Hayek’s overcoat

Lord Robert Skidelsky is unlikely to have understood the anecdote in his opening remarks in the LSE Hayek/Keynes debate. He related that, after addressing an audience of Cambridge economists in 1931, Hayek had been asked,


And that Hayek had replied,

‘Yes, but [pointing to his triangles on the board] it would take a very long mathematical argument to explain why’.

Indeed, the argument does take a very long time to explain to economists who lack the basic understanding.

Hayek’s triangles (to which Skidelsky made no reference) were to illustrate the structure of capitalistic production; and Hayek later criticised Keynes for not having taken the time to understand capital theory. It is a criticism that applies to most Keynesians today.

Briefly stated, an investment boom that is triggered by an excessive expansion of credit diverts capital toward long-term projects, many of which are doomed to falter in the ensuing bust. ‘Housing’ is the most recent illustration and ‘green’ energy is a likely candidate for the future.

As an excess-credit boom diverts resources to long-term capital projects, fewer goods are produced for more immediate consumption. Yet, expenditures are raised all round, which means that excess demand adds impetus to the boom. 

In the most recent illustration, as rising property values stoked higher levels of consumption, too little saving could be identified as the universal feature of excess-credit booms.

As the recent boom went bust (as was inevitable) the temptation grew (as is usual) for the state to intervene in support of non-viable projects. (With the $3 billion ‘Cash for Clunkers’ scheme to boost US automobile sales, costs were estimated to exceed benefits by about $2000 per vehicle.) Before an economy can thrive, however, mistakes must be remedied; which is something else that Keynesians fail to grasp.

So, where there has been too little saving, it makes no sense to encourage any consumer into the High Street to purchase a new overcoat.

