Foul Weather Austrians

I am puzzled by the resurgence of Austrian Business Cycle theory among Sachs, Krugman, Baker and many others who you would not ordinarily associate with the theory.  Sachs, for example, writes:

…the US crisis was actually made by the Fed… the Fed turned on the monetary spigots to try to combat an economic
slowdown. The Fed pumped money into the US economy and slashed its main
interest rate…the Fed held this rate too low for too long.

Monetary expansion generally makes it easier to borrow, and lowers
the costs of doing so, throughout the economy. It also tends to weaken
the currency and increase inflation. All of this began to happen in the

What was distinctive this time was that the new borrowing was concentrated in housing….the Fed, under Greenspan’s leadership, stood by as the credit boom gathered steam, barreling toward a subsequent crash.

What is puzzling about this is two-fold.  First, there is no standard model that I know of (say of the kind normally taught in graduate school) with these kinds of results.  Second and even more puzzling is that the foul-weather Austrians don’t seem to draw the natural conclusion from their own analysis.

If the Federal Reserve is responsible for what may be a trillion dollar crash surely we should think about getting rid of the Fed?  (n.b. I do not take this position.)  The true Austrians, like my colleague Alvaro Vargas Llosa, have long taken exactly this position.  So why aren’t Sachs, Krugman et al. calling for the gold standard, a strict monetary rule, 100% reserve banking, free banking or some other monetary arrangement?  Each of these institutions, of course, has its problems but surely after a trillion dollar loss they are worthy of serious consideration.

Nevertheless, I haven’t heard any ideas, from those blaming the crash on the Fed and Alan Greenspan, about fundamental monetary reform.  (Can Sachs, Krugman et al. really believe that it was Greenspan the man and not the institution that is to blame?  That seems naive.)

Instead, the foul weather Austrians seem at most to call for regulatory reform.  But that too is peculiar.  Put aside the fact that banking is already heavily regulated, have these economists not absorbed the Lucas critique?  In short, suppose that whatever regulation these economist want had been put in place in earlier years.  Would the crash have been avoided or would the Fed have simply pushed harder to lower interest rates?  After all, the Fed lowered rates for a reason and if the regulation reduced the effectiveness of monetary policy in creating a boom well then that just calls for more money.


we just need the *right* greenspan in there, alex. c'mon, man.

What was distinctive this time was that the new borrowing was concentrated in housing....the Fed, under Greenspan's leadership, stood by as the credit boom gathered steam, barreling toward a subsequent crash.

If the housing bubble was caused by low interest rates and is the Fed's fault, then how do they account for the greater run-ups in housing prices elsewhere? An excerpt from the recent End of the Irish Miracle piece:

"The average house price topped $490,000 at the beginning of last year, an increase of more than 300% in just over a decade, compared with 130% in the U.S."

Here's the situation for the UK:

"UK house prices 'nearly tripled'. Average house prices have nearly tripled across the whole country during the past decade"

And what about the euro-zone as a whole?

"The euro area average index of real housing prices has risen almost as much as that of the US and is now (as that of the US) about 40% above its 30-year average."

But I'm sure that Krugman, et al know this perfectly well. So what game are they playing? Election year politics, obviously (and in that game an argument doesn't have to right to be useful).

The whole Austrian thing is too inside-baseball for me.

When an institution works pretty well for a century, maybe it works pretty well, in general. Maybe "taking away the punch-bowl" is a critical piece of making it work.

I think the bigger, scarier, issue is that congress is considering props to keep the house-bubble inflated(!)

These men are not writing as economists. They are writing for the political sphere of debate. When they have written for the technical sphere, I bet they said different things.

Also, remember that these are people who generally see the world as needing to be controlled from the top. When something bad or good happens, the top is where they will look. That's the paradigm they follow.

Maybe it's the Ron Paul effect.

Slocum, anecdotally it seems to me that the EU runup in RE prices lagged the US.

Spain, for example, started to crumble after our market did.

I think the difference between Ron Reagan and Ron Paul had more to do with their demeanor than their policy prescriptions. True, Reagan slowly moderated from his initial Reason Interview stances, due to the realities of Washington, but his platform was not timid, when running against Carter and the 1970s economic concepts of Galbraith et al.

The difference is that Ron Reagan spoke with pride and humor about a strong free market America and a crazy, foolish and evil communist Russia; while Ron Paul whines about inflation and the Fed.

