Commentary: Economics of Financial Crises and Business Cycles

0:00I'm going to discuss each of the three papers in the same sequence that they were presented. And so I'll start talking about this great leveraging paper, which is very much to my own taste in papers of this sort. It's a bridge-building paper, where he brings into view both the hardcore monetarist framework in the relationship between money supply and the price level, and on the other hand brings in the Austrian view in terms of credit expansion, and shows what that relationship is between them. It's a paper, as he pointed out in his presentation, that could be written only After 1980, actually, because of the extreme co-movement of credit and money before that period, it's a period that has come to be called the Great Moderation, when seemingly the quantity of money, quantity theory of money doesn't apply, at least it's not as much as it did before.

1:09and the turning point was 1980 with the legislation called Depository Institution Deregulation and Monetary Control Act of 1980 if you don't know that legislation it's actually misnamed it's called deregulation it should be called re-regulation they didn't really deregulate anything they just switched them around a little bit but they did it in ways that blurred the distinction between the different monetary aggregates and sent monetarism into a tailspin essentially because they didn't know any longer which monetary statistic to look at. Some of you might remember Alan Greenspan testifying to the Joint Economic Committee that said in a sort of a forlorn tone, we just don't know what money is anymore.

2:08And then I actually made it onto the Jay Leno show, where Leno was musing about, you know, don't know what the qualifications are for being a Fed Chairman, but at least he ought to know what money is, you know. But that really ushered in a new era where maybe we should look at something other than And he endorsed the quantity theory of money, although at that time he understood the quantity theory of money as simply being a supply and demand approach to monetary analysis.

3:10And it was contrasted with the state theory of money, which was a claim that money is imbued with value by the state. Well, we could appreciate his rejection of that. What was left then was simply the application of supply and demand, which he pioneered through the regression theorem by showing how we could apply supply and demand analysis to the value of money. The application entailed sort of first order considerations about what's going on with what's now called the velocity of money, kind of a misnomer for that statistic, and what's What's going on with real growth? You have to make allowances for those changes before you can come to the statement that inflation is always and everywhere a monetary phenomenon.

4:07Actually what Mises would claim is that by inflation we mean an increase in the money supply and one of the most obvious consequences of that is rises in prices. So the point So, the point is that that idea wasn't lost on Mises, he knew it very well. But if the topic was something different, namely booms and busts, and what causes a boom to go bust, then the focus was not strictly on the quantity of money. It was on credit expansion. And significantly, the episodes of boom and bust, and even the big one, boom in the 20s and bust thereafter, did not involve price-level inflation.

4:55There wasn't much inflation during the 1920s, but there was a lot of credit expansion. And that gave rise to some discoordination in the economy and eventually a bust. So it was much more straightforward in applying the Austrian theory than it is to the monetarist theory. In fact, Friedman, the monetarist in general, don't even look at the 1920s for possible causes of the downturn. Friedman christened the 1920s as being the golden years of the Federal Reserve when the Fed was doing just the right thing, and precisely because the price level wasn't changing. So when he looked for causes of the downturn, he looked at 29 and 30 and 31 to see what was going on then and not what was going on during the 20s when you had all the credit expansion and the discoordination in the capital structure, okay?

5:55So we can see a lot of relationships between the Austrians and the monetaries in that sense. Now one thing I like to emphasize with respect to this paper is something that I think is in the paper, it's either in there or I read it into there. You can never be quite sure what the case is, but I'll let the author tell me whether I'm reading off the edge of the page or between the lines or whatever. We know from the Austrian theory that pressing interest rates below the natural rate is what caused the discoordination in capital markets and inevitably gives you a bust. Well, it turns out there's more than one way to depress interest rates below the natural rate.