I remember Duncan Wheldon saying in the same debate that if you had a rotten tooth, the austrians say that you should just leave it, adn the keynesians are trying to remove the tooth. Of course, the opposite is true. The Austrians are the ones saying that you should remove the rotten tooth, and the keynsians are the ones saying you should just eat more sugar in order to cure the tooth. Of course, that remedy doesn't really work
An excellent, concise article.
Hayek could also have pointed out, however, that he's also arguing against the government paying people to go and buy overcoats, which is different from him going out and buying one himself with his own resources (which is to discuss the fiscal rather than the monetary side of stimulus spending).
Excuse me, but that concept seems to have no bearing on reality. An expansion of credit does not deny credit to immidiate consumption - employment was much higher DURING the bubble than after it. People were investing in homes, and shopping. Where exactly is there ANY data that during the middle of the last decade immidiate consumption was dropping as all the new credit went into longer term projects? Were the shops of london going out of business in 2003-4? And since when do savings determine immidiate consumption!? Savings are in fact the opposite, the choice of future consumption over present/immidiate consumption! Does not a dropping of savings in fact signify a choice being made to consume NOW as opposed to in the future? You are trying to turn reality on its head, and that isn't a complex arguement, just a daft one. Its one thing to say that an arguement is complex and only a few can understand it - that is plausible. But if such a purported argument also contradicts the empirical evidence, well then, perhaps all that complexity is merely a very complicated way to divert from reality, and that is not a good thing.
RE: Anonymous "Where exactly is there ANY data that during the middle of the last decade immidiate consumption was dropping as all the new credit went into longer term projects? Were the shops of london going out of business in 2003-4?" As I understand it Steele's point still stands. Long term investments (houses) were oversubscirbed. Money flowed into capital rather than out through income. Consumption was still high, but not relative to capital and asset prices. If it had moved into immediate consumpion we would have seen higher inflation and interest rates would have been hiked.
'Indeed, the argument does take a very long time to explain to economists who lack the basic understanding.' Yes, of course, people just don't understand you. That's why all of Hayek's students abandoned him in the 1930s - they were just too stupid. Demanding savings on a grand scale is a fallacy of composition. If desired savings are higher than investment opportunities - as they are in a slump - then the level of output will adjust as people hold onto cash reserves. This is what is happening RIGHT NOW. 'Briefly stated, an investment boom that is triggered by an excessive expansion of credit ' Two points: - No such thing as excessive expansion. There is no 'natural rate' of interest - Sraffra dealt with this a long time ago. No, Hayek did not 'refute' him and neither did Lachmann. Even Bob Murphy has admitted this recently. - The funny thing is that ABC is all about misallocation of INVESTMENT, which means it has nothing to say about this crisis, which was excessive consumption and asset prices. Hayek tried to get round this by redefining consumer durables as capital goods, but you aren't allowed to redefine reality to fit in with your theory. 'The Austrians are the ones saying that you should remove the rotten tooth, and the keynsians are the ones saying you should just eat more sugar in order to cure the tooth. ' Nope, Keynesians simply say there's no reason the rest of your mouth should turn rotten because of one tooth. We do think the banks need to fail or be vastly restructured, and house prices need to fall. But there is no reason for this to correlate with a downturn in the rest of the economy. Malinvestment yesterday doesn't have to mean low investment and unemployment today.
Unfortunately, neither Hayek nor Steele have an explicit mathematical model to make precise all the assumptions behind their story. It is therefore irrefutable and a rather pointless exercise.
Cahal - 'excessive consumption and asset prices' are the effect, you've missed the cause. The recent boom and bust is entirely, indeed perfectly explicable by ABC theory because it was caused by central banks running low rates of interest. This was the cause - the excessive consumption and asset prices are the effects. Whether one intervenes or not to rectify the effects is a different, although related, question - although you must at least ponder whether, having caused the crisis, state mechanisms are a good means to solve the resultant problems. We have, however, seen the effects of Keynesian policy in Japan and in other instances: sustaining malinvestment is exactly what gives you unemployment for a decade! That there is no 'natural' rate of interest is simply an argument for not having state organisations attempting to find one! The point remains that if monetary authorities exist which have the power to control interest rates, thus influencing the level of credit creation in an economy, distortionary effects will result. I can't think of anything which better describes the boom and bust of the past twenty years.
