Lesson 4 of 7
Ideas that travelled
Dispersed knowledge, credit-driven booms and financial frictions appear in mainstream work under other labels. What travelled, and what did not.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- The knowledge argument travelled and kept its author's name. It is the one part of this tradition that mainstream economics teaches as standard.
- Credit-driven booms travelled without the name: the mainstream route is financial frictions grafted onto otherwise standard models.
- What did not travel is the capital structure: the claim that a boom changes which stages of production expand, which almost no mainstream model represents.
A heterodox school can be right about something and get no credit, or be absorbed so thoroughly that the label falls off. Both have happened here, and telling which is which is a useful exercise in reading an economics literature.
Three claims, and how far each one travelled
Travelled, with the name attached
- Knowledge is dispersed and cannot be centralised.
- Prices carry information nobody holds in full.
- Cited as Hayek, in economics and beyond it.
- Taught in courses that teach nothing else from this school.
Travelled, under other labels
- Credit conditions drive booms and busts.
- Appears as financial frictions, the financial accelerator, the financial cycle.
- Attributed to its own mainstream lineage, not to this one.
- Measured by central banks and settlement institutions.
Two of the three are now ordinary. The third is still a minority position.
What plainly travelled
The 1945 knowledge paper is the single most cited thing this tradition produced, and it is cited by economists who take nothing else from it. The argument that a central authority cannot assemble knowledge that only exists in particular circumstances of time and place is not a heterodox position now.
That is worth stating because it cuts both ways. It shows a heterodox argument being accepted on its merits. It also means that a reader who meets the Austrian school through that paper has met the part everyone agrees with, and may be surprised by how contested the rest is.
What travelled under another name
Credit as a driver of fluctuations came back into mainstream macroeconomics after 2008, and it came back through a different door. Borio's survey describes the prevailing strategy as a conservative one: additional financial frictions grafted onto otherwise well behaved equilibrium models built on real business cycle foundations with nominal rigidities added.
He also records where the notion had been kept alive in the meantime, naming Minsky and Kindleberger as economists outside the mainstream in whose accounts financial booms and busts had continued to feature while the subject was out of fashion elsewhere. The Austrian tradition is not on his list, which is itself a fact about how this literature sees its own ancestry.
So the idea travelled and the lineage did not. A reader looking for Austrian influence in a modern paper on credit cycles will usually find none claimed, and should not assume borrowing where parallel development is the simpler explanation.
What travelled further than a reader expects
Borio's list of the features a satisfactory model of the financial cycle would have to capture is closer to this tradition than the label suggests. The first is that the boom should not merely precede the bust but cause it, which he contrasts with the dominant view of fluctuations as responses to random exogenous shocks. The second is debt and capital stock overhangs: credit loosens financing constraints, resources are misallocated, notably capital but also labour, and too much capital in overgrown sectors holds back the recovery afterwards. The third is that non-inflationary output and sustainable output need not be the same thing, so a stable price level can accompany an unsustainable path.
Those three are recognisable to anyone who has read the earlier courses in this track, and they are stated in a survey published by an international institution, with no reference to this tradition anywhere in it.
What did not travel
The stage structure. The distinctive claim is not that credit booms end badly, and not that capital is misallocated; the survey above says both. It is that a rate held below some sustainable level reorders production by distance from consumption, drawing resources toward activities whose output is furthest away, and that the bust is the undoing of that particular pattern.
Nothing in the mainstream literature represents production that way, and the previous course explained why the evidence for it is thin. That is the honest boundary of this lesson.
Check yourself
Which idea from this tradition travelled with its author's name attached?
- The structure of production
- That knowledge is dispersed and prices carry information nobody holds in full
- The natural rate of interest
Show the answer
Answer: B.
The 1945 paper is cited across economics by people who take nothing else from the school, which makes it the clearest case of absorption.How does Borio describe the mainstream route back to credit?
- As a return to Austrian capital theory
- As financial frictions grafted onto otherwise standard equilibrium models
- As abandoning equilibrium modelling entirely
Show the answer
Answer: B.
His 2012 survey calls the prevailing strategy conservative and describes it in exactly those terms, anchored in the New Keynesian framework.What has not been absorbed?
- That credit booms end badly
- That a boom changes which stages of production expand, and the bust undoes that pattern
- That property prices matter
Show the answer
Answer: B.
The stage structure is the distinctive claim and is represented in almost no mainstream model, which is also why it is the hardest claim to test.Sources
- Hayek, 'The Use of Knowledge in Society', American Economic Review, 1945, reprinted in Individualism and Economic Order, 1948, chapter four.
- Borio, 'The Financial Cycle and Macroeconomics: What Have We Learnt?', BIS Working Paper 395, December 2012, introduction and section two: the description of the prevailing modelling strategy as financial frictions added to equilibrium models, the naming of Minsky and Kindleberger as the writers outside the mainstream in whose work the notion survived; and section 2.1, for the three essential features a model of the financial cycle would have to capture: that the boom causes the bust rather than merely preceding it, the debt and capital stock overhangs with misallocation of capital and labour, and the distinction between non-inflationary and sustainable output.
What this leaves out
- This is a heterodox tradition. The mainstream account of the same phenomenon differs, and nothing here is a forecast or a view on any security.
- Nothing here claims that mainstream work on credit borrowed from this tradition. Borio does not name it among the accounts that kept the notion alive, and parallel development is the simpler reading.
- The financial accelerator literature is named here as Borio describes it. Those papers were not obtained for this course, and no claim is made about their contents beyond his characterisation.