Why The Austrian Business Cycle Theory Is Wrong

One of the surprisingly popular theories as to why the recession occurred is known as the Austrian Business Cycle Theory (ABCT), which argues that not only is the government not the solution to the recession, but in fact, it is also the cause. It claims that the recession was caused by the government artificially lowering the interest rates and distorting the economy leading to a recession. As you can imagine this theory is very popular among libertarians eager for an excuse to absolve the market of blame for the crash. It is promoted by Ron Paul and Peter Schiff who claim to have predicted the Financial Crash (and the next one too). It is also completely wrong and dangerously so.

The Theory

The Austrian Business Cycle Theory gets its name from the fact that many of its original advocators were Austrian, though it is now an American ideology. It argues that when the central bank artificially lowers interest rates this causes banks to over-lend. Investments seem cheaper and therefore plans that wouldn’t have otherwise been made go ahead, creating malinvestment. The expansion of credit leads to inflation and a distortion of the economy. In particular there is an unsustainable investment in production such as the building of new factories. Eventually, the unsustainable bubble bursts and the investments have to be abandoned and the economy allowed to re-adjust. During this period the economy is in recession and workers are unemployed as they re-adjust to more sustainable plans. Crucially, unlike other theories, recessions are viewed as a necessary healing time that the economy must go through, any attempt to shorten them only delays the recovery and makes the problem worse.

Hangover Theory

The ABCT is commonly explained using the metaphor of a hangover. This turns an economic lesson into a Greek morality tale of hubris. It argues that cutting interest rates is like cutting the price of alcohol with the result that people drink too much. Eventually people run out of drink and wake up with a terrible hangover the next day. As painful as it is, it must be endured both as part of sobering up and as punishment for getting too drunk. Keynesian policies advocated by Paul Krugman (to supporters of the ABCT Krugman is the eternal enemy) are the equivalent of hair-of-the-dog, that is to say, trying to avoid a hangover by continuing to drink (launching a fiscal stimulus or keeping interest rates low). This only makes the damage worse in the long run and delays the necessary recovery. In the Austrian view you must swallow your medicine and cleanse your system.

Natural Rate Of Interest

Crucial to the ABCT is the notion of a “natural rate of interest” that is, how much it would cost to borrow if it wasn’t for government interference. Austrians view central bank control over the interest rates as a price control over a commodity that should be left to the market (though interestingly, they predict over-demand rather than under-supply as the problem). They argue that banks are a business just like any other, if they want to attract savers they will raise their interest rates and if they want to attract borrowers they will lower the interest rate. Between these two pressures banks will find an equilibrium that exactly suits the state of the economy. However, any diversion from this point by the government will distort the economy.

The natural rate of interest is so crucial to the ABCT that it cannot function without it. Which is why it is a shame that it is not true. The problem is that banks are nothing like other businesses (as anyone who has been following the papers over the last few years can surmise). When deciding how much money to save, ordinary people do not consider the interest rate they will receive or compare the rates of various businesses. The decision to save has more to do with how much is left over of your wages after paying bills as well as the temperament of the individual. Cautious people save regardless of interest rate and reckless people care even less. Likewise when borrowing money, the flexibility on part of the bank is valued more than the interest rate (for example Anglo Irish Bank was popular because developers knew they could receive money even though the interest rate was higher).

There is a further problem as the ABCT assumes there is only one natural rate of interest in the economy. However, there is no reason to think this is the case (unless there is only one commodity in the economy or it is a barter economy, which believe it or not, is what the original proponents assumed). Rather there would be one rate for houses, another for cars, another hotel construction etc. This point was even conceded by Fredrick Hayek himself who acknowledged that there is no one natural rate of interest. Without one natural rate of interest, you can’t claim the government is forcing rates too low and therefore the theory crumbles. That one of the main Austrian theorists admitted this shows how bad a problem it is.

Predicting The Crash

It is claimed that the ABCT is such a good explanation of recessions that Austrian economists both predicted the Great Depression and the Financial Crash of 2008. Unfortunately these claims fail to live up to expectations. Hayek studied the economy and market as part of his job at the Austrian Institute For Business Cycle Research where he also wrote monthly bulletins. At the end of 1928 he wrote that “The credit situation is to be described as awkward and difficult, but not as dangerous.” Here he expresses some uneasiness, but hardly a prophecy. However, his case loses all credibility when reading the bulletin of October 26th, 1929 (two days before deepest drops). Hayek writes that “However, at present there is no reason to expect a sudden crash of the New York stock exchange. However, it is not impossible that the end of the absolutely amazing price increases has arrived, and [that] the [price] level should slowly crumble. The credit possibilities/conditions are, at any rate, currently very great, and therefore it appears assured that an outright crisis-like destruction of the present high [sc. price] level should not be feared.” This is the equivalent of someone claiming in September 2008 that the economy was not going to crash and at worse would suffer a soft landing. The evidence for Mises is even scantier and needs less discussion (suffice to say there is no evidence to support the claim he did).

Some Austrian economists did predict the 2008 crash, but this is an example of being right for the wrong reasons. There is no mention in ABCT of asset bubbles, excessive debt levels, lack of regulation, bad debts, stock market crashes or basically any of the features of the 2008 Financial Crash. Low interest rates certainly did contribute to inflating the boom, but they are a small piece of the picture, not the core. The notion that Austrian economists predicted the crisis is not on its head by a footnote by one of their own. After outlining the ABCT as above, Murray Rothbard drops a bombshell that discredits Austrian claims. He writes that “To the extent that the new money is loaned to consumers rather than businesses, the cycle effects discussed in this section do not occur. (Rothbard 2004 [1962]:995–996).” In other words the ABCT predicts a bubble and burst only if businesses receive most of the lending. If consumers do, then there will not be a bubble. As the boom through the 2000s was driven by consumer borrowing (mainly to buy property) the ABCT falls flat on its face.

Brittle Economy?

It is strange to hear Austrian economists who otherwise worship the market as perfect, superior to all other institutions and incapable of failure, claim that only four years of below average interest rates will almost destroy capitalism. Is the economy that brittle and that unable to adapt, that a not significant change causes it to buckle and snap? The market which otherwise is praised as the ultimate form of efficiency becomes a wildly unstable machine swinging from drought to flood with every change of interest rate. The problem for ABCT is that history disagrees. There have been periods of low interest rates without causing asset bubbles or major recessions resulting. Interest rates are merely another cost for a business and a minor one at that. Do bubbles result from all reductions in business costs? If wages temporarily decline will that lead to an unsustainable bubble? The Federal Reserve began raising interest rates as early as 2005, yet rather than dampening the boom (if interest rates were the main driver) it kept roaring on. There is a marking lack of correlation between interest rates and economic activity, making ABCT a theory without a basis.

Why Aren’t We In A Bubble Now?

The final nail in the coffin of the ABCT comes from the fact that although interest rates are at an all time low at the moment, there is no bubble or boom; to the contrary the economy is stagnating. Proponents of the ABCT claim this should lead to another bubble and many have embarrassed themselves by the failure of this prediction. It must be concluded that interest rates are not the driving force of booms. Furthermore, the massive money printing of Quantitative Easing has not lead to the mass hyperinflation as warned or another bubble, the reality has been more of a damp squib. This is especially important as Austrians seem to believe that Keynesian economics amounts to nothing more than wildly printing money, despite the fact that the idea behind QE was promoted if not created by conservative darling, Milton Friedman.

Let The Fire Burn

It’s best to think of the ABCT response to recessions as if your house caught on fire but the government decided not to send fire fighters. After all, it is the people’s own fault they weren’t watching the cooker and if everyone knew the government would put out their fires no matter what, well then everyone would take up smoking and throw cigarette ash around like confetti. No, the fire should be let burn as interference would only make things worse and the fire will naturally die out. Now this is technically true, just as all recessions do end even if the government doesn’t intervene, but left to itself far more damage is done. Refusing to fight recessions is like refusing to fight fires; the problem will last longer and spread to otherwise safe places. We may not like the cost of a fire service or that it will lead to government agents in our house, but when your house is on fire special exceptions must be made.

Conclusion

So that is why ABCT is wrong. It greatly exaggerates the importance of interest rates and completely misunderstands the causes and solutions to recessions. The evidence does not support it and instead shows many examples of times when changes in the interest rates did not have the extreme results predicted. Its refusal to fight recessions is not only wildly incorrect, but positively dangerous. Even conservative icon Milton Friedman declared that “I think the Austrian business-cycle theory has done the world a great deal of harm.” In making the government the scapegoat for recessions they blind themselves to the solution. There just isn’t the evidence to support the ABCT and were governments to ever fall under its sway, then disaster would result.

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124 Comments

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124 responses to “Why The Austrian Business Cycle Theory Is Wrong

  1. Wow! This one was a tour de force. I am not an economist (I have a personality! ;o) but I am married to one and I have read up on the topic and this is as good a skewering of poor thinking as I have read. Well done! Part of the problem as I see it is economists haven’t agreed upon a procedure by which things are “proven.” For example, if a theory claims to predict financial system crashes, it must apply the theory historically to the ten most recent such crashes and then publish those analyses to be criticized. Instead, what we have are people posting opinions to which they claim they have a “right” and then arguments go back and forth (such as yours above) and no consensus is achieved.

    In hard sciences, these cycles often take years but end up in a consensus (consider the debates over the Ozone Hole and CFCs, the debate over climate change, etc. or even the pursuit of the Higgs boson). Each of these has taken decades but convergence on a conclusion has taken place. Nothing similar seems to happen in economics. Ideas seem to go out of favor but are rarely disproven partially because there is no accept form of an economic proof. Now that would be a research topic well worth exploring.

    • Thanks, glad you like it. Unfortunately economics is much more politicised than other subjects and as a result there is far less consensus. Instead there are far more claims that people wish were true than actually are. So people claim Ron Paul predicted the crisis and resent any attempt at disagreement.

      What is interesting about economics is that we are currently having the same debate Keynes had in his time. In fact we are probably worse off as Keynes won his debate yet today policymakers seem to have forgotten his lesson.

      • Bob Robertson

        It’s too bad you’re wrong on every point.

          • James Reilly

            I’m just curious. Do you think its sustainable to keep buying all the products that are made over seas, with money printed out of thin air, that never makes its way back into the US, because of a lack of capacity in this country to produce goods desirable in other countries for prices they can afford?

            Do you think that other countries are going to keep selling us goods for dollars they will never be able to use?

            Do you think that unlimited printing has unintended consequences?

            Do you think that’s what the function of interest rates is? To control the supply of money?

            Should the treasury just be able to print what it wants without borrowing?

            • First of all, I’m not American so its problems are not mine. Second of all the American trade deficit is relatively small, only 3% of GDP. Sure its a problem but not a devastating one. Thirdly, money is not printed to pay for the imports. So in the first paragraph we have three major problems with your argument, none of which is actually related to my post or the comments you are replying to.

              “Do you think that other countries are going to keep selling us goods for dollars they will never be able to use?”

              Who told you other people can’t use dollars? Whoever it was they were wrong. People can use dollars to buy American exports, convert them into their own currency or invest in America.

              “Do you think that unlimited printing has unintended consequences?”

              Who said anything about unlimited printing? You seem to be arguing with someone but I don’t know who it is. I’m not arguing for unlimited printing nor is the Federal Reserve engaging in it (it has a limit, just a high one).

              “Do you think that’s what the function of interest rates is? To control the supply of money?”

              No.

              “Should the treasury just be able to print what it wants without borrowing?”

              No and the American government is not doing this. QE was not used to pay for government spending it was used to pay for financial assets.

              Your comment reads as though you’ve watch a few youtube videos and read a few blogs and got a half-digested notion of Austrian economics that can “school” those dum statist Keynesians. Unfortunately you’re only convincing yourself and your comment is attacking a parody rather than the real thing.

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  3. Congrats! Barry Ritholtz at ritholtz.com just linked to this article.

  4. jmh530

    I came here via Barry Ritholtz’s site and I’m not really familiar with your other writings. I think you make a few good points, but you’d be better off extending this to a much longer piece to give the piece more detail. In particular, the Austrians have responses to many of your arguments. Your argument would be more convincing if you were to say what the typical Austrian response to a particular criticism is and why you think it’s wrong.
    Some areas I’m sympathetic:
    1) Some Austrians have drastically overestimated the probability of hyperinflation due to QE. This stems from their initial failure to understand the theory. However, I think this fear came from mainly non-academics.
    2) I’m not particularly happy with the natural interest rate concept since it’s not observable. However, the argument that the Austrian theory falls apart because there’s more than one natural interest rate seems silly. It’s an abstraction. You could make it more complicated and say there’s a natural term structure of default-free interest rates and then all other debt is priced off that. Not sure what it adds to do so, but it avoids your concerns.
    3) Your point about Rothbard’s footnote in MES and its connection to the 2000s appears mistaken. Rothbard refers to consumers, but he is implicitly talking about consumer spending and housing is typically classified as investment. However, you’re right that he isn’t particularly clear in that footnote (why wouldn’t an ABC-boom occur if consumers spent the money on durables?). Nevertheless, the point seems limited. Other Austrians argued that there was an ABC-like boom in 2004.
    Some areas that were not so good:
    1) Hayekians, at least, don’t advocate a policy of doing nothing after an ABCT-style crash. Hayek advocated stabilizing MV, the purchasing power of money.
    2) Austrian views were never really adopted by politicians in the Great Depression or its aftermath. So I don’t take Friedman’s criticism to heart. I believe Larry White wrote a paper on this (and Hayek advocating stabilizing MV)
    3) Your points about Mises’ and Hayek’s predictions are not very solid. If their predictions are wrong, then that doesn’t necessarily mean the theory is wrong.
    4) The Austrian would respond to your point about why we are not in a bubble now, by pointing out that the theory is about interest rates relative to the natural rate. The natural rate in their theory is potentially time-varying and unobservable. It very well could be low enough so that there is no deviation from existing interest rates.
    5) You seem to associate advocating fiscal stimulus with Keynesian macro a bit too much. Perhaps some Austrians do as well.
    6) There is a much greater connection between interest rates and economic activity over time than you give credit for.

    • jmh530

      This line “This stems from their initial failure to understand the theory. ” should have “of QE” added to the end.

    • Thanks for your comment and I find it interesting that you find it too short, as my fear was its too long (I have a self-imposed limit of 2000 words of my posts)

      I agree completely on your first point, though I would note that there are quite few academic Austrian economists, hence the reliance on non-academics and even non-economists.

      Without a natural rate of interest, how do you say that the interest rate is too high or too low? These are relative terms, but relative to what?

      1) There is of course variance among Austrians and I had to generalise. The form of Austrian economics most popular at the moment on the internet is completely opposed to any form of government intervention.

      2) Not quite, but the idea that the economy should be left alone and the Depression run its course, was implemented and quite destructive. Not entirely Austrian but similar in terms of policy.

      3) Not necessarily, but one of the main selling points of the ABCT is its supposed ability to predict and explain recessions. If they were not able to predict the Great Depression, then there goes one of the main appeals of theory

      4) The problem with that theory is that it only works in hindsight. If we cannot know what the natural rate is, or if we are above or below it, then the theory loses most of its force. It will be too late to do anything about the bubble. Also if 1% interest rate is not below the natural rate, then I don’t know what is.

      5) I plead unashamedly guilty

      6) Possibly.

  5. William

    The Austrians are right when it comes to e.g. Japan in the 1970s & 1980s and China from 2000 up to now. In those cases the central bank played a crucial role in setting rates at an artificial (low) in stead of being determined by th a force called “Mr. market”.

    • The problem with Japan had more to do with speculation and irrational exuberance than the ABCT necessarily.

      What do you think of the above criticism of the natural rate of interest? Does it exist and is it set by the market?

