Two Problems with Austrian Business-Cycle Theory

Even though he has written that he no longer considers himself an Austrian economist, George Selgin remains sympathetic to the Austrian theory of business cycles, and, in accord with the Austrian theory, still views recessions and depressions as more or less inevitable outcomes of distortions originating in the preceding, credit-induced, expansions. In a recent post, George argues that the 2002-06 housing bubble conforms to the Austrian pattern in which a central-bank lending rate held below the “appropriate,” or “natural” rate causes a real misallocation of resources reflecting the overvaluation of long-lived capital assets (like houses) induced by the low-interest rate policy. For Selgin, it was the Fed’s distortion of real interest rates from around 2003 to 2005 that induced a housing bubble even though the rate of increase in nominal GDP during the housing bubble was only slightly higher than the 5% rate of increase in nominal GDP during most of the Great Moderation.

Consequently, responses by Marcus Nunes, Bill Woolsey and Scott Sumner to Selgin, questioning whether he used an appropriate benchmark against which to gauge nominal GDP growth in the 2003 to 2006 period, don’t seem to me to address the core of Selgin’s argument. Selgin is arguing that the real distortion caused by the low-interest-rate policy of the Fed was more damaging to the economy than one would gather simply by looking at a supposedly excessive rate of nominal GDP growth, which means that the rate of growth of nominal GDP in that time period does not provide all the relevant information about the effects of monetary policy.

So to counter Selgin’s argument – which is to say, the central argument of Austrian Business-Cycle Theory – one has to take a step back and ask why a price bubble, or a distortion of interest rates, caused by central-bank policy should have any macroeconomic significance. In any conceivable real-world economy, entrepreneurial error is a fact of life. Malinvestments occur all the time; resources are, as a consequence, constantly being reallocated when new information makes clear that some resources were misallocated owing to mistaken expectations. To be sure, the rate of interest is a comprehensive price potentially affecting how all resources are allocated. But that doesn’t mean that a temporary disequilibrium in the rate of interest would trigger a major economy-wide breakdown, causing the growth of real output and income to fall substantially below their historical trend, perhaps even falling sharply in absolute terms.

The Austrian explanation for this system-wide breakdown is that the price bubble or the interest-rate misallocation leads to the adoption of investments projects and of production processes that “unsustainable.” The classic Austrian formulation is that the interest-rate distortion causes excessively roundabout production processes to be undertaken. For a time, these investment projects and production processes can be sustained by way of credit expansion that shifts resources from consumption to investment, what is sometimes called “forced saving.” At a certain point, the credit expansion must cease, and at that point, the unsustainability of the incomplete investment projects or even the completed, but excessively roundabout, production processes becomes clear, and the investments and production processes are abandoned. The capital embodied in those investment projects and production processes is revealed to have been worthless, and all or most of the cooperating factors of production, especially workers, are rendered unemployable in their former occupations.

Although it is not without merit, that story is far from compelling. There are two basic problems with it. First, the notion of unsustainability is itself unsustainable, or at the very least greatly exaggerated and misleading. Why must the credit expansion that produced the interest-rate distortion or the price bubble come to an end? Well, if one goes back to the original sources for the Austrian theory, namely Mises’s 1912 book The Theory of Money and Credit and Hayek’s 1929 book Monetary Theory and the Trade Cycle, one finds that the effective cause of the contraction of credit is not a physical constraint on the availability of resources with which to complete the investments and support lengthened production processes, but the willingness of the central bank to tolerate a decline in its gold holdings. It is quite a stretch to equate the demand of the central bank for a certain level of gold reserves with a barrier that renders the completion of investment projects and the operation of lengthened production processes impossible, which is how Austrian writers, fond of telling stories about what happens when someone tries to build a house without having the materials required for its completion, try to explain what “unsustainability” means.

The original Austrian theory of the business cycle was thus a theory specific to the historical conditions associated with classical gold standard. Hawtrey, whose theory of the business cycle, depended on a transmission mechanism similar to, but much simpler than, the mechanism driving the Austrian theory, realized that there was nothing absolute about the gold standard constraint on monetary expansion. He therefore believed that the trade cycle could be ameliorated by cooperation among the central banks to avoid the sharp credit contractions imposed by central banks when they feared that their gold reserves were falling below levels that they felt comfortable with. Mises and Hayek in the 1920s (along with most French economists) greatly mistrusted such ideas about central bank cooperation and economizing the use of gold as a threat to monetary stability and sound money.

However, despite their antipathy to proposals for easing the constraints of the gold standard on individual central banks, Mises and Hayek never succeeded in explaining why a central-bank expansion necessarily had to be stopped. Rather than provide such an explanation they instead made a different argument, which was that the stimulative effect of a central-bank expansion would wear off once economic agents became aware of its effects and began to anticipate its continuation. This was a fine argument, anticipating the argument of Milton Friedman and Edward Phelps in the late 1960s by about 30 or 40 years. But that was an argument that the effects of central-bank expansion would tend to diminish over time as its effects were anticipated. It was not an argument that the expansion was unsustainable. Just because total income and employment are not permanently increased by the monetary expansion that induces an increase in investment and an elongation of the production process does not mean that the investments financed by, and the production processes undertaken as a result of, the monetary expansion must be abandoned. The monetary expansion may cause a permanent shift in the economy’s structure of production in the same way that tax on consumption, whose proceeds were used to finance investment projects that would otherwise not have been undertaken, might be carried on indefinitely. So the Austrian theory has never proven that forced saving induced by monetary expansion, in the absence of a gold-standard constraint, is necessarily unsustainable, inevitably being reversed because of physical constraints preventing the completion of the projects financed by the credit expansion. That’s the first problem.

The second problem is even more serious, and it goes straight to the argument that Selgin makes against Market Monetarists. The whole idea of unsustainability involves a paradox. The paradox is that unsustainability results from some physical constraint on the completion of investment projects or the viability of newly adopted production processes, because the consumer demand is driving up the costs of resources to levels making it unprofitable to complete the investment projects or operate new production processes.  But this argument presumes that all the incomplete investment projects and all the new production processes become unprofitable more or less simultaneously, leading to their rapid abandonment. But the consequence is that all the incomplete investment projects and all the newly adopted production processes are scuttled, producing massive unemployment and redundant resources. But why doesn’t that drop in resource prices restore the profitability of all the investment projects and production processes just abandoned?

It therefore seems that the Austrian vision is of a completely brittle economy in which price adjustments continue without inducing any substitutions to ease the resource bottlenecks. Demands and supplies are highly inelastic, and adjustments cannot be made until prices can no longer even cover variable costs. At that point prices collapse, implying that resource bottlenecks are eliminated overnight, without restoring profitability to any of the abandoned projects or processes.  Actually the most amazing thing about such a vision may be how closely it resembles the vision of an economy espoused by Hayek’s old nemesis Piero Sraffa in his late work The Production of Commodities by Means of Commodities, a vision based on fixed factor proportions in production, thus excluding the possibility of resource substitution in production in response to relative price changes.

A more realistic vision, it seems to me, would be for resource bottlenecks to induce substitution away from the relatively scarce resources allowing production processes to continue in operation even though the value of many fixed assets would have to be written down substantially. Those write downs would allow existing or new owners to maintain output as long as total demand is not curtailed as a result of a monetary policy that either deliberately seeks or inadvertently allows monetary contraction. Real distortions inherited from the past can be accommodated and adjusted to by a market economy as long as that economy is not required at the same time to undergo a contraction, in total spending. But once a sharp contraction in total spending does occur, a recovery may require a temporary boost in total spending above the long-term trend that would have sufficed under normal conditions.

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60 Responses to “Two Problems with Austrian Business-Cycle Theory”


  1. 1 Greg Ransom October 3, 2012 at 11:29 pm

    In Hayekian macro, monetary / asset / shadow money / production distortions can be endogenous and don’t have to be the result of the central bank, ie systematic distortions can be endogenous and can heightened by regulatory pathologies and systematic failures of transparency or systematic failures of risk perception or false optimism, etc.

