As always the best way to explain anything is with a story - and in this case a true story.
Forest fires are a major concern in many parts of the U.S., upsetting lumber companies who saw profits burn and individuals who saw the trees ablaze. The Government decided to try and better the situation. They spent money and time to train personnel and improve infrastructure and after a few years, they had stopped the various small fires from breaking out. Everybody seemed happy. Success? Not really.
A few years after this there was a forest fire, and it burnt hotter and faster than ever, burning down nearly 32% of the forest! Soon there were more of these larger fires that were similarly fierce and destructive. But why was this happening? Hadn't they solved the problem? Soon they realized that those small forest fires that used to occur actually helped burn away all the undergrowth and deadwood, without actually reaching any of the mature trees and larger parts of the forest. By preventing these small fires, the undergrowth and deadwood had now accumulated, now acting as a fuel to the fire and spreading it further into the forests and even destroying many of the older mature trees.
The Lesson: Nature was better off not disturbed in this case; nature takes care of itself in the long run.
Austrians feel the same way about the free markets, and government intervention. They even propose that periods of depression are just a cycle in any healthy economy, acting just like the cleansing fires in the forest! In the aftermath of a depression, new business opportunities and industries will emerge, and this is how capitalism and business cycles occur. Keynesians, on the other hand, have always advocated rules, laws, taxes, etc. to control and mould market forces.
Austrian economics differs from Keynesian economics in the basic approach to solving economic problems. Austrians believe that nature should be allowed to run its course and the lesser the Government interferes in free markets, the better it is. They believe that by understanding and predicting how people will react to different conditions (and by reactions they mean planned or logical actions and not knee-jerk reactions) one can understand and predicts what's likely to happen next.
The Austrian School of Economics believes that the human and social element plays an equally important role in understanding prices, market movements as well as money and value creation. Often dubbed as economic philosophers, these economists make most of their findings more theoretical than mathematical. So their's are not purely model-based predictions.
Keynesians, on the other hand, believe that Governments are an important market intermediary, and while its role is not properly defined, they believe that State intervention, pricing and policy controls are essential tools to controlling, understanding and predicting market conditions. Keynesians are adept at using models and modelling tools to make their predictions.
Austrians vs. Market Monetarists on the Housing Bubble
In the standard Austrian view, when the banking system (nowadays led by a central bank) injects credit and pushes interest rates artificially low, it sets off an unsustainable boom. However, the distortion is not merely monetary: During the boom, malinvestments occur. Because the capital structure of the economy becomes internally inconsistent, eventually some entrepreneurs must abandon their projects because there are insufficient capital goods to carry them all to completion. This appears to us as a “recession,” in which many firms lay off workers and scale back their operations, if not close shop altogether. Although painful, the recession period is necessary for workers and other resources to get reallocated to more sustainable niches of the economy.
In a nutshell, the Austrian narrative recognizes the role that private sector miscreants can play in any particular historical boom but argues that these excesses were fueled by the easy money policy in the early 2000s enacted by then Fed chair Alan Greenspan. By flooding the market with cheap credit that came from the printing press rather than genuine saving,
Greenspan pushed interest rates (including mortgage rates) down to artificially low levels. This caused (or at least exacerbated) the bubble in house prices and misallocated too many real resources to the housing sector. When the Fed got cold feet and began gently raising rates from mid-2004 onward, the bubble in house prices eventually tapered off and turned to a crash.
Link #1: Evidence That Changes in Interest Rates Affected Home Prices
To validate the Austrian explanation of the housing bubble, we must first establish that interest rates did indeed fall into unusually low territory during the boom phase, while they were hiked going into the bust. Figure 1 below shows the “real” (i.e., consumer price inflation–adjusted) federal funds rate, as a quarterly average from 1970–2006:
As Figure 1 indicates, the federal funds rate (which was the Fed’s target variable at this time), taking account of price inflation, was pushed down to negative 2 percent by early 2004. This was the lowest it had been going back to the late 1970s. Then interest rates began rising after 2004.
It wasn’t just short-term rates, but also mortgage rates, that fell during the peak years of the housing bubble. In Figure 2, we plot conventional thirty-year mortgage rates but also include year-over-year increases in the Case-Schiller Home Price Index (HPI).
