Bubble or Growth?

by Jerry O’Driscoll

In an interview with The Wall Street Journal, German Chancellor Merkel called for an end to risky growth policies built on asset bubbles.  “In recent years we’ve had the Asian crisis, the new economy crisis, and now this great international financial and economic crisis — we can’t slide into a crisis every five to seven years.”  As she notes, however, the central banks of the major economies have implemented “unorthdox” policies to increase borrowing and lending in the current crisis.  Those policies risk yet another asset bubble.

Merkel is a physicist by training, not an economist.  She chose the laden-term of “sustainable” growth to describe the policy she favors.  She clearly has in mind growth fueled by the underlying forces of productivity and thrift, rather than central bank credit and government budget deficits. In Germany, she has adopted the policy of the “thrifty Swabian housewife” — one saves rather than borrows to finance consumption.

Under Alan Greenspan, the Fed promised to reinflate after the collapse of a bubble. And did so. Low average inflation justified continuation of easy money.  As Mario Rizzo has noted in a post here, changes in relative prices are as important as the measured inflation rate.  Low or zero inflation can mask important changes in intertemporal prices that drive malinvestments (unsustainable investments).  Globalization — 2.5 billion Chinese and Indians producing for the market –suppressed measured inflation and further masked changes in intertemporal prices.  The housing boom and bust resulted.

At a crucial moment, Ben Bernanke provided the intellectual justification for Greenspan’s policies.  Not surprisingly, as Fed chairman Bernanke continued them and, indeed, raised the ante: not one-percent overnight interest rates, but near-zero. It is instructive that in the nearly 100 years after the end of the Napoleonic Wars and until the eve of World War I, the Bank of England’s Bank Rate never went below 2 percent and was usually well above that level.  That was with a gold standard “anchoring” prices and providing real, long-run stability of prices.

Bernanke tells us that the lesson of the Great Depression is that we must never allow deflation.  Apparently now deflation also includes falling asset prices.  That was not the lesson drawn by Friedman and Schwartz in their classic study of U.S monetary history.  On p. 15 of The Monetary History of the United States, 1867-1960, they summarize the experience of the Greenback era, which “casts serious doubts on the validity of the now widely held view that secular price deflation and rapid economic growth are incompatible.”

The Austrian economists of the 1930s — Mises, Hayek and Robbins — have often been depicted as saying governments shouldn’t act to counteract economic downturns.  It would be better to say that governments can’t act systematically to counteract the effects of the unwinding of an asset bubble or financial boom.   The “unorthodox” policies of the Greenspan/Bernanke Fed not only generated recurrent cycles in asset prices, but have now given us the first whiff of actual deflation in many years.  The Fed is following Keynes’ advice of monetary policy “a outrance,” but the downturn continues as markets unwind from past monetary excess.

21 thoughts on “Bubble or Growth?

  1. Prof O’Driscoll,

    You wrote,

    The Fed is following Keynes’ advice of monetary policy “a outrance,” but the downturn continues as markets unwind from past monetary excess.

    What does “a outrance” mean?

    It appears to me that you are at odds with Prof Rizzo about this, that, while you believe a downturn should be allowed to run its course, he believed that it should be counteracted by currency manipulation.

    Was that correct?

  2. The solution for ending, or at least for preventing, asset bubbles proposed by Axel Weber, the governor of the Bundesbank, and which seems to be tacitly endorsed by Angela Merkel as well here, is an active monetary policy, designed to preemptively deflate an emerging bubble, either through an increase of the reference interest rate beyond the normal – short-to-medium term – requirements of price stability, or through other – long-term stability enhancing – monetary policy tools. This is what he calls “the symmetric approach for monetary policy”, which should counter the adverse incentives and moral hazard issues created by the standard countercyclical monetary policy. I haven’t found much details about his proposals, but prima facie this is a far cry from Milton Friedman’s auto pilot monetary policy. It seems that he wants an activist counter-bubble monetary policy.

  3. “It appears to me that you are at odds with Prof Rizzo about this, that, while you believe a downturn should be allowed to run its course, he believed that it should be counteracted by currency manipulation.”

