Tyler Cowen Is Wrong On Austrian Theory & Interest Rates
As many of you have already seen, Tyler Cowen has again criticized the Austrian view that the low Fed funds rate was the main factor behind the housing bubble. His views doesn't differ dramatically from mine as he appears to concede that it was one of the factors behind the bubble, and as I believe that other factors were involved (mainly moral hazard created by previous bailouts, but also things like the Community Reinvestment Act and Wall Street incompetence). The difference thus lies in the relative importance we attribute to these factors. Also, he criticizes the Austrian business cycle theory on some points.
The case for arguing that it was the main factor lies in the fact that the boom started in 2001, with mortgage debt and house price growth being above 10% despite the recession and with construction activity unusually enough increasing during a recession. The reason why it happened during that year was that the Fed in less than a year cut interest rates from 6.5% to 1.75%.
As for his argument about long term interest rates and short term interest rates, that is a restatement of Greenspan's argument for absolving himself of guilt which I rebutted here. In short, first of all, short-term interest did have a direct impact on the market due to the spread of adjustable rate mortgages. And furthermore as I explained there are several reasons to believe long term interest rates will be affected. The reason why they didn't rise further after the Fed started to raise rates again in 2004 was that the market had already priced in the hikes (the 10-year yield had risen from 3.3% to 4.7% between June 2003 and June 2004 in anticipation of the coming rate hikes).
As for his and Paul Krugman's argument that consumption would have to fall during the boom and that there is no reason to expect a boom for that reason, that argument overlooks two things. First of all, consumption does in fact fall in relative terms during booms (at least relative to investments, in these days with trade deficits, it need not fall relative to GDP). The reason there is no absolute reduction is precisely because the boom is financed with the creation of new money (as opposed to voluntary savings), which due to the time lags involved do not immediately reduce consumer purchasing power and therefore consumption.
And in addition to the aforementioned effect of a higher real money supply due to the inevitable time lags involved, there is also another reason why higher relative investments have a more positive effect on output than higher relative consumption. Namely the fact that higher investments cause production capacity to expand and so boost supply in addition to demand, while higher consumption by contrast do not cause production capacity to expand. In fact, during busts the effective production capacity tends to fall as the production capacity specifically designed for the production of investment goods is no longer used.
The case for arguing that it was the main factor lies in the fact that the boom started in 2001, with mortgage debt and house price growth being above 10% despite the recession and with construction activity unusually enough increasing during a recession. The reason why it happened during that year was that the Fed in less than a year cut interest rates from 6.5% to 1.75%.
As for his argument about long term interest rates and short term interest rates, that is a restatement of Greenspan's argument for absolving himself of guilt which I rebutted here. In short, first of all, short-term interest did have a direct impact on the market due to the spread of adjustable rate mortgages. And furthermore as I explained there are several reasons to believe long term interest rates will be affected. The reason why they didn't rise further after the Fed started to raise rates again in 2004 was that the market had already priced in the hikes (the 10-year yield had risen from 3.3% to 4.7% between June 2003 and June 2004 in anticipation of the coming rate hikes).
As for his and Paul Krugman's argument that consumption would have to fall during the boom and that there is no reason to expect a boom for that reason, that argument overlooks two things. First of all, consumption does in fact fall in relative terms during booms (at least relative to investments, in these days with trade deficits, it need not fall relative to GDP). The reason there is no absolute reduction is precisely because the boom is financed with the creation of new money (as opposed to voluntary savings), which due to the time lags involved do not immediately reduce consumer purchasing power and therefore consumption.
And in addition to the aforementioned effect of a higher real money supply due to the inevitable time lags involved, there is also another reason why higher relative investments have a more positive effect on output than higher relative consumption. Namely the fact that higher investments cause production capacity to expand and so boost supply in addition to demand, while higher consumption by contrast do not cause production capacity to expand. In fact, during busts the effective production capacity tends to fall as the production capacity specifically designed for the production of investment goods is no longer used.
posted by stefankarlsson at 5:35 PM
3 Comments:
what is the austrians' view re: "shock therapy"? is your fellow swedish economist anders aslund, ultra-liberal, shock therapy proponent, considered one of austrians?
No, he is not considered to be an Austrian as far as I know.
It should also be pointed out that the securitization boom was accomplished by credit vehicles that were financed by short-term paper, and so relied fundamentally on artificially low short-term rates. These vehicles were a mechanism by which Fed monetary policy leaked into the rest of the yield curve.
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