Tyler Cowen links to a recent paper which explores credit expansion and financial crashes. Cowen comments that Austrian Business Cycle Theory (ABCT) needs more Minsky. I disagree. It reminds me of a passage that I had highlighted in Piketty’s Capital in the Twenty-First Century, on bubbles and self-fulfilling expectations. One thing that makes ABCT so attractive to me — one of the most attractive facets of Austrian economics, in general — is the emphasis on rule-following behavior. This requires interpreting Hayek’s 1930s work on industrial fluctuations through a 1940s Hayekian lens. One way to interpret the business cycle is to ask why certain rules work for some period of time, which we can call the “boom,” and why these rules suddenly create erroneous decisions during another period of time, the “bust.”

Piketty offers a conventional psychological theory of the self-fulling bubble,

[T]hese anticipated future prices themselves depend on the general enthusiasm for a given type of asset, which can give rise to so-called self-fulling beliefs: as long as one can hope to sell an asset for more than one paid for it, it may be individually rational to pay a good deal more than the fundamental value of that asset (especially since the fundamental value is itself uncertain), thus giving in to the general enthusiasm for that type of asset, even though it may be excessive. That is why speculative bubbles in real estate and stocks have existed as long as capital itself; they are consubstantial with history.

— p. 172.

The above is representative of a fairly common way of explaining bubbles and financial crises. Other explanations, such as Minsky’s might be more sophisticated, but they essentially grasp towards the same idea. I find their insight to be somewhat trivial, because they are vague theories that simplify agents’ behavior in financial markets to “they buy what they think everyone else will buy.” But, and this is an empirical question, I doubt that very many investors make their choices based on the expectation that an asset will continue to rise in value, despite that price diverging from “fundamentals.” Instead, what we see is investors justifying their decisions based on their reading of the “fundamentals” — i.e. the national housing market will not suffer a bust —, only to find out that their interpretation is wrong.

What ABCT does, once fully synthesized with Hayek’s later work on knowledge, institutions, and rule-following behavior, is embrace rational, informed decision-making in financial markets, and then explain how these rules can lead to welfare reducing outcomes if these rules are “distorted.” Hayek’s early model simplified all of these behavior-constraining rules to profits. Investors chase profits, because profits signal healthy, strong investment. Where assets grow in value is where there are profits. To investors, these increased revenue streams are the “fundamentals.” They invest in an asset because that business, or that market, is doing well. Any theory of the business cycle has to explain why these expectations, and the “fundamentals” (the heuristics) that guide them, are suddenly reversed — why do markets, which usually read the “fundamentals” so well, fail in bulk?

Minsky needs ABCT, not the other way around. The ABCT is, so far, the most complete demand-side theory of reversed expectations. I will refrain from claiming it’s the best, because so far maybe it hasn’t been compared to adequate alternatives. And, undoubtedly, ABCT is far from perfect, itself. You also need to take an empirical approach, because the lessons of ABCT have to be generalized — the narrow model is not perfectly applicable (as is the case with every theory). But, the point I want to make is that the credit-boom aspect is not what’s unique to ABCT. You can find that in Minsky. Other economists have made similar connections (e.g. Alan B. Taylor). What’s unique to ABCT is how it puts the story together by trying to explain investors’ behavior, and why this behavior turns out to be systemically suboptimal. It provides a sophisticated explanation, and I don’t think Minsky — or others who rely on psychological, rather than institutional, explanations — succeeds to the same degree.