Link #2: Evidence That Monetary Inflation Affected the Level of Interest Rates
In the previous section we established the fact that interest rates really did fall to historically low levels as the housing bubble intensified, while the cooling off of the boom went hand in hand with rising interest rates.
However, some apologists for the Fed argue that Alan Greenspan had nothing to do this. Why, it was Asian saving that explains what happened with US interest rates during the 2000s.
I have elsewhere directly rebutted the “Asian savings glut” explanation;2 see the citation in the endnotes for the details. However, in this chapter let us clearly establish that changes in the growth of the US monetary base went hand in hand with movements in the federal funds rate, just as any economics textbook would suggest. We provide this data in figure 3:
Look at how the two lines in figure 3 are (almost) mirror images of each other. Specifically, when monetary base growth is high, the federal funds rate is low. And vice versa, when the growth in the monetary base slows, the fed funds rate shoots up.
There is nothing mysterious about this. To repeat, this is the standard explanation given in economics textbooks—not just Austrian texts—to explain how a central bank “sets” interest rates. When the central bank wants to cut rates, it buys more assets and floods the market with more base money. And when the central bank wants to raise rates, it slows the pace of monetary inflation (or even reverses course entirely and shrinks the monetary base).
Recall from chapter 5 that the “monetary base” consists of paper currency and member banks’ deposits at the Fed. Therefore, the Federal Reserve has absolute control over the monetary base; those rascally Asians who have the gall to live below their means can’t directly increase the US monetary base. As figure 3 shows, when US interest rates fell sharply in the early 2000s, this occurred during a period of rapid growth in the monetary base. If the Fed didn’t want interest rates falling so low in the early 2000s, it shouldn’t have engaged in so much monetary inflation.
Link #3: Evidence That the Housing Bubble Led to “Real” Problems in the Labor Market
Last, there are some economists—such as Scott Sumner, whose views on NGDP targeting we critique in chapter 16—who argue that the Austrians are wrong for thinking that the housing bubble had anything to do with the Great Recession. (See the articles in endnote 1 for more details on Sumner’s perspective.) In this last section, we provide two additional charts to show that the Austrian explanation holds up just fine in this regard.
First, in figure 4 we plot total construction employment against the civilian unemployment rate:
As with the previous charts, this one too is exactly the kind of picture Austrians would expect to see. Total construction employment surged from about 6.7 million in 2003 up to 7.7 million by 2006, but then began falling fast in mid-2007. This movement in construction employment was the mirror image of the national unemployment rate, which dropped from some 6 percent in 2003 to the low 4s in early 2007. After that, it began rising sharply, mirroring the crash in construction employment, hitting 10 percent in mid-2009.
Finally, let us plot the movement in total construction employment against an index of home prices:
As the chart makes clear, the movement in total construction employment seems intimately related to the bubble in house prices. They both rose together from 2003, they both tapered off going into 2007, and they both began plummeting going into 2008.
Conclusion
In this chapter, we have applied the generic Austrian theory of the business cycle to the specific case of the US housing bubble and the ensuing financial crisis/Great Recession. Specifically, we showed that interest rates—including not just short-term rates but also thirty-year mortgage rates—fell to historically low levels just as the housing bubble accelerated into high gear. We then showed that the fall and rise in interest rates corresponded with an increase and slowdown in the Fed’s monetary inflation, just as any econ textbook would suggest.
Finally, we showed that the movement in home prices behaved as would be expected with respect to total construction employment and that this in turn tied up in the obvious way with the national unemployment rate. We have thus shown empirical evidence for each crucial link in the standard Austrian story of how “easy money” can fuel an unsustainable boom, which leads to an inevitable bust.
In closing, we should note that the Austrians didn’t merely explain the Fed’s role in the housing crash after the fact. On the contrary, in September 2003—five years before the financial crisis—Ron Paul testified before the House Financial Services Committee,3 arguing that federal subsidies to housing, through such entities as Fannie Mae and Freddie Mac, were merely setting the country up for a housing crash. He also mentioned that the Fed’s inflation would merely postpone the day of reckoning and make it that much more painful.
