Hayek Lives

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.

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