Stylized Facts, Public Policy and the "Crack Up Boom"

|Peter Boettke|

When I was an undergraduate perhaps the most repeated lecture of Dr. Hans Sennholz was the one on the various stages of inflation and economic crises.  Even the housewives, Sennholz would declare in his characteristic manner, become aware of the depreciation of the purchasing power of money during the last stage of the inflation.

Sennholz's lectures are embedded in my brain, and I have all his books on my shelves.  But while these resources are there and in fact are part of my "DNA" as an economist, I often do not access them for a variety of reasons.  But as we entered the 2000s, I was drawn back to Sennholz's writings again and again, and his lecturers continually are accessed from deep in my memory to think about the pieces of news concerning the financial crisis we are treated to daily.

Sennholz's The Age of Inflation and Money and Freedom along with Murray Rothbard's What Has Government Done to Our Money are about as readable as any treatment of monetary policy one can read.  And in the context of the broad brush strokes they both paint with, the picture they paint is about as good as you are going to get concerning the destructive consequences of inflation, and the intimate connection between government spending, and government monopoly control over the money supply, and inflation.

But reading Sennholz and Rothbard leads one quickly back to Mises, as both derive their approach from Mises.  In reading Mises I am always struck by how fresh he still reads, and how relevant his analysis of contemporary policy in the first half of the 20th century still is relevant for us at the beginning of the 21st century.  Of course, there is the enduring insights that transcend time and place --- Mises is the master communicator of the inexorable laws of economics.  But he is also full of practical applications of economics to matters of public policy.

One of those issues is his analysis of the "crack up boom" (see Human Action, 426-428).  As I re-read those pages tonight while working on a paper dealing with the financial crisis since 2008, I am left wondering why this explanation hasn't been applied in the discussions we have had on the blog about monetary policy. At the risk of going out on a limb, let me say that I have become convinced that the nominal income targeting position staked out by Scott Sumner (and endorsed in varying degrees by Selgin, White and Horwitz) is mistaking the data that would result from the Mises stages of inflation approach with data that would result in a toy economy were a debt-deflation downward spiral was taking place.  What if what we are seeing is the beginning of a "crack up" boom, rather than a deflationary spiral caused by monetary policy mistakes?  If that is right, then efforts to ease monetary policy to off-set a collapse will not be the solution to our economic woes.  Instead, we need to think through the specifics of the "crack up" boom and the institutional environment within which decisions are being made today.  It is important to point out contra Cowen and Caplan (and others who buy the supposed rational expectations critique of ABCT) that Mises's section on the "crack up" boom is entitled "The Anticipation of Expected Changes in Purchasing Power".  The argument Mises provides is in my reading consistent with a non-mechanical interpretation of rational expectations, and it is consistent with the stylized facts of the credit transmission mechanism locking up while the supply of credit was plentiful.

When I do a google scholar search of "crack up boom", I don't see any discussion about the idea among monetary theorists such as Selgin, White or Horwitz.  There is a discussion among hard money folks on the internet, and in some journal articles by Cochrane, Carden, Salerno and Huelsman.  But the idea isn't even really applied in those writings to address our current situation.  I am wondering why?  Am I reading too much into Mises's discussion of expectations and the demand for money? Doesn't Mises's theory explain the stylized facts of our day in a way that is consistent with economic theory?

Why is the "crack up boom" not discussed more in the journals and on the shelves?

 

Comments

[Bill Woolsey]

Perhaps I don't remember correctly, but I think Mises' notion of a crack up boom would require output or unemployment targeting in the face of every more rapid decreases in the purchasing power of money. Nominal income targeting isn't real output targeting. If relalocation of resources require higher unemployment or depressed output, then unemployment will be higher and output lower.

Expectations of a falling purchasing power of money causes a reduction in the demand for money and increased demand for goods and services. The higher demand causes the prices to rise--a lower purchasing power of money.

With nominal GDP targeting, the reduced demand for money (and increased spending on output) elicits a smaller quantity of money.

An alternative way to describe it is that the crack up boom involves rising velocity, compounding the growing quantity of money, resulting in more rapid expansion in money expenditures on output. A target for money expenditures requires that the quantity of money to fall (or at least grow less rapidly) to offset the rising velocity.

What motivates all of this in Mises is a futile effort to keep real interest rates low enough to maintain demand for capital goods employment in capital goods industries.

With Nominal GDP targeting, real interest rates rise and the demand for capital goods fall. (Demand, or at least money expenditures, on consumer goods rise.)

To the degree that malinvestment limits the abiltiy to expand the production of consumer goods, then the price level does rise, but only in inverse proportion to the reduction in output.

