Jerry O’Driscoll explains how a competent understanding of the phenomena requires Hayekian thinking.

And the Fat Man. A parable for our times.

on the reality of current economic situation and how we got here.

Housing production* is exactly the kind of thing Hayek identified as a time delayed production good which can absorb credit, capital, and leverage in a bandwagon of false expectations, only revealed as structural malinvestments at the end of the artificial boom when credit, inputs, and leverage unavoidably become scarce — and false promises are revealed as impossible to fulfill expectations about the price and supply of inputs, outputs, leverage, and credit.

So Vernon Smith’s account of the American trade cycle 1920-2010 (pdf) as a housing cycle cashes out like a hand in the glove with the conceptual categories of Hayek’s trade cycle theory.  A general point I’ve made before.

Want shorter Vernon Smith?  Read it here.

*On housing as a long period production good, see F. A. Hayek, The Pure Theory of Capital.

Edward Leamer and Russ Roberts have explained how the boom/bust cycle has been shaped by government policy, and directed into such sectors as housing and finance.  In Hayek’s economics housing is a long-term production good, an open target for malinvestment — and the idea that the boom / bust malinvestment cycle can take many different forms is fully consistent with Hayek’s account of the production / relative price distortions of the credit cycle / artificial boom, as Hayek explains in an interview from 1978:

JACK HIGH: The Austrian theory of the cycle depends very heavily on business expectations being wrong. Now, what basis do you feel an economist has for asserting that expectations regarding the future will generally be wrong?

F. A. HAYEK: Well, I think the general fact that booms have always appeared with a great increase of investment, a large part of which proved to be erroneous, mistaken. That, of course, fits in with the idea that a supply of capital was made apparent which wasn’t actually existing. The whole combination of a stimulus to invest on a large scale followed by a period of acute scarcity of capital fits into this idea that there has been a misdirection due to monetary influences, and that general schema, I still believe, is correct.

But this is capable of a great many modifications, particularly in connection with where the additional money goes. You see, that’s another point where I thought too much in what was true under prewar conditions, when all credit expansion, or nearly all, went into private investment, into a combination of industrial capital. Since then, so much of the credit expansion has gone to where government directed it that the misdirection may no longer be over-investment in industrial capital, but may take any number of forms. You must really study it separately for each particular phase and situation.

I recently came across a terrific Bloomberg On The Economy podcast with James Sweeney and Carl Lantz on “shadow money” — assets which are used as the equivalent of money during the snowball of the asset bubble / artificial boom.

The problem Sweeney and Lantz identify is that the stock of money expands and contracts across the boom and bust cycle in the domain of “shadow money” — leading to the differential distortions of the structure of relative prices and supplies across asset classes, and discoordination between planned levels of investment, savings, and consumption, as well as discoordination between economically sustainable streams of rival production processes.

Listen to the podcast or dowload here (mp3).  Listen for a discussion of Hayek toward the end of the conversation.  The podcast discusses ideas contained in their paper “Long Shadows:  Collateral Money, Asset Bubbles and Inflation” by Jonathan Wilmot, James Sweeney, Matthias Klein, and Carl Lantz (pdf).

Wilmot, Sweeney, Klein, and Lantz begin their paper with this quotation from Friedrich Hayek:

“There can be no doubt that besides the regular types of the circulating medium, such as coin, notes and bank deposits, which are generally recognised to be money or currency, and the quantity of which is regulated by some central authority or can at least be imagined to be so regulated, there exist still other forms of media of exchange which occasionally or permanently do the service of money.

Now while for certain practical purposes we are accustomed to distinguish these forms of media of exchange from money proper as being mere substitutes for money, it is clear that, other things equal, any increase or decrease of these money substitutes will have exactly the same effects as an increase or decrease of the quantity of money proper, and should therefore, for the purposes of theoretical analysis, be counted as money.”

Friedrich Hayek, Prices and Production 1931 – 1935.

They continue their quotation from Hayek in the middle of their paper:

“It is necessary to take account of certain forms of credit not connected with banks which help, as is commonly said, to economise money, or to do the work for which, if they did not exist, money in the narrower sense would be required.  The criterion by which we may distinguish these circulating credits from other forms which do not act as substitutes for money is that they give to somebody the means of purchasing goods [or securities] without at the same time diminishing the money spending power of somebody else. …. The characteristic peculiarity of these forms of credit is that they spring up without being subject to any central control, but once they have come into existence their convertibility into other forms of money must be possible if a collapse of credit is to be avoided.”

