An important recent posting to the Hayek-L email list from economist Roger Garrison (more on Garrison here):
Fiona and Lanny are certainly correct to observe that low interest rates can cause home owners to refinance their mortgages and to spend the lump-sum gain on consumer goods. And they are correct to note that the policy-induced bout of consumer spending has been the only game in town since the 2001 downturn. Greenspan's continued monetary ease has served only to bolstered consumer spending.
They are dead wrong, however, as seeing this phenomenon―-especially in the contest of the post-boom economy--as contrary to the Austrian theory.
Even during the boom, consumption spending gets a boost. Mises repeatedly characterizes the credit-driven boom as a period of "malinvestment and overconsumption." The two effects follow straightforwardly from the familiar loanable-funds theory. When the interest rate is depressed below its natural level, investors invest more (moving down along the demand for loanable funds); and at the same time, savers save less―and hence consume more (moving down along the supply of loanable funds. This is what is meant when we say that credit expansion drives a wedge between saving and investment.
Richard Strigl, in his 1934 _Capital and Production_, recognizes the dual effect of artificially low interest rates in terms of the intertemporal structure of capital. The capital structure, he points out, is pulled at both ends against the middle (my phrasing, but very close to Strigl's). At the same time that longer-term projects are being undertaken, the resources needed for their completion are being depleted by increased consumption. This constellation of effects is what makes the subsequent downturn inevitable. Mises expressed these matters in his 1912 book in terms of the subsistence fund.
Only after my _Time and Money_ was in print did I realize―-with the help of Richard Ebeling-―that the notion of the Hayekian triangle being "pulled at both ends against the middle" was recognized in the interwar literature. Fritz Machlup, in a 1933 lecture, noted the salient difference between Hayek's rendition and Strigl's rendition in this regard. It is true that Hayek was not sensitised to the overconsumption aspect of the boom. At points, he even denied it-―in his attempt to make the concept of "forced saving" more acceptable to his critics. (In retrospect, we see that Hayek's "forced saving" really didn't refer to "saving" at all, but rather to a pattern of investment at odds with people's saving preferences. His "forced saving" was Mises's "malinvestment.")
In the post-boom period, a lot of the malinvested capital is being liquidated. In this environment, low interest rates will not inspire investors to undertake still more investment projects. This is an important part of the Austrian theory, and Greenspan's post-2001 experiments with successive interest-rate reductions have provided much evidence for it. The demand for investment funds has fallen precipitously―-not because of a Keynesian waning of the "animal spirits" but because of disruption of the production process caused by the prior credit expansion. The only component of spending left to be stimulated, then, is consumer spending.
The current circumstances also dramatize the dilemma that Hayek wrestled with over the years. In the post-boom period, the Federal Reserve is in a Catch-22 situation. If the Fed continues its cheap-credit policy, then the liquidation process is slowed and the resources needed to complete projects and to make the capital structure whole again are increasingly devoted to current consumption. If the Fed ends its cheap-credit policy, then the economy may well spiral down in a "secondary deflation." (This downward spiralling of income and expenditure was the only aspect of the whole episode that was on Keynes's radar screen. He thought it was triggered by an "autonomous" decrease in investment demand.)
I am continually puzzled as to why critics of the Austrian theory are so quick to accept some potted version of that theory and to see virtually every aspect of the current macroeconomic environment as evidence against it.
Roger W. Garrison
Hayek Visiting Fellow
London School of Economics
Garrison is responding to economist Fiona Maclachlan and Hayek biographer Lanny Ebenstein, who's earlier postings can be found here.
Posted by Greg Ransom
