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NOTE Current Market Conditions: 13 Oct. 2008

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I'm here with Roger Garrison, a professor of economics at Auburn University. I enjoyed

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interviewing him over the summer at the Mises University and we're here again today to get

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a little bit of an update on some things going on in the markets and some analysis of the

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The current trends in light of Austrian theory. Of course, he's the author of Time and Money

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and possibly the preeminent living business cycle theorist. So welcome, Dr. Garrison.

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Well, so let's talk first about the extent to which the Austrian theory explains what's

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going on. How is it possible to watch markets today and not have an interest at least in

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the Austrian theory?

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Well, of course, there has been an increased interest in the Austrian theory just because

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of the current crisis. It fits the Austrian theory much better than the Keynesian or monitors

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or certainly the new-fangled real business cycle theories and all that. I think there's

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been a lot of interest as shown by the Google website with hits coming up dramatically on

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Austrian economics. And the very fact that it's having such a dramatic effect in a long-term

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sort of industry, namely the housing industry, is even more evidence that the Austrian theory

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is very much in play here.

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Yeah.

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There doesn't seem to be any competitive theories, it strikes me, or maybe I'm not aware of them.

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But what other explanation could you have for this cluster of entrepreneurial errors?

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Well there seem to be none.

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In fact, it's not just that there's no good answers.

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The questions aren't being asked because most all of the modern theories, whether it's

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New Keynesian or New Classical or Real Business Cycle Theory are assuming a state of equilibrium,

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are assuming rational expectations, are assuming efficient markets. It rules out from the very

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beginning any possibility of a genuine cyclical movement. So when something like this goes wrong,

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then the reaction is, well, let's fix it and get things back to where they should be. Right. At the

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At the theoretical level, there's just an absence of any ability to explain what's going on.

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At the policy level, it's just a reversion to the O-line Keynesian theory.

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Simply stimulate with fiscal policy, stimulate with monetary policy, do what you can to rekindle

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the boom.

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And, of course, the problem is that the boom in the first place is an artificial boom,

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and it can't be rekindled once it crashes.

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One of the things that's frustrating about this whole business is that there doesn't

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seem to be any real way that it can be somehow disproven that they are correct in their analysis.

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Because it seems like no matter what happens, if they inject money in and the markets go

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down, they say, oh, well, we haven't done enough.

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in the 1950s and 1950s, and goes back to his 59th book on Keynesianism.

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I suppose it's essential to live through these kinds of times to focus the mind on some of

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these essential questions about business cycle theory. In that sense, you must be pleased.

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I mean, everybody's thinking about this topic now.

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That's right. That's right. I've gotten quite a few emails asking for sites to different

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things and references and so on. It's gratifying. And I've gotten emails from old students that

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say, now I finally get it. I see how it works. I see what you're talking about.

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I suppose that's right. Even in your classes, when you say, well, the Boehm-Bawerk cycle,

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now people are aware of what you're referring to. For a long time, people wouldn't have

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any idea.

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That's right. And this semester, I'm teaching a history of thought class in just covering

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Menger and the orders of goods and the follow-on with Boehm-Bawerk and so on. And I took one

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lecture and simply quit tracking the history of thought and showed the direct application

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of Minger's and Boehm-Bawerk's theory to the current situation.

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So you get a payoff from that theory and not just one step in the development of modern

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economics, because modern economics has lost sight of that part, which is a part of the

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story.

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Does it also strike you just how much history is repeating itself here?

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You read something like Rothbard's Great Depression and we see almost a transcript of the headlines

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of today.

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That's right.

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That's right.

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There's a lot of common features of the bust, and it's tied to the fact that the misallocations

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are related to the temporal dimension of the economy.

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The interest rate is wrong going through the boom, and that misallocates resources intertemporally.

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That's sort of a constant in the Austrian theory of the business cycle.

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It turns out the particulars of each cycle differ one from the other, but in ways that

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are themselves understandable.

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It turns out that most artificial booms, certainly the ones we're familiar with in the 20th century,

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are booms that ride piggyback on whatever else happens to be going on at the time.

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The dot-com boom just over-leveraged the boom that actually had some technological roots

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and the housing boom that we've just been through.

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It was a standard Austrian boom that was riding piggyback on the subprime crisis that itself

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Is this what creates the illusion that, in some sense, business cycles are related?

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The illusion that in some sense the business cycles are related to technological change?

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I think so.