As far as I know, Mises didn't argue that firms will expect inflation and then will raise prices progressively faster and progressively price themselves out of sales, resulting in growing surpluses of products and resources.

[Peter Boettke]

Bill,

Thank you. But my question is more blunt than that ... in the paragraph where you write "What motivates all of this in Mises is a futile effort to keep real interest rates low enough ..." Right, and isn't that what we saw?

And the mechanism is that expectations catch up to inflation (as Sennholz said even the housewife understands the depreciation). Wouldn't that show up in the credit mechanism locking up? Or am I trying to fit a square peg into a round hole.

I am thinking aloud and want to be checked if my intuition is way off.

Pete

[Steve Horwitz]

FWIW, I have never ruled out this possibility and in fact I've argued (and did on national TV tonight) that inflation is the bigger problem than deflation right now, which is why I don't like QE2.

I think, Pete, you're sliding between the argument that there was an increased demand for money/liquidity in the fall of 2008 in the heat of the crisis (one I agree with) and the argument that what we need right now is more money/liquidity (and argument I don't agree with and have never made).

Those are two distinct points, as Larry W so nicely put it at the session at the SEAs.

The other point is that even if one believes that the least damaging world given a central bank is one in which the bank should respond to changes in the demand for money, it could mean that one things PY should be stabilized, or it could mean it should grow at a specified rate. The phrase "nominal income targeting" doesn't distinguish among those possibilities in and of itself. Thus your phrase "partial" endorsement. But it always seems you want to lump me (us) in with Sumner when push comes to shove even though I don't think any of us would agree with how gung ho he is about monetary expansion.

[Ryan Murphy]

Unless I'm seriously confused right now, the recent cycle looks absolutely nothing like a crackup boom. Maybe it's because I think more in terms of "catching a tiger by the tail" or whatever. But doesn't there need to be a progressive increase in the anticipation of future increases in the supply of money, coupled with even faster provisions of the supply of money, for it to be a crackup boom wherein the currency collapses? This is the thing that I would think Mises was talking about since it happens again and again in the history of the world when fiat money gets out of hand. Nothing like that has taken place. Markets continue to expect a near zero inflation rate. And, if my understanding is correct, the accelerating supply in the printing of money basically pushes up velocity, which in turn pushes price level up even further. Velocity fell off the face of a cliff.

Whether or not you agree with it, the current idea is that the Fed needed to increase inflationary expectations just to ease price stickiness problems. Where or not you agree with it, the belief was that all physical dollars were getting hoarded by banks because of the "deflationary" expectations.

For there to be a crackup boom, the public would _need_ to believe that the fed will continue accelerating the rate of inflation to maintain full employment. But no one, not even a delong or a krugman, believes we should have accelerating rates of inflation. The most insane thing they seem to say on the monetary side is that we should have something like a 6% inflation rate _that_does_not_move, not to increase inflation further whenever we fail to reach full employment. Even that type of behavior, if actually implemented, would not in itself cause the type of expectations needed for the crackup boom to initialize.

Can QEII cause something resembling a crackup boom? Yeah, I think it can, but not for the reasons you said. Nassim Taleb had some great imagery in describing printing money like getting hyperinflation- it's like getting ketchup out of the bottle; all the sudden out of nowhere the inflation will shoot up if you print enough money. If you start getting hyperinflation, the fed could respond any number of ways. But I don't think what we're seeing right now at all resembles the expectations of the crackup boom.

[Peter Boettke]

Ryan,

How would you describe the Greenspan put?

How would a self-correcting reaction to a Greenspan put look if not what was taking place in 2008?

And if we are not attempting to reinflate between 2008-2010, while people are refusing to buy the policy, then what else is the Fed doing?

And don't you believe in our current set of policy institutions that fiscal imbalances are inflationary?

So again I ask, what theory do you think fits the stylized facts of our contemporary history from 1950 to 2010?

[Ryan Murphy]

From the section you cited:

"The characteristic mark of this phenomenon is that the increase in the quantity of money causes a fall in the demand for money. The tendency toward a fall in purchasing power as generated by the increased supply of money is intensified by the general propensity to restrict cash holdings which it brings about. Eventually a point is reached where the prices at which people would be prepared to part with 'real' goods discount to such an extent the expected progress in the fall of purchasing power that nobody has a sufficient amount of cash at hand to pay them. The monetary system breaks down; all transactions in the money concerned cease; a panic makes its purchasing power vanish altogether. People return either to barter or to the use of another kind of money."

