Contra Axel Leijonhufvud’s banking theory

I have a lot of respect for Axel Leijonhufvud. While I disagree with some of his economics, he mostly gets it. He’s a member of the monetary disequilibrium team, a sort of crossover between the Austrian/paleomonetarist/Keynesian world, a genius economic UFO. But his latest paper for the latest CATO Journal, titled Monetary Muddles, is just…weird. It demonstrates at the same time good insights, misunderstandings and lack of banking knowledge.


Leijonhufvud’s insight is that an Austrian business cycle-type crisis, such as our previous crisis (at least in his view), involves a redistribution of income:

Changes in financial regulation and in the conduct of monetary policy have not only played a very significant role in generating the financial crisis but have also been important in bringing about a large shift in the distribution of income over the last two or three decades.

This, at first, sounds very true to me (and I’ll get back to that later in the post). But the devil is in the details. Leijonhufvud gets almost his whole banking theory wrong. Yes you read correctly: (almost*) the whole of it.

First, he seems to adhere to the endogenous money theory. The culprit? Inflation targeting, which makes “bank reserves in highly elastic supply” at “the ruling repo rate”:

In my view, the complete endogeneity of the monetary base associated with inflation targeting has failed us.

I won’t repeat again why this isn’t accurate (see here, here, here, here, here, here, here…).

Second, all banking regulations and reforms that actually have endangered the banking system (he’s focusing on the US), are for him sources of stability. So the Glass-Steagal act “successfully constrained the potential instability of fractional reserve banking” and the restrictions on interstate banking/branching “gave the [US financial sector] great resilience.”

This is how he explains it:

I used the metaphor of a ship with numerous watertight compartments. If one compartment is breached and flooded, it will not sink the entire vessel. In the field of system design, this would be seen as an example of modularity (Baldwin and Clark 2000). Modular systems have several advantages over integral system. The one relevant here is that failure of one module leaves the rest of the system intact whereas failure in some part of an integral system spells its total breakdown. In the old U.S. modular system of financial intermediaries, the collapse of the S&Ls in the 1970s and early ’80s was contained to that industry. It did not bring down other types of financial intermediaries and it had no significant repercussions abroad. In the recent crisis, losses on mortgages of the same order of magnitude threatened to sink the entire American financial system and to spread chaos worldwide.

And deregulation broke this successful model:

The deregulation that turned the U.S. financial industry into an integral system is one of several instances where the economics profession failed spectacularly to provide a reasonable understanding of the subject matter of their discipline. The social cost of the failure has been enormous. At the time, the abolishment of all the regulations that prevented the different segments of the industry from entering into one another’s traditional markets was seen as having two obvious advantages. On the one hand, it would increase competition and, on the other, it would offer financial firms new opportunities to diversify risk. Economists in general failed to understand the sound rationale of Glass-Steagall. The crisis has given us much to be modest about.

Regular readers of this blog already know that the real story is pretty much the exact opposite of what Leijonhufvud believes, that financial deregulation is a myth (unless you wish to leave aside the whole Basel framework) and that US banking sector has always been fragilised by its granularity and lack of nationwide integration (you can see why here and here). His ‘watertight compartment’ metaphor isn’t applicable: banks evolve within economic systems that are not ‘watertight’, people, capital and income flow from one compartment to the other. If S&Ls failed in the US, it was because of regulations that applied specifically to them.

However, he does have some good insights when he remarks that the latest crisis implies consequences that were not originally foreseen by Mises and Hayek when they theorised the Austrian business cycle theory. This is why I called some time ago for it to be ‘updated’ in order to remain relevant and academically serious.

He is also right that the crisis implied a redistribution of income and that the pre-2008 boom involved “change in income distribution in favour of income classes whose marginal propensity to spend on the goods in the CPI basket is low.” But he sees bankers and financers as the main beneficiaries of the redistribution. While it is undeniable that the finance sector generates supranormal profits when interest rates are maintained below their natural Wicksellian level, the latest boom witnessed a much more economically damaging type of income and capital redistribution. And this one wasn’t due to monetary policy (although amplified), but to banking regulation: risk-weighted assets distorted the allocation of credit and allowed a major redistribution of capital towards real estate investors and sovereign borrowers, all of which benefited from below-equilibrium borrowing rates. This is the true issue of the latest crisis, the one that generated the malinvestments that eventually triggered our economic collapse.

