Friday, June 19, 2009

Easy money creates bubbles, which inevitably cause depressions when they pop. It’s Greenspan’s fault.

From The Money Illusion:

"Was Krugman right in 2002?

Yes, if you give his remarks a very charitable interpretation. I am referring to the remarks discussed by Arnold Kling here and here, which have received a lot of attention recently.

To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.

As everyone knows by now the once kooky and discredited Austrian business cycle model has now become conventional wisdom. Easy money creates bubbles, which inevitably cause depressions when they pop. It’s Greenspan’s fault. Paul and I are still not on board the Vienna express, but we are in an awkward position. (Thank God I didn’t have a blog in 2002!)

Here’s what I think is a defensible view of what Paul might have meant. (Notice I use first names in the times I agree with him.) The words are mine, not Paul’s:

“Business investment is tanking. A sharp fall in overall investment can often lead to a depression. The Fed should reduce interest rates to maintain adequate NGDP growth. Because tech is so overbuilt, the lower interest rates may not be enough to bring business investment back to normal levels, instead other types of investment and consumer durables will have to pick up the slack. We can expect the housing sector to expand if rates are cut sharply. In the classical model we would then be moving along the investment PPF from less business investment to more housing investment, instead of moving far inside the PPF (as in the 1930s) with less overall investment as the economy tanks. Let’s hope bankers lend money to people who are likely to repay their loans, so that the bankers do not lose hundreds of billions of dollars, and their jobs. Monetary policy has no choice but to proceed on the assumption that we should stabilize the overall macroeconomy, and let the private sector decide where to allocate resources. I am not asking the Fed to target housing, merely predicting it will expand if we have the appropriate level of AD.”

Would that statement have been defensible? I think so, even today. But if he wrote that poorly no one would read his blog. Short, provocative, counter-intuitive statements are more fun, but can come back to bite you.

[PS, I hope no one will tell me that bankers didn't lose money. They did.]

Update: Off topic, but since I am praising Paul Krugman, I don’t recall seeing a better post exposing the problem with the Republican Party than this."

  1. Nick Rowe
    19. June 2009 at 13:33


    Yep. What is worrying is the possibility that sometimes the natural rate might be so low that it will be impossible to avoid a bubble in at least some asset prices.

    I was writing on a similar theme in February. Because it seems that Greenspan’s critics are confusing two different argument:

    1. Greenspan caused a bubbles by setting interest rates below the natural rate (implausible).

    2. Greenspan caused a bubble by setting interest rates low in an absolute sense. (more plausible).


  1. Don the libertarian Democrat
    19. June 2009 at 18:05

    I don’t understand the Spigot Theory at all. If interest rates are low, that is surely an incentive for some financial transactions, but not all. Everyday, as human agents, we confront incentives and disincentives. Actual human agents then act on them.The idea that human agents act mechanically means that there is no agency involved at all in the action. That view of human action is clearly useless in my view, but others seem to credit it.

    In the housing bubble, low interest rates will sensibly lead to the buying of houses for some time. However, as the price of houses go up, the low interest rate loses more and more of its value. Going forward, there will come a point when the purchase of a house, even at low interest rates, does not make sense given the vagaries of human life. We went way over that sensible limit in the bubble, and low interest rates can only explain a part of such buying. You need an incredibly BS narrative to overcome such prudence,which we had, and many people bought it. Not me. I sold my house, and I’m no genius.

    The Spigot Theory says that if you keep interest rates low ( leaving low to you theorists to define ), then a bubble will necessarily emerge. It is a purely mechanistic explanation. Even if you claim that this position has uses in explaining the economy, you still need to explain and defend the underlying assumptions and presuppositions that this view is based upon. In a certain sense, that’s what philosophical explanation is; namely, an exposition of the underlying presuppositions of a theory or explanation.

