28 Apr 2009

Answering Scott Sumner’s Questions About Austrians

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Scott Sumner asks some great questions about the Austrian view of the financial crisis. I’ll do my best to balance brevity against comprehensiveness in my answers.

1. Why did NGDP collapse late last year?

I’m not saying this is the whole story, and someone might plausibly say I’m confusing cause with effect, but I think the following were all involved:

(a) People panicked because they were told by “the authorities” that the entire world financial system was on the brink of collapse. So the demand for cash shot way up.

(b) The real economy was due for a serious correction after the housing boom. In this article written in September 2007 (which itself was based on an analysis I made in July 2007), I was calling for the worst recession since the early 1980s. That clearly hadn’t “hit” as of last summer, so I was not surprised that things finally started falling apart. I don’t know why it happened late last year, except to say that the Fed and Treasury had been doing unprecedented things (TAF etc.) to keep the plates spinning. Once people realized that Paulson and Bernanke were bluffing, and that they had no clue what they were doing, panic set in and people understood that there would be no magic undoing of the malinvestments of the boom years by “injecting liquidity” or other such crankish schemes.

2. Could a suitably expansionary monetary policy have stopped NGDP [nominal Gross Domestic Product] from collapsing?

Of course. What was the growth rate in Zimbabwe’s nominal GDP? (I actually don’t know but I’m assuming >> 0%.)

3. Wouldn’t Hayek have favored enough monetary expansion to keep NGDP from collapsing?

You mean Friedrich, right? If so, I’m not sure. I believe the mature Hayek thought the Fed should have prevented M1 from falling during the Great Depression, but that’s not the same thing as propping up NGDP. The best single paper on Hayek (and Robbins’) changing views of “liquidationism” in the 1930s I’ve seen is this one [pdf].

4. Hayek originally thought that the Depression was a needed corrective for the excesses and misallocations of the late 1920s. He later changed his mind and argued that the Fed should not have allowed NGDP to collapse. Was he right to change his mind?

No. Read the book.

5. If monetary policy could not have prevented an NGDP collapse, what is your story? Is it the Keynesian liquidity trap? (I assume the answer is no.)

I do not fear NGDP collapses. I eat units of food, not dollar bills.

6. If a suitably expansionary monetary policy could have prevented an NGDP collapse, should the Fed have tried to do this?

No. Please don’t ask me again.

7. If the answer is no, why not? Wouldn’t that have prevented the collapse in manufacturing in Asia late last year? What is the structural imbalance corrected by having 10s of millions of Chinese loose jobs making stuff like shoes? (Presumably there was no shoe bubble.) Are Austrians worried about the U.S. trade deficit?

Are you comparing shoemakers to prostitutes?

The world economy was in an unsustainable configuration during the boom years of 2002-2005. The flow of consumption goods (including durable goods like housing) coming out of the capital structure pipeline increased, but at the expense of necessary maintenance. See this article for a very simple, yet numerical, model of what I’m talking about.

I think he sometimes overshoots into too much “commonsense” simplicity, but I think Peter Schiff is dead right when he ridicules the notion that Asia needs US consumers to fuel their economic growth. The idea seems to be, if Asia didn’t have fat lazy Americans grabbing iPhones and plasma screens, then the Asians would be thrown out of work. That’s the crudest of…well something, I don’t know what. I wanted to say Keynesianism but I think it’s older and more primitive than that.

During the boom years, the Chinese and other net exporters were willing to ship Americans consumption goods, in exchange for a growing stockpile of claims on future income. This was clearly unsustainable. So yes, the expansion of Chinese export sectors–to the extent that they were catering to purchases made by Americans who were falsely believing themselves to be rich because of rising house and stock values–was indeed a “bubble.” If American real estate had grown at a “proper” rate, then those Chinese exporters wouldn’t have seen their demand grow so quickly.

