Thursday, February 6, 2014


3. The Fed did it?: critique of “exogenous” explanation of the crisis

The other central point of the argumentation that is made from the Austrian Business Cycle Theory in order to sustain that the State caused the crisis refers to the preponderant role of the Federal Reserve (Fed) in the generation of the “credit bubble”. In this manner, the problem is not the free market, deregulation or the dynamics of private banks but rather the distorting action of “central agent”.

Taking into account the important caveat that the Federal Reserve is, in institutional terms, a private organization and not a government organization (as is often believed), one can answer the Austrian's argument in two ways.

First, by demonstrating that the causal process involved is not as simple or straightforward as the Austrians claim. There have been periods of significantly low interest rates in which asset bubbles or substantial recessions have not occurred. Interest rates are merely another cost of companies among many others. In fact, the Federal Reserve began to raise interest rates in a period as early as 2005 but even so the bubble doesn’t burst. Likewise, the economist Nouriel Roubini, internationally promoted as who predicted the crisis, had said in his lecture September 2006 at the International Monetary Fund, that an “imminent” crisis would occur in early 2007 (13). However, the economy seemed to be working perfectly even until early 2008 and the bubble did not burst until September. Therefore, the correlation between economic activity and interest rate is not as simple or straightforward as to try to make a reliable prediction based only on it. (14)

Second, by attending to the distinction between the monetary aggregates and their respective dynamics. Austrian economists tend to illustrate his argument by referring to a Central Bank which manipulates “the” money supply. However, it is widely accepted (from orthodox neoclassicals to the heterodox post-Keynesians) that there is an important distinction between the types of monetary aggregates. The aggregate M0 is a narrow measure of money supply and M3 is the broadest. While M0 is strictly controlled by the Federal Reserve, M3 basically depends on the specific action of individual banks. Thus, if one wants to find evidence that “the Fed did it”, such as the Austrians argue, must be verified that the dynamics of M0 is much more correlated with the crisis than the dynamics of M3.

Is there such evidence? In his article “Debunking Macroeconomics”, heterodox economist Steve Keen gives relevant econometric information in this regard (15). Specifically, he establishes, for the period 1990-2012, the correlation between changes in M0 and M3 and the dynamics of real economy (taking the level of unemployment inversely). In what follows, the graphs presented by Keen:

Graph 1

Graph 2

As shown in Graph 1 the correlation between M0 and economic activity is weak and has the wrong sign, whereas the correlation between M3 and economic activity is strong and has the correct sign. Therefore, according to this, you can consistently say that the dynamics of the crisis is more due to the action of individual banks rather the action of Central Bank (the Fed).

But you could still argue that the initial action of the Fed is what has distorted the dynamics of banks. However, this reply should be dismissed becausethe correlation between changes in M0 and changes in M3 is (…) strongly of the wrong sign for the pre-crisis period from 1990-2008 (-0.55), and only barely positive for the post-crisis period (+0.14)”. (16)

Therefore, there is no solid basis for considering the current crisis as a merely “exogenous” phenomenon regarding the market caused by the arbitrary intervention of a central agent (Fed) in a financial system which would work perfectly without such intervention. You cannot ignore the context of “moral hazard” generated by private banks, the “toxic assets”, the role of “rating agencies” (with the implied corruption) and the specific influence of private agents in the process of deregulation. All this, then, must lead us to an “endogenous” explanation of the crisis.


14) It must be said, however, that the Roubini’s theory, an heterodox and multidisciplinary economist, incorporated many more items than the mere Austrian Business Cycle Theory and therefore is much more plausible.
15) Steve Keen, “Debunking Macroeconomics”, Economic Analysis & Policy, vol. 41, nº 3, December 2011.
16) Steve Keen, Ibídem, p. 160.

You can contact the author of this article in: “Dante Abelardo Urbina Padilla” (Facebook) and (email)