The Economist: Austrian school provides the best explanation
I recently criticized The Economist for its very confused Keynesian analysis of monetary policy in Europe . Its analysis of China's impact on the global economy in its latest issue is however a lot more impressive. Apart from a few minor details, its provides a interesting and correct analysis of the subject.
Some of the more interesting paragraphs is when they point out that given a positive supply-side shock in terms of increased availability of cheap goods from China, positive consumer price inflation is not a good thing and in this context praises the Austrian school analysis.
"In its latest annual report, the Bank for International Settlements (BIS) asks whether it is really desirable to maintain positive inflation rates when China is boosting the world's productive potential so dramatically and thus reducing the prices of so many goods. In other words, are central banks targeting too high a rate of inflation now that China has joined the global market economy?
During the late 19th-century era of rapid globalisation, falling average prices were quite common. This “good deflation�, which was accompanied by robust growth, is very different to the bad deflation experienced in the 1930s depression. Today, we would again have had “good deflation�—but central banks have instead held interest rates low in order to meet their inflation targets. The BIS frets that this has encouraged excessive credit growth.
This echoes a fierce debate in the 1920s. At that time, a similar jump in the world's productive potential (then caused by technology-driven productivity growth) was reducing manufacturing costs. Some economists suggested that, in such circumstances, overall price stability might be the wrong policy goal. Instead, they argued, average prices should be allowed to fall to pass the productivity gains on to workers and consumers as higher real incomes. But just like today, monetary policy prevented prices from falling. And an overly loose policy then inflated the late-1920s stockmarket bubble.
The Austrian school of economics offers perhaps the best framework to understand what is going on. The entry of China's army of cheap labour into the global economy has increased the worldwide return on capital. That, in turn, should imply an increase in the equilibrium level of real interest rates. But, instead, central banks are holding real rates at historically low levels. The result is a misallocation of capital, most obviously displayed at present in the shape of excessive mortgage borrowing and housing investment. If this analysis is correct, central banks, not China, are to blame for the excesses, but China's emergence is the root cause of the problem."
Good, very good. But why did they then just two weeks ago then call for the already inflationary ECB to aggravate these misallocations by becoming even more inflationary? Either they are schizophrenic or (more likely) their writers ( The Economist's articles are never signed and their writers are anonymous) disagree with each others, some being pure Keynesians and others being more or less Austrians.
Comments (8)
"The entry of China's army of cheap labour into the global economy has increased the worldwide return on capital. That, in turn, should imply an increase in the equilibrium level of real interest rates."
Why does this statement follow?
Thanks for the answer in advance
Published: August 1, 2005 9:42 PM
If you look at borrowing and lending as a real business, i.e. market-driven based on risk/returns; then an increase in worldwide return on capital will cause banks, etc.. to charge more in interest because they can get more back from the borrower (since a borrower could presumably invest in China and tap its high return on capital that results from the cheap labour costs), and also because there will be more people wanting to borrow to invest in China.
Another way of looking at it is: suppose the interest rate is 10% from the bank, and the rate of return on capital in China is 15%... then there is a profit of 5% for doing nothing other than borrowing money from the bank and lending/investing it in some firm in China... and so _tons_ of people will do this until the demand and supply balance itself out at some new (higher) equilibrium point for real interest rates.
But since interest rates on fiat money are somewhat arbitrarily set by central banks for the purpose of messing with inflation, etc.., then what the interest rate should be (based on the market) and what it actually is get more out of sync, leading to larger problems when it all sorts itself out.
There's a chapter in Mises's Money and Credit about it I think (and maybe in Human Action too).
Published: August 1, 2005 10:29 PM
Not to dismiss entirely that the main thrust of the Economist article is surprisingly clear-sighted, but I'm not sure they've done the cause much of a service when they write:
"The Austrian school of economics offers perhaps the best framework to understand what is going on. The entry of China's army of cheap labour into the global economy has increased the worldwide return on capital. That, in turn, should imply an increase in the equilibrium level of real interest rates. But, instead, central banks are holding real rates at historically low levels. The result is a misallocation of capital... most obviously displayed at present in the shape of excessive mortgage borrowing and housing investment..."
Isn't this a very squint-eyed synopsis of Austrian capital theory?
Just because firms can spend more of their budgets on capital than on the new, cheaper labour, why does this imply equilibrium real interest rates mustbe higher? We Austrians don't subscribe to a productivity theory of interest, after all, do we?
Surely, in an honest monetary system, real interest rates are set by the availability of savings(about which this process says nothing and which the empirically-observed increase in profits might be enhancing)as much as by the demand for loanable funds?
Of course, those profits are themselves measured in inflating money and/or depreciating currencies and so may not actually represent much in the way of any extra real return at all, but that is just another element of our modern-day illusion.
On another tack, we should not call housing an "investment" - it is a hoard, or a durable supply of, consumption services, not expenditure on a productive or reproductive good.
Mortgage credit is just another form of consumer credit and tends to shorten the productive structure, even as our profit-seeking corporate captains are trying to lengthen it.
