The shadow of September, 2008 looms large on the economics profession. Whatever we think of the crisis itself, it has been an opportunity for the critics of the economics profession to criticize and to argue for their own approach to the problems of economics. In the Spring/Summer edition of the Cato Journal, the ever-worthwhile Axel Leijonhufvud has done just that, adding to his previous commentary, with “Monetary Muddles.” There are two themes that particularly interest me. I’ll comment on them below.
The first theme is the question of whether the market economy is stable and how we should approach that question. What I like, quite a bit, about Leijonhufvud’s approach is that coordination is in the forefront. In exploring the question of stability, the Swede treats the economy not as a machine existing apart from the action of individuals, but as a network of contracts that emerges from that action:
On any given day, the functioning of a market economy is governed by an intricate web of contracts and less formal promises and understandings. Errors occur. Some promises are broken. For the system as a whole to work reliably, it must isolate those cases and deal with them in more or less short order. But in some circumstances, one default will trigger another. Under normal conditions, such chains of default will be short. (Ibid: 186)
Whether the market is stable is a matter of coordination. If the intricate web that Leijonhufvud writes of is perfectly coordinated with the future intentions of its entities and with the future circumstances of the world they are surrounded by, then the market economy will remain stable. As long as it is perfectly coordinated, then there is nothing that can upset that coordination. As long as the entrepreneurs involved can perfectly foresee the future state of the world, whether its whether a creditor of theirs will go bankrupt or whether there will be a bad harvest in three years, error is impossible. The ex post has been collapsed into the ex ante, equilibrium is established and so there isn’t any logical space for an event that can disrupt the coordination between entrepreneurs constituting the economy.
When thinking about the stability of the market economy, I cannot help but to think about ecological collapse as a theoretical parallel. When an ecosystem collapses, an ecosystem suffers a dramatic reduction in the population of animal species it can support. That cataclysm generally reveals itself as a discontinuity when we chart out the population level over time. A paradigmatic example of ecological collapse is the collapse of the Atlantic cod population off the coast of Newfoundland in 1992. After decades of intense fishing, the population suddenly collapsed. The decline wasn’t gradual or expected, but sudden, taking the entire fishing industry by surprise.
In the article, Leijonhufvud finds a beautiful way of describing this temporal asymmetry by quoting The Sun Also Rises: “In Hemingway’s The Sun Also Rises, one of the protagonists asks his friend: ‘How did you go bankrupt?’ ‘Two ways,’ went the answer, ‘gradually, then suddenly’” (Ibid: 181). Although the causes leading up to the event were decades in the making, the collapse of the Atlantic cod population, much like the value of sub-prime loans, was sudden. Per Bak’s phenomenon of self-organized criticality is also quite interesting here, but I lack the time to provide the lengthy description Bak’s theory deserves.
In discussing the recent crisis, Leijonhufvud’s argument is a curious synthesis of an Austrian view that the crisis was a product of an over investment boom with the view that the financial regulation was made possible by deregulation. It isn’t all that surprising that Leijonhufvud would argue such a position. Both of those views share his concern with coordination and the interconnectedness of the market economy. He champions the Austrian business cycle approach: “The period leading gradually to the recent sudden crisis has the hallmarks of an ‘Austrian’ boom”(Ibid: 181). In discussing the recovery from the crisis, much like Austrian theorists, he using the metaphor of recalculation: “A financial crisis reveals a large, collective miscalculation of economic values. The incidence of the losses resulting from such miscalculations has to be worked out before the economy can begin to function normally again” (Ibid: 187).
Once the boom has taken its course and interfered with the calculation of value so as to create error in the ways that entrepreneurs coordinate with one another, crisis is unavoidable. To suppress the crisis would be to prevent the process of the correction of those wrong values interfering the correct coordination of entrepreneurs within the economy. Yet before we take Leijonhufvud to be arguing for laissez-faire, let’s not forget that he wrote of the critical role of government right after: “Because the process of a crash is unstable, it cannot be left for the markets and bankruptcy courts to work out the eventual incidence. If we had done so this time, it would have led us into another Great Depression” (Ibid). For Leijonhufvud, economic crises are political, requiring governments to do something about them—the second theme of note in “Monetary Muddles.”
In the course of an economic crisis, there will always be winners and losers. Politics can’t be avoided in that determination. Leijonhufvud criticizes current governments’ reliance on monetary policy in making decisions about who wins and who loses. Indeed, he even goes as far as to argue that the independence of central banks is incompatible with a democratic society: “Once it is realized that monetary policy can have all sorts of distributional effects, the independence doctrine becomes impossible to defend in a democratic society” (Ibid: 192). Here, I am very pessimistic since the power to make monetary policy through legislation would attract a whole lot of lobbying and would probably still be skewed to the advantage of those with the access to the halls of power. Nevertheless, Leijonhufvud is spot on in asserting that the economics profession has skirted the political questions that must accompany an economic crisis.
Overall, “Monetary Muddles,” much like the vast majority of Leijonhufvud’s corpus, is very much worth reading carefully. Coordination is always on the forefront in the way that he tackles the questions of economics. Moreover, he is always willing to grab political questions with both hands. Both are qualities that make Axel Leijonhufvud a theorist to admire.