From Odograph:

When an institution works pretty well for a century, maybe it works pretty well, in general. Maybe "taking away the punch-bowl" is a critical piece of making it work.

Then, later:

I was rounding-up, using the post-Depression Fed as my starting point

So, were you then conceding the point that maybe the Fed has not worked well at all? One could also add in all the central banks that have failed in the past, and the other ones committing the same errors today.

The current crisis will likely pass, but the errors get larger and larger over time as total debt always outstrips total output. Eventually the entire edifice collapses.

As for Krugman and his ilk, they will be inflationist cheerleaders once Democrats are in the presidency. They have no intellectual honesty.

Slocum, anecdotally it seems to me that the EU runup in RE prices lagged the US.

Spain, for example, started to crumble after our market did.

Yes, but the point is no Greenspan easy-money policies (that allegedly caused the U.S. housing price run-up) have been in effect in the UK and eurozone markets.

Alex Reed,

I think Tabarrok is correct- keeping lending standards higher, or even raising them would have been contrary to the outcomes desired. If lending standards had been kept fixed, then the low interest rate policy would not have had the desired effect. The Fed would then have had to lower rates even more (or found even more ways to extend credit), and you would have ended up in the same place.


The Fed was instituted in 1913, during the Wilson administration. Though the country was technically on a gold standard, that was, in fact, a fraud, as was demonstrated by 1933's dollar devaluation (another fraud that was demonstrated by 1971's breaking of the final link between gold and the dollar).

No, the Fed get a lot of the blame for the Great Depression, it gets a lot of the blame for the stagflation of the 1970s and the deep recession of the early 1980s, and the present mess is almost entirely blamable on the Greenspan Fed's less-than-zero real interest rate policies.

A central bank can work if you can guarantee that it will maintain a fairly stable monetary unit, but such a central bank has never existed. This suggests that it will never exist. And once you start down the inflationary path, the incentives are to never deviate and to only accelerate the rate.

There are only two options: (1) inflate the debt away and destroy the currency, or (2) allow the debts to be realized and losses assigned to the proper parties. No one in government ever advocates the second of these options.

OK, maybe I'm thinking of the whole matrix of post-Depression institutions and mechanisms which (to my mind) formed a moderate, regulated, market, economy.

That didn't seem to bad to me ... until something happened in the 70's and 80's. And at this point I still see that 70's/80's thing as a breaking point, and inflection from past patterns, rather than the 1913-present rule.


What past pattern? There is no pattern that existed in the past that we don't see today. It is a boom/bust cycle caused by credit expansion and credit contraction. A central bank just makes it systemic.

I realize the past pattern you are trying to identify with is the period of 1950s to the 1970s, but trying to find something unique in that period of boom compared to, lets say, the boom period of 1983- 2000 is just fallacious.

If the Fed (and broader gov policy) was constant, what caused that? odograph:

The crux of the cause of our monetary mismanagement, especially since 1965, is the assumption that the money supply can be managed through interest rates, specifically the federal funds rate. We should have learned the falsity of that assumption in the Dec. 1941-Mar. 1951 period. That was what the Treas. – Fed. Res. Accord of Mar. 1951 was all about. During Vocker's tenure, he just widened the Fed Funds Bracket-Racket.

Even worse, Paul Volcker targeted non-borrowed reserves instead of total reserves. That is, today Bernanke is using only borrowed reserves in his control of the creation of new money & credit. That is, one dollar of borrowed reserves has the same legal-economic base for expansion of the money supply as one dollar of non-borrowed reserves. At times during 1979-1983 period, borrowed reserves were 10% of total reserves. And so it was obviously impossible to control the money supply using non-borrowed reserves as a policy rule.


Uh, no. What the Wikipedia page shows is that broad money supply has been growing geometrically nearly non-stop since the inception of the Fed. There have been lowering of the rates of growth from time to to time, but the trend is up, and up more, nearly the entire time of the Fed's life.

You really need a logarithmic scale to see this trend in the correct perspective. I will see if I can dig one up.

From 1982 to the most recent data point the money supply is up 117%. The prior 25 year period the money supply was up 240%. So based on this time period the expansion of the money supply has decelerated.

Problem was not Greenspan, lax regulation so much as inflation targets that overlooked asset prices. For more detail see:
Ensuring financial stability
March 27, 2008
How to fix the error in monetary policy.

