On Austro-European business cycle theory

by on September 17, 2010 at 12:49 am in Books, Economics | Permalink

On the origins of the crisis, Raghuram Rajan writes:

It is true that the European Central Bank was less aggressive, but only slightly so; It brought its key refinancing rate down to only 2 percent while the Fed brought the Fed Funds rate down to 1 percent. Clearly, both rates were low by historical standards. More important, what Krugman does not point out is that different Euro area economies had differing inflation rates, so the real monetary policy rate was substantially different across the Euro area despite a common nominal policy rate. Countries that had strongly negative real policy rates – Ireland and Spain are primary exhibits – had a housing boom and bust, while countries like Germany with low inflation, and therefore higher real policy rates, did not. Indeed, a working paper by two ECB economists, Angela Maddaloni and José-Luis Peydró, indicates that the ultra-low rates by both the ECB and the Fed at this time had a strong causal effect in relaxing banks’ commercial, mortgage, and retail lending standards over this period.

That is taken from Rajan's response to the recent Krugman-Wells review of his book.  I am especially interested in this passage because I once made a version of Krugman's argument myself.

If you read the whole review, and response, you will see that this has become what is known as a "contested exchange."  Hat tip goes to Clive Crook.

Sunset Shazz September 17, 2010 at 2:14 am

Great piece by Rajan. A wonderful antidote to the “blame the thrifty foreigners for making us borrow and consume” trope.

Andrew September 17, 2010 at 6:51 am

I’m not sure if interest rates work this way, but a low rate could force people to make it up on volume. In that situation to say “it wasn’t the rates, it was the lowered standards” would be incorrect.

Bill Stepp September 17, 2010 at 8:14 am

Krugman is so incompetent that if were working for a firm instead of in a tenure-protected academic postition, he would have been fired long ago.

Chaitanya September 17, 2010 at 9:07 am

Re; ^

Furthermore, the cavalier method by which Rajan states this: “Simplistic mantras like “more stimulus† are the surest way to detract us from policies that generate sustainable growth.” lead me to believe not that Rajan *disagrees* with Keynes, but rather has never actually grappled with him and the consequences of a hypothetical deficient aggregate demand situation. Scott Sumner at least understands the issues and then disagrees instead of treating fiscal “stimulus” as a “Simplistic mantra” which it is surely not.

Andrew September 17, 2010 at 10:09 am

Another hypothetical. Let’s say that the total mortgage market is 100% with X% lowest creditworthy. Let’s call X 20%. Now, let’s say that Fannie and Freddie aren’t allowed to pursue the lowest 20%. However, they expand from the 50% highest all the way down to the 20.1% mark. Others take the bottom 20%. Is it still right to say that Fannie and Freddie weren’t partly responsible?

Greg September 17, 2010 at 10:28 am

@ Chaitanya…

It’s just you. That’s a ridiculously well-written response… and frankly, it’s 1/1000th as partisan as Krugman’s typical banter.

Andrew September 17, 2010 at 11:28 am

“I don’t understand his polarizing appeal at all.”

I think it’s important that you(we) understand it. That’s why I talk about him.

Fanon September 17, 2010 at 8:39 pm

*Nobel prize. Snark works best if you proof read.

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