Credit and leverage are at the heart of Friedrich Hayek’s conception of the boom and bust cycle. In the current crisis leverage and credit are receiving a good bit of attention — and even a few economists are beginning to take notice of their significance. But in Hayek’s work, leverage and credit have always been the very heart of the story. This is particularly clear in Hayek’s foundational work on macroeconomics, Monetary Theory and the Trade Cycle, most particularly in Part IV of that book. Far to few are familiar with Hayek’s central work on credit, leverage, and the trade cycle. Let’s make a step toward correcting that here. We’ll begin by cutting directly to Hayek’s explication of a cascading “virtuous” circle of leverage in the financial sector, creating a bandwagon bubble of expanding credit and good times:
.. once one bank or group of banks has started the expansion, then all the other banks receive, as already described, a flow of cash that at first enables them to expand credit on their own account without impairing their liquidity. They make use of this possibility the more readily since they, in turn, soon feel the increased demand for credit. Once the process of expansion has become general, however, the banks soon realize that, for the moment at any rate, they can safely modify their ideas of liquidity. While expansion by a single bank will soon confront it with a clearinghouse deficit of practically the same magnitude as the original new credit, a general expansion carried on at about the same rate by all banks will give rise to clearing-house claims which, although larger, mainly compensate one another and so induce only a relatively unimportant cash drain. If a bank does not at first keep pace with the expansion it will, sooner or later, be induced to do so, since it will continue to receive cash at the clearing house as long as it does not adjust itself to the new standard of liquidity.
So long as this process goes on, it is practically impossible for any single bank, acting alone, to apply the only control by which the demand for credit can, in the long run, be successfully kept within bounds; that is, an increase in its interest charges. Concerted action in this direction, which for competitive reasons is the only action possible, will ensue only when the increased cash requirements of business compel the banks to protect their cash balances by checking further credit expansion, or when the central bank has preceded them by raising its discount rate. This, again, will only happen, as a rule, when the banks have been induced by the growing drain on their cash to increase their rediscount. Experience shows, moreover, that the relation between check payments and cash payments alters in favor of the latter as the boom proceeds, so that an increased proportion of the cash is finally withdrawn from the banks
We’ll get back to how this gets started and where it takes us in a moment. But I’d like to turn all the pages and lay out the bottom line of Hayek’s conclusion regardiong the relation of leverage / credit to the trade cycle and the classic macroeconomic question of whether a stable price level assures us of a stable macro-economy. Hayek’s conclusion? The expansionary bubble of the leverage / credit cascade assures us that a stable price level can not guarantee us a stable macro-economy:
The fact, simple and indisputable as it is, that the “elasticity” of the supply of currency media, resulting from the existing monetary organization, offers a sufficient reason for the genesis and recurrence of fluctuations in the whole economy is of the utmost importance — for it implies that no measure that can be conceived in practice would be able entirely to suppress these fluctuations.
It follows particularly from the point of view of the monetary theory of the trade cycle that it is by no means justifiable to expect the total disappearance of cyclical fluctuations to accompany a stable price level — a belief Professor Lowe seems to regard as the necessary consequence of the monetary theory of the trade cycle. Professor Röpke is undoubtedly right when he emphasizes the fact that “even if a stable price level could be successfully imposed on the capitalist economy the causes making for cyclical fluctuations would not be removed.” …
Once this is realized, we can also see how nonsensical it is to formulate the question of the causation of cyclical fluctuations in terms of “guilt,” and to single out, e.g., the banks as those “guilty” of causing fluctuations in economic development. Nobody has ever asked them to pursue a policy other than that which, as we have seen, gives rise to cyclical fluctuations; and it is not within their power to do away with such fluctuations, seeing that the latter originate not from their policy but from the very nature of the modern organization of credit. So long as we make use of bank credit as a means of furthering economic development we shall have to put up with the resulting trade cycles ..
