In this paper the vision of the “Young” and “Elder” Lamfalussy on the origins of instability in capitalist economies will be contrasted. The young Lamfalussy found the origins of instability in medium-term cumulative processes in the real sector of the economy, very much inspired by the vicious circles in the British and Belgian economies in the postwar period. The Elder Lamfalussy focused on financial innovations and the short-term myopic behavior of financial markets, very much inspired by his experience of the Latin American debt build-up and ensuing crisis in the early 1980s. The Euro area crisis showed the importance of both processes, as it was the consequence of both short-term myopic behavior in financial markets and medium-term cumulative processes in the real sector.
While being a distinguished central banker, close to the empirical reality, Lamfalussy remained faithful to a strongly Keynesian Weltanschuung, which he had already acquired as a young economics student. In Lamfalussy’s view, the market economy was inherently unstable. However, over time his view on the origins of the instability of the economy shifted. In this contribution the vision of the “Young” and “Elder” Lamfalussy on the origins of instability in capitalist economies will be contrasted (Maes 2023). The young Lamfalussy found the origins of instability in medium-term cumulative processes in the real sector of the economy, very much inspired by the vicious circles in the British and Belgian economies in the postwar period, in contrast to the virtuous growth processes of the German and Italian economies. The Elder Lamfalussy focused on financial innovations and the short-term myopic behavior of financial markets, very much inspired by his experience of the Latin American debt build-up and ensuing crisis in the early 1980s. The Euro area crisis showed the importance of both processes, as it was the consequence of both short-term myopic behavior in financial markets and medium-term cumulative processes in the real sector (especially the real estate sector and competitiveness).
In the following years, Lamfalussy would extend his analyses to the other main European economies (Maes 2009). In “The United Kingdom and the Six. An Essay on Economic Growth in Western Europe“, Lamfalussy (1963) provided an analysis of the divergence in economic performance between the countries of the European Community and the United Kingdom. Lamfalussy showed the virtuous circle of the EEC growth performance, “competitive advantage in world markets, leading to faster growth of exports; export-oriented growth, raising the share of investment in the national product; higher investment ratio, calling forth a faster growth in the productivity of labour and leading, therefore, to renewed competitive advantage in world markets” (Lamfalussy 1963: 116-117). The virtuous circle of the EEC countries contrasted naturally with the vicious circle of the United Kingdom (or Belgium).
Later, Lamfalussy gave a negative answer to the question whether the redistribution of risk improved financial stability. His argument was strongly influenced by his analysis of the Latin American debt crisis. In his view, the shift to a generalised use of floating interest rates in medium-term bank loans, during the petrodollar recycling, allowed banks to protect themselves against the erosion of their margins of intermediation. However, it also had the effect of passing on short-term market interest rate movements to borrowers. With negative real interest rates in the 1970s, credit demand was stimulated, leading to a period of over-expansion. The return to positive real interest rates in 1979 placed a “crippling” burden on many debtors. The ensuing debt crisis threatened the world financial system. Lamfalussy concluded: “Innovation allowed banks to transform margin risk into capital risk which, in this case, was probably a greater threat to the stability of the international banking system – not to mention its rather disastrous effects on the borrowers themselves” (Lamfalussy 1986: 14).