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I'm a first year econ PhD student and my macro professor assigned us the paper topic:  "What has the downturn and the major government policies carried out to address it tell us about macroeconomic theory?"  My professor has been exposed to the Austrian School but sticks to his neoclassical guns.  I've tried to present the Austrian explanation as best I can.  I don't know how to attach files here so I've just pasted the whole thing.  Questions/comments/whatever.. :

 

 

 What has the Downturn and the Major Government Policies Carried Out to Address It Tell Us About Macroeconomic Theory?

 

To many people, the collapse of the housing bubble and its devastating ripple effect through the financial sector came as a big shock. Even Federal Reserve Chairman Ben Bernanke was utterly blindsided by the crisis. Bernanke, when asked about the possibility of a housing bubble in a 2005 CNBC interview, argued: “Well, unquestionably, housing prices are up quite a bit; I think it's important to note that fundamentals are also very strong. … I think it's fair to say that much of what's happened is supported by the strength of the economy.” The interviewer followed up by asking Bernanke what the likelihood of a recession might be, to which Bernanke replied: “It's a pretty unlikely possibility. We've never had a decline in housing prices on a nationwide basis. So what I think is more likely is that housing prices will slow, maybe stabilize: might slow consumption spending a bit. I don't think it's going to drive the economy too far from its full employment path, though.” Bernanke later added: “I do think this [housing speculation] is mostly a localized problem, and not something that's going to affect the national economy. (2005a)”

The point here is not to imply that Bernanke is stupid; far from it. Bernanke received the highest level of education in mainstream economic theory. After majoring in economics at Harvard, Bernanke earned his PhD from MIT where Robert Solow was one of his dissertation supervisors (Bernanke's dissertation topic w as “the implications of uncertainty for investment and the dynamics of the business cycle”) (2010e). Bernanke's views were not rogue among his peers; the bursting of the housing bubble caught virtually the whole of mainstream academia by surprise. 

Adherents of the Austrian school, however, had been anticipating the housing bubble as early as 2002. Robert Blumen (2002a) in 2002, Frank Shostak (2003a) in 2003, Peter Schiff (2008a) in 2004, and Stefan Karlsson (2004a) in 2004 are a few examples of such prognosticators. Indeed, the economic downturn taught Austrian economists nothing about macroeconomics they didn't already know from reading Ludwig von Mises. Rather, it merely bore out in practice what Austrian economists have been preaching in theory since the early 20^th century. Whether mainstream economists will heed these lessons remains to be seen.

To understand the causes of unsustainable economic growth (which is followed inevitably by a recession ), it is necessary to first understand the causes of sustainable economic growth. As a starting point, examine an economy producing on or around its production possibilities frontier (PPF), such that this economy produces just enough goods to maintain a steady consumption level while gross investment is just enough to offset capital depreciation. Given contemporary knowledge constraints, the only way to permanently increase future consumption levels is to invest more resources and labor into current production of capital goods. If society is to invest more, people first must save more. Since we stipulated that this society already is producing at its PPF, an increase in savings can come about only by reducing current consumption levels. Understanding this tradeoff is essential: Absent technological developments or the discovery of new resource pools, sustainable long term growth requires a temporary reduction of present consumption; only this abstention from consumption frees up the resources for investment in capital goods that will pay dividends in the future. Over the investment period, meaning the time necessary for the project to be completed and start turning a profit, resources will be tied up without producing immediate yield. During this time the investors will eat into their savings to meet their desires for immediate consumption, while waiting to reap the rewards of their investment. The length of the investment period a society can support thus depends on the time-preferences of the individuals who comprise that society.

Time-preference is a fundamental concept of Austrian economic analysis. Time-preference refers to the degree to which people prefer present goods over future goods. Generally speaking, people exhibit positive time-preference and discount the present value of future goods accordingly. Even if the Federal Reserve didn't inflate the money supply, most people would prefer $1000 in the present over an iron-clad claim on $1000 12 months in the future. Because the time gap creates an opportunity cost (meaning that while the money is out of the investor's possession, he cannot use it to satisfy other more immediate desires), a potential investor will discount the present value of his claim on 1000 “future dollars” based on his own valuation of the foregone opportunity. A potential creditor with a low time preference who has enough resources to cover most of his present desires may lend $1000 to a borrower for one year, so long as the borrower promises to pay back the money and a 5% premium, thereby promising to pay the lender $1050 in one year. A person with less savings, however, may attribute greater value to $1000 foregone over the same period than his financially secure counterpart. This person would have a high time-preference, and so he might charge a 10% premium and demand $1100 upon maturity of the loan. This premium, which is charged even when the borrower is at no risk of defaulting and the money supply is held constant, is what Eugene von Bohm-Bawerk termed “originary interest”.

The Austrian analytical framework illuminates an intimate relation between the concepts of time-preference, interest, savings, and investment. The time-preference of individuals determines how much they are willing to save. Their savings and time-preference (as well as the prevailing market rate) affect the compensation they demand for lending money to entrepreneurs who invest in projects that will benefit society in the future. The longer these projects take to complete, the greater the interest penalty the entrepreneurs suffer for tying up the production factors. The interest rate coordinates the time-structure of production with the time-preferences of consumers, lenders, and borrowers.

Individuals in the economy who wish to increase their future consumption exhibit lower time-preferences. They reduce present consumption; they eat at restaurants less, go to the movies less, etc. As a result, producers of such consumer goods or lower-order capital goods (producer goods that are closer to the final consumer product) realize lower profit margins. Accordingly, they scale back production and lay off workers. At the same time, the additional savings made available will induce banks to lower their interest rate on loans. This will encourage entrepreneurs to invest in longer production processes that appeared unprofitable at the old interest rate, but now appear profitable at the lowered rate. Also, the cost to the entrepreneurs of buying resources and labor for the production of higher-order capital goods (such as factories, tools, etc.) will be lessened because the consumer sector will have less financial power to bid for those scarce resources. The lower costs for the entrepreneur’s factors of production will further strengthen his profit estimations. To summarize, when people save more – defer their consumption to the future – this in turn sends a signal to the entrepreneurs by way of the reduced interest rate to invest in production processes that will yield consumption goods in the future. This is one particular manner in which market prices – the interest rate being the price of borrowing money – coordinate the activities and plans of market actors by allocating scarce resources in ways that reflect society's preferences.

The entrepreneurs beginning work on long-term projects will be able to complete them without distorting the economy. The resources that no longer flow into the production of lower-order capital goods will be used instead to construct the entrepreneur’s higher order capital goods. The restaurants and movie theaters will contract operations and lay off workers, while the entrepreneurs building long-term projects will expand operations and hire workers. Although these investment projects don’t produce immediate benefit to society, people will be able to subsist in the meanwhile because of their lower consumption preference and increased savings. An interest rate truly reflective of society’s time-preference – that is, one not manipulated by central banking or fractional reserve banking – will generate a society with enough savings to sustain themselves until the investment projects are completed. As the projects are completed and start turning profits, society will enjoy a higher standard of living without enduring a consequent recession. This model of disciplined investment is how society achieves long-term growth.

When the government wrests the nation's currency from free market forces, however, mandates that its notes be legal tender for all debts public and private, and creates a central bank with the power to print money at will, what results is the recurring boom-bust cycle that commonly – and mistakenly – is attributed to the free market.

Although one of the stated goals of the Federal Reserve Bank is to promote stable prices, the value of the dollar has fallen over 95% since the establishment of the Federal Reserve in 1913 (2010a). Monetarists view price inflation as the primary threat posed by loose monetary policy. While price inflation as a result of monetary inflation is generally harmful because it transfers wealth from those who receive the new money late to those who receive it early, there is a more pernicious force at work: Easy credit throws off business calculation and causes the inter-temporal misallocation of resources. I concentrate on credit injection into the loanable funds market because that is the most common method of monetary expansion the Federal Reserve pursues.

