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Is the low Fed Funds rate to blame?
Consider that the Greenspan Fed maintained a 1.75% Fed fund for 33 months (December 2001 to September 2004), a 1.25% for 21 months (November 2002 to August 2004), and lastly, a 1% Fed funds rate for 12+ months, (June 2003 to June 2004).
Here is the link. But no, I don't side with Austrian Business Cycle Theory in citing loose monetary policy as the main factor in the artificial boom which preceded the crash. I view the boom as having been fueled by new global wealth, most of all in Asia, and the liquification of that wealth through credit and the desire for additional risk.
Note that if an increase in real wealth fuels the investment boom, consumption can be robust or even go up at the same time as the rise in investment. Now, in the boom preceding the current bust, was American consumption robust? Sure. If the investment boom had been driven mainly by monetary factors, investment would have gone up and consumption would have gone down, as explained here. (Try a rebuttal here.)
Loose monetary policy did contribute to the bubble. In that sense I would defend a modified Austrian theory. But other reasons also suggest that monetary policy was not the main driver. Money has a much bigger effect on short-term rates than long-term rates. Even long-term real rates have only mixed predictive power over real economic activity, including investment. The Austrians have never developed much of a theory of bubbles. Ideally you would have a good bubble theory, with Austrian-like monetary factors stirring up the bubble even more. But you can't get away with pinning so much of the blame on the government, as modern Austrians are wont to do. "Bubbliness" is a private sector imperfection and relabeling it as "government distorting price signals through monetary policy" doesn't much change that.
Posted by Tyler Cowen on October 21, 2008 at 06:21 AM in Economics | Permalink
Comments
You should do a blogging heads episode/debate with Arnold Kling. I could show it to my high school students. The world would be a better place.
Posted by: josh at Oct 21, 2008 7:26:57 AM
You write : "Bubbliness is a private sector imperfection"
Anna Schwartz says to the WSJ : "If you investigate individually the manias that the market has so dubbed over the years, in every case, it was expansive monetary policy that generated the boom in an asset."
In principle, how could such an issue be settled?
Posted by: Gu Si Fang at Oct 21, 2008 7:36:18 AM
If the investment boom had been driven mainly by monetary factors, investment would have gone up and consumption would have gone down, as explained here.
I don't understand why you accept this claim? Total spending must equal total income, as Krugman says. More investment means less consumption.
But that assumes my income comes from withing 'the system' so to speak. What if I was printing up my own money? I could certainly expand my investments without decreasing my consumption.
What am I missing?
Posted by: Marcus at Oct 21, 2008 8:00:37 AM
@ marcus:
"What am I missing?"
maybe Capital consumption, as in Tyler's link to the rebuttal.
higher investment with higher consumption is possible, if the latter comes from a reallacotion of resources from the maintenance of the current capital stock to production. Eventually the capital stock will deteriorate and consumption fall to a lower level.
Posted by: bb at Oct 21, 2008 8:23:23 AM
We live in a mixed economy and the reasons for bubbles are mixed. However government sets the parameters. If the parameters are expansive then private actions will push to the limits prior to being reined in by reality. If limits are less "expansive" there is less room for a bubble.
In the current case, the subprime problem began with the New Deal mortgage guarantee, LBJ`s taking the guarantee off the Federal books and then the Clinton approval of sub-prime mortgages.
Posted by: John Bailey at Oct 21, 2008 8:31:21 AM
While many bubbles have been fed by loose monetary policy, and certainly that policy helped stimulate the US housing bubble, Schwartz is simply wrong about the general statement. Did loose monetary policy cause the original tulipmania in 1636-37? Answer: No. There are plenty of other counterexamples.
Very pro-free market experimental economist, Vernon Smith, and his colleague, David Porter, who used to be at George Mason, have been doing experiments on bubbles in experimental markets for a good 20 years now. Bottom line: bubbles are very ubiquitous and happen in lab situations all the time without "loose lending" and even with finite time and known time horizons with known fundamentals, divident payments. With enough experience, people can learn to avoid bubbling, but the tendency to engage in speculative bubbles is very deeply rooted.
Posted by: Barkley Rosser at Oct 21, 2008 9:05:58 AM
"Bubbliness" is a private sector imperfection and relabeling it as "government distorting price signals through monetary policy" doesn't much change that.
