Patterico's Pontifications


The Austrian Theory of the Business Cycle: Part Two in An Occasional Series of Posts on the Fed

Filed under: General,The Fed — Patterico @ 3:17 pm

One of my commenters, Dana (but not the Dana who posts here), responded to my assertion that the Fed has contributed to booms in the stock market and housing sector with the following comment:

Caused by the Fed in what way? If you are saying that the Fed has done so by working to keep interest rates low, I’d agree, at least in part, but the Fed really had little choice in this: the Fed was attempting to help economic growth following the downturns in 1991 and 2001, and there would have been no support at all for raising interest rates at those times. Since economic growth wasn’t as strong as people would have liked, especially following the 2001 recession, all of the pressure was for keeping rates low.

I started to write a response and realized that, with the amount of energy it was going to require, I might as well make it into a post. In June I argued that ending the Fed is a free market solution, and promised future posts on the Austrian theory of the business cycle and related concepts. Now is as good a time as any to continue the project.

The implicit assumption underlying Dana’s comment is twofold, and is held by most mainstream economists: that 1) the proper response to an economic downturn is to lower interest rates, and 2) the Federal Reserve should be entrusted with manipulating interest rates to make macroeconomic corrections in the economy.

I believe both assumptions are misguided. To explain why, I need to explain the Austrian theory of the business cycle.

The Austrian theory of the business cycle, developed by Ludwig von Mises and refined by F. A. Hayek, addresses the following question: why is it that there are times when all entrepreneurs seem to be making bad decisions, all at the same time? The free market, of course, assumes that many entrepreneurs will make bad business decisions — and when they do, their businesses should fail, to make way for better ones. But in this process, entrepreneurs with better foresight should succeed — in other words, the market selects for the very best entrepreneurs. So it seems odd, then, when in a recession or depression, great numbers of these people all make bad decisions, all at the same time. What explains that? Why would all the very best entrepreneurs all make bad decisions at once?

The answer lies in banks, especially central banks, engaging in artificial credit expansion and (worst of all) manipulation of interest rates.

Imagine a world with no Federal Reserve setting interest rates. In this hypothetical Shangri-La, the market would set interest rates. So: what would cause interest rates to go up and down? The conclusion is simple if you think of credit as a good, like any other good, subject to the laws of supply and demand. The more credit is available, the cheaper it will be — and the less credit is available, the more expensive it will be. If banks have a lot of money to lend, they will have to compete with one another to get people to borrow from them — and that means lower interest rates. If banks have very little money to lend, then demand will increase relative to supply, and borrowers will have to compete for that limited credit by offering higher interest rates. Easy enough so far, right?

Now, when do banks have a lot of money to lend? If you take the Federal Reserve out of the picture, the answer is: banks have a lot of money to lend when a lot of people are putting money in the bank. Consumers are usually in one of two modes: either they are spending a lot, or they are saving a lot. When they are saving a lot, two things happen: 1) banks have more money to lend, and interest rates naturally should go down, and 2) there is less demand for consumer products, because consumers are spending less.

Businesses, like consumers, go through natural cycles. Sometimes they are focused on long-term expansion — things that are not going to pay off today, but which will increase production capacity years into the future. This includes activities like research and development, or building factories. Conversely, sometimes businesses are concerned with providing more consumer goods right now, and put long-term expansion on the back burner.

At this point we need to take a small step back and provide a couple of necessary definitions. (Don’t worry: it’s very simple stuff.) Even the simplest good has an entire production structure behind it. For example, Milton Friedman popularized Leonard Read’s example of the lengthy production process involved in manufacturing a pencil in his series “Free to Choose”:

Look at this lead pencil. There’s not a single person in the world who could make this pencil. Remarkable statement? Not at all. The wood from which it is made, for all I know, comes from a tree that was cut down in the state of Washington. To cut down that tree, it took a saw. To make the saw, it took steel. To make steel, it took iron ore. This black center—we call it lead but it’s really graphite, compressed graphite—I’m not sure where it comes from, but I think it comes from some mines in South America. This red top up here, this eraser, a bit of rubber, probably comes from Malaya, where the rubber tree isn’t even native! It was imported from South America by some businessmen with the help of the British government. This brass ferrule? [Self-effacing laughter.] I haven’t the slightest idea where it came from. Or the yellow paint! Or the paint that made the black lines. Or the glue that holds it together. Literally thousands of people co-operated to make this pencil.

The process to deliver that pencil involves multiple stages. Those stages of production that are closer in time to the point of sale — such as the transportation of the pencils in trucks to the store — are called “lower-order” stages of production. The parts of production that are further removed from the point of sale — such as planting the trees that will eventually be chopped down for the wood, or mining the iron ore to make the steel to make the saws that cut down the trees — are “higher-order” stages. Investment in the higher-order stages will have the eventual benefit of making the production process more efficient, and making the product cost less . . . but it may take years for that investment to pay off. Conversely, investment in lower-order stages (the store needs more pencils! Hire more trucks to deliver them!) is unlikely to lower the cost of the good, but it will ensure delivery of a sufficient supply in the immediate future.

The key here is time preference. If it is important to deliver more consumer goods right now, a business will tend to invest more in the lower-order stages of production (hire more trucks now!). So investment in lower-order stages is good when consumer demand is high right now. Conversely, if consumer demand is low, it may be a good time for a business to engage in things like research and development, or investment in other higher-order stages of production — things that won’t pay off today, but that will ensure efficient production in the future.

