Help re: someone challenging ABCT based on this business cycle

Economics Economics Questions
1

OK, I’m having a discussion with someone on another forum in a thread that is entitled:

Why Are We Still in a Recession?

I made the claim that our current problems are due to the Fed’s ramping up the money supply and artificially holding interest rates too low for the years leading up to “The Great Recession”, causing a classic boom/bust cycle.

I copied a link to Roger Garrison’s Power Point presentation to a class on YouTube which I thought did a good job of explaining it.

I was challlenged, however, by someone claiming that the hypothesis didn’t match up to the facts:

chap08 : JeffDB, just on the video. If you believe the model presented, then please tell me, if (1) “the interest rate is dominant in the early stages of production”, and (2) over the last year we have had extremely low interest rates; then why, over the last year, have we not seen a massive investment boom in the early stages of production? Why, in fact, have we seen the exact opposite?

My followup was that it was like trying to keep someone going with coffee, that eventually you couldn’t keep them awake anymore with the stimulus etc. We had been in a boom cycle for a long time and the resources just weren’t there to keep it going.

chap08 replied:

JeffDB, thanks for the response. I understand, but go back to the question I put to you. You haven’t answered it - and I don’t think that you will you be able to. According to the original theory, the artificially low interest rates cause over investment in the higher orders, or early stages of production (malinvestment = over lengthening of the Hayekian triangle). This is not what we observed. What we observed was a real estate boom (around the world as you describe). That’s different.

What we actually observed was under investment in the early stages of production prior to the collapse of 2008. But given that, and given the other points in my question, we should, according to the model, have seen an investment boom in the early stages of production over the last year. This would have been driven by the prior under investment and smart entrepreneurs responding to low interest rates. Of course we haven’t seen that. We have seen the exact opposite. That, in summary, is because of two key things:

  1. The model gets some important details wrong.
  2. The model fails to take in to account the collapse in demand and increased desire for saving, that are driven by our psychological reactions to the bust.

Any thoughts on his contentions?

2

Overinvestment in durable consumers’ goods like houses IS an overinvestment in a higher order of production. A new house is a lower order producers’ good for the unit services it is expected to provide in the near future and a higher order producers’ good for the unit services it is expected to supply in the distant future.

An investment boom is characterized by higher investment than there WOULD HAVE BEEN without the artificially low interest rates, not necessarily higher than the period before. In brief, we SHOULD have had a MORE steep and painful liquidation of malinvestments than we did, but that was precluded by Bernanke’s credit expansion.

3

He did have a followup in which he expounded upon his thesis and in reply to my response. Here’s an excerpt:

http://seekingalpha.com/user/436500/comment/877855

  1. Austrian theory is not just that low interest rates cause malinvestment, it is explicit about what malinvestment occurs and how it happens. According to Austrian theory, we should have seen over investment in capital goods manufacturing and under investment in retail and consumer goods. The recession would then start when it was discovered that businesses had over invested in capital goods and investment now needed to be re-directed to consumer goods. (If you don’t know what I’m talking about here, see Rothbard’s Economic depressions: causes and cure, it’s a good short summary). This is almost the opposite of what we did see, which was a consumer boom. There was comparatively little investment in capital goods in the US.
4

He’s still making the same mistake of not realizing the “consumer boom” (housing) is a boom in higher order goods, because it’s a DURABLE consumers’ good.

5

I found the article he mentioned:: Economic Depressions: Their Cause and Cure - http://mises.org/tradcycl/econdepr.asp

I think these are the types of passages he was alluding to when he alleged that the Austrian economics predicted a boom in producer goods and a dearth of consumer goods

Here is another fact of business cycle life that must be explained–and obviously can’t be explained by such theories of depression as the popular underconsumption doctrine: That consumers aren’t spending enough on consumer goods. For if insufficient spending is the culprit, then how is it that retail sales are the last and the least to fall in any depression, and that depression really hits such industries as machine tools, capital equipment, construction, and raw materials? Conversely, it is these industries that really take off in the inflationary boom phases of the business cycle, and not those businesses serving the consumer. An adequate theory of the business cycle, then, must also explain the far greater intensity of booms and busts in the non-consumer goods, or “producers’ goods,” industries.

“For the time-preferences of the public have not really gotten lower; the public doesn’t want to save more than it has. So the workers set about to consume most of their new income, in short to reestablish the old consumer/saving proportions. This means that they redirect the spending back to the consumer goods industries, and they don’t save and invest enough to buy the newly-produced machines, capital equipment, industrial raw materials, etc. This all reveals itself as a sudden sharp and continuing depression in the producers’ goods industries. Once the consumers reestablished their desired consumption/investment proportions, it is thus revealed that business had invested too much in capital goods and had underinvested in consumer goods.”

.“there were not enough savings to buy all the producers’ goods, and that business had misinvested the limited savings available. Business had overinvested in capital goods and underinvested in consumer products.”

6

Right, and there is nothing inconsistent with the housing bubble and the business cycle as portrayed here by Rothbard. He only thinks there is, because, again, he doesn’t realize that durable consumers’ goods are producers’ goods.

7

Housing is a long-term durable good, which is extremely sensitive to reductions in the rate of interest. To quote Wicksell:

  • An abnormally large amount of investment will now probably be devoted to durable goods (a result of an artificially reduced market rate of interest relative to the natural rate)… There may result a relative overproduction of such things as houses and a relative underproduction of other commodities. Interest and Prices, pp. 96.
8

Thanks for the help guys, it’s much appreciated.

It also jogged my memory of Peter Schiff repeatedly warning about the housing bubble in the years leading up to the eventual popping of that bubble.