I’ve been a consistent advocate of the Mises–Hayek theory of industrial fluctuations — ABCT, for short — as the most relevant model to interpret the “Great Recession.” Unfortunately, the empirical work to apply theory to history has been mostly preliminary and inadequate (although, of course, some attempts have been better than others). I’m interested in taking up some of the work myself, if I find the time. This post serves the purpose of collecting some of my thoughts on the topic; similar ones may follow. The end product, ideally, will be a paper.

To claim that my focus is only applying ABCT is a bit misleading. Most of my concern does revolve around how well the theory fits history, but I’m convinced that there are other theories that also have some explanatory power. Sometimes, I think the substance of other models is implicit in the Mises–Hayek one, but since some economists emphasized certain aspects of the business cycle more than others it helps to include them in the analysis more explicitly. Other theories that are somewhat compatible (depending on how you interpret them and what you decide to leave out) include Irving Fisher’s theory of debt deflation — at least, as far as “secondary deflation” goes —, Hyman Minsky’s theory of leverage build-up and financial crises (e.g. Keen [2011]), and work that centers on financial mechanics. Examples of this latter category include work on balance sheet recessions by Richard Koo, and the interpretation of the financial collapse by Gary Gorton (also, Gorton [2010] and Gorton and Metrick [2009]), and Jeffrey Friedman and Wladimir Kraus.

The history of the financial sector before and during the financial crisis is pretty well documented, and I think that most people more-or-less agree on the broad details (,or maybe not). Where there is disagreement is on the “social function” of different types of financial instruments and actions, but I don’t think this is too relevant or important. Also, there is disagreement on why history followed the path it did — was it greed, regulations, government more generally, ignorance? This is the question that I’ll seek to answer empirically, by attempting to apply ABCT to the data.

Early on, there was some blogosphere discussion, mostly between libertarians, on whether or not ABCT has any explanatory power. It seems as if the controversy has died since the years immediately following the financial crisis, but the essence of the debate revolved around whether a housing bubble is really an example of a credit-induced boom in the capital goods industry. There was a point when most economists, and not just Austrians, did treat durable goods as the equivalent of capital goods. But, the more I think about it, the more I come to believe that it really doesn’t matter.

The common description of ABCT is where the rate of interest on loanable funds falls due to the central bank or an act of credit expansion, “unbacked” by savings. The typical ideal type then depicts this new credit as flowing into the capital goods markets, gradually lengthening and widening the structure of production. The essence of the theory, though, I believe is not in how the structure of production changes as a result of credit expansion, but on the role of “phantom profits” in causing these alterations. Liquidity injections increase nominal demand for certain products, stimulating investments along these lines, and when this demand ceases or decreases then these new businesses suddenly become unprofitable. In the real world, changes in the structure of production might not follow the pattern developed by Friedrich Hayek in Prices and Production — his triangle now the preferred diagram to depict capital theory —, but this doesn’t mean that ABCT isn’t relevant.

Allow me to momentarily digress.

The enigma that remains in explaining the Great Recession is: what caused changes in housing prices? The worst of it all, answering this question explains why the financial sector behaved the way it did — the weakest point of most books on the topic. The logic behind issuing adjustable rate mortgage loans, near the crest of the bubble, rested on the belief that prices would continue to rise. That way, a borrower who would otherwise risk default would be able to refinance the house. These loans were considered low risk, and those that weren’t were simply packaged into securities, where the mixing of loan qualities was meant to spread the risk. The financial system swam neck-deep in the mortgage market on the basis of the belief that housing prices would continue to ascend. At the very worst, most supposed, price stagnation or fluctuations would occur only as isolated events, in specific geographic locations.

Why the housing market? During and following the 2000–02 recession, Greenspan’s Federal Reserve reduced the Federal Funds rate; the discount rate and 30-year mortgage rate correlate pretty well in terms of pattern of movement. The macroprudential regulatory framework also encouraged banks to invest in the mortgage market, because these were generally rated relatively highly and could be securitized, including by an agency. In a sense, credit expansion fed itself. Old loans would be packaged, sold, re-packaged, and re-sold. Investment banks would buy it from loan originators, which could issue more loans. This organization of the mortgage market induced even lower mortgage rates, since the risk was being more widely distributed. This process of credit expansion into the housing market is what pushed the increase in home prices.

The essential feature of the Mises–Hayek theory is present: credit expansion creating profitable investment opportunities that otherwise wouldn’t have existed. What caused the malinvestment to present itself? Stagnating prices between late 2005 and early 2007 (the change in direct occurred in mid-2006, according to the Composite-20 Case–Shiller index). This is the second part of ABCT, where the “phantom profits” dry up and investments based on them begin to falter. It is a case where the profit and loss process is distorted for a substantial period of time, and people make certain investments that seem profitable under given, predicted conditions. When the foundations of profitability — credit expansion — give way, the whole edifice comes crumbling down.

Of the entire puzzle, explaining why the housing market began to sputter is the most difficult piece. Was it the slight increases in the discount rate (these, again, correlate with changes in mortgage rates)? Alternatively, a lot of economists blame adjustable rate mortgages, because these started to be lent out in high volumes in 2005. Thus, it was in 2007 that many of these loans saw their teaser rate periods end, coinciding with increases in default rates. But, this was a symptom of more fundamental changes. It wasn’t supposed to be a problem, since that plan was for the homeowner to refinance. The key issue is that the plan was undermined by stagnating, and then falling, housing prices!

(This is certain to be one of the most difficult answers I will be looking for. I hope that it isn’t obvious, and that I’m completely missing what’s in plain sight!)

My general task is to figure out how the structure of production changed, and what I’m leaving out. I also have to be able to recognize the limitations of ABCT. For instance, part of the proceeding liquidation was caused by Federal bankruptcy laws, that induced a scramble for liquidity and premature bank failures. The Mises–Hayek theory provides a basic structure and a “big picture.” The details are more complicated, and largely decide how the story unfolds. Of course, I’ll also have to consider competing interpretations. But, from where I stand now it seems that ABCT is the best framework in which to explain the period between ~2000–09.