Boom, Bust, and Bubbles
Money & Macro3

Boom, Bust, and Bubbles

A Mengerian Account

This paper is also available on SSRN as a PDF.

The literature on business cycles is characterized by a number of broad approaches, each of which emphasizes its own set of stylized facts to explain. Two approaches in particular have introduced themselves as “monetary” theories in the sense of explaining economic fluctuations with a monetary shock: the older is now more commonly referred to as capital-theoretic (e.g. Hayek 1933; Garrison 2001), after its transmission mechanism, and the newer is associated with the Monetarist counterrevolution of the 1960s (e.g. Friedman 1993; Yeager 1956).

The two are not obviously compatible. Capital-theoretic approaches tend to see recessions as following on the heels of a boom caused by a positive monetary shock, whereas monetarist approaches see recessions as caused by an exogenous negative monetary shock. Reconciliations have been offered (e.g. in Horwitz 2000), mainly from the capital-theoretic side. Nevertheless, the approaches are sufficiently divergent, both in their methodologies and in the stylized facts they answer, that the points of contact in any reconciliation end up being rather few. The capital-theoretic approach is rich, microfounded, and process theoretic, but relies heavily on non-operational or unobservable concepts like roundaboutness (Samuelson 1966; Lewin & Cachanosky 2014; Harwick 2016b) or the natural rate of interest, and has therefore – at least in its canonical form – had limited empirical success (Lester & Wolff 2013; Luther & Cohen 2014). The monetarist approach, by contrast, is fully operational and enjoys some empirical success so far as it goes, but fails to address the stylized facts that cry out for a capital-theoretic explanation. In particular, systematic capital misallocation is a salient yet neglected feature of business cycles, even if that misallocation 1) does not proceed along the lines indicated in the canonical capital-theoretic accounts, and 2) is not sufficient to explain other salient features of business cycles.

Rather than reconciling the canonical accounts of the two approaches, this paper draws on themes from both, as well as from newer theoretical developments, to offer a sketch of an alternative account centering in the dynamics of asset bubbles. In doing so, it retains the microeconomic richness and process orientation of a capital-theoretic approach without sacrificing the operationalization and falsifiability of a monetarist approach, and subsumes the stylized facts of both.

It will be necessary to cover some well-worn ground in order to get to this destination. The following section is therefore primarily expositional; the core argument follows in the third and subsequent sections.

As I have argued of the other approaches, this approach too starts from a series of stylized facts about business cycles. These are:1

  1. Cyclical fluctuations are not confined to a single firm or industry. Rather, the whole economy moves together in periods of “good times” (boom) or “bad times” (bust).
  2. The boom is characterized by inflation. It is generally brought to a halt by a crash or crisis, followed by a period of recession, which is characterized by deflation in spite of central banks’ scrupulousness in avoiding monetary contraction.
  3. The crisis often (though not always) centers in credit markets, specifically in one asset or industry which we may call the “bubble”, and spreads out from there. The bubble’s industry, once the bubble “pops”, remains in recession longer than the economy as a whole.

All three facts are brought together in an account I call “Mengerian” after Carl Menger’s (1892) account of the emergence of a commonly accepted medium of exchange as the self-reinforcing increase of a particular commodity’s “moneyness”, or (in the context of financial markets) liquidity. A similar process can explain the emergence of asset bubbles, a process of which the monetary and capital approaches to the business cycle are but two aspects.


Theoretical Background

Menger’s Account of the Emergence of Money

Like the more familiar account of institutional change in Demsetz (1967), Menger’s account of the emergence of money begins by enumerating the inconveniences of an initial situation (barter exchange), explains how an institutional shift (the introduction of a medium of indirect exchange) would mitigate those costs, and concludes by demonstrating the actual predominance of this institution in our present world. Unlike Demsetz’ account, however, Menger’s does not take for granted the process by which social institutions converge to least-cost practices. Instead, his account proceeds from what we might anachronistically call micro-foundations to demonstrate explicitly that small-scale self-interested action can snowball into a macro-phenomenon.