Demand for money has risen. Maybe that relationship will change, but we'll be able to see it as it's happening in the data.

I don't see how you can argue that Mises would say that this is a crack-up boom when the diametrically opposite of its "characteristic feature" is taking place, unless you have a curious definition of the demand for money. Given what banks are doing (sitting on basically all the money that comes into the system), I'd have trouble fitting that behavior with any metric which suggests that demand for money is falling.

This is probably just me, but I don't completely understand what your questions have to do with money demand/velocity as the world exists today.

I would describe the Greenspan put as bad incentives that made the magnitude of the business cycle worse.

People are refusing to raise inflationary expectations. Increases in the supply are money in 2008-2010 just led to a decrease in velocity since the Fed pays interest on banks sitting on money. It doesn't have anything to do with a dropping demand for money.

I don't know if the current set of policy institutions are inflationary unless you define inflation to mean "printing money" (which would be of course true tautologically). If the fed stops printing money before the ketchup bursts from the bottle, it will have little effect on the price level (that is obviously not impossible- the point at which it "bursts" is an empirical question we have no good data on). If it goes on too long, yes it will be inflationary.

I would compare the current situation to 1990s Japan. I believe that Bernanke sees the similarity and wants to raise inflationary expectations to 2%. Japan's central bank's policy was to keep it at 0%, and that's just silly if you are a New Keynesian who isn't an ideologue and who will ignore all monetary data to get more stimulus. That probably describes Bernanke. Perhaps I would not subscribe to the mainstream point of view, but that's what is probably going on in the mind of Bernanke. I don't find a 2% inflation target to be particularly terrifying considering the alternatives from 1950-2000. I also don't see why it would necessitate a crackup boom, unless you want to argue that an inflation target in Japan of greater than 0% would cause a crackup boom.

I mean, I think I'm probably out of my depth here. I've been verbose, but my point is just that I don't see any evidence of an decrease in the demand for money. All traditional measures suggest an increase.

[Pietro M.]

As long as banks are ill, risk aversion is high and (ris adjusted) return rates are low, there won't be much inflation because the creation of inside money will be subdued, despite the reckless creation of base (rectius, debased) money.

In these conditions the only way to create inflation is to put money directly into consumers' hands by helicopter drop. For those who don't like the Japanese stagnation, it may be great to have a '70s-style stagnation in its stead, bundled with hippies and LSD.

Should risk aversion fall, riskiness fall, return rates on investment rise and banks' balance sheet recover, then there is some possibility of stagflation even without helicopters.

Anyway, I don't expect a crack-up boom any time soon, first because of these obstacles on the road to inflation, and because we are still a long way from igniting a feedback loop in which higher prices causes lower money demand and viceversa. This hasn't happened in the '70s, at least not in the Western world, and it is not going to happen soon.

My maximum likelihood estimation is that we are heading toward a sushi-style stagnation.

[RPLong]

Prof. Boettke, absolutely I think you're right.

Ryan Murphy is correct that we have not yet reached the "crack-up boom," and none of us have lived through one, so we don't really know what the crack-up boom would look like.

However, Mises goes out of his way later in the chapter to point out that additional monetary stimulus will cease to have the desired effect once people figure out that the stimulus is temporary.

All the "demand for money" questions are also well treated in Human Action during the earlier chapters about money substitutes and banking.

I'm a bit out of my depth, too, because I've _only_ read Mises, not Rothbard et al. But I'm won over by Mises' explanation. My only hesitation is that I'm not sure where we are in the build-up to the crack-up boom because at the young age of 30, I've never really felt a monetary crisis before. I'm not sure where the tipping point would be.

[Peter Boettke]

RPLong,

This is what I was trying to say ... in my language I said we are at the "beginning". It is a "stages of" type argument.

Look these things unfold over decades not years. CA didn't get in the shape it is in, in a few years, neither did the PIIGS countries. And the same fundamental monetary and fiscal policy institutions that were in operation in the 1970s that Milton Friedman, F. A. Hayek and James Buchanan identified as the source of our ills are _still in operation_. So either they were wrong then as now, or they were right then and we didn't heed their advice so they are right now as well. And Mises identified the issues in the 1940s.

I just re-read Milton Friedman's Money Mischief --- that was written in 1992. He claims in that book that we have no idea what a world fiat system will do; but his prognosis is not good. Go back and reread Capitalism and Freedom and Free to Choose as well. Friedman is identifying the political economy costs as well as the economic costs of monetary mischief. Look at Hayek's Constitution of Liberty, and then look at LLL and think about what a policy arena would look like in a political economy of freedom. It is NOT what we have, and the concerns that Hayek raised about the breakdown of the monetary framework are just as relevant today as they were in 1960.

