Russ Roberts

Boettke on the Austrian Perspective on Business Cycles and Monetary Policy

EconTalk Episode with Pete Boettke
Hosted by Russ Roberts
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Peter Boettke, of George Mason University, talks with EconTalk host Russ Roberts about the Austrian perspective on business cycles, monetary policy and the current state of the economy.

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0:36EconTalk is a finalist in the 2008 Weblog Awards. Voting begins Jan. 5, 2009. Links and info at www.econtalk.org. Intro. Austrian theory of business cycles and role of monetary policy. What is unique and distinctive? Austrian position says, while there may be macroeconomic problems, there are only microeconomic explanations and solutions. There are aggregate phenomena like unemployment and inflation. Causes should be rooted in the choices that people make. Trade cycle: Money works its way through the system. An increase in the money supply doesn't automatically lead to inflation, but leads to relative price changes would equate to the quantity theory of money. Quantity Theory: Irving Fisher, revitalized by Milton Friedman: accounting identity: MV=PT (M is money; V is velocity, the number of times it turns over; equals aggregate value of economic activity; T is transactions, P is the average price level. If M goes up, and V and T don't change, the P goes up; simplest explanation of "inflation is always and everywhere a monetary phenomenon." But Friedman and others worked on the role of expectations; and long and variable lags. Inflation wouldn't go up overnight unless everybody expected it. Can get real effects from monetary policy. Mises, in book Theory of Money and Credit, fully endorses the Fisher position against "monetary cranks"--belief that you can solve a problem by printing money. In the mindset of the early 1920s, confusion of the real and monetary side; but don't want a mechanical interpretation, that money is just a veil. Money is a joint; or a loose joint. Jointness between increase in supply of money and real side, it takes a while. Injection effects. Richard Cantillon argued that money comes in at a particular point and ripples through economy like a pond. Bob Lucas, rational expectations, Understanding Business Cycles, confusion between relative and general price, island model.
7:34Relative price and price adjustments. Particular price changes, not all commodities at once. Friedman, helicopter, might have more money, but prices would adjust in general, wouldn't fix poverty. What is the Austrian take? Price signals get distorted and cause real effects. Can't have a real helicopter drop. Non-neutrality of money. Money is not neutral in the sense that prices adjust up at once. Money is one half of all exchanges: goods trade for money. Barter: goods trade for goods. If you screw around with money, you screw around with goods because you get relative price effects. Why is that such a big deal? Combine with the next aspect: capital structure. Not just K, aggregate capital, but goods combined together. Multiply specific. Can't turn a beer-barrel plant into a soccer ball plant overnight. Amount of capital in the economy; enhances labor. At any point in time we have a certain amount of capital, which we aggregate through prices. Capital flows in response to return. Austrian critique: At a point in time: if you have a car factory, shut down, goes out of business, capital goes to next best use. Claim is that the assembly line for a car company is not very liquid. Money is liquid, but not the assembly line, which is only good for cars or close substitutes. Can't be tranformed to make bubble gum or windmills. If the signals that led to that production, then the investments are particularly costly. Parent with little kids go through a dinosaur phase: make with play-dough or with legos. With play-dough, easy to modify. With legos, have to follow instructions or start over. Capital structure in capitalist economy is more like legos than like play-dough, but mathematically treated like play-dough. Matters because costliness of mistake means rip apart, build back up, and no production or entertainment taking place. Play-dough--don't bake the clay. Combine the monetary side, like instruction sheets for legos; capital side. Transmission mechanism through the credit market. Savings of some become the investment funds for others. If interest rate is artificially lowered, appears to have more savings in the economy than needed to justify investments; what used to be an unprofitable investment at a higher interest rate now appears to be profitable; buy into investments, ripples through economy; but if those investments are not the best, real scarcities come back, could appear to be profitable but not be profitable. Hang-over theory, boom and bust cycle.
17:29What financial intermediaries do. At a given point in time, some people want to do something with their excess of income over spending; and others want to consume more than their income. They get matched together through, banks, investment banks, stock market, etc. Munger podcast. Interest rate adjusts. At a high enough interest rate, I'll give up some consumption today for consumption tomorrow. Introduces risk and uncertainty because of possibility that the lender won't keep his promise. Collateral. Look for outside guarantees. Monetary policy comes in, artificially lowers the price of future consumption--the interest rate--inducing too much investment. Mal-investment. Relative price story. Interest rate overall affects all intertemporal decisions. Sufficient story? Transmission mechanism: money injected into a particular stream. Austrians--Mises and Hayek developed theory in 1910s-1930s; Kunt Wicksell. Not much theory developed since that time on nitty-gritty; but institutions have changed. At that, loans made to particular businesses; now we have to examine the institutional details. Financing investment; or in recent years, maybe financing consumption behavior. Money as a ragged process; capital structure is made up of particular goods combined together. Distortions from prices of those goods. Money is the one thing that affects all the exchanges in the economy. Businessmen didn't suddenly get stupid--just confused by the signal. Can that confusion fit with our understanding of expectations? Rational expectations model. Adaptive expectations in Friedman; Lucas, forecast future and wrote back into your actions today, which would nullify this stuff. Mises--elastic expectations. Lincoln's Law: can fool some of the people some of the time but you can't fool all of the people all of the time. If you have anticipated inflation, prices adjust up. Problem is that it's difficult for businessmen to sort out if it is a real change in demand or supply or if it's a monetary distortion. Picking the right timing is hard.
25:04Housing, today. Shiller podcast: people make mistakes, get exuberant, once you see appreciation of an asset, you can rationally start investing so long as you get out before the bubble pops. 1997 tax reform, distortion. Asset had been taxable: capital gain taxable unless you rolled it over; after 1997, you could get the cash out. Distorted the choice, changed relative return on housing relative to other assets. In 2001, Greenspan lowered the Federal Funds rate, worried about the recession; adjustable rate mortgages got very cheap, making it cheaper for people to buy houses. Securitization phenomenon. Trillions poured into housing instead of other kinds of investment; capital that normally would have gone into other innovations--health, entertainment. Nice to have more and bigger houses, but it was artificially introduced. But that would just have been a mistake, not a catastrophe. Catastrophe was when interest rates rose and people couldn't pay mortgages back. Austrian story of boom-bust compounded by other mistakes. To light the powder keg, have to have all these other kinds of restrictions. Monetarist and Austrian story do not have to be at odds. Murray Rothbard, Milton Friedman. Rothbard's story is about 1920s; Friedman's is about the 1930s and Great Contraction. Both about policy mistakes. In both stories, contraction and inflation are not enough; need Higgs's microeconomic restrictions that prevented market from adjusting. Adam Smith: economy strong enough to withstand a hundred impertinent follies. But maybe not 1000. After 9/11, monetary expansion. Combination of factors creates the difficulty we are dealing with today. Austrian economics, good old economics. Debate: inflation is a ragged price adjustment which causes distortions more than just shoe-leather cost. Austrian argument on deflation: in a growing economy, should see a decline in price level. George Selgin.
