Of Course the Fed Did It
That the Federal Reserve caused the housing bubble seems like a statement of the obvious to me and really anyone with even superficial understanding of sound economics. I've already discussed the denial of Alan Greenspan, a man with an obvious personal interest in denying it.
Sebastian Dullen of Europe EconoMonitor may not like Greenspan have a personal interest in denying the role of the Fed, so presumably his denial is based on lack of understanding of sound economics. He advances somewhat different arguments than Greenspan, yet his arguments if anything makes even less sense.
His first argument is a repetition of Fed governor Frederic Mishkin's absurd argument that high interest rates encourages risky investments. The idea, it seems, is that by
making it more expensive to borrow, only risky investments will provide sufficiently high return to make it worthwhile, and so risky investments will increase.
Yet that makes no sense at all. Making it more expensive to borrow will reduce lending growth overall and not shift in any particular direction in terms of low and high risk. The risk in risky investments is a perceived cost for investors, for which they demand compensation. Therefore, they will not consider high risk investments more attractive just because the cost of borrowing is high. The level of risk free interest rates have really nothing to do with this at all. Instead, the effect of higher interest rates will simply be to reduce investments in general, and investment projects with a pay off far into the future in particular. But there is no reason to believe it will cause any shift in investments of different risk levels.
He further argues that the 1983-1986 housing boom is an example of a housing boom under tight monetary conditions. Which is completely misleading. Paul Volcker's monetary tightning was in 1980-82, and the housing boom followed after he implemented dramatic interest rate cuts in 1982. The housing boom followed just after that, with an increase in residential investments of 41.4% in 1983. That year, the MZM measure of money supply rose a full 24.8%, confirming the theory that looser monetary policies creates housing bubbles.
He then argues that the stock market bubble of the late 1920s is another example of a bubble supposedly not caused by the central bank. Which is complete nonsens as the 1920s had a significant monetary expansion, as Murray Rothbard showed in his book America's Great Depression. Dullen argues that real interest rates were high in America in the late 1920s, so monetary policy couldn't be loose. Yet the high real interest rates reflected structural factors related to the positive supply shock to production and profits. The fact remains that real interest rates were lower than they otherwise would have been due to Fed policy.
Sebastian Dullen of Europe EconoMonitor may not like Greenspan have a personal interest in denying the role of the Fed, so presumably his denial is based on lack of understanding of sound economics. He advances somewhat different arguments than Greenspan, yet his arguments if anything makes even less sense.
His first argument is a repetition of Fed governor Frederic Mishkin's absurd argument that high interest rates encourages risky investments. The idea, it seems, is that by
making it more expensive to borrow, only risky investments will provide sufficiently high return to make it worthwhile, and so risky investments will increase.
Yet that makes no sense at all. Making it more expensive to borrow will reduce lending growth overall and not shift in any particular direction in terms of low and high risk. The risk in risky investments is a perceived cost for investors, for which they demand compensation. Therefore, they will not consider high risk investments more attractive just because the cost of borrowing is high. The level of risk free interest rates have really nothing to do with this at all. Instead, the effect of higher interest rates will simply be to reduce investments in general, and investment projects with a pay off far into the future in particular. But there is no reason to believe it will cause any shift in investments of different risk levels.
He further argues that the 1983-1986 housing boom is an example of a housing boom under tight monetary conditions. Which is completely misleading. Paul Volcker's monetary tightning was in 1980-82, and the housing boom followed after he implemented dramatic interest rate cuts in 1982. The housing boom followed just after that, with an increase in residential investments of 41.4% in 1983. That year, the MZM measure of money supply rose a full 24.8%, confirming the theory that looser monetary policies creates housing bubbles.
He then argues that the stock market bubble of the late 1920s is another example of a bubble supposedly not caused by the central bank. Which is complete nonsens as the 1920s had a significant monetary expansion, as Murray Rothbard showed in his book America's Great Depression. Dullen argues that real interest rates were high in America in the late 1920s, so monetary policy couldn't be loose. Yet the high real interest rates reflected structural factors related to the positive supply shock to production and profits. The fact remains that real interest rates were lower than they otherwise would have been due to Fed policy.
posted by stefankarlsson at 7:24 PM
3 Comments:
we were on a gold standard during the 1920's. This means that there was minimal inflation/deflation and definitely not the cause of the great depression. The Great Depression was caused by the threat of across the board tariffs and the eventual tariffs that followed. This set off a global trade war which effectively destroyed human productivity. Going off the gold standard and instituting socialist programs made worse the already desperate situation. Remember on a gold standard, supply effectively adjusts for increasing or decreasing demand.
Check the book Gold: The Once and Future Money, by Nathan Lewis, out to get a better perspective.
Josh, the gold standard of the 1920s was not a genuine one. And the Federal Reserve did in fact manage to increase the money supply significantly, as Murray Rothbard pointed out in his book. A book which you can read for free in the link in the post.
That money supply increase was the cause of the stock bubble. The switch from significant monetary inflation during the 1920s to a significant monetary contraction was certainly the main cause of the depression.
Tariffs arguably made things worse, as did a few other things President Hoover instituted,but the idea that tariffs could have been the main cause of the great depression is simply ridiculous given the small importance of foreign trade to the U.S. economy.
I agree that inflation and deflation a serious distortions that curtail productivity in all forms. However, I just don't see how the Fed could have been causing inflation in the 1920's with the price of gold stable.
I disagree with the quantity theory of a currencies value because in reality, a currencies value has to do with supply and demand. So just because the base money supply is increasing doesn't automatically mean there is inflation. In fact, on a gold standard, the increase in money supply meant that there was a complimentary increase in the demand for money. This is why we saw stable gold and commodity prices. Remember that it is not M2 that should be counted as base money but solely M1.
I also disagree with Rothbard's assertion that the gold standard is good because it is hard to increase the supply of gold. The gold standard is good because the value of gold has been the most stable thing throughout history.
I think you need to read up on some Von Mises and classical value theory.
Also remember that not only was there a global trade war which killed imports and exports. There was also massive tax hikes and budget deficits that also added fuel to the flame.
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