Economist Thorsten Beck posting at the World Bank CrisisTalk Blog:
The loose monetary policy in the first years of the 21st century has been one of the culprits for the boom and subsequent bust in the U.S., but rigorously testing this hypothesis is difficult .. But perhaps we can learn something from a small open economy for which monetary policy decisions can be considered exogenous. A recent paper by Vasso Ioannidou, Steven Ongena and Jose Luis Peydro does exactly this, using a unique dataset on Bolivian borrowers. During the period 1999 to 2003, the local currency was pegged to the U.S. dollar and the relevant short-term benchmark rate was the U.S. federal funds rate. The paper shows that reductions in short-term interest rates do indeed lead to excessive risk taking by banks, which can eventually lead to banking fragility when interest rates rise back to “normal” levels.
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Seems that no matter how much evidence you give them, Keynesians refuse to budge from their irrational positions.
Authors: “We find that the level of short-term interest affects bank risk-taking and the ‘amount of credit risk in the system’.â€
Why would this be? Could it be that those borrowers with good credit have already borrowed all they want and the lower interest rates attract only those with poor credit? In other words, even with the lower rates, banks may face a choice of loaning to poor credit or not loaning at all. This reminds me of the ABCT premise that all of the loans that are profitable at the higher rate of interest have been made. Only those profitable at the lower rate will be left. And if they’re profitable only at a lower rate, then aren’t they the riskiest ones?
Authors: “When short-term interest rates are too low and there is excessive liquidity in the financial markets, prudential standards may have to be tightened, through dynamic and forward-looking capital requirements and/or provisioning, for example.â€
But, the whole point of lowering interest rates is to get more people to borrow. Tightening standards will defeat that purpose.
Authors: “In fact, we find that the lower the interest rates were and the higher they move up afterwards, the worse credit risk will be.â€
In other words, the bust is proportional to the boom?
Its a good read, but unless I’m mistaken the paper does not distinguish between low interest rates driven by central bank credit creation, and low interest rates driven by savings. Many Keynesian and neoclassical economists believe the current crisis was driven more by high savings rates than central bank policy. As the authors mention, the causes of the low interest rates are exogenous to Bolivia.
fundamentalist: “But, the whole point of lowering interest rates is to get more people to borrow. Tightening standards will defeat that purpose.”
Exactly. As Alex Tabbarok said: “Instead, the foul weather Austrians seem at most to call for regulatory reform. But that too is peculiar. Put aside the fact that banking is already heavily regulated, have these economists not absorbed the Lucas critique? In short, suppose that whatever regulation these economist want had been put in place in earlier years. Would the crash have been avoided or would the Fed have simply pushed harder to lower interest rates? After all, the Fed lowered rates for a reason and if the regulation reduced the effectiveness of monetary policy in creating a boom well then that just calls for more money.”
Fundamentalist,
Evidence rarely changes a person’s mind, it, at best, only validates one’s beliefs. At times, evidence can be used to change a person’s mind but usually when that person has no interest in holding onto a belief or wants to find a way to reject that belief. The job and interests of most political economists lie in spraying economic perfume on the schemes of his/her masters or economic stank on the schemes of his/her master’s enemies. My initial training as a Keynesian economist focused on learning how to use cookie-cutter methods to show that whatever random plan you were considering is a solid economic plan or an economic nightmare. If your intended audience was still not convinced, make their eyes glaze over with arcane mathematical formulas. You still miss some but you can usually marginalize them. Why would you want to give that power up?
If you tell someone they are wrong, they will have emotional bias against you, for “insulting” their intelligence. I find you have to appeal to people’s intelligence using fundamental examples, finding that you agree with them on fundamentals. Then try to trace them to the specific issue and show why your fundamentals apply.
Glen: “Evidence rarely changes a person’s mind, it, at best, only validates one’s beliefs.â€
That’s so true. I went from Keynesian to Austrian econ because I didn’t have any baggage to defend. I just wanted to know the truth. If you have a career invested in Keynesian econ, or if your faith in the state gives your life meaning, divorcing Keynesian econ would be hard. Which brings up the principle that in order to know the truth, you have to be in a state of mind in which you don’t care about the consequences.
bob: “…using fundamental examples, finding that you agree with them on fundamentals…”
Agreed! That’s why I’m a fundamentalist!