People often ask me, “OK so what sectors were starved for capital, if you think housing, Wall Street quant departments, etc. expanded too much?” I don’t know, but if we believe in scarcity and moderately full employment of resources during 2002-2005, then there must have been such sectors. I’m a lover, not an applied economist.

I get why we needed housing to decline for eight straight quarters from mid-2006 to mid-2008, but I don’t get why we then needed to violate Hayek’s maxim to keep NGDP from falling, and let NGDP fall sharply—causing massive output declines in sectors completely unrelated to the housing bubble. Recall that those non-housing sectors held up well during the first two years of unwinding the housing bubble–so we are not just talking about manufactured goods like rugs and furniture.

I’m not sure if this answers your question, but here goes: If in August 2007 the Fed hadn’t starting cutting rates (the discount rate at the time, following next month by fed funds target rate cut), and if the government had said, “Well we live in a profit and loss economy, boys, I guess you’ll all be filing Chapter 11,” then there would have been a horrendous quarter or two. But all of the remaining assets owned by the insolvent banks and other financial institutions would have been sold off to the highest bidder, we would have had functioning asset markets, and there would have been no “credit crunch” because everybody would know exactly what the derivatives were worth, and who was holding what.

But that’s not what happened. The government made bolder and bolder moves every month, leading the insolvent firms to believe that if they could just string their investors and creditors along, eventually they would be bailed out. And they were right.

So the Austrian business cycle theory explains why there needs to be a depression following an unsustainable boom. But if the government minds its own business (or better yet, cuts spending and taxes) then the economy can recover fairly quickly.

For example, during the 1920-1921 depression, the government cut the budget outrageously (at least 30% in one year, and I believe even more from 1919 to 1920 I believe) and the NY Fed jacked its discount rate up to a record high for the 1913-1931 period. (I think the record would extend beyond 1931 but I know the above is true for sure.) You had prices fall more than 15% in one year.

So if the Keynesian or monetarist explanation of the Great Depression is right, the 1920s should have been a decade of stagnation.

And yet they weren’t; they were the Roaring Twenties. That’s because Harding didn’t do squat, and so unemployment peaked at 11.7% in 1921 and then was down to 2.4% in 1923. (See this article for more.)

I think Friedman and Schwartz were totally wrong in blaming the “inaction” of the Fed for the 1930s. Was the Fed more inactive then, compared to when it didn’t exist pre-1913? How could it possibly be that the worst depression in US history was the fault of a timid Fed, when there were several bad (but not “Great”) depressions that occurred before the Fed was created?

Oh, and one other question: As you know I am completely contemptuous of those (mostly Keynesians) who use interest rates as an indicator of monetary policy. Interest rates were very low in American in 1931; and very high in Germany in 1923. I believe that interest rates tell us precisely nothing about whether money is too easy or too tight, especially short term rates. The key variable is NGDP growth (which I believe Hayek also favored targeting.) Do you agree with my view that the 1% (short term) interest rates of 2003 were a totally meaningless indicator of the stance of monetary policy?

I agree that interest rates need not indicate the tightness or looseness of monetary policy. But since prices were falling more quickly in the 1920-1921 depression than in any single year from 1929-1933, I think the NY Fed’s discount rate of 7 percent in the first period, versus 1.5 percent in the second period, shows that the Fed was halting money growth in the first period while at least being more liberal in the second. (I didn’t have access to a consistent series on monetary aggregates for the whole period.)

So yes, the mere fact that Bernanke Greenspan brought the target down to 1% (in June 2003) by itself doesn’t prove anything, but I have argued that he allowed the base to grow at rates that were almost as high as any point in the 1970s. So if we think that the Fed was too loose in the 1970s, then I think we can agree the Fed was too loose in the early 2000s.

Also, if we adjust for actual price inflation, then the real fed funds rate went negative in the early 2000s, something that hadn’t happened since the 1970s. (See here.) Since I don’t think the technical productivity of roundabout processes went negative (on the margin), this is a clear indication to me that Greenspan was pushing rates down, rather than passively responding to real changes in the supply and demand of loanable funds.

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