Are Hayek’s and Minsky’s explanations for economic downturns (Past as Prologue 22-3)
competing or complementary? If they are in some way complementary, does this imply that
Hayek and Minsky agree on how best to prevent or correct recession? Explain.
According to Friedrich Hayek, the explanation for economic downturns is due to the culmination
of the simultaneous and erroneous errors of entrepreneurs in the same direction that lead to
economic losses across the economy. Hayek suggests a plausible reason for these simultaneous
mistakes: excessively low interest rate set by the central bank wrongfully encourage businesses
to overinvest in capital goods. This premature economic “boom” in results in excess productive
capacity, making the economy susceptible to a “bust” when production slows.
According to Hyman Minsky, the explanation for economic downturns is due to financial
instability caused by “speculative bubbles” in business cycle fluctuations. These business cycle
fluctuations are caused by an opposing mix of borrowers. During prosperous times, capitalist
economies shift from a predominantly hedge financed economy to one in which there is a greater
population of speculative and Ponzi borrowers. This excess of speculative and Ponzi borrowers
results in an economy characterized by investors that are overburdened by debt and forced to sell
assets to repay loans, causing a drop in asset prices. This swift decline in asset price force more
Ponzi borrowers to withdraw their investments, generating a financial system lacking liquidity.
Thus, it can be stated that these explanations for economic downturn are not entirely competing,
but rather complementary. Both Hayek and Minsky proposed that the failure of firms and other
price setters to coordinate was one of the primary reasons for business cycle crises. There is a
mismatch between those investors that plan to sell future output for enough revenue to repay the
debts incurred during financial projects and consumers that plan to buy future output at such
prices. Both also suggest that the commercial/private banking system, independent of the central
banking system, can play a major role in amplifying economic instability. However, for Hayek,
there is a larger emphasis on the role played by the central bank and the role that it plays in
exogenous money injections into the economy. For Minsky, the commercial bank plays a larger
role. Additionally, the two economists do not agree on the best ways to prevent and correct
recessions. According to Hayek, the best way to prevent an economic recession is through
neutral monetary growth in which the money supply changes to facilitate trade but this not result
in a change in price and the best way to correct a recession would be to avoid expansionary
money and fiscal policies that promote the misallocation of money during times of economic
boom (like the easy money policy and credit expansion). In contrast, Minsky would proposed to
prevent an economic recession, during times of economic prosperity, commercial bank lenders
should substantially limit the amount of loans given to those individuals that have the financial
means of covering the principle and interest payments (to avoid loan defaults). The best way to
remedy said recession would be to remove those speculator and Ponzi investors so that the hedge
borrowers would be able to stabilize levels of consumption and investment.
