From Orthodoxy to Heterodoxy: Financial Crisis Literature Compared

Abstract

In this paper we’ll attempt to explain the connection between interventionism in financial markets, financial crises and economic downturns, as the main cause of the financial crisis mainstream models; As well as the connection between the theories of Austrian and Minsky’s economic cycle as branches of heterodox economic theory. In order to achieve this target, we’ll begin with a brief introduction of mainstream financial crises models in the orthodox economic literature, then we’ll examine the statements of the Austrian Business Cycle Theory and the Financial Instability Hypothesis, and evaluate whether a connection between the two. We conclude that Financial Instability Hypothesis can be studied as a particular case of the Austrian Business Cycle Theory.

Full text

Scientific Annals of Economics and Business
63 (SI), 2016, 71-87
DOI: 10.1515/saeb-2016-0136
FROM ORTHODOXY TO HETERODOXY:
FINANCIAL CRISIS LITERATURE COMPARED
Ignacio MARTÍNEZ*, Gabriel MURSA**
Abstract
In this paper we’ll attempt to explain the connection between interventionism in financial markets,
financial crises and economic downturns, as the main cause of the financial crisis mainstream models;
As well as the connection between the theories of Austrian and Minsky’s economic cycle as branches
of heterodox economic theory. In order to achieve this target, we’ll begin with a brief introduction of
mainstream financial crises models in the orthodox economic literature, then we’ll examine the
statements of the Austrian Business Cycle Theory and the Financial Instability Hypothesis, and
evaluate whether a connection between the two. We conclude that Financial Instability Hypothesis can
be studied as a particular case of the Austrian Business Cycle Theory.
Keywords: financial crisis, boom-bust cycles, Hyman Minsky, Austrian School, Knut Wiksell
JEL classification: B53, E12, E14, E58, G01
1. INTRODUCTION
The financial crisis started in 2007 has shown the fragility of the financial system,
also the feebleness of almost a decade of continuous economic growth. Mainstream
economists faced the impossibility of their models to prevent the crisis, or even to offer a
plausible explanation, that’s why they have resorted to heterodox economic theory
looking for answers.
In section 2 we present a brief review of the mainstream financial crisis models and
highlight their weakness; in section 3 we expose the Austrian Business Cycle Theory and
Financial Instability Hypothesis, as most representative tendencies in heterodox study of
financial crisis; in section 4 we face the heterodox theories looking for commonalities and
differences; finally, in section 5 we present our conclusions.
* Faculty of Economics and Business Administration, University of Sevilla, Spain; e-mail: ignmarfer1@gmail.com
(corresponding author).
** Faculty of Economics and Business Administration, Alexandru Ioan Cuza University of Iasi, Romania;
e-mail: gabriel.mursa@gmail.com.
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Goals and methodology
Our aim in this paper it’s to face the Austrian Business Cycle Theory and Financial
Instability Hypothesis as representative branches in the heterodox economy and highlight their
main elements in their analysis on business fluctuations. As secondary goals we will present a
literature review on mainstream financial crises models and point out their main weaknesses.
In order to achieve our targets, we base our scope in a causal chain analysis which
allow us to disaggregate the main components from those different theories and find out
how and why these components are connected.
2. MAINSTREAM FINANCIAL CRISIS MODELS.
Following Laeven and Valencia (2008), a financial crisis could be defined as: “a
country’s corporate and financial sectors experience a large number of defaults and financial
institutions and corporations face great difficulties repaying contracts on time. As a result,
non-performing loans increase sharply and all or most of the aggregate banking system
capital is exhausted. This situation may be accompanied by depressed asset prices sharp
increases in real interest rates, and a slowdown or reversal in capital flows. In some cases,
the crisis is triggered by depositor runs on banks, though in most cases it is a general
realization that systematically important financial institutions are in distress.” (Laeven and
Valencia, 2008, p. 5).
We also can find a close definition in Bordo et al. (2001), who define a banking crisis as
a period of “financial stress resulting in the erosion of most or all of aggregate banking system
capital”, and by Reinhart and Rogoff (2008), who define a crisis to be “one of two types of
events: 1) bank runs that lead to closure, merger or takeover by the public sector of one or
more financial institutions; 2) in the absence of runs, closure, merger, takeover or large scale
government assistance of an important financial institution (or group of institutions) that marks
the start of a string of similar outcomes for other financial institutions”.
2.1 First-generation or fundamentalist models
First-generation or fundamentalist models are based on the "incompatible trinity”
(Mundell, 1963) the theoretical incompatibility between fixed exchange rate systems,
perfect capital mobility and the independence of monetary policies. The development
thereof didn't attempt to clarify what factors that led to a monetary crisis, rather the attempt
was to study the impact by the stabilisation plans of the prices of various exhaustible
commodities
1
.In essence, these models try to determine the point of foreign currency loss
that would force a central bank to re-align the parity of its currency. In brief, the models can
be expressed through the following equations (Prati and Sbracia, 2010, pp. 18-19):
     