In the following year, 2004, Mark Thornton wrote a prescient article for Mises.org entitled “Housing: Too Good to Be True,”4 in which he warned:
It has now been three years since the U.S. stock market crash. Greenspan has indicated that interest rates could soon reverse their course, while longer-term interest rates have already moved higher. Higher interest rates should trigger a reversal in the housing market and expose the fallacies of the new paradigm, including how the housing boom has helped cover up increases in price inflation. Unfortunately, this exposure will hurt homeowners and the larger problem could hit the American taxpayer, who could be forced to bail out the banks and government-sponsored mortgage guarantors who have encouraged irresponsible lending practices.
Because Austrians tend to downplay the ability of economics to provide numerical predictions, its critics often mock the school as unscientific and useless for the investor. But the experience of the US housing bubble and bust shows that the Austrians, armed with Mises’s theory of the business cycle, gave far better guidance than, say, Ben Bernanke.
How Nixon and FDR Used "Crises" to Destroy the Dollar's Links to Gold
Since August 15, 1971, the US dollar has been completely severed from gold. President Richard Nixon suspended the most important component of the Bretton Woods system, which had been in effect since the end of World War II. Nixon announced that the US would no longer redeem dollars for gold for the last remaining entities that could: foreign governments. Gold redemption had been made illegal for everybody else, so this action finally ended any semblance of a gold standard for the US dollar.
In Crisis and Leviathan, Robert Higgs showed how in the twentieth century the US government grew in size and scope primarily during crisis periods like wars or economic depressions. The powers gained during those periods were often advertised as “temporary,” but history shows that governments rarely relinquish powers. This “ratchet effect” applies to the way Nixon “temporarily” suspended gold redemption in 1971—the resulting regime of unbacked fiat dollars remains in effect today.
What Was the Bretton Woods System?
The Bretton Woods system was designed by the Allied nations, led by the United States, near the end of World War II as a postwar international monetary order. The US dollar would become the world’s reserve currency, which foreign governments could redeem for gold, even though US citizens could not. This prohibition was not new for US citizens, since Franklin D. Roosevelt outlawed private ownership of gold coins and bullion in 1933.
To get foreign governments to join the agreement, the US promised to redeem dollars for gold at $35 per ounce, which limited the extent to which the supply of dollars could be expanded. International trade was slow to restart after World War II, which meant that the Bretton Woods system of gold exchange was not fully tested until the late 1950s.1 Yet, even by this time, US inflation meant that Japan and countries in Western Europe were holding a reserve currency that was falling in value, especially relative to the promised $35-per-ounce price of gold.
The US could only use diplomatic pressure to slow the foreign governments’ requests for gold redemption. Even so, the US lost about 55 percent of its stock of gold from the early 1950s to the end of the Bretton Woods system in 1971.
In a last-ditch effort to maintain the Bretton Woods system in 1968, the US tried to implement a “two-tier gold market” such that central banks around the world would participate in one market that would seek to keep the $35-per-ounce dollar-to-gold ratio, and would not buy or sell in the other tier: the private, free gold market.
This, of course, quickly fell apart. By 1971, President Nixon could not contain the effects of the monetary inflation used to pay for the Vietnam War and Lyndon B. Johnson’s Great Society programs (including Nixon’s own expansions). Amid a host of desperate interventions such as new tariffs and wage and price controls, Nixon also “temporarily” suspended gold convertibility. He sought to “protect the position of the American dollar as a pillar of monetary stability around the world.”
The dollar was completely severed from any commodity backing, making it a purely fiat money. The Federal Reserve could now inflate without any regard for redemption demands from private citizens, businesses, foreign governments, or foreign central banks.
The Result: Inflation
Anyone should have been able to predict the consequences of this event. A government with a ready buyer of debt in the form of an unrestrained central bank can spend much more, since the redistributive effects of inflation are less obvious than taxation. Gold redemption was a strict limiting factor for the Fed—now the only constraints are political and subjective, despite the appearance of technical expertise at the Fed.
THE GREAT DEPRESSION
SOURCES: