The Vienna and Stockholm schools: A dynamic disequilibrium approach

Abstract

The neoclassical synthesis’ inability to explain the behaviour of credit resulted in monetary policy generating false signals for investors. These false signals led to large and unexpected losses for the world’s pension schemes. As Stiglitz and Minsky argued, credit is external to general equilibrium because credit markets do not clear and are inherently unstable. Moreover, their analysis highlighted two of the characteristics of credit bubbles that drive this instability. Excess business profits are a critical factor in driving increased credit expansion as investors look to continue to increase the rate of profit growth. This increased level of business profits then helps to drive down the cost of capital due to lower expected default rates, thus providing the fuel for further credit expansion. However, the models that have been constructed to identify credit bubbles have generally relied on price stability to provide the framework for such an identification. Indeed, Minsky based his model on Fisher, thus requiring a rise in the general price level and deviation from equilibrium to signal the existence of a credit bubble. Furthermore, this model has been widely popularised via Kindleberger in his ground-breaking book on business cycles and bubbles.² Hence it is perhaps unsurprising that the majority of investors and central bankers in the summer of 2007 did not believe that the rise in asset prices was unsustainable as inflation remained subdued.

Theories that explain the trade cycle in terms of fluctuations in the general price level must be rejected not only because they fail to show why the monetary factor disturbs the general equilibrium, but also because their fundamental hypothesis is, from a theoretical standpoint, every bit as naive as that of those theories which entirely neglect the influence of money.

Friedrich Hayek¹