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About the article
Published Online: 2013-06-12
“My thesis in this lecture is that macroeconomics in this original sense has succeeded: Its central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades” (Lucas 2003).
The author wishes to thank the two anonymous referees of the Journal. Their remarks helped to improve both the substance and the form of the present paper. They of course do not bear any responsibility for its content.
Huerta de Soto (2006 , 511–535) offers a detailed comparison between the Austrian and the monetarist theories of money, capital, and the business cycle.
The so-called “subprime crisis” is not limited to the problem of subprime mortgages, and not even to the housing sector. The name “subprime cycle,” although much too narrow, will be used all along in this paper.
For detailed presentations of the Austrian theory of the business cycle, see von Mises (1980 , 399–404, 2006 , 1998 , 547–583), Hayek (1967 ), Rothbard (2009 , 994–1021), Garrison (2001), and Huerta de Soto (2006 ).
The aggregate M1 (coins, notes, and demand deposits) is not a good indicator of the changes in the money supply because banks are allowed – under the retail deposit sweep programs – to sweep transaction or demand deposits overnight into saving deposits (Anderson and Armesto 2003; Anderson 2003). The author wishes to thank an anonymous referee for these references.
The federal funds rate is the interest rate at which banks lend their balances (i.e. federal funds) at the Federal Reserve to other banks, usually overnight: the banks that have excess reserves of their customers’ money lend these funds to those that have insufficient reserves, in order for each of them to maintain just the required (legal) quantity of reserves. The Federal Reserve manipulates this rate by carrying out open market operations.
The same kind of policy is used today against the consequences of the subprime crisis. Is the Fed currently manufacturing the next big crisis? This is a perfectly legitimate and alarming question from the point of view of the Austrian School.
Source: Bureau of Economic Analysis, U.S. Department of Commerce (http://www.bea.gov/national/index.htm#gdp).
Source: National Bureau of Economic Research (http://www.nber.org/cycles/cyclesmain.html).
According to this index, housing prices had remained stable between 1989 and 1993, and then increased 148% between 1994 and the 2006 peak.
Thornton (2005) shows the close correlation between skyscrapers building and business cycle. This connection is indeed relevant, and it can be remarked that in 2009–2010 the Arab Emirate of Dubai at the same time endured a harsh financial crisis (November 26, 2009) and inaugurated after 8 years of building the highest skyscraper in the world (January 4, 2010).
The Austrian School makes the very important point here that a significant malinvestment can take place while the inflation rate in consumers’ goods is small or nil (this is also what happened in the years preceding the 1929 crash: see Rothbard 1963).
This price index includes all items less food and energy. Bernanke (2010, 8) explains: “Core inflation excludes the prices of food and energy. Because it excludes the most volatile components of the price index, core inflation was often used by the FOMC as an indicator of the underlying trend of inflation.”
“The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and keeping us permanently in a quasi-boom” (Keynes 1973 , 322).
If the rate of growth of the money supply remains constant, then its effect on prices will eventually be correctly anticipated and a corresponding purchasing power component will be added to the market interest rate. The latter will thus increase, and in order to reduce it again the monetary authorities will have to create greater quantities of money.
“The downturn in home prices began at the regional level in late 2005 when home prices began peaking in the Boston, Detroit, and San Diego markets. At the national level, the peak did not occur until the summer of 2006 as more markets were starting to slide. Beginning in January 2007, national home prices entered their now 2-year decline. On average, U.S. home prices have been in a sharp annual decline since that date, with record low appreciation rates recorded each consecutive reporting month” (“S&P/Case-Shiller Home Price Indices 2008, A Year In Review,” January 13, 2009).
This result is corroborated by the data on commercial and industrial loans: the total value of loans shows no sign of decrease until 2008 (see Fred® Economic Data: Total Value of Loans for All C&I Loans, Domestic Banks). Similarly, during the year 1999 the federal funds rate increased from 4.7 to 5.5% while total loans kept on increasing too: the upsurge in the fed funds rate did not immediately stop monetary creation.