Here’s the thing: long-term investments in higher-order stages of production typically require a business to borrow money. The longer the period of time it will take for the investment to pay off, the longer the period of the loan. The longer the period of the loan, the more important it is for the interest rate to be low — because long-term loans are very sensitive to interest rate changes. Businesses (and individuals too, of course) are far more likely to take out long-term loans when the interest rate is low, because the longer the loan, the more money they save. That means that borrowing for investment in higher-order stages of production typically happens when interest rates are low.

When interest rates are allowed to fluctuate with the free market, all this works in harmony. When consumer demand is low, people save more. The interest rate is lower, causing businesses to invest in higher-order stages of production. Times of low interest rates are a good time for businesses to make such investments, because the need to provide great numbers of consumer goods is not great when people aren’t buying them in great quantities.

By contrast, when demand for consumer goods increases, people are saving less. Interest rates rise, and businesses divert their profits into investment in lower-order stages of production, the better to deliver greater amounts of consumer goods to the public in a short time span.

Now consider what happens when a central bank artificially lowers interest rates. Businesses are incentivized to invest in higher-order stages of production. However, this action is not balanced by a lowering of consumer demand, and there is no increase in savings. Consequently, there is unexpected competition for the same resources. For example, when consumer demand is low, the trucking business takes resources away from delivering consumer goods, and moves them into delivering materials for, say, factory building. But when consumer demand is still high, trucks are in demand for delivery of consumer goods and for delivery of raw materials to build factories. The competition for resources drives up prices of inputs into production, and the long-term projects end up being more expensive than the businesses anticipated. Businesses start to fail, and a recession or depression hits.

The central observation here is that central planning never works in a complicated market economy. To some extent, people have internalized this lesson when it comes to prices of goods. At least a significant segment of the public understands that when the government sets prices, through price controls or otherwise, this introduces distortions into the market economy and makes it less efficient. But for whatever reason, we seem to have a tolerance for central planning when it comes to setting price controls for credit. Interest rates, after all, are nothing more than the price of credit. Why do we think it’s a good idea to allow a central authority to set that price, any more than we should tolerate central planning for any price in a free market?

To come back to Dana’s question, then: lowering interest rates when the economy is not doing well is a bad idea. Recessions/depressions are caused by malinvestment by businesses responding to manipulation of the price of credit. The proper response is to let the economy readjust, and keep government out of the way. This is what the U.S. did in 1920-1921, and that recession disappeared right away. Conversely, Hoover and then FDR monkeyed with the economy after the onset of the Great Depression, and with their actions they extended the misery unnecessarily for years.

Let’s put a stop to central planning. It didn’t work when Josef Stalin did it, and it doesn’t work any better when Janet Yellin does it.


Ending the Fed Is a Free Market Solution: Part One in An Occasional Series of Posts on the Fed

Filed under: General,The Fed — Patterico @ 7:50 am

Baghdad is about to be overrun by terrorists; we have a crew of liars in the Administration; and the dollar is headed towards collapse. Let’s talk about the last, which is not in the headlines every day, but which is probably the worst of the three problems.

The situation is caused by government interference in the free market. Look at the latest manifestation of what is truly a huge and ongoing crisis: the collapse of the housing bubble. The housing bubble, recall, was actually sought after by our Keynesian economic betters like Paul Krugman, who said in 2002:

To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.

Yes, he really said that. Wish granted, Mr. Krugman. By artificially keeping interest rates low, the Fed spurred construction far beyond the market’s natural appetite. Banks rushed to provide demand to meet the supply, waiving normal loan requirements. CDOs were created to market the bad debt. All the while, banks felt secure, knowing that if (when) the bubble burst, the government would have their back. Fannie and Freddie had their wink-wink government guarantees, and the federal government and the Federal Reserve stood ready to provide billions to bail these institutions out and keep credit flowing.

But the Fed’s artificial lowering of interest rates started the whole trainwreck.

I’m reading a book in which the following insightful quote appears:

The market rate of interest provides crucial information for the smooth operation of the economy. A central bank setting interest rates is price-fixing and is a form of central economic planning. Price-fixing is a tool of socialism and destroys production. Central bankers, politicians, and bureaucrats can’t know what the proper rate should be. They lack the knowledge and are deceived by their own aggrandizement.

That quote is from a book called End the Fed. (Click through if you want to know who the author is.)

I intend to write more, as time permits, expanding on the concept of ending the Fed. I will explain the Austrian theory of the business cycle, and argue that this theory leads one to the conclusion that the Fed should be abolished. I’ll address the argument that the Fed smooths out recessions, explaining the causes of bank panics in the 1800s (hint: it’s almost always inflation created and/or aided by government policies). I’ll refute the idea that 18 recessions since the beginning of the Fed is a better track record than we had without a central bank. All that is for future posts.

But for now, just think about that quote. If you truly support the free market, you can’t support the Fed. You’re supporting price-fixing.

Let me know what you think.

P.S. I know: this is unlikely to happen right now. We’ll revisit the idea after the dollar collapses and see if you’ve changed your mind. Everything I am writing these days is geared towards the discussion we will have then.

Powered by WordPress.

Page loaded in: 0.0693 secs.