In other words, the existence of a system allowing for leverage and credit guarantees the existence of a “loose joint” in the market economy — a “loose joint” that guarantees an unavoidable cycling of boom and bust :
Elasticity in the credit supply of an economic system, is not only universally demanded but also — as the result of an organization of the credit system which has adapted itself to this requirement — an undeniable fact .. But we must be quite clear on one point. An economic system with an elastic currency must, in many instances, react to external influences quite differently from an economy in which economic forces impinge on goods in their full force — without any intermediary; and we must, a priori, expect any process started by an outside impulse to run an entirely different course in such an economy from that described by a theory that only takes into account changes originating on the side of goods. Once, owing to the disturbing influence of money, even a single price has been fixed at a different level from that which it would have formed in a barter economy, a shift in the whole structure of production is inevitable; and this shift, so long as we make use of static theory and the methods proper to it, can only be explained as an exclusive consequence of the peculiar influence of money. The immediate consequence of an adjustment of the volume of money to the “requirements” of industry is the failure of the “interest brake” to operate as promptly as it would in an economy operating without credit. This means, however, that new adjustments are undertaken on a larger scale than can be completed; a boom is thus made possible, with the inevitably recurring “crisis.” The determining cause of the cyclical fluctuation is, therefore, the fact that on account of the elasticity of the volume of currency media the rate of interest demanded by the banks is not necessarily always equal to the equilibrium rate, but is, in the short run, determined by considerations of banking liquidity.
Next lets look at what might set a credit / leverage cascade in motion — the causes certainly don’t have to be internal to the financial system itself. It could be a regulator change (the CRA), it could be a real shock (a new technology), etc. No matter, each of these will set in motion cyclical changes in credit and leverage — changes that will be expressed in differentially significant ways through the different sectors of the economy:
It must be emphasized first and foremost that there is no nece ssary reason why the initiating change, the original disturbance eliciting a cyclical fluctuation in a stationary economy, should be of monetary origin. Nor, in practice, is this even generally the case. The initial change need have no specific character at all; it may be any one among a thousand different factors that may at any time increase the profitability of any group of enterprises. For it is not the occurrence of a “change of data” that is significant, but the fact that the economic system, instead of reacting to this change with an immediate “adjustment” (Schumpeter) — i.e., the formation of a new equilibrium — begins a particular movement of “boom” that contains within itself the seeds of an inevitable reaction. This phenomenon, as we have seen, should undoubtedly be ascribed to monetary factors, and in particular to “additional credit” that also necessarily determine the extent and duration of the cyclical fluctuation. Once this point is agreed upon, it naturally becomes quite irrelevant whether we label this explanation of the trade cycle as a monetary theory or not. What is important is to recognize that it is to monetary causes that we must ascribe the divergences of the pricing process, during the trade cycle, from the course deduced in static theory.
From the particular point of view from which we started, our theory must be regarded most decisively as a monetary one. As to the incorporation of trade cycle theory into the general framework of static equilibrium theory (for the clear formulation of which we are indebted to Professor A. Lowe, one of the strongest opponents of monetary trade cycle theory), we must maintain, in opposition to his view, not only that our own theory is undoubtedly a monetary one but that a theory other than monetary is hardly conceivable. It must be conceded that the monetary theory as we have presented it — whether one prefers to call it a monetary theory or not, and whether or not one finds it a sufficient explanation of the empirically determined fluctuations — has this definite advantage: it deals with problems that must, in any case, be dealt with for they are necessarily given when the central apparatus of economic analysis is applied to the explanation of the existing organization of exchange. Even if we had never noticed cyclical fluctuations, even if all the actual fluctuations of history were accepted as the consequences of natural events, a consequential analysis of the effects that follow from the peculiar workings of our existing credit organization would be bound to demonstrate that fluctuations caused by monetary factors are unavoidable.
