Noah Smith has another piece up taking a swipe at heterodox economics and what he calls the “Folk Theory of the Business Cycle”. He says:
A lot of people seem to subscribe to what I call the Folk Theory of business cycles (not to be confused with the Folk Theorem of game theory). Roughly speaking, this is the idea that:
1. Debt growth is necessary for GDP growth.
2. As GDP grows, debt levels become too large, leading to an economic crash.
3. Therefore, booms cause busts, through the mechanism of debt accumulation.
He then goes into a series of arguments against this theory. But this is nothing more than a strange misrepresentation about how some heterodox economists think about the business cycle. Noah, as he proved in his last post, doesn’t understand heterodox economics very well and appears to be out of his comfort zone here.¹
First, I am not really a “heterodox” economist. Heck, I’m not even an economist so my views shouldn’t be taken as being representative of any/all heterodox economists. But I am a market practitioner whose career has revolved around understanding financial statements and financial institutions. And since heterodox economists focus a good deal on accounting I tend to find components of their views complementary to my own work. In my opinion, if you can’t explain the financial system through financial accounting then you can’t begin to understand it. Debt is important because it explains a balance sheet relationship between assets/liabilities and income statement “flows” so, while I might not be an adherent of the “Folk Theory”, I am not so quick to dismiss it as Noah is.²
Second, aside from being total misrepresentations, Noah’s arguments reject basic financial accounting and are, quite simply, unconvincing. For instance, Noah says the “Folk Theory” is wrong because quality of debt matters more than quantity of debt:
“what’s important is not the amount of debt, but the quality of debt, as measured by credit spreads and junk bond shares.”
Noah has just plagiarized Minsky’s Financial Instability Hypothesis thereby “proving” his argument by using the most essential idea of the theory he rejects!³ You can’t make that up. Minsky called this “ponzi finance” and said that a capitalist system will sometimes (not always, as Noah falsely asserts) move into a period of stability where the quality of financing erodes and creates an environment where the economy becomes increasingly fragile due to a lower quality of debt financing. Basically, as capitalists get comfortable and overconfident they relax lending standards and degrade the quality of their own balance sheets thereby setting the stage for potential instability.
Thirdly, is it even controversial that debt can finance bad investment? How many financial crises do we need to go through before mainstream economists start focusing more on the importance of private debt? There have been a multitude of debt financed crises throughout history, but even if the GFC was the only one ever, wouldn’t that be a large enough and important enough event to make this one piece of data very relevant? I would think so. And the GFC was a near perfect display of Minskyan instability.
Lastly, heterorodox economists don’t argue that debt is necessary for GDP growth, but it is an important form of financing that will tend to increase alongside growth. If you don’t have healthy entities willing to expand their balance sheets to borrowers or healthy borrowers willing to borrow then you might not have sufficient investment which drags down growth. This is basically what we’ve been living through for the last 7 years. The lack of healthy consumer balance sheets has coincided with sub-par borrowing to finance spending and investment thereby resulting in lower than normal growth.
Understanding debt dynamics in the economy does not mean that debt always causes crisis or that anyone actually knows what the tipping point is. But it does highlight an important point that, until recently, most of mainstream econ didn’t really focus on – debt matters and is not just a veil over the real economy. I am surprised this is still controversial, but apparently it is….
¹ – Senor Smith has previously made erroneous comments regarding Post-Keynesian Economics such as “private sector debt is bad”. Pardon my bluntness, but this is beyond a basic misunderstanding.
² – “Mainstream” economics is a big tent just as heterodox economics is. But I will unfairly generalize in this piece. I am using “heterodox” in this piece to refer to Post-Keynesians.
³ – Minsky said:
“In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy with a sizeable body of speculative financial units is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make position by selling out position. This is likely to lead to a collapse of asset values.”
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