I am very confused as to why I don't seem to be able to communicate my points clearly, or perhaps I am confused over the points so my communication skills are weak.

[Peter Boettke]

@Ryan --

My point is that the data follows a causal chain and in fact trails behind the _mechanism_. So empirical analysis often gets confused or misidentifies the actual causal mechanism.

We have a lot of "contradictory" evidence --- I am trying to think through the simplest economic explanation. Look at the Cochrane entry I posted the other day and his point about the trillion sitting there. We have an impending crisis of public pensions, state's are bankrupt, federal government is bankrupt, and Fed is there to print money. Why aren't 30 year rates through the roof? But why is gold spiking to new heights? See what I mean?

There is a lot of noise in the "data" and that can only be clarified through the right theoretical lens.

Again, this is NOT my area of concentration as an economist --- I really only know what it is that I already know --- but I have a political economy angle that I have been developing and stressing.

[Bill Woolsey]

Long:

What is the "desired effect" of the money creation?

To Mises, the assumption is that the desired effect is a lower real interest rate and a stimulation of demand for goods of higher order. In our situation, it would be the demand for houses.

If the Fed targeting new home contruction, and tried to raise the quantity of money fast enough to use up all of the excess capacity in housing (keep all the carpenters busy,) then we could be on the way to a crack up boom. However, we would actually start observing faster and faster increases in the prices of everything.

The nonhousing sectors of the economy would suffer bottlenecks of resource availability. And while housing prices might rise, the demand for houses would still lag compared to the level of the boom. More rapid money creation (and increased velocity and money mulitiplier) would just keep on direct ever growing expenditure to sectors where it is needed, and bottlenecks keep prodction from rising, and the housing industry would be plauged by shortages of those same resources, so that it cannot be expanded enough to hire the unemployed carpenters.

Now, I argued that a target for a growth path of NGDP would not generate a crack up boom. Of course, the Fed isn't targeting a growth path of NGDP. It is targeting inflation.

If inflation expecations get up to 2%, then the Fed claims it will restict its money growth. If, at that inflation rate, housing starts are still lower than at the peak of the boom, and carpenters are still unemployed, then, that is what happens. I am pretty sure that the Fed believes that this is true. That is, when inflation gets back to 2%, the real demand for housing will still be less than boom levels and there will still be unemployed carpenters. There will, however, be more demand for other things.

If you assume that the current level of base money, slated to be about $2.6 trillion, cannot be decreased, then, if the money multiplier and velocity return to "normal," that is, their pre-recession levels, then the price level will be much, much higher and there would be massive inflation to get there. But, the Fed intends to reduce the quantity of base money if and when the money multiplier and velocity rise.

And I am reasonably confident they aren't targeting housing starts. (I am a bit worried about this committment to keeping the Federal funds rate low for an extended period of time.)

Mainstream economists understand that structural factors can raise unemployment and reduce the level of real output (put it on a lower growth path.) Expansionary monetary policy until demand rises enough so that output and unemployment get to some real target is not really on the table. Let's just put up with higher and higher price inflation until production and unemployment get to the desired levels is not on the table.

I don't understand why people are brushing off arguments against that view. "We" won that battle.

Now, it is obvious that all sorts of interventions are being used to increase the demand for houses. But I don't think that is what monetary policy is aimed at doing. And I really don't think anyone is trying to get housing production back up to the level of the previous boom. These interventions are aimed at preventing what they assume is some kind of overshooting. (well, undershooting.)

[RPLong]

Prof. Boettke - My apologies. Your points were clear to me, but then I myself started rambling and probably made it sound as though I didn't understand.

I think the Misesian explanation is crying out to be modernized, because much has happened to the banking and credit world since he published Human Action. While I think Mises' explanation remains as true as ever, I think someone needs to take the explanation through the steps it should take in a modern financial system. Well, I've been thinking about a PhD - maybe it's my job! haha...

Bill - I am still trying to wrap my head around the NGDP concept, so I'll try to refrain from commenting on that. I'm new to this stuff. As I understand it, NGDP sounds a lot like Lockean money Velocity to me. Mises was skeptical of this concept, and I admit that I am, too. But I don't fully understand it, so I haven't made up my mind.

However, I will say that a confounding aspect of the "housing" market (quotations to be explained in a moment) is that people and firms use their housing and real estate equity to finance future risks. So far, most macroeconomist blogs etc. I've read seem to come from the position that housing is just another sector of the economy. But housing is deeply entrenched in the financial system and therefore a housing boom is far less transparent than, say, a dot-com boom.