It should also be reminded that in the Austrian perspective, voluntary savings cannot trigger a malinvestment and thus cannot lead to a crisis: see the classic criticism of the “paradox of saving” by Hayek (2008 ).
Explanations relying on the greed of bankers and on the deregulation of financial markets will be left aside. They are criticized in a detailed and convincing way by Friedman (2009) (see also Norberg 2009, 49–54, and Horwitz and Boettke 2009, 11–12). See, however, the point made in note 36 below.
This is one of the points made by Prychitko (2009) in his Austrian criticism of Minsky’s theory: see note 37 below.
The annual value of the new subprime mortgages in the U.S. has grown from $65 billion in 1995 to $332 billion in 2003 and to $600 billion in 2006 (Chomsisengphet and Pennington-Cross 2006, 37, Bernanke 2008). The subprime mortgage market that represented 4.5% only of the new mortgages in 1994, reached 20% in 2006 (Bernanke 2008). The aggregation of all these subprime mortgages then amounted to approximately $1,300 billion.
According to the official site: “The Community Reinvestment Act is intended to encourage depository institutions to help meet the credit needs of the communities in which they operate, including low- and moderate-income neighborhoods, consistent with safe and sound banking operations” (source: ffiec.gov/CRA/history.htm).
Source:Board of Governors of the Federal Reserve System, Reg BB Community Reinvestment (federalreserve.gov/bankinforeg/reglisting.htm#BB).
Code of Federal Regulations, title 12, part 228, § 11.
Code of Federal Regulations, title 12, Appendix A, ratings. The five ratings for each bank, each type of banking activity, and in each community are: outstanding, high satisfactory, low satisfactory, needs to improve, and substantial non-compliance.
The Gramm-Leach-Bliley Act of 1999 (Public Law 106-102) repealed and replaced the Glass-Steagall Act of 1933, and permitted from then on to create new kinds of financial institutions called financial holding companies– combining a commercial bank, an investment bank, a securities firm, and an insurance company. However, these consolidations were only allowed on the condition that the bank had received a satisfactory rating on the CRA tests: “An election by a bank holding company to become a financial holding company… shall not be effective if… not all of the subsidiary insured depository institutions of the bank holding company [have] achieved a rating of ‘satisfactory record of meeting community credit needs’, or better” (Public Law 106-102, 113 stat, 1350).
See the amazingly prescient paper by Holmes (1999).
Notice that, from the Austrian point of view, the problem is not to bring a “response” to the housing bubble, but rather to avoid its existence in the first place.
The credit-default swaps and the Basel Committee on Banking Supervision will not be evoked here.
The alt-A loans have a medium risk, intermediate between the (low) risk of prime loans and the (high) risk of subprime loans.
Different kinds of securities are taken into account in these amounts: MBS (mortgage-backed securities), CMOs (collateralized mortgage obligations: MBS in which the mortgages are first packaged and then divided in tranches of different qualities that are sold separately) and CMBS (commercial mortgage-backed securities: MBS on commercial property). These securities are issued by the three GSEs (Fannie Mae, Freddie Mac and Ginnie Mae) and by other financial institutions. Source: Securities Industry and Financial Markets Association (sifma.org/uploadedFiles/Research/Statistics/SIFMA_USBondMarketOutstanding.pdf).
Friedman and Kraus (2011) show that a “proximate cause” of the financial crisis of Q4 2007 was the so-called “Recourse Rule” enacted by U.S. financial regulators and requiring American banks to have five times more capital for business and consumer loans than for AAA-rated MBS. This regulation “appears to have encouraged U.S. banks to accumulate nearly a half-trillion dollars of triple-A MBS” (2011, 2).
Prychitko (2009) identifies two weak points in Minsky’s theory from an Austrian point of view: first, it does not offer any theory of stabilization and stability, and second it rests on a psychological variable, namely optimism. According to Minsky, optimism creates the boom, while for Austrians it is the boom – caused by the credit expansion – that generates and amplifies optimism.