 
 
   

 
where ,  and  represent the logarithms of national income, monetary supply and price
level; a, b and c will be positive constants;  will be the nominal exchange rate;  will
represent the national interest rates; and finally,  and  will be, respectively, the stock of
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73
domestic credit and of foreign currency in the hands of the central bank. The main
limitations of these models are the following (Alonso Neira, 2004, pp. 86-89):
 The pre-eminent role of the volume of international reserves in detriment to the
role played by interest rates.
 The assumption that political and monetary authorities are static agents, such that
they would establish an unsustainable economic policy for their fixed exchange rate and
wouldn't change.
 They foresee a secular behaviour in the deterioration of foreign currency reserves.
2.2 Second-generation models or models of self-fulfilling speculative attacks
Second-generation models arose in response to the monetary turbulence experienced
by the international economy, and especially by Europe with the failure of the EMS, in the
first third of the 90s. The non-existence of deteriorated fundamentals
2
left the first-
generation models without analytical value.
Second-generation models are based on assuming the existence of an authority (either
governmental or a central bank) that periodically conducts a cost-benefit analysis of
maintaining the parity of the exchange rate, wherefore the government or central bank will
establish their priorities around internal and external targets and, based on the incompatibility
between them both, will try to minimise their loss function, which is defined as:
       
