Financial Instability and Mitigating Uncertainty

  Financial Instability and Mitigating Uncertainty

    Recently while re-reading multiple Misesian accounts of uncertainty, it became apparent to me the similarities between the Austrian and Post-Keynesian accounts of incalculable uncertainty. However, importantly, both these schools diverge for reasons that are primarily ideological, particularly on financial instability and its relationship with uncertainty, especially considering the Austrian belief in free markets and the Post-Keynesian belief in regulated financial systems to mitigate uncertainty and the business cycle.

    

    While the Austrians seem to adopt a conception of uncertainty similar to that of the Post-Keynesians, for an odd reason they seem to lack the idea of how this pertains to uncertainty and wild swings in investment behavior, i.e., animal spirits and their relationship to an economy even without "inflationary" distortions in the economy's capital structure. To Austrians, the economy is fundamentally stable1 despite incalculable uncertainty in the economy, making the future unknowable and consequently subject to mass error to the Post-Keynesians but oddly enough stable to the Austrians. This belief seems to be contradictory to anyone who understands uncertainty in the form known to Davidson, Mises, and Keynes, Austrians seemingly use it for one part of the analysis but then completely disregard it the next! This necessarily means that the Austrians end up without a theory of the market process that incorporates the business cycle with uncertainty, even in a world without a central bank or “fractional reserve banking” to inflate the money supply and cause malinvestments. Investment to the Post Keynesians is fundamentally uncertain, considering that investment is fundamentally an activity that is for the future, it is intertemporal in nature, and as the Post-Keynesians like Davidson pointed out, the future is transmutable, i.e., the future is malleable and will shift in any direction possible manipulated by contingent human beings and their subjective expectations about their investments in the future. Due to this, in a world of non-ergodicity, we can’t determine objectively (probabilistically) that the future is fixed and a certain investment will be closer to the objective probability functions, the future has not yet been created and still is in the process of being created by entrepreneurial actors to push the economy in a new dynamic direction. This lucid account of the market process by the Post-Keynesians adequately refutes and describes the market process, but it also gives insight into the economic reality of industrial fluctuations, using the same conception of a transmutable reality and uncertainty of investment. 

    Due to the fact the economy’s investments are constantly uncertain and subject to constant error due to the malleable nature of the future and direction of the market economy, it cannot function without losses, and furthermore, due to the uncertain nature of the future, we necessarily need to consider entrepreneurs all at a time find themselves getting “cold feet” about their investments due to certain factors or simply too many losses are realized at a time when over-investment in a certain sector occurs, this leads to economic collapse or a recession. While termed “animal spirits” by multiple economists, it has been pointed out that the concept of animal spirits is a red herring by blogger Lord Keynes, however, I will not go into this currently. These mass panics generally occur due to the nature of investment, we cannot know the outcome due to the nature of the transmutable economy, furthermore, to add to the unstable nature of investments, it must be considered that in a modern market economy immense amounts of capital, financial and material resources, are at work. This significantly increases uncertainty and fear of the future for the entrepreneur at work, due to the sheer amount of resources and financial investment poured into his project, he is forced to deal with the thought of failing and consequently being forced to deal with liabilities that he must manage to pay off if the investment fails close to fruition or the entrepreneur suddenly feels that his investment cannot sell in the market and consequently pay off creditors, leading to sudden “cold feet” in order to prevent catastrophic losses in the future. This effect is simply applied to a singular individual, however, we can apply this to an economy-wide scale, such as speculatory markets. 

Speculatory markets are fundamentally different from the standard supply-demand analysis of standard markets, rather than bidding on the present they are bidding on something that is not physical in the present and the future value of an investment, i.e., the speculatory process is primarily decided upon by subjective expectations that are subject to radical change based on profit and loss signals or entrance of new information in the economy. Before I proceed, it is important to consider what expectations are and how they affect production processes. Production processes are often intertemporal, they are usually about directing resources that exist in the present to make a profit in the future, hoping that in the future consumers will subjectively believe that it is a good offer at that time, this is necessarily speculation. What entrepreneurs use to guide their future production decisions and their choice on the distribution of products are determined by subjective expectations about the future. Let us use an example to demonstrate this:

    Geoffrey is an entrepreneur wishing to produce jewelry in a less cost-intensive, but higher quality, manner. However, Geoffrey must necessarily need subjective expectations about consumer demand but also about creditors and their confidence in his project. If Geoffrey’s subjective expectations are mistaken about the consumers’ preferences, Geoffrey is punished with losses and unable to pay off his creditors. Geoffrey, consequently, is quite cautious about such a production process that involves a massive amount of resources, speculation, and financial capital. His subjective expectations about creditors and consumers change his production techniques and the fate of the production process, whether or not it is followed through on or liquidated. As demonstrated, subjective expectations are integral to the way market economies function and the way individual production processes’ techniques are determined. Considering that subjective expectations must be considered with all economic analysis, it must also be considered that the concept of the “nerve” of investors is important, and when moving around so much capital in an economy they are essentially gamblers, and gamblers are constantly subject to swings in their “nerves” and consequently the fate of the economy due to production processes. G.L.S Shackle illustrates this concept quite nicely when considering the Keynesian theory of involuntary employment: 

“(sc. Keynes’) ... theory of involuntary unemployment is perfectly simple and can be expressed in a paragraph, or in a sentence. If you express it in a sentence, you simply say that enterprise is the launching of resources upon a project whose outcome you do not, and cannot, know. The business of enterprise involves investment, the investing of large amounts of resources--huge sums of money--in things whose outcome you cannot be certain of, which could perfectly well turn into a disaster or a brilliant success.

The people who do this kind of investing are essentially gamblers and they can lose their nerve. And if they decide to withdraw from trade, they sweep their chips up from the table. If they decide it’s too risky, if their nerve gives out and they can’t bring themselves to go on investing, they cease to give employment and that is the explanation. When business is at all unsettled--when there’s any sign at all of depression--or when there’s been a lot of investment and people have run out of ideas, or when their goods are not selling quite as fast as they have been, they no longer know what the marginal value product of an extra man is—it’s non-existent. How can you say that a certain number of men have a certain marginal productivity when you can’t know what the per-unit value of the goods they would produce if you employed them would sell for?”2

    For many reasons, entrepreneurs in speculatory markets and financial markets are constantly subject to losing their nerve for any reason, from being too “risky” to simply inventory isn’t being sold at a rate satisfactory to the entrepreneur. Whatever the cause of these investors to lose their nerve, investment demand is consequently subject to large fluctuations due to “animal spirits” or for a better choice of words, malleable long-run, and short-run expectations. This is the result of an economy such as one that is common in a majority of contemporary occidental market economies, massive changes in investment demand due to the transmutable and radically uncertain future. The Austrian failure to comprehend financial instability due to subjective expectations and a transmutable direction of the market economy has dire consequences for economic policy, such as the standard dogmatic policy proposals of Austrians, such as completely abolishing the central banking system in favor of “free banking” or “100% reserve banking”. The sole root of the business cycle, en masse to the Austrians, is primarily inflationary credit expansion3, with no other conception of how financial instability exists due to the uncertainty of the future, a failure to apply subjective expectations everywhere, unlike the Post-Keynesians, who seem to be better subjectivists than the original subjectivists in the tradition of Carl Menger! 

    The question then of how do we mitigate these massive swings in investment demand and radical uncertainty of the kaleidic market process arises. This is where Post-Keynesians generally suggest a form of government intervention in the form of counter-cyclical monetary policy, in order to make sure entrepreneurs in the market gain certainty back about the economy and investment. Unfortunately, Austrians disagree here, with their claim on the Austrian business cycle and the lowering of interest rates causing distortions in the capital structure of the economy, further exacerbating the issue. I will keep my concerns on the Austrian theory of industrial fluctuations based on reswitching aside for now, and simply discuss the matter of expectations to Austrians and Post-Keynesians in recessions. 

    To the Austrians, there is a concept of “Regime Uncertainty” undergirding their theory of expectations and government intervention in the economy during a recession, or at least a large portion of it. To Austrians, regime uncertainty is the rationale behind the reason why Roosevelt never achieved full employment with his “Keynesian” policies with his New Deal and other policy measures to induce economic development. Regime uncertainty, put simply, is a lack of confidence amongst investors caused by uncertainty about what the government is intending to with their businesses and further limiting their business’ expansion through certain regulationist policies. Due to regime uncertainty in the US, investors lost confidence in their investments and preferred to stop investing, lest they deal with the Federal Government’s intervention. While this is a notion that is valid, it does explain very little of what happened in the Great Depression as a whole. What truly kept investment expectations pessimistic with individuals in the economy was falling aggregate demand and financial instability. Had the government completely failed to intervene with no “Keynesian” stimulus, even if the capital stock had been rebuilt the damage that would have occurred would have been even more catastrophic on the US economy, with investor confidence being completely shaken and flight from the country to a country that was undergoing “Keynesian” stimulus and stimulating aggregate demand, and preventing falling aggregate demand from harming business expectations and consequently investor confidence in the economy. 

