It’s Hard Being a Bear (Part Four): Good Eco­nomic The­ory

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I delayed pub­lish­ing this on the blog because I thought it was worth sub­mit­ting it to a news­pa­per for first pub­li­ca­tion on the anniver­sary of the Lehman Broth­ers col­lapse. That has occurred: a slightly edited ver­sion of this post (for rea­sons only of length, I has­ten to add!) is in today’s Syd­ney Morn­ing Her­ald (page 4 of the print ver­sion), WA Today, and prob­a­bly sev­eral other news­pa­pers in the Fair­fax chain.

You have just come from your annual med­ical checkup, where your doc­tor assures you that you are in robust health.

Walk­ing jaun­tily down the street, you bump into a prac­ti­tioner of alter­na­tive med­i­cine. He takes one look at you and declares “You have a seri­ous tumour! It must be removed or you will die”.

You ignore him as you always have, and con­tinue your merry way down the street. One day later, a stab­bing pain sud­denly crip­ples you, and you col­lapse to the pave­ment.

In agony, your call your doc­tor, who ini­tially refuses to send an ambu­lance because he knows you are well.

When you lapse into a coma and stop talk­ing mid-sen­tence, your doc­tor con­cludes that per­haps some­thing is wrong, and sends an ambu­lance to take you to hos­pi­tal.

Ini­tially the doc­tor waits for you to revive spon­ta­neously, because he still knows there’s noth­ing really wrong with you. But as your pulse starts to weaken, he reluc­tantly calls a retired doc­tor who had expe­ri­ence of a sim­i­lar inex­plic­a­ble mal­ady in the dis­tant past.

She pre­scribes mas­sive doses of tran­quilis­ers, painkillers, vit­a­mins, and oxygen—all sub­stances that had been removed from the med­ical panoply due to recent advances in med­ical the­ory. Reluc­tantly, your doc­tor fol­lows his retired colleague’s advice—and mirac­u­lously, you start to revive.

After a year of expen­sive med­ical treat­ment, you return to the same robust health you dis­played before your inex­plic­a­ble ill­ness. Tri­umphant, if some­what puz­zled, your doc­tor declares you well once more, and releases you from inten­sive care.

As you stride con­fi­dently away from the hos­pi­tal, you have the mis­for­tune to once again bump into the prac­ti­tioner of alter­na­tive med­i­cine.

But they haven’t removed the tumour!”, he declares.

One shouldn’t have to spell out the details of such an anal­ogy, but in times of wide­spread denial, one has to:

  • You are the econ­omy;
  • The tumour is a mas­sive accu­mu­la­tion of pri­vate debt;
  • Your doc­tor is Neo­clas­si­cal Eco­nom­ics, and the retired col­league is a so-called “Key­ne­sian” Econ­o­mist — who doesn’t know it, since her med­ical text­books were poorly writ­ten, but he’s actu­ally fol­low­ing another econ­o­mist called Paul Samuel­son, not Keynes (and your doctor’s text­books are so bad they don’t war­rant dis­cus­sion);
  • The alter­na­tive med­i­cine prac­ti­tioner fol­lows Hyman Minsky’s “Finan­cial Insta­bil­ity Hypoth­e­sis” (which is based on what Keynes actu­ally did say—as well as the wis­dom of Joseph Schum­peter and, in whis­pers, Karl Marx);
  • The moment you hit the pave­ment is the begin­ning of the Sub­prime Cri­sis; The col­lapse of Lehman Broth­ers is the moment when you slip into a coma; and
  • The day the doc­tor takes you off life sup­port and declares all is well … is next month.

The final rea­son for me being a bear is that I am that prac­ti­tioner of alter­na­tive med­i­cine. Minsky’s “Finan­cial Insta­bil­ity Hypoth­e­sis” has been ignored by con­ven­tional econ­o­mists for rea­sons that are both ide­o­log­i­cal and delu­sional. A small band of “Post-Key­ne­sian” econ­o­mists, of whom I am one, have kept this the­ory alive.

