Only Inconsistent With Neoclassical Economics

Robert Schiller is at it again, claiming that bubbles are inconsistent with economic theory, and therefore tries to go outside the realm of economics.

"Economists, in particular those at the Federal Reserve, are loathe to believe asset markets have become bubbles because bubbles seem inconsistent with rational investor and consumer behavior, the bedrock of economic analysis. “The notion of a speculative bubble is inherently sociological or social-psychological, and does not lend itself to study with the essential toolbag of economists,”"

He may be right that they are inconsistent with neoclassical economic theory, but he need not leave the field of economics to explain them. All he need to do is study Austrian economics, or more specifically the Austrian business cycle theory.

And besides, going into sociology or socio-psychology doesn't really solve the problem if you intend to remain comitted to neoclassical assumptions. The neoclassical theory has a implicit sociological/socio-psychological theory about the hyper-rational investor, which cannot be changed unless you're gonna change neoclassical theories. Particularly if you're also going to remain committed to neoclassical theories about the neutrality of money and the impossibility that central bank actions will create situations where it could be economically rational for investors to create bubbles, but economically irrational for society as a whole, as the central bank subsidize interest rates for the investor and pledges to limit their damage if they get out of the bursted bubble market too late.

You Should Have Seen It Coming, Larry

Larry Kudlow rightly blasts the wasteful spending related to the rebuilding of New Orleans after it was devastated by hurricance Katrina two years ago.

The problem is that back in 2005, Larry Kudlow attacked the people that criticized the New Orleans spending spree with completely nonsensical arguments. Let's hope Larry and others learn from this that government projects as a rule tend to be very wasteful, with higher costs and less results than private sector projects.

Mark Thoma vs. The Economist

Today, Mark Thoma, who usually don't have much original commentary on his blog but instead publishes the commentaries of others, unusually enough comments and criticizes an article at length. The article in question is the article from The Economist about the benefits of a recession that I told you about recently. Thoma is a leftist Keynesian, so it is hardly surprising that he dislikes the semi-Austrian message of the article. Here is his arguments and my replies.

1. I disagree that we need recessions to have a dynamic economy. Equilibrium means (in simple terms) "no tendency for change" and there is nothing inconsistent with having a constant flow of entering and exiting firms at equilibrium.

When profits are high - as in the traditional price signaling story - there is a rush to enter industries, but the trick is to get there first and take some of the profits before others beat you to it, innovation and technological change are not so important. There are lots of profits to be had by entering with existing technology so, while it does allow the installation of the best and latest technology, there's no strong pressure to innovate. In fact waiting until there is an innovation could be costly.

It's when conditions are tight, i.e. when everyone is making close to zero economic profit, that new cost saving or demand enhancing technological change will pay off. If you have a better product or lower costs than rivals, then you will gain an edge and realize profits. The only way to get ahead is to build a better mousetrap. Sure, conditions will be tight in recessions - that's the traditional creative destruction story - but things are tight in a competitive equilibrium too and the pressure to innovate does not disappear just because the economy is operating at full employment...

...I am not an Austrian economist and I don't play one on the internet, so I won't claim to be able to recite what Schumpeter (or anyone else in the Austrian camp) said about this on a particular page of one of his books, so maybe someone who is an adherent to this "we need business cycles" approach can explain why we cannot wipe out the inefficient while remaining at or very near full-employment.

First, while Schumpeter is an Austrian by nationality, he is not usually considered to be part of the Austrian school of economics, as are for example Carl Menger, Ludwig von Mises, Friedrich Hayek, Murray Rothbard and George Reisman (the latter two aren't even Austrian by nationality). So I won't try to defend Schumpeter's arguments. But in the Misesian version of the argument, a lot of inefficient companies are being artificially sustained through monetary expansion. In order for factors of production to move on to more efficient companies, these inefficient companies have to be destroyed. This requires tighter monetary conditions, which together with the usual time lags in reallocation in resources will produce a short-term decline in production (aka a recession).