Wilmot, Sweeney, Klein, and Lantz then comment:

Hayek’s point is that the economy can create its own media of exchange in order to economize on the use of inside and outside money when there is significant demand for some type of money for use in purchasing assets. Of course, when assets can themselves serve as collateral, allowing for leveraged purchases, then they take on money-like properties. And when financial assets serve as collateral for borrowing to purchase yet more financial assets (buying on margin) this form of shadow money can become particularly potent in driving asset price overshoots and bubbles.

I also recommend the transcript of an “On The Money” podcast with Sweeney and Lantz from Jan. 5, 2010 on the same topic.

UPDATE — Ellen Brown of Global Research presents a summary of Sweeney and Lantz:

Along with the disappearance of the “shadow lenders,” there has been a dramatic decline in something called “shadow money.” The concept of shadow money was presented by two economists from Credit Suisse, James Sweeney and Carl Lantz, in a Bloomberg interview in May. As explained on DemandSideBlog, shadow money is money the market itself creates in order to finance a boom — “money” in the sense of a medium of exchange. In a boom there is not enough cash to go around, so collateral is used as near money or shadow money. Shadow money can include government bonds, private bonds, asset-backed securities, credit card debt (which can be incurred and paid off without drawing on the M1 money stock), and even real estate (when it is highly liquid and easily tradeable) . . .

Lantz and Sweeney calculate that at the peak of the boom there were six trillion dollars in the traditionally-defined money stock (or money supply). The private shadow stock accounted for $9.5 trillion, and government-based shadow money accounted for another $11 trillion. Thus the shadow money stock dwarfed the traditionally-defined money stock. This can be seen in the chart below provided by Tyler Durden. The blue strips at the bottom, called “outside money,” are dollars printed by the Federal Reserve. The red sections, called “inside money,” are money created as loans by the banks themselves. The green sections, called “public shadow money,” are money created by the government and the Fed as debt (or loans). The purple sections, called “private shadow money,” are the money created as private debt securities by the shadow lenders.

Lantz and Sweeney estimate the total drop in private shadow money (the purple blocks) during the current credit crisis at $3.6 trillion. This has been offset by an increase in public shadow money, both from the massive borrowing needed to finance the federal deficit and from the aggressive liquidity measures taken by the Fed in converting private securities into loans.  Those measures helped prevent an even worse drop in the commercial money supply than actually occurred, but they were not sufficient to eliminate the credit squeeze from lowered commercial lending, which continues to act as a tourniquet on the productive economy.

Mark Calabria and Steve Hanke explain.

Steve Hanke takes a look at the evidence and concludes that Alan Greenspan is simply b*llsh*tt*ng the public when he directs attention to a “global savings glut” and claims that the Federal Reserve has no responsibility for the current boom and bust cycle.  Quotable:

What is a bubble? There are many types. One type is created when the Fed’s laxity allows aggregate demand to grow too rapidly. Specifically, a demand bubble occurs when nominal final sales to U.S. purchasers (GDP – exports + imports – change in inventories) exceeds a trend rate of nominal growth — a trend rate that is consistent with “moderate” inflation — by a significant amount.  During Mr. Greenspan’s 18-year tenure as Fed chairman, nominal final sales grew at a 5.4% annual trend rate. This reflects a combination of real sales growth of 3% and inflation of 2.4%. But there were deviations from the trend …

The last big jump in nominal final sales was set off by the Fed’s liquidity injection to fend off the false deflation scare in 2002. Fed governor Ben Bernanke (now chairman Bernanke) set off a warning siren that deflation was threatening the U.S. economy when he delivered a dense and noteworthy speech, “Deflation: Making Sure it Doesn’t Happen Here,” on November 21, 2002. He convinced his Fed colleagues that the deflation danger was lurking. As then-chairman Greenspan put it, “We face new challenges in maintaining price stability, specifically to prevent inflation from falling too low.” By July 2003, the Fed funds rate was at a then-record low of 1%, where it stayed for a year. This produced the mother of all liquidity cycles and yet another massive demand bubble.

During the Greenspan years, and contrary to his claims, the Fed overacted to real or perceived crises and created three demand bubbles. To obtain a better handle of the mother of all liquidity cycles, observe that, by late 2001, the central bank had already pushed the effective Fed funds rate below the 3%-4% range for the neutral rate (a rate consistent with long-run price stability).