    Sophisticated “Austrian” business cycle theory means Hayek — don’t accept any stick figure substitute, ie don’t pretend that Hayek’s theory is just about the central bank and it’s interest rate policy — it certainly is not. To reduce Hayek to a central bank and the interest rate is to fail to engage Hayek and Hayekian macro.

    Although I’m well aware that almost nobody has studied Hayek’s macro seriously, and the bogus stick figure cartoon is the preferred entity to “engage”.

    David writes,

    “to counter Selgin’s argument – which is to say, the central argument of Austrian Business-Cycle Theory – one has to take a step back and ask why a price bubble, or a distortion of interest rates, caused by central-bank policy should have any macroeconomic significance.”

  2. 2 Greg Ransom October 3, 2012 at 11:41 pm

    Hayek goes into the microeconomic detail of this, which has everything to do with real resources and has nothing to do with gold. Why don’t you engage Hayek’s actual detailed account? You invent a substitute which does not engage the considerations Hayek actually puts on the table.

    David writes,

    “the notion of unsustainability is itself unsustainable, or at the very least greatly exaggerated and misleading. Why must the credit expansion that produced the interest-rate distortion or the price bubble come to an end? Well, if one goes back to the original sources for the Austrian theory, namely Mises’s 1912 book The Theory of Money and Credit and Hayek’s 1929 book Monetary Theory and the Trade Cycle, one finds that the effective cause of the contraction of credit is not a physical constraint on the availability of resources with which to complete the investments and support lengthened production processes, but the willingness of the central bank to tolerate a decline in its gold holdings. It is quite a stretch to equate the demand of the central bank for a certain level of gold reserves with a barrier that renders the completion of investment projects and the operation of lengthened production processes impossible, which is how Austrian writers, fond of telling stories about what happens when someone tries to build a house without having the materials required for its completion, try to explain what “unsustainability” means.

    David also writes this:

    “the consequence is that all the incomplete investment projects and all the newly adopted production processes are scuttled, producing massive unemployment and redundant resources. But why doesn’t that drop in resource prices restore the profitability of all the investment projects and production processes just abandoned?”

    You’ll have to explain to me how this addresses Hayek. I don’t see how it does.

  3. 3 Greg Ransom October 3, 2012 at 11:44 pm

    This is not Hayek’s central argument on this issue:

    David writes,

    “Mises and Hayek never succeeded in explaining why a central-bank expansion necessarily had to be stopped. Rather than provide such an explanation they instead made a different argument, which was that the stimulative effect of a central-bank expansion would wear off once economic agents became aware of its effects and began to anticipate its continuation.”

    It should be noted that both Hayek and Mises address fiat money, and do not merely engage various forms of the gold standard.

  4. 4 andrew lainton October 4, 2012 at 12:00 am

    You are slightly unfair on Sraffa as in a letter to Bose he said he made absolutely no assumption about fixed factor proportions – but that is by the by. In the light of that his theory should be interpreted not as Iron+ wheat etc. but (commodity fulfilling the function of iron)+(commodity fulfilling the function of wheat) etc. which can be substituted.

    Not to defend ABC theory but the relation between the real and monetary economy, and how blockages in one can impact on the other, must be central to business cycle theory. For example you cannot substitute land easily if your commodity is a single storey house. Indeed real estate bubbles throughout history have often been popped by unexpected shortages in real resources, for example the infamous Florida real estate bubble of the 20s – whose bursting led to a national real estate downturn which helped trigger the great depression – was triggered by railway companies being pressured to refuse to import building materials (people were starving as there was no economic incentive to import food) and then a ship sinking in the harbour preventing the only alternative route. Homer Hoyte is very good on the role real resource shortages play in real estate bubbles.

  5. 5 Frank Restly October 4, 2012 at 12:42 am

    “In a recent post, George argues that the 2002-06 housing bubble conforms to the Austrian pattern in which a central-bank lending rate held below the “appropriate,” or “natural” rate causes a real misallocation of resources reflecting the overvaluation of long-lived capital assets (like houses) induced by the low-interest rate policy.”

    Um no. The originations of the housing bubble can be tracked back to a 1983 decision to eliminate housing prices from the consumer price index. That presents a quandry for fed policy makers since most housing purchases are debt funded, and yet the Fed’s reaction function to rising housing prices is not raise the cost of servicing that debt.

    And so, interest rates could have been much higher, and a housing bubble still could have occurred.

  6. 6 Madjay October 4, 2012 at 3:48 am

    Interesting post! I really need to learn more about macroeconomics in general or Austrian economics in particular to follow these debates. In fact, I was left puzzled right at the start, when you mention the argument that central banks kept interest rates artificially low, and this lead to excessive investment.

    I don’t know whether this is a fair representation of the Austrian view of the causes of the recession, but I have heard the argument made by several people, particularly those critical of Keynesian solutions to the recession. My problem is, how can central banks artificially depress the REAL rate of interest? Isn’t this the price at which desired debt matches desired saving? If real interest rates are low, doesn’t this just suggest that desired saving is too high? I’d like to understand the mechanism by which central banks can force savings, particularly in deregulated markets with massive international capital flows.

    Also, in response to Frank Restly’s point, house purchases just transfer funds from buyer to seller. So if credit expands and drives up house prices, this should feed into the rest of the economy eventually and cause CPI inflation. The fact it didn’t is another point consistent with excess savings driving the current recession, and credit expansion being a symptom, not a cause.

  7. 7 reason October 4, 2012 at 5:54 am

    Besides which a housing bubble is not a housing bubble – it is a land price bubble. If you name it correctly a lot of sloppy thinking can be avoided.

  8. 8 PeterP October 4, 2012 at 6:36 am

    MMT would say that the gold constraint is purely voluntary, we could finance the expansion with fiat money and not private debt, as long as the real productivity/resources are there. So the ABCT tells us not about the nature of the economy, but simply describes a faulty monetary system which needlessly halts an expansion with ample support in real productivity. FWIW

  9. 9 Greg Ransom October 4, 2012 at 7:19 am

    It needs to be added, David, that Hayek explicitly points out the way in which money / money substitutes / credit can systematically distort price, production and consumption relations is contingent on particular institutional and economic factors, eg the development of different regulatory regimes, the changing shape of who gets credit and where, what sort of credit is given a “to big to fail” backstop, what credit is subsidized by the government, what parts of the credit and production and consumption stream are pathologically regulated, etc.

    Hayek is explicit on that.

    Explicit.

    It’s part of the argument and was from the beginning.

    It’s fallacy of argument and just bad scientific reasoning to ignore this central fact.

  10. 10 Harry October 4, 2012 at 8:08 am

    “A more realistic vision, it seems to me, would be for resource bottlenecks to induce substitution away from the relatively scarce resources allowing production processes to continue in operation even though the value of many fixed assets would have to be written down substantially. Those write downs would allow existing or new owners to maintain output as long as total demand is not curtailed as a result of a monetary policy that either deliberately seeks or inadvertently allows monetary contraction. Real distortions inherited from the past can be accommodated and adjusted to by a market economy as long as that economy is not required at the same time to undergo a contraction, in total spending. But once a sharp contraction in total spending does occur, a recovery may require a temporary boost in total spending above the long-term trend that would have sufficed under normal conditions.”

    This is DSGE modeling in a barter-based, non-finanical world with continuous, reversible, linear dynamics and no leverage. In this worldview, Humpty-Dumpty can always be put back together again no matter how far he has fallen, how many pieces he became, and how much debt he carried. In more recent terms, GM and Chrysler would have been fully resurrected out of bankruptcy “with existing or new owners” but without a government bailout, Lehman would not have sent the markets into a tailspin, and AIG would be just another liquidated company. So much for this worldview.

  11. 11 Frank Restly October 4, 2012 at 8:48 am

    Madjay,

    “Also, in response to Frank Restly’s point, house purchases just transfer funds from buyer to seller. So if credit expands and drives up house prices, this should feed into the rest of the economy eventually and cause CPI inflation.”

