Saturday, January 7, 2012

Yglesias Explains Austrianism [and Fails]

Matt Yglesias tries to give Slate's readers a thumbnail sketch of Austrian economics demonstrating only that he's unfamiliar with, um, Austrian economics. Now, it isn't the vicious take-down I expected, but it does contain the usual inaccuracies -- particularly when he tries to refute the theory of booms and busts.
More broadly, the Austrian story of investment booms and busts doesn’t actually explain recessions and unemployment. Spending patterns shift all the time without sparking a recession. People stop buying BlackBerrys and they buy iPhones instead. Or people stop buying boot-cut jeans and buy skinny jeans instead. Across sectors, maybe people go see fewer movies and with the money they save they eat out at nicer restaurants. A business that curtails its investment spending should have extra money to pay out as dividends. Or if they want to horde the cash, it sits in a bank for someone else to lend out.

It may seem “obvious” that the decline in housing activity caused the current recession, in line with the Austrian view, but in fact fixed residential investment turned negative in 2006 [Link in original]. It stayed negative for more than a year before the recession began, and then continued negative for a couple more quarters before it turned severe. People spent less on home-building and renovation and more on other things. If investment spending in general declines, you would expect spending on consumer goods to rise to offset it. In practice, this doesn’t always happen and you get a recession. It’s this anomalous collapse in overall spending that needs explaining, and describing some of the past spending as “malinvestment” doesn’t help you understand it.

First, it isn't the Austrian view at all that the recession was caused by the decline in housing activity; it was caused by the Federal Reserve's monetary expansion policy which allowed the explosive growth in housing. The eventual drop in home building and home sales were merely symptoms of the recession which was triggered by the collapse of the mortgage markets. Much of the housing built during the boom turned out to be malinvestment because the demand for it was artificially created by cheap mortgages and the federal government's insistence that consumers with poor credit and low incomes be granted loans.

But such malinvestments are disguised until the credit that supports them is withdrawn. It is only then that it becomes obvious that a bubble had formed and is now deflating. The theory posits that the inevitable bust is caused by the central bank's hiking of interest rates. Interestingly enough, that was not the case this time. The banks, themselves, raised rates and eventually ceased lending out of fear for their own survival, but the effect was the same.

Homeowners with poor credit histories and/or incomes insufficient to make payments began to default first. The banks tightened their credit requirements which caused homes to remain unsold. Construction companies began laying off employees and curtailing their purchases of raw materials. Housing prices fell as sales slowed causing millions of mortgage-holders to go "upside down." And, as people lost their jobs, even more loans became delinquent. By the first quarter of 2008, not only residential investment was falling, but investment in general followed by consumer spending. It's only natural that consumers spent less; unemployment usually requires it.

Yglesias then makes a very curious statement: "If investment spending in general declines, you would expect spending on consumer goods to rise to offset it."

Why on earth would you expect that? I can only assume Yglesias is speaking of personal investment, but the investment figures in the national accounts refer to business spending. As mentioned above, as credit tightened at the beginning of 2008, businesses found it more difficult to extend lines of credit and obtain funding for expansion. As they cut back their investments (spending), they also began to shed jobs. Since this investing is in the form of purchases from other businesses, those also saw a drop in sales and started shedding labor as well.

It shouldn't be a mystery why, when people are put out of work, their consumption spending drops. This process gathered speed all during 2008, culminating in the September banking panic. Yglesias states that it is this "anomalous collapse in overall spending that needs explaining." Consider it explained.

[UDPATE:] I also want to address one other point Yglesias mentioned: this oft-stated objection to Austrian theory.

But it doesn’t make much logical sense. For one thing, as George Mason University economist Bryan Caplan, who’s ideologically sympathetic to the Austrians, points out, it’s hard to understand why businesspeople would be so easily duped in this way. If Ron Paul and Ludwig von Mises know that cheap money can’t last forever, why don’t private investors? Why wouldn’t firms avoid making the supposedly dumb investments?

I suppose it is fair to say that businessmen are duped by low interest policy, but they are not easily duped. The Fed's artificially low interest rates are not short term deals. In fact, they often last for years. And during that extended period, all sorts of markets become distorted by activity that wouldn't otherwise have occurred. I mean, spurring new business activity is the purpose of Fed operations, isn't it?

As an example, my former employer, a manufacturer of liquefied industrial gases (oxygen, nitrogen, argon, etc.) found a very profitable market supplying liquid nitrogen to the Wyoming shale oil fields starting in around 2003. With the world price of oil soaring, shale oil extraction had become viable and we were running flat-out to supply the quantities of nitrogen demanded. In fact, the amounts were growing so huge that we were trucking product from hundreds and even thousands of miles away at tremendous expense (diesel fuel's price had soared along with oil's).

The company decided to double the capacity of its Denver plant and just as it neared completion in 2008, the bubble popped. Oil prices swiftly crashed below the shale oil's break-even point, the fields shut down and the multi-million dollar plant expansion was mothballed before it had ever even been started up. It had ended up being a malinvestment.

But in 2004-2005, when the decision was being made to expand nitrogen production, it wasn't obvious at all that oil was in a bubble. China's stupendous industrial growth was most often cited as the reason for oil's rising prices. And with India following closely behind along with a booming U.S. economy, there was little reason to think conditions would change. It's perhaps easy now to realize what a foolish assumption that was, but it was near-universal thinking at the time.

So, it isn't simply a matter of businesses embarking on risky ventures they realize wouldn't pay off at a higher cost of capital -- that's almost always taken into account. No, it is the ever-expanding circle of market distortions caused by longer and longer periods of credit expansion that eventually create the atmosphere in which serious business miscalculations can be made. It sounds as if a good dose of capital theory might be in order for both Yglesias and Caplan.

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