Economics Questions

Re: My take on the ABCT

wilderness — Tue, 19 May 2009 16:01:21 GMT

Speaking of the human action role in this. This in today's news. Housing permits hitting record low.

Re: My take on the ABCT

meambobbo — Mon, 18 May 2009 16:25:19 GMT

Daniel J. Sanchez:
However, it's hard to imagine the housing bubble fitting the picture of producers investing heavily in higher order goods, only to have factors of production bid away from them later. This would mean home owners invested too heavily in the capital good of "house-which-will-mature-into-a-house-in-the-future". Were the factors of production of this process bid away from homeowners, thereby reducing their profits and making the production process non-viable? But once the house is built, the only complementary factors of production necessary for turning the house into a future-house are time and maintenance expenses. Obviously time can't be "bid away", so did housing prices collapse because the homeowners suddenly couldn't afford the basic upkeep of their homes anymore (minimal roofing requirements, etc)? That seems extremely unlikely.

They couldn't afford the most basic maintenance requirement - paying the note. The price of interest rose, and those with ARM's could no longer afford them.

The construction companies, and all their beneficiaries, also have a production process that is not in line with consumer desires. Here's a good explanation by Mish in attempt to call out Krugman's Keynesian nonsense.

Re: My take on the ABCT

wilderness — Mon, 18 May 2009 13:57:59 GMT

Daniel J. Sanchez:

wilderness:
These firms sold CD's and insurance (credit-swaps) on these CD's (mortgage investments) and as long as the prices of houses went up, then people made virtual money on these virtual investments. They look good for a portfolio to show worth of a company, but if they were actually paid out in currency, a run on these investments to have them cashed in, the firms promised more than they actually had to give back if investors wanted currency instead of CD's, their credit-swap, etc...

AIG was the one buying, not selling, mortgage-backed securities. Buying an MBS is basically taking over as lender for portions of a bunch of home loans. So as an owner of MBSs, AIG was basically in the home loan business. MBS's aren't bank notes, so the only thing analogous to a run on them would be if everybody started wanting to sell them, and stopped wanting to buy them on the market. This would drive down the value of AIG's MBSs. But that wouldn't really matter if home borrowers continued making their payments. AIG would still be getting a steady stream of principal and interest payments. In fact, they would gleefully buy up even more of the underpriced MBSs. So it's not a problem of people "cashing out", per se. The problem is that the MBSs stopped giving AIG a steady stream of principal and interest payments, because home borrowers weren't making their mortgage payments.

Right. That's what I was getting to. And homeowners are not just people that will live in the houses. Also contractors build homes without a buyer to move in. Houses by were I live have been built in a housing development by contractors. They have been for sale for well over 6 months now without buyers. These are also houses kin to those seen torn down in California in that one thread here in the forum. I don't know if the contractors or banks own those houses that are up for sale still. One would think contractors couldn't possibly make monthly mortgage payments on numerous houses they built for months at a time.

Daniel J. Sanchez:

Of course if the rest of the market cashes out before AIG does (as really happened), then AIG has a problem, because they'll be forced to sell at a loss, or we'll be forced to bail them out (as really happened).

Frannie and Freddie involvement too.

Daniel J. Sanchez:

You could say the investments and the money were virtual for the economy as a whole. But the MBSs weren't virtual investments for AIG. And the income they earned and the price they got weren't virtual either. They were real, but risky. If AIG had cashed out in time, somebody else would have been left holding the bag.

When I say virtual, I mean real, but I'm saying these types of monies are not hard currencies not even U.S. fiat dollars. They are probably even virtual in the sense they are data bits in a computer cause nobody has the actual cash to put in hand or pocket that these investment firms were dealing with.

Daniel J. Sanchez:

Now you're right that they did sell credit-default swaps, and that these were basically insurance policies. AIG's counterparties paid them a steady stream of premium's as long as certain loans (especially home loans) didn't go into default. But if they did default, AIG would have to pay their counterparties large sums (as really happened). Again, here the problem of the "run" isn't really the underlying problem; if everyone flocked out of CDSs, but the underlying loans didn't default, and the counterparties kept paying their premiums, AIG would still be sitting pretty. The underlying problem is not the run: it's the underlying default.

"Mortgage backed securities can be considered to have been in the tens of trillions, if Credit Default Swaps are taken into account."

Thus the "run" I'm referring to is the default occurs and now all these people/investors now want their money. But when obligations and promises on payments to investors are in the tens of trillions no investment firm actually had this money. Just like banks don't actually have all the money they loan out. I'm not saying these are the same type of runs, they are different, but as in all confidence scenarios in economic institutions if they promise to pay more than they have then a run and collapse before all payments to investors is paid out will occur. Thus the government stepped in saying "To big to fail". Also the money reached into the trillions due to the same pool of houses could be speculated upon numerous times. I don't know if this was on CDS or MBS or some other form of Wall Street game.

Daniel J. Sanchez:

wilderness:
Well the Wall Street firms did promise more than they actually had in currency to pay out. Once the investors realize that a lot of people invested especially in these virtuals of CD's and credit-swaps and they also realized these firms could never pay out all the money to all the investors, then there are runs on these virtual accounts (the assets) in the Wall Street firms. No investor wants to be left holding nothing due to a firm going under. It's the same idea as a run on the bank. The Wall Street investment firms promised more than they had.

Regarding investment banks, they took the savings of other people (not so much their own money, like AIG did) and used them to buy MBSs FOR the investors. Just as with AIG's MBSs, the real problem is if the mortgage payments stop coming in, and the MBS value falls as a result. MBSs don't have a face value, like a bank note, so it's not a matter of the investment clients rushing in to get their money "out" of the investment bank before the investment bank runs out. The investment clients get their money "out" of whoever will buy the MBSs they want to unload, not the investment bank itself. The investment bank is just the middle man.

Ah, I see. So a buyer is needed. But then the CDS come into play. And they reached into the trillions. So if an investor had enough CDS coverage, then they could get their money back that way. But the investment firms themselves would need to unload these or fail. But somebody invested and would lose money. The investment firms being the biggest losers. Yet a big loser like Lehman Brothers brought in big wins for AIG cause AIG bet against Lehman Brothers. I believe Goldman Sachs did the same. Yet AIG swelled so big the government won't be able to even keep up with providing zombie assistance. Fiat, the Italian car company, gets subsidized from the Italian government and is trying to get billions of subsidies over a 2-3 year period from Berlin too as part of this take-over deal of Chrysler. So through the back door of Chrysler U.S. government will be bailing it out which trickles to Fiat with gets bailouts currently from Italian government and trying to get some from German government.

Re: My take on the ABCT

Daniel J. Sanchez — Mon, 18 May 2009 07:02:39 GMT

edward_1313:

Durable Consumer good = part immediately serviceable good + part indirectly serviceable good

The latter requires additional time, the complementary good. A TV, a house, car, etc. are goods that continuously mature into present goods. Their future services are, subjectively speaking, capital goods. Often the more a durable a consumer good, the farther into the future its services will acrue, so that for all intents and purposes it may be called an increasingly higher order good.

Ah, that makes sense. Thank you.

However, it's hard to imagine the housing bubble fitting the picture of producers investing heavily in higher order goods, only to have factors of production bid away from them later. This would mean home owners invested too heavily in the capital good of "house-which-will-mature-into-a-house-in-the-future". Were the factors of production of this process bid away from homeowners, thereby reducing their profits and making the production process non-viable? But once the house is built, the only complementary factors of production necessary for turning the house into a future-house are time and maintenance expenses. Obviously time can't be "bid away", so did housing prices collapse because the homeowners suddenly couldn't afford the basic upkeep of their homes anymore (minimal roofing requirements, etc)? That seems extremely unlikely.

Re: My take on the ABCT

edward_1313 — Mon, 18 May 2009 06:29:11 GMT

Daniel J. Sanchez:

krazy kaju:
In Austrian terms, durable consumer goods and capital goods are called "higher order goods."

Consumer goods are, by definition, not higher order, at least not according to Rothbard in MES...

The means to satisfy man’s wants are called goods. These goods are all the objects of economizing action.Such goods may all be classified in either of two categories: (a) they are immediately and directly serviceable in the satisfaction of the actor’s wants, or (b) they may be transformable into directly serviceable goods only at some point in the future—i.e., are indirectly serviceable means. The former are called consumption goods or consumers’ goods or goods of the first order. The latter are called producers’ goods or factors of production or goods of higher order.

... and Mises in Human Action...

Economic goods which in themselves are fitted to satisfy human wants directly and whose serviceableness does not depend on the cooperation of other economic goods, are called consumers' goods or goods of the first order. Means which can satisfy wants only indirectly when complemented by cooperation of other goods are called producers' goods or factors of production or goods of a remoter or higher order.

Since the structure-of-production-only take on the theory doesn't involve consumer goods, it doesn't seem to explain housing bubbles.

Durable Consumer good = part immediately serviceable good + part indirectly serviceable good

The latter requires additional time, the complementary good. A TV, a house, car, etc. are goods that continuously mature into present goods. Their future services are, subjectively speaking, capital goods. Often the more a durable a consumer good, the farther into the future its services will acrue, so that for all intents and purposes it may be called an increasingly higher order good.

De Soto treats this in his book and Hayek spends a lot of time on it in "The Pure Theory of Capital".

Houses, etc., are all explained by the ABCT.

And BTW, none of the above quotes by M & R contradict this. They would certainly agree.

Re: My take on the ABCT

Daniel J. Sanchez — Mon, 18 May 2009 03:28:49 GMT

Daniel:
I've postulated that the reason why the housing bubble popped was because the homebuyers could not afford their payments. When the homebuyers made their calculations, to see if they could afford the house, they didn't account for such a huge rise in their cost of living (such as, the price of gasoline, food, education, energy, and so on, although not including the mortgage).

I postulated that very same thing a while ago too. But I don't think rise in the cost-of-living was accelerating any more when the bubble burst than it was in the thick of it. The continuous rise in the cost-of-living was fine as long as it was out-paced by the continuous rise in the value of their homes (plus the rise in wages).

I don't think it's a coincidence that the Fed finally started allowing the interest rate to rise around the same time as the housing bubble started to pop. Money was reasserting its value as a means of saving. So the value of houses started to revert to reflect demand for it as a consumption good, without the premium it had as an optimal means of long-term savings.

Re: My take on the ABCT

DanielMuff — Mon, 18 May 2009 02:59:16 GMT

I've postulated that the reason why the housing bubble popped was because the homebuyers could not afford their payments. When the homebuyers made their calculations, to see if they could afford the house, they didn't account for such a huge rise in their cost of living (such as, the price of gasoline, food, education, energy, and so on, although not including the mortgage).

Re: My take on the ABCT

Daniel J. Sanchez — Mon, 18 May 2009 02:39:04 GMT

krazy kaju:
An increase in the money supply does not cause a crisis. If the money supply increased equally across all sectors of the economy, there would not be any malinvestment, only price inflation.

Indeed, that's why I wrote this:

The money supply increase in the present system is in the form of bank money. This bank money is made available as new and additional credit.

I know the ABCT is not about David Hume's "Angel Gabriel Scenario", which you describe.

krazy kaju:
In Austrian terms, durable consumer goods and capital goods are called "higher order goods."

Consumer goods are, by definition, not higher order, at least not according to Rothbard in MES...

The means to satisfy man’s wants are called goods. These goods are all the objects of economizing action.Such goods may all be classified in either of two categories: (a) they are immediately and directly serviceable in the satisfaction of the actor’s wants, or (b) they may be transformable into directly serviceable goods only at some point in the future—i.e., are indirectly serviceable means. The former are called consumption goods or consumers’ goods or goods of the first order. The latter are called producers’ goods or factors of production or goods of higher order.

... and Mises in Human Action...

Economic goods which in themselves are fitted to satisfy human wants directly and whose serviceableness does not depend on the cooperation of other economic goods, are called consumers' goods or goods of the first order. Means which can satisfy wants only indirectly when complemented by cooperation of other goods are called producers' goods or factors of production or goods of a remoter or higher order.

Since the structure-of-production-only take on the theory doesn't involve consumer goods, it doesn't seem to explain housing bubbles.

Regarding lower interest rates inducing the purchase of more truly higher order goods, that is exactly what I meant when I wrote,

3. Interest Rate Decrease, which causes a general

4. (a) Longer Term Investment Increase, and, aided by 2(b), a (b) Sharp Demand for Particular Assets Increase, the first of which causes a general

"Longer Term Investment" implies a lengthening of the chain of production; that is, adding more links (more higher order goods). I didn't want to write that out, because I thought it would be obvious, and I wanted to keep it from getting any more complicated than it already was.

krazy kaju:
However, since people's time preferences have not changed or have changed very little, they will consume more than they did before, thereby reallocating their money to lower order industries. These lower order industries (e.g. retail) then experience higher profits and are able to attract more investors, pay higher wages, hire more workers, and bid away resources from higher order industries. This causes higher order industries to be less and less profitable, forcing them to lower wages and/or lay off workers while returning less profits to their investors.

It seems to me that the increase in spending of wage earners would play itself out mostly in price inflation, not in a dramatic shift in the structure of production. Industries that make goods of the first order (retail) get higher profits. They use those higher profits to bid up prices of goods of the second order, giving the industries that produce them higher profits. Those industries in turn use their higher profits to bid up prices of goods of the third order and so on.

Let's say the increased spending of wage-earners gives Wal-Mart higher profits, but not the company that makes the wheels for the toy cars that it sells. Wal-Mart and the Toy Wheel Company both go onto the brick market. Wal-Mart's enhanced purchasing power bids up the price of the bricks. The Toy Wheel Company must pay more for the bricks than it otherwise would have, so it does indeed take a hit. But Wal-Mart takes hits too. First of all, it's not the only retailer that has more purchasing power. So Rite-Aid and Target also bid for the bricks, and the price of bricks rises for retailers too. Of course, considering only this much, they are still much better off than the higher order producers, because the latter don't have the higher profits of the former... YET. I say yet, because Target is not only in the market for bricks with its enhanced purchasing power. It's also in the market for toy cars, as are Toys R Us, Costco, Walgreens, and lots of other retailers who've experienced the same boom as Wal-Mart. So the prices of toy cars get bid up. The toy car companies, flush with profits, then bid up prices on toy wheels. And the poor old Toy Wheel Company eventually gets its higher profits too. Of course they get it later, which means the process does benefit the lower order producers more. But it doesn't seem to be enough of a shift in fortunes to completely explain such a calamitous bust.

Do you think that people, after getting raises, tend to borrow more in absolute terms? For example let's say a spendthrift who always borrows up to the hilt gets a raise. Wouldn't he then borrow up to his new, higher hilt? If so, then wouldn't this create an upward pressure on interest rates? And if so, wouldn't an increased interest rate make production processes which were just barely viable under a previous lower interest rate no longer viable?

I know a sustainable economy is at bottom about there being enough savings to see through the production processes. I just think that the way that fact expresses itself is through the interest rate. If society's average time preference was actually higher, and therefore the wage earners, after getting a raise didn't borrow more, then the interest rate would stay low, justified by the increased savings, and the longer-term investment projects would see fruition. But in the case of artificial credit expansion inducing the interest rate lower, the time preference is most likely not higher. And this will express itself when the interest rates go back up to normal.

Re: My take on the ABCT

Daniel J. Sanchez — Mon, 18 May 2009 00:29:17 GMT

wilderness, thanks so much for taking the time to tackle this.

wilderness:
I don't know if malinvestment is to be explicitly considered in the ABCT or not.

At least according to "classical" ABCT it is:

Projects which would not have been thought "profitable" if the rate of interest had not been influenced by the manipulations of the banks, and which, therefore, would not have been undertaken, are nevertheless found "profitable" and can be initiated....

If... the banks decided to halt the expansion of credit in time to prevent the collapse of the currency and if a brake is thus put on the boom, it will quickly be seen that the false impression of "profitability" created by the credit expansion has led to unjustified investments.

(From Mises' "Austrian Theory of the Trade Cycle" Essay)

[

wilderness:
The malinvestment becomes a drag on individual businesses especially if they grow so large it begins to outweigh what real money (assets or currency) a business actually has to offer in the form of payments on its obligations. For instance, the investment firms, AIG and crowd, over-invested or promised obligatiosn in payments that they could not deliver upon. As long as the market was bringing money into these firms, then the money going out could be equally met. Yet once their overhead became so large they could no longer meet their expanses, then a problem.

There are two distinct forms of bubblelicious malinvestment that the above formulation talks about: (1) the malinvestment from shorter-term to longer-term production processes, and (2) asset bubbles. The overhead you're talking about is increased longer-term investment (my "4a"). Firms will only voluntarily take on more overhead if they think it will eventually pay off. In the case of firms whose profits are not based on the asset bubble, the increased overhead IS the bubble. But the overhead reaching a critical point is not what pops the bubble, except only indirectly. It is only after the chain of events I outline leads to an interest rate hike that the increased overhead becomes unsustainable. It is the interest rate hike that pops their bubble. In the case of firms whose profits were based primarily on the asset bubble, it is not the overhead that is the problem: it's the calamitous drop of the asset prices. These two problems are distinct, but interrelated.

wilderness:
These firms sold CD's and insurance (credit-swaps) on these CD's (mortgage investments) and as long as the prices of houses went up, then people made virtual money on these virtual investments. They look good for a portfolio to show worth of a company, but if they were actually paid out in currency, a run on these investments to have them cashed in, the firms promised more than they actually had to give back if investors wanted currency instead of CD's, their credit-swap, etc...

AIG was the one buying, not selling, mortgage-backed securities. Buying an MBS is basically taking over as lender for portions of a bunch of home loans. So as an owner of MBSs, AIG was basically in the home loan business. MBS's aren't bank notes, so the only thing analogous to a run on them would be if everybody started wanting to sell them, and stopped wanting to buy them on the market. This would drive down the value of AIG's MBSs. But that wouldn't really matter if home borrowers continued making their payments. AIG would still be getting a steady stream of principal and interest payments. In fact, they would gleefully buy up even more of the underpriced MBSs. So it's not a problem of people "cashing out", per se. The problem is that the MBSs stopped giving AIG a steady stream of principal and interest payments, because home borrowers weren't making their mortgage payments. Of course if the rest of the market cashes out before AIG does (as really happened), then AIG has a problem, because they'll be forced to sell at a loss, or we'll be forced to bail them out (as really happened). You could say the investments and the money were virtual for the economy as a whole. But the MBSs weren't virtual investments for AIG. And the income they earned and the price they got weren't virtual either. They were real, but risky. If AIG had cashed out in time, somebody else would have been left holding the bag.

Now you're right that they did sell credit-default swaps, and that these were basically insurance policies. AIG's counterparties paid them a steady stream of premium's as long as certain loans (especially home loans) didn't go into default. But if they did default, AIG would have to pay their counterparties large sums (as really happened). Again, here the problem of the "run" isn't really the underlying problem; if everyone flocked out of CDSs, but the underlying loans didn't default, and the counterparties kept paying their premiums, AIG would still be sitting pretty. The underlying problem is not the run: it's the underlying default.

wilderness:
Well the Wall Street firms did promise more than they actually had in currency to pay out. Once the investors realize that a lot of people invested especially in these virtuals of CD's and credit-swaps and they also realized these firms could never pay out all the money to all the investors, then there are runs on these virtual accounts (the assets) in the Wall Street firms. No investor wants to be left holding nothing due to a firm going under. It's the same idea as a run on the bank. The Wall Street investment firms promised more than they had.

Regarding investment banks, they took the savings of other people (not so much their own money, like AIG did) and used them to buy MBSs FOR the investors. Just as with AIG's MBSs, the real problem is if the mortgage payments stop coming in, and the MBS value falls as a result. MBSs don't have a face value, like a bank note, so it's not a matter of the investment clients rushing in to get their money "out" of the investment bank before the investment bank runs out. The investment clients get their money "out" of whoever will buy the MBSs they want to unload, not the investment bank itself. The investment bank is just the middle man.

Thanks again.

Re: My take on the ABCT

krazy kaju — Mon, 18 May 2009 00:18:17 GMT

Wrong. What you're describing is a credit cycle. It implies that all the government needs to do is to keep interest rates low. During a boom/bust cycle, the fundamental changes are not in interest rates, but in the productive structure of the economy.

An increase in the money supply does not cause a crisis. If the money supply increased equally across all sectors of the economy, there would not be any malinvestment, only price inflation.

What does cause a crisis is a decrease of the interest rate without an increase in the supply of savings. This decrease in the interest rate has to be funded by having new credit created. This funds special high cost projects. It funds the purchase of machinery, land, factories, houses, apartment buildings, vehicles, and other capital and durable consumer goods. In Austrian terms, durable consumer goods and capital goods are called "higher order goods." This increase in the purchase of higher order goods stimulates the production of said goods. Companies which produce these goods experience higher profits, attract more investors, hire more workers, and raise wages. In essence, they buy up resources which would be used by lower order industries. However, since people's time preferences have not changed or have changed very little, they will consume more than they did before, thereby reallocating their money to lower order industries. These lower order industries (e.g. retail) then experience higher profits and are able to attract more investors, pay higher wages, hire more workers, and bid away resources from higher order industries. This causes higher order industries to be less and less profitable, forcing them to lower wages and/or lay off workers while returning less profits to their investors. Lower profits means less consumption, which then means lower profits for lower order industries which produce consumption (lower order) goods. These lower order industries are then forced to continue the cycle by lowering wages, laying off workers, and returning less profits to their investors. Unemployment increases and consumption falls while the malinvestments made during the boom are liquidated and credit contracts.

Re: My take on the ABCT

britainland — Sun, 17 May 2009 15:52:13 GMT

Perhaps you could send this to somebody like Walter Block; I'm sure he would be able to point out any problems.

Re: My take on the ABCT

wilderness — Sun, 17 May 2009 15:18:31 GMT

Edit: I made a mistake: Everywhere in this post where it says "CD" it should read mortgage-backed securities.

Daniel,

I am not well versed in the economic aspects. I am familiar with some aspects and maybe this will help me worm my mind into what you wrote here in order to conceptualize. I don't know if malinvestment is to be explicitly considered in the ABCT or not. I know it also has to do with credit expansion, which you mentioned. The malinvestment becomes a drag on individual businesses especially if they grow so large it begins to outweigh what real money (assets or currency) a business actually has to offer in the form of payments on its obligations. For instance, the investment firms, AIG and crowd, over-invested or promised obligatiosn in payments that they could not deliver upon. As long as the market was bringing money into these firms, then the money going out could be equally met. Yet once their overhead became so large they could no longer meet their expanses, then a problem. These firms sold CD's and insurance (credit-swaps) on these CD's (mortgage investments) and as long as the prices of houses went up, then people made virtual money on these virtual investments. They look good for a portfolio to show worth of a company, but if they were actually paid out in currency, a run on these investments to have them cashed in, the firms promised more than they actually had to give back if investors wanted currency instead of CD's, their credit-swap, etc...

So to use the housing bubble as an example which most of these virtual assets in Wall Street sat upon and still do, when people don't have the money to pay their loans/credit and thus these malinvestments by the banks don't bring returns houses close up/foreclosures. Banks trying to get as much money back as possible so they don't get hit hard by all their malinvestments try to get the money invested in the houses back by selling the houses at lower prices (to get some kind of return on these malinvestments). The CD's and thus credit-swaps backing up the CD's (virtual assets) in Wall Street are invested in the housing sector. As the housing prices drop then so do the value of these Wall Street virtual assets. Therefore investors want the money on these virtual assets because as anything on Wall Street, when the prices of these virtuals drop, then investors want to come out of the deal with more money than they put into these virtuals. So they sell. The credit-swaps were insurance on the price of these virtuals too, so, this really makes it difficult for the firms that promise a certain value on these virtuals by providing insurance on them if these virtuals drop in value. So the investors when they sell are promised by the insurance credit-swaps a certain amount of return in their sellings. Well the Wall Street firms did promise more than they actually had in currency to pay out. Once the investors realize that a lot of people invested especially in these virtuals of CD's and credit-swaps and they also realized these firms could never pay out all the money to all the investors, then there are runs on these virtual accounts (the assets) in the Wall Street firms. No investor wants to be left holding nothing due to a firm going under. It's the same idea as a run on the bank. The Wall Street investment firms promised more than they had. There stocks fall. Confidence falls. People don't know who to trust anymore. Which businesses are tied to what firms (AIG is tied to numerous upon numerous businesses, my brother through a railroad company has insurance that leads back to AIG for instance). So people panic basically as the stocks keep dropping cause it was all a speculative bubble. More promised than the firms actually had to give back. The banks had malinvestments so they lent out more than they ever do (fractional reserve banking; fiat money system).

So now the government steps in and promises returns on everything. This is all to stop the panic. The government through the Federal Reserve could keep printing money to go through all these investment firms and banks to bring returns to all the investors/customers that are selling and just want out cause they just don't know (1) how far the virtual prices will drop and thus the investors will lose the money they put in and they don't want that (2) these firms could collapse so the investors don't want to lose their investments. So now the government is the creditor of last resort backing up all these promises to investors by firms that promised more than they actually had. Once this process starts that when all the information usually comes out as to how crippled these firms are, except, years ago it could be seen that these firms were offering payments to too many investors, more than the firms could actually pay back.

The housing prices could drop. The banks made bad investments by loaning too much and then they have to eat those loans when the people can't pay those loans back. So the banks get crippled some go under and housing prices will drop and the free market resets itself cause those houses were priced way too high to begin with. They were priced too high and weren't allowed to drop due to forces in the market that are happening right now. The government bails out the fiat banks (I don't even think they are fractionally reserved cause the U.S. dollar is not backed by gold so not backed by any commodity like gold or silver means these are actually fiat banks) and thus the banks don't lose their money due to the malinvestments. Housing prices drop, but since prices throughout the market aren't allowed to drop due to government propping up (if firms, banks, and badly invested businesses collapse then prices would drop everywhere cause malinvestments are bubbles, virtual money that isn't actually there like those credit-swap promises, CD's, and fiat loans by the banks.). The malinvestments are the credit bubbles cause of the investments built on these investments (houses) that can't be paid for (bad loans/bad credit by banks). When the loans are not paid for banks become insolvent. Investment firms invested on houses (most were AIG, Goldman Sachs, Bear Sterns, etc...) see their investments drop in value. Investors want out. The veil is pulled down, as the malinvestment and real worth of these firms come to light. Investors pull out. Firms don't have the capital to meet all their promises to investors. Government steps in keep the promises these firms and banks promised (investment assets and bank's solvent accounts).

The interest rates pushed down artificially by the government makes credit abundant and makes investment on futures look profitable. Yet the banks founded on fiat can never hold water if their credit system of loans aren't paid due to malinvestment (bad loans). Investment firms investing in houses and other assets (but this was a housing bubble example, but other sectors of the economy intertwine) see their investment prices drop as houses are dropping in worth because they are being foreclosed and thus losing value, and thus banks sell them at lower price just to get some kind of return. The artifical lowering of interest rates is just that. Artificial and has nothing to do with the actual needs in the economy. So people see them drop and think good time to invest, when actually a bubble is forming. Bubbles are malinvestments, returns that can't happen.

This is long, but I'm trying to understand what you wrote. I think I have a handle on understanding what you wrote, but I couldn't write what you wrote, Daniel. You are more knowledgeable on this than I. So maybe using what I wrote you can condense it down and point out how this fits into your Steps on the ABCT.

Looking forward to learning.

Re: My take on the ABCT

Daniel J. Sanchez — Sat, 16 May 2009 21:07:37 GMT

Here is a new iteration. This one is more complicated, but more complete, because in it I attempt to integrate asset bubbles into the theory. My thanks to meambobbo for stimulating my thought in the direction of trying to figure out this crucial other aspect of the business cycle. After some meditation, this is what I came up with:

Stages

1. Money Supply Increase causes a general

2. (a) Credit Supply Increase and an ongoing (b) Purchasing Power of Money Decrease, the first of which causes a general

3. Interest Rate Decrease, which causes a general

4. (a) Longer Term Investment Increase, and, aided by 2(b), a (b) Sharp Demand for Particular Assets Increase, the first of which causes a general

5. (a) Demand for Labor Increase and (b) Demand for Capital Goods Increase, which cause a general

6. (a) Wage Rate Increase and (b) Capital Goods Price Increase, the first of which causes a general

7. Credit Demand Increase, which causes a general

8. Interest Rate Increase, which, along with 5(b), causes a general

9. (a) Longer Term Investment Decrease back to normal, and along with the completion of 2(b), a (b) Sharp Demand for Particular Assets Decrease.

The above describes a finite expansion of the money supply. There is nothing inherently circular about this progressive response to artificial money and credit expansion. The theory might even be called the Austrian Business Blip Theory (ABBT) were it not for the government's recurrent interventions into the markets for money and credit.

Causal Explanations

1 to 2(a). The money supply increase in the present system is in the form of bank money. This bank money is made available as new and additional credit.

1 to 2(b). The new and additional money is progressively distributed throughout society, bidding up prices as it goes along, and thereby progressively reducing the purchasing power of any given currency amount.

2(a) to 3. The interest rate is the price of credit. Increases in supply cause decreases in price. Therefore, a general increase in the supply of credit will cause a general decrease in interest rates.

3 to 4(a). The lower the interest rate, the more viable are longer term projects funded by investment borrowing.

2(b) and 3 to 4(b). Because the currency unit gets a smaller return (the low interest rate), and is also losing purchasing power (higher prices), it becomes less attractive as a means of saving than certain other asset classes (like houses).

4(a) to 5. Longer term production processes generally require more labor and goods than shorter term production processes.

5 to 6. Wage rates are the price of labor. Increases in demand cause increases in price. Therefore, a general increase in the demand for labor will cause a general increase in wage rates. Also, an increase in demand for capital goods will cause an increase in the prices of capital goods.

6(a) to 7. This is my own either new or independently formulated contribution. I've been avidly reading works and listening to lectures to try to understand the ABCT. It was tough at first, partially because I was trying to foist up price inflation as the dominant element in my understanding of it. It only started making sense when I let that drop and read and listened more carefully; this led me to realize that what the theory was chiefly concerned with was not price inflation but artificial credit expansion and its temporary effect on the interest rate.

Then it all started to click, but still only incompletely. In expositions of the theory, the explanation of the boom phase generally made sense to me, but things would always get muddy concerning how the boom became a bust. Often the explanation would focus on why the bust was, according to capital theory, inevitable, with Hayekian triangles, and Bohm-Bawerkian insights into what the interest rate represents. I in no way doubt the veracity of these analyses, but too often the concrete human motivations and actions that actually embody the turn from boom to bust was left out. Even when those concrete motivations and actions were present, the causal links didn't quite make sense to me. For example, I would often read that workers, after getting their raises in stage 6, would (a.) go out and spend their additional money, and that would bring their savings and consumption back to their normal ratio according to their time preference and that this led to (b.) not enough savings being available to see all the long term projects in stage 4 to their completion. But in everything I've read or listened to, it's never been explained (at least for my understanding) exactly how (a.) leads to (b.). Again, I in no way doubted that it does happen; it seems theoretically necessary. But how?

Then, motivated by the recent post asking for a concise explanation of the ABCT, I started trying to construct the above step-by-step explication. I tried to make it as clear and direct as possible. But, I kept getting stuck at stage 7. I kept asking myself, "what is the bridge from 6 to 8?" Then I thought, "stage 8 is just the opposite of stage 3. Just as an increase in the supply of credit brought about lower interest rates, higher interest rates must come about from either a decrease in the supply of credit or an increase in the demand for credit." Then it finally hit me: the savings-to-consumption ratio is indeed essentially what determines the interest rate, but not immediately so. The concrete human action that embodies the reestablishment of the normal savings--to-consumption ratio is more borrowing. People generally have an income-to-debt ratio they're comfortable with, according to their time preference. If they get a raise, they don't suddenly become more thrifty than before; so they borrow more, generally in proportion to the increase in their wages.

7 to 8. This increased demand for credit then raises interest rates.

8 and 5(b) to 9(a). The higher interest rates, along with the increased capital goods prices (6b), cause the long-term projects from stage 4 to no longer be viable. Boom gives way to bust, as businesses rush to reallocate resources away from the non-viable longer term ventures to viable shorter-term ventures.

8 and the completion of 2(b) to 9(b). An increase in the money supply must be finite (or at least abbreviated), or else hyperinflation will result. Any finite increase in the money supply will cause a finite increase in prices. The new money will progressively bid up prices, but eventually the new money will reach all sectors, and then prices will stop generally rising. Thus, the money will stop losing purchasing power (and actually start gaining purchasing power, as money naturally does in a market), while the particular assets that had replaced money as a means of saving start to depreciate (as real assets tend to). These changes, along with the increase in the rate of interest, completely reestablishes money's attractiveness as a means of saving. Savers flock out of the asset classes they had flocked into, and back into money, causing the prices of those assets to plummet.

Regarding the 6(a)-7 analysis, I know I could very well be wrong. Or I could be right and silly at the same time, if that was what ABCT scholars were saying all along, and I was just dull to it. In any case, I thought I'd share my thought processes with those of you who are also trying to teach themselves economics (and political philosophy, history, etc.) as best they can.

I would very much like to hear any comments and corrections you would like to offer.

Sincerely,

Daniel J. Sanchez

Re: My take on the ABCT

meambobbo — Sat, 16 May 2009 04:51:47 GMT

Sounds good to me, but I am definitely no expert.

As far as the length and size of the money injections, definitely the longer and more widespread, the larger the cycle. We just had a GLOBAL cycle prolonged for a LONG time. Thank you, central bank coordination.

As far as one-shot injections, this can radically alter behavior if large enough. FDR's plan to change the dollar from 1/20 oz of gold to 1/35 caused massive bank runs and collapsed half the banks. If people tried to quickly jump into popular assets, reducing money's purchasing power, there may be more "one-shots" down the road. It's not really about what has happened, but expectations of what will happen. Is the injection viewed as a one-time thing, or a sign of more to come? With government control of money and credit, there is far less certainty in rational economic planning, which I believe will ultimately drive people towards precious metals.

Notice that the FED has recently attempted such a one-shot and it has resulted in a steady stream of growth. Banks know it would be foolish to try to make all their loans for the year on the same day. And they themselves need a cushion to absorb still undetermined losses. Thus, besides direct government spending, the FED can't pump money into circulation in a one-time manner. Conversely, Greenspan didn't add a [terribly] huge amount of reserves for bank to lend against, but they lent heavily anyway.

Re: My take on the ABCT

Daniel J. Sanchez — Sat, 16 May 2009 04:12:04 GMT

So it seems that the artificial credit-induced long-term investment bubble would happen even with a one-time monetary expansion. But the price inflation-induced asset bubbles only happen with continuous monetary expansion.

Tell me if this makes sense:

In any given market condition, there will generally be one asset which is optimal for your #1 (longer-term saving), due to a good level of and balance between purchasing power storage and liquidity; also there will be one asset optimal for #2 (short-term saving) due to the same considerations as #1, but leaning more toward liquidity. Of course, nothing says people must have only two such categories. Savers may have a diverse spectrum of savings desired for their various balances between purchasing power storage and liquidity. And often, the optimal asset for several different categories will be the same: the common currency.

If the currency is being devalued at a certain small rate, it might then become less attractive as a means of extremely long-term saving than some other asset class, which has a lower rate of real depreciation than other asset classes. Then if the currency is devalued faster, it might then become less attractive as a means of mid-term savings than that same asset class. And if it is devalued faster still, it might become less attractive as a means of short-term savings than that asset class.

So in an asset bubble, over-and-above the appreciation due to monetary expansion, there is a premium given to certain assets by virtue of their role, not just as a good, but as a store of purchasing power. Certain assets are better stores of purchasing power than others. Savers realize this and buy up those assets, increasing the prices of those assets and thereby sending the market a signal regarding the superior money-ish (in terms of storing purchasing power) qualities of that particular class of asset to other savers, who also pile in. Thus whatever is seen as a superior means of saving will have its value spiral upwards, due to the tremendous demand brought about by all of society replacing money with it for a certain portion of their savings.

But once the currency devaluation stops, money is seen as the optimal store of purchasing power for longer-term saving again, since it doesn't depreciate in-and-of-itself (outside of policy-induced depreciation) like most other assets do. So people flock back to money, and the asset price bubble pops.

Does that sound right?