where    would be the divergence of the target variable with respect to its potential or
optimum;   would indicate the devaluation rate of the domestic currency;  would
represent the priority of maintaining the external target (exchange rate) over the internal
target; and finally,   would tell us the median cost in terms of credibility of the
devaluation.
2.3 Third-generation or “twin crises” models
The Asian crisis at the end of the 90s refocused the idea that monetary crises were the
result of the governments' inability to be disciplined with their economic policies and/or that
they showed fundamental disequilibriums, thus not allowing governments to back the parity of
their currencies. This is the context within which von Hagen and Ho (2003) refer to “twin
crises” as the mutual relationship that exists between banking crises and monetary crises. But
there are other definitions in this regard, such as those by Glick and Hutchinson (1999) or by
Kaminsky and Reinhart (1999). Using the models of monetary crises prior to the Asian crises
as a reference (prior to 1997-98), twin crises models could be classified as follows
3
:
2.3.1 Models of moral hazard
These models follow the guidelines of the previously explained first-generation models
of monetary crises, but in this case, banks will be ones to adopt an inconsistent policy in
their activities.
The process of asset creation
4
by the banking system, thereby mismatching maturities
and risk levels
5
would explain how bank runs (and the subsequent bankruptcies due to not
being able to repay sight deposits to customers) would cause internal credit to collapse,
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Ignacio MARTÍNEZ, Gabriel MURSA
would cast doubts about the sustainability of the fixed exchange rate and would incentivise a
speculative attack, thereby turning a bank crisis into a monetary crisis. The mechanism
according to which a bank liquidity crisis is transferred to a monetary crisis would be the
existence (explicit or implicit) of a government guarantee of bank deposits. This
endorsement in turn provides feedback to the mismatch of bank maturities by generating
moral risk, given that, if the necessary liquidity is not available to handle withdrawals by
depositors, it would be the state (or central bank) that would cover the liquidity needs of the
banking system. Thus, whether by injecting newly minted money or by selling foreign
currencies, keeping the exchange rate fixed will be impossible.
2.3.2 Random withdrawal models
Random withdrawal models are based on the events that we posed as characteristic of
the second-generation models. They are models of multiple equilibriums based on self-
fulfilling expectations about the viability of the banking system, whose fate will ultimately
depend on the herd behaviours of depositors. A banking crisis will turn into an economic
recession through a credit crunch process.
If we use the random withdrawal model in an open economy developed by Chang and
Velasco (1998), and starting with banking that mismatches maturities as in the models of the
preceding section, this model is based on four initial assumptions:
1) Domestic banking is financed in the domestic market through sight deposits and in
the international market through short-term foreign loans.
2) Multiple equilibriums are derived, which are linked to self-fulfilling changes in
expectations about the solvency of banks, by both domestic depositors and by international
lenders.
3) The vulnerability of a country would be explained by the relative short-term
exposure to foreign debt.
4) There is a central bank that has a dual mandate: it must maintain the parity of the
fixed exchange rate, while at the same time acting as the ultimate lender of a banking system
that operates with a fractional reserve.
These models pose a context in which the very uncertainty about the solvency of banks
is what can precipitate the bankruptcy of these entities. Unfortunately, these models are not
capable of explaining the trigger of the change in expectations, thus the origin of their name
as random withdrawal models.
To this group of models, which are based on the aforementioned first- and second-
generation models, two new categories are added:
2.3.3 “Exogenous shock” models
In response to the lack of a "trigger" in the random withdrawal models, Goldfajn and
Valdés (1997) attribute such a trigger to the variability of international capital flows and to
the actual role played by financial intermediaries.
Based on an exogenous shock to the fundamentals, which deteriorate the net value of
financial entities, creditors (both domestic and foreign) cannot determine the degree of
individual exposure by the various banks to said shock, wherefore the uncertainty about the
solvency of the financial system becomes generalized, which deteriorates the liquidity
6
of the
system as a whole. This deterioration of liquidity materializes in a process of capital flight
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From Orthodoxy to Heterodoxy: Financial Crisis Literature Compared
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resulting from the uncertainty
7
, and it accelerates and aggravates the adjustment process that
the initial shock would have required in the absence of a fragile financial system.
2.3.4 “Balance sheet effects” models
The “balance sheet” models, or crisis at the end of the nineties, which occurred due to
the existence of imperfections in the financial markets. This point of view highlights that the
origin of financial and monetary crises is due to four factors:
1) Transference problems. External perturbations can require strong, real devaluations
of the domestic currency.
2) Liability dollarization. If the debts of banks and businesses are denominated in a
currency other than that of income, these entities will be especially vulnerable to exchange
rate fluctuations.
3) Balance sheets and risk premiums. Related to the preceding, if a strong devaluation
of the domestic currency deteriorates the solvency of domestic entities, it will cause an
increase in the risk premium of that country.
4) Restrictions on the borrowing by banks and businesses. The creditworthiness of
banks and businesses is restricted to the net value of their assets as collateral for loans.
These factors of weakness of the domestic economy would act as accelerators and
amplifiers of the effects of exogenous shocks.
3. HETERODOX FINANCIAL CRISIS THEORIES
3.1 Austrian Business Cycle Theory
Early enunciated as the circular credit business cycle in Mises (1912), combining
elements from Böhm-Bawerk's capital theory and Wicksell's monetary analysis, the
Austrian Business Cycle Theory (ABCT) began as a theory of exogenous cycle caused by
central bank monetary expansions but soon became a cycle theory endogenously induced by
fractional reserve banking. It was not until Hayek (1931) when the Austrian theory appeared
in the international arena thanks to the debates between Hayek and Keynes during the 30s.
Successive generations of economists of the Austrian school have contributed to ABCT to
bring it to its current state, nevertheless we will focus on Huerta de Soto (1998) theoretical
analysis and Garrison (2001) capital based macroeconomics framework.
Table no. 1 – Main elements of the Austrian Business Theory
Element
Description
Entrepreneurship
Drive individual behaviour
Assets supply
Equities, liabilities, bonds, etc.
Money and deposits
Monetary supply
Endogenus, elasticity based on profit-seeking behaviour of the
financial intermediaries and fractional reserve banking
Capital nature
Heterogeneus
Representative agent behaviour
Entrepreneurship
Source: prepared by the author
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We shall start with basic notions in capital based macroeconomics, Figure no. 1
shows an initial equilibrium situation where: a) is a Hayekian triangle which represents
the economies capital structure, divided in production stages; b) is the production
possibilities frontier (PPF), which shows the combinations between consumption and
investment for a given technology level; c) represents the loanable funds market, where
the interest rate shall be determined.
Source: Garrison (2001, p. 50)
Figure no. 1 – Steady state in Capital based macroeconomics
The diagrammatic exposition of the ABCT developed in Garrison (2001, pp. 57-83)
was initially planned to explain an exogenously induced business cycle drove by a Central
Banking monetary injection.

 

 

  

 
 

 
(I)
As we can see in (I), the monetary injection () increases credit supply and puts
downward pressure below their natural rate. Padding the supply of loanable funds with
newly created money drives a wedge between saving and investment, further reducing
interest rates. This environment of low interest rates sends the signal to entrepreneurs to
undertake investment projects with later maturities and, finally, results in a change to
productive structures, as we can see in Figure no. 2.
a)
b)
c)
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Source: Garrison (2001, p. 69)
Figure no. 2 – Unsustainable growth in capital based macroeconomics
With no change in intertemporal preferences, the current amount of saving decreases
as the interest rate falls, while the amount of investment, financed in part by the newly
created funds, increases. This behavior it’s incompatible with the actual PPF so the struggles
for the real resources saved appear, initially this results in sectorial inflation. In Figure no. 2
those struggles are pointed as over-investment, over-consumption and forced savings. The
bust could be explained as: “[…], entrepreneurs encounter resource scarcities that are more
constraining than was implied by the pattern of wages, prices, and interest rates that
characterized the early phase of the boom. Here, changing expectations are clearly
endogenous to the process. The bidding for increasingly scarce resources and the
accompanying increased demands for credit put upward pressure on the interest rate.
Inevitably, the unsustainability of the production process manifests itself as the
abandonment or curtailment of some production projects. The consequent unemployment of
labor and other resources impinge directly and negatively on incomes and expenditures. The
period of unsustainably high level of output comes to an end as the economy falls back in
the direction of the PPF. Significantly, the economy does not simply retrace its path back to
its original location on the frontier. During the period of over-production, investment
decisions were biased by an artificially low rate of interest in the direction of long-term
undertakings. Hence, the path crosses the frontier at a point that involves more investment
and less consumption than the original mix.” (Garrison, 2001, pp. 72-73).
Now we’ll turn capital based macroeconomics endogenous by the introduction of
fractional reserve banking exposed in Huerta de Soto (1998, pp. 200-231). In a banking
system which operates under fractional reserve banking, an exogenous monetary injection is
not necessary for the proper conditions for an investment boom. As soon as Banks doesn't
need to maintain the total amount of their deposits, credit supply is no longer equal to
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Ignacio MARTÍNEZ, Gabriel MURSA
savings, tends to be systematically higher. That's why we'll go to substitute credit supply
shows in (II) by:

   
    
(II)
where:
d: the money originally deposited in the bank’s vault;
c: the cash or reserves ratio maintained by the bank, in keeping with the banker’s experience
and his careful judgment on how much money he needs to honour his commitments;
k: the proportion of loans granted which, on average, remain unused by borrowers at any
given time.
This contribution allows us to explain the business cycle in endogenous terms and also
has an implication on the extent of the economic cycle. Since it’s the fractional reserve
banking who drives the credit expansion we can expect an increase not just in firm's debts
also in households one's, because during the previous stages till the boom collapses,
households tries to maintain their purchasing power financing their purchases with newly
created credits. As we'll see below, this point has important analytical implications.
3.2 Financial Instability Hypothesis.
Hyman Minsky is probably one of the most important economists in the post-
Keynesian economics tide, not only due to his contributions in the field of economic
theory or analysis but by his role as economic advisor for different international
institutions and Governments. During the 60s and 70s, Minsky developed a new approach
to study the business cycle, maintaining the essential elements of Keynesian thinking,
allowed to go beyond the classical explanation of a sudden stop in investment plans
caused by the famous animal spirits, in words of Minsky: “As economic theory, the
financial instability hypothesis is an interpretation of the substance of Keynes's General
Theory. This interpretation places the General Theory in history.” (Minsky, 1992b, p. 1).
Following van den Hauwe (2014, p. 2): “Minsky’s financial instability hypothesis is a
model of a capitalist economy which does not rely upon exogenous shocks to generate
business cycles of varying severity: the hypothesis contends that historical business cycles
are compounded out of the internal dynamics of capitalist economies as well as out of the
system of interventions and regulations designed to keep the economy operating within
reasonable bounds”. But maybe the most clarify summary of the Financial Hypothesis
(FIH) is shown in Minsky (1992a, pp. 7-8): “A main theorem of the financial instability
hypothesis is that the internal dynamics of capitalist economies leads, over a period
dominated by the successful operation of a capitalist economy, to the emergence of
financial structures which are conducive to debt deflations, the collapse of asset values
and deep depressions”.
As we saw earlier in the ABCT, under the FIH the investment boom will starts
exogenously, caused by tax cuts or a wrong designed monetary policy, or endogenously,
with a change in expected gross profits after taxes drives by animal spirits. We’ll focus in
the second one. The main elements of the FIH collected in Minsky (1974) are presented in
Table no. 2.
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Table no. 2 – Main elements of the Financial Instability Hypothesis
Element
Description
Animal spirits
Drives investment descisions
Financial assets
supply
Inside assets (private)
Real capital, equities, etc.
Outside assets (public)
Public debt and money
Portfolio
composition
   