    I may be incorrect, but Professor Rizzo clarifies in the comments section of his most recent post that he is taking the perspective of Keynes:

    “Perhaps I should have made this clear: The point of view I am adopting in the post is that of Keynes to show that Krugman and others who believe that we are in a liquidity trap have forgotten an important consideration. *If* we are in a liquidity trap, then — according to Keynes’s analysis — one reason is likely to be the countercyclical use of interest rate policy.”

  4. If d.g.lesvic is talking about the issue of deflation, I do not choose to address that. This is because it has been *exhaustingly* discussed over at The Austrian Economists and elsewhere.

  5. Thank you for the comments. The French phrase means to the utmost, unlimited expansive monetary policy. The Bernanke Fed appears to be following Keynes’ advice. I think I should let Prof. Rizzo answer for himself. Classic central bank policy was described as “leaning against the wind,” avoiding too-rapid an expansion or counteracting contractions. Pre-emptive deflation of a bubble fits that perspective.

  6. Zach,

    There is way too little here that is clear to me.

    Prof Rizzo,

    Inasmuch as Prof O’Driscoll has raised “the issue of deflation” here, it would certainly seem that the discussions of it at the Austrian Economists blog didn’t exhaust the matter for him. And they certainly didn’t for me, either, inasmuch as I was barred from them.

    Prof O’Driscoll,

    Since Prof Rizzo has chosen not to speak for himself, it looks like the ball is back in your court.

  7. George Selgin has written the most about deflation. And Richard Ebeling made some excellent comments on Mises’ treatment of inflation and deflation in response to an earlier post by Prof. Rizzo. The bottom line is that falling prices that reflect productivity improvement and technological change are not a problem and ought not to be resisted by monetary expansion. I also recommend reading the chapter on the Greenback era in Friedman and Schwartz.

  8. Prof. O’Driscoll,

    But what about falling prices reflecting the downward phase of an interventionist business cycle?

    Ought they be resisted by monetary expansion?

  9. Which prices? Asset, final goods, wage rates? The answer matters a great deal as explained in Hayek’s Prices and Production. Again, Prof. Rizzo’s earlier posting on why relative prices always matter is on target.

  10. The prices that you implied in this statement, above:

    “The bottom line is that falling prices that reflect productivity improvement and technological change are not a problem and ought not to be resisted by monetary expansion.”

    The falling prices that do not reflect productivity improvement and technological change, but something else.

    What else?

    You’re the professor.

  11. Let me try a different approach.

    You asked, which prices, asset, final goods, wage rates?

    Let’s take them one at a time.

    First, asset.

  12. A prediction.

    Asset, final goods, wage rates.

    It won’t make any difference. The answer will be the same in every case. For whatever the price, asset, final good, wage rate, it reflects the state of the market, however it came about, and tampering with it masks that reality, and misdirects the market.

    It is, in every case, as Mises said, like backing up over the victim again, or, two wrongs not making a right.

  13. And while I’m sure that Milton Friedman’s history of the Greenback era is worth reading, the subject here is still economics, not economic history, and, for that, economics itself, I prefer Mises to the man he slaughtered at every turn.

  14. dg lesvic,

    When the rate of saving rises, the supply of credit can increase without adverse consequences, because there are real resources “backing up” the additional money. In a free market for banking and money, this would occur automatically when the demand to hold money increases; banks can afford to issue more liabilities when creditors call in their debt less frequently. In principle, this is no different for banks than for any individual.

    However, with a central bank like the Fed, the natural market mechanism will not function, and rising rate of saving might not be matched by increasing supply of credit. The normal criticism of the Fed is that it keeps market rates below natural rates, but I think Professor Rizzo’s position is that, on occassion, it can also keep market rates above the natural rate. Both create coordination problems, so if you are opposed to the former, the shouldn’t you also be opposed to the latter?

    Anyway, this was discussed at length both on this blog and The Austrian Economists blog, and this will be the last I have to say to you on the matter.

  15. Kelly, you are a serious man and deserve a serious answer.

    You asked me a specific question: if I was opposed to the former, shouldn’t I also be opposed to the latter?


  16. Mr Hamou,

    I merely glanced at your piece, but got the impression that you see inequality as the cause of the problem, and would recommend redistribution as the cure.

    Is that right?

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