What I mean is that it conceivably generates mutli-sector malinvestment. I think this is throwing off a lot of macroeconomists because they see the current financial situation as being rooted in housing, and so their looking for exclusively housing-based malinvestments. There are plenty of those, sure, but I think more important is the fact that the housing bubble bled over to everything. What makes this situation so difficult is that we have to sort through so many economic sectors to find all the malinvestment.

That's my response to the "bottleneck" concept, but please remember, I am very much a newbie in this realm and I might not fully understand what you're saying.

[Bill Woolsey]

Pete:

The credit mechanism locking up would have to be people not wanting to lend. But what do they do? They spend on goods and services.

We should observe rapid growth in sales of goods and services. The firms, supposedly, would not be able to borrow to fund production. There would be shortages. Prices rise.

I think that generally firms use current cash flow to fund the purchase of resources in these situations. But, of course, if spending outstrips the ability of firms to produce things, prices still rise, even if firms can come up with funds to buy the resources. (I am convinced by Sumner that during the recover of prices when gold was devalued in the depression, firms were able to finance expanded production even though the banking system was closed down.)

And I don't think credit markets lock up.

I think this is what you have in mind. People expect higher inflation and so will only lend at higher rates. Those expecting higher inflation, should be willing to borrow at higher rates. But suppose the lending expect higher inflation than those that borrow? (Housewives tell their husbands not to buy bonds at low rates, but firms don't expect the prices of their products to rise so much.) The supply of loans falls more than the demand rise, market interest rates are higher, and the quantity of credit is smaller.

But what do the people do rather than lend by purchasing bonds? Hold money? When they expect inflation? Why?

But, maybe I don't understand what you are thinking.

Generally, expected inflation should cause people to want to borrow more, and lend less and instead spend now.

I don't see how this makes credit markets lock up. And if the Fed keeps interest rates low in the face of this, the borrowers just spend more and the other lenders (other than the Fed) lend even less and spend even more.

[George Selgin]

Mises "crack up," as I understand it, follows attempts to hold interest rates below their natural levels by means of accelerating growth of M and MV. Stabilizing MV--and especially stabilizing it at a "conventional" (that is, pre-boom) level or growth rate, shouldn't usually suffice to drive interest rates below their natural levels. It may, on the other hand, keep them from rising above those levels.

I haven't, by the way, taken as firm a stand in the debate about QE2 and NGDP targeting as Pete suggests in his post. In fact, I'm not so sure that present spending growth rates are too low. Much depends on what you consider the "normal" trend.

[Bill Woolsey]

George:

Growth rates are fine.

The growth path is much lower than the 1984-2008 trend growth path.

When do you give up reversing a deviation from the previous growth path?

[Richard Ebeling]

My understanding of Mises' analysis and explanation of the "crack-up" boom is that it is a particular, near-final stage of a prolonged period of monetary expansion and rising prices at an accelerating rate.

Again, from my reading, it is clear that Mises was drawing some theoretical conclusions from his study of historical and contemporary events. He had closely studied the hyperinflation during the French Revolution and was very familiar with the details of the Continental Notes inflation during the America Revolution. And he, obviously, drew conclusions from the Great German and Austrian inflations through which he lived.

Indeed, the "crack-up" boom is the theoretical conclusion from watching the stages of the German inflation, leading to it's near total collapse in the autumn of 1923. The accelerating decline in the demand for money to hold -- which is the cash balance aspect of the "crack-up" -- involves that stage of the inflationary sequence when individuals know longer believe that the price rises of the past will be reversed at some point in the future; that the price inflation will continue; and, then, finally that the rate of depreciation will exponentially grow to such a degree that individuals undertake that "flight into real goods" and out of holding money. People exchange money for "anything" that is believed to be likely of greater value tomorrow than the unit of money they are holding.

At this point, that "strange" phenomena occurs: a "shortage of money" in a flood of money creation. This is because under the expectations concerning future depreciation, people push up prices in general so high that there is "today" not enough actual currency in circulation for everyone to pay those higher prices. Then, if the monetary authority "responds" to this "shortage" of money in circulation by creating even more money, it merely exacerbates the problem and brings the final crack-up even closer because this additional monetary expansion intensifies the inflationary process and people's expectations.

People need money to buy goods today, but their very expectations of tomorrow's rate of inflation, pushes prices up so high today that the actual stock of existing currency is not sufficient to meet the "needs" for money.