This isn't totally on-topic, but I'd really like to see a mainstream economist seriously address ABCT. I don't think its as powerful an explanation as the folks at LMvI would have us believe (since I think there are plenty of other causes of clusters of bad investments), but there are a few things I've never heard addressed:

If prices coordinate economic activity, what does the rate of interest coordinate?
We know lower interest rates mean more loans are taken out. How much more debt is the 'right' amount?
If the interest rate doesn't coordinate inter-temporal action, what does?

I don't think rational expectations helps at all, because we are talking about irrational actions on the part of groups, not individual actors. As much of modern economics has shown us, rational individual behavior does not necessarily produce good outcomes for a group of individuals.

None of Tyler's critiques of ABCT have made any sense to me. I think he's tried to claim that banks don't have strong incentives to lend out the new funds they acquire, which sounds very wrong to me.

Markets are efficient as long as they pause to look at the information available and analyze it. The problem with human nature is it doesn't always wait for enough information to make an intelligent decision. There is that herd instinct, the feeding frenzy part in our brains from primitive days that helped us survive in more dangerous times. Now it can be a hindrance to the use of common sense.

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Try Bryan Caplan's critique of Austrian economics here. Scroll down to section 3.4 where he critiques the ABCT.

Oh, and more to the point, Bryan doesn't seem to offer any alternative to view to what interest rates do, how they should be "set", or what the effects of the Fed's manipulations are. Thats really what I'm after: An explanation of intertemporal coordination and interest rates that does not require one to accept ABCT on some level. As I've said before, I'm not convinced ABCT is nearly as significant as the LvMI thinks it is (given the many other likely causes of clusters of malinvestments), but I'm not convinced its as useless as many of the GMU bloggers seem to indicate.

I haven't read Robert's paper yet, but the precis makes it sound like he doesn't understand Hayek, who rejected the concept of the ave. period of production (for good reason).
Also, ABCT doesn't depend for its validity on a Hayekian triangle, which is only one way to look at ABCT.
As to the other criticism above about the macro/micro/(other?) trichotomy, what praytell is there other than micro- and macroeconomics?


What do you think about the argument that investors will err, but their errors won't be systematically biased? ie some investors will think the real interest rate is higher, some will think it is lower, and so capital won't be future-oriented due solely to lower nominal rates?

I think that flipping may overcome this, along with rigidities the government instills in the capital market, but I don't have a strong theory for this to present to you, it just seems intuitive. (My feeling is that ABCT can explain a lot, but needs some updating and expansion.)

Hmm, I'd never thought of flipping in that context.

If investor's estimates of the real rate of interest is all over the place, would that create an arbitrage opportunity between the the lower estimators and the higher ones? They'd be willing to pay more for capital they thought would yield a better present worth.

Suppose we had 4 investors who each owned identical pieces of capital making them $100 per year, but each estimated the real interest rate differently. So they'd estimate the present worth of each piece of capital as being:

A 5% $95
B 15% $87
C 25% $80
D 35% $74

I would think that regardless of the true interest rate, A would end up owning the most capital, while D would end up owning the least. So the capital falls into the hands of the person most likely employ it for uses too far in the future? Property is flipped towards people with ever-decreasing opinions on real interest rates? Would the same analysis apply to banks borrowing reserves from each other, meaning the most irresponsible banks would get most of the dough because they'd be willing to pay the most for it?

In normal situations, I'd think different estimates of the value of a factor of production to be a good thing, because they'd represent the Hayekian knowledge each individual had on how best to use that factor. But in this case most of the actors won't have specialized, local knowledge of the rate of interest, they'll just be wrong.

Am I way off on this? I've been coding for about 15 hours straight now, so I may well be :P


In your example: what is the real interest rate? At what point do these investments fail?

If some people overestimate the real interest rate, they will be less likely to invest in long term projects because they will expect it to rise later, hence they will reduce the total amount of long-term investment. Yes, those who underestimate it will get the most long-term capital, but that doesn't mean that the average length will necessarily increase.

For example, if most people overestimated the true rate, you'd have reduced long term investment. If most people underestimate it (the usual ABCT story maybe) then you'd have too much long-term investment. But if some err one way and some the other, they would cancel each other out.

I think thats the theory. Did I misunderstand you?

Regardless of what Krugman, Sachs, or Paul might think, the new currencies are already here. The big boys don't trust the Fed any more, nor even the euro, so they are brewing up something better. It's Carl Menger on derivatives.

I think entrepreneurs have a rather good understanding of this, surprisingly enough.