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In fact, that goes back to the 1920s when we had massive innovations in mass production

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of automobiles, electrification, home appliances, processed foods, developments in the chemical.

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So it seems like there's some technology in play, as certainly there was.

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But if the Fed hadn't been in play at the same time, those technological factors would

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simply have given us strong economic growth.

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But those factors were leveraged to the point, over-leveraged, where instead we got boom

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bust.

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So when the new money is injected into the economy at the first stages of the boom, then

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we can't expect to see the effects of the malinvestment to be spread evenly across the

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economy then.

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No, no.

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Sector-specific?

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No, no.

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Sector-specific in two ways.

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It's sort of theoretically sector-specific in that whatever is interest rate sensitive

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is going to get more of a boost, and then historically sector-specific in the sense

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that whatever else is going on at the time is what tends to get amplified the most.

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Housing was an issue in the late 20s and the early 1930s, wasn't it?

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Well, it was.

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and more land prices in that period, and of course, land is a quintessential long-term factor, it lasts a long time, and so when interest rates are low, land prices are bit up, and you've got land bubbles in Florida and elsewhere that couldn't be sustained, and they come crashing down as they did.

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What's with this ethos that has developed or is this typical among the American public

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that somehow their house of the prices must expand way above the average rate of returns

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every year?

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That's right.

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It comes to be expected.

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A trend doesn't have to go on for very long before people who normally pay no attention

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to economics begin to think that it's permanent.

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I remember reading years ago of problems with deflation in the last part of the 19th century,

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and the question was raised, it was a survey question, do you think it will ever be possible

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to do anything about this deflation? And the answer typically was no, you're always going

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to have it. Deflation will always go on, and the government might slow it down, but there's

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The stories I recall hearing from people who are investing in stocks, under the pretense of almost an infallibility, whatever they pick is going to go up.

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I recall shaving one day in front of somebody and somebody stopped me and said, what blazer are you using and how do you like them?

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And I said, well, why? He said, well, I'm considering an investment in shaving blade.

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This is not a professional investment, this is regular, you know, you wonder.

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I wondered at the time, is this the peak of the boom?

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Do you expect that we're going to see a replication of this downward pressure on prices? And what is that a result from, if it does impact that?

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The Real Sector has already been affected by decisions made over the years under conditions of artificially low interest rates.

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Just to give you an example, there are lots and lots of large sport utility vehicles out there on the road that are being leased.

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And all those things are going to be turned in in the next two to three years as those leases run out.

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And the contract residuals on all those automobiles is way above any conceivable market price that those vehicles might have.

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and so you're going to have lots and lots of those large vehicles sitting on dealerships, lots, over the next several years, they can't get rid of them and they're worth only a fraction of what their prior market value would have been.

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Which leads to layoffs and bankruptcies?

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I think the only going business will be the paving industry that has to make bigger lots for all those cars to settle.

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I've already been talking to some companies over the last several weeks that are already laying off people.

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Of course, the unemployment data is so late in coming in, but it seems like we're already starting to see the effects of this.

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The Austrian Theory is just now catching on, or catching people's attention, is that for

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For years, the Federal Reserve have set their interest rate looking at not much more than

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inflation and unemployment. Those are the two key variables. And with the Austrians,

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that's really not the most important things to look at. They want to look at interest

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rates and the allocation of resources relative to saving, actual saving, and look at money

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Creation, and that sort of thing. But to show you the extent of the complacency,

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we remember the episode several months ago where Phil Graham concluded that we

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live in a nation of whiners. Wasn't that his expression? We live in a nation of

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whiners. And the reason he said that, I'm fairly sure, is he's a very conventional

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macroeconomist. He looked at the unemployment rate and at the time it was

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The Federal Reserve, fiat money, fractional reserve banking, Human Action, Man Economy and State, The Theory of Money and Credit

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in 2002 and 2004. It's a pretty easy judgment call to say that's too low and it's going

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to mean trouble ahead.

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What is the Fed's objective, macroeconomic objective right now, as you understand it?

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Well, of course the objective right now is all on liquidity. They're simply trying to

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save the financial sector by figuring out still more and more ways to pump in liquidity,

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including actually paying interest on reserves, making it cheaper to hold reserves, getting

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paid for it, holding the discount rate down, they're doing a lot of credit swaps, or they're

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trading treasury bills for bad loans, and everything they can do to get the banks to

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They attribute the lack of lending to fears, as if it's irrational fears. But what we should understand is they're real fears. There is a lot to fear out there that by relinquishing some of the liquidity they do have, they actually risk insolvency. That's a bad gamble.

