Tuesday, October 21, 2008
A Call to Popperians: How Can We Pit Cowen vs. ABCT?
In this post, Tyler Cowen acknowledges my capital-consumption story, and contrasts it with his own explanation. In a nutshell: Tyler is saying that the housing boom was fueled by the real savings of foreigners, and this explains how it is physically possible that Americans consumed more (TVs, iPods, etc.) at the same time that they were expanding the housing sector.
In contrast, Tyler says, the Austrian story would need to link the booming housing sector with falling consumption. After all, if the boom is artificial and based on Fed funny money, then there is a tradeoff between houses and iPods; Americans couldn't have had more of both from 2001 - 2006.
Especially as Tyler clarifies in the comments of the above thread, his point is that yes, capital consumption (a la my sushi story) is theoretically possible, in order to reconcile the facts with the Austrian story. But, he says, the evidence seems to point to his theory.
Well let's do a test! And to make it extra scientific, let's lay out our criteria right now, and THEN go look at the data. (Obviously I know how some of the below will turn out, but not all of it.) So in the comments please give me additional areas in which Tyler's theory and mine give opposite post-dictions (i.e. predictions after the fact).
(1) If I'm right, housing prices should have gone up when Fed was cutting rates, and they should have peaked/started falling when Fed starting raising them.
(2) If Tyler is right, housing prices should have gone up with increased savings in foreign countries that invest in US assets. We could probably refine this some; help here. E.g. maybe we want to look at growth in Treasury holdings by the Bank of China. And then housing prices should peak / fall when the foreign banks slow down their purchases.
(3) If Tyler is right, rising home prices should be accompanied by a rising (or at least stable) dollar. After all, if it's foreign savings coming in that are pumping up the housing sector, that has to put upward pressure on the US dollar. (I grant this this is self-serving, since we know what happened to the dollar. But the direction is right, don't you agree? I.e. if Tyler's story were true, wouldn't it have propped up the dollar?)
(4) I admit I haven't fully worked out all the nuts and bolts of it, but surely the theory that there was massive capital consumption occurring is consistent with a falling dollar. As I say, it's a bit tricky because the Austrian story is that people were consuming capital without being aware of it.
Any other ideas? The obvious problem with the above is that I know how at least 3 of them are going to turn out, so there's a danger that I say, "Yeah, my story predicts a falling dollar" when maybe I wouldn't have said that in 2000.
So can people come up with ways to separate Tyler's theory from mine, that rely on rather obscure things that aren't currently common knowledge? Or maybe that rely on things that switch, to mark the difference between the expansion and the contraction? I'm thinking of things that would happen in the different sectors of the Chinese and US economies, in terms of a Hayekian triangle.
I guess another obvious one is:
(5) Tyler's theory shouldn't require a major recession, whereas mine does.
And the beauty of (5) is that it's still not decided! So I will say this, if unemployment has peaked, then I am wrong. We have not yet begun to recess, if the ABCT explains what happened with housing.
In contrast, Tyler says, the Austrian story would need to link the booming housing sector with falling consumption. After all, if the boom is artificial and based on Fed funny money, then there is a tradeoff between houses and iPods; Americans couldn't have had more of both from 2001 - 2006.
Especially as Tyler clarifies in the comments of the above thread, his point is that yes, capital consumption (a la my sushi story) is theoretically possible, in order to reconcile the facts with the Austrian story. But, he says, the evidence seems to point to his theory.
Well let's do a test! And to make it extra scientific, let's lay out our criteria right now, and THEN go look at the data. (Obviously I know how some of the below will turn out, but not all of it.) So in the comments please give me additional areas in which Tyler's theory and mine give opposite post-dictions (i.e. predictions after the fact).
(1) If I'm right, housing prices should have gone up when Fed was cutting rates, and they should have peaked/started falling when Fed starting raising them.
(2) If Tyler is right, housing prices should have gone up with increased savings in foreign countries that invest in US assets. We could probably refine this some; help here. E.g. maybe we want to look at growth in Treasury holdings by the Bank of China. And then housing prices should peak / fall when the foreign banks slow down their purchases.
(3) If Tyler is right, rising home prices should be accompanied by a rising (or at least stable) dollar. After all, if it's foreign savings coming in that are pumping up the housing sector, that has to put upward pressure on the US dollar. (I grant this this is self-serving, since we know what happened to the dollar. But the direction is right, don't you agree? I.e. if Tyler's story were true, wouldn't it have propped up the dollar?)
(4) I admit I haven't fully worked out all the nuts and bolts of it, but surely the theory that there was massive capital consumption occurring is consistent with a falling dollar. As I say, it's a bit tricky because the Austrian story is that people were consuming capital without being aware of it.
Any other ideas? The obvious problem with the above is that I know how at least 3 of them are going to turn out, so there's a danger that I say, "Yeah, my story predicts a falling dollar" when maybe I wouldn't have said that in 2000.
So can people come up with ways to separate Tyler's theory from mine, that rely on rather obscure things that aren't currently common knowledge? Or maybe that rely on things that switch, to mark the difference between the expansion and the contraction? I'm thinking of things that would happen in the different sectors of the Chinese and US economies, in terms of a Hayekian triangle.
I guess another obvious one is:
(5) Tyler's theory shouldn't require a major recession, whereas mine does.
And the beauty of (5) is that it's still not decided! So I will say this, if unemployment has peaked, then I am wrong. We have not yet begun to recess, if the ABCT explains what happened with housing.
Comments:
I'm hoping Tyler will participate in this.
I'm also hoping someone will explain his comment over at MR more clearly:
There is of course a literature on capital maintenance expenditures over the business cycle. The countercyclicality of maintenance is a) evidence that real interest rates are really not the driving forces behind business decisions over the cycle (if so maintenance would be favored over consumption), and b) not big enough to account for the more general comovement in other sectors -- including new investment and consumption -- during the cycle. I discuss many other related issues in my book *Risk and Business Cycles*. There are *possible* ways to get comovement on the upswing, but it's far from obvious that any of them work out in quantitative terms.
I'm also hoping someone will explain his comment over at MR more clearly:
There is of course a literature on capital maintenance expenditures over the business cycle. The countercyclicality of maintenance is a) evidence that real interest rates are really not the driving forces behind business decisions over the cycle (if so maintenance would be favored over consumption), and b) not big enough to account for the more general comovement in other sectors -- including new investment and consumption -- during the cycle. I discuss many other related issues in my book *Risk and Business Cycles*. There are *possible* ways to get comovement on the upswing, but it's far from obvious that any of them work out in quantitative terms.
# posted by 
: October 22, 2008 at 12:33 AM
: October 22, 2008 at 12:33 AM
I'm not an economist but there could be some "masking effects" happening that have allowed apparent consumer growth combine with capital consumption.
Since the fall of the Berlin Wall, the opening up of China and the pursuit of market reforms in India, the global marketplace is much bigger than it was before. All else equal, this should lead to a greater range of and lower prices for consumer goods. These improvements in the efficiency of the consumer goods supply would mask some of the Austrian effects. In short consumers have been getting more bang for their buck than in the past, and there is some risk this is misinterpreted as just more bucks going to consumer purchases?
Does this hypothesis make sense?
Since the fall of the Berlin Wall, the opening up of China and the pursuit of market reforms in India, the global marketplace is much bigger than it was before. All else equal, this should lead to a greater range of and lower prices for consumer goods. These improvements in the efficiency of the consumer goods supply would mask some of the Austrian effects. In short consumers have been getting more bang for their buck than in the past, and there is some risk this is misinterpreted as just more bucks going to consumer purchases?
Does this hypothesis make sense?
# posted by : October 22, 2008 at 5:36 AM
: October 22, 2008 at 5:36 AM 
Brian,
The standard response to that (good) objection is that investors move from one mania to the next. E.g. we also think cheap credit fueled the dot-com boom, but then when Greenspan brought interest rates down to 1% in June 2003, people weren't going to start plowing it back into Amazon.com at that point. Instead, they put it into something "real" like housing.
By the same token, if Bernanke keeps rates low / brings them down even more, until the economy "recovers," then that will spur a boom in some sector, but it won't be housing again.
The Austrian theory doesn't say which specific malinvestments will occur, it just says that artificially low interest rates leads to them.
The standard response to that (good) objection is that investors move from one mania to the next. E.g. we also think cheap credit fueled the dot-com boom, but then when Greenspan brought interest rates down to 1% in June 2003, people weren't going to start plowing it back into Amazon.com at that point. Instead, they put it into something "real" like housing.
By the same token, if Bernanke keeps rates low / brings them down even more, until the economy "recovers," then that will spur a boom in some sector, but it won't be housing again.
The Austrian theory doesn't say which specific malinvestments will occur, it just says that artificially low interest rates leads to them.
earth that was:
Right, I agree (assuming I understood your point). I think Tyler and I are both right; i.e. there really was a lot of foreign saving and investment coming our way, and I think there really was a lot of bogus credit coming from the Fed.
To put it another way, consumption would have risen even without low Fed rates. But I'm claiming that it rose more than that "correct" amount, due to the Fed pump priming.
Right, I agree (assuming I understood your point). I think Tyler and I are both right; i.e. there really was a lot of foreign saving and investment coming our way, and I think there really was a lot of bogus credit coming from the Fed.
To put it another way, consumption would have risen even without low Fed rates. But I'm claiming that it rose more than that "correct" amount, due to the Fed pump priming.
Bob,
If we liken a bubble to an uncoordinated Ponzi scheme, what would be the effect of an "investor" (i.e. the Fed) pouring huge amounts of capital into a Ponzi scheme. I would imagine that the scheme would last much longer and attract many more "investors" because returns would stay high.
I don't think it fully matters that the fed spigot perfectly correlates to the beginning or the end. Small bubbles could simply be a human phenomenon, exacerbated monstrously by the Fed. The inertia of the new entrants would maintain the house of cards for an indeterminant amount of time. It's only when the rates of return slow down does the house of cards collapse.
If we liken a bubble to an uncoordinated Ponzi scheme, what would be the effect of an "investor" (i.e. the Fed) pouring huge amounts of capital into a Ponzi scheme. I would imagine that the scheme would last much longer and attract many more "investors" because returns would stay high.
I don't think it fully matters that the fed spigot perfectly correlates to the beginning or the end. Small bubbles could simply be a human phenomenon, exacerbated monstrously by the Fed. The inertia of the new entrants would maintain the house of cards for an indeterminant amount of time. It's only when the rates of return slow down does the house of cards collapse.
This is what I said on Marginal Revolution, which is relevant here...
Luis:"In the sushi story, there used to be 25 workers taking care of capital depreciation by repairing nets & boats (the delta*K above) - when 20 of those workers are reallocated (some to fishing and rice farming) doesn't net investment fall? Only 5 workers are allocated to investing in the new outboard motor."
Prices.
The investors in the scheme, in this case the people of the island, believe that the 5 workers they have allotted to the task will perform the function of the previous 25. In the long term they may be right, however the crisis comes before then.
To put things in terms of normal Austrian theory. There is no "unit of capital", Piero Sraffa demolished the notion. Capital is heterogenous, all that can be said about certainly it is that it has a money price. A tractor, plough or warehouse has a price to a community of buyers. This doesn't tell us how much productive capital there is overall.
If money is created and given to Fred then others in an economy don't know that. They continue their plans as though prices will move as they have in the past, as does Fred. Fred is now rich and can afford to make more long term plans. As a result plans across the economy become more long term.
This results in bidding up the price of capital goods. That doesn't mean though that the aggregate price of those capital goods is the same as their utility. If the number and composition of capital goods stayed the same then they would still be bid up.
Tyler: "There is of course a literature on capital maintenance expenditures over the business cycle. The countercyclicality of maintenance is a) evidence that real interest rates are really not the driving forces behind business decisions over the cycle (if so maintenance would be favored over consumption), and b) not big enough to account for the more general comovement in other sectors -- including new investment and consumption -- during the cycle. I discuss many other related issues in my book *Risk and Business Cycles*. There are *possible* ways to get comovement on the upswing, but it's far from obvious that any of them work out in quantitative terms."
Yes, capital consumption isn't necessarily a problem.
However just because there is comovement demonstrates nothing. Money creation distorts the price of investment goods just as it distorts how they are used.
Luis:"In the sushi story, there used to be 25 workers taking care of capital depreciation by repairing nets & boats (the delta*K above) - when 20 of those workers are reallocated (some to fishing and rice farming) doesn't net investment fall? Only 5 workers are allocated to investing in the new outboard motor."
Prices.
The investors in the scheme, in this case the people of the island, believe that the 5 workers they have allotted to the task will perform the function of the previous 25. In the long term they may be right, however the crisis comes before then.
To put things in terms of normal Austrian theory. There is no "unit of capital", Piero Sraffa demolished the notion. Capital is heterogenous, all that can be said about certainly it is that it has a money price. A tractor, plough or warehouse has a price to a community of buyers. This doesn't tell us how much productive capital there is overall.
If money is created and given to Fred then others in an economy don't know that. They continue their plans as though prices will move as they have in the past, as does Fred. Fred is now rich and can afford to make more long term plans. As a result plans across the economy become more long term.
This results in bidding up the price of capital goods. That doesn't mean though that the aggregate price of those capital goods is the same as their utility. If the number and composition of capital goods stayed the same then they would still be bid up.
Tyler: "There is of course a literature on capital maintenance expenditures over the business cycle. The countercyclicality of maintenance is a) evidence that real interest rates are really not the driving forces behind business decisions over the cycle (if so maintenance would be favored over consumption), and b) not big enough to account for the more general comovement in other sectors -- including new investment and consumption -- during the cycle. I discuss many other related issues in my book *Risk and Business Cycles*. There are *possible* ways to get comovement on the upswing, but it's far from obvious that any of them work out in quantitative terms."
Yes, capital consumption isn't necessarily a problem.
However just because there is comovement demonstrates nothing. Money creation distorts the price of investment goods just as it distorts how they are used.
# posted by : October 22, 2008 at 4:04 PM
: October 22, 2008 at 4:04 PM
What's the reasoning behind this paragraph? :
In contrast, Tyler says, the Austrian story would need to link the booming housing sector with falling consumption. After all, if the boom is artificial and based on Fed funny money, then there is a tradeoff between houses and iPods; Americans couldn't have had more of both from 2001 - 2006.
Is it the following: Interest rates fall and bank loans are taken out for longer term investment projects. Resources are thus competed away from consumption oriented industries to capital producing industries. Prices for consumer goods should rise and thus consumption fall.
Is that the story Tyler would tell?
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In contrast, Tyler says, the Austrian story would need to link the booming housing sector with falling consumption. After all, if the boom is artificial and based on Fed funny money, then there is a tradeoff between houses and iPods; Americans couldn't have had more of both from 2001 - 2006.
Is it the following: Interest rates fall and bank loans are taken out for longer term investment projects. Resources are thus competed away from consumption oriented industries to capital producing industries. Prices for consumer goods should rise and thus consumption fall.
Is that the story Tyler would tell?
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