I work in a large computer manufacturing company. This company does everything it can to avoid having long supply lines. It insists that suppliers own the components almost until the last minute a computer is assembled. Then once the components are bought the money only changes hands after a payment period. It keeps virtually no stock. The suppliers behave in a similar way, they keep rather more stock though. They can afford to since their cost per component is low most of the cost in computer components is the R&D to design them.

For all this effort much time is involved in making products. My company start cooperating with the component companies on design years earlier. The component companies begin R&D maybe 5 years before the product is sold. The major tooling costs to build things like silicon masks occur years before the product is sold in many cases.

I think its quite correct that businessmen don't look at the interest rate much. However, they look at opportunity cost. If a process to end product is too slow then that can cost more because of the lost opportunity of allocating resources to faster products. The opposite can occur too. It may be a mistake to invest in projects that are too short.

Suppliers of components - which are often medium size companies - borrow to finance their investments. Some don't borrow, but the financiers that own them do, or they compare their returns to benchmark rates such as the Dow and interest rates. Anyway, if interest rates are low then it is in the interest of the component suppliers to perfect everything. They can have long design cycles and invest years before safely. If interest rates are high they can't.

Some would say "what company only makes the interest rate?" well, very few make that little. However, some lose their market and go bankrupt. Some make losses for years running. So, investors must request a large premium on the interest rate to protect themselves. A company with long term viability is one that can make the interest rate plus this risk premium for its shareholders.

I don't think the natural rate of interest really comes into it, except in uncompetative markets. In competative markets a business must take a similar amount of time over production as its competitors do. If its competitors are willing to wait for years it must be willing to do the same. Otherwise it won't be able to produce products or they will be too expensive.

For example it took years for 802.11n wi-fi to be developed with all the parties involved investing all the way through. Any company whose financiers thought the payoff wasn't worth the wait would have had to have pulled out of the market.

In the world of mobile phones some component vendors have been prepared to lose tens of millions every year for maybe 5 years in the hope of future payoff. These companies have severely damaged the other group who insist on making some profit.

"Those under-estimators would own the long-term projects, and use those projects to undertake projects which would more easily fail as they would tend to have difficulty paying back creditors (in the case of fixed interest rate loans, the creditor would have more difficulty staying solvent, having loaned out funds at a too-low of a rate)."

Or, because the other investors are choosing short term projects fewer long-term projects are chosen overall, and they tend to be the less risky (less likely to fail), because they are the best of the crop (investors wanting to do well and all). That is the idea, I think.

"Of course, I think its very dubious to assume that entrepreneurs would even think to consider what a 'natural' rate of interest would be, or have any knowledge of ABCT. I've never spoken to one who had ever heard of it. Many don't even have a theoretical understanding of prices as signals in the economy."

Right, but their tendency to profit maximize makes them aware of inflation and interest rates generally. They do watch what the Fed does. If they see the Fed meddling with interest rates, they take this into account. Notice all the articles on the Fed in business magazines, Wall St. Journal, NY Times, etc. They won't have a sophisticated economic analysis, but they probably take it into account in less precise ways - hence they err but their errors cancel out.

Again, just presenting the view - not defending it in full. And I think rigidities mess everything up.

Tyler, you say you don't subscribe to the Austrian theory of the business cycle. I'm interested in reading your opinion on why you don't subscribe. Is it for the same reasons that Bryan Caplan disavowed his erstwhile Austrian appellation?

I have two comments to add to the mix: one regarding inflation and the second regarding the housing crisis and regulation, which I think are separate issues.

First regarding inflation and its measure.
If one advocates free market economics, shouldn't the most reliable assessment of inflation be the price of gold? The monetary reform of the 1980's suppressed all but the minutest changes in the price of gold until 2004 (hovering at $400/oz plus minus $50/oz the entire period except for small deflationary period that accompanied the year 2000 recession) Since 2004 however it shot up at an almost linear rate reaching $800/oz this year (with a speculative hiccup in between reaching almost $1000/oz), indicating an agressive inflation on the part of the fed.

Second regarding banking regulation and the housing bubble. Definitely the peak of subprime mortgage (2004-2006) issuing coincides with the inflationary (as measured by gold) period after 2004, so the inflation did not help at all. Also, the major inflation during 2004- is consistent with the recessionary correction occuring now. Nevertheless, we should not forget that government regulation specifically requiring and encouraging the issuing subprime mortgages are primarily to blame for the housing aspect of the crisis. Similarly, CAFE fuel economy regulations and pro labor union policies are equally blameworthy for the predicament of american automobile industry.

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