Does the U.S. risk repeating the mistakes that led to the Great Depression? The Bank for International Settlements’ annual report, released Sunday, suggests that it does, and offers a remedy steeped in the doctrine of Austrian economics.
In the 1930s adherents of the “Austrian school,” named for its Austrian-born proponents Ludwig von Mises, Joseph Schumpeter and Friedrich Hayek, argued the Great Depression represented the unavoidable remediation of misallocated credit and overinvestment in the 1920s. The Austrian school largely failed to become orthodoxy as first Keynesian demand management appeared to end the Depression and later monetarism blamed the Depression on inadequate attention to the money supply.
Austrian economics, however, has enjoyed a minor revival in the last decade, most prominently at the Basel, Switzerland-based BIS, which has few formal banking duties but is an important talking shop (it is sometimes called the “central bankers’ central bank.”) The BIS’s leading “Austrian” is a Canadian, William White, the head of the bank’s monetary and economic department and sometimes-rumored successor to retiring Bank of Canada governor David Dodge. In a 2006 paper Mr. White wrote that under Austrian theory, “credit creation need not lead to overt inflation. Rather…. the financial system … create[s] credit which encourages investments that, in the end, fail to prove profitable.” This leads to an “an eventual crisis whose magnitude would reflect the size of the real imbalances that preceded it [because] the capital goods produced in the upswing are not fungible, but they are durable. Mistakes then take a long time to work off.” He argued that in recent decades, “financial liberalisation has increased the likelihood of boom-bust cycles of the Austrian sort.”
Although the concluding chapter of the BIS’s latest annual report, released Sunday, never mentions the Austrian school, it is suffused with its influence. “Virtually no one foresaw the Great Depression of the 1930s, or the crises which affected Japan and Southeast Asia in the early and late 1990s, respectively,” it begins. “In fact, each downturn was preceded by a period of non-inflationary growth exuberant enough to lead many commentators to suggest that a ‘new era’ had arrived.”
It notes that “the prices of virtually all assets have been trending upwards, almost without interruption, since the middle of 2003.” While fundamental economic improvements are at the root, “the market reaction to good news might have become irrationally exuberant. There seems to be a natural tendency in markets for past successes to lead to more risk-taking, more leverage, more funding, higher prices, more collateral and, in turn, more risk-taking… [S]uch endogenous market processes … can, indeed must, eventually go into reverse if the fundamentals have been overpriced.”
Apart from financial imbalances, the report argues the world economy also displays dangerous misallocations of capital. In its “recent rates of credit expansion, asset price increases and massive investments in heavy industry, the Chinese economy also seems to be demonstrating very similar, disquieting symptoms” to Japan in the 1980s. “In the United States, it is the recent massive investment in housing that has been unwelcome from an external adjustment perspective. Housing is the ultimate non-tradable, non-fungible and long-lived good.” In other words, the U.S. could be stuck with a lot of houses that are hard to sell to each other and impossible to sell to foreigners, and won’t need replacement for a long time.
What does the BIS say central bankers should do? Essentially, relax their single-minded focus on price stability, and tighten monetary policy when “a number of indicators — not just asset prices but also credit growth and spending patterns — are simultaneously behaving in a manner that indicates increasing exposures.” In other words, when easy credit is fueling excesses, raise interest rates to end the party, even if inflation is quiescent.
In practical terms, few central banks are ready yet to heed the Austrian prescription. Federal Reserve Chairman Ben Bernanke spent a lot of his life arguing just those sorts of prescriptions helped bring about, and deepen, the Great Depression. (See, for example, his 2002 speech, “Asset-Price ‘Bubbles’ and Monetary Policy.” Under him, the Fed remains focused on inflation. The European Central Bank has recently reasserted the importance of money and credit growth in its deliberations, but its policy for practical purposes also remains focused on inflation. The Bank of Japan comes closest to sharing the BIS view and has routinely cited the risk overinvestment as a reason to raise rates, but it has recently stopped tightening as inflation remains near zero.
As Mr. White has acknowledged, the Fed can rightly argue its practice of leaving bubbles alone and cutting rates to mitigate their bursting appears to have worked well. The post-stock bubble rate cuts may have in turn created a housing bubble whose consequences haven’t fully played out. But the strength of economic growth since 2002 appears to have placed the burden of proof on advocates of an alternative policy.
This isn’t to say Fed officials are unsympathetic to some of the BIS’s diagnoses. Some, in particular New York Fed president Tim Geithner, regularly warn that risk-taking is at an extreme and a reversal could trigger a self-reinforcing spiral of price declines and asset sales. Yet, having thought it over, they’ve concluded anything the Fed does with interest rates to address this risk would likely make matters worse. –Greg Ip
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