Thursday, February 21, 2013

Austrians and Predicted Inflation: My Reply to John Carney

Your points in the November 29 column on Paul Krugman and the Austrians makes good points, and I would like to make a few comments of my own.

I do believe that when one makes apocalyptic comments, one gets what he deserves if the predictions don't pan out. As you said, that does not mean the Austrians are wrong regarding money and inflation, but expansions of money, especially in the way that the Fed has gone about doing so, are going to have a number of effects, rising consumer prices being only one of them.

I also believe that some of the Austrians, when they predicted near-instant hyperinflation, should have known better. An expansion in the monetary base can lead to what Milton Friedman called the "pushing on a string" effect, as an expansion of bank reserves will not increase the amount of money in circulation (at least not significantly) if businesses and individuals are not borrowing.

This is not to say that the Law of Marginal Utility, as applied to money, is somehow invalidated. An expansion of money in circulation will mean that the value of the marginal unit – in this case, the dollar – will fall, which means more money will be necessary to complete monetary transactions. That is the straight Law of Marginal Utility, and it applies to money as much as it would to anything else that is scarce.

As Murray Rothbard points out in his book, America's Great Depression, the amount of money in circulation during the 1920s grew, and he terms that as "inflation." However, according to the Consumer Price Index of that time, consumer prices fell by roughly one percent a year, which the late Jude Wanniski used as "proof" that Rothbard was wrong when he claimed that the 20s was an inflationary period. What we witnessed was an apples-and-oranges kind of comparison, as most people (including most economists) generally are used to defining inflation as an increase in the government's CPI, but the Austrians would say that changes in the CPI would be the result of inflation and in our case, the result of the monetary policies of the Fed.

While both Austrians and the Monetarists would see inflation as a monetary phenomenon where changes in relative prices of goods and services occur because the value of money, which is used to denote those relative price relationships, changes as the supply expands and contracts. The Austrians take one step further, however, as they go beyond the quantity effects of increases in the amount of money and look at how these monetary increases change the relative prices of real goods. In other words, the significant effect of changing the amount of money in circulation is not necessarily the changes in consumer prices (although they will change over time relative to the money in circulation), but rather the effect that monetary changes will have upon the relationships of the value of real goods to each other.

This point is vital, for the Austrians hold in their business cycle theory that when the central bank manipulates the banking system to increase the amount of money in circulation, the larger effect is not in consumer price changes but rather the fact that relative values of real goods are changed in a way that directs longer-term investment into lines of production that would seem to be profitable but over time turn out not to be. We certainly saw that in the housing boom and in the tech boom a decade earlier. Investments were directed into production lines that could not be sustained, given the preferences of consumers and their own financial constraints.

In the meantime, the actions of the central bank, when added to various policy initiatives by government, can create these booms that are unsustainable within a market setting and sooner or later are exposed by the markets themselves. When the meltdown became absolutely apparent in September 2008, we were seeing a situation where the market was declaring the mortgage securities held by Wall Street firms to be near-worthless.

(I would like to add a separate point here. Why is it that when a firm tries to manipulate the market to make an asset look more valuable than the market would say it is, authorities view that as being illegal, but when the Fed does it, as it is doing with its QE policies, that is considered "good for the economy"? After all, by purchasing billions of dollars of mortgage securities, the Fed is manipulating their values, given that the sheer purpose of Ben Bernanke's actions is to artificially raise security prices, which is deemed criminal behavior if a private firm does it.)

Krugman has explained that these bubbles were due to nothing more than the failures of private markets, and that unless government regulators intervene, markets always will go over the cliff because, well, because markets are just like that. Yet, if one holds that price signals really do matter, then one would ask why all markets do not behave in the manner we saw. Why not an automobile bubble or a bubble gum bubble or a firewood bubble? Instead, Krugman wants to absolve the Fed, Freddie and Fannie, and the various government agencies that were pushing home ownership and refinancing through policies of having played any part whatsoever in the housing bubble, as he wants us to believe that the problems were due solely to what he and other Keynesians believe to be the inherent failures that automatically accompany market transactions.