Ahh comments here are hard to read without spaces! 'The recent boom and bust is entirely, indeed perfectly explicable by ABC theory because it was caused by central banks running low rates of interest.' I disagree - monetary policy was too tight. Check house prices, CDO issuance, they are all at their most volatile when rates are high. Obviously it would take too long to discuss this fully but that is part of the Keynesian explanation for the boom. 'We have, however, seen the effects of Keynesian policy in Japan and in other instances: sustaining malinvestment is exactly what gives you unemployment for a decade! ' Nobody is arguing to prop up bad banks (apart from the banks). Private debt levels and misallocation are incredibly important. 'That there is no 'natural' rate of interest is simply an argument for not having state organisations attempting to find one! ' Money is inherently a function of government rather than a commodity to be produced and consumed by the private sector. The government must have some criterion for what they accept as taxes, so they simply have to be involved or the money becomes meaningless. So the hand of the state isn't really 'distortionary' in that sense. It's not about 'natural' it's about 'good' or 'bad'. There is no neutral policy. I feel like 'pure' Austrians are sort of stuck in the past. The closest thing we have to the original intent of the Austrian school is the work of Minsky and, more recently, Steve Keen - a focus on malinvestment, private debt levels, etc.
Cahal - How you arrive at a view that house prices and interest rates are unrelated utterly baffles me, and I think anyone with an ounce of economic sense. Over the decade '97-'07, the Repo and Bank rates were consistently below 6% (I'm not sure of the average, maybe 5%?) compared to the far higher levels of the two previous decades. UK house prices more than quadrupled, as an average. A similar policy can be observed in the USA, Ireland, Iceland, Spain and so on. Are you seriously, seriously trying to convince us that these two phenomena are wholly unrelated? Are you seriously trying to tell us that looser monetary policy over that decade would have been a sensible policy? Because I think virtually every sensible person I know what be baffled by the lunacy of that statement, it's ignorance of obvious data and obvious cause and effect. The idea that 'money is inherently a function of government' is a nonsense and is unsupportable by historical and theoretical evidence. i) The point about government needing to accept a particular form of money as legal tender is only relevant in an economy (like ours) where there are massive government interventions. Take away that massive government and the necessity for government to control money disappears. It would be quite easy for a government which persued its proper functions (upholding of property rights via defence and the constitutional and legal system) to collect the small amount of money necessary to fund these activities without the kind of gross monetary distortions you consider necessary. ii) Government could quite easily collect such taxation it required under (i) in any of the currencies that would emerge in a free market in money. The US government of the 1840s operated under such a type of monetary environment, for instance, so there's no reason to suppose that any modern government couldn't do the same. It's not Government that needs to control money per se, it's the massive, welfare state driven governments of the c20th that need to do so. That is, of course, an argument for doing away with the welfare state, not for keeping government in control of money. iii) Just because government fiat money is 'necessary' (of course it is not, see above) under such a set of economic circumstances, this does not follow that government control of money and interest rates is not the cause of the recent economic crises that ABCT so aptly describes. iv) Government control of interest rates must always be bad, even if it may be somewhat better or worse in certain sets of circumstances. This is because government cannot obtain the necessary knowledge to set interest rates, must set them at a national level (or higher, in the EU) when there are local variations, and faces incentives which prevent it arriving at a proper level even if it could know what such levels were.
Housing Bubble / Financial Crisis Timeline: Pre-2001: CRA, mortgage interest deduction, government guarantees and other support for the housing sector has long been in place. Both major political parties desire to promote home ownership. Developing countries’ and their citizens’ savings are invested in long-term Treasurys, bringing down long-term rates including traditional mortgage rates. These factors support housing values from the mid-1990s onward, even after the bursting of the dot.com bubble. Post 9/11, Americans culturally become focused on their own homes rather than travel or external recreation – improvements such as granite countertops, additions, home entertainment centers, become sought-after. Lending standards typically include credit (primarily, repayment history) check, income and debt service coverage check, and loan-to-value (loan amount versus value of the home being financed). This has not changed in years. The way you go about buying a home is to first become pre-qualified for a mortgage up to $X. This is based primarily on your ability to cover the loan payments. The lower the rates, the higher your pre-qualification, and vice versa. You’ll be approved for that amount subject to loan-to-value limit on the home you are purchasing – but generally the purchase price is the deemed value. This assumes that nobody wants to overpay and assumes a slow and steady increase in values with population growth. Low delinquency and default rates on mortgages have been the norm for decades. For decades, historical delinquency and default rates were effective ways to predict future delinquency and default rates . Most people fix for a long period of time, and when rates spike, fewer people take out mortgages and not many mortgages “re-set” at the higher rates. Short rates have never plummeted and then sprung back up, leaving a relatively flat yield curve, thus there has been no incentive to finance with short-term money. ARMs and HELOCs exist but are not as popular, as the curve has been relatively flat and there has not been a period characterized by a massive, sudden creation of new home equity out of thin air. Because of the historically low delinquency and default rates, and government guarantees, and because a pool of loans diversifies risk, CDOs look like a rational way for banks to go a little further out on the risk-return curve to get a little more yield. The pressure to do this increases as bond yields fall, due to the increase in foreign savings. Refinance-with-cash-out and HELOCs are approved based on the above factors and an appraisal, which generally is based on comparable sales. The same comps can be used to appraise an unlimited number of homes. If you have a 100-home development built in the 1950s in a stable neighborhood with limited turnover, you might have three homes that were bought in the 1990s and sold between 2000-2002. Because to-date, values have not changed for the better in any rapid fashion, this has not yet been a recipe for disaster. Banks finance these builders with interest-carry at floating rates – thus if short-term rates were to plummet, the same rates that fuel the repayment source also lower the debt service. But this has not happened yet. Subdivision-development loans to most private developers of 10-100 unit sub-divisions, are based on a project-finance model, with cash draw to build 1-2 speculative homes and 1-2 pre-sold homes at a time. They are reviewed annually. Again, in a stable market which has never seen a massive temporary influx of credit, this is not a bad model, the only model possible unless you want all builders to also maintain apartment complexes with income streams. Mortgage closing attorneys, home sales closing attorneys, real estate agents and mortgage brokers are paid per transaction, thus have no incentive other than possibly reputation to think of the transaction beyond immediate terms. But-for bubble periods, this is not a significant risk – the risk of rapid changes in value is lower than the risk that the home will turn out to have termites, etc… The internet makes all markets including real estate much faster-paced – you can take a virtual tour of a home, search listings in a neighborhood, etc… In Sum, the government provides important supports to the housing market and housing and credit systems assume some small amount of monetary accommodation but are not built to deal with dramatic shifts in monetary policy. The market for real estate and mortgages has evolved, but not in a necessarily bad fashion, as long as values and rates remain stable. “The system” has worked very well for decades and are built for the environment that has slowly evolved over those decades. The secondary market for mortgages has grown, and is seen as relatively safe, precisely because the system has worked so well. There is unforeseen exposure to volatility in short-term rates, particularly on the down-side – but short-term rates are set by fiat and have not previously been volatile, at least not on the downside. 2001: In response to the collapse of the dot.com bubble and the 9/11 shock, the Fed cuts the discount rate (and as a result, short term Treasury yields) to record lows, where they stay for almost three years. Some economists cheer this on – whether tongue in cheek or not – precisely as a way to inject cash into the economy through increasing home values. There is no other specific stated reason for the policy other than generally to “support” the economy. 2001-2003: More people buy new homes with ARMs. The payments are incredibly low. The low pricing results in lower debt service for the same debt – meaning the borrowers can qualify for higher debt levels. The expanded credit soon translates into higher amounts paid for the same homes. 2002-2004: People notice the values going up. Would-be renters start to scramble to buy “before we’re priced out of our dream of one day owning a home.” Would-be laborers in non-housing-related fields enter construction, and over the next few years make six-figure incomes, not through the value-add of the houses they build but through the appreciation in value of the land between their purchase of the lot and their sale of the finished home. Would-be professionals in non-housing-related fields become real estate closing attorneys, agents, appraisers. 2002-2004: A refinancing boom begins. The 3-4 homes sold in the subdivision for $100M-$200M more than their purchase price 4-5 years earlier translates into a $100M-$200M increase in appraised values for the other 96-97 homes in the subdivision. People refinance with ARMs, with cash out, increasing their mortgages by $150M, and the payments actually decrease. People take on HELOCs – second position, floating rate mortgages. The money is then spent, temporarily boosting the local and broader retail economy. Banks and other institutions invest in huge mortgage-lending infrastructure to meet the demand for housing credit. 