ABCT and Interest Rates.

Economics Economics Questions
1

Austrians, do you agree or disagree with this statement from Milton Friedman:

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy… After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

2

“…has been tight, …has been easy”

Armed with powerful weaponry such as (1) arbitrary lead/lag parameters and (2) a central money creator, anyone could “empirically” beat any data series into any desired submissive position.

In some countries, abundance of outside food donations is generally a sign that food has been tight, and dearth of food donations is generally a sign that food has been abundant.

3

‘High’ interestrates can be to low and ‘low’ interestrates can be too high. So basically; you can’t tell.

Friedman is wrong in thinking that he can generalize from past experience. Interestrates are a price and, just like any price, you can’t make any claims based on historical empirics wether or not too high means x or too low means y, from the standpoint of a historian.

In Austrian theory: ‘too low’ means under the natural rate and ‘too high’ the reverse. A low interestrate will cause monetary injections. That is what we call ‘loose money’.

But the Austrian is talking about a different phenomena in that case compared to what Friedman is talking about.

4

Okay.

To avoid contradiction with the first statement I’ve quoted, you must mean that Austrians can calculate the “natural rate” unproblematically; is that correct?

5

No; of course not. You can’t calculate the natural rate outside the market process. You can’t know the price of bread outside the market process. And wether or not you are an Austrian (economists), doesn’t have any influence what so ever.

And obviously; there is no contradiction. It’s perfectly consistent.

looking at any price in history (set by government) you can’t know wether it’s too high or too low, just by looking at the price. One can understand (verstehen) that it’s too or too high low, based on an interpretation of the facts of the historical circumstance. But that’s a different ballgame.

The same price can be too high in one period of time and too low in another. Especially with something like the interestrate: because interestrates (in the real world) aren’t just based on originary interest; but on risk-assessment as well.

When the Austrian talk about the interest rate being ‘too low’; one isn’t saying: ‘ah, look: it’s 4%, but the average long term trend in economics, is 6%; so it must be too low’ and vice versa. When an Austrian is saying ‘the interestrate is too low’, he means that, given the situation, it should be higher. Signs that give you a clear view that the interestrate is too low are, for example, the monetary base expanding enormously or the interestrate being zero. They are counterfactual concepts.

Like saying: ‘I think this food has been in the microwave for too long’. You can’t say that based on the time it was in the microwave, because you can’t know how long it had to be in there. (Maybe it was deep frozen, so it had to be 7 minutes, or it wasn’t, and than it’s only 4.) But you can know it from deducing it from comprehending that food shouldn’t be like this (all burned up and all). I don’t want to overstretch the analogy, but that sort of grasps the concept.

What Friedman does, is looking at the time it was in the microwave, without looking at the food before it got in, nor at the food when it came out and saying ‘well, if food is in it longer then 5 minutes, it’s bound to be in there too long and it’s less then 5 minutes, it’s bound to be too short’. But that, obviously, doesn’t make any sense.

I really don’t get how you can say ‘in order for you to avoid contradiction, you must mean the austrian can calculate the natural rate unproblematically’. It’s not just that you are interpreting it wrong. It’s really: I have literally no idea how you can interpret it like that.

6

[n.b. I use the term “liquidity trap”. I define it below; I do not meant it in the classical Keynesian-Hicksian sense, but rather by the more modern definition (as specified below).]

The interest rate is a price mechanism, and as was established in that other thread, not the only thing which factors in an entrepreneur’s decision whether or not to invest. If we define a liquidity trap as a situation in which despite an increase in available credit, there is a stagnation or a decrease in private investment, then I think it’s possible to claim that at the time of Friedman’s writing (and perhaps still; I haven’t been keeping track of the Japanese economy) Japan was in a liquidity trap (per Krugman). So, Austrian theory largely relies on the notion that this new credit will enter circulation through loans, but in a liquidity trap this may not be the case.

If money in circulation (or with a velocity greater than zero) is decreasing, despite low interest rates (due to a liquidity trap), then it makes sense that one could confuse low interest rates with tight money. John Maynard Keynes said that the only possible example of the liquidity trap he could think of was 1932 (his definition of the liquidity trap was simply a lack of lending due to high uncertainty [TGT, p. 205-207]). Furthermore, Rothbard chronicles the state of the money supply at the time, noting that uncontrolled reserves (i.e. loans outstanding, demand deposits, etc.) were contracting faster than controlled reserves, which explains why there wasn’t an accelerating expansion in the supply of money in the United States.

So, I think there is more to high and low interest, and tight and easy money respectively, than Friedman suggests.

7

Friedman is ignoring many of the variables he himself pointed out, namely that the liquidity effect holds under the ceteris paribus condition, and that the various effects of monetary expansion are temporally disconnected. Furthermore, Milton Friedman could never grasp the concept of relative price alterations/manipulation; he always thought in pure aggregates. No Austrian would say that you can’t have general price inflation and historically high interest rates. According to ABCT, interest rates will spike once the rate of monetary expansion is no longer able to maintain the malformed capital structure (this may or may not coincide with general price inflation). This is precisely what happened in the 30s (which proceeded a period of intense monetary expansion and low interest rates–low relative to the natural rate).

And finally, Volcker allowed interest rates to rise in the 70s in order to purge the economy of malinvestments. This sent the economy into a recession, which was then followed by a period of robust economic growth. Unfortunately, Greenspan’s inflationary policies turned robust growth into an unstable inflationary boom. If the Federal reserve elevated the FFR through contractionary monetary policy, interest rates would skyrocket, the economy would go into a depression, and we would most likely see intense general price deflation.

I’m pretty sure you took this quote out of context. Friedman knows better.

No one can calculate market clearing prices–that’s what markets are for. Your implied argument rests on the premise that markets are perfect and invulnerable to manipulation, which is, of course, absurd. This is why mainstream macroeconomics is in serious trouble and why so many are turning to behavioral economics, Hyman Mynsky, and the Austrian school.

8

just a suggestion, but i think that the communication in this thread would be greatly improved by introducing distinctions between nominal and real interest rates.

http://en.wikipedia.org/wiki/Nominal_interest_rate

in most cases, we only directly observe the nominal interest rate, which is the interest rate before adjusting for inflation (nominal interest rate (i) = real interest rate (r) + inflation (p)). friedman is saying a lot of people see falling nominal interest rates and assume that the Fed is flooding with money (that falling nominal rates are attributable to falling real rates). that may be true, but it need not be the case. it could be that people are actually expecting negative inflation (deflation), which is certainly not caused by expansionary monetary policy.

Friedman is essentially saying it is unproductive to judge the direction of monetary policy based on solely on interest rates. and this message would come through loud and clear if we simply cleaned up our terminology.

PS* it would also help some avoid making confusing statements like these. “No Austrian would say that you can’t have general price inflation and historically high interest rates.” on the contrary we likely expect periods of inflation to be associated with high nominal interest rates, because people would take expectations for continued rising prices into account when settling on a nominal rate of return.

9

First of all, I reject the nominal/real distinction, or at the very least, I find it unessential.

How is this confusing? It doesn’t get any clearer.

[edited]

10

esuric,

i am sure this is yet another difference in terminology between austrians and the mainstream, but in mainstream usage the liquidity effect refers to the notion that monetary expansions are followed by falling nominal and real interest rates. so i am not quite sure what you mean at the moment.

PS* http://faculty.chicagobooth.edu/john.cochrane/research/Papers/Return%20of%20liquidity%20effect.pdf

11

You’re right, I apologize. Mishkin wasn’t too clear in his textbook.

12

no worries