Guest post by Hal Snarr
In a 2010 Bloomberg Television interview, former Federal Reserve chairman Alan Greenspan said, “The general notion the Fed was propagator of the bubble by monetary policy does not hold up to the evidence. ... Everybody missed it — academia, the Federal Reserve, all regulators.”
Everybody missed it? Not according to Axel Leijonhufvud. In 2008 he wrote, “Operating an interest-targeting regime keying on the CPI, the Fed was lured into keeping interest rates far too low far too long. The result was inflation of asset prices combined with a general deterioration of credit ... a variation on the Austrian overinvestment1 theme.” Randall Forsyth concurred, writing in early 2009, “The Austrians were the ones who could see the seeds of collapse in the successive credit booms, aided and abetted by Fed policies.”
So, no, Alan. You missed it. Most mainstream economists missed it. Austrian economists didn’t miss it.
The Failure of the Mainstream
Despite the unprecedented fiscal and monetary action taken by the Bush and Obama administrations, which pushed the per capita budget deficit to more than twice the previous record, and the Fed, which quadrupled its balance sheet, the U.S. economy continues to be stuck in a deep recessionary gap. Instead of acknowledging the failure of these actions, policy makers have doubled down. As the Fed continues to print money to buy securities directly from Treasury and hold rates near zero, asset bubbles are reflating, excess reserves have exploded, and bad economic news pushes stock markets ever higher. Yet with the pedal pushed to the metal and no spark from the engine, economists surveyed by the National Association for Business Economics in 2012 said they wanted current American fiscal or monetary policy to continue. A year later, economists in that same survey still said monetary policy was about right.
In a 2013 New York Times column, Paul Krugman acknowledged that the housing bubble he had prescribed for the 2001 recession had resulted “in the greatest economic crisis since the 1930s,” but called for the Fed to ignore the “babbling barons of bubbleism, and get on with doing [its] job” of fighting high unemployment. And creating bubbles.
Money printing and low interest rates are clearly one part of a much broader problem.
The system the Fed oversees is wracked with moral hazard. Lenders make riskier loans than they otherwise would knowing their back is covered by the government – by the Federal Deposit Insurance Corporation, by the Fed as “lender of last resort,” by the too-big-to-fail doctrine, and by mortgage securitisation by Fannie and Freddie. Privatised risks; socialised losses.
All these backstops are necessary because fractional reserve banking is inherently unstable. The money that is lent into existence can vanish at a moment’s notice. The bank panic sparked by the Lehman Brothers collapse resulted in a massive shortage of reserves that was filled with a 578 percent increase in discount loans.
Although economic prosperity is linked to core tenets of Austrian economics, namely economic and political freedom, the school is routinely dismissed by the very mainstream macroeconomists who called for bubbles, missed the calamity, and now say they know how to fix it. (We’re talking about you, Paul Krugman.)
This is so despite, in markets that are relatively free of government intervention (e.g., cellular phones, televisions, software, computers), prices are falling, quality is rising, and consumer choice is increasing.
On the other hand, in industries owned, managed or heavily regulated by government (e.g., banking, education, healthcare, housing), what is typical is inflation, stagnant quality, inefficiency, bailouts and moral hazard.
Yet despite having reality on its side, the Austrian school has not gained wider acceptance. This is perhaps due to mainstream macroeconomics offering sellable solutions to politicians. Whereas Austrian economists generally refuse to support politically-popular welfare programs when unemployment is high, mainstream macroeconomists do not. Keynesian “solutions” like public works projects, extensions to unemployment insurance compensation, and payroll tax cuts, are well-received among politicians and working-class voters. Supply-side and Chicago-School policy prescriptions too, like fiddling with capital gains taxes and interest rates, and minor deregulation, find some appeal.
Mainstream macroeconomics’ sellable solutions have consequences however – consequences fixed with additional interventions. The American tax code has nearly doubled in length to over 70,000 pages in twenty years, yet the loopholes still remain, and the pages keep growing. During that same period, over 1.4 million pages have been added to the Federal Register, yet mistakes continue to happen, and re-regulation continues apace. During the last five years, the Fed has held rates near zero and paid banks to not make loans. Consequently, the accumulation of intervention has coincided with long-run growth slowing to a crawl.
How does mainstream macroeconomics miss all this, and why has it doubled down on policies that appear to be setting the table for future asset bubbles and financial crises?
The fatal conceit of mainstream macroeconomics is too much aggregation.
The answer to excessive aggregation is Roger Garrison’s Capital Based Macroeconomics. Garrison’s capital-based overview avoids mainstream macroeconomics’ fatal conceit by disaggregating economic output into its stages of production.
Expenditures on first stage capital goods, like rubber and steel, were committed to the production of second stage capital goods two periods ago. Expenditures on second stage capital goods, like tires and engines, were committed to the production of final goods last period. Adding these expenditures gives mainstream macroeconomics’ investment expenditures, which ignores the inter-temporal allocation of resources. Expenditures on final stage goods, like automobiles, are known as consumer expenditures in both macroeconomic views.
In capital-based macroeconomics, consumption and investment are more realistically modelled as short-run tradeoffs (right). When consumers save more (and consume less), the supply of loanable funds rises. This lowers interest rates and raises investment in the earlier stages of the disaggregated capital structure, (even as consumption and profits fall in the later stages that are less affected by interest rates).
Increased saving and lower interest rates results in a deepening of the capital structure. Shrinking profits prompts innovation. Lower interest rates promote the discoveries, production, and adoption of new products and cost-saving technologies.
In the segmented labour markets of capital-based macroeconomics, wages do not all fall when consumption declines, as they do in mainstream macroeconomics. Though falling consumption decreases wages in the final stage, wages in earlier stages rise as firms redirect resources. The widening wage differential draws workers to earlier production stages. This migration reduces final stage labour supply, and raises earlier stage labour supply, resulting in the final stage wage rising up toward the wages that prevail in earlier expanding stages.
After savings-induced investments have worked their way through the economy, the productive capacity of the economy has expanded, resulting in higher overall consumption. Though this contradicts Keynes’s so-called Paradox of Thrift, it is the process by which economies sustainably progress.
It does not work well when government interferes in markets, however. Especially not under a regime that makes wages and prices sticky, and interest rates centrally planned.
These last two are linked. Because persistently high unemployment is the unintended consequence of wages made artificially sticky, the mainstream “cure” is monetary intervention.
But the cure is worse than the disease. When the central bank creates this counterfeit capital interest rates fall and investment increases, all while savings decline – the very opposite of how it would work without the central bank’s meddling. This drives a wedge between production in earlier and later stages, and between investment and savings precisely equal to the amount of money that the Fed creates. The resulting malinvestment and overconsumption represent a competition for resources, pushing asset prices ever higher and the economy beyond its productive capacity. This is what Austrians refer to as a central bank-induced boom.
The boom is unsustainable. Investment and consumption are higher than they would have been in the absence of monetary intervention. As asset bubbles inflate, yields increase, but so too do inflation expectations. To dampen inflation expectations, the Fed withdraws stimulus. As soon as asset prices start to fall, yields on heavily leveraged assets are negative. As asset prices decline, increasingly more investors are underwater. Loan defaults rise as mortgage payments adjust up with rising interest rates. When asset bubbles pop, the boom becomes the bust.
Hal W. Snarr is an assistant professor of economics at Westminster College in Salt Lake City, Utah. This post first appeared at the Mises Daily. It has been slightly edited.
1. Actually malinvestment. But a good try.