Grant, aside from the context of FRB, why should lowered interest rates driven by actual savings cause a crisis? If you bring back FRB, the Austrians are by admission, correct…
Inquisitor, I’m not saying savings-driven low interest rates would cause a crisis, only that this article cannot say one way or another. Many economists, such as Tyler Cowen, blame a savings glut for the low interest rates which fueled the housing bubble, so I really don’t think its striking at the core of the mainstream’s consensus.
Grant,
I think it is important that we get some consensus on what exactly defines the savings glut hypothesis. I can think of a few different ways that a savings glut might be defined and I will attempt to examine what the effects of this will be. We can first categorize the source of the savings into two distinct classes: those savings which at their root are sound and based in a matching of consumer time preferences to the prior investment (i.e. not the result of malinvestment), and alternatively, those savings which are not sound and come from a mismatch in time preference to prior investment (perhaps as the result of prior inflation).
Next we can look at the effect of a fairly constant time preference on the part of the foreign savers as compared to a variable time preference. Combining these provides 4 cases to investigate.
1) Sound savings and constant time preference: This leads to sustainable growth and is not a contributor to the business cycle.
2) Sound savings and variable time preference: This can lead to entrepreneurial error, but can not be classified as a business cycle. The signal of rising interest rates will signal entrepreneurs to scale back their projects, but there will not be the cluster of errors which ABCT attributes to interventions in the interest rate.
3) Unsound savings and constant time preference: This will contribute to a business cycle as Hayek asserts in the Pure Theory of Capital p. 394.
4) Unsound savings and variable time preference: See 3.
I would contend that any contribution that the savings glut had on the current business cycle would have to have come from unsound savings that were the result of prior Fed inflation. Even case 2 can be absolved of contributing, for if the interest rate were not allowed to rise in response to the voluntary rise in time preference, the blame must be places on the intervention in the interest rate as ABCT postulates.
I would like to add a slight clarification to my prior post. The change in time preference can logically go from low to high or from high to low. This indicates that I should investigate a total of 6 cases, but it is hard to justify that a change in time preference from high to low would have any contribution to a business cycle. If we add these cases we get:
5) Sound savings and a decrease in time preference: this leads to sustainable and likely increased growth as compared to the constant time preference case.
6) Unsound savings and a decrease in time preference: this may have the effect of mitigating some of the malinvestment, but it is hardly conceivable that it would entirely counteract the prior inflationary effects. Please see the prior reference to Hayek.
Stanley,
Though I agree with much of what you are writing, I don’t think ABCT explains everything about modern bubbles. Specifically, the last two big bubbles we’ve had were in very specific industries (housing and Internet stocks). As far as I know, no variant of ABCT explains why malinvestments would be channeled into specific sectors of the economy.
I’m certainly not claiming to have all (or even any) answers, but I did recently read an interesting summary of bubbles in experimental economics, here: http://www.theatlantic.com/doc/200812/financial-bubbles
In short, the author makes the case that bubbles in financial markets can occur when there is enough information asymmetry in traders (usually from some traders being inexperienced with current market conditions). Knowledgeable traders can use a bubble to fleece the inexperienced, and so often purchase assets at values they know to be inflated. Changes in the trading environment (e.g., the rise of the Internet or CDOs) can make previously-knowledgeable traders become the victim of a ponzi-bubble. The market does eventually punish the foolish and reward the prudent, but with some assets this can take a long time. The kicker is that the most successful traders in these experiments were the ones who rode the bubble and took advantage of the foolish, not the traders who only invested according to fundamentals.
Of course, an easy supply of credit (regardless of the source) only fuels this process. I’d think that without central bank credit creation, we’d have fewer, shorter bubbles, but we’d still have some. Market conditions change, people make mistakes, and it takes time for the market to punish the foolish.
I believe this thesis explains why we’ve seen the last two big bubbles occur in very specific, innovative industries. I don’t think it explains everything; for instance, why don’t knowledgeable traders short the market instead of taking advantage of the bubble?
Grant,
Although the article you posted was interesting, it still seems that the take home message is too much money chasing too few goods creates a bubble. The speculation produced by an improper trajectory created by unknowledgable leaders of the crowd contributing to the bubble does not explain why there was so much money for speculation in the first place. That is, where did the leaders get so much cash in the first place, and were did the crowd get theirs to push the price skyward? I could see inflation and its effects on increasing time preference and the money stock as more of a factor on risky behavior and speculation than novel financial instruments.
