Sunday, April 25, 2010

Speculative Bubbles and the Natural Interest Rate

One problem with "Austrian" Macroeconomic thinking is excessive focus on scenarios where the natural interest rate, and so, the supply of saving and demand for investment, is given. The "classic" scenario is where the demand to hold money is assumed given as well, and then an increase in the quantity of money pushes the market interest rate below the natural interest rate.

Suppose instead that investment demand increases because of a speculative bubble in housing. The "cause" is the projection of past price increases into the future. People invest in order to profit from those expected price increases. If there are people who will be willing to pay high prices for the houses in the future because they want to live in them, then there is nothing irrational about this investment plan. It is only a speculative bubble if the reason people are paying higher prices for the homes is that they plan to sell them to someone else at a still higher price, but that person will only pay that price because they plan to sell to still someone else at a yet higher price. It is a speculative bubble if there is no one at the end who is willing to pay the high price in order to live in the house.

Suppose that instead of this kind of bubble behavior, people are investing in houses now because radio messages are received from outer space. Alien settlers are on their way with ships full of great consumer goods. They will exchange those for houses when they arrive. Assuming the messages are true, then purchasing a home is a great investment project. It will generate large amounts of future output. (And, when the messages turn out to be a fraud, the result will be somewhat like the bursting of the speculative bubble.)
So, what are the effects of an increase in investment demand? Investment demand is made up of investment demands for all sorts of different types of capital goods by a variety of different firms. (This analysis includes residential investment demand by households along with the rest.) If the demand for residential investment increases, the sum of the demands increases as well.

At the existing level of the natural interest rate, the demand for investment is greater than the supply of saving. The natural interest rate is higher. Assuming that the market interest rate was equal to the natural interest rate before, and then rises with the natural interest rate, then the quantity of investment demanded will fall and the quantity of saving supplied will rise. At the new equilibrium, the amount saved and invested are both higher. This increase in the amount saved is equivalent to a decrease in the amount consumed. Less is spent on consumer goods and services. The increase in the amount invested is an increase in the purchases of capital goods. There is a shift in the allocation of resources.

The increase in the market interest rate to some degree chokes off the increase in the demand for residential housing. However, it also reduces the demand for all other types of capital goods. Naturally, there will be an increase in the derived demand for sawmills, forests, brickyards, and the like. But like the homes themselves, these added derived demands will be dampened by the higher market interest rates. Still, there are presumably some capital goods less directly related to housing production that will also see their demands fall due to the higher interest rate.

The increased market and natural interest rates imply an increase income from capital. Other things being equal, that would be an increase in aggregate income. How is that possible? If the basic identify of macroeconomics is that aggregate income is always equal to output, then how can those earning greater capital incomes do so when output is limited by the existing productive capacity? It is because the new homes are worth more than the other capital goods (or currently produced consumer goods and services) being sacrificed.

In the scenario of a speculative bubble, this greater value is an illusion by assumption. With the alien immigrant scenario, the value of the bonanza of products they will bring is being pulled into the present.

What about labor? Those constructing new homes to take advantage of their high prices demand more labor. Wages rise so that those producing other capital goods and consumer goods will use less labor, freeing up the labor needed to construct new homes. Assuming that the quantity of labor supplied rises in response to higher real wages, the quantity of labor used in production rises. This increase in labor input provides a second, more tangible source of added current production.

The result of the great profits that can be generated from housing production (or more exactly, the expectations of those profits) results in higher real wages and higher real capital incomes. Because the homes and capital goods used to produce houses are so valuable, real output rises just from the shift in the composition of output, and then it also rises because higher real wages draw out more labor input.

This real boom is consistent with scarcity. Leisure, other capital goods, and so far, current consumer goods are being sacrificed. Housing and capital goods used to produce housing are being produced. The illusion of created by the speculative bubble (or the space alien settlers) is motivating these sacrifices and creating the real boom.

Is it conceivable that current consumption could rise in this boom? To the degree that higher real wages bring forth an increased quantity of labor, it is obvious that current consumption can rise. As the workers earn higher incomes, it is likely that they will increase their current consumption.

Even ignoring this effect, it would be possible for those receiving increased capital incomes to expand their consumption. Resources, including labor and existing capital goods, can be stripped from various capital projects, for example, dams, and used to produce consumer goods and new homes. Income, output, and consumption can all expand because the houses being produced are so much more valuable than the dam project.

So leisure and alternative capital projects are sacrificed, and real wages, employment, real labor income, real capital income, the real capital stock (including houses,) aggregate real income, aggregate real output all expand. If the cause was the alien immigration, then when they arrive, the past sacrifices are shown to be justified. The sacrificed capital projects (the dam) don't produce output, but the trade goods brought by the aliens compensate for the sacrificed products.

But suppose the aliens don't arrive. Suppose it turns out that the radio messages were a fraud. Everything must go into reverse. Real wages must be lower. Employment will be lower. The real capital stock will fall. All of those houses aren't so valuable after all. Real capital incomes must fall. The production of consumer goods must fall.

Of course, if the cause of the great profits in housing was a speculative bubble, then it was always a fraud. That is, it must eventually end.

In my view, the best macroeconomic environment to for the necessary readjustments is to keep total cash expenditures on a stable growth path. While real wages and real capital incomes may need to fall (and certainly grow more slowly for a time,) stable growth in nominal incomes imply that this will require price inflation to a higher price level. If the failure of nominal wages to keep up with inflation results in people quitting work or dropping out of the labor force, this is the proper response. The decrease in labor input will reduce the productive capacity of the economy, but at the same time that the loss in real income reduces the demand for consumer goods. And, of course, the lower real interest rates may well cause reduced saving out of that reduced income, and at the same time increase the profitability of those investment projects that had been crowded out by the housing investment.

I hope that my analysis of the impact of an increase in the demand for investment has been suggestive. Could something like this have occurred during the housing boom? Suppose central banks are targeting the market interest rate so that increased investment demand results in an excess supply of money? Certainly more analysis is necessary. But recognizing that the natural interest rate can and does change is a good start.


  1. The "classic" scenario is where the demand to hold money is assumed given as well . . .

    According to Milton Friedman, changes in demand to hold money are usually gradual, except when they are in reaction to changes in the quantity of money.

    Suppose instead that investment demand increases because of a speculative bubble in housing. The "cause" is the projection of past price increases into the future.

    Are there any historical examples of asset bubbles not coinciding with 'easy credit' - expansion of the quantity of money via the financial system driving the market interest rate below the natural rate?

    People invest in order to profit from those expected price increases.

    For the speculation to be attractive, the expectation must be not only of price increases, but increases great enough to be competitive with other investments. Easy credit promotes that situation from both directions, driving asset prices up and interest rates down.

    Granted that an asset bubble in the absence of easy credit can be imagined and described theoretically, I am skeptical that such a thing has happened, or can happen, in the real world.

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