      • William

        Interest rates are (in about 95% of the cases) determined by a force called “Mr. Market”. If you want to call that “the natural rate” O.K, no problem. It’s simply a matter of “Demand & Supply”. Look at what rates did from 1950 up to now. As far as I know, in EVERY recession (long & short term) rates went down and when BOTH long & short term rates rise then we can declare the “Recession” to be ending. Check it out !!! But short term rates ALWAYS move (much) faster (in both directions) than long term rates. And that’s why the difference between long rates & short rates (=yield curve) is a VERY good tool to gauge the health of an economy.

        From 1950 up to 1981 both long and short rate went (on average) higher signaling that there was a growing demand for capital relative to supply. From 1981 up to 2012 both rates went lower together. Signaling falling demand for capital.

        Now with long term rates rising a number of people say “the recession is ending”. I don’t believe that because now short term rates remain (very) low. So, something different is afoot.

        The chinese Central bank DID set rates at an artificial low rate (below the “natural rate”) and that has fueled a complete insane investment boom in the last say 12 years. It’s like Japan in the 1970s & 1980s but at a much larger scale. Hence the chinese bubble is MUCH larger.
        The problem with artificially set rates (too low) is that it distorts the price signals for capital (=interest rates). E.g. projects that aren’t profitable at say 6% become profitable at say 2 or 3%. Hence the over investment in China now, Japan in the 1970s & 1980, Brazil in the 1970s, Germany in th 1930s & the Soviet Union in the 1950s/1960s.

        Michael Pettis has written some excellent articles at his blog, on this topic.

        http://blog.mpettis.com/

        • It is true that interest rates are always lowered during a recession and raised during the boom. However, this is not due to market forces, but due to the central bank adjusting the rate. I don’t know how you can claim that this example supports your point.

          • William

            Nope. I have a chart with both the FED’s fund rate and the 3 month T-bill rate. And it’s clear that the T-bill rate went lower much earlier than the FED’s fund rate.

            http://www.4shared.com/archive/QOBJA-4W/interest-rates.html

            You’ll see that the t-bill rate (green) in 2007 + 2008 went lower much faster than the FED’s fund rate.

          • William

            Nope. In a recession investors pull their money out of stocks and into T-bonds. In a economic uptrend investors pull their money out of T-bonds and into other investment assets (stocks, real estate, corporate bonds). Hence the movements in rates. And then the FED ALWAYS follows.

            To mask that they’re not in control of rates they start blabbing about “Tapering”. When the FED says “we’ll leave interest rates very klow well into 2014, 2015, 2016″ then they say that they see no reason why “Mr. market” is going to push rates higher before 2014, 2015, 2016. They see simply no reason for an economic recovery before 2016.

            Some folks call it the “Open mouth comittee”.

          • William

            In the stockmarket crash of 1873, 1929, 2007/2008 US short term rates went down to almost nothing. In 1929 & 2007/2008 there was a FED. But in 1873 there wasn’t a FED around. So, the FED was NOT responsible for lowering rates. It was a force called Mr. Market. That’s where your theory about a Central Bank lowering rateas is completely nonsense.

          • William

            It took some time to find the appropriate file on my laptop but here we go.

            Take a look at this chart. You’ll see that the 91 day T-bill rate (as set by the market) during 2007 & 2008 dropped much faster than the Feds Fund rate ot the Fed Discount Rate. So, the FED lowered rates, FOLLOWING the market rate.

            http://www.4shared.com/photo/cekpeb2qce/ch_rtssh.html

            Here a chart that shows that short term rates always move much faster (in both directions) than long term rates.

            http://www.4shared.com/photo/S7392UrTce/0123USTRates.html

      • Jan

        Nice post.And yes this Austian hype thing is crap,as famous economist Mark Blaug once wrote about Austrian methodologies “It´s so cranky and idiosyncratic that we can only wonder that they have been taken seriously by anyone.” and legendary Nobel economist Paul Samuelson wrote that “I tremble for the reputation of my subject” after reading the “exaggerated claims that used to be made in economics for the power of deduction and a priori reasoning [the Austrian methods].”
        You probarly read this blogger “Lord Keynes” he has put the this
        pseudo scientific right wing ideology in the garbage can more welldone than any other i think.
        He should have a some sort of prize for his hard work debunk this nutjobs!
        Why the Austrian Business Cycle Theory is Wrong (in a Nutshell)

        http://socialdemocracy21stcentury.blogspot.se/2013/08/why-austrian-business-cycle-theory-is.html

  6. Michael Valentine

    The irony of course, is that the current country of Austria, is by current US Standards, a social democracy. But it has had a great economy for the past 20+ years, and some of the lowest unemployment in Europe, and the US for that matter. Indeed, real Austrians, are more Keynesian, than “Austrian”.

    • Yes it also ironically had one of the largest Socialist Party in Europe too. It is currently a positive example of Keynesianism and government intervention.

      I heard a story that all the famous economists of the Austrian school returned home after WW2 for a big dinner. The host began praising the positive effect that Austrian economists had and the booming economy that resulted. Then they realised that all the positive effects occurred after they left and none of their ideas were implemented.

  7. Dave

    I hate when people pick Schiff as the representative Austrian. Try Mish! You can go through his archives and see how Austrian economics, when applied well (and let’s face it, all macro schools of thought are generally applied poorly to the real world), was able to diagnose what was happening and predict the severity of the crisis accurately.

    Here are some prescient examples:

    Comparing the US economy to Japan in 2005 due to the housing bubble:

    http://globaleconomicanalysis.blogspot.com/2005/03/its-totally-new-paradigm.html

    Calling out a widespread (beyond the US) housing bubble in 2005:

    http://globaleconomicanalysis.blogspot.com/2005/03/housing-bubble-is-in-its-final-blowoff.html

    In 2005, calling out that the Fed’s actions would lead to a housing and stock market crash, and that this would lead to a gold bull market:

    http://globaleconomicanalysis.blogspot.com/2005/04/gold-hui-euro-relationship.html

    And those 3 posts are just from his first 2 months of blogging!

    Here is Mish taking down Schiff’s arguments (two of many times) in 2007:

    http://globaleconomicanalysis.blogspot.com/2007/12/not-your-fathers-deflation-rebuttal.html

    http://globaleconomicanalysis.blogspot.com/2007/12/peter-schiff-replies-to-deflation.html

    Here is Mish calling the top of the stock market in July 2007 when it was close to its October 2007 peak:

    http://globaleconomicanalysis.blogspot.com/2007/07/quotes-of-day-top-call.html

    Here is Mish taking down Krugman’s reponse to the hangover theory:

    http://globaleconomicanalysis.blogspot.com/2008/12/krugman-still-wrong-after-all-these.html

    And here is Mish predicting in 2009 that the unemployment rate would remain elevating for years to come (recall at the time, there was a debate about how quickly employment would bounce back):

    http://globaleconomicanalysis.blogspot.com/2009/09/depression-debate-is-this-depression.html

    Anyway, those are some greatest hits. Sure, he’s made some incorrect short term calls (and readily admits so… in fact, he usually caveats short term calls as risky in the first place). I’m not qualified to say that ABCT is “correct,” but I think Austrian economics clearly offers a useful lens through which to view the economy, and these links offer real-time proof of that. I bet you cannot find another economist (outside of perhaps Shiller) making such prescient real time calls over an extended period of time, let alone an entire macro school of thought that got it this right ex-ante.

    • William

      Ah. But MISH (wrongfully) thinks that the FED determines interest rates and the FED DOES NOT.

      • William

        And MISH thinks that in deflation rates fall. Wrong. That’s still INFLATION. In a real DEFLATION rates rise. (like they did from 1950 up to 1981).

    • I’ll admit that I’ve never heard of Mish before, but in fairness to him, he seems pretty smart for an Austrian economist. He seems to actually study the evidence and doesn’t seem to engage in the usual hyperbolic anti-government rhetoric or the obsessive Krugman bashing, common to most libertarians.

