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Prof Horwitz,

Do you think its accurate to say that the Fed's inflation provided the fuel and incentives for the bubble, while the regulatory environment and securitization of mortgages directed the boom into the housing sector?

I'm not familiar with mortgage regulations, but I was surprised to learn about the protectionism and lack of fraud prosecution in the credit rating industry.

I suspect that a comparison between a 'natural rate of interest' and a market rate is more of a theoretical issue than a causal factor. The real problem is the effective expansion in the supply of loanable funds that leads to an increased demand for current production factors and then to an unclearable supply of future finished goods. A bank will tend to loan everything it has available to loan, largely independent of the achievable interest rate yield and the riskiness of the last dollar loaned.

The market interest rate will tend to control the discounted present value of stocks, etc., but not be the controlling factor for marginal investments that have any level of uncertainty at all.

Regards, Don


I think your first paragraph has some truth to it. I also think that rising home prices, caused by a variety of factors from real growth in places, to land-use and other regulations, to speculation, also helps explain where the problems have manifested.

Very good links, Steve. And very appropriate comment at this moment.

O'Driscoll's article is very enlightening. I've had a lot of trouble with analysis of the bond market and inflation expectations.

The situation is: The bond market is barely discounting any pickup in inflation, but the commodities markets (almost all of them) are signalling intense speculation away from the dollar (how else to interpret the acceleration in so many commodities prices when Asian demand, the other most likely explanation, is not rising that fast across the board?).

O'Driscoll points out that it already happened in the 70s. The bond market was the last one to realize the situation. Commodities traders were more alert (even if they ultimately overreacted).

I believe that the massive Chinese and Middle Eastern purchases of bonds are distorting the whole picture in the bond market. Their accumulation of dollars (China: 50% of Chinese GDP and rising) is frightening.

This is all very confusing for me. If house prices are falling isn't this the opposite of inflation? Also, if people can't afford certain mortgages don't they just simply switch to renting? Why should it cause a recession? Sorry, for the ignorance.

Dear Prof. Horwitz,

as far as I understand Hayek a passive stance of the Fed in the light of a general shift in the rate of profit (or natural rate) caused, for instance, by technological innovation may very well cause a unsustainable boom. It is only in Prices and Production (1931) where Hayek - I guess in response to the Great Depression - focuses solely on the banking system as initiating the cycle. In 'Monetary Theory and the Trade Cycle'(1929), 'Profits, Interest and Investment'(1939) and 'The Pure Theory of Capital' (1941), however, he indeed allowed for both, the money and the natural rate, to induce the cycle. If the profit schedule shifts upwards the banking system could avoid the boom-bust sequence by shifting the money rate accordingly. This is how I understood the op-ed by Phelps. I quote Hayek (1929) himself:

"It must be emphasized first and foremost that there is no necessary reason why the initiating change, the original disturbance eliciting a cyclical fluctuation in a stationary economy, should be of monetary origin. Nor, in practice, is this even generally the case. The initial change need have no specific character at all, it may be any one among a thousand different factors which may at any time increase the profitability of any group of enterprises. For it is not the occurence of a 'change of data' which is significant, but the fact that the economic system, instead of reacting to this change with an immediate 'adjustment' (Schumpeter) - i.e. the formation of a new equilibrium [by upward shift in the money rate of interest; amv] - begins a particular movement of 'boom' which contains, within itself, the seeds of an inevitable reaction." Hayek (1966[1929]), pp. 182-83.

And the sole purpose of his 1939 essay on 'Profits, Interest and Investment' was to show that with a money rate of interest hold constant, the profit induced boom is frustrated even without any attempt to shift the money rate upward to match the shift of the profit schedule (Ricardo Effect):

"The main point om which this revised version [of the business cycle theory compared with the 1929 and 1931 version; amv] differs from my earlier treatments of the same problem is that I believe now that it is, properly speaking, a rate of profit rather than a rate of interest in the strict sense which is the dominating factor." Hayek (1939), p. 3

And: "[...] it may be not so much the money rate of interest as the rate of profit and real wages which govern the decline and eventual revival of investment." ibid., p. 37.

Thus, the cause as well as the upper and lower turning point of the boom-bust cycle can all be explained with the money rate of interest being constant from the very beginning.

Arash, I admit to never having read Hayek's original works on ABCT. Isn't the general consensus that savings-induced (i.e. capital or technology-induced) booms don't bust, while credit-induced booms do? It seems to me that all booms are profit-induced, but the question is where the profits come from, correct?

It also seems to me that one should have to take the liquidity of the credit markets into account when trying to determine how much of an effect a market rate away from the natural rate has on intertemporal coordination.


I have no quarrel with this sentence:

"Thus, the cause as well as the upper and lower turning point of the boom-bust cycle can all be explained with the money rate of interest being constant from the very beginning." In fact, I've argued in my own work that if the banking system does not respond (= constant money rate) to changed in the natural rate, intertemporal discoordination can result.

But Phelps is saying something different, or at least is sufficiently ambiguous to be open to this interpretation. He is saying that it is "the boom" that causes the change in the natural rate of interest. That is not a position Hayek takes. He certainly allows that the natural rate can change for a whole variety of reasons, as your quotes illustrate, but *that is not a "boom"*

Historically, when Austrians have talked of a "boom," they/we have meant something that is necessarily "unsustainable" and must end in a bust. As Grant notes, changes in the desire to save are NOT "booms" in the sense of being unsustainable, *as long as the banking system responds appropriately.* That is, it's not a "boom" until the banking system screws up, hence Phelps' claim that the boom causes the divergence between the natural and market rate isn't quite right.

Changes in time preferences or other things can cause a divergence between the natural and market rate with the market rate remaining unchanged. But it's not a "boom" in the sense of being unsustainable growth (or recession-inducing directly in the case of a fall in the natural rate unmatched by a fall in the market rate) until the banking system doesn't do its job.

In composing this, I realize that my quarrel with Phelps is more over his use of the word "boom." For Austrians, that has a specific connotation of being inherently unsustainable - it must lead to a bust - as distinct from "secular growth" which need not. Roger Garrison's book makes these distinctions very clear, including graphically. If Phelps had just said the following instead, my changes in *s, I'd be fine:

"We should consider Hayek's argument that the upheavals *during normal economic activity* may change the natural rate of interest. If *such activity* left it elevated, failure by the central bank to raise its interest rate correspondingly would cause inflation to begin rising *and create a boom that must end in a bust*. Something like that may be happening now."

Hello Grant.

Well, yes. Growth will not bust if investment periods are lengthend by means of additional voluntary savings which signal a lower time preference by a decrease in the money rate of interest. And I also agree that bank-induced liquidity increases money capital beyond the level given by voluntary savings and hampers intertemporal coordination. I also agree with Prof. Horwitz that the bust we face right now is due to the inflationary stance of the Fed. I was just concerned with his statement that - in general! - the boom-bust cycle can only be initiated by the banking system, that is, by decreasing the money rate below the natural rate and that therefore Phelps misunderstood Hayek in locating the initiating cause in a change in the natural rate. It is of course self-evident that investment booms are always caused by higher profitability. But there are three ways this can happen: decreasing costs of production, lower money rates of interest (capitalization factor) and an upward shift in expected yield. Technological revolutions like the ICT revolution shifts up the latter and banks (including the central bank) need only remain passive and additional funds will pour into the capital market and - since invested - will increase nominal income. This boom is self-defeating if the new income generated is not entirely(!) spend on investment goods, that is, saved. Here central banks may very well face the informational problems which Phelps has emphasized. So Prof. Horwitz - from whom I learned a lot - is right: the Fed is the villain in generating the last boom-bust cycle. But the banking system does not has to be! Sometimes - and I think this is very much Hayeks position - there are cycles without a villain: if expected yields increase and are financed within a fractional reserve system where credit by the very nature of the system is elastic, there are no discretionary mistakes out there. Perhaps - and this was Rothbards point of view - the fractional reserve system is evil ... I don't know.

Mr. Horwitz,

D'accord. I think there is no general disagreement. If we define boom as unsustainable, there is no boom if the natural rate hikes and no more funds are created 'out of thin air.' But I may have misunderstood you because you claim:

"But it is not the boom that causes this deviation in the natural and market rates, rather the boom is the result of that deviation, caused most likely by the Fed inflating in the first place, driving down the market rate."

The Fed does not need to lower interest to allow for a boom if the natural rate shifts upwards. All it need to do is to remain passive and leave the money rate the way it is. This suffices to generate funds which can finance malinvestments only. But agree that the Fed did so and that still worsens the situation.


Read this again and note my caps:

"But it is not the boom that causes this deviation in the natural and market rates, rather the boom is the result of that deviation, caused MOST LIKELY by the Fed inflating in the first place, driving down the market rate."

Again, I have made precisely the argument you are making (that the Fed's passivity can cause problems if the natural rate rises) in my 2000 book and elsewhere. As an empirical matter, I think it's "most likely" or "more likely" to be the case that Fed action causes the problem, but we agree that it's inaction can as well.

One other comment:

I do disagree that there can be cycles "without villains." If the Fed doesn't respond when it should, it's a villain. Same if a 100% reserve system can't adjust the quantity of money when the demand to hold it changes. I'm not sure that Hayek believed what you say he believed.

If it's true, as myself and others have argued, that under the right monetary/financial/regulatory institutions, changes in the natural rate will be matched by changes in the market rate, and if it's also true that deviations between the two are what cause cycles, then the only reason cycles arise is because institutions aren't right. Hence, cycles, as opposed to secular growth or sectoral declines as part of that growth, are always the result of bad institutions, who are thereby the villains of the piece.

Stupid question,

When you guys refer to the Fed as "acting" and "reacting", do you mean its adjustment of the interest rates? Or do you refer to its action of buying T-bills with freshly-printed dollars? I was working under the definition of the later, which of course its always doing to some extent.

