Best of the Week
Most Popular
1. The Trump Stock Market Trap May Be Triggered - Barry_M_Ferguson
2.Why are Central Banks Buying Gold and Dumping Dollars? - Richard_Mills
3.US China War - Thucydides Trap and gold - Richard_Mills
4.Gold Price Trend Forcast to End September 2019 - Nadeem_Walayat
5.Money Saving Kids Gardening Growing Giant Sunflowers Summer Fun - Anika_Walayat
6.US Dollar Breakdown Begins, Gold Price to Bolt Higher - Jim_Willie_CB
7.INTEL (INTC) Stock Investing to Profit From AI Machine Learning Boom - Nadeem_Walayat
8.Will Google AI Kill Us? Man vs Machine Intelligence - N_Walayat
9.US Prepares for Currency War with China - Richard_Mills
10.Gold Price Epochal Breakout Will Not Be Negated by a Correction - Clive Maund
Last 7 days
JOHNSON AND JOHNSON - JNJ for Life Extension Pharma Stocks Investing - 17th Aug 19
Negative Bond Market Yields Tell A Story Of Shifting Economic Stock Market Leadership - 17th Aug 19
Is Stock Market About to Crash? Three Charts That Suggest It’s Possible - 17th Aug 19
It’s Time For Colombia To Dump The Peso - 17th Aug 19
Gold & Silver Stand Strong amid Stock Volatility & Falling Rates - 16th Aug 19
Gold Mining Stocks Q2’19 Fundamentals - 16th Aug 19
Silver, Transports, and Dow Jones Index At Targets – What Direct Next? - 16th Aug 19
When the US Bond Market Bubble Blows Up! - 16th Aug 19
Dark days are closing in on Apple - 16th Aug 19
Precious Metals Gone Wild! Reaching Initial Targets – Now What’s Next - 16th Aug 19
US Government Is Beholden To The Fed; And Vice-Versa - 15th Aug 19
GBP vs USD Forex Pair Swings Into Focus Amid Brexit Chaos - 15th Aug 19
US Negative Interest Rates Go Mainstream - With Some Glaring Omissions - 15th Aug 19
GOLD BULL RUN TREND ANALYSIS - 15th Aug 19
US Stock Market Could Fall 12% to 25% - 15th Aug 19
A Level Exam Results School Live Reaction Shock 2019! - 15th Aug 19
It's Time to Get Serious about Silver - 15th Aug 19
The EagleFX Beginners Guide – Financial Markets - 15th Aug 19
Central Banks Move To Keep The Global Markets Party Rolling – Part III - 14th Aug 19
You Have to Buy Bonds Even When Interest Rates Are Low - 14th Aug 19
Gold Near Term Risk is Increasing - 14th Aug 19
Installment Loans vs Personal Bank Loans - 14th Aug 19
ROCHE - RHHBY Life Extension Pharma Stocks Investing - 14th Aug 19
Gold Bulls Must Love the Hong Kong Protests - 14th Aug 19
Gold, Markets and Invasive Species - 14th Aug 19
Cannabis Stocks With Millennial Appeal - 14th Aug 19
August 19 (Crazy Ivan) Stock Market Event Only A Few Days Away - 13th Aug 19
This is the real move in gold and silver… it’s going to be multiyear - 13th Aug 19
Global Central Banks Kick Can Down The Road Again - 13th Aug 19
US Dollar Finally the Achillles Heel - 13th Aug 19
Financial Success Formula Failure - 13th Aug 19
How to Test Your Car Alternator with a Multimeter - 13th Aug 19
London Under Attack! Victoria Embankment Gardens Statues and Monuments - 13th Aug 19
More Stock Market Weakness Ahead - 12th Aug 19
Global Central Banks Move To Keep The Party Rolling Onward - 12th Aug 19
All Eyes On Copper - 12th Aug 19
History of Yield Curve Inversions and Gold - 12th Aug 19
Precious Metals Soar on Falling Yields, Currency Turmoil - 12th Aug 19
Why GraphQL? The Benefits Explained - 12th Aug 19
Is the Stock Market Making a V-shaped Recovery? - 11th Aug 19
Precious Metals and Stocks VIX Are About To Pull A “Crazy Ivan” - 11th Aug 19
Social Media Civil War - 11th Aug 19
Gold and the Bond Yield Continuum - 11th Aug 19
Traders: Which Markets Should You Trade? - 11th Aug 19
US Corporate Debt Is at Risk of a Flash Crash - 10th Aug 19
EURODOLLAR futures above 2016 highs: FED to cut over 100 bps quickly - 10th Aug 19
Market’s flight-to-safety: Should You Buy Stocks Now? - 10th Aug 19
The Cold, Hard Math Tells Netflix Stock Could Crash 70% - 10th Aug 19
Our Custom Index Charts Suggest Stock Markets Are In For A Wild Ride - 9th Aug 19
Bitcoin Price Triggers Ahead - 9th Aug 19
Walmart Is Coming for Amazon - 9th Aug 19

