25 Oct 2008

Megan McArdle & ABCT: The Silly Woman Theory of Error

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Reader Bashkim Rrahmoni notified me of a Megan McArdle attack on Austrian business cycle theory. I was going to cut her some slack, but the more I thought about it, the more ridiculous her post struck me. In “The evil man theory of failure,” she tries to play it above the fray, transcending the foolishness of left and right:

Both right wing Austrians and many liberals have a common theory of how all this happened: Alan Greenspan dunnit. The mechanisms by which he accomplished his foul task are different in the two cases, of course. Austrians, and many other free-market types, believe that by lowering short-term interest rates after 9/11, Alan Greenspan made the housing bubble, and its eventual bust, inevitable. The liberals think that by failing to regulate . . . er, something (usually either mortgage originations or CDS’s) more closely, he made the crisis inevitable….

Here’s the problem: if markets are so great, how come the entire system can be brought low by a smallish injection of short-term capital? The alternative question for the liberals: if regulation is so great, how come one guy, or one fairly minor bill, can apparently single-handedly destroy the most heavily regulated industry in America that doesn’t actively involve radioactive material? If your preferred system is really that fragile, then maybe we should be looking into alternatives.

OK, we all get her point, and maybe it’s a good one with regard to the leftists. (Will Wilkinson takes this tack too, and I think he and McArdle are on to something. But that’s probably my bias talking; maybe a leftist could blow them up the way I’m about to do to McArdle.)

OK, first we’ll show the specific details of how silly McArdle’s post is (vis-a-vis the Austrians), and then we’ll pull back and do a “McArdle is a Moron” from 50,000 feet.

This “smallish injection of short-term capital” corresponded to the lowest that the Fed had set inflation-adjusted rates since 1979. I explain the matter in this piece, but here’s the relevant graph:

And note too in the above chart, it’s not like Greenspan had cheap credit for three weeks or something. He held the (nominal) fed funds rate at a ridiculous 1% for an entire year. And the year in question was June 2003 to June 2004. Did that coincide at all with the housing boom? Surely a coincidence.

OK sure, Greenspan made credit really cheap. But maybe that was partly a result of the infusion of foreign investment, the bogeyman that Tyler Cowen and Alan Greenspan are blaming. (“And my scheme would’ve worked, too, if it hadn’t been for those meddling savers in China!”) So let’s just look at something that Greenspan directly controlled, namely the monetary base. The below chart shows the absolute change in the monetary base from the prior year; so be careful, this is in dollars, not percentages:

As you can see, Greenspan let the base grow far more than at any time in prior US history. (The big spike up and down is because of the Y2K scare; they flooded the system with liquidity so people wouldn’t pull out their money. Also, in % terms Greenspan’s actions were not unprecedented, but still significant.) From January 2001 to June 2004, the monetary base grew by $154 billion–and remember, this is the base of the money-and-credit pyramid. I know Ms. McArdle gets a lot more readers than I do, but still, if she considers $154 billion in base money just a “smallish injection”–te salute, Ms. McArdle!

Finally, the big picture: Suppose I blamed the economic disaster in interwar Germany on the guy(s) running the printing press. Would McArdle ridicule that as an evil Kraut theory?

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