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« What is the relationship between quality institutions and economic growth? | Main | Austrian Theory of the Business Cycle »

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For a kick off - we need to distinguish between a monetary contraction and a fall in the Consumer Price Index. A lot of the current debate conflates the two, which isn't helpful.

Defining terms is important, but it's hard to make headway when a concept is painted as such an ogre. Atkeson & Kehoe's 2004 AER piece opened my eyes up a lot on this.

http://ideas.repec.org/p/fip/fedmsr/331.html

Taking "deflation" to refer to a general downward movement in prices of final goods, the Rothbardian claim that deflation is a necessary step in recovery from an Austrian-type malinvestment cycle is just plain bad economics, and bad Austrian economics at that. Consider: the boom involves a _temporary_ distortion of relative prices, including artificially low interest rates, due to excessive M growth. The boom is unsustainable because factor prices eventually "catch up" to their GE values. In other words, the corrective purge doesn't require any contraction of nominal M or absolute deflation. Such deflation (the "bad" kind, according to my prod. norm. argument) only does more harm, by putting relative prices off track again.

As Mises correctly observed, to rely on deflation to make up for damage done through inflation is like backing over your neighbor's cat to make up for running it over in the first place.

The problem is, as aje indicates, distinguishing between different things.

What is the direct consequences of misallocation that are inevitable? What are the indirect consequences that could possibly be changed?

Now, to mainstream economists the concern is the latter indirect consequences. I think they consider that these consequences are always much worse than the problems associated with inflation. I think this is gut feel based on histories of the Great Depression.

I think most economists have not read Horowitz's paper on the negative consequences of inflation or anything like it. To them it is just a minor tax. So, the question they ask about inflation is "why not if it saves us from another Great Depression".

Another major part of the problem is that in mainstream econ once a crisis is over we get back to equilibrium. Equilibrium with K representing capital. Hence the problem in the mainstream economists mind is "how to get back to the steady state as quickly as possible". Once K is aggregated that is the only significant problem. So, it has something to do with capital theory.

Dr. Selgin,

The boom is unsustainable because factor prices eventually "catch up" to their GE values.

But the housing market did not crash because relative prices caught up. When the Federal Reserve stopped pushing down interest rates, the market was exhausted of speculation. Demand fell suddenly as the only home bidders left were those who wanted somewhere to live. Prices then fell sharply to reflect real supply and demand.

People had begun using their home equity in lieu of ordinary savings, and with the high price of their home, it felt safe to increase spending on luxuries like consumer electronics, automobiles, and vacations. When the market crashed, home owners, understandably, started to tighten their wallets.

But the capital structure of society had already produced goods and services on the expectation that the old pattern of spending would continue. Before capital reformation can take place, surely we should see a significant fall in prices in the short run, right? Inventories need to be cleared, losses accounted for, and companies bankrupted, before prices start rising again.

I guess I would just like you to expand upon your objection. Thanks.

Oops! That first line in the last comment should be inside quote marks.

I think the problem is that there are really several different secondary effects after a bust.

Firstly, during the boom long-term capital goods become mispriced - too highly. Future spending plans become built around investment returns that won't occur. So, there need to be two sectors that suffer, the capital goods sector firstly. And secondly those that are reliant upon incorrect expectations of profits from the capital goods.

The really sticky problem is where money and deflation stand in this.

I'm undecided about that at present.

For Lee: The point is that the fed couldn't keep interest rates low forever. Monetary pressure eventually pushes up factor prices, raises the general demand for credit. Attempts to keep rates artificially low would end in a "Wicksellian" spiral leading to hyperinflation. So, in practice, and assuming that the central bank is determined not to let inflation rise without limit, rates must come back to their natural levels, and the money-based boom must end.

In any event, the boom ends because relative prices have adjusted, so there's no need at that point to resort to deflation to make them adjust!

Dr. Selgin,

Did Rothbard suggest that we "resort to deflation to make [prices] adjust", that is, employ contractionary monetary policy to lower prices? Although I have read little of Rothbard's work, that doesn't seem credible.

In any case, my confusion seems to have arisen from the words "catch up". They suggested that inflated home prices should not have fallen, but other prices should have increased proportionately. But in your last comment, you said, "the boom ends because relative prices have adjusted", not necessarily caught up. Although the latter allows for some falling prices, the former does not.

Let's also hope that the central bank is determined to not let inflation rise without limit.

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