ABCT, the Housing Bubble, and the Expansion of the Higher stages of Production

Economics Economics Questions
1

As I have been rereading some ABCT texts and looking at our current crisis, I keep running into roadblocks inside my head when applying the ABCT to the housing bubble. The ABCT commonly states that businessmen take out loans for higher stages of production, meaning those which are more remote from consumption. However, since interest rates have only been lowered because of an expansion of fiduciary media, the real resources (construction material, capital goods, etc) have not, so the businesses must pay higher prices for these goods. In order to continually do so they must borrow more, which raises the interest rate. Of course the interest rate may continue to fall because the Fed keeps printing more money, and keeping hyperinflation out of the picture the crucial fact is that the interest rate must rise and the projects started are no longer profitable.

However (and I may be wrong on this) housing is closer to consumption. When picturing the ABCT in my head I imagine booms in more industrial plant, mining, and manufacturing sectors. Housing is closer to consumption, people buy houses mainly to live in them and live it up. While people do look at them as investments for the future, I am having trouble seeing as how they are part of the higher stages of production.

Can anyone help me out on this? Thanks.

2

bump to refresh

Thanks.

3

Housing is a durable good. The period of savings that must be accumulated lasts over years, while the period of savings that must be accumulated to buy dinner or a hair cut is only one day.

4

Ignore the “lengthening of the structure of production” part of the theory. It doesn’t make sense and it never will. Lower interest rates do not necessarily correspond to longer term investments.

Besides, low intest rates only contributed marginally to the housing bubble and certainly had nothing to do with the current unemployment levels. I suggest looking at the ABCT as merely one possible contributer to a “perfect storm” of both government and market failure, not the entire story.

5

A house is like a capital good in that it requires an investment in the present in order to provide a benefit in the future. Because the production of a house takes place now, but the “consumption” of the house will occur over an extended period of time, houses generally require loans just like any other capital good.

6

Ignore it? That seems a little weird because then the vast majority of the theory would be incorrect. The part I’m trying to get is why the investments made are not profitable for housing. For higher order production stages then resources are not freed from lower stages. For a house then the resources are being devoted to construction when they should go elsewhere.

7

Housing is a strange sector, but when the cheap money was steered into housing, what happened? First, people were pulled into that market who did not treat houses as consumer goods, but as investment goods. Second, just look at the mechanics of it. If I’m speculating in the housing market, what do I do with the cheap money? I buy up resources that have other, more profitable (if the money supply hadn’t been inflated) uses, and use them to build houses. Certainly, I’m not going to live in all of them. For me, this is a higher order good - I make the houses (which takes a period of time) in order to sell them to others, not for my own consumption. Either I won’t find buyers or, if I do, it might turn out that they don’t actually have the savings and they won’t pay the loans (as happened.) This brings us to the ABCT.

8

Look at where the newly created money goes. Housing was extraordinarily cheap, at least in the short run, to buy during the bubble, you could get a loan for zero down or less (many cases of being able to immediately turn around and get a home equity loan so you came out of the deal with more money).

Could this have happened without a massive expansion of the money supply?

The regulations and tax laws in place only influenced where the newly created money went. If it wasn’t housing, there would have been a boom in another industry where you needed to take on long term loans. But the money would have went somewhere, and we still would have had an ABCT boom and eventual bust.

Jesus Huerta de Soto is much clearer than most about where the money could go (it could go into consumer credit instead of producer credit, like in this boom at least in the States). You might want to add his Money, Bank Credit, and Economic Cycles to your reading list (it’s available in the literature section as a free download).

9

Why would the majority of the theory be incorrect? The theory is that under certain conditions, an exces supply of money will result in malinvestment. The amount of the malinvestment is equal to the amount of credit generated by the short run increase in the real supply of money. Production process length has nothing to do with it.

10

housing is interest-rate sensitive because people need loans, plus a lot of money got steered there because of all the government regulations, zoning laws, fannie/freddie, home-ownership society lowering of standards, etc.

11

Of course it does.

Interest compounds, it’s obvious longer processes of production (and more durable consumer goods) are going to be affected more by interest rate movements.

12

You’re wrong for two reasons.

One, there is something called reswitching in which a lower interest rate can actually lead to a shorter prodction process.

Second, interest rates have nothing to do with the Austrian theory anyway. Simply an excess supply of momey shouldn’t lead to longer processes.

13

reswitching - http://mises.org/daily/1148

a single source to back up your claim? maybe something that mentions time preference…(or somehow doesnt !)

14

Murphy doesn’t deny reswitching. He just says it’s reasonable to assume it doesn’t happen very often. This is true, but my theoretical point still stands.

I used Mises’ version of the ABCT from the Theory of Money and Credit. He may mention interest rates there but they are not central.

Here’s a more modern source: http://www.springerlink.com/content/c9860q27833t4021/

15

<<And third, the main harm from loose monetary policy is not that it encourages entrepreneurs to behave more recklessly with capital, but that it encourages precisely the people who can’t afford capital at the market rate to borrow, and makes them the marginal trader. >>

obviously. marginal traders mentioned are precisely the ones ‘activated’ by realtively lower interest rates

If you give the entrepreneur more time to produce a given output, he can generally do it with fewer inputs of labor and raw materials. Or we could put it this way: If you give the entrepreneur the same amount of labor and raw materials, he can produce a greater output the more time he is given to work with.

More generally, the basic Austrian vision of the effects of saving can be summed up like so: If individuals are willing to sacrifice consumption goods (on the margin) now, this allows the creation of more tools, machines, factories, etc. than would have existed otherwise. This in turn renders labor more productive, so that after the new capital goods are produced and have been integrated into the economy, average output (and hence consumption) is higher than it would have been without the increased saving. Böhm-Bawerk felt that this story was accurate, because at any given time there are more technically efficient but very time-consuming processes “on the shelf” that are unprofitable at the market rate of interest, but would become profitable at lower rates.

what do you dispute here? <<<<<<<<<<<<<

Does Samuelson’s model cast doubt upon this? That is, does Samuelson feel that in the real world—as opposed to the one with only two techniques of production—the “simple tale” as told by Böhm-Bawerk and others is wrong?

No, actually he doesn’t. After showing how his hypothetical technology would allow for a drop in the interest rate to cause a lower capital stock and lower steady-state consumption, Samuelson says:

Whether it is empirically rare for this to happen is not an easy question to answer. My suspicion is that a modern mixed economy has so many alternative techniques that it can, so to speak, use time usefully, but will run out of new equally profitable uses and is likely to operate on a curve of “diminishing returns”…

In other words, after demonstrating the logical possibility of a world in which Böhm-Bawerk et al. are wrong, Samuelson admits that when it comes to the real world, his own suspicion is that these writers are exactly correct.

16

Ok technically you’re right on this one.

But you’re wrong here.

Mises in Human Action said outright that inflation of itself does not cause the business cycle, only artificial credit expansion does. And once you go through the theory of production it becomes obvious why it’s so.

17

An increase in the supply of money MAY lead to an excess of credit. I don’t see why this should be correlated with longer processess.

18

That’s the point, you said lower interest rates are irrelevant to Austrian theory.

That’s wrong, Austrian theory differentiates between what happens when inflation leads to credit expansion, and when it doesn’t.

It’s an example. One that fits most of real world scenarios, and you have to come up with cute unrealistic ones to contradict it. So you were wrong to say that poiting to length of production processes doesn’t make sense (and never will).

19

Interest rates are a theorized transmission mechanism. I say they are a bad indicator of the Austrian theory. Say the increase in the money supply leads to a temporary increase in credit along with a rightward shift in the demand for investment. The interest rate will stay the same but there still might be malinvestment. The increase in credit is not necessarily correlated with lower interest rates.

The original question was whether or not housing is an early stage or a late stage. My point is the answer is ambiguous. We can define length of process any way we want but we won’t gain any insight from it.

20

yes, they are lower than what they would have been otherwise. you are not thinking ceteris parabis. abct is a theory of malinvestment, its based on intertemporal disequilibrium. entrepeneurs are fooled by easy credit, into thinking that time preferences have changed. i.e. that consumers will prefer greater future consumption over present consumption than previously. this is later revealed to have been an illusion cause by loose money. and so all these greater ideas for investment to serve the forward looking consumer turn out to have been foolish. they represent sunk costs and wasted resources.

I suppose axles have nothing to do with propelling motorcars forward, they are only a transmission mechanism…