George Selgin noticed one of my blog comments on David Beckworth's Macro and other Monetary Musings, where I say that I am a ABCT skeptic.
ABCT stands for Austrian Business Cycle Theory.
I describe myself as a skeptic because I believe that under most monetary regimes, excessive money creation does not lead to malinvestment in any consistent way. Malinvestment is the construction of capital goods that are only profitable with interest rates lower than the natural interest rate.
In the ABCT, these inappropriate capital goods are constructed when an excess supply of money causes the market rate to fall below the natural interest rate. When the market rate inevitably rises back to the natural interest rate, labor and capital devoted to the production of those capital goods must be shifted to the production of consumer goods and services. This results in additional structural unemployment. The natural unemployment rate is higher and the productive capacity of the economy is lower for an extended period of time.
I am skeptic because with most monetary regimes, the reversal of any decrease in the market interest rate due to an excess supply of money is foreseeable and so constructing capital goods that are only profitable if the lower market rates persist is an entrepreneurial error. Taking the current value of some short and safe interest rate, such as the federal funds rate, and projecting it into the indefinite future, is more like idiocy than entrepreneurial error.
If one focuses solely on a scenario where the supply of saving and the demand for investment are unchanging, so that the natural interest rate remains constant, and moreover, that the demand to hold money is constant so that any increase in the quantity of money is an excess supply of money, then the ABCT seems obvious. However, when one considers temporary changes in saving or investment, and so, temporary changes in the natural interest rate, everything becomes much more ambiguous. This is especially true when the demand to hold money is also subject to change, so that excess supplies of money, and a market rate below the natural interest rate, can be associated with increases, decreases, or an unchanged quantity of money. (That the demand for hold money can change is well understood by free bankers like Selgin.)
The market interest rate falls. Is that due to an excess supply of money or a decrease in the natural interest rate? If it is due to a decrease in the natural interest rate, is it permanent or temporary? Clearly, there is plenty of room of entrepreneurial error here. That such errors are made should be no surprise. That malinvestment occurs, should be no surprise.
Suppose that there is a central bank manipulating short term interest rates subject to the restriction that the inflation remain is expected to remain 2%. If the market rate is below the natural interest rate, then more rapid growth in demand will result in higher inflation sooner or later. The central bank will be forced to raise short term interest rates in the future. The scenario where the central bank seeks to hold market interest rates down in the face of ever accelerating inflation is inconsistent with almost every plausible monetary regime.
Now, the central bank lowers short term interest rates. Is this market rate below the natural rate? Or, has the natural rate decreased? Is that decrease temporary or permanent? Before committing to investment plans, firms must determine what will happen. Sure, any one firm can just look at long term interest rates. And so, these worries can be shifted to bond speculators--how much is a long term bond worth? What will happen to short interest rates over time?
Presumably the central bank would have lowered short term interest rates because it believed that the natural interest rate is lower. Presumably the central bank has some reason to believe this. Presumably entrepreneurs (or at least those speculating in bonds) will see that same evidence as well. If they are wrong in retrospect, then malinvestment is likely to have occurred. Still, the reason for the malinvestment was that the entrepreneurs made errors.
The logic of my skepticism very much depends on this notion that any decrease in short term interest rates due to an excess supply of money will be reversed in the near future. It is even possible that the result will be extra high short term rates once the inflationary consequences of the error develop.
And that is the reason for my second thoughts. The Fed appears to be influenced by new Keynesian theory. In the unusual situation where short term rates have hit zero, so that further decreases are "impossible," then the orthodox new Keynesian solution is to commit to keeping short term interest rates at zero for an extended period of time. It is my understanding that the whole point is to create an unsustainable boom! How could this plan not create malinvestment? While it remains true that building a dam that would only be profitable with zero interest rates for the next 50 years would be foolish, the Fed's plan would appear aimed at leading to more modest malinvestment.
More troubling from a quasi-monetarist perspective is the impact of responding to the zero nominal bound on short and safe assets through the purchase of long term bonds. If this does result in lower long term interest rates, so that entrepreneurs undertake investment projects only profitable at such rates, isn't that also generating malinvestment?
Of course, as I have argued before, purchasing long term bonds can actually result in higher long term nominal and real interest rates. Obviously, the central banks purchases of bonds tends to raise their prices and lower their nominal yields, but these purchases can be offset by even greater sales by others currently holding bonds. And if those selling the long term bonds use the proceeds to purchase consumer or capital goods, real and nominal expenditures on output can expand despite higher interest rates on long term bonds. In that scenario, the nominal higher interest rates on long term bonds reflect higher expected real growth and inflation.
In that scenario, purchases of long term bonds by the central bank do not lead to malinvestment. Unfortunately, if the central bank believes that its goal is to keep long term interest rates low, and it expands its purchases of long term bonds to offset the process above, it would be generating malinvestment.
Interest rate targeting is a bad idea. It is especially bad when its purpose is to create expectations about interest rates in the future.
A clear commitment by the central bank to a target for GDP (spending on output,) would be a great help in generating recovery without malinvestment due to market interest rates being below the natural interest rate now or over the next few years. And while malinvestment isn't the certain consequence of the Fed's vague commitment to keep interest rates at near zero until 2013, it is hard to think of a better way to generate malinvestment than committing to low interest rates in the future.
P.S. I believe that the housing boom did lead to substantial malinvestment. I think that it did have the effect of raising the natural unemployment rate and depressing productive capacity. I am skeptical that an excess supply of money by the Fed was a necessary or sufficient cause of the housing boom.
P.P.S. Privatizing hand-to-hand currency and breaking the zero nominal bound on short and safe assets would help avoid malinvestment as well.