    Many economic theories and explanations seem to be based on Behaviorism, or, as in the case of Milton Friedman, Correlative Explanations put forward as Mechanistic Explanations. Since correlations can change, this type of view often leads to confirmation bias, where the theory or explanation keeps getting adjusted in ad hoc ways to explain natural anomalies involved in correlations involving human behavior.

    No doubt, there are technical adjustments that can mechanically work. However, they then still need to be correlated with human action.

    The only criticism that makes sense to me is that Greenspan could have raised interest rates to bust the bubble at some point. The Fed could lean against the wind. But, just as the Fed is a lender of last resort, it is a leaner of last resort, and will only do such a thing when the bubble is bigger than our faces.

    If requiring more of a down-payment as housing prices rose could have stopped the bubble, then low interest rates can’t cause the bubble. Here’s a paper giving my view of how this would work:


    Economic Letter—Insights from the Federal Reserve Bank of Dallas

    Vol. 4, No. 4
    June 2009
    Federal Reserve Bank of Dallas

    Taming the Credit Cycle by Limiting High-Risk Lending
    by Jeffery W. Gunther”

    I hope that I made some sense.

20. June 2009 at 09:43

Don, You and I are really on the same wavelength. Did you see Tyler Cowen’s analogy where he discusses a banana subsidy? He assumes the banana subsidy caused people to build their roofs out of bananas. Then it rains hard and all the roofs collapse. Then people blame the government. Perhaps the banana subsidy contributed indirectly to the problem, but isn’t the main problem that people stupidly built their roofs out of bananas? The equivalent concept here is sub-prime lending, which reached pretty absurd levels regardless of interest rates.

I also have a bias toward public policies that promote saving (to offset most of our public policies, whhich discourage saving.) So I like ideas such as minimum down payments for loans made by any federally insured banks.

Nick, If it was hindsight, then I might agree with you. But it depends how deterministic you want to get. Are we allowed to “do over” the Fed’s interest rate decision of September 16, 2008? My view on blowing more bubbles has always been the following, whenever it comes up in discussion:

Let’s not try to go back to the bubble days of 2006, let’s use monetary policy to get back to mid-2008, when housing was already deeply depressed, the rest of the economy was ok, and unemployment was in the mid-5s. I don’t think that’s an unreasonable way of thinking about the optimal monetary policy’s impact on the economy. And I don’t view mid-2008 as a bubble economy. Yes, housing was stronger than today, but I think we have now overshot the goal (on the downside.)

Current, There is no way to know the equilibrium real rate, and the government shouldn’t even try to figure it out. Target NGDP and let the markets set rates. BTW, many economists think the equilibrium real rate is something like negative 5 or 6%. I think those estimates are meaningless, because they assume the economy is expected to stay weak. With appropriate monetary policy the economy would be expected to recover quickly, and thus the equilibrium real rate would rise sharply.

Joe, Starting with your last point. I agree that Krugman wasn’t advocating a housing bubble, but he was advocating a monetary policy that he expected to produce a housing bubble—I don’t think there is any dispute about that. And I agree with him in a sense, although I don’t like the term ‘bubble’ because it means different things to different people. I will make 4 observations about monetary policy:

1. Low rates were appropriate in 2002. If rates had been higher in 2002, then they would have been much lower in 2006. Why? Because if rates had been higher in 2002, the recession might have been a depression, leading to low rates in 2006.

2. The housing boom was partly caused by weak business investment (which is the real reason rates were low in 2002, not the Fed as many assume), and partly by high savings rates in Asia. I have no idea the relative importance of these two factors in the early period. But once business investment recovered in 2006, then high Asian savings rates became relatively more important.

3. Monetary policy was a bit too expansionary in 2004-06, but not because of the housing bubble, rather because NGDP was growing too fast. The housing bubble was a side effect.

4. The housing bubble did not cause our current crisis, tight money in late 2008 did.

Jon, Doesn’t the natural rate reflect both saving and investment schedules? How can it just reflect one side of the market?

No comments: