Bubble trouble: not an easy money problem

By Lorenzo

The notion that “easy money” created asset booms is levelled (famously by Austrian school economists such as von Mises and Hayek) against the 1920s boom and by a range of commentators about the Great Moderation boom. In both cases, the Fed (dominated by Benjamin Strong as New York Fed Governor up to 1928 and by Alan Greenspan as Fed Chair 1987-2006) is held to be to blame.

Non-inflationary booms

Yet in both periods there was a dramatic lack of goods and services inflation. So, somehow “easy money” was bidding up asset prices but not prices of goods and services. This seems an odd claim. Even on the basis that goods and services production is rising strongly (which it was in both periods–the former due to recovery from the Dynasts’ War and technological advance in manufacturing, the latter largely due to the increasing integration of India and especially China into the world economy), why would rising supply of goods and services somehow “mop up” over-supplied money but leave increasing amounts “left over” to bid on assets?

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Good times are here again

Worse, there was considerable variety in the degree of rises in asset prices, particularly in the Great Moderation. People talk about “the housing price boom” but housing booms did not occur in all countries and, in the US, there was great differences in the level of prices surges and collapses between housing markets. So, “easy money” was apparently not only somehow being shunted across to assets but not goods and services, but it was also being shunted far more dramatically into particular assets and not others–including particular housing markets and not others.

Suppose we could identify a period which was also marked by asset booms and busts but not by “easy money”? Would that not suggest that such events are not somehow an odd substitute for goods-and-services inflation?

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These will connect people far faster than ever before — the sky is the limit in the new economy

As I have discussed before, we can indeed identify such a period–the various railway manias and other asset booms and busts of the C19th; a period of silver standardsgold standardsbimetallism and a noted lack of “easy money”.  The issue is not “easy money”, it is of incomes rising beyond past experience, so rising savings (due to the permanent income effect), creating demands for assets complicated by unstable expectations (pdf) from technological innovation (pdf). Since how new technologies are going to pan out is not known, there is great scope for booms and busts in assets based on new technology (such as railways or IT). This would not, however, explain the recent housing booms.

Central banks did not create the rising (real) incomes, however; rather, the lack of inflation from their policies encouraged saving and, along with the rising incomes, drove up demand for assets. Expectations of continuing prosperity meant there was not a flight to safe assets, but rather continuing demand for assets expected to provide good incomes or capital gains or both.

Cycles and catastrophes

A more sophisticated version of the easy money=boom argument is the theory of the unsustainable boom–central banks hold interest rates below their natural level, which leads to over-investment in capital goods which fail to generate the required returns, so there is a bust. (A particularly approachable rendition of the theory is given Roger W. Garrison’s Time and Money: the macroeconomics of capital structure [pdf]; technology is treated as remarkably unproblematic, however.)

The problem with this argument is that will get you a mild business cycle, with some poorly performing or busted assets, but it will not get you the sort of collapse that generates the Great Depression or the Great Recession. For that, you need a generalised flight to safe assets (i.e. people dramatically cut spending on goods and services) because there are widespread poor expectations about future income. The more confident people are in the future value of money, the more incentive they have to hold onto their money, so the less spending, so the worse the expectations of future income. It is not easy money which magnifies the downturn towards catastrophic levels, but tight money.

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Hence ensuing expectations of easy money tend to encourage economic activity. FDR‘s explicit commitment to reflate the US price level led to the fastest expansion in US industrial production on record, before the National Industrial Recovery Act (NIRA) and surging wages brought the recovery to a screeching halt, with growth resuming only after the US Supreme Court declared the Act unconstitutional. In our time, expectations of easier money lead to stock market rallies, which die off when the expectations fall away. But these are about hopes of changes in monetary conditions, not the continuation (of tight money).

(Hayek called the tight money which catastrophically magnified the downturn “secondary deflation“; though that did not stop him getting the Great Depression seriously wrong at the time in much the same way Austrian commentators have generally been getting the Great Recession wrong. This paper [via] is an excellent starting point for arguments over the Great Depression.)

The Great Depression and Great Recession were periods of very low interest rates, which is what one would expect. For, as Milton Friedman said decades ago, in his famous 1967 Presidential Address (pdf):

As an empirical matter, low interest rates are a sign that monetary policy has been tight–in the sense that the quantity of money has grown slowly; high interest rates are a sign that monetary policy has been easy–in the sense that the quantity of money has grown rapidly. …

Paradoxically, the monetary authority could assure low nominal rates of interest–but to do so it would have to start out in what seems like the opposite direction, by engaging in a deflationary monetary policy. Similarly, it could assure high nominal interest rates by engaging in an inflationary policy and accepting a temporary movement in interest rates in the opposite direction.

