Ending Austerity in the Austerity Debate

August 1, 2010

by Mario Rizzo  

What has been disappointing about the recent stimulus vs. austerity debate is the recycling of arguments that have been gone over many times before in many newspapers and blogs. The debate has become tiresome and unenlightening.  

The major feature of the debate that is responsible for the lack of enlightenment is, well, its unrelenting macro-aggregate character.  The main variables are excess demand for goods, excess supply of financial assets, total government spending, deficit to GDP ratios, government debt to GDP ratios, the confidence of economic agents in government bonds (as measured by yields), and so forth.  

Is there anything important going on beneath the surface – factors that have a more direct causal relationship to the decisions of real economic agents?  

Now a breath of fresh air!  

I recently came across some articles on the dangers of prolonged very low interest rates. They appear in The Economist, American Economic Association’s Papers and Proceedings (“The Credit Crisis” by Douglas Diamond and Raghuram Rajan), the Annual Report of the Bank for International Settlements, a summary blog post by Rajan, and most recently a Financial Times article by Rajan, “Bernanke Must End the Era of Ultra Low Rates.”  All of these are well-worth studying. 

What is particularly interesting about this work is that it shows that important distortions can be produced by excessively low interest rates before either “full employment” is reached or the price level begins to rise at all. Below are some of my own observations based on reading the above articles and papers.   

1. Let us remember that the housing-market bubble occurred without any major episode of price-level inflation. The collapse of innovative derivative securities was also not the result of price-level inflation. Therefore, right at the outset we should be suspicious of those who concentrate their attention on unemployment, inflation, and government debt.  

2. One of the most important distortions of prolonged periods of very low interest rates is the increase of incentives to bear risk. This is sometimes described as the search for yield. Modern finance theory suggests that the optimal tradeoff between expected return and risk shifts in the direction of greater risk when expected returns fall. (Tyler Cowen has a good discussion of this in a business cycle context in his book, Risk and Business Cycles.)  

3. Unfortunately, the precise extent and nature of this additional risk is not easy to identify ex ante. The more unprecedented economic conditions are, the less relevant is recent experience. Increased leverage makes for increased uncertainty.   

4. While the effect of Fed policy is initially on short-term interest rates, the effect spreads to longer-term rates. There are a number of mechanisms by which this occurs. However, if short-term interest rates are expected to be low for a substantial period, banks will finance longer-term loans with short-term debt. The profits generated by the spread between very low short rates and higher long rates will encourage this.  

5. In general, one danger of this banking activity is that a more future-oriented real capital (or production) structure will be encouraged by the fall in long rates but be quite vulnerable to the rise in short-rates under the control of the Fed. This is a case where the plans of the savers and providers of loanable funds are not in fundamental (or long-run) coordination with those who supply or create the real capital structure.  

However, at this particular point in the business cycle the danger is more that there will not be sufficiently rapid re-allocation of resources away from the unsustainable sectors.

6. In the long-run view, the present period of ultra low interest rates is part of the process by which moral hazard is created. If banks know that when they get into trouble by responding in a boom to low interest rates, they will be rescued by another recessionary period of low interest rates, it is difficult to see why they should stop engaging in problematic behavior.  

The current period of low interest rates needs to be reversed, in my view, before the traditional macroeconomic warning signs of trouble appear. The problem will not show itself in the grand aggregates until it is too late.

15 Responses to “Ending Austerity in the Austerity Debate”

  1. Bob Murphy Says:

    Great post, I’ve been reading Rajan’s stuff too.

  2. Bill Stepp Says:

    Very good post. The Aug. 2-8 issue of Bloomberg Businessweek has a good article, “Low Rates Are Starting to Squeeze Bank Earnings.” Low rates have been a factor in causing their net interest income to fall (save for Wells Fargo, which appears to be an outlier). At the same time they’ve tightened their lending standards, cutting the demand for loans.
    Rajan appears to be firmly in the Austrian camp on this issue.
    Austrians are uniquely positioned to understand the effect of interest rates on capital structures and how this effects economic activity.
    It’s been a while since I read Rothbard on interest rates, etc. in MES, but my recollection is that his discussion on these things is solid. Is my memory faulty?


  3. Excellent post and on the mark. Point #1 is key and vindicates Hayek’s position in the 1930s. Monetary inflation affects resource allocation even if there is no measured final goods inflation (e.g., CPI inflation).

