Saturday, September 12, 2009


The Infamous Counterfactual

In my exchange with two critics on Kudlow's show--and by the way, I should acknowledge publicly that Kudlow was extremely nice to me, going out of his way to let me talk on two separate occasions since I'm not used to rumbling with the big boys--I was saying that the conventional wisdom regarding the "rescue" of the credit markets is (as usual) exactly backwards. We were told that TARP and the Fed interventions were necessary to prevent the credit markets from seizing up, lest regular-Joe businesses lose the ability to meet payrolls and so forth.

The odd thing about this claim is that the volume of business loans was at all-time high in October 2008 (when TARP kicked in), and has since fallen steadily, down about ten percent through the most recent data point. (Or is it datum point?) See for yourself in the chart below; note that the huge spike shows when Bernanke pumped all the reserves into the financial system.

And for those of you who despise Monday-morning quarterbacking, recall that I was on this in real-time (picking up on the work of Alex Tabarrok).

Of course, Austrian economists are big on "counterfactuals." This is why we get so much grief from positivists. At Mises University we stress that economic laws are a priori and can't be tested, just like you don't take a ruler and compass (not the needle kind) and go "test" the Pythagorean theorem. For example, the Law of Demand doesn't actually say, "If prices go up, quantity demanded goes down." Rather it says, "Other things equal, if prices go up..." In other words, it is a counterfactual claim.

Ironically, I explained the primacy of economic logic, as opposed to simple historical data crunching, in a Mises Daily article from 2004 where my target was a fellow with the initials LK. (And no, it wasn't Lenny Kravitz.) So I am perfectly happy with counterfactual claims that apparently fly in the face of what "the data" tell us.

However, regarding the Treasury and Fed interventions and the credit markets, I have a perfectly good theory to explain what happened: Bernanke and Paulson started guaranteeing everything in sight, and the conventional wisdom became, "It was a mistake to let Lehman fail." So of course the spreads on certain types of debt would shrink back to "normal" levels; there's no reason to prefer Treasurys over Goldman debt if you think Goldman is backed up by the feds.

At the same time, banks would stop advancing new loans to medium- and small businesses, who weren't ever going to get bailed out, because the economy was still awful and most important because Bernanke literally began paying them NOT TO make new loans.

Economists are big on saying incentives matter. So why should we be surprised that when Bernanke injected hundreds of billions in new reserves, and then began paying interest to banks for keeping those reserves parked at the Fed, that the amount of loans to the private sector started dropping?

But couldn't someone then say, "well if it dropped that much starting in October, can you imagine how much lower it would be if it weren't for TARP?"
Jesse, yes, since that's what they said on the tape, I do believe it's possible someone could say that. :)
I've heard defenders of the "credit crunch"-view saying the market for corporate bonds crashed, so companies who normally got their money from issuing bonds instead loaned them from the banks. The bigger companies crowded out the small and medium-sized and hence created a credit crunch for all but the biggest companies. What do you think about that defense?
Per, I suppose you've to elaborate on that. Why were bigger companies outbidding smaller companies? Was it because a tightening of standards removed startups and small companies of the market as they hadn't built reputation or had little collateral to present?
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