      Personally, I think Schiff is an idiot and has little understanding of economics (though a decent understanding of how to grab sensational headlines). I try to avoid giving people like him attention, but I included him as he is probably someone a lot of people would be familiar with, especially if they don’t have a background in economics.

  8. An outstanding piece Robert and what a coincidence that it touches on a subject I am putting a piece together on.

    Since economics is not my forte its great when I can come across pieces like this that refute and debunk the notions put out there by libertarian economic think tanks.

    I am puzzled about one thing so please straighten me out on this. You said “Without one natural rate of interest, you can’t claim the government is forcing rates too low and therefore the theory crumbles.” Does not the Fed’s prime interests rate here in the states impact all other rates since they are the primary source of lending money?

    • Thanks, glad you liked it.

      On your question, you seem to have two points. My quote refers to the fact that “interest rates are too low” is a relative statement. Without a reference point is doesn’t hold, hence the necessity of the natural rate of interest.

      The FEd certainly does influence the world lending rate due to its size, though the European Central Bank would be more relative in Ireland.

  9. “Some Austrian economists did predict the 2008 crash, but this is an example of being right for the wrong reasons”

    So did some Keynesian economist (i.e. Krugman) and for the right reasons too.

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  15. Colin

    “The final nail in the coffin of the ABCT comes from the fact that although interest rates are at an all time low at the moment, there is no bubble or boom; to the contrary the economy is stagnating.”

    This is a narrowly scoped remark. Are the market sell off in emerging markets considered a bubble? India, Indonesia, turkey among other countries are experiencing massive declines in asset prices. What bubbles? The whole point to ABCT is that you can’t micromanage economies, hot money flows into assets and areas you cannot control which lead to instability and bubbles.

    • The point of that remark was that if low interest rates lead to booms that distort the economy then why is that not happening at the moment?

      The declines in emerging markets is due to the withdrawal of capital from the periphery to the core. The crisis in America and Western Europe is causing multinationals based there to batten down the hatches and withdraw investments from abroad.

      • These interest rates are artificial and people know it. See my comment below. John Taylor claims rightly that the rates set by Greenspan in the 2003-2005 were the cause of the housing bubble, the catalyst for the Greater Depression. Taylor is not an Austrian.

  16. Colin

    Then de facto, money in those countries being withdrawn can be considered speculative bubbles. Artificially low interest rates here have lead to speculative bubbles in other countries with more “natural” interest rates. I agree that we should be doing as much as possible to solve this crisis but there is a difference between what caused this crises and solutions to the crises.

    “The General Theory of Employment, Interest and Money”, published in 1936, Keynes argued that the private sector is not always rational and that during times of economic contraction (recessions), governments should make up for the shortfalls in private sector spending through the use of monetary and fiscal policy. He argued that the Government could accomplish this using a two pronged attack. First, the central bank should use monetary policy and lower interest rates to stimulate demand. Second, the government should use fiscal policy and increase government spending to stabilize output. This is the correct response to a recession. The problem is that we were doing these things before a recession. What Keynesians also leave out is that John Maynard Keynes argued for governments to run surpluses during boom times so that there is no net government deficit over an economic cycle.

    • Well the reason money was invested abroad was because capital ran out of profitable (at least on the same level) ventures in the developed world and secondly because interest rates were actually higher in emerging economies.

      You’re correct in your analysis of Keynesian economics. I will say that true Keynesians do oppose budget deficits unless the economy is below full economy. So for this reason they opposed the Bush tax cuts and tax cuts during economic booms in general

  17. I’m not an Austrian economist, I’m just a trader. But your arguments against the Austrian theories themselves don’t make sense. How could it possibly be good for an economy in the long run to lower interest rates to such a low level? It seems Ron Paul et al’s theories are valid to me.

    Perhaps it’s selfish as I don’t really care either way — it’s been a fantastic boon to my trading to have the Fed act like idiots — but it’s pretty clear that we’re destroying our currency (and, our long-term economy) with these policies.

    Whatever.

    • The thing is that those interest rates were never meant to be kept low in the long run and in fact the Fed began raising them after 2005. They were merely meant to be a short term boost to the economy after the 2001 recession.

      I’m not sure what you mean by destroying the currency as the dollar is just as widely accepted as ever. Depreciation is not a bad thing as it boosts exports and reduces imports by making them more expensive. In fact many Eurozone countries (such as Ireland) wish they had the option of depreciating their currency.

      • William

        The Austrians are right in the sense that Central Banks (CB) shouldn’t have propped up the economy by issueing this much credit after 2008. CB are indeed feeding the populus with more alcohol. In that regard the “hangover” analogy is very good. The “hangover”will be MUCH worse. And that’s where Krugman goes off the rails. He advocates MORE stimulus. He wants more (credit) inflation.

      • GM

        Boosting exports and reducing imports, i.e. boosting GDP. The fact that it means the country is poorer (can’t afford to consume what it produces or buy what anybody else produces) is just an irrelevance.

        Throw away your textbooks.

        • Hang on, so increasing the money flowing into your country and reducing the money flowing out actually makes a country poorer? What sort of crazy world do you live in? Do you ever wonder why people don’t take Austrian economics seriously?

          • GM

            There is no point in economic activity beyond satisfying consumer desires. Having the highest GDP or the best trade balance in the world doesn’t mean anything if the real standard of living is poor.

            Please do throw away those textbooks and start again.

            • If we have a higher GDP then we have more money therefore we can buy more goods and satisfy more consumer desires. Therefore higher GDP equals more consumer desires satisfied. How are you not getting this obvious point?

              The only case where GDP could divorce from living standards would be if there is high inequality, but you don’t see to view inequality as a problem, so I doubt this is the point you are making.

  18. Solid post. However, I’ll have to warn you, you are entering deep waters here ;). But seriously, there have been lots of debates over the ABCT, especially on your point 2, the natural rate of interest, and they get really nasty. I don’t know if you read this blog

    http://socialdemocracy21stcentury.blogspot.com/

    But blogger “Lord Keynes” has written a lot of posts about the natural rate of interest. You should check them out, as well as some of the Austrian responses.

    Also, I’m curious, have you read the exchange between Hayek and Sraffa on the ABCT? It’s very good and I suggest you read, if you haven’t already.

    • Actually Lord Keynes was one of my main sources and his meta compilation of posts on Austrian economics was really helpful, though a bit overly technical.

      I have heard that Sraffa demolished Hayek and that’s where Hayek admitted that there is no one natural rate of interest. However, both of them have a reputation for being very hard to understand, so I haven’t gotten around to it.

  19. Any economic theory that somehow considers the government, its actions and effects as anything other than natural is clearly flawed. Wallace’s theory of evolution excluded mankind. Darwin’s theory included everyone, Darwin himself not excepted. It is especially ironic since no economic theory can exist without some concept of property, and property is, if nothing else, a government function. Not only has Austrian theory failed in predicting and understanding the real world, but it has seriously flawed philosophical underpinnings.

    • I agree that the division between the government and the market as though they are separate institutions is a false dichotomy. The markets and private property need the government in order to function.

      • GM

        We need laws and we need courts, both of which were provided long before the modern nation-state, and both of which exist in many forms today outside of the governmental domain.

        • Are these just random comments? You need some supreme body to enforce the law whether it is the state or the tribe. I’d love to here of any laws or courts existing outside of the government, though I don’t see how it is in anyway related to this post.

  20. GM

    You aren’t in a position to criticise ABCT, I’m afraid, because you don’t understand its economic foundations. ABCT can only be understood after somebody already understands the much more basic economic principles on which it rests.

    • So the various sources I read and linked at the beginning are all wrong? The Mises Institute doesn’t understand ABCT? Why is it any time I criticise Austrian economics, instead of engaging you dodge the point and claim I don’t understand. Why not point out what I got wrong?

      • GM

        I’ve had to point out to you on another thread that the first rule of economics is scarcity. How are you going to understand business cycle theory if you don’t understand scarcity?

        • Actually economics has moved on since the 19th century and scarcity is not the main issue it used to be. In fact it is a rather boring issue that doesn’t tell us much. Scarcity = you can’t buy everything. Well, duh. Not exactly illuminating nor do I see how it is related to the ABCT.

          • GM

            It’s relevant because business cycle theory relies on the trade-off between the choice to engage in consumption or investment. Low interest rates make investments appear more profitable than they really will be, promoting excessive leverage and speculative investments while also suggesting to people that they can afford more consumption in the short-run (since their successful investments will make them richer in the long-run, too).

            If we accept scarcity then we know that there are physical limits which constrain us, that something cannot be created out of absolutely nothing, and that there is no escaping from the tradeoff between the long-run and short-run.

          • Travis

            The economic problem, sometimes called the basic, central or fundamental economic problem, is one of the fundamental economic theories in the operation of any economy. It asserts that there is scarcity, or that the finite resources available are insufficient to satisfy all human wants and needs. – Wikipedia

            Without scarcity, there is no economics, we could get whatever want, there would be no need for money or producing, or in other words, means would be infinite.

  21. GM

    Re: mentioning Peter Schiff, one of the nice things about Youtube is that it lets us watch mainstream non-Austrian people embarrass themselves in front of him again and again (and again).

    • You can also use youtube to find clips of Peter Schiff predicting hyperinflation and financial collapse. Why should we take him seriously?

      • GM

        He predicted financial collapse before the housing and financial crisis, explained why it was going to happen and how the government would react, and he was right. Mainstreamers laughed in his face when he said that houses were overpriced in 2006-2007. And he has always maintained that hyperinflation is a possibility, not an inevitability. In this clip, he said that Bernanke is “on the course” of “runaway inflation”. That’s consistent with everything else he has said. He hasn’t got everything right (e.g. USD strength in 2008 surprised him), but his track record is still very impressive.

        • He has claimed a crash was coming many times, and happened to be right for the wrong reasons in 2008. His false predictions regarding inflation and the second collapse that was supposed to happen show that his framework is wrong. Schiff is a joke who got lucky once.

          • William

            I was (past tense) a “Schiff believer” as well. But his flawed predictions of Hyper-Inflation were absolutely wrong (for the time being ONLY). Schiff and the “Austrians” are right that there WILL be a “purge” of all the bad debt. But Schiff & Co. fail to see that this will be EXTREMELY DEFLATIONARY !!! Where Schiff & Co. IS right is that the US WILL experience Inflation AFTER the Deflationary purge of all the bad debts. And it remains to be seen whether that will turn into “Hyper-Inflation”.

            In that regard I would point to what Hugh Hendry has said:
            “Hyper-Inflation requires Hyper-Deflation”.
            “Hyper-Inflation is a political choice”.

            And Schiff is absolutely right when he’s talking about “A second collapse”. In too many respects the situation is similar to that in 2007/early 2008. But in the next crash the USD WILL go higher, NOT lower !!! What is going to crash is the US T-bond market.

          • GM

            Indeed, he may have been right for the wrong reasons. That’s what makes real-time economics so controversial – it’s so hard to figure out which are the causes which are the effects.

            And he does get things wrong sometimes.

            But if you followed his advice, you would have avoided the tech bubble, avoided the housing and financial bubble, and you would currently be avoiding the bond bubble. You would have been buying gold since 1999.

            If you followed mainstream advice, you would not have been doing any of these things. No contest, is it?

            • You see GM you have this strange view hat economics is divided into Austrians and non-Austrians and there is diversity within the non-Austrian camp. So when you speak of the mainstream you lump together all the theories you disagree with. So Robert Lucas and Steve Keen are lumped together as “mainstream” economists. I recommend you read up about the schools of economic thought (my most recent blog post) and the wide range of theories on the recession ranging from the Efficient Market Hypothesis to the Financial Instability Hypothesis. Maybe then you wouldn’t view things as Peter Schiff versus the world.

              • GM

                I don’t want to read about different schools, I only want to understand the truth. The fact that economics has splintered into different schools can only be a sign of how unscientific it has become.

                • William

                  Then you should follow the work of Steve Keen. He has build a mathematical model on how debt, income & GDP interact. That’s a scientific approach.
                  Did one of the Austrians ever build a mathematical & scientific model ?

                • This isn’t religion where there is only one truth and all else is heresy. Closing your mind to different opinions is merely economic fundamentalism and not much better from the religious kind. People will always disagree and view the world differently, so this debate should be seen as a strength not a weakness.

  22. It is flawed and ignorant of the environment to say that ABCT is wrong because 0% interest rates should spur economic expansion. These interest rates are artificial and smart people know this. The Fed has a $3.6 (and growing) “balance sheet” that must be dumped on the credit markets. The US has a $17 trillion debt that will put severe pressure on the credit markets when the economy is healthy again.

    • William

      Those 0% rates on short term debt is NOT artificial. That’s the result of “Demand & Supply”. Investors seek safe investments and T-bills have the least price risk. So, people avoid price risk and buy T-bills and then push short term rates to (nearly) zero.

      • So if the Fed was not heavily involved in T-bill purchases with electronically created money (not to mention what they create off the books) we would still have 0% rates?

        • William

          Yes. Besides that the FED does not buy T-bills. It buys longer dated T-bonds.
          Remember “Operation Twist” (2011) ? It sold short term (< 1 year) T-bonds and bought 20+ year T-bonds in an attempt to push down lower long term rates. But they failed because other holders of those T-bonds sold their 20+ year bonds.
          Another misconception: The FED does not create money. It doesn't "Print money". It creates credit for commercial banks.

          • Yet with the threat of taper we see similar yield responses in all Treasuries. Which says that Fed involvement has an effect on the full range of Treasuries.

            • William

              Nope. All the “taper talk” is just that: talk. It’s simply the market that demand higher yields The FED isn’t responsible at all. And the short term rates didn’t move that much/at all.
              But the FED can’t come out and say they’re not in control of rates. That would shock the markets, even more. Just a matter of demand & supply. Nothing more.

    • “These interest rates are artificial and smart people know this.”

      But the interest rates in 2003 were just as artificial yet according to the ABCT “smart” were completely tricked by them. How did that happen?

      • Then let’s say that the 0% rate is quite a different animal than the 2003 rate. Also, we had massive political and regulatory force working to start a housing bubble if you remember– that would be the government intervention that ABCT says is an evil force to the economy. ABCT was right.

        • “Then let’s say that the 0% rate is quite a different animal than the 2003 rate.”

          Why? How is it different? How does it make sense to say low interest rates cause bubbles but even lower interest rates don’t?

          “we had massive political and regulatory force working to start a housing bubble if you remember”

          Under a Republican administration? Tell me, is the current Democratic administration less interventionist that Bush was?

          • Because at 0% there is no place to go. When 0% fails, it signals desperation (enter QEx) so I believe 0% is quite a different animal.

            Yes, under a Republican administration the “ownership society” policy of Bush, Rove, et al was the political force behind the housing bubble. And I do believe the current administration is not trying to put everyone in a house regardless of their ability to pay for it so certainly less interventionist than Bush in that regard.

  23. William

    In one regard Robert Nielsen is an “Austrian” as well, because he believes rates are set/determined by the FED. They’re not. They’re determined by a force called “Mr. Market”.

    The best explanation for why (both short term & long term) rates went lower since 1981 is given by Gary Shilling in his book “The Age of Deleveraging”. Shilling predicted in 1979/1980 that rates would start to go lower. Although he has some blind spots, he is a very shrewd economist.

  24. William

    - I knew this comment would generate some repsonse.
    - I wrote “I one regard”.
    - I am a Keynesian as well because without (consumer) spending the economy is dead.
    - But what the “Austrians” do “get” is that lower and lower rates (as determined by “Mr. Market”) lead to A LOT OF malinvestment.

  25. In general as I told Ms. Coppola you can hardly hold ABCT accountable in 2008 when your govt and central bank has violated every tenet of ABCT for the past several decades (at least). The last 15 years, when the claim is that we have conquered the business cycle, have been the most chaotic and disruptive we have seen outside of WW and the Great Depression.

    • “violated every tenet of ABCT for the past several decades (at least)”

      Huh? You’re not making yourself very clear. Central banks may have lowered interest rates below what Austrians would like but I’m not sure if this counts as “violating” the ABCT. Also ABCT predicts this should lead to a speculative bubble. Why hasn’t this happened?

  26. In 2008 we were looking at massive malinvestment in homes. How many households suffered huge losses virtually overnight? Home equity loans were terminated. So we are supposed to believe this is meaningless and that low rates should trigger an immediate expansion/bubble regardless of the status quo? And because low rates in these circumstances do not spur an expansion/bubble that ABCT is disproved?

    • ABTW, any government that was following ABCT would never have allowed the housing bubble to begin with. You describe perfectly how ABCT predicts that artificially low interest rates lead to overproduction which is exactly what happened with housing in concert with or instigated by misguided politicians. Then given a mess that ABCT would never have created, you expect ABCT to cure it!

      • I don’t think you either fully understand ABCT or the argument in this post. ABCT doesn’t propose any cures, nor is it possible for any government to follow it. ABCT is a theory as to how bubbles and recessions form.

  27. William

    ABCT has another flaw. They blame the FED for causing the bubble. Yes in the 1920s & 2000s there was a FED around but there was a financial bubble in the early 1870s followed by a crash. But in those days there wasn’t a FED around.

    • Again, John Taylor blames the Fed for the housing bubble and Great Recession (I call it the Greater Depression) by setting artificially low rates from 2003-2005 and he is not a Austrian.

      • I have read the paper you are referring to and its quite poor. Its basically a rehash of Republican talking points that try to blame the government and completely absolve the market.

        Taylor seems particularly annoyed that the government didn’t follow his rule and this seems to be a large reason of why he blames them for the recession. He seems to believe that if only people listened to him, none of this would have happened.

        • It is apparent that your aim is political and the ABCT bashing is a means to your political end.

          When ABCT is wrong, people will not be writing articles telling us it is wrong. Until then, I think ABCT has a lot of relevance.

          • That’s ionic because ABCT sole appeal is that it allows conservatives to blame the government for the recession. Its entire appeal is political.

            “When ABCT is wrong, people will not be writing articles telling us it is wrong. Until then, I think ABCT has a lot of relevance.”

            That sentence makes absolutely no sense.

            When ABCT is wrong, how we will know unless people write articles? You seem to imply that as long as people points out the flaws in ABCT, he theory holds, whereas if it is treated with silence, it must be wrong. Like I said that makes no sense.

            • ABCT fully explains/predicts the housing bubble and your article explains why as well as anything I could offer. And you are blaming ABCT for not having a valid response for the housing bust caused by something it (ABCT) would never have allowed in the first place. THAT makes no sense.

      • William

        - Taylor thinks the FED should set rates at about or slightly above the rate of inflation. But which inflation ? The REAL inflation (e.g. Shadowstats) or the concocted one, churned out by the gov’t ?
        - However the US gov’t could have done a number of things to prevent the bubble. But the gov’t didn’t do that. Too many influential people were profiting too much from the bubble.
        - ýou’re trying to make the data fit your view. Short term US rates went down from early 2001 (6%) to ~1% in late 2002/early 2003. Rates started to move higher in mid 2004. In parlance of the ABCT: “The FED started to raise rates in mid 2004″. But isn’t that precisely what Taylor advocated ? Raising rates ?
        (Nevertheless: It’s Mr. Market that determines rates, NOT the FED).

        • Mr. Market can only set the rates when money supply is fixed at any given moment. But the housing bubble proves that current policy calls for unlimited credit, manipulated interest rates, manipulated inflation, and money is available for every mortgage applied for.

          Think back to the mortgage rates (12-14%) of the early 80s. Those rates shutdown any chance of a housing bubble. Mortgage money came at a high price because is was competing with business demand for credit (as well as for autos, home additions, etc.) and the REAL rate of inflation was a key part of that interest rate spike that stopped any chance of a bubble. AND ALL OF THIS IS IN THE CONTEXT OF A WELL CONTROLLED, FINITE MONEY SUPPLY WHICH WE NO LONGER HAVE.

          The modern day Fed has many tools and much power to manipulate rates. It was not too long ago that the Fed had no influence on long term rates– no longer true.

          My complaint with Taylor is that he is clearly a status quo, establishment guy. Other wise,he has a rules-based approach to Fed mgmt that takes the drama and phony intellectualism out of the Fed. He should be the next Fed chairman.

          • William

            You’re overlooking a thing called “reality”.

            The reality doesn’t support your claim of “fixed money supply”. Yes, in the 1970s rates doubled (from ~ 7% up to ~ 15%). But in those days the monetary base increased AS WELL.

            See what happened between 2000 and 2008. Demand for credit went throught the roof because of e.g. the housing bubble. Yet, rates didn’t go through the roof like in the 1970s.

            If the FED has “many tools” and “much more power to manipulate rates” then why didn’t the 30 year T-bond yield go much lower when the FED performed “Operation Twist” in late 2011 ? Then they sold short term paper (< 1 year) and bought 20+ year bonds.

            • I never said the money supply does not increase. I said “at a given moment” which means that massive demand for mortgages is met with rising rates rather than unlimited credit and unlimited mortgage money.

              Interest rates and inflation are manipulated. There is no way we can have a massive demand for mortgage money like 2003-2006 and never see an interest rate above 6.9%. If the interest rate were real and credit and mortgage money were not unlimited (and competing with all other credit demands), the rate would have hit 10% and up choking off the housing bubble. (I assume you believe that the so-called Great Moderation was an act of God). Also, mortgages began taping into the ARTIFICIALLY low short term rates set by the Fed in the form of ARMs.

              Operation Twist started in 2011 didn’t work? Check this:

              http://ycharts.com/indicators/30yeartreasury_bond_yield

              Most of this is supported by John Taylor who you blame for his Republicanism. But he is well respected and his Taylor rule has a wide acceptance in the economic community.

              • William

                - Nope. Rates are a function of Demand & Supply and are not an act of God. The best explanation I came across of why (especially long term) rates went lower after 1981 is given in Gary Shilling’s book “The age of Deleveraging”. And NO, this has nothing to do with one Ronald Reagan or Jimmy Carter.
                - See what (both short & long term) rates did since say 1950. In every recession both short & long term rates went lower and in a recovery those rates went higher. Rates go higher becasue demand for capital is increasing. Demand & Supply.
                - The USD is the world’s reserve currency and that means that demand & supply for T-bonds is determined NOT by ~ 310 million people but by ~ 7 billion people. And you still think that a bunch of guys at the FED can control rates in the ,long run ?

                • To put it in your terms. Yes. Supply and Demand. And both Supply and Demand are manipulated.

                  Item 2 – Intuitive but there’s more to it as evidenced by the UNPRECEDENTED (let me repeat my caps – UNPRECEDENTED) bubbles of the last 15 years.

                  I AGREE. The Fed cannot control rates in the long run. But that was not your assertion. You said Operation Twist, a short term manipulation of long term rates, did not work. It did.

                  • William

                    Nope. Operation Twist didn’t work. this was implemented in late 2011 when rates already had gone down. Operation Twist was implemented because the FED noticed that Non US buyers were starting to reduce purchases of T-bonds.
                    Yes, rates are manipulated !!! By a force called Mr. market and not some guy called Greenspan. Because the FED always follows market rates.
                    See what happened in 2007 & 2008. Short term rates went lower much sooner than the Fed’s fund rate.
                    And when they say that they will leave short term rates this low well into 2015/2016 then it’s an admission that the FED – at this moment – doesn’t see any reason why Mr. Market is going to push rates higher before 2015/2016.

                    • Delusional. Good luck with your political agenda.

