That system of laws, therefore, which is connected with the establishment of the bounty, seems to deserve no part of the praise which has been bestowed upon it. The improvement and prosperity of Great Britain, which has been so often ascribed to those laws, may very easily be accounted for by other causes. That security which the laws in Great Britain give to every man that he shall enjoy the fruits of his own labour is alone sufficient to make any country flourish, notwithstanding these and twenty other absurd regulations of commerce; and this security was perfected by the revolution much about the same time that the bounty was established. The natural effort of every individual to better his own condition, when suffered to exert itself with freedom and security is so powerful a principle that it is alone, and without any assistance, not only capable of carrying on the society to wealth and prosperity, but of surmounting a hundred impertinent obstructions with which the folly of human laws too often incumbers its operations; though the effect of these obstructions is always more or less either to encroach upon its freedom, or to diminish its security. In Great Britain industry is perfectly secure; and though it is far from being perfectly free, it is as free or freer than in any other part of Europe.
EconTalk 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.
Relative 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.
What 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.
Housing, 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.
Speed 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.
Credit 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.
Language: 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.
Credit 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.