The effective rate stayed well below the neutral range until early May, 2005. The pattern for the real effective Fed funds rate was similar to the one followed by the nominal effective rate. By late 2002, the real rate had dropped into negative territory, where it stayed until mid-2005.  It’s not surprising that Stanford University Professor John B. Taylor, in his highly critical book on the Fed’s pre-crisis policies, Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis, concluded that there “is clear evidence of monetary excesses during the period leading up to the housing boom.”

The most recent aggregate demand bubble wasn’t the only bubble that the Fed was pumping up  .. the Fed’s favorite inflation target — the price index for personal consumption expenditures, less those for food and energy — was increasing at a regular, modest rate. Over the 2003-08 period, this metric increased by 13%.  The Fed’s inflation metric signalled “no problems.” But abrupt shifts in major relative prices were underfoot. Housing prices measured by the Case-Shiller index were surging, increasing by 44.8% from the first quarter in 2003 until their peak in the first quarter of 2006. Share prices were also on a tear. The most dramatic price increases were in the commodities. Measured by the Commodity Research Bureau’s spot index, commodity prices increased by 92.2% from the first quarter of 2003 until their peak in the second quarter of 2008.

The dramatic jump in commodity prices was due, in large part, to the fact that a weak U.S. dollar accompanied the mother of all liquidity cycles. Measured by the Federal Reserve’s trade-weighted exchange index for major currencies, the greenback fell by 30.5% from 2003 to mid- July 2008. As every commodity trader knows, all commodities, to varying degrees, trade off changes in the value of the U.S. dollar.  When the value of the U.S. dollar falls, the nominal dollar prices of internationally traded commodities — like gold, rice, corn and oil — must increase because more dollars are required to purchase the same quantity of any commodity. Contrary to claims by Messrs. Greenspan and Bernanke, the Fed played a central role in blowing asset bubbles, shifting relative prices and creating massive distortions in the economy …

Read the whole thing.

Marius Gustavson explains how Hayekian macro helps.

Foy and Stransky on the bust and Soros’s Institute for New Economic Thinking.  Quotable:

George Soros’s $50M investments would have been better spent by sending a copy of .. F.A. Hayek’s The Constitution of Liberty to everyone in his rolodex.

It’s become newly fashionable today, but Hayek has ALWAYS emphasized the existence of a risk cycle in the midst of the boom / bust cycle.  Here’s an example:

“Inflation at first merely produces conditions in which more people make profits and in which profits are generally larger than usual.  Almost everything succeeds, there are hardly any failures.  The fact that profits again and again prove to be greater than had been expected and that an unusual number of ventures turn out to be successful produces a general atmosphere favorable to risk-taking.  Even those who woud have been driven out of business without the windfalls caused by the unexpected general rise in prices are able to hold on and to keep their employees in the expectation that they will soon share in the general prosperity.”

Paul Krugman and Tyler Cowen spew ink in the water on Hayekian macro — and an army of blogosphere Davids swoop in to decontaminate.

Fred Foldvary:

Recent research by economists Moritz Schularick and Alan M. Taylor have confirmed the theory that economic booms are fueled by an excessive growth of credit. They have written a paper titled “Credit Booms Gone Bust: Monetary Policy, Leverage Cycles and Financial Crises, 1870–2008″ (http://www.nber.org/papers/w15512), published by the National Bureau of Economic Research.

A major cause of the Great Depression was a credit boom, as analyzed by Barry Eichengreen and Kris Mitchener in their paper, “The Great Depression as a credit boom gone wrong” (BIS Working Paper No. 137, http://www.bis.org/publ/work137.pdf). Eichengreen and Mitchener cite Henry George’s Progress and Poverty as providing an early theory of booms and busts based on land speculation. They also credit the Austrian school of economic thought, which in the works of Friedrich Hayek and Ludwig von Mises, had developed a theory of the business cycle in which credit booms play a central role. Henry George’s theory of the business cycle is complementary to the Austrian theory, as George identified the rise in land values as the key role in causing depressions.

An expansion of money and credit reduces interest rates and induces a greater production and purchase of long-duration capital goods and land. The most important investment and speculation affected is real estate. Much of investment consists of buildings and the durable goods that go into buildings as well as the infrastructure that services real estate. Much of the gains from an economic expansion go to higher land rent and land value, so speculators jump in to profit from leveraged speculation. This creates an unsustainable rise in land value that makes real estate too expensive for actual uses, so as interest rates and real estate costs rise, investment slows down and then declines. The subsequent fall in land values and investment reduces total output, generates unemployment, and then crashes the financial system.

I note without comment that for a short time as a young man F. A. Hayek was very much taken with Georgist ideas …

In The Independent.