33:49Speed of adjustment [taping Dec. 27, 2008]; housing prices too high and needed to fall. The reason that adjustment it is so catastrophic is not the human side, renters masquerading as owners; it is the destruction of institutions. New ones don't just spring up. Garbage turning to treasure overnight; but the process of reallocation is not so pretty. Liquidation, let some businesses go broke; let people who are prudent buy the assets imprudent people misused. Court system has evolved; bankruptcy laws, not so easy when a giant corporation goes as a pizza house down the street. In the current situation, we've taken a market correction and because of our policy responses, increased the distortion of the incentives that actors have an increased uncertainty, exacerbating the problem. Credit freeze, credit crunch, people who ten or fifteen years ago would have gotten loans didn't have a problem still getting loans. Had to have 20 percent down, mortgage couldn't be more than one quarter of your monthly salary; professors, even with secure jobs, couldn't buy particularly big houses. Standards collapsed. Shiller explanation: wild string of optimism, wild string of pessimism. Not just what happened, but why did it happen? 1997 tax change; community reinvestment act; lawsuits threatened against banks for having standards, etc. NY Times article yesterday blaming Bush, community, part of the problem but not the whole problem because these problems go way back.
39:32Credit crunch: opposite. Easy to get a loan now if you go back to the old standards; Freddie and Fannie back to conventional loans and 20% down, decent credit. If you want to borrow $418,000, though, over the $417,000 limit, hard to get a loan. Banks aren't lending to each other and not lending short term to other institutions. Bizarre overnight market that Bear Stearns was in precipitated the problem. Tax Act of 1997 started the housing price explosion; but what started the financial collapse: Government treatment of Bear Stearns. Question: What would have happened if the government had not been the facilitator of the marriage of Bear Stearns and JP Morgan. Bear Stearns bankrupt, investing in assets that weren't as valuable as thought, dramatically lower; all of a sudden a lot of institutions that were going to bail Bear Stearns out overnight were worried that they wouldn't get their money back. Bernanke and Paulson said they can't let this happen. Why not? Let 'em go bankrupt. Kling podcast. If they got tied up in bankruptcy court, whole financial system would lock up, is the story. What would have happened if the government had done nothing? Second question: Reason they were in this highly leveraged world was because of the mismanagement of monetary policy. Unconvincing argument. Why weren't they more resilient, why would they have put themselves in a position to be so susceptible to monetary policy? Go back to combination of policies. Easy money policy of 2001 fueled the fire; also government sponsored entities like Fannie and Freddie and idea of too big to fail; privatize the profits and socialize the losses encourages riskier behavior. Lose accountability and calculability; value of assets no longer tied to a market. Breakdown of the Soviet system: assets had value but no market value. Quick privatization at least allowed assets to get values. Evaluation trap. What would have happened? Counterfactual always toughest argument to hold. Various forms of bailouts and subsidies, imprudent decisions allowed and created a credit freeze--which was what they were trying to prevent. Pull the bandaid off quickly. Mises: "You don't cure a man with bronchitis by shooting him in the chest." Would cure the bronchitis. Run over guy in the street, let's back up; run over him again. Munger podcast. Twenty years from now we will have the scholarship and evidence. Awkward that Paulson was a Goldman-Sachs guy. Institutions viewed as so venerable they couldn't be allowed to fail. Bernanke as Fed Chairman. Maybe venerable at a point in time. Arthur Anderson, one of big five accounting agencies, and the Enron scandal; what if we felt we couldn't have let Anderson fail lest every other big accounting agency fail? Makes it more painful to slow it down. Friedman: Need not just profits, but losses. Need profits to encourage risk taking and losses to encourage prudence. Anna Schwartz: Bernanke knows the price system but he's fighting the wrong war.
52:07Language: Word "Market failure" gets thrown around a lot. Doesn't refer to a firm going out of business. Refers to systemic distortion that markets themselves are causing, due to the fact that the natural incentives themselves are flawed, as opposed to the flaws created by government institutions. Distinction. People argue there is a market failure because there are externalities; could be true, and could be room for government in those situations. If you had a system of rent controls and had a shortage of housing, that's not a market failure because the cause--the rent controls--is government mandated. Health care, Lipstein podcast. Why did Bear Stearns engage in this behavior? Why not more prudent? They face an incentive where the downside risk wasn't that big to them. People knew that housing prices couldn't come down; moral hazard. Did Bear Stearns managers think they were too big to fail and that the government would always bail them out? Holding Fannie and Freddie paper and were aware that the government guarantee all of that; that they understood. But they just made a mistake. Not as simple as saying housing prices are going up, so don't worry. They worried, and were clever as ways to insulate against risk. Not aware of what the consequences would be in this circumstance.
56:27Credit expansion, overprovision of credit, encourages resources to flow into areas that get distorted prices that cause an ultimate correction to take place; and the pain of that correction is hard. That Austrian story is not well-respected by mainstream economists. What is the alternative theory? Keynesian story, half of the mainstream economic community: what is their story? May be macroeconomic problems but only microeconomic explanations and solutions. Have to tell a story that begins in an equilibrium and has a shock that brings an adjustment back. Rational agents in the story. Bob Lucas, after 1970s Lucas Critique, idea of equilibrium theory of the business cycle. Islands, relative price adjustments--nodes of economic activity that didn't communicate perfectly; confusion causes problems. Problem with that idea is that it's hard to work it through with a consistent rational expectations perspective. Real business cycles. Keynesian model: human choice, aggregate demand; behavioral economics, people get giddy. What would be the Keynesian response to the Austrian story? The conditions under which markets work require such strict assumptions about rationality and institutions, competitive market that in the absence of those conditions, market agents are caught by alluring hopes and haunting fears and need government as a corrective, to provide the stability. Austrian theory has been tied up with arguments that have been settled, like gold standard. If you break down the story, ragged price adjustments, capital is made up of heterogeneous goods, then the Austrian story is not unusual from any sort of coordination story. Axel Leijonhufvud. Burden on idea that it's a particular transmission mechanism, but multiple ways we can be distorted by government activity.

