Expansionary monetary policy and decreasing entrepreneurial quality

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172

ExpansionaryMonEtary policy and dEcrEasing EntrEprEnEurial Quality

Lucas EngELhardt

ABSTRACT : Austian business cycle theoy has been citicized on the basis of “ational expectations.” That is, easonably high quality ente-peneus—which ae equied fo economic gowth—should be able tofoesee the business cycle and theeby avoid making malinvestments. Asnoted by Evans and Baxendale (2008), this agument ignoes the fact thatentepeneus ae heteogeneous in quality. Ameican housing data fomthe past 25 yeas suggests that entepeneus ae moe likely to makeeos when inteest ates ae unusually low. This suggests that duingthe boom eithe entepeneus become foolish—o, as suggested byEvans and Baxendale (2008), fools become entepeneus.

KEYWORDS: business cycles, entrepreneurship, rational expectations

JEL CLASSIFICATION : B53, D84, E32, E43, E52

IntroductIon

One of the geatest contibutions of Austian economics is thetheoy of the business cycle. The Austian theoy explains how

Lucas M. Engelhadt ([email protected]) is Assistant Pofesso of Economics atKent State Univesity, Stak Campus.

VOL. 15 | NO. 2 | 172–194

SUMMEr 2012

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173Lucas Engelhardt: Expansionary Monetary Policy…

booms diven by expansionay monetay policy lead inevitably to busts. The theory has the benet of being built on a foundationof premises that many nd intuitive or undeniable. Interest ratesdo impact the choice of capital investments. So changes in inteestates can lead to potentially devastating changes in the value of paticula types of capital. While much of moden mainsteammacoeconomics ignoes the fact,1 capital is, in fact, meaningfullyheteogeneous. Monetay policy does impact inteest ates and,as emphasized by Evans and Baxendale (2008), the availability of

funds fo stating investment pojects. Once we acknowledge theinsight of Mises (1980 [1934]) that monetay policy cannot keepinterest rates low indenitely, Austrian business cycle theory owsnatually fom the pemises.

Despite the fact that the pemises ae tue2 and that the conclusionof Austian business cycle follows, thee ae citicisms of the theoy.Some follow the fom of the agument of Milton Fiedman, whodeclaed, “The Hayek-Mises explanation of the business cycleis contadicted by the evidence” (1969). A caeful eading of thestatement in light of the logical positivism of Milton Fiedmansuggests that Fiedman is not citicizing the Hayek-Mises theoyas a theoy. He does not seem to deny its pemises o the pocess by which the conclusion is eached. rathe, his citicism3 seems to be that the evidence suggests that thee ae othe, moe impotantforces that determine the shape of economic uctuations. So, whilethe Austian theoy might be “tue” in the sense that it is “valid,” itis not a “true explanation” of business uctuations, as other forcesae moe impotant.

Other criticisms—such as that presented by Caplan—suggest thatthere are actually internal problems. In particular, Caplan suggests that:

1 This fact is suppoted diectly by a handful of mainsteam economists such asSolow (1955), and, moe ecently, Altig, Chistiano, Eichenbaum, and Linde (2004).It is probably fairest to say that the mainstream “ignores” capital heterogeneity—not that the mainsteam “denies” it.

2 The essential elements of the Austian business cycle theoy ae thee: thatmonetay policy tempoaily lowes inteest ates, that inteest ates impactdierent investments dierently, and that capital is heterogenenous. Feweconomists—egadless thei school of thought—deny any of these.

3 This is made most clea when consideing Fiedman’s “Plucking Model,” aspesented, fo example, in Fiedman (1993).



174 The Quately Jounal of Austian Economics 15, No. 2 (2012)

Given that interest rates are articially and unsustainably low, whywould any businessman make his protability calculations based on theassumption that the low interest rates will prevail indenitely? No, whatwould happen is that entepeneus would ealize that inteest ates aeonly tempoaily low, and take this into account. [Emphasis in oiginal.]