    Ummm, not necessarily. Housing prices were replaced with owner’s equivalent rent in the consumer price index. Because OER carries a heavy weighting, higher home ownership rates tend to depress rental costs and the consumer price index.

    I don’t dispute the fact that consumer credit expansion has an inflationary impact. I dispute that the inflationary impact is properly measured in the consumer price index.

  12. 12 Rob Rawlings October 4, 2012 at 9:16 am

    ABCT at its most simple level is a theory of how an injection of new money via the banking system causes price distortions that lead to some projects appearing profitable that otherwise would not. Even as the new money is created market forces will begin to work that will reverse out the effects. This means that if the “malinvestment” projects caused by the boom are to be continued new money will need to be created not only to keep interest low but will also need to factor in “inflation expectations” and this will eventually become unsustainable without running the risk of hyperinflation.

    The longer the boom goes on the more the economy will have moved away from it optimum structure of production. What happens when the CB finally abandons the low-interest rate policy? Firstly I think that many Austrians would agree that maintaining a constant value of money (via some sort of targeting – with the aim of preventing a deflationary crash ) would be the optimal monetary policy at this stage. However in my view this will only minimize not eliminate the bust. The structure of production needs to adjust and this will mean that RGDP will likely fall for a while before getting back on its growth path. In David’s view falling asset and labor prices may rescue some of the “malinvestments” when the boom ends. While I can see the logic in this view I think that once the recovery is underway and the price structure more accurately reflects consumer preference then these “malinvestments” would need to be liquidated eventually.

  13. 13 Ralph Musgrave October 4, 2012 at 9:42 am

    If central banks HAD raised rates prior to the crunch, the result would have been excess unemployment, since inflation in that period was not out of hand. Which raises the question: why were central banks in the absurd position of having to choose between excess unemployment and a crunch? Or to be more accurate, ASSUMING they had had perfect foresight, and could have seen see what was coming, why would they have been faced with that absurd choice?

    Reason is that they have chosen an absurd policy tool to regulate demand: interest rate adjustment. Here’s just one absurdity. At the start of a recession, there is a SURPLUS of capital equipment, thus cutting interest rates so as to encourage investment is exactly what is not needed.

    In a genuine free market, the increased demand for loans with which to engage in property speculation would raise interest rates, which would ameliorate the speculation. But if people just shift resources to speculation from other areas there may be no effect on inflation, thus CBs don’t adjust interest rates.

    And that is compounded by fractional reserve banking. That is, given what looks like loads of borrowers with respectable collateral, the private banking system just creates savings out of thin air to lend out. It doesn’t need to raise interest rates. Commercial bank lending relative to the monetary base in the UK exploded in the four years prior to the crunch.

    But George Selgin is pro fractional reserve, which means the above simple solution doesn’t occur to him – so he goes for a much more convoluted explanation.

    Or am I being unfair?

  14. 14 Greg Ransom October 4, 2012 at 11:08 am

    Untold numbers have been utterly unable to imagine how Darwin’s causal mechanism could possibly produce the effects he claims for it.

    This does NOT count as evidence against Darwin, and this does not count as an argument against his mechanism.

    What is more, the fact that educated people insisted they couldn’t conceive how Darwin’s theory could account for the phenomena doesn’t provide good evidence that these people had a deep command of either Darwin or the range of phenomena under consideration.

  15. 15 Greg Ransom October 4, 2012 at 1:50 pm

    Hayek like Darwin provides an multi-instantiated how possible mechanism, NOT a how actual mechanism.

    The how possible mechanism has to be filled in given contingent factual realities in unique historical contexts.

    Darwin was blunt — the how actual facts could never be completely known or proved, the events took place in the past, and could never come close to being observed in their complete totality.

    Hayek’s ‘how possible’ argument is incredibly general — the fact of the existence of money, credit, contracts, and rival time pathways allowing for superior or inferior production and consumption by rival individuals explains how systematic discoordination is possible given the fact of global plan coordination.

  16. 16 Mark Stamatakos October 4, 2012 at 6:19 pm

    Frank,

    Are you suggesting that the CPI has been manipulated or erroneously adjusted? Why should we bother to include housing prices in inflation?

    You know, that inflation that is “holding steady” at 2%

    Chuckle, guffaw, chuckle.

  17. 17 Julian Janssen October 4, 2012 at 8:14 pm

    My only exposure to quasi-Austrian views on the business cycle are from Gunnar Myrdal’s “Monetary Equilibrium”, where he sums up the monetary theories of Knut Wicksell. Even if less sophisticated than the New Keynesian model, the discussion of deviations from the “natural rate” of interest and its effects on investment offer a fair explanation of a cause of output/income fluctuations.

  18. 18 Donald A. Coffin October 4, 2012 at 8:40 pm

    “Those write downs would allow existing or new owners to maintain output as long as total demand is not curtailed…”

    Indeed, this is exactly what happened in the steel industry in the U.S. in the two decades following the 1979-84 near collapse of that industry. The rapid worldwide expansion of steel-making capacity pushed steel prices down. The consequence was that firms with older, less productive capital found themselves in difficulty. But if those assets could be acquired at fire-sale prices (as happened, for example, with LTV–what was being carried on the firm’s books as several billion dollars worth of capital assets were acquired for $250 million), the firms could and did continue to produce steel proftably.

  19. 19 Frank Restly October 4, 2012 at 8:54 pm

    Mark,

    “Are you suggesting that the CPI has been manipulated or erroneously adjusted? Why should we bother to include housing prices in inflation?”

    The consumer price index has been adjusted numerous times two of which are the replacement of housing prices with owners equivalent rent in 1983 and the Boskin Commission recommendations in 1996.

    I am suggesting that because most housing is financed with debt and because the federal reserve regulates the price level by changing the cost of debt service, either all references to housing must be excluded from the CPI or some mixture of rental / home owner cost must be included.

    Interest rate policy is obviously a blunt tool. The federal reserve can set interest rates, but they really have no control over how debt is used. This is what supply side tax policy is supposed to be about – directing capital (debt or equity) to productive uses but that message has been lost upon political hacks and television talking heads.

    Of course with every political season that passes, mention of tax policy degrades into the liberal “tax breaks for the rich” or the idiotic “tax breaks pay for themselves”.

  20. 20 Mark Stamatakos October 4, 2012 at 9:52 pm

    Frank,

    I think the bottom line is this. Whether you think Hayek is right or Keynes or whoever, what we have now in the United States for an economic policy is an abject failure. I don’t pretend to know why or where to put the blame (that is why I am here I suppose, to learn), but I do know that something is drastically wrong. Whether we need to blame the government, the consumer himself, the Fed, our military spending, our tax policy…I am grasping for straws man.

    I am a simpleton economically, but not so simple to see what is going on around me. Major costs that regular Joes like myself must incur are simply moving at a rate where very soon I fear I will no longer be able to afford them. College costs have made inflation look like a re-creation of the hare and the turtle. As an example, I graduated from DePaul University in 1997 for about $13,000 a year living off campus and working my way through school. Today, that same education at DePaul runs nearly $31,000. Does the CPI include that in its “numbers?” This is nothing more than another bubble if you ask me…both the scam that college costs are and the debt financing citizens have undertaken to gain access to it. When will this bubble burst is the question, and how much more will it cost me and everyone else to deal with it?

    My home, which I purchased at the height of the housing bubble, is now underwater and has proven to be a destructive nightmare to my very modest middle class dream. I continue to pay on a mortgage that is 79,000 less than when I purchased it. Instead of defaulting and walking away, I continue to fork over the money out of some sense of obligation to be a responsible American. My question is, why do I have to be responsible if the investment bankers and gamblers on Wall Street were not? Perhaps those same individuals realized that taking those tremendous risks and losing was a WIN/WIN…when the Fed is the lender of last resort why worry about consequences?