I would think that the reason why our present bubble manifest itself in real estate and financial derivatives is because of prior state interventions resulting in an unnaturally derived higher rate of return in these industry. The Tech bubble could be explained as being a sector of the market less hampered by regulation and at the time offering a better rate of return as well. Then the bubble and wealth effects kick in and reinforce these phenemena. The bubble’s existence is always controllable by the existence of lack thereof of a free market in interest rates (even fractional reserve “free banking” will have interest rates manipulated by a third party to the saver and the borrower). The bubble’s focus is ultimately determined by rates of return, but it is difficult to predict how the infusion of money will affect the very landscape upon which it operates. Furthermore, it is difficult to predict how interventions will transform this landscape during the boom phase, perhaps redirecting the focus or broadening the scope of the bubble.
Grant: “Of course, an easy supply of credit (regardless of the source) only fuels this process. I’d think that without central bank credit creation, we’d have fewer, shorter bubbles, but we’d still have some.â€
The con men and the gullible are variations in greed. The con man is greedy enough to be willing to defraud a customer and the customer is so greedy he beomes imprudent and thinks he can get rich quickly. It has been said that you canned con an honest man. In addition, I once had a wise old econ professor who said the most common mistake people make is to believe the good times will last forever. That makes them gullible.
Someone has said that greed is like gravity. Blaming the financial mess on greed is like blaming airplane crashes on gravity. It’s always there. The question is what allowed greed to get out of control this time? The article argues that American credit expansion was the key to the Bolivian bubble because by linking to the dollar Bolivia surrendered monetary policy to the US. Without the credit expansion, interest rates would have been higher and people would have been more prudent, giving con men fewer opportunities.
Grant: “As far as I know, no variant of ABCT explains why malinvestments would be channeled into specific sectors of the economy.â€
I think you’re right on that. Hayek and Mises say you have to look at the sectors where the new money enters the economy to be able to see which areas will experience the bubble. In popular finance, not the academic kind, it’s believed that money jumps from overbought sectors to underbought ones. For example, Kyosagi (Rich Dad Poor Dad) has written that the very wealthy had gotten out of the stock market bubble long before the crash and put their money in commodities and real estate. He was a big promoter of real estate investing and doesn’t like the stock market. If he’s right, then the smart investors are value oriented contrarians and get out of bubbles before they burst and into a sector that has underperformed for a while and is unpopular.
But there are only a few major sector choices, commodities, real estate, bonds and the stock market. I’m betting that the next bubble will be in stocks because it will take years to absorb excess housing, and I think investments in oil production will keep prices low there for a while. Bonds are high and the stock market is low. The Feds have been furiously pumping money into the economy. When the economy bottoms, much of that will go into the stock market.
What’s a savings glut? Sounds like something I want to have
Bubbles – I think of the classical mechanics problem of a weight on slick surface attached to a spring. You stretch it out and it oscillates back and forth. With sound money and a free market that initial bubble can only be pushed out a bit, so the subsequent rebound and oscillations are small. With what we have today, the flow of money is too high and forces the weight too far out– it slams back and oscillates wildly…. or breaks!
I suppose a lot of people with a lot of savings could be duped into buying into a bad project… but that happens regardless of the model. It’s always better if people spend their own money rather than borrow recklessly and spend others money. People in my experience are more careful when they have more to lose.
-r
There was a lot of intervention that encouraged the housing bubble, that much is obvious. However, the same can’t be said nearly as easily for the dot-com bubble (which was obviously not nearly as much of a problem).
fundamentalist, obviously I’m not trying to blame the bubble on greed. My point is that, for an individual bubble, the source of liquidity is irrelevant. The actors participating in the bubble don’t know the difference between a change in time preference and a change interest rates. As ABCT shows, this can fool investors into starting projects that cannot be completed.
However, those were not the circumstances we found ourselves in with these last two asset bubbles. They were ponzi schemes, where investors bought assets they knew would never turn a profit with the hopes of selling them before their maturity. Only a constant influx of liquidity – from savers or central banks – makes this possible.
Though I think some ponzi-bubbles are inevitable, I think these monstrous ones we’ve seen lately is an expected outcome when you insure savings: Savers aren’t very diligent about putting their savings in the hands of people who will use it well.
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