That is: articially low interest rates wouldn’t aect the choiceof capital investments—at least not in a way that would lead toentepeneus late wishing they could undo those choices. Thispaticula type of objection has been called the “ational expec-

tations” citicism of Austian business cycle theoy.4 This objectionis fa fom new—in fact, Mises himself suggested it. So, those thatsupport Austrian business cycle theory have oered a numberof esponses to this citicism. This pape will povide additionalagument and some empiical evidence suppoting one of thesedefenses: that oered by Evans and Baxendale (2008). In short,their explanation suggests that entrepreneurs dier in quality andthat, duing the boom, lowe quality (that is moe eo-pone)entepeneus ae the “maginal entepeneus”5 who detemine

the couse that capital goods makets take.

This pape uses data fom the US housing maket6 fom thepast 25 yeas and shows that: (1) conta Caplan, the pices in thehousing maket ae moe esponsive to shot-tem than long-teminteest ates despite the fact that shot-tem inteest ates aemoe likely to be distoted by monetay policy, (2) the sensitivityto shot-tem inteest ate levels inceases as inteest ates fall,which can be intepeted as a sign of inceasing entepeneuial

4 Though not dealt with in detail in this pape, Tullock (1987), Cowen (1997), andWagne (1999) pesent simila aguments—all elying on the fact that ente-peneus with ational expectations would not make systematic eos esultingin malinvestments.

5 That is, the additional entepeneus that ae now able to make investments.Though, as noted by an anonymous referee, the dierence may be in the entre-peneus’ plans as much as in the entepeneus.

6 Housing is a easonable focus fo a few easons. Most obviously, the boom and bust of the ealy 2000s was clealy closely connected to the housing maket.

Housing also has the benet of being a common capital good with a long “periodof poduction” fo the sevices it povides. Finally, data is eadily availablethat focuses on housing pices and motgage inteest ates fo vaious lengthsof mortgages—allowing us to examine the diering impacts of short-term vs.long-tem inteest ates.




“foolishness” (in suppot of Evans and Baxendale [2008]), and(3) that these tendencies do a easonably good empiical job of explaining the movement of housing pices ove the past 25 yeas(conta Fiedman).

An oVErVIEW oF AuStrIAn BuSInESS cYcLE tHEorY

Austian business cycle theoy suggests that business cyclesae lagely the esult of entepeneuial eos that ae caused by

unsustainable monetay policies. The pocess begins when the banking system engages in cedit expansion, inceasing lendingwithout any incease in eal savings. This pocess may occu fomlending of money that was peviously held in eseve, o, as noted by rothbad (2008 [1983]), by the issuance of additional demanddeposits with no need fo eseves to leave the bank doing thelending, o by an incease in the eseves povided by the cental bank which then povide a foundation fo additional lending bycommecial banks. The newly available funds tend to push downinteest ates, which ceates the illusion that thee ae moe esoucesavailable fo investment in long-tem pojects. Fom the boowes’perspective, there is no dierence between funds made availablethough cedit expansion and funds made available though ealsavings. Therefore, the lower interest rate has the same eect as aeal decease in social time pefeence: entepeneus invest moein longe tem pojects. At the same time, the decease in inteestates tends to decease the quantity of eal savings, so that ealesouces ae becoming less available fo long-tem investmentsthan they wee befoe the cedit expansion.

So, thee is a contadiction in the stuctue of poduction. Onthe one hand, entepeneus ae attempting to use esouces to begin moe long-tem pojects. On the othe hand, consumes aeconsuming moe esouces to satisfy thei pesent desies. Even-tually, the contadiction has to wok itself out. One way in whichthe contadiction can wok itself out is by an incease in inteestates. Since the change in inteest ates was bought about by cedit

expansion athe than by a eal change in time pefeence, thosethat eceive income as entepeneus ty to expand thei long-tempojects will consume and save based on thei time pefeences,and their level of savings is not sucient to keep interest rates as




low as they wee duing the cedit expansion. Theefoe, as longas the expansion in cedit is tempoay, the low inteest ates will be tempoay as well. Once inteest ates incease, those long-teminvestments that entepeneus began will be shown to be unpof-itable. Theefoe, many will be abandoned as the capital stuctueadjusts back to a sustainable conguration that is consistentwith the social level of time pefeence. Altenatively, if ceditexpansion does not halt, the boom comes to an end in a unawayination. Since resources are limited, the new money created by

cedit expansion will dive down money’s puchasing powe. Asmaket paticipants come to expect a deceasing puchasing powein the futue, they become less willing to hold the depeciatingmoney. As demand fo money dies up, the money loses value,and eventually falls fom use. Once the maket eaches this point,cedit expansion is impossible.

The lesson of Austian business cycle theoy is clea. Ceditexpansion esults in an investment boom. Howeve, many of theinvestments made duing the boom wee eos and will pove

unprotable. At some point (often because of rising interest rates)the eos ae evealed, and boom tuns to bust.

tHE IMPortAncE oF EntrEPrEnEurIAL QuALItY

It has long been known that this theory rests on an importantassumption: that entepeneus ae fooled by the pocess. That is,when inteest ates ae (tempoaily) low, entepeneus cannot

expect them to rise in the future. If they did, one expects that theywould be more hesitant to borrow to fund long-term projects. If noone boows to fund long-tem pojects, then the boom neve stats.If the boom never starts, then the bust cannot follow. While this isnot the only citicism of the Austian theoy of the business cycle, itis pehaps the citicism that shows the most undestanding of theundelying theoy. That being the case, it should not be supisingthat this citicism was leveled against the theoy by Ludwig vonMises himself in his Theory of Money and Credit (1980 [1934]):

It is... possible for all the consequences of variations in the value of moneyto be eliminated if the individuals engaged in economic activity clealyecognize that the puchasing powe of money is constantly sinkingand act accordingly. If in all business transactions they allow for what




sometimes by those who have the wong theoy),7

and who havea keen eye fo elevant indicatos. The second eason we shoulddoubt this theory comes from the prot and loss system’s ability tosot entepeneus by thei quality. Entepeneus who do a poo job foecasting futue demand fo thei poduct (o the futue costsof production) will tend to suer losses, while those that do a good job foecasting futue demand and costs of poduction will tend tooutpefom. So, ove time, poo entepeneus will be diven outof the market while those that remain are relatively high quality. If

an undestanding of business cycles helps an entepeneu pedictthe futue demand fo o cost of poducing thei poduct, thenwe would expect entepeneus that do not undestand businesscycles to be “weeded out” by the maket pocess. Theefoe, ovetime, business cycles should become less sevee, as the elativelypoo entepeneus ae emoved fom the maketplace.8

Anothe possibility is advocated by roge Gaison (1986).Gaison suggests that the poblem is eally game theoetic in

nature. Individually, there is no particular problem with an entre-peneu taking advantage of tempoaily low inteest ates. The business cycle only occus because many individual entepeneusty to take advantage of this oppotunity. So, what is individuallyrational is collectively irrational. Individually, there are protsto be made duing the boom, so maket paticipants have eveyeason to paticipate—even if they know that the boom is going tocome to an end. This agument is futhe developed by Cailli andDempste (2001). Thei vesion of the Pisone’s Dilemma ente-

peneus face duing the boom makes the following assumptions:

Assume that the maket ate of inteest has fallen below the natualrate of interest. Assume that a particular rm, Firm X, knows that thedecease in the maket ate of inteest is the esult of an incease in theavailability of cedit and not the esult of a decease in the undelying ateof time preference…. Firm X is faced with the decision to either increaseinvestment o maintain the cuent level of investment. Assume Fim

7 After all, both the Austrian-inuenced Peter Schi—the well-known star of theYouTube video “Peter Schi was right”—and the Keynesian Paul Krugman sawthat the housing bubble was, in fact, an unsustainable bubble.

8 Of couse, the fact that entepeneus ae motal suggests that this pocess isneve complete.




X does not know what the other rms will do and that Firm X wishesmaximizes its prots relative to all other rms….

If Firm X increases its investment while all other rms increase investment,its prot level will remain unchanged relative to all other rms; thatis, the change in Firm X’s relative prot is zero. If Firm X increases itsinvestment while all other rms maintain current level of investment,Firm X will nd its relative prots increasing. If Firm X maintains itscurrent level of investment, there will be no change in relative prots.

The resulting payo matrix resembles that in Figure 1:

Figure 1. Carilli and Dempster’s Payof Matrix

All Other Firms

Increase Investment Maintain Investment

Increase

Investment

Maintain

Investment

F i r m X

Rel. Profit = 0

Rel. Profit < 0

Rel. Profit > 0

Rel. Profit = 0

Rel. Profit = 0

Rel. Profit > 0

Rel. Profit < 0

Rel. Profit = 0

The esult is that the dominant (and maximin—that is “bestworst case”) strategy for Firm X is to increase investment. If theother rms increase investment, then Firm X experiences nochange in relative prots (as opposed to a relative loss). If otherrms maintain investment, Firm X experiences an increase inrelative prots (as opposed to no change in relative prots). So,individually, Firm X has a strong reason to increase investmentregardless what other rms do.

Cailli and Dempste make thee poblematic assumptions intheir argument. First, that an entrepreneur’s payo is captured byrelative prots. Second, that a rm’s only options are to increaseor maintain investment. Third, that rms are concerned only with




short-term boom-time prots rather than long-term post-bustlosses. Let us conside each in tun.

Assuming that entrepreneurs care about relative prots impliesthat, if thee ae two entepeneus, and both ae taking equallosses, then they ae just as content as if both wee eaning equalprots. This is clearly false. Payos should be listed on the basisof absolute—not relative—prots. (Just to highlight the absurdityof the argument here: Carilli and Dempster’s payos create theappeaance that if eveyone paticipates in the boom by inceasinginvestment, then no one is any worse o than if no one participatedin the boom. Austian business cycle theoy suggests this is false.The waste of capital that occus in the boom implies that, in theend, rms—and society—are worse o if the boom occurs than if it does not.)

Second, Cailli and Dempste’s stategies ae too limited—theeis cetainly a possibility of entepeneus deceasing (o halting)investment entirely. In fact, it seems plausible that an entrepreneur

who undestands Austian business cycle theoy might choose toexit the maket entiely once the boom sets in. Since the timingof the cisis is unpedictable and society ends up pooe afte the bust than it was befoe the boom, exiting the maket and waitingfor the unprotable rms to liquidate may be the best availablestrategy. In fact, we can modify Carilli and Dempster’s strategiesand payos and nd that a rational entrepreneur may choose notto invest duing the boom, if they take a long view.9 Suppose thatFirm X expects other rms to invest during the boom. In that case,

Firm X knows that, ultimately, the bust will come and those rmsthat have increased or maintained investment will suer losses.So, Firm X has a choice: either join in the boom and—eventually—take losses, or exit the market, avoiding the losses. Clearly, protsof zero are better than losses, so if Firm X expects other rms toincease investment, ceating an unsustainable boom, then along-sighted Firm X will exit the market. In fact, this argumentis sucient to show that if we follow Carilli and Dempster in

9 In a similar way, one could imagine the traditional prisoners breaking their dilemma by ecognizing that thei associate was waiting to kill any snitches once thei sentencewas up. Pisones with a long view will ecognize that the loss of thei lives moethan osets the shorter prison sentence, and will refuse to confess.




applying the maximin criterion to predict Firm X’s behavior, wewill predict that Firm X sits out. Since the maximin criterion onlyconsides the wost case scenaio fo each available choice, it isclea that the possibility of post-bust losses fom maintaining oincreasing investment will lead a maximin-playing Firm X to notinvest at all, as the wost case—in fact, the guaantee—is that notinvesting will result in zero prots.

