2007–09 Under an Austrian Lens

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.

  • http://stickmanscorral.blogspot.com/ Grant

    Jon, it’s quite separate from the empirical study that you are mulling here… But here is a very interesting paper by Geanakoplos et al. (2012) from the May issue of the AER. It is an agent-based simulation of housing bubbles that is modelled on data from Washington DC. They provide some nice discussion, however, on some of the empirical work that has preceded theirs… with particular emphasis on the role of interest rates.

    Interestingly enough, their findings indicate that the housing boom and bust of 1997-2007 was largely due to the change in leverage (loan-to-value ratios) and not low interest rates.

    • http://economicthought.net/blog JCatalan

      That last sentence is basically what ABCT argues, as well. Credit expansion is synonymous with an increase in leverage, if the former is a product of lending.

  • Rob Rawlings

    Hi Jonathon,

    For me the jury is still out on the relevance on ABCT for the period in question. I would welcome your comments on the following scenario;

    - The CB lowers interest rates below the natural level.

    - This has 2 separate effects

    1. cheaper loans mean that some longer term investment projects now appear profitable. This effect will tend to increase the length of the structure of production.
    2. loans for consumer goods are also cheaper encouraging greater spending on the kinds of goods for which loans are typically taken out. This effect will have an indeterminate effect on the structure of production. If the additional demand is for goods with short production times then the length of production may be shortened.

    - assume that business people expect that the lower IR are only temporary and don’t rush into longer term projects so most of the new money goes into consumer loans that are spent on goods with a short production time (say housing)

    - This spawns a housing boom with lots of resources going into this industry that would not have gone there if IRs had stayed at its natural rate.

    - Eventually (either because of a change in IRs or for some other reason) the boom comes to an end. Much of the investment in housing now proves to be wasted. RGDP falls as the economy restructures away from housing.

    - The excessive debt caused by the need to lend out the new funds causes a debt/deflation driven recession.

    Would the above count as a ABCT type episode or would the fact that the structure of production shortened as the new money went to consumers mean that it wouldn’t ?

    (I am happy to categorize housing as a ‘consumer durable” or even a capital goods, I don’t think that changes things much – the important thing is that the boom changes, but does not lengthen , the structure of production.)

    • http://economicthought.net/blog JCatalan

      Some clarifications. The rate of interest has no direct relationship with the length of the structure of production; it doesn’t lengthen just because loans are cheaper. What causes a lengthening of the structure of production in Hayek’s model is changing relative prices. So, what makes some business ventures profitable aren’t a reduction of the costs of lending (the costs of capital goods rises, remember), it’s an increase in the prices of the output (i.e. profits). And the length of production doesn’t refer to the length of any particular technique, but the number of stages before the final consumer good is actually produced; it could be that a process with nine stages takes less time than a process with five stages, depending on the techniques being used.

      Whether it fits in ABCT, it might be that the only similarity is that prices were distorted. The type of malinvestment might have been very different from what Hayek modeled. But, we do see other basic similarities: volatility in capital goods prices, relatively stable consumer good prices, and credit expansion. I don’t know how long the production process is for housing (how many stages are involved), but I think it’s difficult to decide a priori that it is short.

      • Rob Rawlings

        Re “The rate of interest has no direct relationship with the length of the structure of production;”

        I see the causality as:

        At the margin lower interest rates make additional borrowing to buy expensive capital goods that will last a long time and to invest in additional projects where the product will not be sold for several years to appear to be profitable . This in turn drives up the price of the capital goods involved and increases their production (and so on backwards) causing the relative prices changes that Hayek identified – but there is a direct correlation between lower interest rates and the above process that leads to the lengthening, at least in my opinion.

        • http://economicthought.net/blog JCatalan

          It may be possible that lower interest rates induce build-up of excess capacity, but this isn’t what the Mises–Hayek theory predicts. But, excess capacity build-up presumes that the potential future output, and the proceeds received from selling this output, will be profitable. In other words, it presumes demand for their products. The Mises–Hayek theory is really about how money injections can distort profitability and, therefore, expectations of profitability. To push the case further, I can’t stress the difference between the notion of the “length of the structure of production” and technique. The former has nothing to do with the actual length, in Newtonian time, of a specific production technique. It only has to do with the number of stages between the earliest stage and the final consumer good product.

  • Rob Rawlings

    Apologies, I spelt your name wrong.

  • Current

    I think you should broaden your analysis to include countries outside the US.

    The UK and Ireland also had large property booms and busts. The bust in the UK came shortly before the bust in the US, I think Ireland was about the same time.

    Neither place has a significant volume of sub-prime lending or securitization. In both places adjustable-rate mortgages are the standard, almost nobody has a fixed-rate mortgage and it’s been like that for decades. This clearly disambiguates the “financial innovation” question from the ABCT question.

    • http://economicthought.net/blog JCatalan

      Those are good points. What literature is there that gives an overview of the data?

      • Current

        To be honest I haven’t looked that much and I haven’t found that much when I have been looking. Anthony Evans has discussed it a bit. The Bank of England and the National Statistics Office provide statistics on lending, interest rates and the housing market.