The financial crisis and recession has turned economic thinking on its head. Economic textbooks which presume recessions never occur and unemployment is a voluntary decision have failed to keep up. However, luckily there have been a group of economists who have created theories that describe the world as it really is, not as they wish it was. They took key insights from the Roaring Twenties and the Depression Thirties and individually developed theories for how the economy boomed and why it went bust. There is Hyman Minsky’s Financial Instability Hypothesis, Irving Fisher’s Debt-Deflation Spiral, Richard Koo’s Balance Sheet Recession and John Maynard Keynes theory of aggregate demand. Each explains a part of the business cycle, today I want to piece them altogether to create an overarching theory.

Minsky begins his theory at the very beginning before the boom has occurred and the economy is still recovering from the previous recession (there is always a previous recession). Banks are cautious and unwilling to lend to any but the safest of investments. Businesses too are cautious about expanding or engaging in new ventures. The priority for everyone is to repair their balance sheet and rebuild the defences after the last storm. This over cautiousness is an opportunity for those willing to leave the comfort zone and take advantage of gaps in the market. The success of these investments encourages businesses and banks to be less cautious and expand lending. The economy begins to boom as spending increases. Old inventories are replaced, equipment is improved and pent up demand is released.

However, it is never clear when to stop. Businesses keep expanding and investing, in the process creating jobs and income for consumers who spend it, in turn creating demand for more investment. The economy is in a self-perpetuating cycle where each increase in spending further increases spending. The increase in income makes it easy to repay loans and encourages banks to be lax about lending standards. The economy as a whole forgets the last recession and instead focuses on the boom, after all this time is different. In this economy, to stand out as a risk taker you must have considerably low lending standards and highly speculative investments. If a business doesn’t, its rivals will and thus competition and groupthink pushes the boom higher still. The sight of so much easy money makes it look like only a fool could lose out and even if you believe asset prices are too high, you can always pass it on to someone who doesn’t.

Eventually this boom reaches a peak, a so-called Minsky Moment, before crashing down. All bubbles eventually burst as investors run out of people to sell the assets onto and the banks lax lending process eventually catch up with them. It is usually something minor that sets off the crash, but it quickly snowballs. A bank or important business fails and investors start to get worried. So they sell off some assets to cover themselves. This causes prices to drop and margins to be called (essentially loans must be paid and a margin is a loan with spectacular returns if prices rise and can easily destroy you if prices drop). Banks start taking losses and sell even more assets to make it up. However in a crash, everyone is selling and few are buying and thus the price goes into freefall. Each trying to save themselves inadvertently drags the whole economy down. Loans get defaulted on and banks realise how much they over extended themselves in the boom. The dominant issue of a crash is uncertainty. No one knows how bad things are, who is affected and how badly. Hence people pull their money from everything in a fire sale panic. This means that even safe and responsible banks fall into trouble as no one can tell the cautious from the reckless. The entire financial system is based on trust and when this breaks down, the system fails.

Irving Fisher explains how a financial crisis can drag the whole economy down and turn a panic into a depression. Key to the problem is deflation, that is, lower prices. Now we would think that cheaper goods are a good thing, but actually it can be enormously damaging to the economy. Let’s explain. When an asset (say a house) is falling in value (experiencing deflation) no one wants to buy as it will be cheaper next month. However, property developers also know this and for the same reason want to sell. However, the very process of selling pushes the price down, which makes more people wait before buying and owners more desperate to sell.

Crucial in Fisher’s analysis is the role of debt. Most stock market speculators and property developers did not have the money to buy the assets but rather bought on credit. So long as prices are rising, this is no problem, but once they fall, everything changes. The more heavily indebted you are, the more you gain if prices rise, but the more you lose if they drop. Hence even small price drops can cause major financial problems. The response to this is to sell assets and try to raise money to pay off their loan. However, this pushes down the price creating deflation. Here is the crucial reasons why deflation is disastrous. Prices and income are lower, but the debt is the same. In real terms, the level of debt has risen at exactly the time struggling speculators don’t need it to. Many are forced to default causing their assets to be seized, but the banks are now struggling with a pile of bad debt so they try to sell the assets, which pushes down the price, which causes more defaults and so on as the economy spirals downwards into depression.

This crisis causes businesses to revalue their priorities. Normally (as all economic textbooks say) businesses focus on profit-maximisation. However, according Richard Koo’s view of the Balance Sheet Recession, during the boom they have built up large debts while their assets have now plunged in value. Many of them may technically be insolvent; therefore their priorities have changed to paying down their debt. Hence businesses now forgo new investment and do not take out new borrowings; instead they focus on repairing their balance sheet. This explains why monetary policy has been so ineffective. Lower interest rates are meaningless if banks refuse to lend and businesses refuse to borrow. Businesses naturally do not want attention drawn to their debt level, so they do not discuss the matter; instead discourse gets focused on other areas. This means that the economy stagnates with unemployment stuck at a high level and no one willing to invest in order to put people to work. This period lasts as long as it takes for businesses to reduce their debt to manageable levels.

Finally, there is the role of Keynes. While others focused on the cause of the boom or the bust, Keynes has had most influence on what we should do to get out of a recession. The fundamental problem with the economy is a lack of demand. That is to say, not enough people are spending in the economy. After all, my spending is your income. Now some may prefer if the private sector increased its spending and that way reduced unemployment, but businesses and consumers are too burdened by debt to expand. Hence the government is the only option. The government must spend in order to end deflation and restore confidence to the economy in order to allow businesses to deleverage and start investing again.

If the government invests in infrastructure it provides jobs and reduces unemployment. These new workers will spend their money providing a boost for local businesses who can in turn afford to spend and hire and so on in a virtuous cycle. This is known as the multiplier effect and shows how government spending can have a large effect on the economy, possibly even double the initial investment. This influx of money will help repair businesses balance sheets and stop the economy on its downward spiral. The increase in income that consumers now have will encourage businesses to invest and expand to meet this demand. As there will be less people unemployed, social welfare costs will be lower and these newly employed workers will be paying taxes, therefore the budget deficit will actually reduce. Hence a short run budget deficit leads to a long run surplus.

An issue I had with heterodox economics was that while it was accurate in its criticism of neo-classical economics, it lacked a coherent alternative. However, as I read more I came across many separate ideas which I have now patched together to give an overall view of the boom and bust cycle. This theory accurately describes the Great Depression, the Celtic Tiger years in Ireland and most importantly of all the Great Crash of 2008.

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