    Money’s effects work first through asset prices, then to goods prices. Walker Todd argues that is also the sequence in Keynes’ finance theory.

  4. Greg Ransom Says:

    A LOT of Rajan reads like it’s straight outta Hayek.

  5. Greg Hill Says:

    Question for you:

    Why wouldn’t entrepreneurs recognize that the Fed had pushed the interest rate below the “natural rate,” that the supply of artificially cheap credit couldn’t last, and that the rational course of action would be to avoid undertaking too many “roundabout” projects? Alternatively, when interest rates were artificially low, why wouldn’t entrepreneurs borrow heavily at fixed interest rates (selling long-term bonds) and then hold onto the borrowed funds to assure he or she had the funds needed for the completion of the structure after credit tightened?

  6. Mario Rizzo Says:

    Economists can’t be sure. Entrepreneurs don’t know either. But as with the housing bubble if you get out in time you don’t care.

  7. Greg Hill Says:

    Mario,

    If “economists can’t be sure” that interest rates are “excessively low,” how is the Austrain Fed Chair going to set the Fed Funds rate?

    And if entrepreneurs informed by Hayekian capital theory can’t tell when interest rates are “excessively low,” how is competition supposed to weed out firms with mistaken views about future rates of interest?

  8. Bill Stepp Says:

    Entrepreneurs generally don’t think like economists; they are concerned more with sales revenue (and its growth), profit and loss, and cash flow. They are concerned with specific investment projects, and their return on capital vs. their cost of capital. They also think about competitors and business trends, particularly as these effect their businesses.
    There are exceptions, such as John Paulson’s real estate bubble short sale, which involved some deft macro analysis. But his line of work is one that benefits more from that sort of thinking than, say, the corner dry cleaner or grocer.

    I do think that business owners of all types could benefit greatly from an understanding of Austrian economics, particularly ABCT.
    I also think economists could benefit at least as much from understanding business and accounting. I still remember the disdain for business held by some of the economics professors in school. No brownie points for guessing what side of the political aisle they were on.

    And the worst piece of advice I ever got in school was to not study accounting, the lingua franca of business. That was my worst mistake.

  9. Greg Hill Says:

    Bill,

    Fair points as far as they go. But I’ll bet you lunch that there’s not an S&P 500 firm that makes investment decisions without looking at a macro forecast.

    And while there’s a lot going on within the macro aggregates, these aggregate concepts, themselves, now belong to the subjective worldview of a great many individual entrepreneurs.

  10. Bill Stepp Says:

    Greg,

    Right re: macro forecasts and the S&P 500 firms, etc. But how much are most of these forecasts worth–a trumanian bucket of swill?
    (For some good commentary on some of the macro stuff, see the recent book The Drunkard’s Walk, which explains why all the talk about why unemployment was x.y%, down from x.y +.1% is so much r-a-n-d-o-m
    v-a-r-i-a-b-l-e hot air.)
    Although they no doubt look at the top-down macro forecasts, and maybe even enploy their own forecasters-soothsayers-crystal-ball-gazers, they still drive their businesses with a bottoms up project-by-project approach in which ROC vs. WACC trumps Y = C + I + G (as in garbage).

  11. Greg Hill Says:

    Bill,

    Got it: the macro forecasts are useless, but firms use them anyway. Why doesn’t competition drive all these macro forecasters, and the firms that buy their forecasts, out of business? Perhaps you could develop an Austrian theory of “stupid expectations” to explain why they all stay in business.


  12. Greg Hill is asking a good question.

    Most firms no longer have economists, but many still buy macro forecasts. Perhaps it is a way of figuring out what one’s competitors are thinking: Keynes’ beauty contest story. Or, firms know they need to second-guess the Fed. The behavior needs to be explained, but not denied.

    But no one can sort out “natural” or “equilibrium” interest rates from market rates (which are influenced by monetary policy). There are only money prices and interest rates.

    Chuck Prince knew the music would end, but the incentives forced him to keep dancing. He hoped there would be a chair for him when the music stopped. Was it personally a bad bet for him (as opposed to Citi’s stockholders, bondholders and the taxpayers)?

  13. Bill Stepp Says:

    But Jamie Dimon grabbed a chair while Chuck Prince was still dancing…and it was quite a while before the music stopped.


  14. Bill Stepp,

    Point taken. There is much irony in the situation, however. A little role reversal was at play.


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