COMMENTS (35 to date)
Greg Ransom writes:

For those who want to know more about Austrian Trade Cycle theory, I don't recommend more highly the collection of articles by Roger Garrison found here:

http://www.auburn.edu/~garriro/articles.htm

Greg Ransom writes:

It should be noted that Boettke only skims the surface on how and why monetary caused distortions in the structure of production cause the sorts of "macroeconomic" problems seen in an economic bust.

E.g. see Hayek's discussion of complementary production goods, and how longer length processes which are only chosen because they increase output also make possible the productive use of latent or potential permanent goods (e.g. empty land) which is only made economic because of the existence of the newly produced non-permanent, longer period goods (e.g. housing and office buildings and factories).

See Hayek's discussion in _The Pure Theory of Capital_ (Collected Works edition), pp. 71-83.

And note well that Hayek includes housing as among "capital" in his account of distortions in the structure of production (p. 77): "Included under this term [i.e. "capital"] are .. and all consumers' goods existing at the moment insofar as they are non-permanent soources of final income".

A deep and central divide between Hayek and Keynes and most "macroeconomists' is on the very nature of investment (and the nature of the economic explanation of investment) and this difference lies at the core of their deep disagreements over trade cycle theory.

It would take an extended explanation to get the point across, so I won't attempt it here.

Those interested should read the first 5 or 6 chapters of Hayek's _Pure Theory of Capital_.

Another central issue -- hardly touched by Hayek himself and most other Austrians -- is the role of heterogeneous labor and the various relations of this labor to changes in the structure of production, and the adding to and taking away of non-permanent capital and latent permanent resources across the boom & bust cycle.

Greg Ransom writes:

Let me correct this so there are no misunderstandings:

For those who want to know more about Austrian Trade Cycle theory, I can't recommend more highly the collection of articles by Roger Garrison found here:

http://www.auburn.edu/~garriro/articles.htm

Daniel writes:

Excellent podcast!

Chris writes:

I am an undergraduate economics student, trying to make sense of, not only coursework, but life, generally. Economics can be a difficult subject to grasp. This podcast has helped me to understand why others are so opposed to government bailing out financial institutions. Great job Russ and others, and excellent job at planning to bring a Keynesian on the show sometime soon. This is a diverse discipline and rather than alienating other theories, we may do well to listen to other people's perspectives. Difficult to do when there's no shared reality, or enthymeme, but something we can strive for. I'll recommend this podcast to other students. Great job again!

jayson writes:

Thank you Russ for a fantastic podcast. The podcasts that are full of economics information are the ones that interest me the most. I also wanted to say thank you for your contributions on NPR lately, I have enjoyed you sharing your views on NPR.

Unit writes:

About the question of why Bear Stearn didn't realize the risks and whether moral hazard (or "too big to fail" mentality) was at play, it seems to me the error was of a technical nature. It's not that they thought that house prices would go up for ever, they thought that in some areas they might very well come down but not in other areas and that their strategies of spreading risk around were sufficient protection. The problem with the loose monetary policy is that it helped crystallize this conviction long enough to the point that it infected the whole system. So it's a story of malinvestment that is hard to reconfigure, like the lego dinosaur: it's a CreditDefaultSwapasaur.

mk writes:

Very interesting podcast.

I haven't listened closely to the whole thing yet, but I will still hazard a question:

The ABCTers argue (if I understand correctly) that government involvement, e.g. tax rates, monetary policy, subsidies etc., creates distorted incentives -- a "false signal" -- which confuses entrepreneurs into investing in the wrong things. Eventually they realize they were "duped" and a painful process of disinvestment/reinvestment occurs.

I have some questions about this story. First, doesn't it only hold if government intervention is variable? Suppose there is a fixed subsidy for car production. Whether or not this is a "false" market signal, it is constant for as long as the subsidy regime exists. So when will the disinvestment occur? After the government pulls the subsidy, or before? And what if the subsidy lasts forever?

To restate the first question, as long as government policy is constant, how can it cause business cycles?

Second, even if government policy is non-constant, so are lots of things! So is fashion, so are human likes and dislikes. If the demand for IPods temporarily spikes, but then customers lose interest, does that mean the initial spike was a "false signal?" I'm having difficulty understanding why government policy is any more "false" a signal to entrepreneurs than any other market signal.

One argument I could imagine in response says: if 50 people wanted an Ipod last month, and 100 people want an Ipod this month, then I might expect 150 will want an IPod next month; But if 50 people wanted an American car last month, and the government subsidizes American cars this month so 100 people want American cars, I cannot similarly accurately guess that 150 people will want American cars next month, since the growth is not "organic."

Is that the response? In that case the harm is not from distorted absolute levels of demand, but rather from false movements in demand, which causes entrepreneurs to make mistaken predictions about future demand trajectories.

This is a plausible argument, but the empirical support is the main question. There are plenty of plausible arguments one might make about business cycles.

Greg Ransom writes:

Hayek essentially argues that interest rates set below the nature rate is inherently a non-constant policy choice. You are progressively extending the time structure of production -- which CAN'T go forever. Think about an ever progressive distortion process of progressively expanding money. It's a "red queen" thing -- you have to run faster and faster to keep in the same place -- ever more "stimulus", ever more expansion of the money supply, ever more inflation, etc. Think about how Bush has increasingly ramped up "stimulus" over the years, until now it isn't many billions of dollars in "stimulus" but many trillion.

This is the harder but core stuff that Boettke really didn't really get into.

mk wrote:

"as long as government policy is constant, how can it cause business cycles?"

Greg Ransom writes:

Is it possible for the government to created a monetary/financial caused housing bubble that never pops?

Hayek would say no, not without creating runaway inflation, who's ultimate end unless stopped would be hyper inflation.


mk wrote:

"as long as government policy is constant, how can it cause business cycles?"

Todd writes:

Is it fair to say that the federal reserve played a crucial role in flooding the market with credit, precipitating malinvestment, while the CRA, F&F, & other onerous regulations consolidated the malinvestment in one sector of the economy?