6:44And one of the ways is to externalize risk. Right? Now, credit expansion through a fractional reserve system in the context of central banking, and that's an important qualification, if you have central banking that's running a fractional reserve system, Then there's some inherent systemic risks in expanding the money supply. And if you overdo it, you're going to get the bust, okay? But you also get systemic risk if you have a central, and there's the key, a central mortgage authority. Okay, here comes Fannie Mae and Freddie Mac again. And they have their own way of externalizing risk, and that's to guarantee mortgages.

7:31that are initiated by banks, you might call that bank lending, it's not really bank lending, it's bank initiation of the mortgages that's being actually lent by the mortgage company and then sold as derivatives of one sort or another, you know that story, but that's risk externalization, and that risk externalization can be as dangerous as the externalization of risk that's inherent in fractional reserve banking in the presence of a central bank. And I see that as a contribution in its own right to see that parallel. Several points in the margin of this paper I would write risk externalization, and I think it was implied. I think I was getting it from the paper, but it wasn't as explicit maybe as I would have liked to see it.

8:30So, in any case, with the housing boom, then at the end of that boom, you have a pretty wild distortion of resources toward housing, and then too many houses, too big houses, and too expensive houses, and so on, owned by people who couldn't afford to pay the mortgage, which is very much in line with the Austrian theory. To me, one of the juiciest quotes in that paper is one by Bernanke and Gertler. First I thought it was Geithner. No, it's not Geithner, it's Gertler, it's just a co-author of Bernanke's probably when he was at Princeton. I don't know anything about Gertler.

9:17But the paper, Bernanke is the important one here of course, Bernanke writes this and I'm getting this directly from the paper. He argues that following an inflation target, in other words, in 2% is the rate that Bernanke wants to target, following an inflation target automatically stabilizes the stock market. Really? I don't think so. It automatically destabilizes the stock market, because think about it, if you're going to When you want to target a 2% inflation, and especially in a period where we have some economic growth, real economic growth, then you've got to pump a lot of money into the economy, and you pump it in through credit markets and you lower interest rates.

10:06In the lower interest rates, you get the distortions that the Austrians talk about, and you get an increase in asset prices. Just discounting those asset prices at a lower interest rate gives you that result. And it's an increase in asset prices that doesn't reflect any underlying real economic factors. It doesn't reflect any increased saving, it doesn't reflect anything but the pumping of new money into the economy. There was a period, I'm not sure when Bernanke wrote this, it was probably well before he became Fed Chairman, but there was a period during the final throes of the boom where the Fed worried out loud about what they called asset inflation, which is precisely the rise in stock prices, asset prices, housing prices, as a result of having a very low rate of interest and present value of those things were just artificially high in the same sense that the interest rate was artificially low, okay?

11:14They worried about asset inflation, but worry is as far as it goes. At the end of their worrying, they say, Well, can't interfere with that because we ought to leave that to the market. That was their judgment. Well, sure they should leave that to the market, but they also should leave the interest rate to the market. And if they had left the interest rate to the market, then the asset prices would have been consistent with the underlying economic realities, all right? I don't know if at that point Bernanke had rejected this claim that he had made earlier are about automatically stabilizing asset prices. Now, the paper's praiseworthy, and yet I'm a discussant.

12:05I've got to do a little bit of critiquing. And my only critique is it didn't go quite far enough. What seemed to me is that he walked right up to the threshold of Austrian theory, But didn't step across, okay? And so this morning I want to pull him across, all right? I couldn't help but notice that I did a find function to find how many times he used the word inflation and how many times he used the word unsustainability. I've forgotten the numbers now, but inflation appeared many times on many pages. pages, unsustainability appears but not too much, okay, but he worries or he indicates that credit expansion, per se, independent of a change in the money supply or a change in inflation leads to unsustainable growth, and the paper just begs out for an answer to the question, how so? How so? Right? And of course, the answer to the how so question has to do with the capital structure. It has to do with asset prices being bid up. Or to put it in more Austrian terms, and this is a phrase that I've started using recently and I think is helpful, we can talk about differential interest rate sensitivities. In other words, yes, pumping

13:38Moving credit into the market will lower interest rates and it will drive up prices, but it drives them up in a non-uniform pattern. And the pattern, of course, is the more durable the asset, the higher the price goes, the more early stage the asset is, the higher the price goes, whereas assets that are close to the consumer, late stage production, we might go up a little bit, not much, okay? So you have to look at this change in the pattern of prices, the differential interest rate sensitivities to see just how the economy gets coordinated. And of course that immediately leads you into structure of production, capital heterogeneity, about processes, and the subsistence fund, you remember that?