Accord­ing to Minsky’s the­ory:

  • Cap­i­tal­ist economies can and do peri­od­i­cally expe­ri­ence finan­cial crises (some­thing that believ­ers in the dom­i­nant “Neo­clas­si­cal” approach to eco­nom­ics vehe­mently denied until reality—in the form of the Global Finan­cial Crisis—slapped them in the face last year);
  • These finan­cial crises are caused by debt-financed spec­u­la­tion on asset prices, which leads to bub­bles in asset prices;
  • These bub­bles must even­tu­ally burst, because they add noth­ing to the economy’s pro­duc­tive capac­ity while simul­ta­ne­ously increas­ing the debt-ser­vic­ing bur­den the econ­omy faces;
  • When they burst, asset prices col­lapse but the debt remains;
  • The attempts by both bor­row­ers and lenders to reduce lever­age reduces aggre­gate demand, caus­ing a reces­sion;
  • If the econ­omy sur­vives such a cri­sis, it can go through the same process again, with another boom dri­ving debt up even higher, fol­lowed by yet another crash; but
  • Ulti­mately this process has to lead to a level of debt that is so great that another revival becomes impos­si­ble since no-one is will­ing to take on any more debt. Then a Depres­sion ensues.

That is where we were … in 1987. The great tragedy of today is that naïve Neo­clas­si­cal econ­o­mists like Alan Greenspan and Ben Bernanke allowed this process to con­tinue for another three or more cycles than would have occurred with­out their res­cues.

In 2008, they did it again—only with meth­ods they would have dis­par­aged a mere year ear­lier (“Ratio­nal Expec­ta­tions Macro­eco­nom­ics”, a mod­ern neo­clas­si­cal fad, preaches that gov­ern­ment inter­ven­tion can’t influ­ence the level of eco­nomic activ­ity at all—yet another belief that real­ity has recently cru­ci­fied). This time, while the res­cue has worked, the recov­ery they expect after­wards can’t happen—because there’s almost no-one left who will will­ingly take on any more debt.

This time, there’s no re-lever­ag­ing way out. The tumour of debt has to be removed.

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  • scep­ti­cus

    It’s the skewed allo­ca­tion of power that main­tains a dis­tor­tion out of ‘equi­lib­rium’.”

    Now that I do agree with. Since our soci­ety will always be lop­sided, between gov­ern­ment and pri­vate sec­tors, between cap­i­tal­ists and work­ers, between bor­row­ers and savers, there will never be an equi­lib­rium.

    The notion that a per­fectly bal­anced soci­ety is pos­si­ble, and that once achieved, it would stay that way is wrong, and so are eco­nomic schools of though which pos­tu­late these goals, like marx­ism and aus­trian eco­nom­ics. In any case the def­i­n­i­tion of bal­ance is sub­jec­tive. Also this is not how democ­racy works, it works on a major­ity vot­ing sys­tem, in which the sys­tem in the­ory would be skewed towards the major­ity. Not per­fect, but feel free to pro­pose an alter­na­tive that doesn’t boil down to a tyranny of a minor­ity.

    There­fore we ought to plan accord­ingly and aim to mit­i­gate exist­ing and antic­i­pated lop­sid­ed­ness as opposed to try­ing to elim­i­nate it.

  • Joe B


    I’ll actu­ally para­phrase Anar­cho a bit here — in Aus­trian the­ory, Equi­lib­rium is the point at which the mar­ket for a par­tic­u­lar good clears and supply=demand. Entre­pre­neur­ial activ­ity throws the sys­tem out of equi­lib­rium by chang­ing either sup­ply or demand for any par­tic­u­lar good, and it is doing this con­stantly. Such dis­rup­tions often occur before any equi­lib­rium price is reached as buy­ers and sell­ers enter and leave the mar­ket.

