Prices Must Be Free To Tell The Truth

by Mario Rizzo

According to an article in the September 6th issue of the New York Times, more and more “experts” are now saying that the government should not try to prop up the housing market but should let prices adjust to their correct levels as rapidly as possible.

Well, you read that here as early as November, 2008 and then again in March 2009. It is part of the continuing myopic harping on aggregate demand which ignores all of the relative price adjustments that a post-bubble economy must experience. The Keynesian habit of ignoring the causes of depressions and dealing only with the analytically-secondary phenomena of aggregate expenditure is or should be unacceptable among intelligent economists.

I repeat what I said in 2008: Let the housing market collapse — fast.

40 thoughts on “Prices Must Be Free To Tell The Truth

  1. Could you clarify how aggregate demand concerns are an objection to relative price adjustments? That is news to me. I’ve always interpreted the home price shibboleth as something pushed by politicos concerned about homeowner votes – I don’t really think of it as having any strong basis in AD thinking. And I can think of several Keynesian bloggers that have said exactly what you said about the direction home prices need to move over the course of 2008 and 2009.

    Are you saying that you don’t consider people who talk about aggregate expenditures as a primary problem to be unintelligent? I want to make sure I understand you correctly.

  2. I’ve always thought about Fed actions on this front as preventing the failure of important financial institutions, rather than propping up prices per se. Certainly there will be disagreement on whether that is wise or not. But that’s not the same as ignoring relative price adjustments.

  3. *don’t consider people who talk about aggregate expenditures as a primary problem to be intelligent

    Mixing up prefixes certainly doesn’t make my case for taking umbrage at being called unintelligent look very good, does it?

  4. Yet on the other hand, under a fractional-reserve banking system this would lead to contraction of the money supply.

  5. Right on, Mario. Where do you see macroeconomics headed in the medium term? Are we headed toward more sophisticated reasoning about complex systems or away? I kind of fear that we’re headed toward more talk about animal spirits and less talk about relative prices and such.

  6. I am simply saying that if you concentrate exclusively on aggregate demand you would look at the decline of housing prices as bringing about a negative wealth effect and thus (further) decline in demand. This is a problem with all aggregate demand thinking.

    Keynesians come into the picture as a group — to the extent that the follow Keynes — of basically not worrying about the causes of the slump (Keynes certainly did not spend much time on this subject).

    Look, the main point is that we must allow housing prices to find their correct level through a market process.

  7. The problem is with models in which there is one price, one wage rate, one interest rate, etc. They don’t allow for the phenomena that I view as the subject matter of this site. No micro policies can come out of such models.

  8. Jerry –
    Again, I agree – but who goes to those models for micro policies?

    You both are right, if we plug our ears and close our eyes and pretend there is no such thing as microeconomics, we come up with some pretty goofy stuff. I just don’t see anyone doing that and I think you’re trying to invent a conflict on a point where Keynesians largely agree because there is both an implicit and explicit microeconomic foundation for Keynesianism.

    Take Joe Stiglitz’s recent article on housing prices. His AD perspective certainly didn’t prevent him from saying that relative prices need to adjust:

    You’ll find other things to disagree with Stiglitz on, sure, but not on housing price adjustments.

    It just gets a little silly to single out Keynesians on a post where the simple point is “housing prices need to deflate”.

  9. @Daniel,

    I normally don’t respond to you directly because you consistently miss the point and take discussions off on tangents. I’ll do it once.

    Mario posted on an actual policy that flows from macro thinking and that ignores micro complexities. You deny the reality.

    The reality is that policy IS being made employing simple (wrong) macro thinking w/o regard to micro issues. That is true on the fiscal side with stimulus, housing policies, temporary tax credits, etc. It is equally true with respect to monetary policy.

    Targetting interest rates inherently ignores needed relative price adjustments. The interest rate (really the term structure of interest rates) is an intertemporal, relative price.

    Keeping short-term interest rates near zero, and buying at the long end (including TIPS, which the Fed should never buy) props up the prices of assets. That prevents changes in relative prices.

    In your last response to me, you chided me for inventing a conflict with Keynesians. I didn’t refer to “Keynesians,” but described a class of models that lead to the kind of real-world policies currenlty being implemented.

    So to your point. I am accusing policymakers (not Joe Stiglitz, who isn’t making policy these days) of plugging their ears and closing their eyes. As you say, that is giving us some pretty goofy stuff.

  10. Stop being such a troll, Daniel. Jerry’s point about the level of aggregation in modern macro models is right, full stop. Mario’s original was similarly straightforward and correct.