14:38Now maybe that's why he didn't step over the threshold, stay away from that, you'll lose your audience. And you may, you may lose your mainstream audience, okay, because their eyes glaze over when they hear that kind of stuff. So he might have known right where to stop, okay? But if he writes a sequel to this paper, then those are the issues I would like to see him deal with okay let me move on to I'm just gonna read the title but I'm just gonna say fractal analysis dot dot dot and all the all the rest of it it's a long it's a long title by Bob Mulligan and I want to deal firstly with his with his theoretical section and then with the empirical I like the theoretical section very much, and partly for reasons you might not expect, and that is that it provides a counter to the common criticisms that we've been hearing among the Austrians even, of the Austrian theory of the business cycle.

15:51Now, let me tell you what the particular aspect of this theory is. Mulligan says, very correctly and very much in line with Mises, that a credit expansion reallocates resources in both directions. It reallocates it to the early stage processes and it reallocates them to the late stage processes. That might almost seem like a contradiction as some of our friendly Austrian comrades claim, but it's not. Mises used the term malinvestment and overconsumption. And he uses that repeatedly in Human Action. And by malinvestment, he means excessive reallocation in the early stages of production. And by overconsumption, he means that people are consuming more than was consistent with the underlying economic realities, which actually is already implicit in the notion that at a low interest rate, people don't save as much.

17:00Right? Yes, right. They don't save as much. So what do they do instead? They consume. They go out and buy flat-screen TVs, big ones, bigger ones, and remodel their homes and buy a second home. You know, they do all sorts of things. They consume. So consumption goes up during the boom, as well as early-stage production. Now, some of our Austrian friends, and I'm thinking of the George Mason crowd, not using crowd in a derogatory sense, people at George Mason that write about Austrian business cycle, they say that the Austrian theory is wrong because it can't explain the co-movements of investment and consumption.

17:48In other words, during a boom, both investment and consumption go up. If you look at the aggregate statistics, they both go up. And how can this be in the Austrian theory? Because according to them, the Austrian theory has it allocating resources away from consumption and towards early stages investment. So consumption ought to go down when investment goes up. And that would be a necessity, it would be sort of a logical necessity, if you're dealing with a two sector model. Consumption here, investment here, and it's all there is, right? And so if one goes up, the other has to go down, and that's their shtick, that's the way they see it. But the Austrian theory differs very much from the neoclassical theory in allowing for multiple stages of production.

18:38You've got lots of stages of production. You use four or five or six for pedagogical reasons, but plenty of stages of production, and there's plenty of room for some resources is to be allocated, as Bob says, from middle stages into early stages and others from middle stages into late stages, each consistent with the market forces that are being faced. In other words, you've got low interest rates, you can borrow and invest in the early stages, and that employs a lot of people who now have higher incomes and don't want to save because the interest rate is so low so they spend and they buy consumption goods. Ultimately that's inconsistent with one another but that's exactly what the business cycle is about. Over time that inconsistency reveals itself in the bust, okay, because it's when those middling stages finally When you mature to final stages, there isn't as much consumer output, and people can't consume more.

19:54I had one critic, again a friendly critic in the Austrian view, reject this idea about the middle stages being raided to send resources in both directions, and he said, that doesn't make sense. That doesn't make sense. is as if you have an assembly line producing cars and lots going on in the early stages, and a lot of cars are coming out the late stages, but nothing's going on in the middle. Doesn't make any sense. Well, that misconceives of Hayek and the stages of production. The way to think of it is, if you have lots of investment in the early stages, That means you're going to have lots of consumption in the out years, in the fairly distant future.

