Risk debt and bubbles

Variation on a theme

Capital-based macroeconomics features the time element in macroeconomic relationships. Time is a fundamental and pervasive dimension in the economics of sustainable and unsustainable growth (Chapter 4) and in several related fiscal and regulatory issues (Chapter 5). The particular treatment of time as one dimension of the Hayekian triangle allows us to incorporate another aspect of the production process. Specifically, the remoteness in time of investment decisions from the eventual availability of consumable goods translates to some extent into riskiness. The more roundabout the production process, the more time for unexpected changes in market conditions to occur. But a fuller understanding of the macroeconomics of risk and uncertainty requires that we look beyond the simple geometry of our capital-based macroeconomic framework.

Time is inherent in a capital-using production process; risks are inherent in all future-oriented undertakings. Considerations of risks willingly borne and of risks not-so-willingly borne can add a new dimension to our theory. Paralleling the contrast in the macroeconomics of intertemporal allocation between preference-based growth and a policy-induced boom is a contrast between preference-based risk-taking and policy-induced risk-bearing. The macroeconomics of risk is not a substitute for the macroeconomics of capital structure (as it is in Cowen, 1997), but it can complement our understanding of the more fundamental intertemporal aspects of the market process.

Integrating considerations of risk can help to increase the relevance and extend the applicability of capital-based macroeconomics. The Hayekian triangle was introduced at a time when Hayek and the rest of the profession were contemplating the dramatic economic boom of the 1920s and the subsequent depression that had yet to find its bottom. The 1990s found the profession in similar circumstances — contemplating America's dramatic bull market of the 1980s and wondering if and how the recession of 1991—2 was related. In a similar time frame, the Asian miracle had somehow turned into the Asian malaise. Do these stories of bulls and bears and of miracle and malaise parallel the older story of boom and bust? It would be a mistake to assume that Hayek's triangulation as applied to the inter-war episode applies in some wholesale fashion to the so-called bubble economies of recent years, but it would be a greater mistake to assume that Hayek's insights have no modern application of all.

Hayek's theory of boom and bust can be modified so as to extend its applicability. After making the appropriate conceptual and institutional adjustments, the story of boom and bust can be retold in a way that sheds light on contemporary macroeconomic problems and helps to put in perspective the macroeconomics of the intervening years which grew out of the Keynesian revolution. The rate of interest figures importantly in both early and modern applications. The needed modification requires that we focus attention on a different aspect of the interest rate, namely, the risk premium.

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