Monday, August 15, 2011

ABCT Skeptic

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.



  1. Prof. Woolsey, I asked this question of Selgin and thought I'd run it by you:
    What do you think of Gary Gorton's work regarding the crisis (and other monetary history as well)? In his research, he hardly mentions monetary policy, and points out that empirical evidence suggest loosening lending standards aren't to blame either. Banks made loans completely dependent on house prices rising in order for those loans to be profitable. When house prices quit rising those loans, which had been securitized into instruments being used as risk-free collateral in the repo market, turned highly unprofitable. How does one see this through the lens of free banking? Thanks.

  2. Bill,

    I'm not very convinced about your reasons to be sceptical.

    I don't think that the real interest rate can be as easily speculated about as you suggest.

    I don't think that monetary policy manifests itself in NGDP straight away. Especially when a change isn't expected. So, there is plenty of time for an injection to cause malinvestments before the rise in prices becomes clear.

    I think concentrating on bond markets where high-level financial agents make decisions tells only part of the picture. If there is a money injection beyond demand then plenty of ordinary people will recieve it and consider it a rise in real income.

    Funnily enough I'm not so sure about the Fed's recent policy. If they succeed in creating price inflation then there's the possibility of ABCT. But since they keep paying interest on reserves and keep supporting near-zombie banks will that actually happen?

  3. Bill,

    I did not read your entire post, so I apologize in advance if this response misses anything you covered.

    You write,

    "Malinvestment is the construction of capital goods that are only profitable with interest rates lower than the natural interest rate."

    This is not true. If interest rates remained low, it would not make the investment any more profitable. The entire focus on "natural rate", in any case, in my opinion misses the point. It's not about interest rates; a falling interest rate just causes an increase in investment in second order goods (which, in turn, leads to an increase in earlier order goods).

    The focus on interest rates misses what really matters, which is a distortion of prices. These investments aren't profitable under any interest rate (except a naturally lowered interest rate), because what is occurring is an increase in investment without the required increase in capital goods (savings). That's why they are malinvestments; they are unprofitable because the necessary savings don't exist for their completion.

  4. Tapp:

    I agree with Gorton that there was a run on the shadow banking system. Unlike Gorton, I don't think that the loss benefits of that system for the distribution of credit is the source of our current economic difficulties.

    It is troubling that for only a slightly higher yield, depositors were willing to put their funds in poorly diversified and poorly capitalized institutions. Why don't they have some kind of option clause on repurchase agreements? It all seemed to be based on the illusion that a depositor can solve any problem by getting out first. Not everyone can do that.

    My response to the situation is that it is very important to have a system of rapid bankruptcy for institutions issuing money. I hadn't worried much about massive insolvency of banks before. I was more worried about liquidity issues.

  5. Catalan:

    I don't think you understand the Austrian Business Cycle Theory.

    Capital and saving are different things.

    Not enough capital (saving) makes little sense.

    By the way, I don't deny that inability to complete projects is part of the traditional story, but you are wrong that the distortion of market and the natural interest rate is beside the point.

    The interest rate is the market price that provides intertemporal coordination (or not,
    if something goes wrong.)

    The actual changes in the prices of consumer and capital goods aren't essential to the process. That depends on the elasticities of supply. Oddly enough, little actual change in prices, and more change in the composition of output--more malinvestment.

    I understand that stories about incomplete projects are part of the tradition. I think that is mostly an error, but even to the degree it is true, you are wrong to identify that as the Austrian Business Cycle Theory.

    The "you can't finish the dam" story is probably false. The problem is that after you finish the dam, you have a lot of dam producing capital goods that you have nothing to do with. The complementary factors (other things you need to use with them) have more valued uses. Constructing other sorts of capital goods that help produce goods and services for the nearer future.

    But this story very much has to do with interest rates. It takes a couple of years to get any electricity from the dam, and some of the electricity from the dam won't be produced and paid for for decades. At a higher interest rate, this delay makes the make the present value of those revenues too low to cover the cost. But the cost is the opportunity cost, the value of the goods that could be produced in the nearer future with the resources needed to produce a dam. But the problem is that some of the resources don't have alternative uses.

    I would suggest focusing less on Austrian Business Cycle Theory and more on basic micro. Then return to it.

    By the way, don't forget that the lower purchasing power of money raises the price of future electricity that the dam will produce.

    Are you taking that into account when thinking about the process?

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