Published: August 2, 2005 1:13 AM
Sean, what they primarily refered to was not so much Austrian capital theory, but the Austrian business cycle theory-that when governments increase the money supply and thereby pushes interest rates below their natural level for example in an attempt to prevent consumer price deflation this will create distorting over-investments
As for the effect on natural interest rates from an increase in the supply of labor, it is true that Rothbard in Man, Economy and State tried to reject the "myth of the importance of the producer's loan market", but looking at it closely you can see that this rejection by his own admittance only holds in the constructed world of the evenly rotating economy as well as the point towards which the real economy in the long-term moves.
But short-term shocks like a sharp increase in the supply of labor will have the effect of pushing up the return of capital above the long-term equilibrium determined by consumer time preferences, something which in turn implies higher market interest rates.
And of course, in this case the "short-term" is relatively long, since it is likely to be years before increase in labor supply will be absorbed through the higher investment (and thereby supply of capital goods) that is stimulated by the higher returns.
As for whether housing construction could be considered investments or not, this depends on how narrow or broad definition you have of investments. If you define investments as something which will generate money income, then
housing construction and the production of other consumer durables is not investments (although of course in today's bubble mania is producing capital gains ). But if you define investments as any expenditure which will generate future goods and services then housing construction are an investment since it will produce housing services for decades into the future. Whether the narrow or the broad definition should be considered the most appropriate depends on the context.
Published: August 2, 2005 12:02 PM
Hi Stefan:
In response to your answer to Rothbard's rejection of the myth of the importance of the producer's loan market you state, "but looking at it closely you can see that this rejection by his own admittance only holds in the constructed world of the evenly rotating economy as well as the point towards which the real economy in the long-term moves." I thought he was implying that the context of the ERE was sufficient for analyzing the influence on interest rates by the producer's loan market.
If you’re right, and Rothbard overlooked the fact that his analysis crumbles in the real world, I would like to read any articles that might expound on this argument further. Would you mind pointing to any links you know of for this? Thanks!
Published: August 2, 2005 7:17 PM
Sorry, Paul, but I don't know of any articles discussing this as I haven't focused on this issue. But in Man, Economy and State Rothbard does actually in one sentence admit that his analysis only is true for the ERE:
"For, as we have seen, producers benefit, not from the gross revenue received, but from the price spread between their selling price and their aggregate factor prices. The increase in physical producÂtivity will certainly increase revenue in the short run, but this refers to the profit-and-loss situations of the real world of unÂcertainty . The long-run tendency will be nothing of the sort. The long-run tendency, eventuating in the ERE, is toward an equaliÂzation of price spreads."
The ERE is not a irrelevant construct, it is certainly a helpful pedagogic tool to understand the long-run tendencies. But as we all know and as Rothbard certainly knew, we should certainly not assume that the real world will be like it all or even most of the time. I therefore find it strange that Rothbard didn't discuss more (Or perhaps I have overlooked some other part of MES where he discuss it. If so, I welcome if anyone can point to this) what happens during the profit and loss situation of the real world of uncertainty and sometimes in this chapter gave the impression that this was irrelevant.
Published: August 3, 2005 4:15 AM
Hi Stefan:
I'll give you my interpretation. You are right that in MES, Rothbard acknowledges that his analysis of the pure rate of interest is based on the ERE: “We have completed our analysis of the determination of the pure rate of interest as it would be in the evenly rotating economy—a rate that the market tends to approach in the real world. We have shown how it is determined by time preferences on the time market and have seen the various components of that time market.� So the question might be is how strong does he mean the word “tends� to be. Perhaps it is a weak general tendency, disrupted significantly by various real market events not accounted for in the ERE and hence ignored in his analysis. However, I think he answers this in his very next comment: “This statement will undoubtedly be extremely puzzling to many readers. Where is the producers’ loan market?�
I think what Rothbard is saying is that the pure rate of interest is determined not by short-term entrepreneurial profits at all, because these profits will quickly be competed away:
“The long-run tendency, eventuating in the ERE, is toward an equalization of price spreads. How can there be any permanent benefit when the cumulative factor prices paid by this producer increase from, say, 18 ounces to 47 ounces? This is precisely what will happen on the market, as competitors vie to invest in these profitable situations. The price spread, i.e., the interest rate, will again be 5 percent.�
So I’d say he has in fact accounted for the real market behavior, and that he is expressly saying the ERE sufficiently models the market in the analysis of the pure rate of interest because it is a long-term phenomenon on the real market. One way or another, it seems he is saying, it is time preference alone that dictates the interest rate.
“Thus the productivity of production processes has no basic relation to the rate of return on business investment. This rate of return depends on the price spreads between stages, and these price spreads will tend to be equal. The size of the price spread, i.e., the size of the interest rate, is determined, as we have seen at length, by the time-preference schedules of all the individuals in the economy.�
Published: August 3, 2005 1:48 PM
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Published: April 5, 2006 2:06 PM