2003-2004: Values really start to shoot up. Some banks, seeing a decrease in loan-to-value, believe that this will enable them to take on higher risk in other factors of the transaction. Lenders understand that rates will one day increase, but the focus in underwriting is on the transaction, and assumes the rest of the environment will remain. “This borrower might have trouble making the payments if rates go up by 300 bps before the ARM re-prices, but by that time the home will be worth another $150M and he can easily sell or refinance.” Mortgage lenders also consider that they will be selling the loan long before it re-prices. Nobody is thinking that the macro picture is just the aggregate of all of the similar transactions. 2002-2005: Retirees who have some savings built up see second homes in the Sun Belt as a win-win - - buy that second home for recreation purposes but also hold it as an investment, thus not having to choose between spending and investment. A building boom occurs in Florida, Nevada and California. People who get in early enough finance a new home in 2002 and then refi or take out a HELOC in 2004. McMansions become the norm (and in the exurbs and Midwest, ranches), because people can afford them. Home Depot, Tractor Supply Company, Lowe’s, are the chief retailers, because people have to maintain their McMansions. 2001-2004: With rates continually low, delinquency and default rates stay low. If you lower the bar, it makes it easier to clear the bar, thus fewer people will trip on the bar. Institutions continue to use historical delinquency and default rates to predict future delinquency and default rates because their predictive capacity appears to have, if anything, increased. There has never been a period in which millions of people could get 3/1 ARMS in the low 3s and had them re-price in the high 6s, because the rates had never gone that low – so the inability of predictive models to pick this up has never previously been a problem. 2001-2005: With rates remaining so low, the savings rate goes negative. 0% credit cards proliferate. Many people take them on and max them out. There is no incentive to save and every incentive to borrow – if you can get what you want now, with negative real financing cost, why would you save? 2004: The Fed starts to slowly raise rates. There is even more of a frenzy as the former renters who were already thinking “I’d better buy before I am priced out” also think “I’d better buy now while I can still afford the payments, before the rates go up.” Few take the analysis to the next step: “if the rates go up, the values will stop going up.” The “mania” is a follow-on – it is a characteristic of a bubble in the mid-late throes, but it is not the cause. 2005: The short rates are not low enough for HELOCs and ARMs to function as conduits to build up the values and inject new-found cash into homeowners’ pockets. Values peak. Refinancing and HELOC volume slows. 2005-2006: Mortgage lenders, principally those that do not hold on to the mortgages, have spent the last 3 years building out their infrastructure. They need to maintain volume. To do so, with values no longer rising, they need to lower credit standards. This is when the proliferation of no-doc loans, 0% down loans, etc…, occurs. 2007: Those subdivision builders with floating rate loans see their payments going up, and see a slack in demand for the homes they are building. The loans come up for review and the banks stop financing new speculative homes, and pressure the builders to sell faster, even at a discount, to stop the bleeding (interest accruing at the new higher rate). Values start to come down. When a new house sells for $50M less than the same model did a year earlier, this has an effect on comps/appraisals for HELOCs and ARMs – as well as people attempting to refinance their HELOCs and ARMs at fixed rates – that is opposite of the effect of the rising prices 4-5 years earlier. 2001-2007: Prices of non-housing margined assets rise and then plummet as well, in inverse proportion to interest rates. When rates are again cut, commodity prices rise again. Such assets include oil and gold. Oil-rich states such as Texas and Alaska do not suffer the same housing bubble – the values go up but do not come down, as the oil-related revenue continues to fuel a local boom. Gasoline and heating oil prices shoot up, eating up more of the budget of people who bought the McMansions. 2007: HELOCs and ARMs originally priced in the 3s re-price in the 6s, 7s and even 8s, and the payments increase by 50-60%. They cannot all continue to make the payments, particularly with energy and food prices so high. Delinquency and default rates start to spike up. Homeowners with short-term financing are no longer maintaining their consumption levels, and they are not being replaced with new cash-out consumption, and so local and retail spending falls, affecting the economy as a whole. People with non-housing jobs and fixed-rate mortgages lose their jobs and fall behind on the payments. Most of the second-home mortgages are non-recourse. Because of rising fuel prices, it also costs a lot more money to fly to Florida, Nevada and California. If you’re 70 and under-water on a non-recourse mortgage on a vacation home that costs more to visit, your best bet is to mail the keys to the bank, and that is precisely what happens. 