NormD writes:

Why do we expect financial executives to care that the institutions that they run are viable for the long run? It seems to me that their incentives are to make as much money as they can as quick as they can and if after a few years the whole house of cards collapses, they walk away with everything they made and go somewhere else.

Who has a real interest in insuring that financial institutions are viable for the long run?

Grant writes:

Instead of discussing entrepreneurial expectations (rational, etc) as a whole, why don't more Austrians talk about entrepreneurial heterogeneity? Some entrepreneurs obviously have more rational expectations than others.

Many businessmen obviously made errors that cannot be completely explained via the traditional Austrian story of interest rate distortions. It seems to me that once one assumes business and entrepreneurial competence and rationality to be heterogeneously distributed throughout the economy, credit expansion not only influences their decision making process for the worse, but also adversely selects less rational entrepreneurs and businessmen. I think this paints a more compelling story of business errors than moral hazard does.

Greg Ransom writes:


>>why don't more Austrians talk about entrepreneurial heterogeneity? Some entrepreneurs obviously have more rational expectations than others.


Hayek talks about this a bit.

He mentions it, among other things, in the context of the growth and development of individual market rationality over time.

Also, he talks about how the market rationality of individuals can grown across large swaths of historical time, and also how it can grow at different rates among people in more modern market society as compared with folks in more traditional and primitive societies, etc.

Hayek talks about the learning curve for becoming more and more "rational" in the economic sense, and the relative consequences of where you are on that curve.

(Hayek + Mises here and a theorist is on his way -- punch it up with lots of fancy math, and you have a publication).

Hayek isn't a "Chicago guy" on rationality.

Greg Ransom writes:

Armen Alchian and Milton Friedman wrote a bit about this, Alchian in a famous paper in 1950.

You can call this "Austrian" work if you like. Alchian was certainly mightily influenced by Hayek's paper "The Use of Knowledge in Society" written just 5 years before Alchian's paper on the natural selection and evolution of firms and entrepreneurs.

Grant writes:

"It seems to me that once one assumes business and entrepreneurial competence and rationality to be heterogeneously distributed throughout the economy, credit expansion not only influences their decision making process for the worse, but also adversely selects less rational entrepreneurs and businessmen."

Grant writes:

Greg, which Alchian paper are you referring to?

Is entrepreneurial skill mentioned in relation to credit expansion and its effects on the selection of entrepreneurs? From the point of view of many businessmen, bubbles are the result of less-than-rational people getting a hold of capital (e.g., all the normal homeowners who became real estate speculators). The (probably more subtle) effects of interest rates affecting business decisions of otherwise-sound firms is less noticable.

I know there was a recent QJAE paper expressing a similar opinion, but unfortunately mises.org hasn't posted it up yet.

Lauren writes:

Grant asked:

Greg, which Alchian paper are you referring to?

I think he's referring to Alchian's 1950 JPE paper:

“Uncertainty, Evolution and Economic Theory.” Journal of Political Economy 58 (June): 211–221.

Hayek's "The Use of Knowledge in Society" is available online at Econlib.

Eric writes:

"Why do we expect financial executives to care that the institutions that they run are viable for the long run?"

Historically, investment banks were partnerships rather than public corporations. Younger executives had an incentive to focus on limiting the banks' risk -- it was the only way they could be sure it would be there when they were in line to run it.

When the partnership model died, the optimal strategy was short-term bonus maximization rather than long-term viability. This point is probably the most interesting insight of Jonathan Knee's book, "The Accidental Investment Banker". (Well, that, and the idea that the stand-alone investment banks were doomed after the repeal of Glass-Steagal due to their balance sheet weakness!)

Actually, Russ, Knee might be an interesting guest for EconTalk. The book is a quick read and he might have an interesting perspective on the future of the financial system...

Gary Rogers writes:

Excellent podcast! With the terrible advice economists have provided to our government over the years, it is nice to hear something that makes sense.

I do have a few comments on the discussion about the devastation our financial systems suffered from the drop in housing prices. Yes, deflation in home prices caused this but the devestation was caused by leverage. When you look at the combination of these two factors, you have a potentially devastating problem. This is why understanding combinations of patterns is so important.

So, why the over-leveraged institutions? Years of Keynesean policies. Low interest rates and chronic mild inflation discourage savings and encourage borrowing. That combined with other stimulative decisions like eliminating capital gains taxes on home sales (great observation) and both consumers and businesses adjust to the economic climate. The problem comes when it is time to deal with deflation or raise interest rates to fight inflation. Both become devastating events.

Keep up the great discussions. I look forward to your podcast every week.

Phil writes:

Good podcast.

It was mentioned that in the "old days", you needed a 20% down payment and that payments couldn't be over 25% of monthly income.

One question has bugged me about the foreclosure crisis: PMI. My understanding is that unless you have 20% equity in your home, you are required to purchase this insurance policy, called Private Mortgage Insurance (PMI). The purpose of this policy is to guarantee that the bank will collect in the event that the home owner defaults on his home.

