by Mario Rizzo
An increasing number of articles in the popular press are claiming that signs of economic recovery are becoming more numerous. That may be. However, I am not an economic prognosticator and so I don’t know what to make of that.
There is a more basic question. What do people mean by “recovery”? It seems that, if articles in the Wall Street Journal are any guide, recovery is often taken to mean a return to normalcy in some key markets – in particular, the housing market.
Some economists and others are worried that long-term interest rates are rising and, with that, mortgage rates. Part of the rise in mortgage rates will play itself out in reduced re-financing by homeowners. This is a distributional question (and perhaps more than simply distribution when incentives and foreclosure costs are taken into account). I’d like to put this aside right now. The other part of the effect of higher mortgage rates is to prevent more resources from going into the housing sector (or to encourage more resources to leave).
And so what is wrong with that?
We have just come through a period of excessively low interest rates and large amounts of housing construction. Now if one believes that recovery consists of a return to “normal” rates of interest (say, some average of the past ten/fifteen or whatever number of years), then one is implicitly buying the notion that recovery occurs when everything returns to what it was before the crisis.
This will not do as a sensible concept of recovery. Time is irreversible. Resources were misallocated. In light of the overexpansion of the housing sector and of other sectors sensitive to interest rates, the new equilibrium will be – for a while – at a point where there are fewer resources in these sectors. Thus, the equilibrium long-rate of interest is higher than it would have been had the over-expansion not occurred.
The idea that increases in the long-rate of interest will choke off growth and prevent recovery is an artifact of the Keynesian view that investment is a homogeneous phenomenon. In that perspective, all we ought to care about is aggregate demand and not the composition of demand.
Higher interest rates will, it is true, reduce investment demand in certain sectors, but increase it in others closer to consumable output. However, to the extent that consumers were purchasing on credit and buying durables, this particular consumer demand also will contract. Some consumer sectors are like those of remote capital goods in their sensitivity to interest rates. These contractions are consistent with a new, higher equilibrium real rate of interest. We are seeing them now. The problem is that some government policies are designed to reverse, stop or slow them down.
However, uncertainty about precisely where capital should flow and whether other agents will make complementary investments will increase the demand to hold money. (It is this “secondary” or consequential deflation that Keynesians think is the whole story, but it is not.)
But holding money comes at a cost. Opportunities are out there. Sometimes first-movers will make higher profits. But all entrepreneurs will be looking and some will find them simultaneously. Firms will try to predict when others in complementary sectors will move. There is no magic solution to coordination problems.
Government weakens the coordinative properties of markets when it undermines the correction of the central misallocations. Since it cannot stop all of the corrections, even if it is wanted to, agents in these areas will have to guess what it will succeed in doing. This will only add to uncertainty.
The upshot is that the process of recovery cannot and will not produce the status-quo ante. The world will be different because previous resource misallocations have changed the optimal current and future investments in the capital structure. To the extent that the housing market (and other overexpanded markets) quickly begins to look “normal,” it will be due to government preventing necessary adjustments. This will be papering over problems, not sustainable recovery.