    My grocery bill skyrockets year over year. My savings? The biggest joke in the room…less than .15% I have done everything correctly Frank in trying to live the American Dream…live modestly, save, and spend within my means….and I am being crushed. If taxes go up on me in the next two years of a second Obama term, I honestly will have to search for a second job or default on my home.

    My wife talked to me last week about private schools for our kids. I’d have to sell my organs to even consider it.

    Health care premiums threaten to ruin me. To insure my family of four I have seen my premium skyrocket over 80% in the last 9 years. Another decade of that and I might as well switch to homeopathic remedies…it will be all I can still afford. Is it even remotely possible, or even indirectly correlated that spiraling health care costs are connected to an ever expanding fiat currency? I don’t know. I am not savvy enough to.

    While technology and competition drives down costs of many items we use to arrive at the CPI formula we are “given” today, I question the validity of those statistics if you are not the typical frenzied consumer upgrading TVs, phones, and computers every year. I don’t. Those savings are meaningless to me. And while commodity prices fluctuate wildly, Gas prices and my electric bill have simply taken a bigger and bigger chunk out of my yearly budget since went a nation-building in the Middle East. Are the two related?

    Maybe we need more taxes, and less spending. I get that. But in my very simple mind here, what I see is that when the Fed continues to print money to try and stimulate the economy, the value of the dollars and earnings I have decrease a little bit more. Printing money is and has been the hidden inflation that causes my dollars to weaken. Perhaps our markets and our very economic existence cannot exist without central banking oversight, but where are the results? I’d need a raise of about 5 or 6 percent a year just to keep up Frank.

  21. 21 Madjay October 5, 2012 at 1:59 am

    Frank,

    I’m not convinced – credit expansion without an increase in desired savings will inflate everything, including rents.If rents (imputed or otherwise) have not inflated at the same rate as house prices, this must be because real interest rates have fallen. To go back to my main point, I don’t understand how this can be because of anything other than an increase in the desired rate of saving at any given interest rate.

    Mark, I sympathise with your views, but I think you are making a common error which Noah Smith has pegged on his excellent blog Noahopinion. You are confusing inflation with a fall in real wages. There is no reason why printing dollars should necessarily fail to inflate your income in line with your expenditure.

  22. 22 Frank Restly October 5, 2012 at 6:35 am

    Madjay,

    “I’m not convinced – credit expansion without an increase in desired savings will inflate everything, including rents.If rents (imputed or otherwise) have not inflated at the same rate as house prices, this must be because real interest rates have fallen.”

    Suppose you have a group of people making the consumer decision to buy steak for dinner or buy pork chops for dinner. Now suppose that the price of steak is included in the government’s measure of consumer prices and the price of pork chops is not. If more people chose to eat pork chops then the demand for and price of steak will fall causing the consumer price index to go down. If more people chose to eat steak, then the demand for and price for steak will go up causing the consumer price index to go up.

    You are correct, real interest rates did fall during the housing bubble, BUT because house prices are not included in the consumer price index, the degree to which they fell was not measured correctly.

    Here is a chart that compares 30 year mortgage rates with changes in the Case Shiller 20 City Home Price Index. You will notice that the rate of change in home prices for a while exceeded the cost of servicing the loan:

    http://research.stlouisfed.org/fred2/graph/fredgraph.pdf?&chart_type=line&graph_id=&category_id=&recession_bars=On&width=630&height=378&bgcolor=%23b3cde7&graph_bgcolor=%23ffffff&txtcolor=%23000000&ts=8&preserve_ratio=true&fo=ve&id=SPCS20RSA,MORTG&transformation=pc1,lin&scale=Left,Left&range=Custom,Custom&cosd=2000-04-01,2000-04-01&coed=2012-07-01,2012-09-01&line_color=%230000ff,%23ff0000&link_values=,&mark_type=NONE,NONE&mw=4,4&line_style=Solid,Solid&lw=1,1&vintage_date=2012-10-05,2012-10-05&revision_date=2012-10-05,2012-10-05&mma=0,0&nd=,&ost=,&oet=,&fml=a,a&fq=Monthly,Monthly&fam=avg,avg&fgst=lin,lin

    By about 2007, the rise in home prices begain to taper off and collapsed into falling home prices by about 2008. Even though nominal mortgage rates barely moved, the “real” cost of servicing the mortgage rose significantly.

    This is why I said that either housing must be totally excluded from the CPI or the CPI must be adjusted to include housing prices.

    Mark,

    “And while commodity prices fluctuate wildly, Gas prices and my electric bill have simply taken a bigger and bigger chunk out of my yearly budget since went a nation-building in the Middle East. Are the two related?”

    “My grocery bill skyrockets year over year. My savings? The biggest joke in the room…less than .15% I have done everything correctly Frank in trying to live the American Dream…live modestly, save, and spend within my means….and I am being crushed. If taxes go up on me in the next two years of a second Obama term, I honestly will have to search for a second job or default on my home.”

    Let me just say this. The ONLY way the federal government can affect the economy on a nondiscriminatory basis that will have a long lasting effect is by selling a liability that has a high rate of return. All the talk of “stimulus” is just BS. You mention taxes. The federal government could if it chose to, sell you a tax break with a rate of return and a duration (similar to a bond). The rate of return would not be guaranteed (you would have to work a job to receive the return on investment) but it would lower your tax bill while at the same time reduce the federal debt.

  23. 23 David Glasner October 5, 2012 at 10:39 am

    Greg, The point of this post was not to “engage” with Hayek. In 1600 words, that would be pretty hard. I was addressing a certain argument made about our current economic situation that is associated with what is popularly described as Austrian Business Cycle Theory (ABCT), and I noted its tenuous basis in the work of Mises and Hayek. I myself have pointed out that Hayek’s Monetary Theory and the Trade Cycle offered an endogenous theory that did not assign a causal role to the central bank in generating the cycle. But in Prices and Production and in his policy pronouncements in the early 1930s Hayek did attribute a causal role to central bank monetary expansion in causing the 1929-30 downturn. You make all kind of general statements about what Hayek showed or didn’t show, and then say that I should have “engaged” with them. Why don’t you offer me a specific argument or reference in Hayek for me to “engage” with instead of accusing me of ignoring him. That would be a more productive way to “engage” me in a useful conversation about Hayek than just accusing me of creating a “stick figure” to talk about. And I never denied, indeed I explicitly asserted, that Mises and Hayek talked about fiat money. I happen to think that their arguments did not prove that central bank expansion was unsustainable. I agree with them that there could be some cyclical effects associated with a central bank expansion, but they did not demonstrate that the expansion would have to be reversed or that the real adjustment to the expansion would involve a “crisis” at the turning point.

    Andrew, I may have been unfair to Sraffa as you say. Not having read any of his later work and little of his early work, I was relying on second-hand representations that attribute to him the assumption of a fixed proportions technology. Thanks also for the reference to the Florida real estate bubble in the 1920s. My point, however, is that the repercussions of these temporary resource shortages cannot be explained simply by real effects. There has to be a macroeconomic (monetary) explanation conjoined to it.

    Frank, You may have a point there, but I don’t think that change in the method of computing the CPI by itself explains what happened. You have to assume that the Fed had a kind of tunnel vision in focusing only on the CPI without paying attention to what was happening to the rest of the economy.

    Madjay, The theory is that central banks depress real interest rates by supplying newly created cash to supplement the voluntary savings of households. The total of voluntary savings plus newly created cash exceeds the desired debt so that real interest rates fall.

    reason, Fair point.

    PeterP, Without endorsing MMT, I agree that the early Mises-Hayek version of ABCT, an explanation of the 19th century business cycle, was built on the assumption of an operative gold standard. The point was –originally — to explain a particular set of historical phenomena, not to describe the workings of an ideal economic system.

    Greg, You again offer categorical assertions about what Hayek wrote without even a single quotation or reference, presumably expecting me to “engage” with the invisible Hayek residing in your mind rather in the tangible Hayek whose words I can actually read.

    Harry, I am certainly no fan of DSGE modeling, and I don’t think you are understanding me very well if you think that is the argument that I am making.