The process begins with the Fed conducting open-market operations. The Fed buys new or existing US Treasury bonds from the private sector by writing a check on itself. The Fed has no wealth of its own; it's not as though the Fed engaged in voluntary trade with citizens and amassed a reserve of savings that depletes as the Fed buys more treasury debt; instead, it simply prints money into existence to cover its purchases (these days the process is carried out electronically but the principle is the same). The private investors who sold their treasury bonds to the Fed deposit their freshly printed bank notes into their commercial banks. The banks thereby accumulate excess cash holdings and lower their interest rates to encourage more borrowing. At this point, it is pertinent to briefly note the role of fractional-reserve banking, a practice supported by the Fed which greatly magnifies the credit expansion process. When the required reserve ratio is less than 100%, commercial banks can increase the money supply from a checking account deposit by writing loans against the deposit, despite the original funds remaining available to the depositor on demand (and thus not constituting an actual loan to the bank as savings accounts do). While this practice does not affect my analysis in any substantive way, it amplifies the Fed's initial money supply increase and further lowers the interest rate. Robert Murphy (2010a) explains how the “boom” follows from credit expansion:

Superficially, the results of this operation resemble a market-driven expansion. At the lower interest rate, entrepreneurs are given the green light to start longer-term projects. They hire workers and buy raw materials for enterprises that appeared unprofitable at the original market interest rate, but which now make sense given the “cheap credit” supplied by the Federal Reserve.

However, unlike the market-driven expansion, in the government-driven version there is no corresponding drop in consumer spending on restaurants, DVDs, and other retail sectors. On the contrary, these businesses are enjoying an increase in sales, because at the lower interest rate, people have less of an incentive to save and so they spend more on present enjoyments. In other words, while the entrepreneurs who make capital goods are seeing their businesses boom, so are the consumer sectors. It therefore seems that every sector is enjoying growth. The competition to hire new workers leads to increasing wage rates, which further contributes to the general feeling of prosperity.

But we know that this perception of euphoria must be an illusion. The government didn't come up with a new scientific formula or stumble upon an unknown oil field; all it did was print up green pieces of paper and hand them out to entrepreneurs. This action by itself doesn't alter the underlying facts of scarcity. It is physically impossible for the economy to produce more tractors [producer goods] and more television sets [consumer goods] with the same amount of workers, raw materials, and equipment. In a market-driven expansion, consumers had to cut back on television sets (and other consumer goods) in order to allow for more tractors. Yet in the government-driven expansion, initially it seems as if the economy can have its cake and eat it too – that it can produce more capital goods and more consumer goods, without any waiting period. What's going on?

The answer is that the government's distortion of the interest rate has misled entrepreneurs. Remember that one of the functions of free-market prices is that they provide signals which help coordinate economic activity. By making it artificially cheap to borrow capital funds, the government has (loosely speaking) fooled investors into behaving as if there were more savings than actually exist. Therefore what the entrepreneurs in one part of the economy are trying to do with resources, does not mesh with what entrepreneurs in other parts are trying to do, and no one's plans match up with how consumers expect to spend their paychecks. (366-367)

 

The Fed has driven a wedge between savings and investment, with investment outpacing savings. Entrepreneurs, seduced by artificially low interest rates and the seemingly-endless supply of bank credit, embark on projects they should not be committing to because society cannot actually afford to have the resources tied up in lengthy enterprises, given their undisturbed desire for present consumption. Because the entrepreneurs have access to the newly printed Fed notes, they bid scarce resources away from the consumer sector where society prefers them. When the new money filters through to the entrepreneurs' workers in the form of higher wages, however, they rush to spend their paychecks on consumer goods because their time-preferences never actually changed, and because the low interest rate coupled with inflation makes saving less attractive. This spending pushes up the price of the resources that the consumer goods and capital goods sectors both compete over, and the lack of savings will – absent further monetary intervention – cause the interest rate to rise to its true market level. At this point entrepreneurs will realize that they can't profitably afford to finish their projects so they temporarily halt construction or liquidate them entirely. They will also lay off workers, most of whom will need to accept a pay cut to find employment; for it was the credit injection that allowed the entrepreneurs to pay them wages above their market value. This process of reallocating resources into a structure of production that is sustainable given the true preferences of society is experienced as the “bust” phase of the cycle; the recession.

If this analysis is correct, then why does the boom continue for so long without anyone noticing the problem? Shouldn't entrepreneurs notice their mistakes shortly after the workers spend their paychecks? Shouldn't the whole adjustment process be relatively swift? Murphy (2010a) explains why this isn't so:

This delayed reaction is made possible by capital consumption. In other words, it actually is possible for the economy to suddenly produce more capital goods (tractors, drill presses, two-by-fours) and more consumer goods (TVs, iPods, bicycles) simultaneously – at least for a while. The tradeoff can be temporarily postponed if entrepreneurs ignore the wearing out of the existing capital stock. … In order to simply maintain the current standard of living, at least some output every year must go toward replacing the capital goods used up in that year's production. … The charade can continue for years, with everyone seeming to enjoy a higher standard of living, through “eating the seedcorn” and not plowing enough resources back into maintaining the existing economic structure. Of course the vast majority of people don't realize this is occurring – on paper the business-people are making record profits, and are increasing the value of their enterprises. (367-368)

 

The other factor that contributes to hiding the true cost of the boom is that the Fed doesn't simply inject credit once and then sit back. To keep interest rates suppressed below their natural rates, the Fed must continually expand the money supply with ever-increasing doses of credit. Murray Rothbard (1978a) describes this process:

Like the repeated doping of a horse, the boom is kept on its way and ahead of its inevitable comeuppance by repeated and accelerating doses of the stimulant of bank credit. It is only when bank credit expansion must finally stop or sharply slow down, either because the banks are getting shaky or because the public is getting restive at the continuing inflation, that retribution finally catches up with the boom. As soon as credit expansion stops, the piper must be paid, and the inevitable readjustments must liquidate the unsound over-investments of the boom and redirect the economy more toward consumer goods production. And, of course, the longer the boom is kept going, the greater the malinvestments that must be liquidated, and the more harrowing the readjustments that must be made. (237)

 

This analysis describes the Austrian Business Cycle Theory (ABCT). Mainstream economists criticize ABCT, arguing that if entrepreneurs know that the Fed is inflating the money supply, they will adjust their expectations accordingly to prevent the cycle from occurring. There are problems with this criticism. For one, most entrepreneurs are not familiar with ABCT. The Austrian School is neglected in academia and popular thought, although it is experiencing a resurgence in the wake of the 2008 recession. Also, because the bust phase can be postponed through capital consumption and continuous credit injection, it can be difficult for the public to discern the cause-and-effect relationship between monetary policy and recessions.

The biggest flaw with the expectations criticism is that it assumes entrepreneurs can somehow know people's time-preferences, or know how much people are deferring present consumption, absent a price mechanism. The great benefit of market prices is that they transmit information about subjective value and scarcity among a network of agents whose knowledge is inherently decentralized. Entrepreneurs may know that the interest rate has been manipulated, but they still have no way of knowing what the interest rate would have been had the Fed not intervened. Even if they are aware that credit injection is fueling unsustainable growth, they can't typically afford to be prudent and wait it out; they have no idea how long the Fed will continue to inflate the bubble. The skeptical entrepreneur may pass on the easy credit, but his competitors certainly won't; they will borrow the cheap money and use it to bid up the prices of capital goods and resources and labor, and the skeptical entrepreneur will witness his business evaporate unless he too decides to join the rush.

Mainstream economists also claim that the ABCT does not explain the present crisis because houses are consumer goods, not capital goods. These critics are correct to observe that houses are durable consumer goods that may only take a few months to construct, but the investment process begins well before construction with the surveillance of suitable land to purchase. Doug French (2009a) elaborates:

Consultants are hired to produce soil studies and environmental reports, and to determine the availability of utilities and zoning feasibility. … If the land appears to be suitable for residential development, the developer will determine what can be paid for the land to make the project profitable, assuming his projections are accurate for the sales prices of his homes. After that, a price is negotiated and escrow is opened. A hot land market will dictate short escrows of 90 to 180 days, whereas in a typical market, escrows of a year or more are not uncommon.

A key factor in how much is offered in price for the land is the interest rate to be paid on the loan used to purchase the parcel. Low interest rates allow the developer to pay higher prices. Low interest rates also allow for the developer to take on more political and development risk. … In most large urban areas, zoning approvals […] take months in the best of times; now they often take years. … The interest for development and construction projects is financed – it is borrowed – just like the soft and hard costs associated with the development, thus the lower the interest rate, the longer the project has before it must be converted to a consumer good. … Billions in development loans were made to finance projects with the contemplated payoff coming from home buyers.

Human resources especially were directed away from producing consumer goods and services towards the development of housing projects. People flooded into real-estate-related industries – the obvious being construction and real-estate sales. … But jobs indirectly involved in real estate also boomed: title-insurance companies couldn't hire enough people, along with engineers, architects, appraisers, and the like. Plus furniture stores popped up everywhere, because every new home needed new furniture and appliances.

And when houses are built, the signal is sent to commercial developers that more shopping centers are needed. It is thought more office space will be needed because of the increase in indirect real-estate-related jobs, and more industrial space will be required because contractors are expanding to participate in the home-building boom. ...

As the Austrian business-cycle theory dictates, the bust is now in process, clearing malinvestments and reallocating misdirected resources. Houses and buildings sit vacant, while construction workers and real-estate agents are looking for other types of work. The fact is that homes include the land they are built on, and land is certainly a higher-order good.

In the case of the current housing meltdown, the Austrian case is definitely right. Mises and the Austrians are more relevant than ever.

 

Tracing the path of the nominal effective Federal Funds Rate (A1), the data is consistent with the Austrian narrative. From a 2001 rate of 6.5%, then-Fed chairman Alan Greenspan engaged in rapid credit expansion to provide a “soft landing” after the dot-com bubble burst in 2000. Within one year he slashed the Federal Funds rate to under 2%, and continued lowering it through 2004, until it reached a half-century low of 1%. During this time, housing starts and average home prices increased at unprecedented rates (A3, A4; the housing boom began in 1997 for reasons that will be explained shortly, but a large expansion of the monetary base was necessary to maintain the boom). From there, he aggressively raised the FF rate until it peaked at 5.25% in late 2006. At the new interest rates, the housing bubble was finally exposed as the massive cluster of errors it truly was. Entrepreneurs had to halt construction on housing projects because the new interest rates revealed these housing starts to be unprofitable. The market value of the new houses plummeted. People who had taken mortgages, with the equity coming from their perception that housing prices could only go up, found themselves owing more debt than they could afford, and their homes were foreclosed on by the banks. All the mortgages and mortgage-backed securities were revealed to be grossly overvalued because of all the homeowner defaults. This devaluation wreaked havoc on the financial markets.

The Austrian business cycle theory explains how bubbles develop, but why did this bubble arise specifically in the housing market? Part of the answer is that government policies spurred over-investment in home-building.

One regulation that contributed to the housing meltdown is the 1977 Community Reinvestment Act, which encouraged commercial banks to give loans to people with low incomes and poor credit. Under the CRA, “the Fed and other financial regulators have pressured/extorted banks into making more loans to less-than-creditworthy borrowers than they would normally be willing to risk” writes Thomas DiLorenzo (2008b). Although the act passed in 1977, its damage potential was relatively subdued until events in the 1990s gave it serious venom. DiLorenzo continues:

Under the CRA, if a bank wants to make virtually any change in its business operations – merging, opening up a new branch, getting into a new line of business – it must first prove to regulators that it has made “enough” loans to the government's preferred borrowers. …

In order to try and diversify the risk of these loans, the Federal Home Loan Mortgage Company (“Freddie Mac”) pioneered the “securitization” of bundles of these high-risk loans so that they could be sold on secondary markets. Such “securitization” exploded during the 1990s as a result of government regulation. …

In 1994 the Riegle-Neal Interstate Banking and Branching Efficiency Act loosened up the regulatory barriers to bank mergers. Consequently, said Bernanke, “As public scrutiny of bank merger and acquisition activity escalated, advocacy groups [like ACORN] increasingly used the public comment process to protest bank applications on CRA grounds.” In other words, there was a burst of additional legalized extortion perpetrated by the Fed and its pet “activist organizations” beginning in the mid-1990s. ...

Also in 1995, the US Treasury Department created the multibillion-dollar “Community Development Financial Institutions” fund to “provide banks with access [i.e., taxpayers' dollars] to new opportunities to finance community economic development” as “encouraged” by the CRA, said the Fed chairman.