So my question: With all these foreclosures and bank failings, what happened to all this money that was supposed to be going into this insurance policy? Or am I missing something here?

John Dyer writes:

As always, lots of interesting ideas and comments.

One thing that is bothering me about the "whole mess" is that there is no talk about what I feel is the real way that the economy grows, increased productivity. All the talking heads and newspapers ramble on about is loans and money. Isn't the increase in productivity the real growth of, well, everything?

Maybe in a future podcast you could have a discussion about the role productivity plays in moving us all forward.

Thanks,
John Dyer

Greg Ransom writes:

John,

Check out the podcasts found here:

http://www.econtalk.org/archives/growth/

RJB writes:

Great podcast. Definitely more economics lingo than a lot of the other podcasts, but I was able to keep up. There were a couple key insights that really clicked for me, particularly the playdo vs. legos discussion, the notion of misallocation of capital into housing, and the concept that low interest rates make bad investment decisions more practical.

As a big Legos person growing up, that metaphor (simile?) resonated with me. Playdo is really easy to readjust and reform, but you could never get the size and grandeur of something that you construct with Legos. So I started thinking of human capital as Playdo--much more flexible, much more adaptable--and mechanical/industrial capital as the Legos--less flexible but able to build much larger and able to serve as infrastructure for human capital. To push the metaphor, with just Playdo, you can build a 6" tall brontosaurus...but with Playdo and Legos, you could build a 6' foot brontosaurus.

Following the housing meltdown for a long time, I'd thought about the fact that LOTS of people were treating houses as an investment and many of them considered the house as their primary wealth-building mechanism. But until the podcast I hadn't considered that the extra capital poured into housing as an investment was essentially pulled away from other capital-intensive investments. But it makes sense...if you think about the "Giant Pool of Money" (h/t Planet Money) searching for investment opportunities and settling on housing as the "best" option and effectively settling on Growth investments (that only appreciate) rather than Dividend investments (that produce and spin off value/wealth).

And that final insight into the influence of interest rates called to mind something I'd read months ago about McDonalds calling off a plan to install cappuccino machines (and train staff) in all their stores. With low interest rates, it would pay back in a reasonable time frame. But with the new, higher interest rates, it wouldn't. That suggests to me that it was a pretty limited return on investment in the first place that only looked good because they (McDonalds) could essentially get the startup cost (funding for the cappuccino machine purchases) free and so they didn't have to actually make much money to service the debt. In a different debt market where the cost to borrow is higher, the investments follow higher (arguably better) returns.

In all a fantastic podcast that brought me (a non-economist) a lot of deeper insight. Thanks!

Ajay writes:

Decent overview of the Austrian perspective, though Boettke wasn't as clear and relevant as he normally is. He set a high standard in previous appearances but this time he slipped into jargon a bit too much and railed on too much about government interference. Russ's disagreement at the end nonwithstanding, that Bear didn't expect to fail, the focus was too much on trying to pin the current crisis on government. I'm unconvinced that the legal changes and Fed actions had much to do with the bubble, I'd pin the blame more on the savings glut that led to idiot risk modeling and securitization without diligence. This bubble followed the classic pattern of lots of money looking to be invested, followed by idiot financiers finding plausible but idiotic places to put it. The Fed probably contributed almost nothing to that, rates probably would have stayed low even if they'd tried to turn the dial higher, just as how they've currently not been able to get the fed funds rate to match their targets. I think what supporters of free markets should be doing is explaining that people made dumb investments and now the market is punishing them for that, not trying to match the socialists in their scapegoating by blaming government when they blame markets.

Edward J. Dodson writes:

What current economic theory fails to address is the inherent distinction (a distinction appreciated by most political economists of the 18th and 19th centuries) between nature and goods produced from nature. As a market analyst in the housing sector, I have come to appreciate the full importance of this distinction.

Land markets do not operate under the same dynamics as markets for labor, for capital goods or even for credit. My observation over 30 plus years is consistent with what only a small group of economists (e.g., Harry Gunnison Brown, Mason Gaffney, Nicolaus Tideman, C. Lowell Harriss) have confirmed: the price mechanism does not operate with respect to locations in our cities and towns or natural resource-laden lands. There is a strong tendency for owners of land to hoard this resource for speculative purposes. Thus, the supply curve for nature actually leans to the left. Nature is, therefore, exempt from general equilibrium.

The fundamental cause of the current economic crisis is clear to me: a credit-fueled frenzy of speculative behavior (in land, in real estate without regard to debt service coverage ratios, in precious metals, in oil futures, and the stock market. The aggregate frenzy was then exacerbated by an unprecedented level of criminal activity in these markets (e.g., predatory lending, fraudulent property appraisals, inaccurate risk pricing for mortgage backed securities that included subprime mortgage loans, etc.).