                    • William

                      I admit, Operation Twist did work in 2011. But only because Mr. Market ALLOWED it to work. But in 2012 & 2013 the FED continued to buy T-bonds but how well did that work out ? Did rates go (much) lower in 2012 & 2013 ?
                      “Delusional” ? “Political agenda” ? why use these words ? Can’t you stand the fact that I don’t roll over and surrender ?

  28. We have low interest rates set up by the State (beaurocrats + FED + banksters) and money being QEed by the State. The ABCT says that we should be in a bubble, but we are not. So they must be wrong, right? The economy is stagnant so we shouldn’t see booming shares on the stock market, right? Right? Billions of dollars poured into a company that allows you to sent 140 characters of text to other people?

    Before the crisis, the low interest + money printing scheme made it so all the money go to the ordinary people, which bought houses, which caused the real-estate bubble. But currently, even if ordinary people were to get the money they wouldn’t invest in real-estate (we need more time for people to forget about that) so they would invest in the stock market. Which is what is happening. Not at the levels of the real-estate bubble because some of the money get directly to bailing out “too-big-to-fail” corporations.

    Continuing with the false dichotomies started in this article: if ABCT is wrong, Ben Bernanke is right, so Robert Nielsen must agree with bailing out the corporations and rich people getting richer with the help of the state.

    • “Continuing with the false dichotomies started in this article: if ABCT is wrong, Ben Bernanke is right, so Robert Nielsen must agree with bailing out the corporations and rich people getting richer with the help of the state.”

      I abhor binary choices such as this that Austrians often use. You either agree with us or you are an evil statist puppet of corporations. Anyone who reads this blog knows that I do not agree with rich people getting richer. It is quite possible to disagree with both ABCT and Ben Bernanke.

      Also stock market speculation is limited to stockbrokers. Most ordinary people don’t buy shares.

