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Give Credit Where Credit is Due

Austrian Business Cycle Theory, Austrian economics, FOMC, malinvestment, Thomas Hoenig
Thomas Hoenig, Wikicommons

hoenig-fdicThis morning over breakfast at the neighborhood bakery, I read a very nice article in the New York Times concerning the "unconventional" views of Kansas City Fed President Thomas Hoenig–views that have made Hoenig my own favorite Fed insider for some years now. Hoenig's beliefs, as summarized there, struck me as being virtually the same a those I'd put forward in London in what I considered to be a defense of Hayek's thinking about business cycles. Consider:

"The central bank has to be, in a way, a neutral player, and yet we find ourselves trying to stimulate, and the effect is further leveraging,” he said. “If I thought zero rates would bring jobs, I’d want it forever. But it distorts the economy.”

He continued, “In 2003, when we lowered rates and kept them there because unemployment was 6.5 percent — look at the consequences.” Those consequences included the nation’s mortgage feast, followed by its current economic famine.

Returning home, I read this comment from Bill Woolsey on David Beckworth's blog:

I am a bit of an ABCT skeptic, but I am more and more concerned that using a commitment to keep interest rates low in the future is the most likely way to generate malinvestment. In my view, the way to avoid malinvestment despite errors in monetary policy is for people to understand that future short term rates will reflect future conditions. An investment project that is only profitable if short term rates are maintained into the future, is an error. And, by the way, having the Fed purchase long term bonds to directly lower long term rates has a similar problem.

Although I don't call myself an Austrian economist, and am more than happy find fault with arguments by self-styled "Austrians" that I think unsound, I can't help feeling that Hayek deserves a lot more credit than he's getting for having put forward a theory which, whatever its general merits may be, seems to fit the recent boom-bust experience so well. So far as I'm aware, Mr. Hoenig never mentions Hayek, and may not even be aware of the overlap between his own thinking and Hayek's theory. Bill Woolsey, on the other hand, knows about the ABCT, sees the fit to recent experience, but remains a "skeptic." I wonder whether he is merely indicating his disagreement with those more fervent proponents of the theory who seem to insist that it is the only valid theory of cycles.

In any event it seems to me that anyone who believes that the recent bust is to some important extent a consequence of past malinvestment that was sponsored by easy monetary policy ought to acknowledge the fact that F.A. Hayek spent much of his early career warning against this very possibility, and later won a Nobel prize for the work in question. That something akin to his theory, if not the very thing itself, is now subscribed to by many non-Austrians, either with no mention of Hayek's contribution or with somewhat grudging acknowledgment of it only, seems to me both strange and unfair.


  1. I have not read Hayek's academic work, only The Road to Serfdom and assorted articles aimed at a popular audience. I don't often discuss business cycle theory, but I will drop "malinvestment" now and then.

    In Hayek's way of thinking, is a central bank policy the only possible source of malinvestment? Suppose interest rates are very low because an unusually large number of people wish to defer consumption while a relatively small number of people wish to obtain credit. The supply of money is not artificially high. Independent individuals and organizations really want to extend so much credit. They just can't find enough credit worthy borrowers.

    Consider an extreme scenario in which ten people of the same age have a total of two children. These twelve people are the entire population. As the ten oldsters age, they all want to extend credit to the two youngsters and retire well at 65 on the yield of this credit.

    No law of economics implies that the two youngsters can become productive enough to provide the ten oldsters so much retirement, no matter how much credit the oldsters will extend, no matter how low the interest rate, even if the rate is negative.

    The oldsters can extend each other credit to organize all sorts of capital that could make more than two youngsters more productive, if only more than two youngsters existed, but all of this productive capacity is malinvestment in fact, because only two youngsters exist.

    The demographic transition seems practically to guarantee this sort of thing. Why would this transition not create malinvestment like a central bank with an easy money policy?

    Greenspan has suggested along similar (though not identical) lines that rapid growth in China (which faces a very rapid demographic transition following the one child policy) and elsewhere was more responsible than Fed policy for low, long term interest rates, particularly mortgage rates, in the U.S. leading to the housing bubble. What is wrong with this reasoning?

  2. I agree with the first Martin. Some students of Austrian economics can be a little more than off-putting to say the least, especially when they refuse to read any economic literature outside of that prescribed by the Mises Institute.

    I'd say besides ideological reasons (Hayek was an advocate of freer markets and most of the professional academic community wasn't) Hayek's capital and monetary framework was neglected because it is simply incommensurable with the prevailing orthodoxy, which places the "crisis of capitalism" in (long-run) interest rates that are too high, not too low, as Hayek and others argued.

    At any rate, it's unfortunate that more of Hayek's insights weren't integrated into the mainstream.

  3. Prof. Selgin, what do you think of Gary Gorton's work regarding the crisis (and other monetary history as well)? In his research, he hardly mentions monetary policy, and points out that empirical evidence suggest loosening lending standards had no effect as well. Banks made loans completely dependent on house prices rising in order to be profitable. When house prices quit rising those loans, which had been securitized into instruments being used as risk-free collateral in the repo market, turned highly unprofitable. How does one see this through the lens of free banking? Thanks.

    1. Very briefly, jd (as I am overwhelmed by other pressing tasks lately), I generally consider myself a fan of Gary Gorton's work, having referred to it often in developing my own case for free banking. I am less keen, though, on his writings concerning the "Panic of 2007," and especially on his attempt to stretch the "contagion of fear" argument for bailouts–an argument of already doubtful merit even when limited to commercial bank failures–to make it serve as a justification for bailing out investment banks as well.

      As for Gorton's claim that monetary policy and looser lending standards cannot have had any role in the boom since the extent of lending was strictly geared to the rising value of homes, it is the same ludicrous reasoning that underlies the notorious real-bills doctrine. To see the fallacy, consider the following circular reasoning: "Housing prices are rising. Therefore the creation of additional loan-based monetary assets is justified. But that causes house prices to increase still further, therefore… ." All the while, the amount of real collateral lags further and further behind the extent of nominal indebtedness.

      Get the picture?

  4. Yes, thank you for the reply. I've not read your book, so I'm missing a lot of the basics. But it seems to me that from Gorton's work that the belief that house prices would keep going up was an underlying motivator of loans made by a lot of rational actors, even in the absence of monetary policy (the 1930s were forgotten, omitted from models, etc.). My question is (and any commenter can answer)- how would free banking mitigate the irrationality? Or would it not? Would a free banker simply argue that the system remaining after all the losses were realized in a free banking society would be stronger than the one in our current system?

    Also, is there a role for a lender-of-last-resort at all, even one just similar to what Bagehot describes in Lombard Street, in a free banking world? Would there be a role for consortiums of clearinghouses like Gorton describes existing in New York and elsewhere in 1907?

    Thanks again.

    1. To be sure, investors were banking on house prices continuing to rise. But that's just another way of saying that they were banking on the Fed being able to keep them rising.

      Under free banking a mere increase in nominal asset values wouldn't stimulate growth in the money stock unless it included an increase in the supply of bank reserves. Otherwise increased nominal income would tend to cause banks to retrench by conmfronting them a growing demand for reserves and hence with reserve shortages. For the theory I must refer you to my Theory of Free Banking, which is available online at the EconLib site.

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