Charlie writes:

Since I'm an avid fan and listener of econtalk, I hope you'll take this seriously. This was one of the worst podcasts I've listened to. Almost everything in the podcast was half-baked jumping around from ABC to Great Depression to current day to bailout to housing prices without ever really talking about any of them at more than a surface level.

There are huge important questions that never got answered. The relative price story never really got explained. I'm sure there is some explanation about distorting today versus tomorrow, but it was totally absent. And no recognition that the fed funds rate is just one seemingly inconsequential interest rate, you can't tell a "gov't controls the interest rate" without acknowledging that most interest rates are traded on the market and forward looking. There was very little discussion of how credit markets translate to "real" problems. What subverts Modiglianni-Miller type theorems. Slow down and tell the story. There was a brush over of ABCs in the 20s and housing run up, but no explanation of why easy credit must translate into housing bubble. Just because there is money to lend doesn't mean banks had to lend it, or had to leverage. Russ was so interested in telling his own story about a change in tax law, that there was no one to ask "if it was a tax change, why did the market falter" a tax law can make housing go up, but it can't make it go up beyond fundamentals. The Bear bailout discussion was terrible. The central question asked "what would have happened if we had let bear fail?" was never discussed, because neither person knows enough about bankruptcy laws, overnight markets, and modern banking to say anything insightful. It was just Boettke repeating over and over accountability and calcuability. But why didn't the market provide those things. Why was there such vigorous trade in things that had no accountability and calcuability. And can we please point out before someone says "privatize gains, subsidize losses" that bear equity holders lost almost everything.

My constructive criticism is that Russ needs to get back to asking challenging questions of his guest rather than try to tell the story with him so much. The podcasts where Russ is taking a more skeptical challenging view (like Rauschway) is much better at illiciting important information. He needs to get back to slowing his guest down, and asking "how does that happened?" How does that have a real effect? He tried to do it, especially at the beginning, but never got coherent answers. It could have been a great podcast if he just had Boettke slow down and tell the ABC story of today's crisis, and asked a lot of challenging questions about how Greenspan made people act out at the micro level this crisis. The best part of the podcast was when Russ challenged Boettke's view saying "bear just made a mistake" with some support, and then just pushed the whole discussion aside.

I was really looking forward to this podcast. I really want to hear an Austrian defend ABC in the face of challenging questions, and I want to know more about it. I've tried to be constructive, and as someone that listens every week and voted for econtalk several times in this podcast contest, I hope future podcasts improve.

Charlie

Greg Ransom writes:

"Land markets do not operate under the same dynamics as markets for labor, for capital goods or even for credit."

There's no assumption in Hayek that they do. In fact, the opposite is the case. See _The Pure Theory of Capital_.

Lee Kelly writes:

Below is a short essay I wrote to try and explain to someone how I think the Federal Reserve creates booms, busts, and might create hyperinflation.

The table below shows supply and demand for a crate of bananas at varying prices.

Table

400,000 crates are supplied at $100 but none are sold; at $0 no units are supplied but 400,000 are demanded. In both cases there is no profit to be made, because either nobody buys or nobody sells. Under normal conditions the price would move toward $50. If the price is higher, then suppliers have too much inventory, and if the price is lower, then they are turning away potential customers.

Suppose that a politician passes legislation prohibiting suppliers from setting their own price, and decides upon a price ceiling of $25. What would then occur? A quick glance at the table above tells us that 50,000 crates will be supplied and 200,000 demanded, creating a shortage of 150,000 crates. At $25 nobody sells after 50,000 crates have been bought.

An important role of prices is to ration resources. If each buyer purchases 1 crate at $50 and 2 at $25, then when the price is $50 there are 100,000 people who buy 1 crate each, and when the price is set at $25 there are only 25,000 people who buy 2 crates each. With the price ceiling fewer people enjoy more bananas at a lower price, but at the expense of a greater number of people who must go without.

Our politician is unsatisfied. He wanted 100,000 people to buy 2 crates each, and decides to establish the Federal Banana Reserve to combat the problem. Instead of legislating the price, the he intends to increase the supply of bananas until 100,000 people can buy 2 crates each at $25. Since each buyer purchases 2 crates at $25 and only 50,000 are supplied, the FBR smust supply an additional 150,000 crates.

But the FBR is not going to grow bananas. It has magical machines that create banana apparitions. The FBR's banana apparitions look, feel, and smell like real bananas, but as soon as anyone tries to take a bite out of one, it disappears in a puff of smoke. It is these apparitions which the FBR supplies among the real bananas. At first everything runs smoothly. The banana crisis has been averted by the FBR's banana stimulus. 100,000 people can now afford twice as many bananas as before and at lower prices; the politician is reelected.

