article: Ebenstein on Hayek & the Fed’s boom / bust

Quotable:

“Let us focus first on the Fed, since it is the main culprit in the current mess .. The federal-funds rate, the Fed’s favored tool for influencing the economy, stood at 6.5 percent in early 2001–in hindsight, excessively high. The Fed undoubtedly contributed to the downturn of 2000-01 by raising the funds rate between 1998 and 2000.

As a result of the economic downturn it helped cause, the Fed began to cut the funds rate in 2001. The rate had been reduced to the 4 percent range before September 11. The Fed then cut it to 1 percent, where it remained through 2004. At that point, concerned about inflation and heedless of the huge concurrent appreciation in home prices–many financed through adjustable-rate mortgages–the Fed raised the funds rate to 5.25 percent between 2004 and June 2006 ..

Hayek argued that if interest rates are too low they will attract resources to areas of the economy that would not otherwise be attractive investments. This was certainly the case in the housing bubble. The Fed played at least as important a role as inadequate lending standards in the escalation of house prices between 2002 and 2006, when many real-estate markets saw double-digit annual increases in the sales price of a good that could be acquired for a single-digit down payment. This was the Greenspan housing bubble.

That lending standards for purchases and refinancing also collapsed at this point compounded the problem, of course.  Hayek’s view was that prices, including the price of borrowing, broadcast important production and resource-direction signals throughout the economy. If the price of money (which is to say, interest) is unstable, or if it becomes possible to borrow for certain economic activities but not for others, this will distort decisions to buy, sell, or invest.  Artificially low interest rates helped create an expectation of ever-rising prices, which attracted many home-buyers who otherwise would not have chosen to purchase houses at what were already historically high prices.”

Lanny Ebenstein, “The Anti-Keynesian:  Friedrich Hayek sheds light on our current economic troubles”, National Review, Feb. 23, 2009.

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