    Bob, I don’t think your conclusions about the effects of the mispricing associated with below-market interest rates follow from your assumptions. Just because an investment project is undertaken based on a mistaken assumption about future prices does not mean that the entire project becomes unsustainable when prices turn out to be different from what they are expected to be. Full costs may not be recovered, but for the project to be unsustainable even variable costs cannot be recovered. There is no proof that I am aware of that shows that variable costs are not recoverable.

    Ralph, Banks that create deposits out of thin air must induce depositors to continue to hold those deposits. If the deposits were not being held willingly then there would be an increase in prices and total spending. If prices and spending are not increasing by more than the targets for prices and spending, banks are not creating too many deposits.

    Greg, Thanks for the lecture on the similarities between Darwin and Hayek.

    Julian, Even though the choice of Myrdal and Hayek as co-winners of the Nobel Prize in 1974 was widely thought to be implausible, there were actually some interesting similarities in their monetary theoretical work, which in both cases was heavily indebted to Wicksell.

    Donald, Thanks for the historical reference.

  24. 24 Frank Restly October 5, 2012 at 12:43 pm

    “Frank, You may have a point there, but I don’t think that change in the method of computing the CPI by itself explains what happened. You have to assume that the Fed had a kind of tunnel vision in focusing only on the CPI without paying attention to what was happening to the rest of the economy.”

    If you go back and read the fed minutes prior to and leading up to the housing bubble and crash you would realize that the Fed did not have tunnel vision per se, but instead they were led by Alan Greenspan’s matra –

    “It is not the Fed’s role to interfere in the market pricing mechanism, it is the Fed’s role to clean up the mess after markets fall apart”.

    In Fed speak, that literally means provide liquidity – lend when no one else will. The Fed was well aware of what was happening. They just felt that it wasn’t their responsibility to do anything about it.

    That view is a bit of odds with the regulatory powers that are given to the Fed including Regulation T which gives the Fed the power to regulate margin requirements for securities brokers and dealers and Regulation C which gives the Fed the power to regulate SOME mortgage originators.

    There was more to the housing bubble than just the Fed and changes made to the CPI. The entirety of Congress, the President, and the financial sector was cheering the housing bubble on, just as they were cheering on tech stocks during Clinton’s administration.

  25. 25 Jon Finegold October 5, 2012 at 2:15 pm

    This post deserves a longer reply, but I’d like to address one concern. You write,

    But why doesn’t that drop in resource prices restore the profitability of all the investment projects and production processes just abandoned?

    Actually, Hayek makes this point in, if I remember correctly, “Investment That Raises the Demand for Capital.”

  26. 26 Mark Stamatakos October 5, 2012 at 3:31 pm

    Madjay,

    You may be right on the wages. My pay has been stagnant for the last 4 years as my district has frozen what I earn. I do see that if my wages are stuck, modest price increases around me may seem to “feel” like the apocalypse when it isn’t the case.

    But with all due respect to your view, certain sectors of consumer spending that are spiraling out of control seem to make falling wages a moot point. I don’t know how you, or any economist for that matter, can argue with me that college tuition costs are following some sort of normal inflationary growth curve. Ditto on health care premiums and basic food costs. No way. I’d argue, although weakly at best because I don’t quite no how to explain it, that Fed policy of expanding the money supply MIGHT be having something to do with it.

    David, the host here, and I got into it a few times about vibes I was putting out there that I amount to…”conspiracy” theories about the evil nature of government and, by proxy, the Federal Reserve. I do not think that at all. But I do think that running massive Federal Deficits from our Congress, followed by ever more frequent injections of imaginary currency, is not good for people in the middle class. I have read enough to be convinced that sort of pattern is destructive.

    If Krugman is right, and we need to stimulate the economy as aggressively as possible BEFORE moving into deficit hawk mode, than at that point the question becomes how much is needed to do this? 787 billion was not enough. Will another 40 billion a month be?

    I hope I am wrong, and I hope I am just another ignorant American when it comes to understanding what is really at the core of our economic solutions.
    But the longer this goes on, the more I believe that what we have today is beyond the grasp of our most talented economists.

  27. 27 Rob Rawlings October 5, 2012 at 3:50 pm

    “Just because an investment project is undertaken based on a mistaken assumption about future prices does not mean that the entire project becomes unsustainable when prices turn out to be different from what they are expected to be”

    I agree that some projects will still be viable to get to completion even if profits are less than anticipated. My point rather was not about individual projects but rather the overall structure of production. In the process of moving from the distorted structure shaped by low interest rates, back to the optimal structure shaped by natural interest rates, even if deflation can be avoided by good monetary policy, there will still likely be a dip in RGDP as the transition takes place. This will be partially because some projects started in the boom will not cover even variable costs and be closed dwon, and partially because it will take time for new projects appropriate for the optimal structure to reach maturity and their peak output levels

  28. 28 Frank Restly October 5, 2012 at 6:58 pm

    Mark,

    “If Krugman is right, and we need to stimulate the economy as aggressively as possible BEFORE moving into deficit hawk mode, than at that point the question becomes how much is needed to do this? $787 billion was not enough. Will another 40 billion a month be?”

    How secure would you be if your employer instead of paying you a regular paycheck gave you a set of “stimulus” payments – here one day and gone the next? I mean seriously. Do you feel more secure in your future knowing that if you work hard, you have a regular paycheck to depend on? I realize that your budget is strained for a lot of reasons but would stimulus from your employer instead of a paycheck make things better or worse for you?

    If so then why do you believe that government “stimulus” is a good solution? Would you not prefer a contract from the federal government that is not subject to political whims – here one year, gone the next? I mean that is all that stimulus is – a political solution to what should be a straightforward economic problem. The reason that politicians love stimulus is that it builds dependency – not on government itself, but on the party handing out the stimulus packages.

    Krugman is also convinced that “confidence is a fairy” and is not important. You have laid out your economic situation and I am sure there are millions of people across this country that are in a similar situation. Do you feel confident that your economic situation will improve or is confidence not all that important to you?

    My own personal beliefs are that the only way you build confidence with a political organization like the federal government is with contracts. Long term contracts (30 years) are better than short term (4 year election cycle or less).

    Also, have you bothered to ask yourself why government deficits matter? The federal government (unlike a private individual or company) cannot go bankrupt and does not operate to turn a profit. Deficits must be financed by selling a liability aka a contract. What Paul Krugman hasn’t told you is that the federal government can sell equity contracts instead of debt contracts. And guess who might buy those equity contracts – YOU.

  29. 29 Mark Stamatakos October 6, 2012 at 8:35 am

    Frank,

    I am not a fan of stimulus, deficits, or any other current Fed policies. I asked those questions about massive spending then deficit hawking more out of disdain than anything else. Maybe you misread my posts, but I agree with your general positions to the degree I can understand them.

    The sick feeling I have in my stomach though is that inflation as I understand it is really NOT happening, and I am simply suffering from some kind of cognitive illusion. In my frustrations with my wage freeze for four years now, am I displacing that anger into convincing myself that the expanding the currency is causing inflation? I guess I just don’t understand it enough to get it. Maybe the deficit spending really does have nothing to do with it. Maybe its other factors I do not understand.

    Here is what I do get. I am tired of economists explaining away to me “aggregate” explanations for why certain sectors of our economy are expanding over 2% inflation. They are apparently not interested in any micro-economic explanations. College tuition costs, and the three kids I have who will soon be entering into indentured servititude to participate in, are a direct/indirect result of the government getting in the business of doling out federal loans. Same goes for housing and medical care. Government gets involved, things get handed out, costs spiral. I understand that a truly free market for college opportunity (with solely private banks or the colleges themselves supplying the financing) is not perfect either, but with government involved these college wonks understand that students will pay any cost to get that piece of paper.

    So I would sincerely wish that the “experts” who look at me like some caveman still trying to invent the wheel would stop referencing a CPI chart or some other government graph and look at the same data. I also don’t accept CPI at its premise. Don’t tell me electronics are cheaper so I should be saving money. If you want to tell me stimulus and injections of currency help the economy, SEND ME THE DAMN MONEY into my kids 529 plans or help me with a remodification of my 2nd mortgage (which I can no longer refinance due to lacking 20% equity). Instead, where does this stimulus money go…into the hands of governments, bureaucrats, bankers, and foreign central banks all over the world. And this is helping me?

  30. 30 Frank Restly October 6, 2012 at 9:22 am

    Mark,

    “The sick feeling I have in my stomach though is that inflation as I understand it is really NOT happening, and I am simply suffering from some kind of cognitive illusion. In my frustrations with my wage freeze for four years now, am I displacing that anger into convincing myself that the expanding the currency is causing inflation? I guess I just don’t understand it enough to get it. Maybe the deficit spending really does have nothing to do with it. Maybe its other factors I do not understand.”

    You are not suffering from cognitive illusion. Expanding currency in and of itself is not inflationary – what matters is what that expanded currency is used for that is important.

    1. What is the cause of inflation? Ultimately it is the demand for goods exceeding the supply of said goods. Those goods are paid for with money.

    2. How does money begin? Money begins when either you, me, or Joe Dupree borrow that money into existence. We borrow from our bank, who in turn borrows it from another bank, who in turn borrows it from the federal reserve, who in turn lends it into existence.

    3. How is the federal government involved? The federal government can also borrow money into existence. But because the federal government can only create a demand for goods without increasing the supply of goods, its excess demand creates inflationary pressure.

    4. How are interest rates involved in containing inflation? The federal reserve buys and sells government debt to set interest rates. When the interest rate on government debt is higher than the rate of inflation, it can depress private demand for goods while government demand for goods remains high.

    5. But don’t high interest rates also affect production? Most large companies can either borrow money or sell equity to fund production. And so the effect of interest rates on production is not direct. But of course not all companies have equity financing available. And so there are certain provisions in the tax code that lessen the borrowing cost for what the federal government deems to be productive enterprises – mortgage interest, student loan interest, corporate interest, etc.

    So what can the federal government do to help you? Simple, stay out of wars – they are non-productive enterprises. Keep the return on government liabilities (debt and equity) above the rate of inflation – their liabilities become your assets.

    Macroeconomics is really not that hard. Three simple rules.
    1. The federal government cannot go bankrupt
    2. The real value (inflation adjusted) of all government liabilities shall be high, those government liabilities become private sector assets
    3. For God’s sake stay away from micro-economists. They try to compare government finance with private sector finance and screw everything up.

  31. 31 David Glasner October 6, 2012 at 7:49 pm

    Frank, I agree that there was a lot of cheer-leading going on for the housing bubble. In principle I don’t think that it is up to the Fed to decide which asset prices are mispriced and take steps to bring asset prices in line. The Fed has statutory authority over margin requirements, but I don’t know that its track record in adjusting them inspires great confidence.

    Jon, Thanks for the reference. I just read the paper quickly – it’s included in his collection Profits, Interest and Investment. It is related to the point I am making, but comes at it from a different angle, so I am not quite sure what conclusions to draw from it.

    Rob, I don’t disagree that there may have to be some transition in the capital structure, but the allocation of resources in any dynamic economy is always changing as a result of new technologies, changing tastes and fashions, and a 116 other disturbances that are routinely occurring in such an economy, so it’s not clear to me why a restructuring of an economy’s capital structure has to result in a major shock to the time path of GDP (real or nominal). In addition, my contention is that a permanent increase of the money supply, by causing a shift in the distribution of purchasing power, could cause a corresponding shift in the optimal capital structure, so that I don’t see why the original capital structure before the money supply started to increase has some sort of sacrosanct status.

  32. 32 Frank Restly October 7, 2012 at 8:43 am

    David,

    Back to my statement:

    “It is not the Fed’s role to interfere in the market pricing mechanism, it is the Fed’s role to clean up the mess after markets fall apart”.

    “In Fed speak, that literally means provide liquidity – lend when no one else will. The Fed was well aware of what was happening. They just felt that it wasn’t their responsibility to do anything about it.”

    And then your statement:

    “In principle I don’t think that it is up to the Fed to decide which asset prices are mispriced and take steps to bring asset prices in line.”

    I would agree, it is not up to the Fed to decide which asset prices are misplaced. The Fed’s only job is to provide liquidity. And so whose job is it to ensure that the private sector does not borrow it’s way into insolvency?

    That is what is slowly happening.

    From the Fed’s flow of funds report

    1959: Household Sector Assets – $2.01 trillion
    Household Sector Liabilities – $206.6 billion
    Asset / Liability Ratio – 9.73 to 1

    2012: Household Sector Assets – $76.1 trillion
    Household Sector Liabilities – $13.5 trillion
    Asset / Liability Ratio – 5.63 to 1

    Far from becoming wealthier, the household sector is slowly borrowing its way to insolvency. That is what happens when you try to consume more than you produce and borrow to make up the difference. Your asset / liability ratio will eventually go below 1.

    Whose job is it to make sure this does not happen? The federal government. Why can they do this? Because the federal government does not have bankruptcy nor solvency risk. How do they do this?

    1. Borrow money, spend it – of course this is fraught with politics both from the right and from the left.

    2. Sell a liability to the private sector that has a higher future value than the future value of private sector liabilities. In short sell government equity.

    Selling government equity would require a Treasury Secretary that understands macroeconomics and those are few and far between.

  33. 33 Taz von Gleichen October 7, 2012 at 9:43 am

    Quiet technically, and long article. I would always rather go with the austrian theory instead of keynesian money printing.

  34. 34 Blue Aurora October 7, 2012 at 1:47 pm

    Excellent post, David Glasner. Sorry to go off-topic, but did you receive my e-mail?

  35. 35 John October 8, 2012 at 6:42 am

    Mark Toma has up a nice paragraph today, explaining why the Austrians don’t have a clue:

    It turns out the villain in the DSGE approach is the S term, for stochastic processes, meaning a view of the economy as probabilistic system … as opposed to a deterministic one… It is … when economists begin to speak of shocks that matters become hazy. Shocks of various sorts have been familiar to economists ever since the 1930s, when the Ukrainian statistician Eugen Slutsky introduced the idea of sudden and unexpected concatenations of random events as perhaps a better way of thinking about the sources of business cycles than the prevailing view of too-good-a-time-at-the punch-bowl as the underlying mechanism.

    http://economistsview.typepad.com/economistsview/2012/10/what-really-happened.html

  36. 36 Frank Restly October 8, 2012 at 12:32 pm

    “Gorton’s case is ostensibly simple. Where there are banking systems, he says, there will be periodic runs on them, episodes in which everyone tries to turn his claim into cash at the same time. He sets out the pattern this way:”

    •Crises have happened throughout the history of market economies.

    •They are about demands for cash in exchange for bank debt — debt which takes many different forms, not just retail deposits.”

    Really they are about demands for liquid assets. In an electronic bartering system no currency may be used, but that does not mean that all goods and services are equally liquid. And so a flight from illiquid assets to liquid assets could occur without cash existing in any form.

    “•The demands for cash are on such a scale – often the whole banking system is run on – that it is not possible to meet those demands, because the assets of the banking system cannot be sold en masse without their prices plummeting.”

    And so what is needed is not more liquidity but instead better assets. I mean ultimately that is what causes a bank run, a lack of confidence in the valuation of assets. More liquidity won’t solve a thing.

    “•Preventing depression means saving the banks and bankers. As Treasury Secretary Timothy Geithner put it: what feels just and fair is the opposite of what’s required for a just and fair outcome.”

    Again, Treasury Secretaries need to been better versed in economics. You cannot address a solvency issue with liquidity. The way you address solvency issues is with better assets. The only enterprise that can sell better assets is the federal government because they have no solvency risk.

    And those federal government liabilities which become private sector assets do no have to be debt. They can just as easily be equity.

  37. 37 Greg Hill October 8, 2012 at 4:17 pm

    David, great post and you demonstrate admirable patience in replying to comments. You might find this interesting; it covers similar territory: http://www.the-human-predicament.com/2012/03/is-austrian-view-of-great-recession.html

  38. 38 JP Koning October 9, 2012 at 8:05 am

    David,

    George Selgin mentioned Friedman’s plucking model in his post:

    “According to the plucking model, output drops below its “natural” rate whenever slow spending occurs, because there’s a fair degree of downward rigidity in prices and wages. But output seldom rises much above its natural rate, because prices and wages are relatively flexible upwards, so that rapid demand growth tends instead to manifest itself in corresponding upward price movements. ”

    Where do you stand on that? Are there any real effects of an easy monetary policy? That seems to be the bone of contention here. George sees massive real disturbances… my reading of your post is that you don’t see such a policy causing the sorts of disturbances that wouldn’t otherwise occur under normal circumstances (ie “Malinvestments occur all the time”). You seem to buy the idea that lower than normal rates would result in more roundabout production processes (ie. “Although it is not without merit”), but this doesn’t seem to be a problem to you (ie. “might be carried on indefinitely”).

    If so, why not just keep interest rates at 0% all the time? That way you avoid any chance of ever having interest rates above the natural rate, which is when the real damage is inflicted, at least according to the Friedman plucking model.

  39. 39 Pete October 9, 2012 at 7:56 pm

    David,

    Robert P. Murphy responds to your blog post:

    http://consultingbyrpm.com/blog/2012/10/david-glasner-needs-to-re-read-mises.html

    He shows that you are missing huge chunks of Mises’ work that specifically warned against your interpretation of ABCT.

  40. 40 Bill Woolsey October 10, 2012 at 4:52 am

    Using a consumer price index as a target for monetary policy could result in problems like Selgin described. However, nominal GDP targeting looks at the prices and quantities of all currently produced goods and services. This includes capital goods, houses, and intermediate goods.

    So a housing bubble might not show up in the CPI. With a Taylor rule, it might show up as an ouptut gap, actual production rising above potential. Unfortunately, potential output isn’t easy to measure.

    Anyway, I think that a permanent acceleration of money growth, an increase in the inflation target, or an increase in the target growth rate of nominal GDP would not result in crisis but rather gradual liquidation of any malinvestments that developed because entrepreneurs failed to immediately adjust to the new growth rate and path of spending on output.

    However, to understand where Austrians go wrong, assume interest rate targeting (not money supply growth, inflation or nominal GDP targeting.) Further, suppose the interest rate is being targeted an a very unrealistic level. For example, a zero nominal interest rate. Further, imagine this is a public policy that is supposed to be maintained permanently. With our new monetary policy, we will keep nominal interest rates at zero forever.

    As price inflation shows up, this is blamed on one time events, speculators, who knows. The nominal interest is going to stay zero.

    Now, it is possible that the business community will never buy into the policy, but lets give the effort the benefit of the doubt. Entrepreneurs believe the policy will work, and begin levels of investment consistent with zero interest rates.

    Well, the price inflation is going to head towards hyperinflation with this insane policy. And when they finally give up on it, there is a sudden large increase in the interest rate. And now all of those investments that were only profitable at much lower interest rates become unprofitable.

    The demand for consumer goods (and capital goods that can produce consumer goods in the near future) rise. And the demand for some other capital goods fall. So there is a need to reallocate resources. To the degree that the low interest rates have shifted factor shares of income, real wages perhaps might fall. To the degree that money illusion was stripped away by the accelerating inflation and real wages are sticky, this could be difficult. Yes, if nominal wages need to drop, that will be diffficult, but higher output prices will result in demands for higher nominal wages, leaving the real wage/unemployment problem unchanged.

    Now, after you think about this scenario, imagine that any policy that expands the quantity of money or raises spending on output “too high” perhaps at all, but maybe more than 2 percent, will have the same effect, but hopefully not to such an extreme.

    My view is that this “keep interest rates absurdly low as a monetary regime and then give up just before hyperinflation” tells us next to nothing about what happens in the real world.

    Errors in an inflation targeting regime or a nominal GDP regime are nothing like this. Even shifts from a constant quantity of money to a slow growth in the quantity of money, or from modest deflation to modest inflation, or contstant nominal GDP to modes nominal GDP growth, happen nothing like this.

    In the real world, the target for the short term interset rate isn’t fixed. A Taylor rule approach says that its value will change based on what happens to inflation and the output gap in the future. Interest rates “too low for too long” will generate higher interest rates in the future. A suddent break in long term interest rates is going to be due to entrepreneurs (or at least bond speculaors) having a large change in their expectations of the future natural interest rate.

    And, of course, the real world of the gold standard was nothing like “keep interest rates absurdly low until it becomes impossible and entreprenuers buy into the policy” world.

  41. 41 Jon Finegold October 10, 2012 at 10:44 am

    Bill Woosley writes,

    Interest rates “too low for too long” will generate higher interest rates in the future.

    Actually, Mises explicitly agrees with this.

  42. 42 David Glasner October 10, 2012 at 1:54 pm

    Frank, I am not sure that it is anyone’s job to ensure that the private sector doesn’t borrow its way into insolvency. Lenders and borrowers should both have an interest in avoiding that outcome. I any third party has a role in preventing lenders and borrowers from plunging themselves into insolvency it is presumably the legislative and the executive branches rather than the Fed.

    The last time I asked you for a historical precedent for governments “selling” equity claims as an alternative to selling debt, the only example you provided was social security, which is technically a subordinate obligation relative to debt obligations, but individuals generally have little discretion in how much social security claims they accumulate against the government, those obligations being tied fairly tightly to the employment decisions that individuals make. So I really am pretty much in the dark about how you propose that the government sell equity claims. The best I can come up with is that you propose that the government allow people to prepay future taxes in the present at some market determined rate of exchange between current dollars and future tax liabilities. Is that what you have in mind?

    Taz, Keynesians aren’t the only ones in favor of money printing.

    Blue Aurora, Thanks, and yes, I did. I have just sent you reply.

    John, Thanks for the link and the excerpt. There’s a lot to chew on, but it’s not just the Austrians.

    Frank, I agree that liquidity and solvency are not the same. But sometimes, illiquidity can lead to insolvency. The 2008 crisis arose because there was a fear of insolvency that was not necessarily the result of illiquidity, but that does not mean that liquidity problems were not also complicating the picture.

    Greg, Thanks so much for your kind words and the link. I liked your post, which correctly identifies a a another problem with ABCT than the ones I wrote about. Actually, as Gillian Tett explained in her book on the crisis, JP Morgan (and Jamie Daimon) emerged as the premier international bank (and the world’s top banker) by not following the Citibank model which is what ABCT suggests is rational for individual banks.

    JP, My point was not that you can’t get into trouble by keeping nominal rates too low. Rather my point is that nominal rates will tend to adjust back to the Wicksellian natural rate (I am using that as a short-hand expression even though I think it is a problematic term). At that point, the system tends toward a new equilibrium and there may be an adjustment process involving some waste of capital, but there need be no crisis of the kind envisioned by ABCT.

    Pete, Thanks for the reference. I think there is a bit of semantic confusion on everyone’s part here, which I will try to clear up in a new post in the near future.

    Bill, Thanks for that clear exposition, which I think is spot on.

    Jon, Mises was actually right a fair amount of the time, just not as often as ABCT people imagine. Actually, no mortal was ever right as often as ABCT people think Mises was.

  43. 43 Frank Restly October 10, 2012 at 6:06 pm

    David,

    “Frank, I am not sure that it is anyone’s job to ensure that the private sector doesn’t borrow its way into insolvency. Lenders and borrowers should both have an interest in avoiding that outcome.”

