Thursday, September 25, 2008

"Malinvestment" in Ron Paul's Vocabulary

Ron Paul outlines mistaken Austrian Business Cycle theory:
"These governmental measures, combined with the Federal Reserve's loose monetary policy, led to an unsustainable housing boom. The key measure by which the Fed caused this boom was through the manipulation of interest rates, and the open market operations that accompany this lowering.

When interest rates are lowered to below what the market rate would normally be, as the Federal Reserve has done numerous times throughout this decade, it becomes much cheaper to borrow money. Longer-term and more capital-intensive projects, projects that would be unprofitable at a high interest rate, suddenly become profitable.

Because the boom comes about from an increase in the supply of money and not from demand from consumers, the result is malinvestment, a misallocation of resources into sectors in which there is insufficient demand.

In this case, this manifested itself in overbuilding in real estate. When builders realize they have overbuilt and have too many houses to sell, too many apartments to rent, or too much commercial real estate to lease, they seek to recoup as much of their money as possible, even if it means lowering prices drastically." -- Ron Paul, 23 September 2008
(As an aside, I am aware of some discussion on the community forums at of some version of my article.)

Barack Obama has also already gone into more technical detail, on another topic entirely, than I expect from presidental candidates. Last year at Google, Eric Schmidt asked him for "the most efficient way to sort a million 32-bit integers." Obama said, "The Bubble Sort would be the wrong way to go."


Blissex said...

I have asked myself often what has happened in the past that caused some large changes in the economy, as I noticed that jut about any "financial" quantity changed trend in 1995. From a gently sloping trend of growth matching or being slightly higher than GDP, the trend changed to growth much faster than GDP; a set of "hockey sticks".

Some long term graphs, first the most striking:

Then growth of M3 over decades:

Then growth of foreign USA debt:

Then some "relevant" (blue chip) stock prices:

Even IBM's stock price took off in 1995 after a near bankruptcy and losing its domination of IT:

and curiously GE started to do really well only in 1995:

So something important happened in 1995. From the graphs it looks like that it was a gigantic expansion in the availability of "money", and in particular of short term credit.

The only plausible explanation that I found is amazingly from a gold bug (who was inspired by Luskin...):
«The key event that happened around 1995 is that the fractional reserve ratio was not only lowered, it was effectively eliminated entirely. You read that right. The net result of changes during that period is that banks are not required to back assets which largely correspond to M3 or "broad money'' with cash reserves. As a consequence, banks can effectively create money without limitation. I know that sounds hard to believe, but let's look at the facts.»

Once the rules were changed to allow for ever increasing leverage, the system was on a hockey-stick trajectory, and one that got helped, for example with other relaxations:

especially as the financial sector became an ever larger percentage of GDP, stock market valuation and corporate profits, fueled by the seemingly endless availability of credit at a very low cost.

If there is another explanation for the sudden boom in credit availability and thus zooming leverage that started in 1995 I'd like to know.

Devin Finbarr said...

Wow, blissex, that Aaron Krowne article is amazing. Suddenly, all the puzzle pieces start to fit together.

Where do you argue that Ron Paul goes wrong? Your paper has nothing to do with his arguments. All your paper says is that in a firm with reswitching, malinvestment doesn't take the form that one particular Austrian economist ( Hayek) says it will take. Possibly true, but a trivial criticism.

The overall Austrian theory seems to be the most accurate interpretation of events. I mean this crisis has unfolded like a textbook case. Do you have a better explanation? Is there any keynesian/monetarist who was predicting this crisis before it happened?

YouNotSneaky! said...

(just joking)

Anonymous said...

"The overall Austrian theory seems to be the most accurate interpretation of events. I mean this crisis has unfolded like a textbook case."

Well, I've critiqued the Austrian arguments here.

The Austrian theory needs as many unrealistic assumptions as neo-classical economics for it to be an accurate interpretation of events.

I can also agree that problems are caused by the interest rate being lower than the "natural one" but it takes heroic assumptions to argue that capitalist banks will, firstly, be able to find that rate and, secondly, that they will stick to it. They are seeking to make money, which explains why banks have spontaneously implemented fractional reverse banking.

And there are good reasons why Keynes won the debates on the 1930s against Hayek. Kaldor and Sraffa destroyed his arguments. I know that the Austrians dislike to mention that little fact, but it is a fact.

And as Robert's article shows, even if we assume that the "natural rate" can be found and that capitalist banks do not act as capitalists and stick to it, there are other important problems with the theory.

I would suggest the post-Keynesian analysis as a good starting place for an accurate and realistic analysis of the crisis.

An Anarchist FAQ

YouNotSneaky! said...

"I would suggest the post-Keynesian analysis as a good starting place for an accurate and realistic analysis of the crisis."

What do capital related paradoxes have to do with the present crisis? Minsky sort of fits the bill here but then pretty much any theory which has financial crisis in it is going to match somewhat pretty much by definition (hence, my joking link to Lyndon LaRouche). This is more asymmetric information plus principal agent problems plus some really stupid decisions (i.e. behavioral economics).

Robert Vienneau said...

Blissex, I don't know what happened in 1995. I expect to see trend changes around Nixon's administration, what with the end of Bretton Woods. The start of the integration of the xSSR and satellites into the capitalist sphere is an important event. For financial institutions in the USA, the later repeal of Glass-Steagall is of some importance.

As Iain notes, Post Keynesian analysis directs our attention in various ways. The second-hand circulation of debt instruments is money. I wonder if which new instruments became available or acceptable for settling debts among investment banks, hedge funds, etc. in the 1990s.

Devin, with respect to the ABC Theory, Hayek is not just some guy. Whether the theory can get along without certain propositions about the order of goods and the structure of production remains to be demonstrated.

Iain, I certainly agree about the importance of Kaldor's and Sraffa's refutations.