Monetary supply
Endogenus, elasticity based on profit-seeking behaviour of the financial
intermediaries.
Capital nature
Homogeneus fund
Representative
agent behaviour
Profit-seeking, inconsistency in their intertemporal yield maximization.
Agent types
Hedge
Expected cash flows exceed liability payments
Speculative
Expected cash flows allow interest payments but not the
principal return
Ponzi
Expected cash flows may not cover interest payments neither
repayment of principal
Source: prepared by the author
We can find a deeper description for assets and their role in Minsky (1991, pp. 13-14):
“Capital assets generate cash as compensation for their participation in the production process;
financial assets generate cash as the maker is able to fulfil commitments. In addition capital
assets, as wel as financial assets, can yield cash by being sold or pledged. For pledging or
selling to be an option either a broker or a dealer market in assets needs to exist.”
The basic assumptions of the FIH
8
involve: (1) a disconnection between the bid price
and the assets inside their production costs; (2) inside assets demand price component is a
function of their price, based in their expected yield; (3) inside assets supply price
component is a function of the current consumption goods price and the financial costs of
producing new assets; and (4) the current consumption goods price it’s a function of the
investment rate and total spends in consumption goods.
 
(1)
  
(2)
  
(3)
   
(4)
There are also two auxiliary assumptions to explain the investment boom:
    
(5)
     
(6)
When there’s a change in the expected yield of business, assumption (2) implies a
growth in demand prices of inside assets which combine with (5) drives to a growth in the
investment rate. At this point everything looks like a classic investment boom drive by
animal spirits but Minsky introduce here a characteristic feature of the economy system, at
this stage in the business cycle hedge agents are predominant.
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This investment euphoria pushes firms to sue longer-term loans, and then financial
intermediaries (especially banks) begin to take riskier positions in the credit markets, as we
can see in Figure no. 3.
Source: prepared by author
Figure no. 3 – Changes in credit markets during the investment boom
The differential in interest rates between short-term and long-terms loans increase the
expected yield of long-term loans, combined with profit-seeking behaviour that we have
pointed out earlier drives the financial system balance sheets, and the economy as well, to
illiquidity positions. At this point, the speculative units behaviour become as representative
agent. As soon as the total debt starts to grow up, and then the liability payments,
speculative units need higher capital gains from their assets to maintain their profitability
and cancel their loans. This saturation process continues till speculative agents become
Ponzi schemes and their financial survival depends on a continuous increase of their assets
prices, which as far as we know it’s impossible.
The journey from a financially strong economy toward instability would be due to
these three behaviours, produced during the boom: “(1) the growth of financial—balance
sheet and portfolio--payments relative to income payments; (2) the decrease in the relative
weight of outside and guaranteed assets in the totality of financial asset values; and (3) the
building into the financial structure of asset prices that reflect boom or euphoric
expectations. The triggering device in financial instability may be the financial distress of a
particular unit.” (Minsky, 1974, p. 61)
Then we have arrived to the “Minsky moment” or the bust. Face to the impossibility to
afford their liability payments and running out of cash, Ponzi units to selling their assets to
avoid the bankruptcy. This sells reverse the process described in (5) and the financial crisis
becomes an economic depression.
To stabilize the economy and bring the growth back, Minsky (1986, pp. 330-370)
claims for Big Governments which should be able to stimulate the aggregate demand and a
Central Bank which can prevent the fragility of the financial markets by means of an
optimal management of banking system lending exposure through their reserve ratios and
their assets quality.
Short-term credit market
Longer-term credit markets
𝑖𝑠𝑡
𝑆𝑠𝑡
𝑆𝑙𝑡
𝐷𝑙𝑡
𝐷𝑠𝑡
𝑖𝑠𝑡

𝑖𝑙𝑡

𝑖𝑙𝑡
𝐷𝑙𝑡
𝐷𝑠𝑡
𝑖𝑠𝑡 𝑖𝑠𝑡
𝑖𝑙𝑡 𝑖𝑙𝑡
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4. HETERODOX THEORIES FACE TO FACE
4.1 Shared origins
There is an indissoluble nexus between the ABCT and the developments on financial
markets carried out by Post-Keynesian economists (Minsky in particular), and this nexus is
none other than the Swedish economist, Knut Wicksell.
Wicksell’s intertemporal monetary imbalance model
In Wicksell (1898) we can find a distinction that would be key for subsequent
theoretical developments: this is none other than differentiating between the interest rate of
money and the natural interest rate of the market. Based on this difference, he provided a
truly elegant description of the growth process based on credit expansion when the bank
interest rate is below the natural interest rate. Hyman Minsky presents a model of growth of
financial bubbles based on current production prices (PY) and asset market prices (PA),
joined by the transmission belt represented by interest rates where this difference is based in
the expected yield of the firms. For the Austrians this process it’s a bit more complex cause,
close to Wicksell’s exposition, this process its drive by the banking system so as long as the
credit market interest rate didn't come back to the natural interest rate, we'll find a
cumulative process of malinvestment.
The non-neutrality of money
In both branches, the Austrians and Minsky, the role played by monetary injections
and financial markets its central in their analysis. We can find the special emphasis shown
by the post-Keynesian author about the endogenous nature of money in Minsky (1993)
where its pointed how banks increase the money [credit] supply whenever they share the
belief of the borrower that positions in assets or financed different projects. In fact, this
discretionary behaviour of the financial sector should be determinant in the evolution of the
stock [assets] prices.
The Austrian version of the non-neutrality its focussed in the evolution of the relative
prices during a credit expansion, or the “Cantillon effect”: “It enters in particular sectors and
in particular ways. Some prices and incomes are bid up first. The early recipients of the new
money tend to enjoy increased buying power. Gradually the new money circulates around
and penetrates all sectors of the economy, but it reaches some sectors quite late. Selling
prices and nominal incomes in those sectors do not keep pace with the general inflation, and
their real incomes and purchasing powers suffer.” (van den Hauwe 2014, p. 34).
4.2 Institutions, structure and dynamics of the market
Minsky describes a business sector characterised by three types of agents: hedge
investors, speculative investors and Ponzi schemes (Minsky, 1992a). The relative weight of
each type of agent will be determined by what moment of the cycle we are in: hedge agents
would hold relative weight in the initial phases; as the bubble takes off, speculative agents
would hold relative weight; and at the climax, it would be held by Ponzi schemes. So the
question is, are these dynamics due to a failure of institutional design? Or conversely, are
they inherent in the system?
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Even if we accept this taxonomy of agents for illustrative purposes, we encounter an
important failure in the analysis at a technical level. Insofar as the expected cash flows from
an investment project are assessed with a forward approach according to the interest rate of
the loan market, it would be nearly impossible for an agent to determine both the cause of a
change in the interest rate and the real value of their balance sheet and expected cash flows.
It seems evident that it would be more consistent to understand this inherent problem,
which the Post-Keynesian author identifies with capitalism, as a failure of institutional
design, due to both the existence of a central bank with the ability to manipulate interest
rates and due to the lack of a definition of the ownership rights over sight deposits of
fractional reserve banking (Huerta de Soto, 1998, pp. 1-36, 115-165).
4.3 Boom-bust cycle and sustainable growth.
Boom-bust cycles
Hyman Minsky presents a model of growth of financial bubbles based on current
production prices (PY) and asset market prices (PA), joined by the transmission belt
represented by interest rates. In summary:
        
(7)

 
 
(8)
The Austrian school, in turn, puts it down to the privilege obtained by fractional
reserve banking (Huerta de Soto, 1998, pp. 347-385), such that credit expansion in the
banking system would be what endogenously applies downward pressure on interest rates:
        
(9)
   