    Con­cepts like “equi­lib­rium” and “mar­kets clear” are only used in a dynamic sense, or an instan­ta­neous sta­tic sense. 

    From Rothbard’s Man, Econ­omy, and State (

    We must always remem­ber, how­ever, that while a final equi­lib­rium is the goal toward which the econ­omy is mov­ing at any par­tic­u­lar time, changes in the data alter this posi­tion and there­fore shift the direc­tion of move­ment. There­fore, there is noth­ing in a dynamic world that is eth­i­cally bet­ter about a final equi­lib­rium posi­tion.” (p. 323)

    That whole sec­tion (p. 321–329) on the “evenly rotat­ing econ­omy” con­struct addresses both equi­lib­rium and Aus­trian method­ol­ogy in gen­eral.

    Entre­pre­neurs profit only by redress­ing lop­sid­ed­ness. This is in fact the Aus­trian def­i­n­i­tion of “profit.” “Loss” is what they get when their per­cep­tions of lop­sid­ed­ness were wrong.

    Fur­ther­more, this is only rel­e­vant to analy­sis of a sin­gle pair of goods (in barter, although “dol­lars” could be one of these goods), not an entire econ­omy.

    And most impor­tantly, Aus­trian eco­nom­ics doesn’t pro­pose any goals — it only seeks to describe the mech­a­nism by which prices and choices influ­ence each other. Even aus­tro-lib­er­tar­ian ethics does not pro­pose equi­lib­rium as a goal, and it cer­tainly doesn’t aim for a “per­fectly bal­anced soci­ety”. Only a free, peace­ful and sus­tain­able (if occa­sion­ally volatile) one.

    Using the actual Aus­trian inter­pre­ta­tion of equi­lib­rium, I agree with Rustypenny’s state­ment.

    Again, I’m only try­ing to clar­ify Aus­trian the­ory with this com­ment since it has been mis­rep­re­sented yet again.

  • scep­ti­cus

    Well, maybe I’m mis­in­ter­pret­ing rp’s argu­ment but he seems to sug­gest that power dis­tor­tions should be removed to allow equi­lib­rium.

    Also he says that when prices are high sup­pli­ers will step up to pro­duce more and lower prices. Except this does not work when the rate of inter­est on all non-mon­e­tary goods are lower than the rate of inter­est on money.

    Clearly there sit­u­a­tions in which his sim­ple law of sup­ply and demand does not apply, and that is because money is not a veil over barter, and that fact right there, is the biggest dis­tor­tion there is and it ren­ders any notion of equi­lib­rium con­cept non-sen­si­cal. Money, as steve never tires of point­ing out is not neu­tral, and would not be even if it were made entiorely of gold coin.

    This is an expres­sion of lop-sid­ed­ness, or power in the hands of hold­ers of money ver­sus hold­ers of labour, yet aus­trian the­ory has to deny the non neu­tral­ity of money to be self-con­sis­tent. It is the rea­son why, for exam­ple, they deny the exis­tence of the para­dox of thrift.

  • scep­ti­cus

    I meant ‘deny the neu­tral­ity of money’.

  • I think you meant what you actu­ally wrote scepticus–double neg­a­tives can get con­fus­ing!

    Would you like me to delete this revi­sion?

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  • City­doc

    I’m inter­ested to hear what the group’s response would be to the fol­low­ing ques­tion:

    In the next 5 years, do you think the US will:

    (a) Be like Japan (i.e a defla­tion econ­omy).

    (b) Be like Zim­babwe (i.e hyper­in­fla­tion econ­omy).

    © Default on its foriegn debt.

    (d) Be a write-off with the BRIC coun­tries (Brazil,
    Rus­sia, India, China) tak­ing over.

    (e) Be unable to sell any­more US Trea­suries to
    China and the rest of the world.

    (f) None of the above (So what will it be?).

