Business cycle theory as a basis for economic policy

Pascal Bridel, Muriel Dalpont

• Publisher: Routledge
• Year: 2017
• ISBN:
  9781317381976
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

This book aims to start a debate on the relationship between economic theory – and more precisely business cycle theory – and economic policy, emphasising the diversity of views on economic policy which characterised older periods, in contrast to the homogeneity of the analysis and diagnosis provided by current business cycles developments.

Since the 1970s, economic theorists excluding any economic policy interventions and favouring strictly supply-side economic policies have gained a growing influence. The development of Equilibrium Business Cycles theories coincides with the collapse, at least in academic circles, of the Keynesian consensus favouring stabilization policies. The alternative approach which emerged was based on an a priori hypothesis about the stability of the economy – or at least on its remarkable ability to stabilize itself. The direct consequence of this approach is that any stabilization objective for economic policy is not only misguided but also inefficient. There are many reasons why Keynesian policies ceased to be dominant in theoretical circles, but the most helpful circumstances for the rapid propagation of a new revolutionary theory is certainly the existence of an established orthodoxy, clearly inconsistent with the most salient facts of reality.

This book offers a sample of different theoretical approaches to business cycles, examining their respective views on economic policy with the objective of understanding business cycles that have been lost, and identifying those views which explain fluctuations and the way we conceive economic policy. This book was originally published as a special issue of The European Journal of the History of Economic Thought.

Economics of the crisis and the crisis of economics

Axel Leijonhufvud

1. Balance sheet troubles

This is not an ordinary recession. The problems unleashed by the financial crisis are far more serious and intractable than that.

The United States and the Eurozone countries are in the midst of a balance sheet recession. The concept is due to Richard Koo¹ who used the term to summarise his diagnosis of Japan’s economic troubles in the wake of its 1992–1993 crisis. A balance sheet recession is fundamentally different from the garden variety and the usual countercyclical policies are not adequate to cope with it. The questions to be discussed below all pertain to the extraordinary nature of balance sheet recessions in general and, of course, the present one in particular: What makes them different from ordinary cyclical recessions? How do they come about? What makes them peculiarly intractable? What policies are effective or less effective in dealing with them?

Apart from these substantive questions, there is one further question worth considering: What kind of economic theory helps us understand these matters better and what kinds do not?

2. Stability and instability

How did we end up in our present unpredicted predicament? A short answer would be: by not being alert to the symptoms of instability. Almost all bankers, regulators, policy-makers and (of course) economists disregarded the possibility of serious systemic instability. But the widespread assumption that a system of “free markets” is stable needs re-examination.

2.1 Markets for produced goods

The beginning student’s first introduction to economics tends to be the supply and demand model for a produced good. Two negative feedback loops are supposed to guarantee that the equilibrium is reached (ceteris paribus). If supply exceeds demand, price will rise so as to reduce the discrepancy in quantities. If marginal cost exceeds the demand price, output will decline so as to decrease the discrepancy in values. Both feedbacks reduce the deviation from the market equilibrium which is why they are termed “negative feedbacks”.

In principle, it is possible that the interaction between the two feedback controls will generate persistent fluctuations in both output and price but theoretical reasons and practical experience both tell us that this possibility can most often be disregarded. So the conclusion is that we are safe in presuming that the market for any particular produced good will home in towards its equilibrium neighbourhood, which is to say, that the market is stable.

This presumption has been carried over to general equilibrium systems with an arbitrarily large number of goods. This is the case even though theoretical proofs of the stability of general equilibrium exist only for some special cases of limited interest. But as far as I know – and my knowledge is limited – the economists who in the last 20 or so years have based their macroeconomics on GE constructions have shown little interest in investigating their stability properties. Stability has been taken “on faith”.

This faith may have some merit as long as what is being discussed are: (i) non-monetary GE models lacking fractional reserve banks and in which lending and borrowing are intertemporal barter transactions and (ii) budget constraints are always binding and never violated. These conditions are assumed in real business cycle theory, for example, which pretty much dominated high-brow macrotheory just a few years ago. But obviously these assumptions remove us altogether from the world of our experience.