    Hm. . . how about you send me list of errors that you like to correct and I’ll start a blog that propounds those errors? That way you can hop onto the comments section of my blog and set me straight. Would that be okay?

  11. Jesus, calm down. I started commenting on this post because I was genuinely curious what Mario was talking about. The idea that relative price adjustments would be problematic or ignored by Keynesians was simply a bizarre idea to me – I had always understood the disagreement to be over the general price level, not the relative price level.

  12. I don’t think it’s so much aggregate thinking than it is the fear of the unknown: contagion, systemic risk, or “Armageddon” as Stiglitz puts it a NBER paper. This, coupled with politicians and bureaucrats’ incentives to make it look like they’re “doing something” is responsible. Aggregate demand is just a tool these guys use to rationalize on policies they would have advocated anyway.

    And… I’ve been withholding the ‘troll’ comment on Daniel Kuehn for such a long time, I’m glad someone with as much credibility as Roger Koppl said it first.

  13. Of course, thinking exclusively in macroeconomic averages and aggregates is foolish. But relative price adjustments aren’t everything, either!

  14. Mathieu Bédard writes, “I don’t think it’s so much aggregate thinking than it is the fear of the unknown: contagion, systemic risk, or ‘Armageddon’ as Stiglitz puts it in an NBER paper.”

    But Mathieu goes on to pooh-pooh his, quite plausible, explanation of “Keynesian” concerns about a further, sharp decline in home prices.

    Best to follow Mario’s advice, “Let the housing market collapse — fast,” or, as Treasury Secretary Andrew Mellon, put it eighty years ago, “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.”

    I challenge the Austrians to describe in some detail your proposed policy proposals and the economic consequences of these policies, including some very rough quantitative estimates.

    For example, something along these lines: 1) Fannie and Freddie are directed to liquidate their mortgage holdings; 2) mortgage interest rates rise 3 percentage points; 3) home prices fall 30%; 4) the home foreclosure rate doubles.

    Then: 5) 1,000 banks become insolvent; 6) there are runs on other banks; 7) the Austrian wing of the Republican Party succeeds in reducing federal deposit insurance to $50,000; 8) more banks fail.

    Next: 9) the remaining banks sharply reduce their lending in order to rebuild reserves; 10) workers, employed or otherwise, reduce their spending in response to their diminished wealth; 11) sales and profits plummet.

    Meanwhile: 11) once housing prices come into proper relation with other prices, vast resources tied up in home building, including Z million workers, shift to other sectors of the economy; and, voila, 12) the resulting increase in productivity and output draws millions of idle workers into employment, so that, by X date, give or take a year or two, everyone who wants to work at prevailing wages, has a job.

    Of course you may decline to offer your own story on the grounds that Austrians don’t have any use for statistics such as “the average decline in home prices.” But, I think, such a response would be hard to square with Mario’s own advice, “Let *the* housing market collapse — fast.”

  15. What I gather is the flip side of AD thinking was expressed to me by a hard core Keynesian macro prof once when I was in his office. I attempted to make an Austrian point, and he said–I kid you not–“I don’t believe in microeconomics.”

    If Paul Simon were an Austrian, he might have written a song about all the crap he learned in college.

  16. @Greg Hill,

    (1) I believe Hoover quoted Mellon as advocating liquidation, but I can’t find a source that ties that to Mellon himself.

    (2) Yours is a fanatsy scenario and neither good theory nor good history. Theory: markets don’t recover until prices bottom out. History: Until 1929, no one thought the federal government was supposed to “fix” a recession. In 1920-21,for example, the recession was sharp and short. So much so, annual data obscured its magnitude. It was over too soon.(Source on 1920-21: Friedman and Schwartz)

    (3) Read Larry White’s op ed in today’s Wall Street Journal on The Wirtschaftswunder (German economic miracle). Virtual overnight liberalization and reform begat dramatic economic growth. Today Germany has reagn-style economic growth while the rest of Europe limps along, or remains mired in recession. Germany has been reforming, and has shown relative fiscal restraint.

  17. As White points out, Germany recovered after it ditched price controls and rationing directives, which were advocated by J.K. Galbraith and a chorus of other advisors.
    The quote by Erhard is priceless and timeless about the pressure put on him to kowtow to conventional policy wisdom. He must have had some sleepless nights.

    LHW writes: “The West German economy not only left East Germany’s in the dust, it outgrew France’s and the United Kingdom’s despite receiving much less Marshall Plan aid.”

    Despite, professor? Despite?

  18. Jerry and Bill,

    Is it really demanding too much to ask that you outline a scenario that begins with policy changes and then describes their consequences with rough quantitative magnitudes?