    The Austrian story of the economy’s recession, the necessity to build up the capital stock of the economy, is certainly a true story, regardless of the situation to Post-Keynesians or Austrians. The economy, during a recession and the crash, ends up wasting capital and massive losses are inflicted. However, it is not enough to simply wait for the economy to rebuild its capital stock and consequently letting expectations rebound to pre-crisis levels, had this happened the economy would be in an even worse situation after the 2008 crash and the 1929 crash, counter-cyclical monetary policy is necessary for a rebound in investment and business expectations. This belief is not only Keynesian, multiple “Austrians” and like-minded economists have expressed their feelings on countercyclical monetary policy, such as Ludwig M. Lachmann, Gottfried von Haberler, and Wilhelm Röpke:

“During the 1930s Haberler took a view different from either Mises or Hayek about the solution to the Great Depression. His Austrian colleagues argued that the market had to be freed of government intervention, for supply and demand, and savings and investment to re-establish their own new equilibrium. Haberler reached a conclusion closer to that of Wilhelm Röpke, that once begun, the economic downturn of the early 1930s had increased to such an intensity that a “secondary depression” had set in, having little to do with any healthy correction from the mal-investments created by the Federal Reserve’s monetary policy of the 1920s.[10] Rigid costs resistant to downward adjustment,bank panics and failures that caused an actual contraction in the supply of money and credit, and pessimistic expectations on the part of the investment community generated a situation in which only a government-initiated stimulus of spending and “effective demand” could bring about a reversal of the depressionary forces.[11]” 4

“Röpke concluded that this secondary depression served no healthy purpose, and the downward spiral of a cumulative contraction in production and employment could only be broken by government-induced credit expansion and public-works projects. Once the government introduced a spending floor below which the economy would no longer go, the market would naturally begin a normal and healthy upturn that would bring the economy back toward a proper balance.[8]” 5

“In Lachmann's view, the cause of the primary depression was credit expansion by the banking system leading to malinvestment and later liquidation. But once in the throes of a primary depression, there was something to be said for Keynes's theory as an explanation of the secondary depression.” 6

    The present author agrees with a view similar to this, there is a necessity to build of the capital stock after the crash, but to do nothing in an extreme-liquidationist view of the economy, would further exacerbate the situation and prevent business and investment expectations from ever rebounding, leading to capital flight from the economy and economic collapse. 

    While regime uncertainty may have an effect on the economy during the recession and a reason against regulationism, the extreme liquidationist view of the Rothbardian Mises Institute will further exacerbate the situation and it necessarily requires stimulation of effective demand. The Austrian analysis of the economy, while satisfactory in certain sections, largely ignores financial instability and the role of expectations in a recession, from which Austrians can take from Post-Keynesians and economists such as Ludwig M. Lachmann, Gottfried von Haberler, and Wilhelm Röpke.

References: 

1.) Skousen, Mark. “Are Financial Markets Inherently Unstable?: Mark Skousen.” FEE Freeman Article, Foundation for Economic Education, 1 Jan. 1999, fee.org/articles/are-financial-markets-inherently-unstable/

2.) (2014, July 30). An Interview with G.L.S. Shackle: G.L.S. Shackle , Richard M. Ebeling. Mises Institute. https://mises.org/library/interview-gls-shackle. 

3.) There are multiple papers on the similarities between Minsky and the Austrian theory of inflationary malinvestments, such as “An Empirical Examination of Minsky’s Financial Instability Hypothesis: From Market Process to Austrian Business Cycle”. 

4.) Ebeling, R. M. (2000, July 1). Gottfried Haberler: A Centenary Appreciation: Richard M. Ebeling. FEE Freeman Article. https://fee.org/articles/gottfried-haberler-a-centenary-appreciation/. 

5.) Ebeling, R. M. (1999, October 1). Wilhelm Röpke: A Centenary Appreciation: Richard M. Ebeling. FEE Freeman Article. https://fee.org/articles/wilhelm-rpke-a-centenary-appreciation/. 

6.) Lachmann and the Subjective Paradigm. Online Library of Liberty. (n.d.). https://oll.libertyfund.org/page/lachmann-and-the-subjective-paradigm.