  29. Patrick Trombly

    2001–Present – a Timeline
    (1) 2001. Jack and Mary are newlyweds with a combined income of $100M. FRMs and ARMs are both priced around 7%. Jack and Mary pre-qualify for a mortgage of $500M (at 40% payment-to-income ratio with payments of $3,325/month). At 80% LTV, their price point is $625M. That is their maximum bid for a house.
    (2) After 9/11, Greenspan cuts short rates. This is achieved through a cut in the Fed’s discount rate and through open market purchases of short term securities with fiat credit. This brings down short rates in the market – in fact this is the planned effect. The policy is maintained and short rates drop by 300-350 bps (a cut of about half) and are held there for years.
    (3) 2003. Joe and Michelle are newlyweds with a combined income of $100K. FRMs have dropped into the 6s. But ARMs are in the low 4s. Joe and Michelle pre-qualify, at the same 40% payment-to-income ratio, for a loan with monthly payments of $3,325/month. But with an ARM at 4.20%, that translates into a loan of $680M. At 80% LTV, their price point is $850M: 36% higher than Jack and Mary’s 2001 price point, based on identical loan payments and debt-to-income and LTV ratios. ARM popularity soars. Millions of “Joe and Michelles” bid house prices up. The asset bubble has formed. The inverse is also true: with no rate cuts, the bubble does not happen – it would be a mathematical impossibility.
    (4) 2002-2004: Builders read the rising prices as a signal of increased demand, and they predictably respond by increasing the pace of building. Builders are also financed at floating rates, typically with interest-carry – the same low rates reduce builders’ cost of capital, and their CAPM equations now way out of whack, inducing overbuilding. This causes an increase in construction wages and employment, as well as use and prices of commodities used in construction (e.g., copper). IRR inputs are distorted via the low rates. It is the classic mal-investment cycle described by Mises and Hayek decades earlier.
    (5) 2002. Long positions in commodities are also financed at margin, at lower rates. Coupled with temporary increased demand from builders, this fuels a commodity boom that will parallel the housing boom.
    (6) 2002-2004. With the low rates, existing mortgage borrowers want to refinance. Refinance applications are evaluated based on payment-to-income and LTV ratios. Payment-to-income improves from the rates and the opportunity to re-amortize. Some homeowners refinance to lower their payment – America starts de-leveraging more slowly, but defaults plummet as payments temporarily decline. However, LTV is determined based upon comparable sales. For every Joe-and-Michelle there are 10 appraisals using Joe-and-Michelle’s purchase as a comp. America leverages up, with no change yet occurring in credit processes or metrics: the standard credit metrics support higher debt levels because of the low rates.
    (7) 2002-2005. Federal policies, with bipartisan support, meant to increase homeownership (the benefit of which is debatable given that it reduces worker mobility) exacerbate the effect of the rates, but this is the frosting – the cake is already baked.
    (8) A cultural shift occurs. We look at homes as hobbies and investments (HGTV ratings, and Home Depot sales soar). We see the values rising and some believe that this results from the culture shift, rather than vice versa.
    (9) 2003-2007. All that printed/borrowed money is spent, temporarily increasing retail employment. This will ultimately raise consumer prices, but this is masked by real price reduction achieved through off-shoring. Those real price reductions temporarily offset the inflation. This, along with a decision to ignore commodity and home prices in CPI, allows the Fed to continue its rate policy yet claim adherence to a “price stability” mandate – itself borne of a baseless fear of deflation.
    (10) 2001-2004. The ECB follows the same rate path as the Fed, and it causes similar housing bubbles in Spain and Ireland – where ARMs are already the norm (actually, with greater impact as the typical loan tenor in Spain and Ireland is 40 years). Construction employment increases, offsetting long-term trends for non-college graduate males, much as it does in the US. Germany is an outlier: it has few ARMs and a strong manufacturing sector.
    (11) 2003-2006. Foreign investors in RMBSs see the same plummeting default rates and spiking collateral values and make the same bets as the banks. Securitization – originally invented to reduce risk by matching long term funds with long term assets and by allowing banks to diversify thus reduce geographic concentration in their local markets – now becomes a channel to globalize the risks inherent in inflating the credit supply. Derivatives follow suit. Low rates increase the amount of debt that a given cash flow stream can service. Lower default rates translate into lower cushion left in the deals, based on VaR models that have worked for decades. Considered with rising collateral values and reduced cost of capital, it is completely logical that derivative investors make the same bets as homeowners, builders and mortgage lenders.
    (12) Before any change in approval thresholds or underwriting models/ratios – any “abuses” – there is a massive asset bubble and a massive increase in debt. The biggest unsustainable boom of all time has been started, and a future “day of reckoning” that will be the main financial event for most people in the US and Euro Zone is already a certainty.
    (13) The “abuses” do happen – but they too happen because of the increase in supply, and decrease I price, of credit. Because the credit supply has been expanded through all these open market purchases with newly printed money, there is still money, in 2004, to lend after all the apparently “good loans” have been made. Because default rates have plummeted and values have increased, such loans do not appear to be as high-risk as they turn out to be. The default rate on home mortgages in the US hits an all-time low in Q4 2004, at about 1%. We now know that this is because households that got into trouble could refinance or sell; all we saw then was default rates. It appeared to be as safe, based on default rates, to lend to someone with a 600 credit score in 2004 as it had been to someone with a 700 credit score in 2002. Similarly, with collateral values rising by 15%-20% per year, it made sense to loosen LTV thresholds. Banks had always used 80% LTV as a rule of thumb because that translated into 70% LTV a few years out. In 2004, based on collateral value trends, 70% LTV a few years out translated into 90-95% LTV at origination. With unemployment low, higher debt-to-income ratios seem OK.
    (14) Some structures later deemed “toxic” or “exotic” are used more often – e.g., “interest-only option with teaser rates” – but interest is over 95% of the payment – it’s the rate that is “toxic” – and only because short rates are so much lower than long rates. If short rates and long rates hadn’t diverged, the “teaser rate” would be 50 bps below the long term rate – - few would opt for it and even if they did, it would not change the payment on a given amount of debt, or the amount of debt that a given income could support. “No doc” and “low doc” loans begin to be issued in greater numbers – to borrowers who either have the income but want a faster process, or don’t have the income but want to sell at a 20% gain (100% gain on an investment with 20% down). At first, these bets pay off. Because of the expanded supply of credit, the rates on these loans are not much higher than the rates for conforming loans. There had never been rules against such loans – the only laws preventing them were usury laws – but with expansion of credit, the rates on such loans falls to the single digits.
    (15) Many refinance transactions and HELOCs are used to term-out credit card debt. Consumer default rates plummet, hitting historic lows in Q4 2005. Credit standards and pricing are adjusted for unsecured debt based on the default rate trend and the fact that there is somehow still a bottomless pitcher of credit to pour (even though savings rates are at historic lows).
    (16) By late 2004 the Fed cannot ignore even their version of CPI. It gradually raises rates from late 2004-2007. As a result, a given income can no longer service an ever-increasing level of debt – it services a declining level of debt. Predictably, prices are no longer bid up. At higher rates and without increasing collateral values, the mortgage refinancing boom ends. Default rates start to climb back up; borrowers who get into trouble cannot simply refinance or sell out as quickly.
    (17) The homes started by those builders in 2002-3 are completed and put to market, further dampening prices. As rates continue to climb, builders’ costs climb with them – exacerbating an already tight margin situation produced by the commodity price bubble referenced above. Ironically, construction employment and wages temporarily increase further, as builders race to complete and sell out of projects. But all of the profit on a development, by 2005, comes from the land.
    (18) The rate and valuation spiral is by 2006 heading downward as rapidly as it had headed upward in 2002-3. This is exacerbated by the new buildings coming to market even faster than in 2005. Credit-wise, the situation is made worse in 2007 as ARMs begin to re-price at much higher rates and payment-to-income levels rise from 40% to 60%. Homeowners are already squeezed by commodity prices which have been driven up by the same low rates and have not yet popped. Default rates keep rising. They return to historic norms – and then start to pass them.
    (19) 2007. In an effort to sell off a few more rounds of mortgage securitizations, fraud and abuse, and poor and/or rushed underwriting, become more common. But the collapse will not be limited to just the last few RMBS issuances.
    (20) 2008. The house of cards collapses. Everyone is affected. Not just borrowers and lenders on, or buyers of, “liar loans.” The spiral is simple: inflation squeezes households and producers; with the Fed and ECB unable to ignore inflation, they raise rates back up. The amount of debt that a given income can service falls, and so do purchase prices. It is impossible to simply refinance to get out of trouble. The ARMs re-price. Builders’ cost of capital soars, and once the existing projects are rushed to completion, no new projects are started, and construction employment falls. With no new money printing, less money is spent, and retail employment falls. The increase in unemployment results in even more defaults. All of the various instruments “derivative” of mortgages (leveraged bets on the mortgages themselves) necessarily collapse. Predictably, the commodities bubble simultaneously collapses (this obviously has nothing to do with “mortgage abuses”).
    (21) 2008-2009: the Fed and ECB respond with credit expansion on a larger scale than in 2001-2003, in an attempt to re-inflate asset prices and stimulate “aggregate demand” – to induce people to buy more and save less. They also buy the “toxic assets” – loans that no longer work – most of which were not fraudulent but in fact had worked at origination based on the numbers; they no longer worked because the numbers had reflected credit expansion, not economic fundamentals.
    (22) 2009-Present: the central banks and other regulators dramatically increase oversight and lending restrictions, sometimes addressing issues that needed to be addressed but often not, and rarely touching on the root causes of the bubble-bust cycle. As an industry we increase the amount of red tape by tenfold all in the name of “preventing the next 2008.” Asset classes through which the central bank credit expansion of the 2000s flowed, and which were bid up and then collapsed, are mistakenly deemed to be inherently volatile. Banks’ ability to lend against these assets is limited, more tightly regulated, and in some cases (investment R/E at some banks) is forbidden – by the central banks that created the bubble.
    (23) 2009-2011. After the crash, as with many bust phases, banks have minimal capital to lend, and are afraid to lend. And investors and companies are afraid to invest, even if they still have capital to do so. Banks, investors and firms are, frankly, confused. In their view, CAPM has failed on all fronts: projected revenue, projected costs, projected cost of capital. All the ratios have failed – banks that adhered at all times to the old debt-to-income, DSCR and LTV ratios may not be shuttered but have suffered almost as much as banks that threw caution to the wind. There is significant turnover at the top – few managers dig deep enough to ascertain that the ratios did not fail – but were simply the victim of erroneous data that reflected credit expansion rather than economic fundamentals. It is easier to just claim that the prior managers (knowingly) “took on too much risk.” This becomes a catch-word: “risk.” This begs the question: risk of what?
    (24) 2011-2012. The growth mandate returns, and the price distortion continues: prices are not allowed to fall to levels at which they can clear because of “stimulus” policies designed to prop the prices back up. De-leveraging obviously must occur, but governments want to borrow more and want private lending to continue, also as “stimulus” to support a simultaneous growth in both investment and consumption. Rates are cut again, and many banks take the bait, causing local booms in margined, annuity-like assets such as NYC CRE and Midwestern farm land. With NYC CRE, NOIs in most neighborhoods have not changed – they simply support more debt because of the lower rates, and as a result, buyers bid up the asset prices and cap rates come down. With QE, cap rates fall further. It is the housing bubble all over again.
    (25) 2012-Present: the central banks impose new capital requirements and stress tests, including a capital and liquidity test assuming a downside economic scenario resembling “another 2008.” Stress testing is always a good idea but the stress in question is the bursting of another central bank bubble, and it is the central banks that are in charge of the stress testing. This is akin to the South Fork Fishing and Hunting Club rebuilding the South Fork dam and then ordering the residents of Johnstown and Cambria to build concrete dikes 100 feet high and 10 feet thick to protect against the next flood.
    (26) It could be possible to cut the credit stream off downstream of the Fed – but this would prevent bubbles only in the asset classes downstream of those cut offs –it’s a bit like eating a diet of cheeseburgers and beer while wearing a corset 24/7 – you’ll simply end up with fat deposits in areas other than the belly. If we don’t lend the money against the asset class that was inflated in the last decade, then credit expansion would result in leverage and inflated prices in other asset classes – taxi medallions, farmland, equities, commodities…. Historically, Germany, where ARMs are rare, really didn’t participate in the housing bubble and bust in the 2000s other than in its economy’s reliance on exports to the others, even though it is subject to the ECB monetary policy. The “twist” might temporarily inflate some bubbles but with no ARMs, the 2000s housing bubble and bust probably does not play out as it did. However, Germany did suffer through a commodity price bubble and bust, and its export businesses were impacted by other countries’ debt-fueled consumption binges.
    (27) Also one has to wonder why, if we agree that the harm caused by credit expansion is so severe, would we want to expand the credit supply to begin with? And why has there been no admission of the Fed’s undeniable causal role? Without the early 2000s rate cuts, the housing bubble, and thus the crash, are mathematically impossible. And if one goes back to read the financial papers at the time, one soon discovers that the primary reason for the low rates was to boost investment, spending and the “wealth effect” – i.e., they deliberately let the genie out of the bottle and hoped somehow to put it back in. Remove the first domino and the rest of them don’t fall – can’t fall. Let the market set the interest rates and this never happens – it mathematically cannot happen. The initial payment on ARMs and “teaser” structures would be the same as the payments on a FRM – opting for those structures would not enable the borrower to take on more debt using the same income, and buyers would not be armed with a sudden 36% increase in credit thus sudden 36% increase in purchasing power to chase the same assets. Wouldn’t that be better? Also, while it makes sense to require real estate appraisals to be ordered independently, and it doesn’t make sense to process “no doc” loans, it is inaccurate to cite loose appraisal processes or no-doc-loans as causes of the bubble. The cause was a temporary, artificial, increase in the supply, and decrease in the price, of credit, carried out by the Fed and ECB, both of which, incredibly, still blame everyone else. “Avoiding the next 2008” can be achieved not through reform by the central banks, but through reform of the central banks, who have never taken ownership of the disaster that they created, and who seem bent upon a repeat performance.

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