Suppose we take stability on faith and trust that “market forces” will always tend to make output and consumption move towards a coordinated equilibrium state. How then explain recessions? Well, there might be conditions that interfere with markets and prevent them from doing their beneficial work. The “wage rigidity” postulated in conventional Keynesian theory as an explanation of unemployment would be an example. The recently dominant dynamic stochastic general equilibrium (DSGE) theory has pursued this logic. But a single “rigidity” does not take us very far in making the models “fit” the data. So we now have large-scale DSGE models with more than a dozen “frictions” and “market imperfections” – with more to be added, you can be sure, when the models do not fit outside the original sample.

It is my belief that this stability-with-impediments approach is quite wrong, that it does not explain recent events, and that it fails to suggest the right policies.

2.2 Financial markets

For more than a hundred years the instability of fractional reserve banking was the dominant topic in what came later to be called macroeconomics. Traditional banks had (i) large liabilities in relation to own capital (high leverage) and (ii) liabilities of very short maturities relative to their assets (maturity mismatch). High leverage and maturity mismatch remain the keys to financial instability today.²

The Great Depression of the 1930s provided the ultimate lesson that taught us how to control traditional banks. Deposit insurance removed the incentives for depositors to run on banks and thereby also the “contagion” that had characterised the banking panics of the past. Reserve requirements served to limit the leverage ratios of banks. The limits on leverage meant that banks by and large were earning the same rate of return on own capital as other industries.³

2.3 Leverage dynamics: The build-up

In the last 20 years, financial institutions have not been satisfied to earn a rate of return no higher than that of other industries. The big investment banks, in particular, have learned to set themselves rate of return targets two or three times what is earned in the “real economy” – and the markets have learned to expect that such returns are actually achieved.⁴ The only way in which such returns can be achieved is by operating at high leverage.

In retrospect, the piling up of leverage not just by financial institutions but also by other firms and notably by households has been the key to American prosperity since the early 1990s. It was an oft-repeated cliché among American economists that the American economy performed better than Europe in the 1990s because of its “flexibility”. The simpler truth is that when more or less everybody spends more than he earns this will keep the “good times rolling”. But it leaves a legacy of debt.

The arithmetic of leverage is simple enough. A bank with a leverage ratio of 30, which can invest in assets earning just ½ of a per cent more than its liabilities, will earn a rate of return of 15%.⁵ (And if the central bank supplies funds at a rate hardly different from zero, it might be able to do a lot better than that!)

Such a handsome return, however, will attract competitors and competition will narrow the margin between rates earned on assets and rates paid on liabilities. To keep its rate of return up as the margin shrinks, the individual bank can pursue one or more of several strategies. First, it can increase its leverage further. Second, it can move parts of its portfolio into riskier asset classes where the rates earned are a bit higher. Third, it can acquire assets too risky for its own portfolio, securitise them in bundles, and sell them off to investors that know no better. Fourth, it may be able to issue shorter term liabilities on which it pays less, such as overnight repo loans.

Competition will push all the major financial institutions in this same direction even as the risks they take on keep growing and their margins keep shrinking. As Charles Price, former CEO of Citigroup, famously quipped: “As long as the music is playing, you’ve got to get up and dance. We’re still dancing”. So the boom ended in 2007 with leverage ratios at historic highs, risk premia at historic lows and maturity mismatches all around.

2.4 Instability and economic logic

The economic analysis taught in universities everywhere tends to presume that markets are stable. Leverage dynamics exemplify instability – positive feedback processes. Instability often turns economic logic on its head. Much that is true when the economy is stable ceases to be true when it is not.

The analysis that I just went through provides an example. Normally, we approve of competition. The more the better. It produces socially desirable results. But the competition that drives leverage dynamics, pushes the competing firms into positions that will suddenly prove untenable – and the crisis that results has severe and adverse social consequences. Moreover, it also has the undesirable result that an already oligopolistic industry sees some of its member firms go under so that industry concentration increases. In the United States, financial institutions that were “too big to fail” to begin with are now “much to big to fail” – although they may not yet be quite in the novel category of “too big to save” that we have seen examples of in Iceland and Ireland and which at one time posed a looming threat in Switzerland.