    Tell us how far home prices would fall, how high mortgage interest rates would rise, what the foreclosure rate would be, how many banks would fail, if any, and so on. This would allow those of us outside the Austrian camp to judge the plausibility of your views about the current state of affairs.

    Articulating the Austrian scenario would bring the argument to a head much more efficiently than arguing about Germany, where real government consumption expenditures since 2007/4 have risen faster than in the U.S. (with fifty states trying to balance their budgets), and where an effective work-sharing program is subsidized by the government. (I hesitate to even mention the peculiar claim that East Germany proves Keynes was wrong.)

    Please, take a risk and tell us what policies you would adopt and what their consequences would be.

  19. @Daniel:
    Please stop wasting people’s time.

    @Greg Hill:
    As far as I know the quote from Mellon is from Hoover’s memoirs and Hoover added that of course he could not listen to Mellon. You see Hoover was a very progressive guy, believed that competition is waste (we ca see the first seeds of fascism here), in forced reduced work hours in order to spread the work to many, increasing the power of labor unions etc. FDR was just an opportunistic man, Hoover was the real thinker for the New Deal.

    But I don’t understand your challenge. You are saying that a market where prices are falling until they find buyers, and most of them wont fall to zero in order for this to happen, it is much worse than a market with artificial high prices, almost no buyers only because the banks are not forced to recognize the fact that they are already bankrupt? If the later market is preferable, than we could just as well raise prices and pretend everything is nice and well, except there are no buyers, but hey, the banks are much sounder.

  20. Niko,

    Let me put my challenge a little differently for you. The Austrian camp says: home prices are too high: they should be allowed to fall; after they fall, people will start buying houses again, and all would be good.

    Your mission (should you choose to accept it) is to describe in some detail the path from “here to there,” giving us an account of how far prices must fall, how many home foreclosures will follow, how many banks will become insolvant, etc.

    I’m not arguing that housing prices should not be allowed to fall, I’m simply asking for an account of the path to the new, presumably superior equilibrium, an account that goes beyond the proposition that when the price of homes relative to other goods declines, resources will find more efficient employment.

    To paraphase Keynes, the Austrian economist sets herself too easy a task in saying that, once the storm has passed, the sea will be calm again.

  21. Greg Hill: is there anyone else in the world who has done what you ask Austrians to do? I’m used to consider “ad impossibilia nemo tenetur” as a methodological principle.

    Is there anyone who knows the fundamental price of houses, or the fundamental level of the Dow Jones, or the natural path of unemployment from now to when specific human capital will be retooled” and the rate will return to normalcy?

  22. Greg Hill,

    It’s impossible for Austrians (or Keynesians, despite their theoretical/empirical hubris) to predict the path of empirical data. Can you predict the closing price of IBM today? I sure can’t, but what I can say for sure is that it will be a market clearing price thanks to the fact that it will be determined by the market, not by Galbraithian/Krugmanian/DeLongian Keynesian planners.
    No one knows what the exact price of housing would be in a free market, but we do know that it would be a market clearing price, and what the implications of that are. That’s what matters.

  23. “Your mission (should you choose to accept it) is to describe in some detail the path from “here to there,” giving us an account of how far prices must fall, how many home foreclosures will follow, how many banks will become insolvant, etc. ”

    No one knows that. That’s why we have (free) markets. And that’s why socialism failed over and over (and over again). If someone could do what you are asking, than the calculation problem raised by Mises (and others before him) would be solved and North Coreens would finally have food on their table.

  24. Dear Austrians,

    Here’s what I find perplexing about the Austrian view, if you’ll permit me to generalize.

    On the one hand, you proclaim with confidence that housing prices are too high, that interest rates are too low, and that inflation is around the corner. On the other hand, you’re unwilling to conjecture how far housing prices should fall, how much interest rates should rise, or when prices will start going up.

    You say this can’t be done because no one can predict the future: that’s what markets are for. But I didn’t ask you to “predict the future,” I simply asked for some ballpark estimates of what would happen in various markets if, say, Fannie and Freddie liquidated their mortgage holdings over, say, the next six months.

    And when someone points out that market interest rates don’t support Austrian inflation expectations, you say, “just wait,” which means, in effect, that you don’t believe long-term bondholders can see what you can see.

    Three questions: Are all these claims consistent with one another? Is the Austrian view of the current crisis falsifiable? If so, what “tests” of your viewpoint would you suggest?

  25. @Greg Hill:
    There is a reason for me stating “(free) markets.” A distorted market is still a market.

    1. Houses prices are too high: I didn’t say this, but many potential buyers seam to think so.
    2. Interest rates are too low: well, you have low or zero savings and you borrow from foreigners in order to fund consumption. We don’t know what the interest rate could be, but not the one today or during Greenspan.