(10)
Even though historically the origin of a large part of asset bubbles can be deemed to
reside in the ability of a central bank to manipulate interest rates, this entity's path of impact
on the economic system takes place through fractional reserve banking, and this is what
ultimately and decidedly generates credit expansion.
We are now at the climax of the bubble, where investments would mainly be Ponzi
games. In view of this panorama, Minsky offers an endogenous explanation based on a
process of debt saturation is presented. Thus, the increase in the weight of interest on the
balance sheets of businesses generates problems of illiquidity:
   
(11)
     
(12)
At the same time, and in an attempt to balance their books, businesses begin to sell
their assets at an increasingly accelerated pace, thereby exceeding, by far, the market's
capacity to absorb this supply of over-valued products:
              
(13)
               
(14)
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This process would be entirely consistent with the ABCT, given that when agents
revise their expectations and comprehend that the production structure is unsustainable, they
begin massive divestments in an attempt to save their business projects, giving rise to
generalized bankruptcies:
       
(15)
       
(16)
Sustainable growth
In Minsky’s FIH, the tendency to fragility of the financial system is inherent to
capitalism, so that sustainable growth is only possible through public intervention carried out
by the Big Players, the Government and the Central Bank. To prevent this natural transition
toward financial fragility during the investment boom, the Government should apply its fiscal
tools (spending cuts and raising taxes) to curb the investment euphoria. Meanwhile the Central
Bank ought to manage the liquidity and the solidity of the financial markets.
Source: Garrison (2001, p. 65)
Figure no. 4 – Sustainable growth in capital based macroeconomics
Under the ABCT as we can see in Figure no. 4, sustainable growth should be
preceded by an increase in social savings to finance new investments. If we continue with
our capital based macroeconomics and compare Figures no. 2 and no. 3, we can find two
essential differences:
(1) there is a movement along the PPF rather than off the PPF.
(2) there is no significant income effect on the supply of loanable funds.
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Ignacio MARTÍNEZ, Gabriel MURSA
Source: Garrison (2001, p. 65)
Figure no. 5 – Secular growth in capital based macroeconomics
The triangle depicts relative changes in spending patterns attributable to increased
savings; it does not show the ultimate increase in output of consumption goods made
possible by increased investment. To visualize the intertemporal pattern of consumption that
follows an increase in thrift, we must superimpose the relative changes depicted in Figure
no. 3 onto the secular growth depicted in Figure no. 5.
4.4 Minsky and the ABCT
This therefore leads to the question: is the Financial Instability Hypothesis compatible
with the Austrian Business Cycle Theory? To be able to answer, first we must qualify the
Minskyan analysis regarding a few points
1) Vision of the financial markets. From Hyman Minsky's analysis, a vision of a fully
banked financial sector is deduced. If we apply Ricardo's law of association (Mises, 1966, pp.
160-164) to the financial sector, it is easy to glimpse how, in the absence of state privileges,
the tendency would be towards specialisation, thereby minimising the costs (Diamond and
Rajan, 1999) of management, administration and valuation of investment projects.
2) Beyond the S-C-P paradigm. The described sequence of events suffers from the
sector paradigm of the Harvard School on market dynamics. Is this really the only
possible result?
3) Central banking and new agents in the market. Since the appearance of the FIH
approach, a series of financial agents and innovations tending to limit the role of central
banks as the providers of liquidity have emerged. By these agents, we are referring to the
integration, globally, of the inter-bank market and to “shadow banking”.
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4) The absence of capital theory. Minsky does not include capital theory as a tool in its
analysis; it's shown especially in his implicit conception of capital as a homogeneous fund.
5) Temporal horizon. Time is the central element in the analysis. For Minsky the
timeline it’s a succession of short-rum equilibriums, where the derived demand effects
prevail, while Austrians focus the scope in the long-run, where discount effect prevail.
Having made these qualifications, if we re-phrase the preceding question, the FIH can
be conceived of as a very particular case of the Austrian Business Cycle Theory, induced by
a combination of animal spirits (unexpected change in investment behaviour) and weak
institutions, especially in commercial law.
5. CONCLUSIONS
To conclude this work, we believe that it is important to highlight the main ideas.
Thus:
1) The disequilibrium caused by different interventions in the market can cause
business owners, when implementing their business function, to make the wrong decisions
and invest in projects in which they otherwise would not have invested due to being
unviable.
2) Generally, the behaviour of the players during cycles tends to be fairly similar: first
