In September 2007, Northern Rock Triggering the First High Street Bank Run in the UK Since 1866

The British bank Northern Rock played a starring role in the unfolding drama of the financial crisis. In September 2007, news that Northern Rock had used emergency liquidity support from the Bank of England led to the first high street bank run in the United Kingdom since Overend, Gurney and Co. in 1866. Following unsuccessful attempts at finding a private-sector buyer, Northern Rock was nationalized in February 2008, a policy outcome that would have struck many people as unthinkable just a few months before. Indeed, the speed at which “the Rock” had gone from being the darling of the city to a symbol of the meltdown was breathtaking. Following its listing on the FTSE 100 in 2000, the share price had been steadily increasing, and the company posted profits of more than £440 million in 2006. Around 5 percent of annual profit was being paid into the Northern Rock Foundation, which grew to be one of the United Kingdom’s largest corporation foundations (giving grants of more than £27 million in 2006), and the company had emerged as a beacon of North East economic renewal through its sponsorship of local sports teams and the planned development of new headquarters. If loyal customers were surprised at the speed of the bank’s downfall, they weren’t alone.

The main problem with Northern Rock’s business model was that its rapid expansion entailed two things: (1) allowing mortgage products to constitute a high proportion of its assets (about 75 percent) and (2) funding this through wholesale markets. [Note that unlike the situation facing many US banks, it wasn’t an increase in defaults on mortgage payments that got Northern Rock into trouble but the freezing up of funding.]  In hindsight, the errors seem obvious, but the board was so oblivious that it planned a 30-percent increase in dividends as late as July 2007. And yet just two months after making a voluntary choice to reduce capital, it required emergency liquidity provisions. When questioned about this decision, Adam Applegarth (then CEO) pointed out that it wasn’t only the board that failed to anticipate the problem; the company had been focused on compliance with the Basel II international standards, working alongside the Financial Services Authority (FSA). Indeed, regulators deserve blame for two elements of this. First, the regulations themselves encouraged aspects of the problem: “Mortgage products had been made so attractive by IRB [internal-ratings-based] adherence to Basel II, that there was an incentive to grow them more quickly than could be funded by depositors.” There is little reason to think that stoking a housing bubble was an aim of Basel II, suggesting that it was an unintended consequence, that the Basel committee was simply ignorant of the activity that it was encouraging. The second failure of regulators was in not identifying the problems after they had begun to emerge. In June 2007, the FSA had approved the approach taken by Northern Rock to satisfy Basel II, partly because “they had Tier 1 capital of a ‘healthy’ 11.3 per cent of RAW [risk-weighted assets].” Despite retrospective protestations, the FSA was hardly trying to rein in a reckless company.


—Anthony J. Evans, “The Financial Crisis in the United Kingdom: Uncertainty, Calculation, and Error,” in The Oxford Handbook of Austrian Economics, ed. Peter J. Boettke and Christopher J. Coyne (New York: Oxford University Press, 2015), 749-750.

There Is No Perfectly Rigorous Way to Define the Length of a Production Process in Purely Physical Terms; This Fact Is at the Heart of the 3 Capital Controversies (Böhm-Bawerk v. Clark, Hayek v. Knight, and the Cambridges)

The Austrian economists emphasize that production takes time, and, other things constant, the longer the (linear) supply chain, the more “time” it takes. Thus, modern production is much more “roundabout” (Böhm-Bawerk’s term) than older, more rudimentary production processes. Rather than picking the fruit in our backyard and eating it, most of us today get our fruit from farms using complex picking, sorting, and packing machinery and specialists to process carefully engineered fruit products. Consider the amount of “time” (for example, in people-hours) involved in setting up and assembling all the pieces of this complex production process from scratch—from before the manufacture of the machines and so on—to appreciate what is meant by production methods that are “roundabout.” Doing things in a more complicated, specialized way is more difficult—loosely speaking, it takes more “time” because it is more roundabout, more indirect—it involves the construction of more intermediate products (or services) before moving to the next step in the process.

The scare quotes for “time” in the previous paragraph are used because, even for simple linear processes, there is no perfectly rigorous way to define the length of a production process in purely physical terms. This essential fact is at the heart of the three capital controversies that have occurred over the last one hundred years: the first in the late nineteenth and early twentieth century involving Böhm-Bawerk and his critics (notably J. B. Clark), the second in the 1930s and 1940s involving Hayek and his critics (notably Frank Knight), and the last from the 1970s onward, lingering until today, known as the Cambridge-Cambridge debate, involving, respectively, protagonists from Cambridge, England, and Cambridge, Massachusetts. ACT [Austrian Capital Theory] was explicit in the first two controversies and implicit in the third. All concerned the essential nature of production in a capital-using economy. Böhm-Bawerk was tackled because of his use of a simplifying, inconsistent theoretical construct: the “average period of production.” It can be easily shown that any attempt to calculate such a magnitude is fraught with insurmountable difficulties except in the simplest of cases—and even there, the calculation is impossible if we consider, as we should, the interest rate implicit in the formula to be compound interest. Böhm-Bawerk’s lengthy, intuitive discussion of the nature of capitalist production as an increasing reliance on produced means of production in specialized production processes became associated with this rather specific and limited formula. Though actually a small part of his work as a whole and arguably an aberration in his breadth of vision, it became the focus for the prolonged and energetic debate in capital theory.

--Peter Lewin and Howard Baetjer Jr., “The Capital-Using Economy,” in The Oxford Handbook of Austrian Economics, ed. Peter J. Boettke and Christopher J. Coyne (New York: Oxford University Press, 2015), 146.

With the Eclipse of Austrian Economics in the 1930s, a Key Perspective on the Importance of the Economy’s Supply Side in Economic Fluctuations Was Lost

After the publication of the General Theory, which Hayek never formally reviewed, and the apparent triumph of Keynesianism, Hayek’s The Pure Theory of Capital was virtually ignored. The Pure Theory was an attempt by Hayek to provide theoretical foundation for an eventual fully developed theory of a money-production economy to compete with Keynes’s “general” theory. Sadly, the whole debate became a mostly forgotten side note in the history of economic thought. What was lost? Backhouse and Laidler  sum it up nicely: “With the eclipse of Austrian Economics in the 1930s, a key perspective on the importance of the economy’s supply side in economic fluctuations was lost.” By ignoring that current investment has an impact on not just the size but also the composition of the future capital stock, Keynes and IS-LM Keynesians, to an even greater degree, lost sight of key insights developed most fully by the Austrians but also by Keynes’s English contemporaries, such as Robertson,  that “mistaken investment decisions made in the present had a capacity to disrupt future equilibria between supply and demand” in either the economy as a whole or in key sectors.

--John P. Cochran, "Capital-Based Macroeconomics: Austrians, Keynes, and Keynesians," in The Oxford Handbook of Austrian Economics, ed. Peter J. Boettke and Christopher J. Coyne (New York: Oxford University Press, 2015), 166.

The Methodenstreit (Dispute Over Methods): The Austrian School Versus the German Historical School

Austrian economists have a reputation for intensive—some would say excessive—ruminations on the methodology of economics. The Austrian moniker itself originates in the Methodenstreit between the early Austrians and the German historical school. The Austrians argued that abstract economic theory has a central role to play in understanding economic phenomena, while the historical school insisted that economists require a large body of evidence about particular historical circumstances before making theoretical pronouncements.

--Adam Martin, "Austrian Methodology: A Review and Synthesis," in The Oxford Handbook of Austrian Economics, ed. Peter J. Boettke and Christopher J. Coyne (New York: Oxford University Press, 2015), 13.

The Foundation of the Austrian Boom-Bust Cycle Theory Is the Cantillon Effects

The foundation of the Austrian boom-bust cycle theory is a general principle of monetary theory known as Cantillon effects.... With Cantillon effects, the allocation of resources and the valuation of assets (bubbles) are shaped by nonneutral monetary changes. Two empirical generalizations contributed to the Austrian emphasis on the importance of the capital-structure approach in analyzing the macroeconomy. In a fractional reserve banking system, especially one supported by a central bank, money creation can be accompanied by credit creation. Credit may be made available in excess of available savings as banks extend loans to entrepreneurs. The money and credit creation process reduces interest rates relative to equilibrium rates. The new pattern of money expenditure directs resources into more labor-saving and “roundabout” methods of production. In addition, a market rate below the natural rate may provide an incentive for reduced saving (higher consumption). The lower interest rate used as a discount factor combined with an inflation-induced illusion of higher expected profits creates a “wealth” or “net worth” effect which artificially increases consumption expenditures during the money-induced boom.

--John P. Cochran, "Capital-Based Macroeconomics: Austrians, Keynes, and Keynesians," in The Oxford Handbook of Austrian Economics, ed. Peter J. Boettke and Christopher J. Coyne (New York: Oxford University Press, 2015), 173.