20:45If you have increased investment in the late stages, that means you have lots of consumption in the immediate several years. But having not much investment in the middle stages means that in those intermediate years, you're going to be short on consumption, right? That's That's what it means, which is exactly the Austrian theory of the business cycle, that the boom is not sustainable precisely because the intertemporal pattern of investment is misaligned with the preferred intertemporal pattern of consumption. That's what it's all about. And the way that Bob Mulligan sets this up makes that very clear. Now, again, I need to be critical of even the theory, and so one sentence that comes out of Bob's paper is that the early-stage production should respond to long-term interest rates, long-term interest rates, okay, so people borrowing more and investing.

21:49And late-stage production should respond to short-term interest rates with which finance consumer spending, all right? Now on the face of it, it's true, but it turns out that even independent of short-term rates, you get an increase in consumer spending precisely because you get increased employment and increased incomes being made by these people who are working in the boom industry. So if a boom is going on, you got a lot of hiring, you got firms bidding for workers, and when they get that money, guess what? They spend it immediately on consumption goods.

22:35And it's not that they have to borrow, but it's certainly that they don't want to save because the interest rate is so low. So they spend it on consumption goods and don't necessarily, they can, but they don't necessarily have to borrow to buy those consumption goods. This was the basis, by the way I might mention, since I've got a few more minutes, I might mention that Hicks, John Hicks, was critical of the Austrian theory on the grounds that people would spend their money on consumption goods immediately after earning it, and so The cycle would be short-lived, so much for Hayek's business cycle theory.

23:22No, it's not short-lived, it's just misallocation in both directions. And it doesn't come to an end until it becomes clear that those middle stages aren't producing the output that's consistent with people's intertemporal preferences. Hick said, this is British terminology, with reference to Dennis Robertson, who had some odd terminology. But he said, they'll spend the money within a Robertsonian week. I was puzzled by that for a while. What does that mean? I asked Richard Ebeling, who's sort What's a Robert Sonian week?

24:31as we would like them to be. And make it clear that the stages of production approach, five or six stages, whatever you want to use, depending on how you want to draw your graphs, is largely a pedagogical device, okay? It's a pedagogical device. Stages just don't align well with firms or with industries or with sectors of the economy, all right, we know that some processes take longer than others, but the different aspects of different processes are divvied up among sectors, among industries, among firms, and you just can't make those one-to-one identifications to get good, Good, Robust, Empirical Results.

25:26Let me give you one example that may be a little anachronistic. I don't know, but it's one I've used before. I think of a paper mill, for instance. A paper mill. And it might be producing paper for making greeting cards or paper for making blueprints. Do they use blueprints anymore? I think they're not blue anymore. Okay, but they still call them blueprints, all right? Now one is late stage, greeting card, one is very early stage, blueprint. You're gonna build a factory maybe, okay? And yet the paper comes from the same paper mill. So is that paper mill early stage or late stage? Well, of course it's both one direction or another.

26:15Now I've pointed this out before on different occasions And one reaction is, oh well, there goes the Austrian theory. If you can't tell which stage is in, how does this theory hold up? And yet, precisely the opposite is true. If you could tell, the credit expansion would be much less disruptive. And I get the idea, for instance, that Austrian economists with empirical orientation orientation might well approach an industrial site, let's say acme industries, that has the gate and acme industries over the, arched over the gate, and the Austrian economist might immediately look around for that little sign that's a Hayekian triangle and a little red light that says you are here, you know, it doesn't exist, okay, they're not telling and the reason they're not telling us, they don't know, okay?