The government also “streamlined” the regulatory requirements for CRA loans in 1995, allowing – and indeed pressuring – banks to make such loans without the benefit of many traditional credit-worthiness criteria, such as the size of the mortgage payment relative to income, savings history, and even income verification! Instead, the Fed told banks that participation in a credit-counseling program, many of which are federally funded, could be used as “proof” of a low-income applicant's ability to make his mortgage payments. In other words, federal bank regulators required banks to make bad loans based on nonexistent credit standards.

 

DiLorenzo mentions Freddie Mac. Freddie Mac and Fannie Mae are government-sponsored enterprises created to provide liquidity in secondary mortgage markets. They act as financial intermediaries to purchase standardized mortgages from banks and package them into securities which they can then sell on credit markets (2002a). Financial intermediaries play a vital role in any developed market economy, but they become forces of capital distortion and wealth destruction when they are government-backed, and therefore don't play by the same rules as private firms. Freddie and Fannie enjoy many privileges over their private competitors, but most significant is their confidence in never fearing bankruptcy because they know the government will always bail them out with taxpayer funds if they are in danger. This promise of government bailout creates a moral hazard; because Fannie and Freddie stand to keep all their profits but can diffuse their losses among the taxpayers, they have a strong incentive to buy and sell high-risk assets. The banks coerced to into making loans to poor credit debtors by the CRA sold many of those mortgages to Fannie and Freddie, who were happy to take on the dubious assets (A5). Private investors bought these repackaged securities from Fannie and Freddie because the government-cartelized ratings agencies (Moody's, S&P's, and Fitch) had rated these financial instruments AAA, the highest rating. This government interference in the housing market swelled the housing sector far beyond it's sustainable capacity.

Austrian business cycle theory elucidates accurate analysis of government remedies. Bailing out the financial giants that made bad loans will prop up the unstable production structure that caused this recession and postpone the liquidation process the market must undergo to recover. The bailouts penalize the taxpayers and the disciplined firms that refrained from making poor loans, and rewards the reckless lenders. TARP and the other stimulus packages administered by Congress and the Fed just add fuel to the fire. Easy credit caused this recession, and the Fed is injecting more credit in an attempt to get us out. Politicians do not understand that every resource they spend to boost GDP or create jobs comes at the expense of destroying private wealth (and it is not merely a wash; whereas the private sector benefits all trade parties through voluntary contract, government takes from some to give to others). Adhering to mainstream logic, the government could print money and pay people to dig holes in the sand and fill them back up; this would boost GDP and employment figures, although clearly society as a whole would be worse off due to this waste of resources (unless you ask a Keynesian, who would laud the resultant boost in aggregate demand). The Federal Funds rate currently hovers around 0%. The monetary base has doubled from July 2008 to July 2009 (A6). As of October 2010, most of the new credit still sits on the banks' balance sheets because they are reluctant to loan it out and entrepreneurs are reluctant to take on new debt. At some point entrepreneurs will regain enough confidence to borrow these new funds, and the money multiplier effect of fractional reserve banking will sink the economy further into the quagmire.

Everything the government is currently doing – from passing stimulus packages to establishing a “Consumer Protection Agency” – will only hamper the efforts of the market to slough off the malinvestments and readjust the structure of production to a sustainable level. While more regulation could, in theory, prevent a housing bubble from reoccurring (never mind that the financial and housing industries were already two of the most heavily regulated sectors in our economy), so long as the Fed continues to pump money into the system, there will be an avenue for those funds and a corresponding asset bubble. Meanwhile, burdensome regulation discourages all investment, including the undertaking of projects society would be able to support. To resuscitate the economy, society needs to save more and consume less so that we can rebuild a sustainable capital structure. The government, however, is inciting the exact opposite behavior by flooding the banks with credit and suppressing the interest rate below its free market price. People have thus far resisted government coaxing to spend frivolously, but this resistance hasn't deterred the Fed; in the September 21^st 2010 FOMC report, the Fed reported that inflation wasn't high enough. The Fed declared that they are “prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate. (2010d) ” Robert Murphy (2009b) provides an apt analogy for the government's response to the financial crisis:

If an allergic man has been stung by a bee, I don't know what to do except rush him to the hospital and maybe scour the cupboards looking for Benadryl. But I'm pretty sure drawing blood from his leg, in order to inject it into his arm and thus “stimulate his immune system,” is a bad idea on numerous accounts – not least of which, is that I'm pretty sure an allergic reaction means your immune system needs to calm down. But the point is, if a bunch of guys hold the man down – he has to be forced to endure the procedure for his own good, don't you know – I feel perfectly qualified in yelling, “Stop!” …

But to make it even more accurate, let's stipulate that a blind heroin addict, who has been convicted of manslaughter on three separate occasions, is the one entrusted with making the transfusion. Naturally he will use one of his own needles for the procedure.

 

If the government was truly interested in preventing recessions, it would take gradual, calculated steps toward abolishing the Fed and restoring commodity money. The only sure way to prevent downturns is to let voluntary trade determine the type and supply of money. People often forget that money, like the market itself, is a product of spontaneous human creation – though not design –, and that medium of exchange have existed in all cultures prior to government currency monopolization. If the government relinquishes this immense power, the market likely would return to a 100% reserve gold standard. Stripped of their ability to inflate the money supply for personal and political advantage, the government would be prevented from inducing boom-bust cycles. Although a particular bank could try to subvert the 100% reserve requirement, any bank that printed more receipts than it had gold to back them up would quickly go bankrupt and have its reputation sullied when their note holders (primarily other banks whose clients traded with patrons of the fractional-reserve bank) tried to redeem them for gold, only to discover that the fractional reserve bank did not have enough gold on hand to redeem all their claims.

The reason people would likely return to a gold standard, as opposed to a different commodity standard or another fiat standard, is the same reason gold came to be used as money in the first place: Its supply is stable, it's homogenous, it's divisible, it's durable, and it is valued by people of all cultures independent of its monetary function. On a 100% reserve gold standard, no central bank could manipulate interest rates, so the interest rates would provide accurate signals about the available savings and time-preferences of society. Entrepreneurs and investors could still make mistakes – after all, people cannot know the future with certainty, which is why you need a market economy in the first place – , but there would be no systematic cluster of entrepreneurial errors and no periods of mass unemployment. Entrepreneurs who invested resources in ways that didn't satisfy the needs of society would lose money, thereby lessening their future impact on the production structure, while entrepreneurs who put resources toward socially valuable uses would profit, thereby increasing their influence over the production structure. There (hopefully) would be no government bailouts at the taxpayers' expense to return production power to the poor forecasters with political connections. If the government were to surrender its monopoly over money and quit intervening in the economy, society would experience unprecedented levels of growth and prosperity.

 

 

Appendix

A1 http://en.wikipedia.org/wiki/File:Federal_Funds_Rate_1954_thru_2009_effective.svg

 

 

 

 

 

 

 

 

 

 

 

A2 http://fee.org/doc/the-house-that-uncle-sam-built/

 

 

 

 

 

 

 

 

 

A3 http://www.goodevalue.com/wp-content/uploads/2008/04/permits_starts_graph.jpg

 

 

 

 

 

 

 

 

 

 

 

 

A4 http://fee.org/doc/the-house-that-uncle-sam-built/

 

 

 

 

 

 

 

 

 

A5 http://fee.org/doc/the-house-that-uncle-sam-built/

 

 

 

 

 

 

 

 

 

A6 http://fee.org/doc/the-house-that-uncle-sam-built/

 

 

 

 

 

 

 

 

 

References

2005a http://mises.org/daily/3588

2003a http://mises.org/daily/1177

2008a http://www.businessweek.com/the_thread/hotproperty/archives/2008/12/peter_schiff_wa.html

2004a http://mises.org/daily/1670

2010a http://mises.org/books/lessons_for_the_young_economist_murphy.pdf

1978a http://mises.org/books/newliberty.pdf

2009a http://mises.org/daily/3894

2009b http://mises.org/daily/3316

2008b http://mises.org/daily/2963

2002a http://mises.org/daily/986

2010d http://www.federalreserve.gov/newsevents/press/monetary/20100921a.htm

2010e http://econ-www.mit.edu/about/economic

 

 

 

 

 

 

I haven't read it yet, but if your professor is a Neoclassical guy with Austrian sympathies, I can't help but recommend you put in some stuff from Roger Garrison in there, he's done an excellent job of putting Austrian theory into a pseudo-neoclassical framework.

http://www.auburn.edu/~garriro/cbm.htm

A good comparison with Friedman's plucking model:

http://www.auburn.edu/~garriro/fm1pluck.htm

 

...anyway, I guess I'll actually read it now.