Austrians, on the other hand, look for the cause-and-effect. Carl Menger, the original Austrian Economist, begins his classic 1871 Principles of Economics with: "ALL THINGS ARE SUBJECT to the law of cause and effect. This great principle knows no exception, and we would search in vain in the realm of experience for an example to the contrary." Why the "irrational exuberance?" Krugman holds to the Keynesian line of "animal spirits" of investors, but that is no cause at all. Why shouldn't "animal spirits" bid down the values? Do they believe that investors are irrational when bidding up asset prices, but are rational when bidding them down? The Austrians would say that Fed policies of driving down interest rates where they would greatly affect mortgage markets, along with the drive-people-into-home-ownership policies of the Federal government created huge incentives for the creation of the housing boom, which ultimately turned into a bubble, and then a huge bust.

Regarding the consumer price effects of the Fed's policy of spreading dollars around the world, we can see some price increases in various commodities, i.e. food and fuel. Those of us who purchase gasoline or go to the grocery story can attest to some very large price increases over the past five years, and farmers where I live tell me they are having to absorb large increases in the price of animal feed, fertilizer, and diesel fuel. While Krugman wants to explain away these changes as being driven purely by inherent "volatility" and economic growth in places like China, it would seem to me that large increases in the money prices of those things denominated worldwide in dollars just might be due to large increases in the amount of money being poured into these assets and lines of production.

There is one more point. The Fed has vastly increased its balance sheet and has been spreading dollars around the world, mostly to purchase "assets" that essentially have little or no value so that the holders of those assets do not have to take the necessary financial bath. Such actions would not necessarily result in a huge increases of consumer prices overall, but they would have the effect of directing real investment away from those lines of production that would be both profitable and sustainable. Whether it is protecting the banks or the "green investors" or governments that have spent themselves into financial oblivion, the Fed has stymied the recovery by forcing assets into production areas that are doomed to failure. The result is what we see around is in the anemic economic growth.

Where some of the Austrians went wrong was in assuming that all of the Fed's new money pumping would be channeled into the purchase of consumer goods, thus driving up their prices. We have to look at where the new money is going, not where we might think it is going.


Curt- said...

Beautifully written, Mr. Anderson. Thank you for this blog.

Dennis said...

Most people define inflation as any increase in prices above zero in some loosely defined measure of consumer prices. There are several problems with this approach:

1. The official measure of inflation has changed over the past thirty years such that current yardsticks deliberately underestimate price rises in certain "volatile" consumer goods. Most measurements now downplay or expunge food and energy prices from official statistics on inflation. The same statistics also overestimate price deflators like increases in computer processing speeds.

2. Inflation does not affect the prices of all goods equally or all at the same time. We saw this clearly during the housing boom in which housing prices skyrocketed while prices of basic consumer goods remained stagnant. Yet Keynesians typically do not recognize the housing boom as an inflationary period.

3. Inflation is not merely an increase in consumer prices above zero. It can also be a positive increase in prices during a period in which the general price level ought to be in negative territory. If the general price level should be negative 20 percent, but is actually registering a positive 2 percent rate, the real rate of inflation is 22 percent, not 2 percent.

The collapse in asset prices that followed the housing boom should have had knock-on effects on asset prices in other sectors and on consumer prices across the board, thus driving the prices of these assets and goods sharply downward as well. Fed pump-priming measures have prevented this from happening as actors in the housing market had their near worthless assets, and the purchasing power that goes along with them, magically restored to full value. The value of these assets, however, cannot be made whole just by shunting them to the Fed's balance sheet. For an economic recovery to occur, the true negative value of these assets must be realized and accounted for.

Anonymous said...

Daniel Kuehn linked to your blog the other day.

You can learn a lot from reading this post and the compliments he gave Bob Murphy too here.