The above agument would be answeed by Cailli and Demp-ste’s assumption (albeit implicit) that entepeneus cae about

short-run prots, rather than the long-run post-bust losses. If anindividual rm expects to be able to prot during the boom andexit befoe the cisis, then they may paticipate in the boom andplan to exit befoe the cisis. This is a eal possibility and it maylead to even infomed investos paticipating in the boom—butthis answe simply denies that ational expectations ae common, because it must assume the existence of a signicant number of foolish investos. Conside the case of an individual, ational,Austian-infomed, entepeneu. Clealy, this entepeneuwould not want to be caught with investments on the eve of thecisis. So, such an entepeneu will seek to sell the investmentsthey have befoe the cisis occus. As long as thee ae a substantialnumbe of poo-quality entepeneus that do not foesee thecisis, a ational, Austian-infomed entepeneu can easonablyexpect to be able to invest in the ealy stages of the boom and exitthe maket shotly befoe the cisis.10 Howeve, the claim of theational expectations citique is that poo-quality entepeneus

ae ae (o, in the exteme case, nonexistent). But, in that case aational entepeneu will not ente the boom, because they willknow that no maket paticipant will buy fom them shotly befoethe cisis, since the othe maket paticipants ae all (o nealy all)ational, and theefoe would be tying to exit at the same time.11 So, this answe to the ational expectations citique only applies

10 Block (2001) ightly points out the impotance of not all maket paticipantshaving ational Austian-infomed expectations fo this pocess to take place.

11 Hee, the mainsteam liteatue on “ational bubbles” is elevant. This liteatuehas shown that asset bubbles can only happen in the pesence of ational expec-tations if the bubble is expected to grow continuously. So, put dierently, since theAustian-infomed ational entepeneus expect the bust to happen eventually,the boom cannot get stated.




if ational expectations ae ae—a claim that the ational expec-tations hypothesis denies. Thus, though this answe is tue (andplays a pat in the agument in this pape), it answes the ationalexpectations hypothesis by claiming that the hypothesis is false,not by showing that Austian business cycles will happen even ina ational-expectations wold.

To be clea: these answes cetainly have tuth in them. The ealityis that not all entepeneus know Austian business cycle theoy,and the entrepreneurs that do know it can, at times, expect to nd

geate fools to sell to befoe the bust happens. But, when faced witha citicism like that posed by ational expectations, one must havea good reason that normal market forces are not as eective duringthe boom as during other times. We all agree that the prot andloss system typically sots out “bad” entepeneus—limiting theiability to do ham, and theeby limiting the size and pevalence of eo. Yet, duing the boom, it seems that many entepeneus fallinto the same types of eos—they undeestimate futue inteestates, and so oveestimate the value of capital goods and thedesiable length of the poductive pocess.

I suggest that the key is that the statement is framed incorrectly.At the beginning of this section, I stated that “entrepreneurs arefooled by the pocess.” This statement is evesed. The eality isnot that entepeneus become fooled. The eality is that, duingthe boom, fools become entepeneus. Evans and Baxendale (2008)suggest that “iationality” on the pat of maket paticipants isnot a widespead phenomenon duing the business cycle—athe

the expansion of cedit daws in “maginal” entepeneus. Evansand Baxendale (2008) point out that entrepreneurs dier in theirquality, and that dierent qualities of entrepreneurs (or entrepre-neurial projects) have an easier (or more dicult) time securingfunds. In a free economy without “easy money,” marginal entre-peneus would be denied funds. Because these entepeneus (othei pojects) ae of elatively poo quality, they will tend not toreceive investment funds—if funds are suciently limited. Oncemonetay injections can beed cedit expansion, funds ae less

limited than when cedit was elatively “tight.” As a esult, thee isa set of entepeneus that will eceive funds when cedit is “easy”that would not when cedit is “tight.” So, the “aveage quality” of entepeneus has declined duing the boom.