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Well, what's the advantage of liquidity? Maybe that's a dumb question, but what is the real point? What's wrong with the period of savings, of pullback, of piling up of reserves?

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Well, there's nothing wrong with it from the bank's point of view and, in fact, even from the point of view of the economist, that, in fact, if the level of uncertainty in the real economy is so increased as it is in these days, it's a rational judgment not to commit funds to loans to prospective borrowers, because if those loans go bad, then not only have you

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In the current climate, one factor I think that is at work is that credit histories are

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no longer a very good indication of credit worthiness going into the future because things

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of Money, The Theory of Money and State, The Theory of Money and State, The Theory of Money

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Murray Rothbard has driven home and many other Austrian economists that what's necessary is to identify the bad investments for what they are in real terms and begin liquidating them as opposed to propping them up with still more cheap credit.

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What are the effects of propping them up with more cheap credit?

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Well, of course, postponing the correction and ultimately making the correction even worse than it would be if you made it currently.

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And that has happened in several rounds, hasn't it?

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The additional factor is the dealing actually with the crisis gets delayed by the financial institutions simply stalling, waiting to see what kind of a sweetheart deal the federal government is going to come up with next.

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This postpones. The politicians talk about the credit markets being in a logjam or frozen or whatever.

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Well, they're just holding back to see what kind of a deal they're going to get from the federal government.

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Actually, I recall seeing several financial commentators on television

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observing how strange it is that the same banks that are begging for bailouts right now are still paying dividends.

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That's right. That's right. Which is to say, that's true. And so they couldn't do that if they were insolvent now or if they were illiquid, but at the same time they just wanted to see what kind of a deal they could get from the government.

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It's interesting. We see the same thing after natural disasters. I remember when we had one several years, some years ago in Auburn.

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The city did not want to clean up before FEMA officials came through town to see what a disaster it was.

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To see how bad it was.

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So you want to make everything look really terrible for the water responsible.

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That's right. That's right.

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Well, what kind of dilemmas does the Fed face right now?

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Why is there no worry about inflationary effects?

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Well, I don't know how much worry there is, but those worries lie in the future, essentially.

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The liquidity that's being created now is pretty much being held on to by the banks.

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When the time comes that the logjam breaks, either because they get their sweetheart deals from the Feds or because real adjustments begin to occur in the marketplace, at that point that liquidity will all of a sudden turn into more loans, which is lending money that didn't exist essentially before the Fed created it.

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and after that you begin to get some inflation and then what the fed is supposed to do of course is

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sop up the liquidity, they're supposed to remove it but politically it's much easier to put it in

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than it is to take it out. Historical episodes suggest that it won't all get taken out if

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any of it is turned up as inflation. Would you favor any kind of restrictions on

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on Bank Lending after this process goes through?

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Well, I think the current episode is just one more episode that favors not just deregulation

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but decentralization.

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The problem is to take control out of the hands of the central authority.

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One way to look at this, and I think it's revealing, is that the Fed, and especially

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Alan Greenspan had claimed for years that you can't tell if we're in a bubble until it bursts.

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He's said that a number of times on different occasions and so on. You just don't know. And

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at the same time, they set interest rates really by the seat of their pants. It was a learning by

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doing process. Each committee meeting, federal open market committee meeting, which occurs

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Money and Credit

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Money and Credit

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Money and Credit

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and see how that works out and then in another six weeks they decide on interest rates again.

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They have no real anchor, nothing to go by that is very substantial.

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I call it a learning by doing process.

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Now the rub comes, given that you don't know if you're in a bubble until it bursts,

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the rub comes that it's a learning by doing process,

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but the doing is done every six weeks.

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But the learning occurs only every ten years.

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So you go on for 10 years learning by doing, and then you learn that you were doing the wrong thing.

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This is not good for the economy.

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So they need to line up their learning and doing to match it with reality.

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Is there a particular chapter from your book that you would recommend that people look at in particular to understand?

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From time and money, well, the key chapter, I guess, would be chapter four, where I walk the reader through the boom-bust process with the Fed expanding the money supply, causing the interest rate to be artificially low, with the predictable consequence that you get a boom and then a bust.

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Thank you very much, Professor Garrison. Thank you.