    The lender’s incentive in avoiding that outcome is dissolved whenever it decides to parlay its loans off to a third party. While this has the effect of sharing interest payments throughout an economy, it also without strong regulation has the perverse effect of lessening credit underwriting standards (see Federal Reserve Regulation Part T concerning mortgage underwriting). The writers of this regulation (Congress) did indeed believe that “someone” should ensure that a mortgage borrower should have some reasonable means of paying off the loan. The Fed threw up its hands and said – nah, we don’t want to do that.

    “If any third party has a role in preventing lenders and borrowers from plunging themselves into insolvency it is presumably the legislative and the executive branches rather than the Fed.”

    And so we agree. The easiest and most non-intrusive way for Congress to do that is to sell equity that has a higher future value than the private cost of debt service. While this will not prevent bankruptcies from happening (generally a liquidity issue), it would prevent mass insolvency from dragging the whole economic system down.

    The Obama administration believes otherwise which is why they have proposed mortgage modifications for underwater homeowners. In my view this a microeconomic approach to a macroeconomic problem. It tries to address the issue by looking in the rear view mirror without understanding the fundamental problem with credit based currencies.

    And really Congress and the federal reserve ran into this problem during the S&L crisis and housing bust of the 1980’s. Apparently they didn’t bother to learn anything from the past, and as history shows, were doomed to repeat the same mistakes and make some even bigger ones.

    “So I really am pretty much in the dark about how you propose that the government sell equity claims. The best I can come up with is that you propose that the government allow people to prepay future taxes in the present at some market determined rate of exchange between current dollars and future tax liabilities. Is that what you have in mind?”

    Yes, exactly. And when the future value of that equity exceeds the future value of private debt, then solvency issues go away completely. Mind you that a borrower still faces bankruptcy risk. Government equity being non-guaranteed, means that buyers of that equity must still exert productive effort to realize the rate of return and must still find buyers for the goods and services that they offer to make debt service payments. But, the price adjustment process on the goods and services that are offered is no longer downwardly rigid. Meaning deflation can happen without threatening solvency.

  44. 44 Frank Restly October 10, 2012 at 6:46 pm

    David,

    The following link was brought to my attention concerning the “Chicago Plan” that was devised by a number of astute economists during the Great Depression.

    http://www.imf.org/external/pubs/ft/wp/2012/wp12202.pdf

    This paper also makes allusions to “government equity” here:

    “In this context it is critical to realize that the stock of reserves, or money, newly issued by the government is not a debt of the government. The reason is that fiat money is not redeemable, in that holders of money cannot claim repayment in something other than money.1 Money is therefore properly treated as government equity rather than government debt, which is exactly how treasury coin is currently treated under U.S. accounting conventions (Federal Accounting Standards Advisory Board (2012)).”

    This interpretation of money newly issued by the government being treated as government equity is problematic. Equity, properly defined in any accounting context, is the residual claim on a property / cash flow after all senior claims have been made whole. By this definition, there is implied risk to the holders of equity that at some point, the valuation of the senior claims on that property / cash flow could exceed the market value of the property / cash flow itself.

    Money as a medium of exchange, should not bear equity type risk. That is ultimately how hyper-inflations happen. Meaning that demands for a riskless asset used as a medium of exchange should not be confused with demands for a risk asset used to finance government expenditures.

  45. 45 JP Koning October 11, 2012 at 7:58 pm

    David: “(I am using that as a short-hand expression even though I think it is a problematic term)”

    Why’s that? Does it have something to do with this post?

    http://uneasymoney.com/2011/09/09/sraffa-v-hayek-2/

  46. 46 David Glasner November 4, 2012 at 3:09 pm

    Frank, OK I agree that when lenders’ incentives to lend are distorted because they can shift the risk of default onto others there is an important role for some government agency to play in correcting those incentives so that lenders do not have an incentive to overextend credit. And I agree that that misalignment of incentives was an important part of what went wrong before the financial crisis of 2008. I understood you to be saying something different. But if that is what you meant, then we agree. Indeed for this kind of misalignment I think regulation not just legislative action is appropriate.

    Sorry, but I am still trying to get my arms around how your proposal would work in practice, so I will have to save a response for some later date.

    JP, Yes, but it has to do more with Keynes’s rejection of the concept in the General Theory in which he argued that there is a unique natural rate for every level of employment. I don’t know about that, but I think that the “natural rate” is definitely sensitive to expectations about the future economic conditions. The same insight also comes out of Thompson’s reformulation model.

  47. 47 Daniel Mendonca October 6, 2013 at 1:04 am

    Greg Ransom correctly pointed out that the arguments against Austrian Business Cycle presented here are only against a straw man target. ABCT deeply analyses pure fiat money regimes, unlike surperficial arguments like that the “original Austrian theory of the business cycle was thus a theory specific to the historical conditions associated with classical gold standard.”
    The truth is, as Greg Ransom pointed out, if you understand the macroeconomic issues and capital structure analysis by Mises and Hayek, these investments in longer and more roundabout process of production and capital, turn out to be losses, even if there is credit to complete it, it will never be profitable.
    Consumers time preferences, the determinant of the natural interest rate, have not became larger because the government is financing these projects with fiat. As time goes by, and money circles the economy, it gets to consumers and they are not spending the money on these projects. So there comes inflation. If the mallinvestiments are still funded, inflation will grow continuously compounded. The ultimate fate of this process is an increased conciousness of inflation when even consumers want to limit their fiat funds, and that is the threshold of hyperinflation.
    Hyperinflation is the ultimate limit to fiat money supply. Hayek wrote:
    “The reason is that the artificial stimulus which inflation gives to business and employment lasts only so long as it accelerates, that is so long as prices turn out to be generally higher than expected. It clearly cannot accelerate indefinitely. But as soon as it ceases to accelerate all the windfalls which kept unprofitable businesses and employments going disappear. Every slowing dawn of inflation must produce temporary conditions of extensive failure unemployment. No inflation has yet been terminated without a “stabilization crisis”. ”
    This clearly puts the previous aurguments against Hayek being miscontructs ignorant of his actual position.

  48. 48 David Glasner October 9, 2013 at 8:07 pm

    Daniel, An investment can turn out to be unprofitable ex post, without being abandoned and turned into scrap. Austrians assume that a small rise in the rate of interest is sufficient to cause the wholesale abandonment of half finished or nearly completed investment projects. I find that assumption highly implausible. The more plausible explanation is that those investment projects are abandoned because the expected demand for the output that those projects were intended to produce has failed to materialize.


  1. 1 Economist's View: Links for 10-04-2012 Trackback on October 4, 2012 at 12:06 am
  2. 2 Browsing Catharsis – 10.05.12 « Increasing Marginal Utility Trackback on October 5, 2012 at 5:05 am
  3. 3 Two Problems with Austrian Business-Cycle Theory | poleconomix.gr Trackback on October 6, 2012 at 7:24 am
  4. 4 David Glasner Needs to Re-Read Mises Trackback on October 9, 2012 at 6:53 pm
  5. 5 Austrian Business Cycle Theory: A Comment | Economic Thought Trackback on October 10, 2012 at 10:35 am
  6. 6 On the Unsustainability of Austrian Business-Cycle Theory, Or How I Discovered that Ludwig von Mises Actually Rejected His Own Theory « Uneasy Money Trackback on October 10, 2012 at 9:57 pm
  7. 7 Admission of Error Is a Rarity in the Geeconosphere Trackback on October 15, 2012 at 7:17 am
  8. 8 The Very Smart David Glasner: Two Devastating Problems with Austrian Business-Cycle Theoryy | FavStocks Trackback on October 17, 2012 at 1:46 am
  9. 9 Two Problems with Austrian Business-Cycle Theory « Economics Info Trackback on October 17, 2012 at 11:01 am
  10. 10 And Now Here’s a Kind Word for Austrian Business Cycle Theory « Uneasy Money Trackback on October 26, 2012 at 12:03 pm
  11. 11 Austrian Business Cycle Theory [part i] « ducati998 Trackback on October 30, 2012 at 9:26 am
  12. 12 Those Dreaded Cantillon Effects « Uneasy Money Trackback on December 6, 2012 at 10:41 pm

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About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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