by Andreas Hoffmann
I want to bring a recent comment by Sornette and von der Backe to the attention of the reader (in Nature 471, p. 166, May 2011). Sornette and von der Backe remind us to pay more attention to disequilibria caused by the fractional reserve banking system to explain the emergence of crises. They particularly recommend a reconsideration of the Austrian School of Economics to derive short-term policy solutions. “We should relearn and expand some of the old economic wisdom about the specific role of banks.”
“Banks are important because they create credit in a fractional reserve system, and credit markets are crucial allocators of capital to entrepreneurs. However, this is not considered in macro-economic models used by central banks (indirect influence through interest rates aside).”
Largely in line with this, the economic historian Charles Kindleberger argues in his 1978 book Manias, Panics and Crashes that macroeconomics
“remains incomplete, even when it brings in production and prices .. if it leaves out the instability of expectations, speculation, and credit and the role of leveraged speculation (p.21).” “Neglect of the instability of credit began by and large with the depression of the 1930s, with the Currency and Banking schools converted into monetarists and Keynesians (p. 65).” “The monetarist-Keynesian debate leaves little if any room for instability of credit and fragility of the banking system, or impacts on production and prices when the credit system becomes paralyzed through loans rendered bad by falling prices (p.67).”
Kindleberger finds that the theory of Hyman Minsky is one of the few up-to-date exceptions that incorporates these finding.
But as Sornette and von der Backe write, there is much to be found e.g. in the (older) Austrian literature by Lachmann, Mises and Hayek that puts a strong emphasis on expectations, innovations and the perverse elasticity of bank credit (instead of solely central bank mistakes) that can be build upon to explain cyclical fluctuations. Given the globalized financial system and its growing importance for the world economy, this seems worthwhile.