These considerations … also explain why interest rates are such a misleading indicator of whether monetary policy is “tight” or “easy.”

So, the high demand for assets in the 1920s and during the Great Moderation were not the “fault” of inflationary monetary authorities. On the contrary, rising incomes and confidence in the non-inflationary stance of monetary policy generated surges in savings which encouraged expenditure on assets. Just as they did during the C19th.

It is possible that US interest rates were held a little low at times during the Great Moderation, but nowhere near enough to explain either the level or pattern of asset prices surges or the extent of the following Great Recession. Moreover, a good case can be made that Fed interest rate policy was appropriate during Greenspan’s tenure.

(Note, arguments about whether prudential regulation was adequate–fairly clearly not–or whether public policy imported moral hazard into financial markets–fairly clearly yes– and how much this mattered are different questions. The issue here is monetary policy.)

The perils of bubble popping

Tight money can most certainly generate busts and, if severe enough, major financial crises. The immediate precipitation of the Great Depression was the Fed, led by Strong’s successor George L. Harrison, raising interest rates to “pop” the late 1920s stock market boom. This led to inflows of gold to the US which, along with the Bank of France’s insane gold-hoarding policies, set in train the contraction whereby, in the words of one study (pdf):

Central bankers continued to kick the world economy while it was down until it lost consciousness (p.2).

saupload_japans_lost_decade

Similarly, the Bank of Japan tightened money to “pop” the Japanese “bubble economy” of the late 1980s but then kept money so tight as to generate Japan’s “lost decades“. While the immediate precipitation of the GFC and then Great Recession was the Fed passively tightening in the face of the ECB’s tight money policies and the European surge in demand for US dollars and gold (i.e. safe assets). Cases of being broken by the fix.

None of which are encouraging examples for central banks “bubble popping”. Stable monetary policy coupled with surging incomes can certainly increase demand for assets, while tight monetary policy can generate or intensify a contractionary flight to safe assets. But asset booms and busts can occur while monetary policy remains stable and without easy money. The explanations for such booms and busts lie in the dynamics of asset markets, not monetary policy.

10 Comments

  1. Tim
    Posted May 15, 2013 at 11:57 am | Permalink

    I still find the Austrian theory of the business cycle more persuasive. I’m no economist but I’m not sure the author has addressed it very well. He does not address the argument about interest rates being artificially lowered, or the eventual need to liquidate investments made when there were inaccurate indications of the amount of capital available. Does this piece purport to refute the Austrian theory of the business cycle? I think it takes more than this to do so. Central bank manipulation of interest rates (giving inaccurate indications of the amount of capital available) is still the best explanation for booms and the inevitable busts that, always and everywhere, follow.

  2. Posted May 15, 2013 at 2:15 pm | Permalink

    [email protected] I am not “refuting” the Austrian business cycle theory, I am just pointing out that it is not a good explanation of asset price booms as we actually observe them and it cannot explain downturns of the scale of the Great Depression and Great Recession.

    Even if one thinks central banks regularly set interest rates too low, given that such only affects new capital construction, not all of which will be unprofitable, it will only get you a mild business cycle.

  3. Posted May 15, 2013 at 5:23 pm | Permalink

    One can accept the Austrian theory is a plausible theory in general without denying the existence of other causes of busts/boom cycles, or concluding that it was the primary cause behind any particular cycle.

    The Australian fashion of downward phase of a cycle will only be triggered when the interest rates are raised to counter inflation, which is what would cause the apparent shift in amount of capital available.

    Even perfect expectations about the amount of capital available won’t do anything to counter problems caused by systemic, unrealistic expectations about the income that can be derived from capital (or certain major classes of capital).

  4. conrad
    Posted May 15, 2013 at 7:20 pm | Permalink

    People always give Japan as an example of a bubble that they then couldn’t recover from, but I can’t help but think that part of the reason they haven’t recovered, and never will in our life time, is because of the demographic structure they have. This will only become worse into future for them as they spend more and more money on economically unproductive things to cope with aging. The same will be true of many places in Euroland — the best they can hope for is stagnate in the long term. This isn’t because of a bubble or economic policy — it’s just what happens with such population demographics.