2008: With the sudden spike in delinquency and default rates, the CDO market collapses. The construction workers, the mortgage lenders, the real estate brokers, are all laid off. Unemployment also increases among the ranks of those who marketed, distributed and sold the items that these people used to buy. The bubble in margined-commodities temporarily crashes as well, at the same time, but recovers when the Fed cuts the rates again, thus preventing price deflation which could have provided some relief to the newly out-of-work. 2008-Present: Fed’s response is to cut rates even lower and flood the economy with money. Federal government’s response is bailouts and “stimulus” spending. Fed ends up buying 60% of the Treasurys at auction in 2011. China, Japan, banks and other institutions buy up much of the remainder. Banks got burned with housing and won’t lend there, but commodities are right back up. Prices are not coming down despite the recessionary conditions, because of the new money. Fuel and food prices do not factor into CPI, thus reported inflation is lower than people’s actual experience. Large businesses have locked-in and used the low rates to de-leverage. They deposit the cash in banks, which is mistaken for “cash on the sidelines” – banks use it to buy Treasurys, since the federal regulators do not make them reserve against sovereign debt but make them reserve up to 11% against private debt. With meager individual savings, a result of the previously-discussed prior decade of spend-spend-spend, there is little left over to invest. The cycle generally starts with emerging firms raising equity from these savings, and cyclical firms getting bank loans to finance equipment production to meet demand from these emerging firms – demand was pulled forward in the 2000s at the expense of savings, and so now this cannot happen. 0% rates do not help. This is the classic Hayekian Triangle. Conclusion: The but-for cause, the first domino, the factor without which most of the other factors would not have occurred and NONE of them would have resulted in a boom-crash cycle, was the Fed’s rate policy from 2001-2005. Alternative Theories: “Mania” – as discussed above, while this was part of the vicious cycle, it was a follow-on event, and would not have happened but for the initial boom, which resulted from the rates. “Exotic mortgage products” – what was exotic about them? The exposure to volatile short-term rates, which previously had not been volatile. “Risk” – risk of what? Risk that the ARMs and HELOCs originated at low rates would re-price at high rates. Risk that the rise in values that resulted from this influx of credit would stop when the influx of credit ended. No-doc and low-doc? Yes, bad risk policies – but again this was a follow-on event – but-for the initial boom, there would have been no massive increase in overhead in the mortgage and housing industry, and the decision “do we lay these people off or do we get more creative about how to maintain volume” would not exist – there would be no infrastructure and no volume to maintain, and these people would have done what they have to do now, which is find work outside of housing and mortgages. And again, most of the damage was done not via this late-cycle detour from historical lending practices but via the fact that the historical lending practices did not account for such a volatile shift in rates. Predicting default rates for a portfolio based on historical rates works as long as the environment does not shift; predicting default rates for an individual loan based on debt service coverage and loan-to-value is rational assuming stable rates thus stable loan payments. “Decline in aggregate demand / not everyone laid off was in construction or mortgage lending” – as noted above, people stopped saving and spent beyond their real means, because the immediate, credit-infused means were suddenly available. This was by-definition unsustainable, which meant that the jobs temporarily created by virtue of that credit-infused demand had to go away when the credit went away. “Savings glut” – the increase in foreign savings did not reverse itself; the low short-term rates did, and that is when the housing market shifted and the bubble burst. “CRA” – amplified the bubble and directed some of the new credit into places like Detroit, but cannot explain the Sun Belt or anywhere else. Bad policies but not the policies that caused the bubble. “Big banks marketing high-risk CDOs as low-risk CDOs” – bad actions, primarily in 2007-2008. When the bubble was bursting, those who saw it first took advantage. That wasn’t the cause of the bubble. You really can’t put the CDOs sold in 2004-2006 on which a higher than expected proportion of the underlying mortgages would go into default three years later into the same category as the last handful of CDOs that they got out the door just before it all fell apart. The actions in the latter category may have been nefarious but the actions in the former were the result of the rapid influx and then pullback of credit. The malpractices that people like Elizabeth Warren complain about are genuinely bad acts that should be punished, but they are not, and should not be confused as being, the cause of the housing bubble and bust, or the prolonged recession that has ensued. The smart money might ride the bubble and jump off in time, sometimes illegally and/or immorally – but it doesn’t create the bubble. This was a credit-bubble, plain and simple. So what are your answers? Reformulate the entire system so that it is not susceptible to volatile monetary policy? Or simply avoid volatile monetary policy?

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