Getting Sober on Wicksell’s Wine Lake – The Financial Instability Hypothesis and the Pool of Funding

A very simple proposition.

The financial instability hypothesis as set out by Minsky and elaborated by Kindelberger, Keen and others is by far the best economic framework to explain business cycles, and especially the major instabilities that come about in ‘balance sheet recessions’ (Koo) and debt deflationary spirals (Fisher/Hoyt).

However the hypothesis is purely monetary.  It depends on Ponzi investors speculating on assets beyond their fundamental value.

This is unsatisfactory as it leaves unexplained the ‘fundamental value’ of goods and assets, and so is a partial rather than a general theory and so not yet up to the wholesale replacement of lame-stream DGSE/NK models.

Let us focus on one moment a potential ‘tipping point’ at the top of the business cycle.

Consider one flawed theory of what causes that tipping, very wrong but in a very interesting way.

That being the ‘subsistence fund/pool of funding’ explanation deriving from classical economics (the Wages Fund) and developed by Bohm-Bawerk, Wicksell and Strigl.  This became one strand in Austrian business cycle theory but by the late 30s had become completely taken over by the even more flawed monetary Austrian explanation whereby central banks create the business cycle.

The funding concept can be very simply explained by the example of a hurricane destroying all fixed assets in ‘Crusoe town’.  To simplify assume no fixed capital.  Then if it took one year to rebuild everything the real ‘cost’ of rebuilding would be the sum of consumption goods needed to provide for the workforce over one year.

The Austrian/Swedish approach went further, consider a choice of techniques of different ’roundaboutness’ that choice is determined by the comparison of the cost of the subsistence fund against the discounted present value of the final output.  In this one good no fixed capital world a more roundabout technique will only ever be chosen unless it is more productive.

Its most sophisticated elaboration was in Wicksell’s celebrated ‘Wine Model’ where there is a single good, wine, used to sustain workers.  In this model Wicksell managed to retain the key elements of Bohm-Bawerk’s capital theory – a subsistence fund and productivity of roundabout methods, even with compounding interest.  However it omitted savings, once that, fixed capital or a capitalist share is introduced the value of the wine depends on the interest rate.  Like Sraffa’s system it cannot be closed without a exogenous interest rate. However subsequent authors (Sandelin) have closed the system by adding a savings function.  In this system the rate of saving, the rate of interest, the economic rate of depreciation and the length of production period are determined simultaneously, however at any one instant in time the pool of funding is fixed and hence causal.  A savings function also enables the introduction of fixed capital by means by the reduction to dated land and labor technique with depreciation (ref Wicksell’s assessment of Ackermans model, and Sraffas correct model of depreciation).  The one thing that cannot survive is a ‘marginal productivity of capital’ as in such a model price and real Wicksell effects are very clear.

The Austrian approach explains the tipping point of business cycles because of a ‘drain’ in the subsistence fund reducing real wealth and consumption.  From the Mises Institute.

When money is created out of “thin air” it leads to a weakening of the pool of funding. What is the reason for this? The newly created money doesn’t have any back-up behind it as far as the production of goods is concerned—it sprang into existence out of “thin air” so to speak. The holder of the newly created money can use it to withdraw final consumer goods from the pool of funding with no prior contribution to the pool. Hence this act of consumption, or nonproductive consumption, puts pressure on the pool of funding. (The consumption is nonproductive because the individual consumes goods without making any contribution to the pool of funding)….

when money is created out of “thin air” it diverts funding away from wealth producers who have contributed to the pool of funding toward the holders of the newly created money. For a previously given pool of funding this will imply that wealth producers will discover that the purchasing power of their money has fallen since there are now less goods left in the pool—they cannot fully exercise their claim over final goods since these goods are not there.

As the pace of money creation out of “thin air” intensifies it puts greater pressure on the pool of funding. This in turn makes it much harder to implement various projects as far as the maintenance and the improvement of the infrastructure is concerned. Consequently the flow of production of various final consumer goods weakens, which in turn makes it much harder to make provisions for savings. All this in turn further weakens the infrastructure and so undermines the flow of production of final consumer goods.

This exposes the deep misunderstanding of bank created money in Austrian economics.  Credit is backed, banks can create ‘money out of thin air’ only so long as they are backed by prior equity and/or future profits.  As and when productive investments lead to the repayment of loans the money is destroyed.  The pool of funding is not depleted, indeed through productivity improvements and economic growth it is enlarged.

However consider a minskyian ‘Ponzie’ investment.  In such a scenario the money is not destroyed, rather it drains the pool of funding reducing aggregate demand. In the dyspeptic wind model where the more wine you drink the more productive you are the economy hits a sobering reality.  Consumers drink less wine, with demand falling debt repayments become unsustainable and the tipping point of the business cycle is reached.

Hence there is a rather deep connection between the different schools of heterodox economics on this issue and a way back in for capital and value theory in the purely monetary post-Keynesian school.

For the issues regarding land speculation in such model see Gaffney and Cleveland under further reading.

Further Reading 

W.O. Coleman,  WICKSELL AND THE AKERMAN AXE MODEL: A RE-EXAMINATION  Australian Economic Papers December 1983

Knut Wicksell Value Capital and Rent – 1970

Richard Ritter Von Strigl Capital and Production – 1934

Bo Sandelin On Wicksell’s Missing Equation: A Comment History of Political Economy Spring 1980 12(1): 29-40;

Eugen Böhm Ritter von Bawerk  Capital and Interest

Mary M Cleveland George International Journal of Socuial Economics  Wicksell and Gaffney: a three‐factor model of the boom and bust cycle 1990

 Mason Gaffney The Amercian Journal of Sociology and Economics Keeping Land in Capital Theory: Ricardo, Faustmann, Wicksell, and George 2008

 

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4 thoughts on “Getting Sober on Wicksell’s Wine Lake – The Financial Instability Hypothesis and the Pool of Funding

  1. “Then if it took one year to rebuild everything the real ‘cost’ of rebuilding would be the sum of consumption goods needed to provide for the workforce over one year.” Is it not the labour commanded (paid labour in terms of KM) concept, of A. Smith, provided that the wage for Smith was equivalent to the subsistance basket .

  2. “Like Sraffa’s system it cannot be closed without a exogenous interest rate. ” I am not sure the phrase reflects Sraffa’s position. He refers to “r” (and “R”) but not to “i”, as far as I remember,..and “r” is endogenous. There is no credit or new money specified to mobilise produced resources.

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