Similarly, macroeconomic policies that ordinarily are prudent become dysfunctional, even reckless, in conditions of severe instability. Conversely, unconventional policies become necessary. We have seen a lot of unconventional policies in the last few years. Unfortunately, not all unconventional measures will be helpful.

2.5 Leverage dynamics: Unravelling

In a process analysed by Hyman Minsky⁶ many years before the recent crisis, high leverage builds up slowly in an economy. Those tend to be years of prosperity. Eventually, the system ends up in a highly fragile state such that some relatively small shock will have enormous consequences.

To lend this statement some concreteness, consider that losses on US sub-prime and AltA mortgages were at one time estimated⁷ at about $235 billion. Not pocket money, to be sure! But the loss of income in the United States over the first two years of the recession was on the order of $6 trillion. A very strong endogenous amplification! The corresponding (approximate) figures for the United Kingdom and for the Eurozone added together would amount to somewhat more than 6 trillion in dollar terms.

This striking disproportion between “cause” and “effect” is to be explained by several interacting positive (deviation-amplifying) feedback loops. High leverage means small losses will render an institution technically insolvent. To avoid failure it will then try to shorten its balance sheet. The knowledge among banks that their counterparties are in the same position freezes interbank markets. The institutions will then find themselves unable to roll over their short liabilities so as to refinance their positions. The ensuing scramble to meet short liabilities and to reduce leverage puts pressure on asset prices and strangles lending. When some banks are forced into “fire sales” of assets, the balance sheets of all are impaired. Growing unemployment and falling incomes undermine the ability of non-bank sectors to service their debt. The quality of bank assets deteriorates. If the general price level begins to fall, the economy is threatened with a true debt-deflation.

2.6 Network structures and instability

This deleveraging dynamic is today even more dangerous than it used to be. The reason is that the structure of the financial industry, nationally and internationally, has evolved into a network of much higher connectivity than it had in the past. The United States provides the most clear-cut example.

The (second) Glass–Steagall Act (1933) embodied the lessons drawn from the Great Depression. One particular aspect of its strategy for curbing financial instability is especially noteworthy. It partitioned the American financial sector into a number of industries and industry segments. Each industry branch was defined by the liabilities that the financial institutions within it could issue and the assets they were allowed to acquire. A firm in one branch could not trespass into another. In some vital respects, the industries were similarly segmented geographically by the states in which the institutions in question were located and licensed.⁸

My metaphor for this Glass–Stegall architecture is that it sought to turn the financial system into an “unsinkable ship” by dividing it into numerous “watertight compartments”. In this it was successful. In the late 1970s and early 1980s, the United States went through the crisis of the savings and loan industry. The assets of the savings and loan industry were basically 30-year mortgages which were financed by short-term deposits. The industry was ruined by the inflation in the 1970s which raised the rates it had to pay on deposits high above what it was earning on old mortgages. (This is a very abbreviated version of the story.)

The point of this historical episode is the following. The losses in the collapse of the savings and loan industry were of roughly the same magnitude as the losses on sub-prime mortgages a quarter century later (and the US economy was significantly smaller, of course). Yet, only this compartment of the financial ship was flooded. The disaster did not engulf the other segments of the American financial sector, nor did it spread to the rest of the world.

We are now in an era of conglomerate banking in which few watertight compartments of any significance remain. The giant banks are engaged in virtually every financial market and not just in their home country but around the world. Also ordinary banks are trading in many more types of assets and liabilities than they used to. The financial system is now a ve...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Table of Contents
• Citation Information
• Notes on Contributors
• Introduction: Business cycle theory as a basis for economic policy
• 1. Economics of the crisis and the crisis of economics
• 2. On the importance of institutions and forms of organisation in Piero Sraffa’s economics: the case of business cycles, money, and economic policy
• 3. Mr Keynes, the Classics and the new Keynesians: A suggested formalisation
• 4. Three macroeconomic syntheses of vintage 1937: Hicks, Haberler, and Lundberg
• 5. Lange’s 1938 model: dynamics and the “optimum propensity to consume”
• 6. Toward a non-linear theory of economic fluctuations: Allais’s contribution to endogenous business cycle theory in the 1950s
• 7. The “Treasury View” : An (un-)expected return?
• Index