  • boma

    Hi all

    I seem to remem­ber there was a fair amount of dis­cus­sion on this blog towards the end of last year regard­ing the mer­its of hold­ing phys­i­cal cash. Well now the fig­ures are out: 

    HOUSEHOLDS are still hoard­ing $4 bil­lion in cash that was pulled out of the banks in Sep­tem­ber and Octo­ber last year, dur­ing what the Reserve Bank has revealed was a panic run.”

    At the peak of the global finan­cial cri­sis, the run threat­ened to exhaust the Reserve Bank’s stocks of $50 and $100 notes and it had to print more to meet the extra­or­di­nary demand, the bank’s annual report released yes­ter­day shows.”,28124,26089580–5018001,00.html

    So now we know why the gov­ern­ment was so keen to enact the bank deposit guar­an­tee.

  • Philip


    (a) I think that this is the likely out­come, though given the level of delever­ag­ing, it could be over more quickly than the Lost Decade the Japan­ese have expe­ri­enced. Unfor­tu­nately, the sec­ond wave of defaults on option-arms and alt-a mort­gages is com­ing soon, 2010–2012.

    As the analy­sis by Mish has shown, the US is already expe­ri­enc­ing the signs of defla­tion.

    I don’t see (b) hap­pen­ing. Those who believe that this out­come will occur are those who adhere to the money-mul­ti­plier model of money cre­ation. As Keen has pointed out, sub­stan­tial infla­tion will not occur unless fiat cre­ation is larger than the destruc­tion of credit. Neo­clas­si­cal pol­icy will ensure this will not occur.

    © is non­sense. The US pub­lic debt to GDP ratio is cur­rently 81%. This is very ser­vice­able, and there is room for more debt spend­ing. As I have noted before, Japan has a pub­lic debt to GDP ratio of 170% (quite pos­si­bly more) and nobody is say­ing that Japan is going to default on its debt and go bank­rupt. The peo­ple who claim © are the morons who missed a $US43 tril­lion pri­vate debt bub­ble, now at 350% of GDP.

    Despite its cur­rent prob­lems, (d) is unlikely to occur even though the BRIC have made eco­nomic inroads. The US is far too big and pow­er­ful to be ‘taken’ over in any mean­ing­ful sense. How­ever, the BRIC have mas­sive inter­nal prob­lems to deal with first before they can even con­sider becom­ing con­tes­tants with the world’s super­power.

    (e) is a long way off yet, despite reports that it is become more dif­fi­cult for the Trea­sury to sell its secu­ri­ties. In order to keep the yuan under­val­ued, China will need to keep on pur­chas­ing Trea­sury secu­ri­ties to ensure the health of its export mar­kets. Despite claims that ‘for­eign­ers’ own the US debt, they account for only 28% of the own­er­ship of US fed­eral debt secu­ri­ties.

  • Ernie

    Very inter­est­ing debate on infla­tion vs defla­tion between Daniel R. Amer­man & Michael ‘Mish’ Shed­lock on the Finan­cial Sence news hour. Steve Keen gets a good men­tion.

    - Ernie.

  • elliottwave


    Come on mate that was not good for Steve to be linked to that silly man who really made a fool of him­self.

    If i was Steve i would ask for an apol­ogy from Mish.

  • Ernie


    Mish is actu­ally been held in pretty high regard in the blog­sphere.

    - Ernie.

  • elliottwave

    Not after peo­ple hear the debate.

    He made a fool of him­self.

  • City­doc


    Thanks for your infor­ma­tive response.

  • I have lis­tened to about half this debate so far, and feel that Mish accounted for him­self very well, and pre­sented the argu­ments he attrib­uted to me very well. 

    The argu­ment against Mish seems to come down to “defla­tion has only hap­pened with gold-backed cur­ren­cies”. Defla­tion cer­tainly was more preva­lent in the 19th cen­tury, but this argu­ment under­plays the long run expe­ri­ence of Japan of tip­ping between triv­ial infla­tion and mod­er­ate defla­tion for the past 17 years.

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