(By the way, in the late 1970s or early 1980s, Milton Friedman, I recall, wrote an opinion piece in the "Wall Street Journal" on this very strange phenomena of a money "shortage" during a monetary inflation because people were complaining, then, of "not enough money" in the economy at that time, just when the monetary spigot was wide open.)

Mises, of course, never argued that every monetary inflation and severe currency depreciation has to "inevitably" result in the final "crack-up" boom. It is the inescapable result if, and only if, the monetary authority pushes an (accelerating) inflation to that point that it generates that change in people's expectations such that everyone "takes flight" out of money.

It is an "if, then" argument drawn as the likely outcome from a theoretical interpretation of the historical experiences of past hyperinflations. Because it does not seem to be possible to "a priori" deduce with "apodictic certainty" the sequence of people's changing expectations during an inflation from the "first principle" of the action axiom.

I don't know if this helps or not, Pete. But this is my understanding of what Mises was explaining when discussing a "crack-up" boom.

Do you think I've missed something?

[RPLong]

Sorry, one last thing to Bill Woolsey.

You mention that Mises' assumption is that the desired effect is a lowering of the real interest rate. My reading of Human Action suggests to me that Mises' idea of a "real interest rate" is very different from the modern/common definition of it.

Namely, Mises speaks of "the original rate of interest," which is an impossible-to-know subjective value assessment on the part of an individual. Next he speaks of the market rate of interest, which is what the lenders charge, and it consists of the "original rate" plus the lender's mark-up, i.e. compensation for taking on the risk of lending. Finally, Mises proceeds to discuss how credit expansion impacts the market rate.

But in the Misesian framework, there is no discussion (unless I'm wrong) of nominal vs. real interest. From what I gather, this isn't a mere oversight; rather, he preferred looking at interest rates differently.

[Steve Horwitz]

As I often say when he talks about Mises: what Richard says.

My understanding of the "crack up boom" has always been that it was the endpoint of a longer inflationary episode, but one in which we get the sort of flight to real values that Richard mentions. The US dollar is nowhere near that point.

Are we in an early or middle stage that will eventually produce such an outcome? That's possible, but I don't think it's a useful device to talk about where we are *right now*.

[Lee Kelly]

Just to echo previous commenters: I don't think a "crack up boom" is a pressing concern at the moment.

Assuming the worst case scenario: the Fed does not contract the monetary base, the multiplier and velocity return to prerecession levels, it is possible for a "crack up boom" scenario to develop, but even then I do not believe it is particularly likely. To do something so irresponsible would really require more direct involvement of politicians.

[Peter Boettke]

Ah, Horwitz actually read my post :), I am explicitly talking about stages and I am specifically talking about the beginning stages, not the end point.

Second, I do believe we are in the process not of a decade long problem, but a generation long of BAD public policies --- the concerned voiced by Friedman in Money Mischief about an irredeemable paper currency, the concerns voiced by Friedman and Friedman in Free to Choose in 1980 about the disease of inflation, the concerns of Hayek in the 1970s about expediency and principle in policy and the concerns of Hayek in 1960 about the steady stream of inflation the anti-deflation bias results in, as well as the concerns of Buchanan and Wagner about a fiscal theory of inflation are all too important to dismiss in understanding our current situation in my opinion. You don't become CA overnight, and you don't become Italy overnight (or Greece, or Ireland, or New Jersey).

I think there is a confusion over the data, and that by not taking a broader view of the data, we are being mislead to believe the situation is one thing, when in reality it is quite another.

I need to process some of the comments a bit more because I have a firm judgement. And I might be wrong, but I think Horwitz caught what I was saying even if he didn't intend to catch it --- can we identify the mechanism at various stages and see the process unfolding (and we should always remember that the outcome is endogenous to our responses).

P.S.: I am reminded in this of Igor Birman's "From the Achieved Level", which was an early critique of Soviet accounting and a revelation of the real situation that was masked by the "data". http://www.jstor.org/stable/150259

Please note date -- 1978, a full 11 years prior to the collapse of real existing socialism and 13 years prior to the collapse of the Soviet Union. Yet he identified the issue in the accounting then. Economic Illusions can last for much longer than we often think they can due to off-setting factors (such as the tremendous resiliency of the market).

[George Selgin]

Thanks to Richard for a very clear exposition of what Mises meant in speaking of a "crack up boom."