Market Oracle FREE Newsletter

Top AI Stocks Investing to Profit from the Machine Intelligence Mega-trend

Why the Mainstream Fails to Understand Recessions

Economics / Economic Theory Jul 03, 2014 - 10:24 AM GMT

By: MISES

Economics

Hal W. Snarr writes: In a 2010 Bloomberg Television interview, Alan Greenspan said, “The general notion the Fed was propagator of the bubble by monetary policy does not hold up to the evidence. ... Everybody missed it — academia, the Federal Reserve, all regulators.”


Everybodymissed it? Not according to Axel Leijonhufvud. In 2008 he wrote, “Operating an interest-targeting regime keying on the CPI, the Fed was lured into keeping interest rates far too low far too long. The result was inflation of asset prices combined with a general deterioration of credit ... a variation on the Austrian overinvestment theme.”[1] Randall Forsyth concurred, writing the following in early 2009, “The Austrians were the ones who could see the seeds of collapse in the successive credit booms, aided and abetted by Fed policies.”[2]

The Failure of the Mainstream

Despite the unprecedented fiscal and monetary action taken by the Bush and Obama administrations, which pushed the per capita budget deficit to more than twice the previous record, and the Fed, which quadrupled its balance sheet,[3] the economy continues to be stuck in a deep recessionary gap. Instead of acknowledging the failure of these actions, policy makers have doubled down. As the Fed continues to print money to buy securities directly from Treasury and hold rates near zero, asset bubbles are reflating,[4] excess reserves have exploded, and bad economic news pushes stock markets ever higher.[5] With the pedal pushed to the metal, economists surveyed by the National Association for Business Economics in 2012 said they wanted current fiscal or monetary policy to continue.[6] A year later, economists in that same survey said monetary policy was about right.[7]

In a 2013 New York Times article,[8] Paul Krugman acknowledged that the housing bubble he prescribed for the 2001 recession[9] had resulted “in the greatest economic crisis since the 1930s,” but called for the Fed to ignore the “babbling barons of bubbleism, and get on with doing [its] job” of fighting high unemployment.

Money printing and low interest rates are part of a much broader problem. The system the Fed oversees is wracked with moral hazard. The FDIC, the Fed being the lender of last resort, the too-big-to-fail doctrine, and mortgage securitization by Fannie and Freddie allow lenders to make riskier loans than they would have otherwise made. Unlike large national banks, credit unions are hesitant to make 30-year fixed rate mortgages. Why? They understand that their net interest margin will be negative if future deposit rates rise above fixed rates on mortgages made years earlier. They also understand that they are too small to be bailed out.

The aforementioned backstops are necessary because fractional reserve banking is inherently unstable. The money that is lent into existence can vanish at a moment’s notice. The bank panic sparked by the Lehman Brothers collapse resulted in a massive shortage of reserves that was filled with a 578 percent increase in discount loans.


Although economic prosperity is linked to core tenets of Austrian economics, namely economic and political freedom,[10] the school is routinely dismissed by mainstream macroeconomists.[11] This is so despite prices falling, quality rising, and consumer choice increasing in markets that are relatively free of government intervention (e.g., cellular phones, televisions, software, and computers). On the other hand, inflation, stagnant quality, inefficiency, or moral hazard is typical of industries regulated, managed, or owned by government (e.g., banking, education, healthcare, and the post office). Thus, it is surprising that the school has not gained wider acceptance. This is perhaps due to mainstream macroeconomics offering sellable solutions. Whereas Austrian economists generally refuse to support politically-popular welfare programs when unemployment is high, mainstream macroeconomists do not. Keynesian “solutions” like public works projects, extensions to unemployment insurance compensation, and payroll tax cuts, are well-received among working-class voters. Supply-side and Chicago-School policy prescriptions, like capital gains tax rate cuts, low interest rates, and deregulation, appeal to investors and entrepreneurs.

Mainstream macroeconomics’ sellable solutions have consequences, which are fixed with additional interventions. The IRS tax code has nearly doubled in length to over 70,000 pages in twenty years.[12]During that same period, over 1.4 million pages have been added to the Federal Register.[13] During the last five years, the Fed has held rates near zero and paid banks to not make loans.[14] Consequently, the accumulation of intervention has coincided with long-run growth slowing to a crawl.

How did mainstream macroeconomics miss it, and why has it doubled down on policies that appear to be setting the table for future asset bubbles and financial crises?

Too much aggregation is mainstream macroeconomics’ fatal conceit.