Bubbliness in housing values specifically has strong public sector components, namely zoning and land-use regulations, as Ed Glaeser's work suggests. However, while regulations do seem to affect the likelihood and length quite strongly, if people are convinced that prices must rise they can rise nearly everywhere.
Still, the role of land-use regulation in bubbles is too often ignored; partially that's because there's so broad agreement in at least the principle of them because they can encompass so many goals, from environmental to aesthetic to simply increasing prices. Even people who oppose the particular regulations in an area (such as DC's density-decreasing regulations) tend to favor different regulations. Also, of course, there's local issues.
If Iceland, Germany, Spain, Arizona, California, Florida, Nevada, and northern Virginia had bubbles, but fast-growing Texas and North Carolina did not, perhaps rather than assault libertarianism it might make sense to ask what's different about Texas and North Carolina. It could just be a lack of local confidence in ever-rising house prices, but there could be something there.
Posted by: John Thacker at Oct 21, 2008 9:06:02 AM
Bottom line: bubbles are very ubiquitous and happen in lab situations all the time without "loose lending" and even with finite time and known time horizons with known fundamentals, divident payments. With enough experience, people can learn to avoid bubbling, but the tendency to engage in speculative bubbles is very deeply rooted.
Indeed it is. In one strict probabilistic sense, bubbles occur infinitely often. As it relates to housing, though, it at least seems to makes sense to avoid public policy that research, such as Ed Glaeser's, has shown makes bubble occur more often.
Posted by: John Thacker at Oct 21, 2008 9:10:56 AM
Is "loose monetary policy" the same thing as "maintaining interest rates at an artificially low level"?
Posted by: pants at Oct 21, 2008 9:15:57 AM
Attributing this entirely to the Fed wouldn't answer the question of why this is a global phenomenon.
Real estate skyrocketed in England, Ireland, and Spain in particular. Why? Is this simply copy-cat mania?
Banks abroad are requiring cash injections from their governments. Why? Are their assets so tied in with American banks that our meltdown is necessarily their meltdown?
Posted by: meter at Oct 21, 2008 9:47:55 AM
It may not be a monetary bubble (which I said at my blog, though not quite as eloquently :P), but there can still be important parts that have been government driven. Like "forcing loans onto subprime mortgagers."
I know that you have already covered things like the Community Reinvestment Act on MR, but it's important to make the caveat that monetary policy is not government's ONLY policy.
Posted by: Robert Olson at Oct 21, 2008 10:33:59 AM
Re: John Thacker
Bubbles can start because those with bounded information sets extrapolate the current rates of return into the future. The rapidly rising home prices induced by land-use supply restrictions caused a trend that naive investors extrapolated. I know this is anecdotal, but I know a man with only a high school education who got burned on the housing bust. I paraphrase him, "I just saw prices steadily rising for several years, so we bought a bigger house than we knew we could afford because we thought we would be able to sell after a few years and pocket the equity. Everybody said that home prices never go down."
I made the same mistake in junior high with baseball cards, and my grandmother made the same mistake with beanie babies.
Bubbles don't need a government intervention to start, but a government distorted trend can cause a bubble.
Posted by: Brian Shelley at Oct 21, 2008 10:39:42 AM
Whether or not one accepts:
1) A big global pool of money that needs to be invested.
2) Easy money from the Fed.
The Spigot Theory, you turn these conditions on and you eventually get a bubble, don't explain the crisis.
After all, it's one thing to argue that these actions cause an increase in investment, it's another to argue that they cause an increase in poor investment. What explains the increase in poor investment is the system of implicit and explicit government guarantees to intervene in a financial crisis.
Posted by: Don the libertarian Democrat at Oct 21, 2008 10:46:16 AM
"Note that if an increase in real wealth fuels the investment boom, consumption can be robust or even go up at the same time as the rise in investment. Now, in the boom preceding the current bust, was American consumption robust? Sure. If the investment boom had been driven mainly by monetary factors, investment would have gone up and consumption would have gone down, as explained here." -Tyler
"higher investment with higher consumption is possible, if the latter comes from a reallacotion of resources from the maintenance of the current capital stock to production. Eventually the capital stock will deteriorate and consumption fall to a lower level." -bb
Notice how savings went to near negitive levels during the last boom and debt levels soared among consumers due to lack of real captial?