Evans and Baxendale (2008) points us in the ight diection—buttheir argument can be taken a step further. It is true that relativelylow quality entrepreneurs will nd it easier to come by funds forinvestment when money is easy by vitue of the fact that theeae moe funds available. At the same time, those entepeneusthat ae high quality and foesee the path that the economy willfollow have an incentive to get out of—o at least moe stictlylimit thei paticipation in—those industies that ae dependenton the pesistence of the boom, especially as the boom continues

and the cisis looms. Fo example, duing an investment boom, thepice of capital goods will tend to ise. While Evans and Baxendale(2008) coectly point out that capital goods cannot be “shoted” inthe same sense that nancial instruments can be shorted, existingcapital goods can cetainly be sold by those ownes who ecognizethat they ae tempoaily ovevalued and that a cisis is coming.This multiplies the poblem that Evans and Baxendale (2008) pointout. Thanks to the cedit expansion, thee ae moe funds availablethan befoe, so maginal entepeneus ae dawn in. Meanwhile, a

gowing numbe of highe quality entepeneus sell thei tempo-aily ovepiced capital to entepeneus who ae oveestimatingits value, which puts even moe esouces into the hands of lowequality entepeneus. That is, Evans’ and Baxendale’s “maginal”entrepreneurs tend to become a signicant part of who is runningthe booming industy.

So the eason that eo becomes so much moe pevalent duingthe boom is not that entepeneus tun into fools. rathe, it is that

fools ae empoweed to become entepeneus.

EVIdEncE FroM tHE HouSInG MArKEt

The ecent boom and bust in the Ameican housing maketpovides an excellent demonstation of the Austian businesscycle theory, and provides a tting anecdote to demonstrate theimpotance of fools joining the maket when cedit becomes easy.In broad terms, the housing boom began in the early 2000s, as the

Fedeal reseve pushed inteest ates to what wee, at the time,ecod lows. (Figue 2) As the policy ates (like the fedeal fundsate) fell, motgage ates also fell—especially shot tem ates onadjustable-ate motgages. Since cheap cedit was available (often




with little to no money down), new homeownes enteed themaket. Howeve, stating in 2005 o 2006, inteest ates stated asteady uphill climb. As adjustable ate motgages saw thei inteestates and payments adjust upwad, many homeownes found thattheir homes were unaordable, and ended up losing them to fore-closue. At the same time, the highe inteest ates and tighte ceditmakets led to a deceased demand fo houses. The fall in homepices combined with low levels of initial equity to push manyhomeownes to the point whee they wee “undewate” on theimotgages—poviding a stong incentive fo such homeownes tosimply walk away fom thei homes.

Fige 2. Eviee fm he Hsig Make

0 1

’ 0 0

0 5

’ 0 1

0 9

’ 0 2

0 2

’ 0 4

0 6

’ 0 5

1 1

’ 0 6

0 3

’ 0 8

0 8

’ 0 9

250

200

150

100

50

0

12%

10%

8%

6%

2%

4%

0

Fed Funds Rate (Left Axis) 1 Year ARM Rate (Left Axis)

30 Year FRM Rate (Left Axis)

Case Shiller Index(Right Axis)

The basic elements of the entepeneuial eos that happenduing a typical Austian business cycle ae all pesent in thisexample. The puchase of a home is a long-tem investment in muchthe same way that buying o building a factoy is, and theefoe

includes an entepeneuial component. Though a homebuyemay not be an entepeneu in the sense that Heny Fod was,the decision to buy a home is an entepeneuial one—that is, it isheavily infomed by the homebuye’s expectations egading the




futue.12

When a peson buys a home, he has expectations about thevalue of the home going fowad (just as those that buy factoieshave expectations about the futue value of the factoy). When apeson buys a home, he has expectations about the value of thesevices that that home will povide in the futue (just as thosethat buy factoies have expectations about the futue value of thepoduct the factoies poduce). When a peson buys a home, hehas expectations about the costs associated with homeowneship(just as those that buy factoies have expectations about the futue

costs of poduction). Austian business cycle theoy claims that, because entepeneus undeestimate futue inteest ates, theyundeestimate the futue cost of poduction and oveestimatethe value of capital goods. The behavio of the housing maketduing the ecent boom was consistent with an analogous eo.Those puchasing homes oveestimated the value of the house andundeestimated the futue cost of owneship. All of this happened because interest rates were articially—and temporarily—low.13 So fools became entepeneus, and made investments in housingthat wee doomed to pefom pooly.