  5. John Turner
    Posted May 16, 2013 at 9:01 am | Permalink

    The author does not distinguish between the two types of easy money. To stimulate the productive or real economy a sovereign government institutes infrastructure projects funded by its ability to put money into circulation. All money created by a budget deficit ends up in the hands of the savers, the well to do and the financial institutions as reserves with the central bank.That deficit will initially put money into the hands of people for whom jobs have been created and they will spend it generating demand that creates more employment.
    That government expenditure only creates inflation in prices if demand presses too hard on the markets ability to manufacture and supply.
    When the financial system increases credit availability by being less prudential, such as by offering margin lending at 80% on share values or increases the amount lent on a mortgage to as much as 90% to fund home purchases the reflexivity problem described by George Souris cuts in; overvalue an asset, lend a high proportion of the value, and the valuation becomes fulfilled. Once enough people believe that the market is permanently on the way up the bubble is on and the subsequent burst is approaching.

  6. John Turner
    Posted May 16, 2013 at 9:18 am | Permalink

    I have added to my earlier comment. I find typing and editing in the small comment box difficult.
    The author does not distinguish between the two types of easy money. To stimulate the productive or real economy a sovereign government institutes infrastructure projects funded by its ability to put money into circulation by increasing expenditure above income. That deficit will initially put money into the hands of people for whom jobs have been created and they will spend it generating demand that creates more employment . With the spending of the newly employed , or those who are earning more through overtime etc, becoming the income and profits of people in selling and manufacturing the new money is re-spent with some at each stage leaking into tax and savings. All the excess money over and above taxation ends up in the hands of the savers, the well to do and the financial institutions as reserves with the central bank. Of course the high savers tend to bid up the price of assets which is why taxation should be progressive. Progressive taxation limits the ability of rentiers to outbid potential lower income people seeking to purchase a home.
    That government expenditure only creates inflation in consumer prices if demand presses too hard on the market’s ability to manufacture and supply.
    When the financial system increases credit availability by being less prudential, such as by offering margin lending at 80% on share values, rather than an earlier lower percentage, or increases the amount lent on a mortgage to as much as 90% to fund home purchases the reflexivity problem described by George Souris cuts in; overvalue an asset, lend a high proportion of the value, and the valuation becomes fulfilled. Once enough people believe that the market is permanently on the way up the asset value bubble is on and the subsequent burst is approaching.

  7. Posted May 16, 2013 at 7:10 pm | Permalink

    [email protected],6 I am talking about monetary policy, not fiscal policy.

    The second part of both comments seems to be agreeing with me in looking to the dynamics of asset markets to explain asset price surges and collapses.

  8. Posted May 16, 2013 at 7:53 pm | Permalink

    [email protected] I am sceptical of the demographic explanation, since the economic stagnation is fairly clearly the fault of the BoJ, the remedy for which is nicely discussed here (pdf).

  9. John Turner
    Posted May 16, 2013 at 7:56 pm | Permalink

    I checked the article cited on the real rate of interest. That was defined to be to be the real fed funds rate consistent with real GDP equaling its potential level (potential GDP) in the absence of transitory shocks to demand. Potential GDP, in turn, is defined to be the level of output consistent with stable price inflation, absent transitory shocks to supply. Surely the Potential GDP must consider how much potential is being missed because of underemployment.
    According to Modern Money Theory, with the current account balanced private financial wealth can only increase if the sovereign government is running a deficit. The currency issuing government and the central bank can minimise asset value inflation by ensuring that the financial sector acts prudentially. New Economic Perspectives have some excellent blogs on all these problems. The failure of the G20 to carry out their own proposal to improve and strengthen regulation, as stated at the close of their meeting on 31 October,1998, led to the GFC. Then, the Western leaders promised to put in place “international principles and codes of best practice in fiscal policy, financial and monetary policy, corporate governance and accounting” to “ensure that private sector institutions comply with new standards of disclosure.”
    Pity they didn’t do so.

  10. Posted May 17, 2013 at 5:15 am | Permalink

    [email protected] MMT is wrong. And prudential regulation is a different matter, I as I explicitly noted in the post.

    And yes, it would be better if the prudential regulation had been better. Though I doubt that would stop asset booms and busts, it would just make the financial system less vulnerable to them.

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