I can see central banks neglecting to adjust interest rates as the market rate shifts, because they are immune to market forces. I cannot see market banks keeping their rates steady when the market rate shifts, because I would think this would quickly lead to insolvency (I think the lack of economic calculation here is the informational problem you mentioned, Arash?). Perhaps I'm confused, but I don't understand how changes in the natural rate could not be reflected in the market rate in a scenario of free fractional-reserve banking.

Lastly, thanks for creating such a great blog. I can't think of anywhere else I see discussions like these in such detail.


Adjusting interest rates and buying government bonds are essentially the same thing. The way the Fed affects interest rates IS through open-market operations (the buying and selling of gov't bonds). And it's not "printing" new dollars. It's simply crediting the reserve accounts at the Fed of either the banks who sell the bonds or the banks of the firms who sell them. No printing press in sight. :)

When the Fed buys and expands the supply of reserves it, cet par, pushes the market rate down by providing banks more to lend, who then must move down the demand curve of their borrowers. Or at least that's the textbook story.

One side note: in its actions this week, the Fed injected liquidity by purchasing other kinds of assets that do not lead to the expansion of the monetary base, at least according to Larry Kudlow:


I understand how the Fed operates mechanically (although I'm not up on all the new-fangled things Bernanke has been trying lately), its the terminology I was asking about. I wasn't sure if Arash was using the term "passive" to refer to a Fed which doesn't adjust its interest rate targets, or to refer to a Fed which isn't conducting open market operations altogether. Unless I'm terribly mistaken, if the Fed is "passive" in the sense that it isn't actively adjusting its federal funds rate target, its still probably doing some inflating via open market operations, yes?

Reading back through the posts, I think Arash was referring to passivity in the sense of active rate adjustments. This was contrary to my intuited meaning of the term.

Mr. Horwitz,

I replied to your last comment but somehow the comment got lost ... I hope it wasn't eliminated on purpose. Ex post, it is obvious that our little dispute is about semantics rather than on theory. But a last defence of Phelps may be allowed: Even though Austrians reserve the term 'boom' for an UNSUSTAINABLE path initiated by money and natural rates falling apart, it might be natural to use the word quite differently when the ABCT is rejected. And even though Phelps makes use of some aspects of Hayek’s theory, he is outside the Austrian macroeconomic tradition – at best sympathetic. It is one think to defend the ABCT on its own grounds, especially if half-hearted attempts are made to integrate it into mainstream thinking. But to expect that non-Austrians may drop the use of the term ‘boom’ in favour of “during normal activity” is another thing. Let’s take the example of Schumpeter: he uses the term boom quite differently than the others (as I know you know). But “during normal activity” would be inappropriate for his theory as well. If the term boom is already monopolized differently by his Austrian fellows, but “normal activity” obviously misses his point, how should he react, what shall he do? I think the term ‘boom’ has do be understood in the light of the theoretical context used by the author, not by the mindset of the reader. It is Prof. Boettke who convinced me – also by way of this blog - to take different schools of thought by their own language and method and to tackle them on their own grounds (if necessary). I do not think that Phelps wanted to restate or recapture the ABCT. Thus, in claiming that a boom increased the natural rate, he claims - as far as I understand him - that we have faced times of extraordinary upwards shifts in the profit schedule, something which cannot fit something like “normal activity.” All my previous comments were founded on this interpretation of Phelps, which didn’t take him on Austrian ground, but as a mainstream opinion with some affinity for the Austrian stress on knowledge problems and dynamics. I am sure that no one outside the Austrian camp understands the term ‘boom’ the way you do, even though you are correct and it should be understood that way. But if this is true and Phelps meant only the exogenous occurrence of extraordinary profits in saying ‘boom,’ for instance, due to the dot.com ‘revolution’ (something like long waves/Kondratieff cycles/New Economy), this indeed is the same as saying the natural rate has shifted up (Mises and Rothbard, of course, wouldn’t agree). You see … semantics only.

@ Grant:

Perhaps my understanding of passivity becomes obvious if you compare Hayek and Mises on this point. Mises holds the view that inflationary credit expansion is due to ideological pressure on the banking system to reduce interest rates (This is also due to his pure time preference theory of interest which does not allow for the "Urzins," i.e. the original rate, to shift with productivity changes). Hayek allows shifts in the natural rate due to productivity shocks. Credit expansion will in this case occur while the central bank or the banking system just stick to their policy and keep the interest rate at the former level! They should have raised the money rate but they don't ... they remain passive.


You are probably right about Phelps using "boom" in a "non-Austrian" way. However, he too needs to recognize what words mean to his audience. If he's using the word "boom" in the context of a discussion of Hayek's cycle theory, he should realize that it has a specific meaning in that theory that may well be different from what he intends the word to mean. So yes, perhaps I'm not being sufficiently charitable to him, but he too should have recognized how the word would be heard in the specific context of a discussion of Hayek.

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