While no theory is perfect, it does seem that our current situation is like a text book Austrian theory scenario.
Posted by: at Oct 21, 2008 10:52:28 AM
Again, you blowhards can continue to incite the cheap "it's all Clinton's fault" mantra and/or the "It's all because of the CRA!!!!" throwaway line, but oftentimes the answer is multidimensional. Strain your rightwing-addled minds for more than 5 minutes. It's rewarding, I promise.
Especially John Bailey_who_has_it_all_figgered_out.
Posted by: meter at Oct 21, 2008 10:56:46 AM
Wait a sec. People wanted to take risk with houses? I don't think so. How 'bout this? Dumb asset sovereigns bid down "riskless" investments until the only things left on the shelf were things that were virtually riskless until everyone bought all of them too and the salesman had to start packaging up garbage that was plausibly risk-free. And, since it was risk free and the return so lousy, people had to lever up.
I remember hearing analysis that China alone accounted -1.5% rate on Treasurys. And not everyone can take government-insured deposits paying out .2% fractionally reserve against them at 10 to 1 and skim the cream off the float. The investment banks were a bad business model, but only because they can't compete with free money.
Posted by: Andrew at Oct 21, 2008 11:08:53 AM
When you pump money into a generally confused market, bubbles will inflate. In this case, it went into the only places money wasn't scared away from recently; first housing, then commodities.
When it went into commodities, consumption expenses went up. This decreased the supply of eligible borrowers and increased the default risk on existing loans even before considering the fall in asset prices.
Posted by: aaron at Oct 21, 2008 11:10:20 AM
"Strain your rightwing-addled minds for more than 5 minutes. It's rewarding, I promise."
Physician, heal thyself.
Posted by: MM at Oct 21, 2008 11:16:11 AM
"Money has a much bigger effect on short-term rates than long-term rates."
Have you not heard of "inflationary expectations"? The Federal Reserve signaled its commitment to inflating the currency by keeping interest rates low through the dot-com crash, so naturally long term rates fell, given the signal that short term rates would remain low for a long time in the future.
Posted by: Anthony at Oct 21, 2008 11:22:00 AM
People wanted to take risk with houses? I don't think so.
Certainly not everyone, but the percentage of non-owner-occupied houses went up dramatically in bubbly areas during the bubble.
The fact that my cable television carries two programs, "Flip This House" and "Flip That House" running against each other simultaneously implies that at least some people wanted to make a quick buck off housing. OK, perhaps they didn't want to take risk, but that's because they thought that they had found a free lunch.
Posted by: John Thacker at Oct 21, 2008 11:26:52 AM
Tyler,
I thought Robert Murphy gava a nice response to your previous post of the ABCT which incorporated the importance of capital theory (something you don't do)...and you have yet to respond to it or acknowledge it. I think you should. Murphy is obviously much more astute in Austrian Economics than you are, Tyler. I'm saying Murphy is necessarily right because of that but I do think his level of understanding on the matter deserves some consideration on your part in form of some acknowledgment in your subsequent posts on this.
I notice that on matters like ABCT, you seem very able and willing to open discussions but rather unwilling to continue a dialogue by addressing Austrian economists who respond to you.
Posted by: John V at Oct 21, 2008 11:42:18 AM
Correction:
I'm NOT saying Murphy is necessarily right...
Posted by: John V at Oct 21, 2008 11:43:57 AM
John Thacker,
If you'd asked most of these people if they thought they seeking out risks, including the speculators and the sub-prime borrowers, I bet they wouldn't have even understood the question.
If I asked the person I bought my house from if they'd considered beta before buying, I imagine them responding, "I used to live in a real dump, so this house was beta."
Posted by: Andrew at Oct 21, 2008 11:48:58 AM
I know a lot of ABCT proponents claim that it is the theory of everything, so showing one minor shortcoming disproves the whole thing for Tyler and Krugman, however, everyone is ignoring the evidence in plain sight even for the last two bubbles.
What were the cliches that everyone knew?
Tech Bubble: "Greenspan put"
Housing Bubble: "Home prices always go up"
Those were things people alctually said, and not just Austrians ridiculing the government.
Posted by: Andrew at Oct 21, 2008 11:54:38 AM
"the desire for additional risk"
make that "the obfuscation of real risk".
Posted by: Oskar Shapley at Oct 21, 2008 12:07:30 PM