Eventually, however, people begin to try and eat their bananas. Suddenly the unwelcome discovery is made that 3/4 of the bananas bought were the FBR's apparitions. Once words gets around, demand drops like a coconut. Buyers realise that to get one crate of real bananas it is necessary to spend $100 on average! The price falls to $50 for 4 crates and only 100,000 people buy for 1 crate of real bananas.

The politician is again unsatisfied. The FBR was intended to allow 100,000 people to buy 2 crates of bananas each, and at first it was successful. But then buyers discovered that they had been fooled. Expanding the banana supply with apparitions eventually created the same problem as legislating the price did.

But a new election is coming up, and the politician desperately needs to do something about this new banana crisis. He orders to the FBR to expand the banana supply with another 350,000 crate stimulus. 100,000 people can now buy 4 crates each at $25 and receive 2 crates of real bananas. The new banana crisis has been averted. Everyone can now afford even more bananas than before and at lower prices; the politician is reelected.

Eventually, however, people begin to try and eat their bananas. Once more the unwelcome discovery is made, but this time 1/8 are apparitions. Once word gets around, buyers realise that to enjoy 1 crate of real bananas, it is necessary to buy 8 crates for $200 on average. The FBR desperately tries expanding the banana supply even more, but each time the cycle repeats the problem gets larger. Any addtitional demand which is stimulated quickly fizzles away when people discover more apparitions.

Inflation of the banana supply gets out of control. Almost every banana is an apparition, people stop buying them altogether, and even the suppliers of real bananas go out of business. In the long run, the FBR destroys the value of bananas by trying to stimulate their supply. In its wake the U.S. is turned into a banana republic.

Lee Kelly writes:

The table link did not work. Here it is.

http://lh6.ggpht.com/_vMHga0GqQO0/SWmM-U-zWrI/AAAAAAAAACc/pDdllH9LCys/Untitled.jpg

[It worked, but you had mistyped the html code to link to it. I've fixed it in your original comment. The replacement url you gave in this comment, though, didn't work--people would have to register first. I've replaced the url in this comment with the working one.--Econlib Ed.]

Brad Hutchings writes:

There are two very memorable bits from this podcast. The hilarious moment was when "we (Pete and Russ) got married". I've listened to this podcast 4 times and I still laugh when that sentence is uttered.

The other memorable moment comes at the end when Boettke suggests that a hindrance to the Austrian view being taken seriously is the vocal proponents. Channel surfing the other day I say Ron Paul and Dick Armey on some show discussing the economy and the bailout and Dr. Paul couldn't help but blame it all on abandoning the gold standard and claim that Austrians had this catastrophe pegged all along. Armey's reaction was the same as mine, just looking into the desk pretending he wasn't in the room. We have a tough job rescuing even the term "Austrian" from the lunatics. Boettke makes a strong case for why we should, i.e. the Austrian macro model makes some sense even/especially in today's context.

emerich writes:

I have read enough on Austrian econ to have heard the argument about distortion in relative prices because money growth leads to inflation unevenly. However, I was disappointed that you didn't discuss this point more fully: does inflation develop systematically earlier or later in some markets than others, if so which and why? And if this argument is true, how could mainstream economists all be overlooking it? It would seem to be a phenomenon that would not be hard to demonstrate empirically, and if it can be demonstrated empirically, its malign effects should become evident, should they not?

Andy writes:

Thank you so much for pushing back about the easy explanation for Bear Stearns' failure. Moral hazard is too easy of an explanation. Principle-agent problems are too easy. Most of the assets in the BS hedge funds were private-label MBS, not GSE MBS, Fannie and Freddie had very little to do with it. Not that F+F didn't have a lot of problems, but they are not solely responsible for the crisis. (By the way, CRA has about 0.01% of the blame for this crisis -- Countrywide and WaMu did not make hundreds of billions of subprime loans because of CRA, give me a break.)

CanOfBliss writes:

Disappointing on two counts.

(1) Too much arguing by analogy. Analogies are useful to illuminate an argument made in an another (logically valid) manner but in this there was too much reliance placed on analogies.

(2) The empty core of Hayek's economics was laid bare in the discussion of value. The idea that value can only be discovered in a market is not useful in a lot of cases (Eg. the valuing of the Soviet assets post collapse) and is useless in valuing many classes of assets: utilities, roads, intellectual property...). Markets discover *price*, not value. The accountant's curse is to know the cost of everything and the value of nothing.

peace
W

AC writes:

How long is Prof. Roberts going to claim ignorance about Austrian theory when talking about it? Someone give the man a little reading material!

AndrewB writes:

One problem I have with the idea that outside 'distortions' of the market create the boom and bust cycle is that without the boom and bust cycle theoretically markets would follow a steadier growth pattern pattern. If markets began following a steadier growth pattern they would become 'safer.' If they become safer people are able to create better systems to exploit the more predictable markets. If people create better systems to make money 'safely' profits begin to exceed production which creates a bubble. Am I wrong?

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