It is, of course, an entirely different question whether these monetary fluctuations would, if not reinforced by other factors, attain the extent and duration we observe in the historical cycles, or whether in the absence of these supplementary factors they would not be much weaker and less acute than they actually are. Perhaps the empirically observed strength of the cyclical fluctuations is really only due to periodic changes in external circumstances, such as short-period variations of climate, or changes in subjective data (as, e.g., the sudden appearance of entrepreneurs of genius) or perhaps the interval between individual cyclical waves may be due to some natural law. Whatever further hypothetical causes are adduced to explain the empirically observed course of the fluctuations, there can be no doubt (and this is the important and indispensable contribution of monetary trade cycle theory) that the modern economic system cannot be conceived without fluctuations ascribable to monetary influences; and therefore any other factors that may be found necessary to explain the empirically observed phenomena will have to be regarded as causes additional to the monetary cause. In other words, any non-monetary trade cycle theory must superimpose its system of explanation on that of the monetarily determined fluctuations; it cannot start simply from the static system as presented by pure equilibrium theory. Once this is admitted, however, the question of whether the monetary theory of the trade cycle is correct or not must, at any rate, be presented in a different form. For if the correctness of the interconnections described by monetary theory is unquestioned, there still remains the problem of whether it is also sufficient to explain all those phenomena that are observed empirically in the course of the trade cycle; it may perhaps need supplementing in order to make it an instrument suitable to explain the working of the modern economic system. It seems to me, however, that before we can successfully tackle this problem we ought to know exactly how much of the empirically observed fluctuations are due to the monetary factor, which is actually always at work; and therefore we shall have to work out in the fullest detail the theory of monetary fluctuations. It is hardly permissible, methodologically speaking, to go in search of other causes whose existence we may conjecture, before ascertaining exactly how far and to what extent the monetary factors are operative. It is our duty to work out in detail the necessary consequences of those causes of disturbance that we know, and to make this train of thought a definite part our logical system, before attempting to incorporate any other factors that may come into play.
Finally, let’s take a closer look at one of Hayek’s more detailed accounts of the leverage / credit cascade:
We must attempt to understand fully the causes and nature of this credit expansion and in particular its limits.The key to this problem can only be found in the fact that the ratio of reserves to deposits does not represent a constant magnitude, but, as experience shows, is itself variable. But we shall achieve a satisfactory solution only by showing that the reason for this variability in the reserve is not based on the arbitrary decisions of the bankers, but is itself conditioned by the general economic situation. Such an examination of the causes determining the size of the reserve ratio desired by the banks is all the more important since we had no theoretical warrant for our previous assumption that it always tends to be constant.
It is best to begin our investigation by considering once again the situation of a single bank, and asking how the manager will react when the credit requirements of the customers increase in consequence of an all-around improvement in the business situation. For reasons that will shortly become clear, we must assume that the bank under consideration is the first to feel the new credit requirements of industry, because, let us say, its customers are drawn from just those industries that first feel the effects of the new recovery. Among the factors that determine the volume of loans granted by the bank, only one has changed; whereas previously, at the same rate of interest and with the same security, no new borrowers came forward, now, under the same conditions of borrowing, more loans can be placed. On the other hand, the cash holdings of the bank remain unchanged. This does not mean, however, that the considerations of liquidity that dictate the amount of loans to be granted will lead to the same result now as when fresh loans could only have been placed at a lower rate of interest or with inferior security than was the case with loans already granted. In this connection, finally, we must mention that the sums we have, for simplicity’s sake, hitherto called cash balances, which form the bank’s liquid reserve, are by no means exclusively composed of cash — and are not even of a constant magnitude, unrelated to the size of the profits they make possible. The danger that, in case of need, the reserves may have to be replenished by rediscounting bills through the central bank, or that, in order to correct an unfavorable clearing-house balance, day-money may have to be borrowed at a given rate of interest, is far less abhorrent when it is possible to extend credit at an undiminished rate of interest than when such an extension would involve a lowering of that rate. But even disregarding this possibility and assuming that the bank recognizes that it can satisfy its eventual need for cash only at correspondingly higher rates, we can see that the greater loss of profit entailed by keeping the cash reserve intact will, as a rule, lead the bank to a policy that involves diminishing the size of this non-earning asset. Besides this, we have the consideration that, in the upward phase of the cycle, the risks of borrowing are less; and therefore a smaller cash reserve may suffice to provide the same degree of security. But it is above all for reasons of competition that the bank that first feels the effect of an increased demand for credit cannot afford to reply by putting up its interest charges; for it would risk losing its best customers to other banks that had not yet experienced a similarly increased demand for credit. There can be little doubt, therefore, that the bank or banks that are the first to feel the effects of new credit requirements will be forced to satisfy these even at the cost of reducing their liquidity.