    What you are asking is to give you the market price and no one can do that. As I’ve said before, prices are found on the market, not in a mathematical model.

    And Austrians don’t predict the future. They never did, never will. You are misinformed.

    Also Austrians have problems with that “falsifiable” term when applied to economics. As far as know, even Popper had some problems with that too.

    This being said, have a good day.

  26. “On the one hand, you proclaim with confidence that housing prices are too high, that interest rates are too low, and that inflation is around the corner. On the other hand, you’re unwilling to conjecture how far housing prices should fall, how much interest rates should rise, or when prices will start going up.”

    I’m not an academic economist, but here’s my attempt at explaining it:

    If government intervention on net acts to prop housing prices up, then the Austrian will conclude that they should be allowed to fall. If government intervention on net acts to lower interest rates, then the Austrian will conclude that interest rates should be allowed to rise. One could debate whether the conclusions about the ‘sign’ of aggregate government interventions in each case are correct, but regardless, the Austrian prescription is the same – let the market allow prices to move about naturally. Quantitative analysis would seem to me to be missing the point. As for specific ‘Austrian’ predictions, those who publicly make them reap the consequences.

  27. Greg,

    I keep my dog on a leash to prevent him from chasing cars. But I don’t know which cars he would chase or for how long. The non-computability of markets is a delicate point. On the one hand we can do “pattern prediction,” as Hayek duly noted. On the other hand we cannot predict more than some general patterns. An example from V. Smith: We could predict that airline deregulation would lower prices and increase miles flown, but no one predicted the hub-and-spoke system. So even so general a pattern as that defied prediction. But we could still point to the inefficiencies of restrictive regulation and correctly say that they were holding prices “artificially” high.

    I always cite a great paper by Vela Velupillai’s that gets at some of these points:

    Velupillai, Vela. 2007. “The Impossibility of an Effective Theory of Policy in a Complex Economy,” in Salzano, Massimo and David Colander (eds.), Complexity Hints for Economic Policy. Milan, Berlin, and elsewhere: Springer.

    I hope those comments help at least a bit.

  28. Greg,

    Sorry for the double posing, but I realize that I have neglected your question about falsifiability. I think the Austrian cycle story is falsifiable. Hayek was reacting in part to the greater volatility of the pig-iron series. So I think it’s testable. I think we have to admit, however, that we have not done a good job of testing the theory. Shame on us. Andrew T. Young did a test published in Economics Letter and found the theory to be statistically significant, but not economically so. We need more work like that.

  29. It is sometimes instructive to recheck the title of the post: “Prices must be free to tell the truth.” When prices are distorted, they mislead actors in their planning. Since we don’t know how distorted they actually are, we can’t predict how much they will change.

    With respect to housing, we know there are both interventions on the supply and demand side. Land-use restrictions have restricted supply, and easy money (low interest rates) has enhanced dmeand. We only know for certain that the inevitable outcome of the two policies are higher home prices. The effect on the quantity of housing is uncertain.

    Will just the demand-enhancing policy be ended? Or some of the supply restrictions, too?

    Thomas Sowell’s The Housing Boom and Bust is very good on the interactions of the supply and demand interventions in housing.

  30. Koppl: Is Young’s paper “Reallocating labor to initiate changes in capital structures: Hayek revisited”, 2005?

    I didn’t know it, thanks. Now I probably need both hands to count all the empirical papers on ABCT. 🙂

    This kind of works are useful, because there can’t be any understanding of the relevance of the theory without observations.

    However, it looks like the paper models the monetary shock as a variation of the target rate (eq. 1).

    Isn’t this like implying that only variations (surprises) in the monetary policy are non-neutral? This goes contrary to Austrian insistence on the natural and market rates of interest, and it would confine non-neutrality to the very short term, eliminating most structural effects, which require “term” variations in the yield curve to become profitable.

  31. “found the theory to be statistically significant, but not economically so.”

    I don’t understand this part. Most observations make no sens with out theory. Any way, I ust don’t understand what the above phrase means.

  32. Niko,

    It’s just size of effect. It’s very likely indeed to be there, but it doesn’t really matter.

    A silly example may get the point across. Let’s say the president could increase GDP by wearing a red tie. Let’s say we did a study and found out that each day of red-tie wearing raised GDP by a dime. The result holds up under every imaginable statistical test and has sky-high *statistical* significance. Okay, bully, but the economic and political significance would be essentially zero. The president’s sartorial choices could have at most $36.60 of impact on GDP, which is not *economically* significant.” (Pop quiz: Why 60 cents, not 50?)

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