Minsky, Austrians and the MMT

In the discussion of the present crisis two kinds of theories are generally being invoked as applicable or as "having foreseen it", by two different groups of people. Interestingly enough they lie on opposite ends of the political spectrum. Minsky's "Financial Instability Hypothesis" is generally associated with a pretty left wing version of "radical Keynesianism", while the "Fed driven malinvestment" story comes courtesy of the Austrian school. There is of course a fundamental difference between the two - the Keynesian view sees fluctuations and bubbles as inherent to the capitalist system, while the Austrians think it's all created by sloppy government/Fed policy - but, aside from that, both of these stories can be reconciled with the present events. (And here is a bit of a synthesis though done from the Austrian side)

At this point I should probably say that my knowledge of both of these approaches is pretty superficial and I'm perfectly happy to be corrected.

To make both stories make sense we need to add in the role of monetary policy in the present crisis. Daniel Davies (among others) has argued (somewhat along the Austrian view, surprisingly) that it was Fed policy to "engineer" the housing bubble as part of its 2000/2001 recession fighting strategy.

So let's accept for the moment that monetary policy was bad. How does the Minsky view contrast with the Austrian view?

In Minsky, as I understand it, waves of euphoria in good times lead to speculative bubbles which then crash resulting in a credit crunch and ensuing bad times. Now, it's partly the job of the Central Bank to step in and try to smooth this "slow movement" by cooling down the euphoria with high interest rates in the good times and expanding credit with low interest rates once the bubble pops (plus regulation and the like). Assuming the above view of monetary policy, the Fed did not do its job in this regard, letting the euphoria and the bubble grow until we got into the present mess. On the face of it, this view roughly fits.

So, to sum up, Minsky:
Naturally occurring speculative bubbles + Fed fails at its role = crisis.

How is the Austrian view different? Well basically it is:
Fed naturally screws up -> artificial speculative bubble = crisis.

You can sort of see why both stories can plausibly fit the present scenario here. In the Austrian view the Central Bank keeps interest rates artificially low, which causes "malinvestment" or in this context the real estate bubble, eventually this policy induced bubble collapses and all those bad investments have to be "liquidated" with a resulting recession.

One significant difference between the two views is how to deal with the situation. In the Minsky view, since these bubbles are inherent to the market, the role of the Fed once the crisis is under way is to provide liquidity. So even though the Fed failed at stopping the bubble in the first place, now that the bubble popped the Fed's job is to continue with the policy of cheap credit until good times return. The same policy that caused the bubble in the first place is the one necessary to get out of the crisis.

In the Austrian view the "liquidation" of "malinvestment" is necessary and even desirable, if the economy is to get back on its track. Hence, the Fed should not provide cheap credit but keep it at its normal level and let the thing sort itself out. Otherwise the "malinvestments" will continue leading to an even bigger necessary "correction" later on.

So while both these theories can offer a somewhat convincing story of how we got here, their fundamental assumptions imply completely different policy actions. And at that point it's basically a confused look and a "who knows".

Let's step back though and think about a "what if" scenario? What if the Fed had raised the interest rates and 'smoothed the euphoria' in the Minsky view or not lowered the interest rates and not caused the bubble in the Austrian view? Well, the most apt reference point here is that of Japan in the early 90's, which also had a real estate bubble (whether naturally occurring or caused by previous lax monetary policy on the part of BoJ). The Japanese Central Bank DID pop that one. And the result was ten years of economic stagnation. We've yet to see how the present situation unfolds and how it compares to that particular outcome.

Anyways. Where does this leave Mainstream Macroeconomic Theory (MMT), which is neither Austrian nor Radically Keynesian? Not applicable, irrelevant, out of touch? After all, in your basic MMT, too lax of a monetary policy just leads to higher inflation which then puts a drag on long term growth (Austrians also have this part). But bubbles and crises aren't a part of it. And inflation hasn't been a problem (yet). So yeah, for present purposes MMT doesn't seem to do us any good in understanding this crisis.

Is that a damning failure? Umm, yes and no. The 'yes' side seems pretty straight forward and basically that's what all the stuff written above is about. On the 'no' side, I think it's important to realize two things about MMT. First, it seeks to describe how the economy operates during "normal times", is in fact pretty good at that aspect (which is where it gets that first 'M' in its acronym), and it just happens that we aren't living in "normal times". Second, and relatedly, the MMT developed in particular historical circumstances and in response to particular historical events. And almost by definition, first-M-in-the-acronym kind of theories are going to change much more slowly than events on the ground. Theory builds on what came before it, it changes slowly, it is "sticky". It evolves rather than jumps. When the world goes out of wack that affects the direction in which the theory evolves but very rarely will it cause a complete overhaul of the theory (a possible exception: General Theory, the Great Depression, and the development of Macro itself). New ideas, new hypothesis, radical new explanations occasioned by crises and unforeseen events even when they seem plausible need to be tested by real life experience, filtered by repeated natural experiments and thoroughly examined on the basis of their yet unexplored assumptions. All this takes time and expecting MMT to be able to explain something unprecedented is like expecting your (fixed) capital stock to instantaneously adjust to its long run level in your basic growth model.

And this of course is what opens up the door for more radical theories like the two mentioned above. The thing is that even though both of them may be able to offer plausible stories about the current events, overall... well, overall, they're wrong. The Minsky "movements" of euphoria driven bubbles seem to be rare. Between 1987 and 2000 too be generous, and 1982 and the present to not be, the theory seemed to have next to no applicability. That's between 13 and 26 years where these kind of fluctuations just weren't there. Similarly, in the same time period, despite very widely different Central Bank monetary policies (or maybe because of it) the 'malinvestment' cycles don't really seem to be either.

When the crisis hits, yeah, you're gonna reach for the shelf and pull down the first bottle labeled "crisis theory" since that's what you need. But when there is no crisis you'll hardly notice that shelf and those bottles are there, and with good reason. Part of the difficulty here is that 'normal times' are, well, normal, while crises only come around once in awhile. This means that you will have a lot more data to test the 'normal times' theory and only a few observations which can be used to sort among possible crisis theories. So the MMT, which is, which needs to be, based on a thorough empirical footing is going to be based on all the data available for normal times and that is what it is going to explain well. But once a crisis hits it will be irrelevant since the observations of crises, within the context of that theory are pretty much bound up to be considered "outliers", being few, in between, and extreme. And being few, in between, and extreme these outliers are not even going to be particularly useful in figuring out which crisis theory is correct. And that's how both the Minsky view and the Austrian view can both wind up providing plausible explanations for what's happening now, even though fundamentally they are very different.

But like I said, when the world goes out of wack that can, and should, influence the direction in which MMT is evolving, even if it cannot make it instantaneously adjust to offer a good explanation. So here's my suggestion. Traditionally Macroeconomics is divided into two branches - Long Run Growth and Short Run Fluctuations. Perhaps the impact of this crisis on Macroeconomics-as-she-is-done is that it really should have three branches; Long Run Growth, Short Run Fluctuations and Crisis Managment. As it is currently, crises, of whatever kind, don't really have much of a place in either LRG or SRF though there is some exceptions/precedents (Krugman's (and others) currency crisis theory for example. Or the whole 'coordination game' approach. All in all, the point is that these approaches probably could use a greater emphasis within the general Macro framework ). This is why MMT doesn't have much of an explanation for all this mess, and why you got to reach for the shelf with the 'extreme' (though not necessarily wrong) theories. Given that I don't think Macroeconomics is really capable of integrating 'crisis theory' into either LRG or SRF - particularly since it is not really capable of integrating these two approaches themselves, whether out of the inherent difficulty or just plain ol' unwillingness to try, something I've complained about before - the next best scenario might be that crises get their own sub-branch within Macro.