And thanks also to Bill Woolsey for asking, "When do you give up reversing a deviation from the previous growth path?" That is exactly the right question--and the one that accounts for my not having taking a strong stand on QE2. It's been quite a few quarters since spending took its nose-dive, and an (arguably) normal growth rate has since resumed. The level of spending is also back were it had been. So, ought we to let bygones be bygones? I lean toward the affirmative (and told David Beckworth so, by the way--even sending him back a version of his own spending growth chart with a trend-line drawn from before the boom and linking up very nicely to the recent trend--thank you very much). So, Scott Sumner fan though I am, I am not quite willing to approve of the Fed's recent move, even putting aside the fact that, on some level, I abhor any move that results in a bigger (hence badder) Fed.

[Jerry O'Driscoll]

Richard focused the discussion. Mises' fear of inflation was based on historical experience. Likewise, the classical economists aversion to public debt reflected their knowledge of history. Already by Smith's time there was a history of sovereign debt defaults and debasements.

Smith argued that a large public debt always ends in default, albeit sometimes through the "pretended payment" by depreciated money.

Pete correctly point to nearly 50 years of bad public policy. In that context, his question makes great sense. Current Fed policy is then a new stage in the process. The end is not inevitable, but is foreseeable.

My Cato colleague, Mark Calabria, comments today on the complications of a Fed insolvency. That will make the Fed more reluctant to tighten. That institutional reluctance will reinforce the Chairman's personal reluctance.

[Roger McKinney]

I don't think people are worried about a crack up boom because everyone assumes the Fed has the tools and the will to prevent hyper inflation.

[Steve Horwitz]

Pete: I read it last night and had the third comment up above. You should be reading your comments more carefully rather than complaining about me not reading your posts! :)

[Current]

I pretty much agree with Ebeling, Woolsey & Horwitz here.

But, I'd add that I think a large part of the problem is that the markets are uncertain about the future. People don't know if the Fed will continue creating money and provoke high inflation, or if they will go into reverse when this happens. That uncertainty makes investing now very difficult leading to the hoarding of money.

RPLong,

In "The Theory of Money and Credit" Mises writes:

"So far as variations in the objective exchange-value of money are foreseen, they influence the terms of credit transactions. If a future fall in the purchasing power of the monetary unit has to be reckoned with, lenders must be prepared for the fact that the sum of money which a debtor repays at the conclusion of the transaction will have a smaller purchasing power than the sum originally lent. Lenders, in fact, would do better not to lend at all, but to buy other goods with their money. The contrary is true for debtors. If they buy commodities with the money they have borrowed and sell them again after a time, they will retain a surplus over and above the sum that they have to pay back. The credit transaction results in a gain for them. Consequently it is not difficult to understand that, so long as continued depreciation is to be reckoned with, those who lend money demand higher rates of interest and those who borrow money are willing to pay the higher rates. If, on the other hand, it is expected that the value of money will increase, then the rate of interest will be lower than it would otherwise have been."

He doesn't really talk about the "real rate of interest" but he does discuss the underlying factors that affect the market rate that we now associate with the real rate.

Notice that in the discussion he talks about the case where "continued depreciation is to be reckoned with". Somewhere else he makes the same argument for appreciation. So, he makes argument that if reasonable expectations can be formed about the future objective exchange value of money then lending can continue. But, in my view, he doesn't imply that this is always possible. He considers both expected and unexpected changes in the value of money.

[Silvano Fait]

Being the dollar the world reserve currency, I think that it is necessary to widen the perspective and to look at the consequences also outside the U.S. - emerging markets in particular. I don't know how much reliable are leading indicators from China, but it seems to me that a classical ABCT is going to develop and Mr. Bernanke played a role in it. I heard that foreign direct investments rose about 27bn of usd, 20 of wich concentrated in commercial and real estate. Notoriously there is an excess of capacity (= malinvestiment) in steel factories as in many others manifacturers. There are enought plants to produce up to 30 milions of car per year against the 18 milions of sales of the previous year. Even admitting that they could run at 80% of their capacity in a satisfactory way they would have to increase production and sales of 1/3. Food and consumer prices are already rising and significant increases in commodities prices are typical symptoms of a prolongued low interest rate policy.

This could be extended also to Brazil, but chinese case is more easy because they mantain a de facto pegged exchange rate and they are very prone to import credit inflation related with QE II. Many reflections of Hayek (as in Monetary Nationalism and International Stability)and Machlup (as in The Stock Market, Credit and Capital Formation) could be adapted and find applications, since the Fed is the main "producer" of global hard money supply.

Personally I consider the crack up boom as "the worst case scenario" theorically conceivable, degenerating into hyperinflation, but not necessarly unavoidable. The same Mises admit the case of a trade cycle running in a growing economy where society will be in the end richer in absolute terms but more poor in relative (i.e. if the cycle wouldn't have been occurred).
I should admit that Mr. Bernanke and his european counterpart are working hard in order to fulfill "austrian's nightmares".

