Tyler Cowen--No, It's Alex Tabarrok--on Foul Weather Austrians

If they had separate weblogs with different color schemes I would confuse them less often. Whatever, Alex Tabarrok is puzzled by two things:

• First, that there are Foul-Weather Austrians--that Sachs, Krugman, Baker, and company even have an Inner Hayek to commune with. Where did they learn this stuff?
• Second, that they appear to regard Foul-Weather Austrianism as a streetcar that they can get off when they choose, long before the end of the line at Goldbug Station.

Tyler--no, it's Alex--writes:

Marginal Revolution: 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 US.

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.

I, too, am puzzled. I will try to think about this today.

N.B.: Add Mike Mussa to the list of Foul-Weather Austrians: http://www.iie.com/publications/papers/paper.cfm?ResearchID=205

Policy interest rates are exceptionally low in most industrial countries: zero in Japan and Switzerland, 1 percent in the United States, 2 percent in the euro area, and at or near historic lows in the United Kingdom and Canada.... The very low level of policy interest rates is an imbalance (relative to normal conditions) that reflects exceptionally easy monetary policies to combat economic weakness. This policy imbalance poses an important challenge for the future conduct of monetary policy. Situations of low policy interest rates and low inflation tend to be associated with unusual inertia in the processes of general price inflation, which makes traditional indicators of rising inflationary pressures less reliable as measures of the need to begin to tighten monetary conditions. Also, these situations tend to be associated with high valuations of equities, real estate, and long-term bonds, which can become fertile ground for large, unsustainable increases in asset prices. In this situation, if monetary policy is tightened too much too soon (perhaps because of worries about unsustainable increases in asset prices), the result can be an unnecessary asset market crunch and economic slowdown, and monetary policy may have relatively little room to ease in order to counteract this outcome.

On the other hand, if monetary policy remains too easy for too long (perhaps because subdued general price inflation gives no clear signal of the need for monetary tightening), then large asset price anomalies may develop before corrective action is taken. The monetary authority would then confront the grim choice of trying to keep an unsustainable asset price bubble alive or trying to combat the collapse of such a bubble without a great deal of room for monetary easing...

Comments

[derek]

Is it President Bush or President Clinton who proves that the office of President of the United States must be abolished? If it is neither, if you feel that a man, and not the institution he leads, is to blame, is that not naive?

[RedCharlie]

It all sounds like a case of common sense waiting for theory to catch up. Just because Austrian economics (seems to?) make sense at one extreme doesn't mean it makes sense over the whole spectrum. Just because two streetcar lines follow the same path in one part of the city doesn't mean they're parallel all the way to Goldbug station. Maybe one takes a left turn at Recessionville whereas the Austrian line continues on with stops at Depression Place and at the La Brea liquidity trap.

[RedCharlie]

"there is no standard model that I know of (say of the kind normally taught in graduate school) with these kinds of results"

IANAE, (and inane as well) but my pedestrian understanding is that when the Fed lowers rates, it is supposed to boost the economy and employment but at the risk of inflation. So, as long as inflation remains moderate, the Fed can keep rates low, right? I mean, the the idea behind Keynesian monetary policy is to ease credit when the economy slows, and restrict it when there is danger of inflationary overheating, no?

And what we apparently have is a period of low rates that did not (immediately) lead to inflation, but did lead to an asset bubble and subsequent crash in asset prices and credit lockup. Greenspan has said that the Fed's job is not to control asset prices, so how could have the Fed known to turn off the spigot before it got out of control?

But is this a problem for the Keynesian model, or a problem with our measurement of inflation? Only the top 20% has really seen any income growth since Bush took office, the rest of us have seen incomes flat or declining in real terms. But the "Bush Boom" has been real for the top quintile, especially the top 1%. But this narrow sliver of the population used their massively rising income to invest, not to consume staples. As Greenspan illustrated with his comments, asset prices are not part of our conventional measurements of inflation. So if a rise in income is confined to the investing class then the normally inflationary effect of that rise in income won't show up in our conventional measurements of inflation.

IIRC, rising house prices don't show up as inflation as long as the monthly payments remain flat. And easy money drives up home prices precisely because it allows one to buy "more house" with the same monthly payment. So even though the cost of housing has risen for everyone (not just the top 20% or top 1%) this hasn't really shown up in our inflation yardsticks.

Add in a large current account deficit that has managed to keep the cost of imported goods low and then mix in offshoring of high-paying manufacturing and tech jobs to help keep wages low, and one has a pretty good recipe for "sublimating" inflation into an asset bubble.

Thus rising income inequality, easy money with low measured inflation, and the housing bubble are not merely coincident, but reinforcing. At least for a while. Of course the difference between an asset bubble and inflation is that asset bubbles aren't sustainable. Bubbles pop eventually. And then all that "sublimated" hot money precipitates out, driving commodities (and inflation) up and assets down.