27:20If they did know, if they did have a very precise quantitative idea about where they were in the structure of production, then it would be easier for the entrepreneur to adjust his production activities in the light of that and maybe to discount at an interest rate that he thought was more appropriate for a time element that he thought was more appropriate, given that a credit expansion was going on. It's precisely that he doesn't know, and that he can only look at prices of his output and prices of his input, which are determined in a decentralized way in the economy, to gauge how much to produce, okay?

28:10Okay, so the empirical front is going to be hard to progress on. The theoretical part is commendable. I like the way that went. Okay, now Nicholas' paper on the expansion into the international sector appreciated this paper for reasons he couldn't possibly expect, And that is that right after I wrote Time and Money, I ended up having several interviews. And the interviewer would ask me, well, in what direction could you expand this? What needs to be done next? And one of the things I said was, well, expand it to include the international sector.

29:01Because I didn't do that. I used a closed economy in my whole book, and that's what Hayek did, you know, that's, I mean that was typical. Let's start, let's start out trying to wrap our minds around the whole economy before we start branching out and figuring out the International. And the reason I recommended that, I had two reasons. One is, I didn't want to try to do it myself, okay? I needed somebody else to do that. So, I'll cheer on Nicholas on that front, certainly. The other reason that was on my mind, I was in England at the time, and visited the British Museum of Technology around Kensington Park, where they had on display, I'd been tipped off about this, they had on display hydraulic analog computer created by A.W. Phillips, okay, I see some of you nodding your head, yes, yes, Phillips, Phillips was kind of a funny guy, and He was a Keynesian, and he undertook to build a hydraulic computer.

30:09You hook it up to the water pipes instead of the electricity. And the flows and the leakages, they were really Keynesian leakages there, would mimic the macro economy in a Keynesian framework, okay? The water was colored with a red dye, which sort of means the Keynesian economies are We're always in debt, but it was really so you could see the water and you see the water flowing and you could pull down the investment and then watch it flow and watch the multiplier and so on. And he was criticized for a lot of things about that computer, but the one thing that people kept telling him, you don't have an international sector.

30:57It's just a closed economy. And he had made about 26 of these computers and sold some to industry and others to educational institutions and so on, but he didn't have an international sector. Well, he decided to get one, and so what he did is he made still one more of those things, but he made the mirror image of it, made it left-handed, okay, so he could put one up by the Other and connect them up and then turn on the water, okay, and see what happens in the international sector. So, you might investigate that to see if you turn on the water and see what would happen in the international sector, okay. Now, I will say that Nicholas has made a significant step beyond Darren Richey. He quotes, he cites Darren Richey in a 2005 article, which is written in English, actually, but published in Spanish, and Richie had sort of a groundbreaking effort to take in the international sector. And it was written, Richie's paper was written while he was an undergraduate as an honors paper. It was pretty

32:18amazing even for that much. He sent me a copy at the time that he wrote it. Now, what Nicholas What Mises has done is identify, more specifically, the channels through which the discoordination in one economy affects another economy through interest rates, yeah, but also through exchange rates. And then he's provided a graphical representation, which I can only admire, and I challenged him to put it in PowerPoint, make those things actually move around, and so on. Although I suspect that those might themselves make it to the British Museum.

33:04But you have to work at understanding the graphics because they're three-dimensional and you have to see what's where and what changes. But once you see it, it does make sense and it certainly corresponds with the theory that that he's positing. But I'll say for his paper, something similar I said for Bob's, and that is that when push comes to shove, Hayekian triangles have no respect for national borders. He himself recognizes this in the short section after those graphics, but the graphics themselves have all the stages in one country and then selling the output in another country. But we know, once we turn the page, that it doesn't work that way, that stage one could be in one country, and stage two in another, stage three in the next one, and stage four maybe back in the home country.

34:01You don't know that there's no respect for international borders. A lot of the Austrian theories, I'm thinking about Hayek's International Monetarism book, sort of work at incorporating international considerations but recognizing first and foremost that economics doesn't much respect international borders. So that sort of is an obstacle to overcome in extrapolating the theory.