Traffic Lights and the Interest Rate

Steven Horwitz

My Freeman column this morning offers a Bastiat-inspired parable about a world where the traffic lights are all stuck on green and what this has to do with the coordinating role of the interest rate and the boom of the business cycle.

 

Comments

[Richard Ebeling]

Steve's point is a critical and crucial one.

That is, what is the "role" or "function" of interest rates in a market economy?

They are intertemporal prices that are meant to integrate and coordinate the term-structure of decisions and choices by savers and borrowers.

Monetary manipulation and control of interest rates by the Federal Reserve is no different than any "price control" manipulation and fixing of market prices.

It prevents prices from "telling the truth." About what fraction of earned income individuals wise to set aside as savings and offer to borrowers on the market.

And to balance the desire to borrow with the choice to make available a portion of the society's real resources for future-oriented investment.

And to see that the time-shape of investments undertaken is consistent with the time-shape of decisions to forgo consumption in the present and over a period of time.

When the Federal Reserve pushes interest rates below the (Wicksellian) "natural rate" -- the interest rates that do the "functions" mentioned, above, then the manipulated price system is sending out wrong signals.

As Steve suggests, it is stuck in one position when the underlying market conditions of supply (savings) and demand (borrowing) suggest intertemporal prices should be sending out different information to the market participants for re-coordinated action and activities.

What "signal" is a market price -- in this case interest rates -- when the the monetary authority sets them at or near zero? (And when adjusted for price inflation -- negative?)

A near or zero price in the market would imply that the commodity in question either has no or practically no demand, or that the quantity offered on the market is so great that no matter how great the demand, it is practically a "free good."

Unless we assume a Keynes-Alvin Hanson world of an absolute lack of any attractive investment opportunities because, well, "we've gone about as far as we can go," (to use the line from the musical "Oklahoma"), this is a total distortion of the savings/investment nexus.

In many ways, the loan markets are markets without REAL prices. And it should not be surprising that without a functioning and competitively-based set of interest rates, distortion and discoordination, and misdirection and malinvestment are all inescapable in a market crucial for economy-wide functioning of the market order as a whole.

In other words, here we go, again!!

Richard Ebeling

[Xerographica]

Huh, and I thought I was the one that invented the traffic lights analogy when I discussed wage ceilings/floors in my post on the dialectic of unintended consequences...

"It's the same concept with the minimum wage. One unintended consequence of these efforts is that high school kids end up making poor career choices on the basis of this inaccurate information. Unions and liberals manipulate traffic signals and change the signal color from red to green. Kids see the green light and drive directly into oncoming traffic. This results in a vicious cycle of inefficient labor allocation that negatively impacts our economy to a great degree."

http://pragmatarianism.blogspot.com/2011/10/dialectic-of-unintended-consequences.html

Interestingly enough... John Holbo offered traffic signals as an example of when it wouldn't be a good thing to give people more choices...

"The thing to realize is that this is false, strictly speaking. Take the most literal driver’s seat case of all: traffic lights. If you abolished rules about go-on-green/stop-on-red you would give citizens a choice they currently do not have. But you would not, thereby, in any meaningful way, be giving them more control over their lives. The opposite would be the case."

http://pragmatarianism.blogspot.com/2012/01/john-holbos-critique-of-pragmatarianism.html

[Steve Horwitz]

And Kirzner was using them as analogy long before that. Nowhere do I claim to have been the first to have done so.

Plus, the first appearance of the analogy in my own work was in 2009 in "The House that Uncle Sam Built":

"Imagine we see an enormous rise in the number of traffic accidents in a major city.
Cars keep colliding at intersections as drivers all seem to make the same sorts of
mistakes at once. Is the most likely explanation that drivers have irrationally stopped
paying attention to the road, or would we suspect that something might be wrong with
the traffic lights? Even with completely rational drivers, malfunctioning traffic signals will
lead to lots of accidents and appear to be massive irrationality."

So sorry to disappoint you, but you neither invented it, nor had it before me.

[Mario Rizzo]

Richard,

"In other words, here we go, again!!"

In all of this discussion about the growing "recovery" there is little reflection on whether the Fed and the other economic-policy players are sowing the seeds for renewed trouble later. It is as if we are in a world populated by amnesiacs. A ground-hog day economy?

I wish I were rich enough to sit back and "enjoy" it all. There will be much of interest going on in the next ten to fifteen years.

[Daniel Kuehn]

re: "In all of this discussion about the growing "recovery" there is little reflection on whether the Fed and the other economic-policy players are sowing the seeds for renewed trouble later."

Does anybody have thoughts on the new DeLong-Summers paper which Brad has posted a summary of? What looks interesting about it is that it sounds like it discusses precisely this issue.

[Steve Horwitz]

I'm too dumb to be able to understand anything such a smart man as Brad DeLong writes (according to him anyway), so I won't make HIM feel dumb by pretending one of the stupidest men alive can actually understand his brilliance.

[Xerographica]

Steve Horwitz, oh man! This is progress! My comment on the traffic signals was in fact in reference to your reference to Kirzner. So I was just joking around when I claimed to have invented the analogy.

But I can easily see how it might not have been interpreted as a joke. There's no way you could have known that I had read your article. You thought to yourself, "this guy made a mistake here! I better correct him!"

This is progress though...because you said absolutely nothing about the fact that I believe that people should be allowed to directly allocate their taxes! Therefore, my tax choice belief is not as easy to refute as my "belief" that I had invented the traffic signal analogy.

It's a very measly clue...but beggars can't be choosers. You guys haven't given me much...errr...anything...to work with. But just in case I haven't already revealed my preferences...it would be all kinds of awesome if you or Boettke critiqued...or endorsed...the tax choice concept.

I'm sure you guys would have no problem beating the best critique that this idea has received thus far... http://pragmatarianism.blogspot.com/2012/03/pragmatarianism-disproved.html

[Daniel Kuehn]

Well, if Mario or others have no objection, they might be interested in it.

I am not entirely sure what to make of it myself. I've read the summary, but haven't had a chance to work through the math carefully. But if it is a strong defense of what they claim it is, that seems to speak to Mario's concern about what people are and aren't paying attention to - and it's worth speaking to.

For some reason I thought he said this would be a Brookings paper, but I'd have to double check that.

[Mario Rizzo]

Where exactly is DeLong's paper (or summary) posted?

[Daniel Kuehn]

Here it is: http://delong.typepad.com/sdj/2012/03/lunch-march-14-2012-the-not-so-simple-arithmetic-of-fiscal-policy-in-a-depressed-economy.html

Not sure when the paper is coming out.

[Daniel Kuehn]

And this is Thoma's cautious summary of it: http://economistsview.typepad.com/economistsview/2012/03/the-case-for-more-fiscal-stimulus.html

[Mario Rizzo]

The whole focus on it-is-not yet time for-austerity and the possibly of paying for the deficit in the longer run is tiresome.

The point is that Greece, for example, is plagued by all sorts of structural (unions, labor laws, bureaucracy) impediments to growth that need attention. Spending, even if it has a temporary stimulating effect, is besides the main point. The main point is to drive down the special interests by reducing the power of the state to subsidize their anti-competitiveness. If not for austerity (so to speak), to whom or what would spending be directed? To the crowd that messed things up in the first place.

It is true that pensioners will be hurt. But there is no way to protect the "worthy" (if they be that -- since they pay not have produced much to deserve their pensions) without the possiblility of true structural reform going down the drain. Everyone is "worthy" once the political system with its "partiality and avidity" (Hume) gets going.

[Bill Stepp]

Did anyone see Bernanke's attack on the gold standard in a lecture he gave at George Washington University? There's a video floating around the internet.

[Healthy Options]

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