[Richard Ebeling]

After reading Pete's reply to Steve, I now think I have a better understanding about what Pete means by the danger of the "crack-up boom."

He is not suggesting or predicting an eminent hyperinflation, or a radical fall in the demand for money holding.

What he is saying, and which he is drawing from Mises' analysis, is that the institutional setting in which monetary policy is being undertaken and the policy and ideological attitudes and beliefs underlying those policy decisions are those that are (may be?) setting in motion the events that will result in such a crack-up boom in the future -- unless there were to be a significant change in the policy and ideological mind-set, and the discretionary institutional setting (fiat money) in which monetary policy is undertaken.

Already before the First World War, in the first edition of "The Theory of Money and Credit" in 1912, and in a 1913 article on 'The General Rise in Prices in the Light of Economic Theory' (which will appear in English translation in volume 1 of "Selected Writings of Ludwig von Mises" from Liberty Fund in 2011), Mises argued that the relatively new policy attitude that the interest rate was to be a policy instrument to be manipulated to influence economic activity, and the growth in the use and supply of fiduciary media (money substitutes not backed by gold reserves in the banking system) was setting the stage for the danger of serious and harmful inflationary forces and cyclical effects in the years to come.

As Mises put it in that 1913 article:

". . .there is a serious danger for the future of the individualistic organization of the economy in the development of fiduciary media; if the legislature does not put some obstacle in the way of its expansion, an unrestrained inflation could easily come about, the destructive effects of which cannot really be imagined."

Thus, the conditions for an eventual "crack-up" outcome was feared by Mises ten years before the actual culmination of German inflation and its destructive consequences in the early 1920s.

And this is what Pete means when he refers to the "early" stages of the sequence of events that from the perspective of future historical hindsight will be seen as the origins of the destructive inflation that he fears lies ahead of us.

Richard Ebeling

[Jerry O'Driscoll]

Silvano Fait is surely correct to draw our attention to the global consequences of Fed policy. He cites relevant examples.

I have argued that QE1 was bringing growth, just not in the US. It also fueled a bubble in Asian real estate.

Now we know a lot of Fed lending was to foreign banks. What reason is there to assume that impact effects (Cantillon effects) of Fed easing must show up first in teh US?

[Pietro M.]

Mises in Selected Writings 3 says that despite the US is an inflationary country (in the '40s!), Mexico would be better off pegged to the dollar because of the benefits of internationa trade. More or less the same problem applies now to the rest of the world. They have to choose: being pegged to a populist currency (the dollar) and import macroeconomic instability (China), do even worse than the dollar (Zimbabwe), or have negative effects in the short run by a continuous appreciation of one's own currency (no one is in this position, although the EU sometimes says it wants to try: EU countries are just too financially imbalanced to foster credibility in the euro). I'd prefer the third option. Of course, a gold standard (i.e., a true unmanipulated international currency) would do much better.

[Pietro M.]

I want to thank Prof. Ebeling for Vol. 3 of the Selected Writings of LvM. I just finished reading it and it's very interesting. I will start Vol. 2 soon, and I've already seen a lot of interesting historical material on the Austrian conditions after WWI.

[Jeff Haymond]

Pete--
Wondered how much of your concern over the process we have already completed (the prior 50 bad years of policy) is tied to the projected federal debt problem that is rapidly approaching? More specifically, if we repudiated the future promises to pay (which we clearly have no money to pay) in Medicare & SS, would this change your thinking about the likelihood of a crack up boom?

Putting the ? a bit differently--is not a crack up boom historically always a fiscal crisis that monetary policy tried to "help"? If that is true, and we get our fiscal house somewhat in order, isn't it possible that as you say the market entrepreneurs will be able to overcome the gov't studidity even w/an often irresponsible monetary policy?

[Peter Boettke]

Jeff,

Yes that is how I would see it, that is why the paper I am writing is called, The Debt-Inflation Cycle and the Great Reccession.

Pete

[K Sralla]

This sounds crazy, but what I am about to report is absolutely true. While I have been reading this, my wife just called from the store and reported to me that stores are running out of merchandise, and prices are shooting up faster than she has ever seen in her life. Now my wife knows nothing about economics or technical definitions of inflation, but honestly, that is what she just told me about 5 minutes ago. Now obviously, this is not a scientific survey and granted it is Christmas, but this report does seem to pass the Grove City College test. So for what it's worth to all you esteemed academic economists, there's a fresh report from the field.