2. Overproducing houses is not like overproducing goods that cannot be stored, i.e. perishables. When too much popcorn is produced relative to demand, it goes to waste. Resources that could be used elsewhere are wasted forever since the excess can't be frozen or stored for the future (or at least assume so for the purposes of illustration, there is that stuff in movie theaters). With houses, there is an intertemporal shift in resource use, but since houses don't spoil in a short period of time, and because people will continue to demand them in the future, overproduction today will result in underproduction tomorrow. The houses were built too soon, and that's an efficiency loss because we gave something up, but when we produce less houses later we can recover (some of) the goods that were lost (too many houses and too few cars in year one, but in year two it's the opposite, too few houses and too many cars relative to the no distortion outcome). In the case of popcorn, since it couldn't be stored, lack of storage means we didn't have the opportunity to produce less later, so there is no way to make up for it, even in part, later on.

That is to say, I hope we don't "creatively destroy" the houses that were (over)built. Sure, some can be creatively transformed into restaurants, business offices, etc., to attenuate the misallocation in the short-run, but there's no need to tear them down and replace them. With time, population and demand will grow, and the houses will be filled. Hula hoop factories needed to be creatively destroyed, they needed to be torn down and replaced - it's unlikely demand will return in the future so having those factories around would be a waste, they would never be re-opened - but houses are not hula hoops. With houses, there is no need to "purge the excesses of the previous boom," just wait for population to catch up (and would it be so bad to have low cost housing available in the interim?).

No, the houses need not be destroyed, particularly not in areas where there are positive population growth. In those areas, demand should indeed catch up-at least in that famous long run where Keynesians say we are all dead. There could however be alternative uses for the land which produces a higher value.

And more to the point, what needs to be destroyed are again not necessarily the houses per se, but the companies, building projects and jobs which built the houses. While the houses perhaps need not be destroyed, as the past building of them are sunk costs, what should be eliminated is any further waste of resources by building more of them. In a world without any adjustment costs, that wouldn't cause any recession. But in a world with adjustment costs (such as the one we're living in), it will.

3. I don't understand the reasoning that says the Fed should not stabilize the economy because it will "create a much wider form of moral hazard. If long periods of uninterrupted expansions lead people to believe that the Fed can prevent any future recession."

The reasoning is that if we stabilize the economy, people will then believe recessions are impossible (or underestimate their likelihood) and make bad decisions, so we shouldn't stabilize at all.

People who believe the Fed can prevent all economic fluctuations will be, so to speak, "creatively destructed" the first time there is a recession. But to refuse to stabilize the economy to the best of our ability because we are afraid people might misperceive the degree of stability that is attained seems misguided to me. I would have thought an Austrian response would be to do what's best for the economy and let those who misperceive be weeded out by the market process (or better yet, that they become informed about the true risks - this is a market failure from lack of information and while I'm pleased to see The Economist acknowledge markets can fail, the solution is to provide the information, not to refuse to stabilize).

The only thing right in this part is that first statement about not understanding the argument. So let me explain it to Thoma and others who don't understand. If the Fed through lower interest rates and the implicit or explicit promise of a bail out encourages asset price bubbles and the excess debt and wasteful over-investments, this creates a situation where such behavior is profitable for the investor-but damaging to the overall economy. This is no different from how say massive subsidies of certain farm products makes it profitable to farmers to over-produce but damaging to the overall economy.

This is certainly not a case of "market failure", as the government in the form of the Fed has knocked out the market's weeding out mechanism.

Finally, I note that Thoma fails to comment at all on one of the most important arguments from The Economist: namely, the need to reduce imbalances such as a too low savings rate and excess borrowing.

EMU Money Supply Growth Accelerates

There have been speculations that the ECB might cancel its previously signaled September rate increase due to the credit market turmoil. It remains to be seen whether they actually will cancel it, but this news of a further acceleration in Euro area money supply growth clearly says that they should go ahead with the rate increase.

U.S. House Price Decline Accelerates

And this was in June, before the recent acceleration of credit anxiety.

Who's Next?

With the bursted housing bubble being already an established fact, and a recession coming soon (if not already present, only not yet revealed in the by necessity lagging statistical releases) in America, the question soon arises about who is next. After all, in many countries house prices have increased as much or more than in America. While there may perhaps be special factors in some of these countries justifying the house price increases in a way no fundamental factors could justify America's house price bubble, certainly some markets are significantly overvalued.

The reason why America came first was that it was home made to a much higher extent than in other cases. Alan Greenspan made interest rates go through a roller coaster ride, being first pushed down from 6.5% to 1% and then raised back to 5.25%. During the period of super low interest rates many subprime borrowers were hooked by Greenspan's teaser rate, only to see their personal finances in disarray when interest rates were raised back to more sustainable levels. Also, many near prime and prime borrowers were able to use their homes as ATM's when interest rates were low and house prices rising, something which they are unable to do so now.

In no country has interest rates been reduced and raised in such a dramatic way as in America, which is why it has been hit first. Still, there are other markets where house markets look highly overvalued.

One example of this is certainly Australia, where house prices have increased again after a brief slowdown in 2005. As I've stated before, Australia would likely have fallen into a recession in 2005 if it hadn't been for the commodity price boom. If America's likely recession directly and indirectly causes a significant slowdown in growth in China, this will end the commodity price boom. And with imbalances in Australia being if anything worse than in 2005, then an end to the commodity price boom will certainly mean an end to the housing bubble in Australia. And an end to both the commodity price boom and housing bubble in Australia will certainly mean an Australian recession.

Also, a number of European countries have housing markets look overvalued. This includes among others Britain, Ireland, Spain, Sweden, Denmark and the Baltic states.

Of particular interest is perhaps Britain. Two factors which have driven the housing boom there now look like they are disappearing. First, global financial turmoil will likely reduce or even end the bonuses in London's all-important financial City-district. That will take a heavy toll on the high end housing market in the greater London area. Second, the net inflow of immigrants from Eastern Europe are already starting to decline and will likely continue to decline more dramatically soon, perhaps even ending or even reversing, as economic growth in Eastern Europe is a lot higher than in Britain and as the decline in births in the early 1990s in Eastern Europe will soon translate into declines in the working age population.

Spain's housing market is already showing signs of cooling and could halt even further if there are more ECB rate hikes. This factor could also damage other overheated housing markets whose interest rates are determined by the ECB -either because they are part of the euro are or have pegged their currencies to the euro-, such as Ireland, Denmark and the Baltic states.

Sweden's housing bubble will on the other hand probably get worse next year as a result of the housing tax reform, so I don't expect any downturn in the Swedish house market until 2009 at earliest.

Have Globalization Increased or Decreased Inflation

In light of the increase in commodity prices in recent years as a result of increased demand from China, India and other emerging economies many people have doubted the argument from me and others that globalization has kept down price inflation. The argument, endorsed by Ben Bernanke and others, is that the increase in commodity prices will cancel out the effect of the entry of cheap finished goods from China and others.

Yet there are at least two good reasons to believe that the net effect from globalization is to keep down prices, even though higher commodity prices will somewhat limit the effect. First of all, globalization means that competition is a lot tougher than it would have been under national self-sufficiency. Secondly, globalization also means increased efficency as production for a global market increases the possibility of economies of scale, which will allow companies to lower prices. Thirdly, so far particularly China buys a lot less than it sells, as is reflected in its huge trade surplus. That means that China is increasing global supply of goods and services a lot more than it increases global demand. And if supply increases more than demand, this implies a downward pressure on prices.

Note however that argument three only applies in today's world. If China's politicians were to realize that a much stronger yuan is in their national self-interest, then this means that the price cutting effect of cheap finished products from China would be greatly reduced, while on the other hand commodity demand from China would increase as commodities are cheaper in yuan terms, putting an upward pressure on commodity prices in dollar and euro terms. It would also reduce factor one, as the competitive pressure from China would be reduced. If U.S. politicians were to have their way and the yuan is significantly revalued, this would greatly increase price inflation in the U.S., reducing the room for the Fed to cut interest rates and thus likely destroy a lot more jobs than reduced import competition would save.