 

EDIT: Read it, looks OK. I reiterate that I think referencing some of Garrison's diagrams would help explain your points, especially about the PPF. Also I'd personally put a citation of "Prices and Production" in the bit about entrepreneurs and information. Lastly, I think you should focus on addressing the main question that you were asked more directly, especially in the introduction and the conclusion. I'd emphasize more the shortcomings of mainstream economic theory, and how AE avoids these shortcomings. Also I'd make some of the wording and structure a bit more "value free"/positive/descriptive, especially in the last few paragraphs.

 

Take all that with a grain of salt though, I absolutely stink at writing papers of any respectable length :)

Thanks for the comments.

I will consider putting some Garrison stuff and some Hayek stuff in, although I'm hesitant to throw in the Hayekian triangle because I think it can be misleading.

I actually had a few paragraphs criticizing the mainstream approach that I ended up getting rid of because it seemed like a bit of a tangent, but I could bring them back.  Instead of criticizing mainstream theory explicitly, I went the Murphy route of saying "Look, Bernanke had the best mainstream education and he drove the economy into the shitter".  As for the value-laden terms, if I can throw those in without obscuring or discrediting my argument, I figure that's a bonus.  Do you think they detract from my argument?

I just skimmed through it in 3 minutes.  I encountered this:

"They reduce present consumption; they eat at restaurants less, go to the movies less, etc. As a result, producers of such consumer goods or lower-order capital goods (producer goods that are closer to the final consumer product) realize lower profit margins. Accordingly, they scale back production and lay off workers. At the same time, the additional savings made available will induce banks to lower their interest rate on loans."

 

Why are banks necessary to explain the lowering of the interest rate due to a fall in time preference?  This is false, even though later, I'm sure you'll explain the roll of banks in tampering with that rate.  But in general, the rate of interest is a broad market phenomenon present in all capital investments.  The loan market (Banks) comprises just part of this bigger and broader capital market. 

I hope Grayson, Esuric, Jonathan or others will be able to take the time to read through and critique your paper for you. 

Maybe Student can weigh in and provide a preview of your professor's opinion, given their common point of view.

In the meantime, I read the paper, and offer my own impressions (which are worth zero in the unhampered market):

Here is the question: "What has the downturn and the major government policies carried out to address it tell us about macroeconomic theory?"

In general, you present ABCT, describe the consequences of government intervention, and connect these to the housing collapse.  But aren't you being asked to critique macro economic theory?  Your last paragraph makes a plea for non-intervention in markets, but that is not what you were asked.  You don't mention macro theory at all in your concluding paragraph. 

I think your position is that mainstream macro has failed in some way, but how?  What is it about mainstream macro that makes it inadequate?  If your position is that ABCT explains the boom / bust, shouldn't at least 1/2 of the paper describe how mainstream macro has failed to do just that?  Perhaps a sub-heading "Why macro economics failed to predict / explain the downturn"?

Perhaps Esuric would be kind enough to provide his bullet point list of mainstream criticism that includes the "capital structure is considered to be a homogeneous blob".  I tried to find it, couldn't.   

I think you should purge the paper of opinion or editorial comment, unless this is acceptable to your professor.

Regarding sources: What is the expectation level, ie, is a variety of sources expected?  Most are from Mises.org, which is great from MY point of view, but what about your professor's?

I skim read it, there are some paragraphs that are very eloquent, very good.

However I would rethink the Bob Murphy analogy that you quote. Whilst 'fun' it may be a bit gruesome, it might not be the best fit in a paper that is more scholarly and less pop.

Captain,

Here is a Mises Daily article from 10/12  that addresses the situation with macroeconomics, or at the very least, Krugmanism. 

My Encounter with Paul Krugman

Nothing we didn't know already, but I think it's a good read, and it might be relevant to this discussion.