ignore a few statements from your post. I have no skin in this (childish if you ask me) game of denouncing certain schools of macroeconomic thought as charlatans or worse. By summing up their paper as "concluded the US housing bubble had little effect on consumer spending patterns" not only ignores the whole point of the paper but also does so in an irresponsible ingenious manner. the paper specifically talks about the ambiguous effects of changes in housing wealth on consumption. This makes intuitive economic sense as for every seller there must a buyer who is willing to provide more of their future income to buy the house. However since we must all live somewhere a rise in the price of housing on net cannot enrich any of us. Raising prices of ANY good signal rising scarcity, which certainly cannot indicate a net economic rise in wealth. When oil prices rise, commissions are created to investigate "excessive speculation" while a rise in housing is considered a forbearance of a new nirvana. the "housing bubble" as you call it is a far more comprehensive topic covering many other aspects of the economy that occured during the same time (i.e. finance, housing construction, future expected earnings, etc.) that the authors of the paper do not dismiss as capable of raising consumption.

  12. MacroStrategy Edge

    Alon – I understand Calomiris' point conceptually. We all need shelter. If the value of our currently owned shelter goes up, then the price of our next purchase goes up, unless we trade down in quantity, quality, or go to renting. But as a practical matter, there are few other ways of explaining unprecedented household deficit spending during the first most of this decade unless we acknowledge that households were monetizing and consuming the capital gains, realized or unrealized, in their real estate holdings. It was a mug's game, but it was a game that was played nonetheless. So this comes back to my original problem with contemporary macro – it is out of touch with the practical realities that matter to the economic outcomes we experience.

    Juan – Yes, Marx had something to say about the role of finance in the evolution of the economy. And there is a need for a new global growth model, as I argued in the post. The point is to figure out practical steps that can be taken in that respect. Quoting dead economists about why the system in place a century and a half ago would eventually fail doesn't get us there.

    Todd – There is a strong emphasis on independent action in Austrian School contributions, no doubt. Personally, I think taking responsibility for one's actions and one's life is a good place to start, but it goes too far if it then leads to the notion we are all atomistic individuals, with no interdependence. But that's just my particular mental fetish.

  13. juan


    Though become senile, the system which exists today is, beneath all the superficialities, the same set of social relations of production and REproduction which existed a century and a half ago. Any talk of 'a new global growth model' must, at the least, recognize the capital system's historical relativity, its absolute limits, rather than constantly struggling to redefine and salvage the no longer progressive but become barbaric. Systems end, are – consciously and not – replaced.
    My 'new model' preference would look towards traditions/practices of council communism [the 'infantile' which Lenin railed against and destroyed after the 1917 revolution].

  14. MacroStrategy Edge

    RTD – Looks like my response last night didn't make it, but I agree, those are elements worth retrieving from Austrian contributions. Am curious how you became familiar with this stuff, as you have a very good grasp of it, and it is off the beaten path for most people.

    Most of all, without falling into the trap of "money is just a veil for real exchange", I believe there is more room for bette mapping between financial and real sides of the economy.

    Minsky made progress here, and from the Austrian side, I have found their emphasis on the actual structure of production – a mesoeconomic or Leontieff type of lens – helpful in realizing macro emphasis on aggregates can also conceal important consideration.

    And I agree, macro may need to be refooted as an asset based economics, rather than an income flow based analysis alone. Keynes was heading there, but the Keynesians ignored much of this. Minsky certainly thought along these lines, although cash flow commitments ultimately ruled his models, and there are some economists associated with the Levy Institute on coherent stock/flow modeling which is promising.

    Drop me an e-mail address and I can send some links that you may find useful. There are few who are willing to explore these alternative perspectives without all the polemics and ideological trappings that tend to come with them.

  15. MacroStrategy Edge

    Juan – Yes, at some level of abstraction the characteristics of the economic system have remained somewhat intact over the past century and a half, but it is important to remember that is at a high level of abstraction.

    Not sure how pre 1917 council communism deals with globalized, complex chains of production and distribution in a world of densely populated urban areas, and with firms and households relying on long horizon financial commitments, specialized labor, etc.

    We have to work with the world as it is, or point to plausible transitions that people are willing and able to take on.

    For example, some people in the area I live in refer to themselves as locavores and attempt to eat food produced nearby, yet I doubt they would be willing to give up their morning coffee from Costa Rica. So it is important to think through what is actually possible given where we are today.

    Regardless, maybe you are looking at an economy organized a along these lines (

  16. juan

    generalized commodity production by wage labor within a legal-political regime of private property is a high level of abstraction?

    why assume workers councils and global production/distribution to be incompatible?

    the actually possible has never been static.

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