Capital-Based Macroeconomics

Roger Garrison’s Capital Based Macroeconomics (CBM) avoids mainstream macroeconomics’ fatal conceit by disaggregating economic output by stages of production.[15] Expenditures on first stage capital goods, like rubber and steel, were committed to the production of second stage capital goods two periods ago. Expenditures on second stage capital goods, like tires and engines, were committed to the production of final goods last period. Adding these expenditures gives mainstream macroeconomics’ investment expenditures, which ignores the inter-temporal allocation of resources. Expenditures on final stage goods, like automobiles, are known as consumer expenditures in both macroeconomic views.

Consumption and investment are more realistically modeled as short-run tradeoffs in CBM. When consumers save more, the supply of loanable funds rises. This lowers interest rates and raises investment as consumption and profits fall.

Shrinking profits prompts innovation. Lower interest rates promote the discoveries, production, and adoption of new products and cost-saving technologies.

Unlike in mainstream macroeconomics, wages in CBM’s segmented labor markets do not all fall when GDP declines. Though falling profits decrease labor demand and wages in the final stage, labor demand and wages in earlier stages rise as firms redirect resources. The widening wage differential draws workers to earlier production stages. This migration reduces final stage labor supply and raises earlier stage labor supply, resulting in the final stage wage rising up toward the wages that prevail in earlier expanding stages.

After savings-induced investments have worked their way through the economy, the productive capacity of the economy has expanded, resulting in higher overall consumption. Though this contradicts Keynes’s Paradox of Thrift,[16] it does not work well when government interferes in markets.

Market interventions like social security, minimum wages, food stamps, and interest rate setting reduce savings, and make wages and prices sticky. Because persistently high unemployment is the unintended consequence of these interventions, monetary intervention is enacted to cure it.

When the Fed creates reserves, interest rates fall, investment increases, and savings decline. The wedge that is driven between investment and savings equals the amount of money that the Fed creates. The resulting malinvestment and overconsumption represent a competition for resources, which pushes asset prices ever higher and the economy beyond its productive capacity. This is what Austrians refer to as a Fed-induced boom.

Conclusion

The boom is unsustainable. Investment and consumption are higher than they would have been in the absence of monetary intervention. As asset bubbles inflate, yields increase, but so do inflation expectations. To dampen inflation expectations, the Fed withdraws stimulus. As soon as asset prices start to fall, yields on heavily leveraged assets are negative. As asset prices decline, increasingly more investors are underwater. Loan defaults rise as mortgage payments adjust up with rising interest rates. When asset bubbles pop, the boom becomes the bust.

Notes

[1] Axel Leijonhufvud, “Keynes and the Crisis,” CEPR Policy Insight, no. 23 (May 2008).

[2] Randall W. Forsyth, “Ignoring the Austrians Got Us in This Mess,” at http://online.barrons.com (3/12/2009)

[3] The Fed’s balance sheet has grown from $869 billion on August 8, 2007 to $3,470 billion on June 10, 2013. See www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm

[4] Sam Ro, “Albert Edwards: The Fed Is Inflating a Housing Bubble to Hide a Destabilizing Economic Problem,” at www.businessinsider.com (9/27/2013), and “General Motors Executive Warns of Impending Auto Bubble,” at http://freebeacon.com (10/8/2013).

[5] See http://money.cnn.com/2014/02/13/investing/stocks-markets/

[6] See http://nabe.com/survey/policy/1209

[7] See http://nabe.com/Policy_Survey_August_2013

[8] http://www.nytimes.com/2013/05/10/opinion/krugman-bernanke-blower-of-bubbles.html

[9] http://www.nytimes.com/2002/08/02/opinion/dubya-s-double-dip.html

[10] For a review of the literature that examines the link between economic freedom and economic growth, see Niclas Berggren, “The Benefits of Economic Freedom: A Survey” The Independent Review 8, no. 2 (2003): 193-211.

[11] For example, see “Fine Austrian Whines” (2013) by Paul Krugman.

[12] See http://taxfoundation.org/sites/taxfoundation.org/files/docs/PuttingAFace2013.pdf

[13] See http://dailycaller.com/2013/05/21/the-towering-federal-register/

[14] See Frances Coppola, “Banks Don't Lend Out Reserves,” Forbes.com (2014).

[15] See Roger Garrison, Time and Money (London: Routledge, 2001)

[16] Thrift may be the handmaiden of Enterprise. But equally she may not. And, perhaps, even usually she is not. — JM Keynes.

Hal W. Snarr is an assistant professor of economics at Westminster College in Salt Lake City, Utah. See Hal Snarr's article archives.

You can subscribe to future articles by Hal Snarr via this RSS feed.

© 2014 Copyright Peter St. Onge - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules