My view of the period from mid-2006 to mid-2008 is as follows:
Too much capital was allocated into housing during 2004-06. After the U.S. housing market peaked in mid-2006, for the next two years we had a mildly painful readjustment, as resources were moved out of housing and into other sectors of the economy. Because it is difficult to re-allocate resources, the structural unemployment rate crept up from the mid-4s in mid-2007 to the mid-5s a year later. Other sectors of the economy kept growing. There were no signs of bubbles in U.S. manufacturing, which grew at the normal rate during the previous expansion, and of course manufacturing prices were well-behaved (unlike housing.) The big bubble was in housing, and after 2006 we had to go through a painful readjustment as labor and capital was re-allocated to other sectors.
Is that right? If this is the Austrian story, then I think it is a good explanation of that two year period. What confuses me is what happened next:
1. Why did NGDP collapse late last year?
2. Could a suitably expansionary monetary policy have stopped NGDP from collapsing?
3. Wouldn’t Hayek have favored enough monetary expansion to keep NGDP from collapsing?
4. Hayek originally thought that the Depression was a needed corrective for the excesses and misallocations of the late 1920s. He later changed his mind and argued that the Fed should not have allowed NGDP to collapse. Was he right to change his mind?
5. If monetary policy could not have prevented an NGDP collapse, what is your story? Is it the Keynesian liquidity trap? (I assume the answer is no.)
6. If a suitably expansionary monetary policy could have prevented an NGDP collapse, should the Fed have tried to do this?
7. If the answer is no, why not? Wouldn’t that have prevented the collapse in manufacturing in Asia late last year? What is the structural imbalance corrected by having 10s of millions of Chinese lose jobs making stuff like shoes? (Presumably there was no shoe bubble.) Are Austrians worried about the U.S. trade deficit?
What I am basically asking here is if the housing bubble was the problem; shouldn’t there have been enough NGDP growth to support the non-housing parts of the economy, while allowing housing to decline as necessary? I get why we needed housing to decline for eight straight quarters from mid-2006 to mid-2008, but I don’t get why we then needed to violate Hayek’s maxim to keep NGDP from falling, and let NGDP fall sharply—causing massive output declines in sectors completely unrelated to the housing bubble. Recall that those non-housing sectors held up well during the first two years of unwinding the housing bubble–so we are not just talking about manufactured goods like rugs and furniture.
I may not post this week because of exams, perhaps we can have a conversation about Austrian macro.
Oh, and one other question: As you know I am completely contemptuous of those (mostly Keynesians) who use interest rates as an indicator of monetary policy. Interest rates were very low in American in 1931; and very high in Germany in 1923. I believe that interest rates tell us precisely nothing about whether money is too easy or too tight, especially short term rates. The key variable is NGDP growth (which I believe Hayek also favored targeting.) Do you agree with my view that the 1% (short term) interest rates of 2003 were a totally meaningless indicator of the stance of monetary policy?
BTW, In case anyone wants to revisit Tyler Cowen’s banana post, I have a different perspective on the Hayek vs. Minsky debate. I think they are both wrong. Can you guess why?
Update (4/29/09): A number of people have emailed two very useful links. I thought I would attach them here to further the discussion. The first is a slide show by Roger Garrison. In the second Lawrence White discusses the views of Hayek during and after the Great Depression. Bill Woolsey says that both White and Garrison have a Hayekian approach to Austrian economics, which seems closer to my view than the Rothbard approach. A few comments:
1. In the slide show, I like Hayek’s approach better than Keynes’. Hayek argues that misleading interest rate signals can make people try to consume more and invest more at the same time. This pushes production past the PPF, and also leads to a lot of inefficient malinvestment. He argues that investment exceeds saving during this boom phase, and that the gap is filled by newly created money. I have a few problems with this.
a. I don’t think investment exceeds saving during the boom. Rather I would argue that both consumption and saving rise during booms. How can this happen? In my view the expansionary monetary policy causes NGDP to expand. Because wages are sticky, real output also rises. Because both real and nominal income increase, both real and nominal C and S can also increase. I don’t like the “money filling the savings gap” story, as you would get the same sort of inflationary boom from a drop in money demand, as from a rise in the money supply. I also don’t think that interest rates are a useful indicator of monetary policy.
2. When the inevitable relapse sets in, output falls back to the PPF. In Hayek’s view, this is desirable. I agree. I believe this was occurring between 2007 and mid-2008. But Garrison also mentions the danger of overshooting, of output falling far below the PPF. I believe this is called a secondary depression. I believe a secondary depression began late last summer or early last fall.
3. Regarding the JMCB paper by White, I am merely going to comment on pages 26 and 27. Hayek says that he initially thought that monetary policymakers should not attempt to arrest the deflation through monetary expansion. But later he came to realize that the monetary authority needed to act aggressively, to do everything possible to prevent falling NGDP. He thought the central bank should increase M enough to offset the fall in velocity. This is also my view. It seems that Hayek later came to realize that the Great Depression was a sort of secondary depression—the bad kind of downturn.
During the 1930s there were basically three views of the Great Depression:
1. Not caused by tight money; and a needed corrective for overexpansion of investment (and malinvestment) of the 1920s. Many conservatives held this view.
2. Not caused by tight money, but also highly undesirable. It needed to be corrected with aggressive government stimulus. This is the Keynesian view.
3. Caused by tight money, or at least errors of omission by the Fed. It was also highly undesirable. This is the modern view of mainstream macroeconomists. It is also my view.
Regarding the current cycle, there are also three views. And at least regarding what I call the “secondary depression”–beginning last fall, they are precisely the same three views that economists held regarding the Great Depression. Only in this case the third view is held by only a tiny number of economists (me, Earl Thompson, and a few commenters on my blog.) I believe it is also the view Hayek would hold if he were alive today, and I also believe it will eventually become the mainstream view, as it eventually did for the Great Depression.
(I am not done with the liquidity trap/interest on reserves question, and the causality question—but I need more time to focus on them.)