I nevertheless still have a lot of respect for Axel (and will definitely keep my old copy of his book On Keynesian Economics and the Economics of Keynes: A Study in Monetary Theory on my shelve).

PS: Another minor issue with Leijonhufvud’s banking theory is his belief that banks “banks leverage their capital by a factor of 15 or so, thus earning a truly outstanding return from buying Treasuries with costless Fed money or very nearly costless deposits.” In reality, banks are often more leveraged than that but complain that, due to the low interest rate environment, they earn almost nothing on assets such as Treasuries and hence see their profitability depressed.

*His argument about the incorporation into limited liability companies of formerly fully-liable partnership investment banks is more debatable.


10 responses to “Contra Axel Leijonhufvud’s banking theory”

  1. Kevin says :

    I’m puzzled by your rejection of Leijonhufvud’s view on endogenity. I read him as saying, not that base money is exogenous in general, but that under inflation targeting the base becomes endogenous. If a central bank credibly commits to an inflation target and makes the discount rate the instrument, they have to accept whatever change in bank reserves is consistent with the inflation target. Hence, the base is determined by the inflation target rather than central bank discretion. I’m not sure why Leijonhufvud considers this a problem, however. Am I missing something?

    • Julien Noizet says :

      Kevin, there is a little bit of truth in what Leijonhufvud said, and this is the view of most MMTers and other endogenous money theorists (although they don’t necessarily specify that it is only the case in an inflation targeting framework).
      Please see some of the links I refer to in my post, where I disagree that, in a longer than short-term timeframe, the base is endogenous.
      The most elaborated endogenous (outside) money theory implies: 1. that banks don’t suffer from the stigma associated with central bank borrowing, and 2. that all banks are mostly homogeneous and expand at the same time and pace (to avoid adverse-clearing) and into assets of the same risk classification (to appear to remain continously homogeneous to external funds providers).

  2. Andrew_FL says :

    “Interest in the Austrian theory will presumably revive. In its original form, however, it predicted that an overinvestment boom would be accompanied by inflation. Mises and Hayek had of course lived through the great post-WWI inflations and knew firsthand not only the great redistributions of wealth that they brought but also the social and political upheavals that followed. There was not much in the way of CPI inflation in the run-up to the recent crisis. So some modification of the original theory is in order. Moreover, we have to consider whether monetary mismanagement may have significant distributive effects even when the price level does not change significantly.”

    This passage came across as bizarre to me, because Hayek pretty much said his starting point for his writings on the business cycle was to debunk the notion that Leijonhufvud attributes to him here!

    Perhaps he’s been reading too much Wicksell, who did take keeping the natural rate of interest in line with the “bank rate” as synonymous with price level stability.

    • Julien Noizet says :

      Two points here:
      – Wicksell didn’t specifically mention anything close to the CPI, but ‘commodity prices’. Which could be included in the CPI. Or not.
      – I think Leijonhufvud’s point isn’t fully accurate. The Austrians did foresee inflation, though not necessarily of the CPI type. However, at their time, when inflation struck, it often was generalised, whereas currently, CPI can remain stable while other commodities and assets experience massive booms. Also, CPI stability doesn’t even imply ‘no inflation’. If productivity improvements should have led to a decline of 3% of the CPI, but central bank’s actions led to a +2%, the ‘hidden’ CPI inflation actually was 5%.

      • Andrew_FL says :

        Julien-thanks, I had forgotten about the CPI vs commodity prices distinction. CPI isn’t what most econometricians mean when they refer to “the price level” these days anyway, but I kind of assumed that “the price level” is what Leijonhufvud meant by referring to the CPI. That one’s on me I guess.

        Anyway I had in mind a few of quotes from Monetary Theory and the Trade Cycle:

        “In order to save the sound elements in the monetary theories of the Trade Cycle, I had to attempt, in particular, to refute certain theories which have led to the belief that, by stabilizing the general price level, all the disturbing monetary causes would be eliminated.”

        “It will be shown, in particular, that the Wicksell-Mises theory of the
        effects of a divergence between the ‘natural’ and the money rate of interest already contains the most important elements of an explanation, and has only to be freed from any direct reference to a purely imaginary ‘general money value’ (as has already been partly done by Prof. Mises) in order to form the basis of a Trade Cycle theory sufficing for a deductive explanation of all the elements in the Trade Cycle.”

        “Wicksell, from the outset, regards the problem as concerning explicitly the average change in the price of goods, which from the theoretical standpoint is quite irrelevant. He starts from the hypothesis that, in the absence of disturbing monetary influences, the average price level must remain unchanged. This assumption is based on another, only incidentally expressed, which is not worked out and which, from the point of view of most of the problems dealt with, is not even permissible; i.e. the assumption of a stationary state of the economy. His fundamental thesis is that when the money rate of interest coincides with the natural rate (i.e. that rate which exactly balances the demand for loan capital and the supply of savings) then money bears a completely neutral relationship to the price of goods, and tends neither to raise nor to lower it.”

        On this last point, I suppose, Hayek may have misunderstood Wicksell. But it’s clear that Hayek is bringing up what he believes is Wicksell’s position-that is, the very position Leijonhufvud has attributed to Hayek!-to explicitly reject it.

    • mckinneyrd says :

      You’re right. Both Mises and Hayek noticed that prices didn’t rise in the 1920s before the Great D. Mises wrote that the only mistake worse than ignoring the quantity theory was to take it too literally. Both understood that prices might not rise if productivity reduced prices and masked the effects of money increases.

  3. mckinneyrd says :

    He needs to read Machlup’s “Stock Market Credit and Capital Formation.” Machlup responds to the popular nonsense in the 1930s that banking could be made “water tight,” which in today’s techno speak is “macro-prudential regulation.” We have continued to make the same mistakes for the past century because no one wants to learn real economics.

    Glass-Steagal would have had no impact on the financial crisis because it did not cover investment banks and that’s where the crisis began. Gorton has the best account of it.

    There is no need to revise the ABCT. As I show on my blog in the post “Car sale are bad news,” at, it always included housing and other consumer durables in the theory as part of capital goods.

    • Julien Noizet says :

      I don’t think it’s a question of ‘fundamentally revising’ the ABCT. But it nonetheless deserves to be complemented, or ‘updated’, to take into account the evolution of the banking system structure over the past century.
      I think Austrians shouldn’t continously rely on 100-year old theories, which would apply in a freer market, but are now to general to really attract the interest of the rest of academia. It doesn’t mean they are wrong. They are right. But not specific enough, and hence a struggle to answer the immediate questions of the wider public.

      • mckinneyrd says :

        Well both Hayek and Mises understood they were doing pure theory and expected later generations to fill in the blanks and apply the theory to their situations. Hayek often suggested what future research should be. Whereas statistics had little application in pure theory, both insisted that statistics are vital to application. I think that later generations have failed to a large extent. Mises and Hayek became more focused on political economy in their last decades and it seems that most Austrian economists I know are stuck there as well. We desperately need some Austrians who are interested in applying the theories to the modern world. I don’t have a PhD, but I’m trying to apply the ABCT to investing. I hear you saying that you would like to see more work done on modern banking and finance. I think the guys at the BIS and Guillermo Calvo at Columbia are doing some of that, but they don’t self-identify as Austrian. I think the guys at the BIS have done more in applying the Austrian insights to finance than any Austrians I know. Frank Shostak and Mark Skousen also do work on investing. I have often wondered why the self-identified Austrian economists aren’t interested in the real world.

        Hayek mentioned whole life insurance as a form of fractional banking that increases the money supply. Today I think mutual funds that allow writing checks do the same, as well as investment banks that do repos and MBS. When Hayek and Mises have written about banks, we should see them as symbols of all the many;ways that fractional banking can take place.

      • Julien Noizet says :

        I agree, but, as you said, most current Austrian economists are more worried about repeating what Mises or Hayek or even Rothbard have said than coming up with something new. As a result, it feels a little bit like Austrian econ is stagnating. The free bankers are among the only ones to actively come up with new theoretical frameworks (combining ABCT with paleo-monetarist disequilibrium theory in the last 30 years for instance).
        I’m ready to write a couple of papers, but I need more free time…

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