Most economists think that macroeconomic disruptions, such as the current recession, can be understood in terms of aggregate indicators such as total employment, the price level, and the money supply. But this view is misleading, particularly in the current economic situation. Worse yet, it misleads us into counterproductive economic policies.

.. an economy matches a population’s desires to the available resources and production technology. When an economy is operating efficiently, expectations are largely fulfilled; desires, resources, and production technology are well matched; and people are reasonably satisfied with their plans, relations, and contracts.

But if the world evolves in a markedly unanticipated direction, people’s existing plans, relations, and contracts require revision. The existing matches between desires, resources, and production technology deteriorate. While this revision occurs, resources are diverted from production, which is less efficient and less well matched with consumer desires, resulting in a reduction in the value of output – a recession.

This “realignment theory” helps explain the current downturn. From 2000 through 2007, millions of American homeowners entered into mortgage contracts to finance their homes. Securities based on those contracts ended up, in part, in the hands of financial institutions. But the adequate servicing of the debt and, therefore, the performance of the securities, were based on expectations of continued rises in housing prices that proved to be unrealistic. When housing prices fell, so did the value of the mortgages and the securities based upon them.

Because financial institutions held much of these securities, their market values declined as well, leaving balance sheets in need of restructuring, particularly given their highly leveraged capital structures. Awaiting that restructuring, financial institutions could not perform as usual, which impeded financial intermediation and called into question plans, relations, and contracts – such as corporate and residential investment or refinancing.

Meanwhile, consumers who held a substantial fraction of their wealth in housing were forced to revise their consumption plans in the face of declining values. This affected all the producers, distributors, and retailers whose plans and contracts were based on now-obsolete expectations.

And so it goes. Eventually, the required restructuring became so widespread that it impacted virtually every sector of the economy. The current recession is as deep as the misalignment of specialized plans, relations, and contracts is extensive. Construction workers cannot become software developers overnight. Automobile companies cannot adjust immediately to a change in consumer preferences regarding what type of cars they want to purchase, or how frequently. Would-be financiers cannot adjust to these plans overnight ..

– Cal Tech economist Bradford Cornell

The whole thing is worth a read. Or listen to it as a podcast.

A phat jam from Russ Roberts & Co. Download the song here.

Hat Tip: CafeHayek. Listen to Russ Roberts’ weekly EconTalk podcast here.

A few notes. Hayek frequently introduced himself as “Hayek — as in High Explosives”. If I made a change, I might add that to the intro.

And Hayek’s friends called him “Fritz”, not “Freddie”, though Hayek preferred “Friedrich” or “Professor Hayek”. In their letters, Keynes and Hayek addressed each other as “Dear Hayek” and “Dear Keynes”.

I might also note that in the 1930′s when Hayek was reducing Keynes to drooling — and sending him back to the drawing board (anybody still reading Keynes’ Treatise?) — Hayek had a good deal more hair on his head than Keynes.

And don’t miss my collection of Hayek quotes on Keynes.

UPDATE:  The lyrics:

We’ve been going back and forth for a century
[Keynes] I want to steer markets,
[Hayek] I want them set free
There’s a boom and bust cycle and good reason to fear it
[Hayek] Blame low interest rates.
[Keynes] No… it’s the animal spirits

(more…)

It’s deja vu all over again.

This whole thing is well worth reading.  But let’s start with The Quote of The Day:

One of the reasons the Federal Reserve gets so much good press is that it’s publishing most of it itself.

Hanke takes on that topic in the second section of his article.  But the guts of the piece come right at the top — and in his cross hairs — Ben Bernanke:

In Jan. 3, U.S. Federal Reserve Chairman Ben S. Bernanke delivered a major speech at the annual meeting of the American Economic Association. In his formal paper, “Monetary Policy and the Housing Bubble,” Chairman Bernanke argued that the Fed’s monetary policy was not responsible for the U.S. housing bubble. He claims that faulty regulation was the primary culprit.

Chairman Bernanke’s claim is a great canard. The Fed is a serial bubble blower. Let’s first consider the Fed-generated demand bubbles. The easiest way to do this is to measure the trend rate of growth in nominal final sales to U.S. purchasers and then examine the deviations from that trend. Nominal final sales grew at a 5.4% annual rate from the first quarter of 1987 through the third quarter of 2009. (more…)

William White — the economists who saw the future — weighs in on what can be done to fix macroeconomics.

In the section I excerpt below White explains how modern macro will remain broken without inclusion of the economic insights of Nobel winning macroeconomist Friedrich Hayek — work White discusses under the label of “Austrian economics”:

traditional Keynesian models, like the modern models, are not very helpful when it comes to prediction and are of limited use to policymakers. Worse, models in the Keynesian tradition also ignore two other considerations suspected of having great practical importance in the current crisis: the insights of the Austrian school of thought and those of Hyman Minsky.

In contrast to the Keynesian framework, Austrian theory assigns critical importance to how the creation of money and credit by the financial system can often lead to cumulative imbalances over time. These imbalances, which ultimately come down to investments that do not end up profitable, eventually implode in the context of an economic crisis of some sort. In today’s terms, unusually rapid monetary and credit growth over the past decade or so led to asset price increases that seemed to have little to do with fundamentals. It also led to spending much higher than historical norms. For example, the household saving rate in many English speaking countries fell to zero or below, even as the ratio of investment to gross domestic product in China rose to almost 50 percent. From an Austrian perspective the danger would be that these imbalances would revert, respectively, to more justifiable and more normal levels. Over the past two years we have seen something of this nature, in both asset prices and spending patterns in the United States, the United Kingdom, and a number of other countries. This is at the heart of our problems. Moreover, for those with an Austrian perspective, the continued and unprecedented investment-fueled growth in China is more a danger signal than a sign of renewed sustainable growth.

Mistaken spending decisions eventually result in stocks of unprofitable (for corporations) or undesired (for households) investment/durable goods that will take a long time to depreciate. In today’s terms, many industries that expanded sharply in response to high demand are now too big and must shrink. Such industries at the global level include financial services (particularly global supply networks), car production, wholesale distribution, construction, and many other intermediate and primary inputs. Moreover, with many production facilities in Asia geared to sell to foreigners, who no longer have the means to pay, a massive geographical reallocation of production facilities seems in order. From this perspective, Keynesian demand-side stimulus might well have near-term benefits, but could eventually have less desirable effects if it impedes necessary adjustments in production capacities. Over time, such considerations matter.

Cash for clunkers programs in countries with very low household saving rates are not optimal. Nor are attempts to hold down exchange rates for countries with huge external trade surpluses. Nor are wage subsidies to support part-time work, if jobs in the industries being supported will never come back.

While all this restructuring takes place, the structural rate of unemployment will be higher and the level of potential out-put lower. Moreover, the reduced potential will come on top of the more traditional effects of downturns associated with such factors as lower investment—sometimes suppressed by tighter credit conditions—and employment and wages that do not adjust quickly (see Cerra and Saxena, 2008). This implies that all policies to expand aggregate demand could stimulate inflation pressures sooner than expected. Given that some of these policies, such as quantitative and credit easing, are themselves unprecedented, and their effects commensurately uncertain, the added uncertainty generated by shifts in aggregate supply cannot be judged welcome now.

More:

there are other challenges to the conventional way of doing things as well. How can we blend into the Keynesian framework some of the insights of Austrian theory? In normal circumstances, using this Keynesian framework in a straightforward way to project output gaps and inflationary tendencies might seem satisfactory. For example, earlier this decade, such a framework seemed to provide an adequate explanation of the simultaneous observation of rapid growth, falling inflation, and very low real interest rates in the global economy (White, 2008). However, beneath this calm surface, Austrian “imbalances” were building up, which eventually culminated in the current crisis. The future macroeconomic research agenda must find ways to identify and react to these pressures. Fortunately, a significant amount of work in the area of identification has been done, and some promising areas for further progress suggested (see Borio and Drehmann, 2009).

One tendency that must be resisted is to see this work on imbalances as related solely to “financial stability.” In part, this tendency is related to the misconception that our current problems are limited to those of a financial crisis. Rather, an important aspect of the issue is how excessive credit and monetary creation can lead to imbalances outside the financial system, with significant macroeconomic implications.

Today, for example, households in the United States and a number of other countries seem likely to spend less, save more, and try to pay down debt. This seems likely to happen regardless of the capacity or incapacity of the financial system to give previous borrowers more credit. How the state of household and corporate balance sheets affects the desire to spend (as opposed to the capacity to spend) is a crucial issue for future research.

A leverage cycle lies at the heart of Friedrich Hayek’s account of the business cycle, as laid out in Hayek’s Monetary Theory and the Trade Cycle.  Heterogeneous agents, asymmetric knowledge, and other limits to markets are bound up in Hayek’s account.  (In fact, Hayek’s macroeconomic work on the division of knowledge in the context of heterogeneous goods is the original wellspring from which the whole of “information economics” began.)

So it’s a welcome development to see macro modelers picking up the Hayekian research agenda.