The primary inconvenience of barter exchange is the necessity of a “double coincidence of wants” – that is, in order to purchase something from my neighbor, I must have something he wants as well. If I want to purchase cabbage from him, and he is in need of a goat, but I raise cows, then we must find another party to the exchange who is willing to exchange cows or cabbage for goats. Needless to say, finding such a willing party for every transaction quickly becomes very inconvenient.2

In order to mitigate these costs, agents in the economy can keep track themselves of the saleability of various goods. By holding an inventory of some relatively more saleable good, even if I have no use for it myself, I increase my chance of being able to overcome the double coincidence of wants and to acquire goods I do have a use for. The key to the story is that my holding such an inventory constitutes a demand for that good, which further increases its saleability. Because the desire of each individual to most effectively satisfy his own wants on the market leads him to hold an inventory of the most saleable good, one good will eventually be converged upon with universal saleability – i.e. money.

The account of bubbles that follows I call Mengerian not only because it explains a macro-phenomenon with reference to self-interested micro behavior, but more importantly, because the key process is the increase of some asset’s saleability, or liquidity. Two important differences must also be noted, however. First, Menger’s account is one of the emergence of social harmony, whereas the following account is one of the emergence of social disarray. And second, though a self-reinforcing quality is common to both stories, a bubble cannot – by definition – persist forever. It is not a network good in the same sense as a basic medium of exchange. Thus, our story involves the further emergence of countervailing forces which must bring an eventual and abrupt end to the phenomenon at hand.

The Monetarist Account of Boom and Bust

A money economy, though vastly increasing the ease with which people can satisfy their wants on the market, introduces its own unique problems, which can be seen best in the light of Walras’ Law. Walras’ Law states that the excess demand for all goods in an economy must sum to zero – that is, unsold inventories of some good implies unsatisfied demand for another. It is related to Say’s Law, which has often been taken to deny the possibility of a general glut or recession. But, as Yeager (1956) notes, “while an excess supply of some things does necessarily mean an excess demand for others, those things may, unhappily, be money.” Because money constitutes one side of nearly every exchange in a modern economy, “an economywide excess demand for money shows up not as specific frustration in buying money, but as dispersed, generalized frustration in selling things and earning incomes” (Yeager 1968). By the same token, an excess supply of money does not show up as a specific frustration in selling money, for it would cease to be money if one could be frustrated in selling it. Rather, it shows up as a general increase in spending – a “euphoria”, or boom. This is simply our first stylized fact: that booms and recessions are economywide phenomena.

Such deviations can result in resource misallocation. To the extent that prices are sticky or rigid, whatever the reason,3 monetary pressure on the price level disarranges relative prices and thus impairs economic efficiency, in addition to temporary deviations from trend output. Nevertheless, the monetarist account recognizes only idiosyncratic resource misallocation, the result of random noise in the structure of relative prices. In contrast, the traditional capital-theoretic account is one of systematic capital malinvestment. This is why Monetarists and New Keynesians regard the allocative aspect of business cycles as of at best second-order importance for the business cycle, whereas capital theorists regard it as primary.

This story will form the basis of our account of the symptoms of business cycles. A general recession and a general boom must be referred to an excess demand for or supply of money, respectively. But the monetarist account leaves several important questions unanswered. In particular, the comparative statics mode of analysis means that the initial monetary disequilibrium must be regarded as an exogenous shock. This is, no doubt, often the case, as Friedman and Schwartz (1963) demonstrated of the Great Depression. Decisions of the central bank are sensibly treated as exogenous to most economic processes (Koppl 2002, p. 123ff), especially where it has large discretionary latitude. But a central puzzle remains: why do we still experience recessions, even now that central banks so scrupulously avoid falls in monetary aggregates? In the absence of a fall in the money stock, an excess demand for money indicates a negative velocity shock – a phenomenon which, though generally treated as exogenous, cries out for further explanation.

The Pyramid of Credit

The third stylized fact brings us into credit markets. The Mengerian twist to the Monetarist story is to take credit markets as a blurring of the line between money and non-money. The usual emphasis in Menger’s story is on the snowball effect by which one good becomes far-and-away more liquid than all other goods. But, Anderson (1917) notes,

the development of money, while it adds to the saleability of the money-commodity, also adds to the saleability of other goods. . . . The fact that goods have money-prices, which can be compared with one another quite easily, in objective terms, makes barter, and barter equivalents, a highly convenient and very important feature of the most developed commercial system. [emphasis in original]

Kroszner (1990) sees this as a continuation of the process Menger described:

The process whereby money’s saleability brings about the increased marketability of other goods may be able to bring about the end of money itself as the medium of exchange. . . . Financial instruments besides money are accepted as the final means of payment, and a growing range of transactions take place without money. . . . More and more acceptable substitutes arise, and an ever growing number of transactions in the economy occur without money as we know it. Various assets – perhaps interest-paying bearer bonds and equity instruments – are used to settle accounts.

More precisely, these various assets are employed to satisfy the demand for the various services of money – as a medium of exchange, and a store of value. The liquidity of an asset, therefore, we will define as its saleability in the Mengerian sense.4 Specifically, liquidity is the ease with which one can sell an asset at its appraised market value, a joint function of its suitability as a medium of exchange and as a store of value.5

Mehrling (2012) arranges these assets into an asset-liability structure, with the most liquid money on the bottom (“base money”), deposits redeemable in base money placed atop it, other assets redeemable in bank money placed atop that, and so on. The quantity of each in terms of the unit of account is indicated by the width at that level, giving the figure the shape of an inverted pyramid. Much monetary economics takes account of only two levels of the pyramid, namely, base money and deposit balances, the ratio between which being called (misleadingly) the “money multiplier”.

The hierarchical character of the pyramid of credit is the rationale behind keeping track of multiple monetary aggregates M0, M1, and M2. However, there are two problems with using these aggregates: 1) With the exception of M0, these aggregates add together the value of imperfect substitutes. The significance for economic theory of this sum is therefore unclear. In addition, 2) given the central role of liquidity in our story, it will be more useful to imagine the pyramid extending much further up through a larger array of assets, including those not typically thought of as monies, such as bonds, equities, and the securities pyramided atop them. Though the most liquid do (as Kroszner argues) sometimes have a somewhat limited circulation as media of exchange within financial markets,6 they substitute for (and have an advantage over, insofar as they bear interest) proper monies primarily in their capacity as stores of value.

The quantity of money relevant for our purposes, therefore, is not merely the sum of a number of asset classes that constitutes quantity of money. The effect on the volume of spending of a bond issue, for example, is less than that of the issue of an equivalent value of banknotes due to the greater liquidity of the latter. Accordingly, the logic of the pyramid suggests the use of something like the Divisia aggregates, which weight various asset classes by liquidity (Barnett 1980). Indeed, Serletis & Chwee (1997) and Barnett (2013) have found that movements in Divisia aggregates predict changes in output and interest rates according to the monetarist story better than simple sum aggregates like M1 or M2. This should not be surprising if the analytical core of this paper is correct: it is not the dollar value of some monolithic “quantity of money” which matters for the monetarist story, but the total volume of spending, which is determined by the supply of and demand for a large variety of imperfectly substituting assets.

In order to see the significance of interest-bearing assets for monetary theory, suppose a fall in interest rates renders bank deposits a closer substitute for treasury bonds as a store of value. On the margin investors shift into deposits, and vice versa for a rise in interest rates – hence the usual negative relationship between interest rates and the demand for money. But, as Barnett (1980) argues,

the value of an economic aggregate (by its definition) cannot change as a result of internal substitution effects. Hence the money market substitution effects destabilizing velocity should be completely internalized by proper aggregation over the money market.

Changes in the composition of the demand for money, even if the total demand for the services of money is unchanged, will appear as spurious changes in the demand for money (and a spurious interest-elasticity) if we use an inapt definition of the money stock. That the Divisia aggregates signify something close to what we have in mind by a broad money stock is indicated by the fact that “the velocity of money is increasingly stabilized as the level of aggregation is increased”. In other words, by including less liquid monies than are usually accounted for in monetary aggregates, we have a quantity with a direct causal impact on the volume of spending, without registering internal shifts in demand spuriously as velocity shocks.


Liquidity and the Bubble

Both within and outside of financial markets, risk impinges negatively upon liquidity. And because each issuer is another point of potential failure, risk increases with each level on the pyramid. A security, for example, will become worthless if any of the following happen: 1) a sufficient portion of the underlying assets fails to be repaid, 2) an institution holding a sufficient portion of the issuer’s deposits fails, or 3) the currency in which the security is denominated collapses. Each of these conditions corresponds to a level of the pyramid below the security. A bond, on the other hand, has fewer points of failure, and a bank deposit fewer still.

For those assets near the bottom of the pyramid whose liquidity is based in their usefulness as media of exchange, convenience will be an essential determinant of liquidity. This includes the traditional physical qualities of good media of exchange – divisibility, durability, etc. – but also, importantly, the time path of the asset’s purchasing power so that prices across time are reasonably comparable. Traditionally this is thought to demand a stable value, and is especially important for that asset in terms of which the unit of account is defined. Per Anderson’s argument above, financial markets could hardly exist at all unless denominated in a stable unit of account, hence their observed withering or crowding out in economies undergoing hyperinflation.

But at higher levels, trading is specialized and occurs on a sufficiently large scale that aspects of an asset’s usefulness as a store of value become more important determinants of liquidity. Fixity of value is an important quality for a medium of exchange, but not for a store of value which has the potential to earn interest.

This difference cuts loose the asset’s nominal anchor, so to speak, and opens the door for speculative shifts in valuation separate from shifts in the value of the currency as a whole. Frankel and Rose (1995) explain the basic mechanism:

Expectations can be described as stabilizing when the effect of an appreciation today – relative to some long-run path or mean – is to induce market participants to forecast depreciation in the future. . . . Expectations can be described as destabilizing, on the other hand, when the effect of an appreciation is to induce market participants to forecast more appreciation in the future.

More aptly, we should call speculation stabilizing or destabilizing, with expectations determining which prevails for a certain asset. To speak of an asset’s “fundamentals”, for example, is to express nothing more than an expectation that the asset’s price will eventually revert to some mean.

Because a unit of account requires a certain stability of value over time, the asset in terms of which it is defined must be subject to stabilizing speculation, at least vis-a-vis the assets against which it is being used as a medium of exchange (Burns & Harwick 2015). Where this is not the case – for example in hyperinflations – the currency quickly loses its usefulness as a medium of exchange, and thus also as a unit of account, even if legal restrictions prevent any other media from being used. For such monies, the switch from stabilizing to destabilizing speculation, for example a bank run or a convertibility crisis, is a catastrophic event. But no such requirement binds financial quasi-monies. The switch from stabilizing to destabilizing speculation is not necessarily catastrophic, and may even signal the onset of a financial “euphoria”. In the case of a self-feeding appreciation, this is what we will call a bubble.

Some asset pricing models refer to any deviation from a calculation of fundamentals as a “bubble”. Our own definition will be narrower and closer to common usage: a prolonged instance of upward destabilizing speculation in a particular asset. Precisely what causes expectations to shift from stabilizing to destabilizing is difficult to pin down with much exactness. The “rational bubbles” that occupy the asset pricing literature, for example, where price increases of a sufficient magnitude can “launch” an asset into a self-fulfilling speculative bubble, are not much more enlightening than “animal spirits” or “sunspots” explanations. In both cases we have an external description of a pattern, but no internal insight by which the formation of expectations can be made intelligible at a sufficiently abstract level.

We may satisfy ourselves with a mere description of the pattern, however, for reasons reminiscent of the Lucas Critique: if the particular justification for the expectation were known in advance, or similar to a recent occurrence, recognition of that fact would render the expectation self-limiting. We see, therefore, a variety of justifications for particular bubbles, but each with a strong sense of “it’s different this time”. It is enough to observe that a sufficiently abrupt and unexpected rise in an asset’s price can induce the expectation of further price rise (Krugman 1991; Lachmann 1956, p. 30ff) and launch the asset into a bubble.

Bubbles in particular assets, of course, most often coincide with general booms. This is to be expected: per the above monetarist account of boom and bust, an increase in total spending not only increases real income until prices rise to compensate, but also raises some prices more quickly than others. The most violent price increases we will expect to occur in financial markets, for three reasons:

  1. Modern monetary systems mediate increases in the money supply through financial markets. The signal to adjust prices therefore reaches financial markets first and most strongly.
  2. Financial markets are thick, and assets are heavily traded. Their prices are, for this reason, extremely sensitive to changes in supply or demand – they are the least “sticky”.
  3. Dornbusch and Fischer (1980) show that a flexibly-priced asset among a constellation of sticky prices can result in the former “overshooting” its equilibrium value in response to a general demand shock. Their model refers specifically to flexible exchange rates and sticky goods prices, but the approach is extensible to the behavior of financial assets relating to goods with a long investment duration.7

Stabilizing speculation will take over for many goods at this point. Asset prices increase before goods prices and then fall back somewhat as the new money permeates the wider economy. But – recalling the reasons why it is difficult to be more specific than this – investors often converge on one focal asset with expectations of continuing price increases.

This being the case, an initial exogenous spending shock is sufficient both for the initial launch as well as the continuing rise of the bubble. The foundation of the bubble’s liquidity is its suitability as an investment vehicle. Rising demand propels its price higher, and as a store of value it becomes more saleable precisely because its price is rising, quite unlike monies further down the pyramid, whose liquidity is founded in part in a more or less stable value vis-a-vis other goods. The bubble finds ready acceptance so long as its price continues to rise at a rate sufficient to avoid disappointing its speculative investors.

The usefulness of the pyramid construct at this point is in highlighting the equivalence of a positive velocity shock at one level of the pyramid with a positive supply shock at higher levels of the pyramid. The total value of the supply of financial assets is generally demand-elastic. Where the price is pegged, as on bank deposits and other media of exchange, an increase in demand occasions an increase in quantity, not price. Where the quantity is fixed, as in financial assets further up the pyramid, the price rises with demand. An expansion of the upper layers of the pyramid in response to a general substitution away from money and into quasi-monies, therefore, can be expressed equivalently as a rise in the total money stock, or a fall in the velocity of the narrower money stock. Importantly, both expressions are consistent with the Monetarist account.

A bubble therefore represents a significant expansion of the broad money supply, over and above the initial increase which launched it, reinforcing its own price rise with a further increase in the volume of spending. Mehrling (2012) argues that during the boom, the pyramid widens (more assets exist at each level), and the layers flatten (assets on different levels become closer substitutes). I would suggest a more apt metaphor for the latter phenomenon is not the flattening of the pyramid, but vertical additions. Closer substitutability between two layers of the pyramid reflects the fact that each level has become more liquid. This implies as well the addition of further layers at the top, as assets which were previously relatively illiquid become sufficiently liquid to substitute for proper monies. The bubble is itself one such asset.

Bubble Popping

Burst and Recession

The foundation of the bubble’s liquidity consists in its status as a focal store of value, driven by a rapidly increasing price. This means that, not only must investors eventually be disappointed, but also that the burst must come as a sudden crash. Once the expectations of investors are disappointed, if its rise in price should slow down, the foundation of its liquidity vanishes at once: it loses its status as a focal store of value, and exits the pyramid entirely.

This in itself represents a significant collapse in the effective money stock. In addition, finding their portfolios on the whole suddenly less liquid, investors in the bubble asset scramble to move their asset holdings further down the pyramid. This depresses both the prices and the liquidity of the assets they sell, causing investors in diverse classes of assets to increase their demand for liquidity as well. The shift in demand down the pyramid leads, in addition to the removal of some of the top layers which are no longer sufficiently liquid to circulate as media of exchange, to the narrowing of the entire pyramid. The combined effect is sufficient to send the economy into recession and manifest the symptoms of the Monetarist business cycle.

This is the answer to our original puzzle: an economy can plunge into depression at the burst of a bubble, despite the best expansionary efforts of the central bank, because an immense quantity of money has either been destroyed or lost its moneyness – a shift which, reckoning further down the pyramid in terms of M1 or M2, will look like a severe velocity shock. As Hummel (2011) notes, the equivalence of a fall in velocity with the rise in the money stock also holds in reverse:

a fall in the broader money stock and a fall in the velocity of the monetary base are exactly the same thing . . . Thus, whether we label a particular decline in aggregate demand a monetary shock or a velocity shock can depend on how broadly or narrowly we define the money stock.

This is certainly the case during a scramble for liquidity. To explain a financial panic with a velocity shock, therefore, is to beg the question. A satisfactory explanation of the event must look further up the pyramid for the assets that have lost their moneyness.

The central bank can, in its lender of last resort capacity, prevent institutions with issues further down the pyramid from failing, and therefore prevent an even more severe contraction as all its monies as well as those pyramided on top of them become valueless, as occurred during the Great Depression when a string of bank failures cut the effective U.S. money supply by a third. In other words, it can in principle prevent the narrowing of the pyramid by providing liquidity (whether it can in fact act fast enough to do so is an open question) – but it cannot prevent the exit of the top layers.

The latter failure does not appear in the official monetary aggregates, a fact which has led to a premature rejection of monetary explanations of the business cycle. Taking M0 as the relevant monetary aggregate would lead one to expect heavy inflation since 2008. Taking M2, one gets the impression that nothing at all has been amiss since the turn of the century. It is only when one includes a sufficiently broad array of substitutes for the services of money that the supposed velocity shock of the Great Recession reveals itself as – after all – a shock to the quantity of money.

Fig. 1. The dramatic expansion of base money (left) and the less dramatic expansion of simple sum M2 (right) in the U.S. from 2000 to 2015.
Fig. 2. The Divisia M4 index over the same period shows a decline from 2008-2010 corresponding to the Great Recession. Barnett & Gaekwad-Babulal (2015) derive a similar result for the Eurozone.

A focus on bubbles and broad monetary aggregates can also subsume the capital-theoretic observation of systematic capital misallocation over the course of the business cycle. Industries whose investments are susceptible to bubbles are not necessarily “higher order” – if such a term can even have a meaning in an economy sufficiently advanced in the division of labor – though such industries as are usually considered higher order may have characteristics that make assets based on their investments more susceptible to launch, in particular a more violent price response (contemporaneous or lagged) to shifts in demand. Instead, investment flows into the bubble asset and funds investment in that area. A bubble in stocks funded overinvestment in mechanization during the Roaring 20s. A bubble in dot-com stocks funded overinvestment in internet startups in the late 90s. And most recently, a bubble in mortgage-backed securities funded overinvestment in residential housing during the 2000s.8

If this is the case, then it will be fairly straightforward in principle to separate out the effects of capital misallocation from those of depressed aggregate demand, and thus to delimit the applicability of the monetary and capital explanations. A general recession must be referred to an insufficient effective money stream. Downward pressure on prices originating from an excess demand for the services of money must have the effect of depressing economic activity, and must do so more or less evenly across all industries, with due allowance for correlations of consumption patterns with the distribution of demand for money (Harwick 2016a). The magnitude of misallocation, on the other hand, can be gauged by the eventual crash in the bubble’s price, which reflects the necessary liquidation of unsustainable investment along that line.



While macroeconomics has incorporated much from finance in the last several decades, especially as the relevance of financial markets came to be appreciated more fully, bubbles have been viewed at best as a small aspect of business cycles – as symptomatic, but not central. This account, by contrast, places them at the center of the story, as leading the process of economic fluctuations. The same sort of theory that explains the emergence of a single money can explain as well the emergence of further monies and their dynamics over the course of the business cycle.

This analysis suggests many lines of further research, first of all in economic history, linking the development of liquid financial instruments with the emergence of a business cycle, and identifying the particular shocks that effect the switch in particular bubbles from stabilizing to destabilizing speculation. In addition, the criteria by which misallocation may be distinguished from excess demand for money must be econometrically operationalized in order to determine the relative significance of each, and to what extent they may be correlated. This division, in turn, bears on the risks of reflation. To the extent that an excess demand for money dominates, liquidity expansion will ease the monetary pressure on prices and speed recovery. To the extent that systematic capital misallocation dominates, expansion risks a destabilizing demand shock which may launch another bubble. Some indeed have worried this was the case when the Federal Reserve flooded the market with liquidity following the collapse of the dot-com bubble, only to face the collapse of a far more severe housing bubble less than a decade later. If both factors are significant, the central bank may face a tradeoff between depression and misallocation that can be improved – perhaps only over the course of several business cycles – by a credible commitment to the stability of the currency’s exchange against a well-accepted anchor (cf. Kydland and Prescott 1977).


  1. These stylized facts do not, of course, describe every recession. NBER’s official definition of a recession is negative GDP growth for at least two consecutive quarters, which could in principle be caused by any sort of sufficiently large disaster. Nevertheless, the type of recession described by our more detailed stylized facts is sufficiently common in modern industrial economies as to deserve a general explanation.
  2. On the applicability (or lack thereof) of Menger’s conjectural history to the actual history of exchange, see Harwick (2017).
  3. Quite a few sources of stickiness and rigidity have been adduced over the years: demand signals reach some sellers earlier than others (Mises 1966, p. 412ff); some are more alert than others to the signals (Phelps, et al. 1970); some interpret the signals as temporary and try to wait it out (Lucas 1972); there are “menu” costs of adjusting prices (Mankiw 1985); firms are locked into long-term contracts and simply cannot adjust (Calvo 1983); etc.
  4. Liquidity as a property of assets is distinct from the popular usage of the term as a property of organizations – e.g. how liquid is such and such bank? Liquidity in this sense is better put as “the value of the bank’s liquid assets” than “the bank’s liquidity”. The bank itself will be highly illiquid regardless of the value of its liquid assets, as mergers and acquisitions are typically difficult and time-consuming to negotiate.
  5. Conversely – and more operationally – illiquidity can be defined as the discount one has to accept on an asset’s appraised value if one needs to sell it in a given amount of time, or the time necessary to sell it at a given price.
  6. Krueger (2012) distinguishes “financial barter (many units of account, many media of exchange)” from “monetary separation (one unit of account, many media of exchange flexibly priced in the unit of account)”. The latter is what he argues prevails in financial markets.
  7. A long investment duration (see Lewin and Cachanosky 2014) is characteristic of, but not sufficient to constitute, heavy industry. Housing, for example, is not a “higher-order good”, but exhibits the same demand response as other “heavy” industries. This characteristic may explain capital theories’ traditional focus on higher-order industries as the primary beneficiary of credit expansion.
  8. I do not mean to take a side in the long-standing “malinvestment” versus “overinvestment” debate among capital theorists (see e.g. Mises [1966], p. 559; Garrison [2004]), a debate which has been generally fruitless due to its notion of time-structure of production rather than a time-structure of investment (Lewin and Cachanosky 2014). I note only that overinvestment in a particular line is equivalent with malinvestment, as opposed to a general overinvestment, which I doubt is a meaningful notion.


BankingBusiness cycleMoneyCarl MengerJeffrey FrankelJeffrey HummelLeland YeagerLudwig LachmannMilton FriedmanPerry MehrlingRandall KrosznerRoger KopplWilliam Barnett


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  • 1

    Michael Pettis

    Aug 17, 2016 at 4:15 | Reply

    I was very, very impressed by this piece and the sensitivity it shows to the concept of money, which is usually treated with a clunky brutality that makes most comment worthless. In fact it is causing me to drop altogether the piece I was planning to do and instead just cite yours, before going on to try to work out the potential impact of certain kinds of “financial engineering” in China. The basic argument is that this financial engineering, which consists little more than massive volumes of SPVs that leverage bonds with interbank funding so as to deliver high-yielding “wealth management products”, has created artificial liquidity in the bond markets, and so increased the moneyness of these assets, in a way that is likely to reverse very quickly and brutally at just the wrong time.

    I think a similar argument may apply to the ECB’s “whatever it takes” put option on bonds issued by peripheral European governments. With their debts rising consistently faster than their debt servicing capacity, the ECB put must become increasingly less credible over time, and if bondholders ever question the ECB commitment and demand that it be made explicit, which I can’t imagine the ECB would ever do, we might see a sharp unexpected drop in moneyness as all these various bond markets fly apart. Needless to say, that could easily make a bad situation awful.

    If this sounds a little cryptic I apologize, but to help explain, way back when the euro was created, everyone except Robert Mundell and me were certain that it would rise sharply against the dollar, even the macro research guys at Bear Stearns, where I ran a bunch of fixed income trading stuff and so used to push them around all the time. Mundell and I expected the euro to drop, and of course it dropped immediately and quickly. I wrote the following piece for the WSJ when I was first getting my head around the concept of moneyness.

    Long comment, I know, but this has to be one of the most interesting areas in economics, an academic discipline that desperately needs to become less useless. Anyway I recommend you keep thinking about money and balance sheets, although as a finance guy, and not an economist, my advice probably isn’t very career friendly.

    • 1.1

      Cameron Harwick

      Aug 17, 2016 at 16:40

      Thanks for the encouragement – I had at one point planned to use this as a dissertation chapter, but shelved it for being too “speculative” (ha ha). I’ll be sure to return to it at some point in the future. There are more than a few folks in the GMU orbit doing research along these lines.

      Your WSJ article is a very elegant application of the logic of moneyness. If the EU should ever face dissolution, I take this to mean that it would require expansive monetary policy to offset the reduced liquidity of the national currencies, over and above whatever expansion would be necessary to calm markets due to the geopolitical implications.

      I’ll look forward to reading your piece on Chinese financial engineering, a topic I’d love to become more familiar with.

  • 2

    Lorenzo from Oz

    Nov 02, 2017 at 19:24 | Reply

    You might have a look at Australia, given that we have not had a technical recession (i.e. two consecutive quarters of negative growth) since 1991. The Economist has been moaning about our housing bubble(s) for almost two decades now. (Do bubbles have time limits?)

    For the lack of technical recession, I blame the Reserve Bank of Australia. Its inflation target of averaging 2-3%pa over the business cycle keeps income expectations anchored so a relatively flat path for nominal GDP. I.e. if P overheats, they lean downwards; if y undershoots they lean upwards, keeping the growth path of Py pretty flat.

    I discussed these matters (well, not housing) in a post some years ago.

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