JB McMunn said...

Where a lot of Austrians blew the call was fixating only on things like M2. The credit market is vastly larger than money supply. Credit contracted and the value of credit on bank balance sheets probably did too, although thanks to the accounting changes made in 2009 there's no way to prove it. Hard to imagine it didn't happen given all the defaults and foreclosures.

Bala said...

Thank you. This is so well written that I have to share it.

p.s.: I have one grammar-Nazi observation, though. Sentence 1 of Para 5 seems incomplete.

Locus said...

In 2002 Krugman said that,

"Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble."

In 2005, Krugman admitted that the Fed *had* created a housing bubble and that it wasn't surprising because...

"After all, the Fed's ability to manage the economy mainly comes from its ability to create booms and busts in the housing market."

But by 2010 Krugman completely changed his story and tried to absolve the Fed by saying...

"These considerations suggest that it would be wrong to attribute the real estate bubble wholly, or even in large part, to misguided monetary policy."

And then by 2012 Krugman started flat-out lying about what he said in the past by claiming he "never bought the story" that the Fed was the cause of the Housing Bubble. I guess it was the other Paul Krugman at the NYT who wrote that column in 2005. ( video: 32:40 mark )

And most recently Krugman has said that the housing bubble was "just one of those things that happens" every once in a while.

I have some serious concerns about Krugman's character.

Dinero said...

Good finds Locus

and here is Bernanke describing the "tools"

Pulverized Concepts said...

What's the plan for the disbursement of Fed-purchased assets when everything returns to "normal"? Were these assets purchased by the Fed at the price the sellers paid for them? And, if so, wouldn't a second housing boom be required to raise their market value to the Fed's investment? Is there a mechanism needed to get reliable buyers to move into these houses? If so, what is it?

Bob Roddis said...

Thanks Locus. I had never before found the Krugman piece from 5/27/05. That's great.

Dennis said...

Were these assets purchased by the Fed at the price the sellers paid for them?

Yes they were. Investor's losses were made to vanish by shunting the worthless assets onto the Fed's balance sheet.

And, if so, wouldn't a second housing boom be required to raise their market value to the Fed's investment?

Theoretically yes, but generally investors, once hurt badly by getting involved in one boom, rarely repeat their mistake by investing in a second one in the same sector. I think this attitude is why the housing market remains moribund despite the Fed's efforts.

Dennis said...

Here an insightful article related to the topic of this post:

Here's a quote:

"The real danger of QE is not the risk of hyperinflation, but the possibility that there is a "bubble" created in the bond market by artificial government purchases and that eventually there will be some failed auctions followed by a quick sharp rise in rates. This rise in rates will affect mortgages, consumer debt and, perhaps most alarmingly, the Federal debt cost. A quick rise in mortgage rates will not only slow down home purchases, but will add to the costs of anyone who has an adjustable rate. The Shadow Inventory which is still estimated at over 2.3 million homes will start to increase again as people are unable to make the drastically higher mortgage payments. Car loans, credit card payments, student loans and other consumer debt costs will increase and further dampen demand. Inflated asset prices will turn over violently."

I'm not so sure, however, that the Fed would allow a bond auction to fail in the first place. They and the U.S. government literally cannot allow such a thing to happen. When enough investors realize that the Fed is openly and regularly rigging the bond market, that will trigger a catastrophic fall in the value of the U.S. dollar and subsequent hyperinflation.

Why aren't we seeing panic selling of U.S. dollars and hyperinflation right now? I suspect the reason is fear, amongst investors, that if one of them raises an alarm there will be a stampede to the exits that may crush them. For the time being, most investors are just keeping quiet. Bubbles are like that.

Anonymous said...

This has now become a new favorite website.
I frequently visit a finance and economic blog where Cray Krugman has now begun to peruse and parade. From now on, each time I see his comments, I will reply and place a link to this blog. :) Nothing, I'm sure, would irritate him more!