there is a period of emphasis and optimism, which is followed by a necessary adjustment
and depression or fear. The periods of optimism and expansion lead to making bad
investments, subsequently causing the recession processes to once again adjust to the same.
This leads to periods of debt overhang, caused by the ease of access to credit (given
that interest rates are artificially low due to intervention in the money market and to the use
of a fractional reserve by banks), and it leads to the necessary periods of deleveraging to
once again correct those business errors.
3) By studying heterodox theories about financial crises, it is possible to clearly see a
connection between these theories (the Austrian Business Cycle Theory and the Financial
Instability Hypothesis of H. Minsky) as branches of heterodox economic theory.
4) Even though the origin of heterodox theories on financial crises could be similar,
the major difference between them both lies in their concept of impact on interest rates, on
market structure and dynamics and even on recession periods (for Minsky, it would be an
exogenous factor, but for the Austrian School, it would be an endogenous factor).
5) The FIH can be conceived of as a very particular case of the Austrian Business
Cycle Theory, induced by a combination of animal spirits (unexpected change in investment
behaviour) and weak institutions, especially in commercial law.
Acknowledgements
We thank our colleague Pedro Arellano Villanueva for his invaluable help in the development of
this paper.
References
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ANNEX I
Main differences between first- and second-generation models
First-generation models
Second-generation models
Characterisation of
investors
Rational expectations + perfect forecast
Self-fulfilling expectations and animal
spirits + herd behaviours + uncertainty
The government's
position
Passive. It does not react to speculative attacks,
thereby modifying its economic policy and
increasing its interest rates
Active. It minimises a loss function,
therefore determining the suitability or not
of keeping an exchange rate fixed
Characterisation of
economic policies
Exogenous: unchanging and prior to a crisis
Endogenous and contingent: they depend on
the evolution of a crisis
Rules of behaviour by
agents
Linear
Non-linear
No. of equilibriums
and characterisation
Single (crisis) and foreseeable
Multiple (crisis versus no crisis) and
unforeseeable
Cause of a crisis
Ex-ante inconsistency between demand
policies and the fixed exchange rate + rational
expectations (which speed up the beginning of
a crisis).
Depletion of reserves
Incompatibility between the internal and
external targets of the economic policy.
Leads to: self-fulfilling expectations + ex-
post inconsistency of economic policies.
Difficulties for raising interest rates
Identification of a
crisis
Predictable and unavoidable. The exchange
rate is doomed to collapse..
Unpredictable and possible, but not certain.
The exchange rate would be viable in the
absence of an attack.
Characterisation of the
financial markets
Fundamental for the development of a crisis.
Private agents perform “rational” arbitrage
operations between the fixed exchange rate
and the shadow exchange rate.
Irrelevant. Their role in the development of
a crisis is described very vaguely. The entire
emphasis is placed on the incompatibility of
the government's policy targets.
Characterisation of
speculation
Stabilising. Points out inconsistencies in the
economic policies of governments. It should
not be penalised or prevented.
De-stabilising. The exchange rate would be
viable in the absence of an attack. It should
be penalised or prevented.
Source: Alonso Neira (2004, p. 97)
Notes
1
We must be aware of the period in which they were developed: after the end of the dollar-gold
standard and the global price re-adjustment or, as it is usually called, the 70s oil crisis
2
There were some relatively high levels of foreign currencies and relatively small budget deficits, and
the growth rates of the money supply and of the general price level were within normal parameters.
3
We find the Barro and Gordon (1983) in one of the most recognizable formulations:
   
 s      
where the central bank would try to minimize its loss function between the production gap   
and its inflation target ().
4
Banks take short-term loans and even call loans and grant credit for different terms.
5
We mustn't forget that there are incompatible causes between the loan and the deposit: while the
depositor seeks full availability and the absence of risk, the loan is based on the loss of availability for
a period of time (explicit or implicit) and the assumption of a certain level of risk. See Huerta de Soto
(1998, pp. 17-23)
6
We must keep in mind that uncertainty not only affects depositors and international lenders: distrust
also filters into the inter-bank market, such that not even the actual participants in the financial system
are capable of assessing the exposure to the shock.
7
We could analyze it as a problem of adverse selection: by not being able to determine the individual
solvency position of each entity, they are all considered to be potentially insolvent
8
See Minsky (1974, pp. 36-40), we summarize it excluding the case of an exogenous monetary shock.
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