A Reverse Austrian Business Cycle Theory?

By Robert Wenzel

Tyler Cowen drops the below post with his limited comment to start:

A Reverse Austrian Business Cycle Theory

Did tight money from the Fed place too high a penalty on deposit funding of mortgages?:

Between 2003 and 2006, the Federal Reserve raised rates by 4.25%. Yet it was precisely during this period that the housing boom accelerated, fueled by rapid growth in mortgage lending. There is deep disagreement about how, or even if, monetary policy impacted the boom. Using heterogeneity in banks’ exposures to the deposits channel of monetary policy, we show that Fed tightening induced a large reduction in banks’ deposit funding, leading them to contract new on-balance-sheet lending for home purchases by 26%. However, an unprecedented expansion in privately-securitized loans, led by nonbanks, largely offset this contraction. Since privately-securitized loans are neither GSE-insured nor deposit-funded, they are run-prone, which made the mortgage market fragile. Consistent with our theory, the re-emergence of privately-securitized mortgages has closely tracked the recent increase in rates.

Here is the full NBER working paper by Itamar Drechsler, Alexi Savov, and Philipp Schnabl.

This absurd view is what caused me to tag those expecting a stock market crash and economic recession after the first Fed rate hike in December 2015 (after the Great Recession) as Austrian-lites.

A hike in interest rates does not in itself mean that the Fed is tightening, especially if the non-manipulated market interest rate would be climbing at a rate faster than then the size of the Fed hikes manipulated rates.

As can be seen from the chart below which matches up the Fed Funds rate (brown line) and the Consumer Price Index annualized percentage change (blue line), for the period in question, the Fed Funds rate hike did not even catch up with the price inflation advance as measured by the CPI until very late in the period.

This is not "tightening."

As Austrian business cycle theory would suggest it was a period of real interest rate climbing (because of the price inflation component), not tightening.

Things were even more dramatic during the period between the Fed funds rate and the annualized change in the Producer Price Index (blue line below).

Whenever you have prices climbing much more rapidly then baby step hikes in the Fed funds rate, it makes sense to borrow more aggressively. It is, in fact, very profitable to do so.

And housing prices were climbing even faster (blue line below):

With all prices climbing at a rate for most of the period at a far greater rate than the Fed rate hikes, it is pretty obvious to see why the borrowing didn't stop.

Finally, it is not the channel by which new money enters the system to impact capital goods but that new money does enter the system and it sure did between 2003 and 2006. It increased by approximately 24% over the period! (see chart below)

In short, there was no "reverse" Austrian business cycle theory event. To hold this "reverse" theory about Austrian theory is to be confused about what Fed "tightening" really is. An increase in the money supply (M2) by 24% over the three-year period is not tightening.

Austrian Business Cycle Theory 101.



-RW