Howeve, we can take the evidence a step beyond anecdotes and boad stokes. Though the use of statistical methods, we can dosome economic history to get an idea of the inuence that interestates had on changing the quality of entepeneuial homebuyes.It seems to be a fact of recent economic history that shorter terminteest ates ae moe volatile than longe tem ates. Fo example,the inteest ate on adjustable ate motgages tends to be moe

12 As noted by an anonymous efeee, the agument hee elies on the fact that we aeall entepeneus—which is cetainly tue, in that we all act based on expectationsegading the futue. The univesal natue of entepeneuship becomes especiallyimpotant when individuals make long-tem investments, like in housing, whilethe entepeneuial component in making a ham sandwich—though pesent—isless impotant, as the uncetainty is less.

13 It may be worth noting that some entrepreneurs who saw how the housingmarket was going to go—most notably Peter Schi—made the decision to rentathe than buy a house duing the boom. This povides some anecdotal suppot

fo the idea that high quality entepeneus that foesee the inevitability of the bust do in fact emove themselves fom the maket duing the boom. As a efeeenotes, it is also possible that some homebuyes sold fo easons othe than goodfoesight, and wee theefoe just lucky. But those homeownes that emainedalmost cetainly did not see the cisis coming, and wee theefoe “low quality.”




volatile than that on xed rate mortgages. Rothbard (2001 [1962])agues that, in a fee maket with a well-established secondaymaket fo debt, thee is no paticula eason that a fee maketshould display these tendencies (see Chapte 6, Section 11)—inteestrates on long-term bonds are just as exible as on short-term bonds, since the pices in the seconday maket can adjust quickly.In mortgage markets, adjustable-rate mortgages and xed-ratemotgages in the data ae fo new motgages—and thee is nopaticula eason that the inteest ate on motgages peviously

issued should impact those issued late. That being the case, theeis no paticula eason that adjustable ate motgages should havemore volatile interest rates in the data than xed rate mortgagesdo. Howeve, the eality in the hampeed maket in which we liveseems to be that inteest ates on shot-tem loans ae moe volatilethan interest rates on long-term loans. I would suggest that theobserved dierence in interest rate volatilities derives largely fromthe fact that cental banks tend to focus thei inteventions on loanmakets with shote tems.14 When the cental bank inceases

the money supply, thee is a new supply of funds fo shot-temloans—without any immediate coesponding change in thesupply of funds available fo long-tem loans. As a esult, duingthe intevention, shot-tem ates ae diven below long-tem ates.When the cental bank deceases (o slows the incease) in themoney supply, thee is a decease in the availability of funds foshot-tem loans—without any immediate coesponding changein the supply of funds available fo long-tem loans. As a esult,shot-tem ates ae diven up moe quickly than long-tem ates.15 If this is the case, then only foolish entrepreneurs will respond inany signicant way to short term rates, as long-term rates are notas distoted by intevention, and theefoe povide a bette signalfo social time pefeences—and theefoe a bette guide towadappaising capital values.

14 As noted by an anonymous efeee, this tendency has been violated with the Fed’secent policies of Opeation Twist, and potentially Quantitative Easing. Thoughnot dealt with hee, it may be inteesting to pusue the question of whethe thischange in focus had an impact on the elative volatility of long and shot teminteest ates.

15 This is also consistent with the fact that the yield curve tends to atten or invertpio to ecessions.




Taking these insights that intevention tends to ceate lagedistotions in shot tem than in long tem inteest ates, and thatfoolish entepeneus will be moe likely to espond to the moedistoted ates, we can develop a few pedictions about how homevalues should espond to inteest ates. Fist, if entepeneus aewise and pay moe attention to long-tem ates, then long-teminteest ates should have a bigge statistical impact on home picesthan shot-tem ates do. Second, if entepeneus ae foolish andpay moe attention to shot-tem ates, then shot-tem inteest

ates should have a bigge impact on home pices than long-temates do. These ae both inteesting pedictions—but neithe eallyspeak to the hypothesis suggested by Evans and Baxendale (2008),and also advocated hee. The claim hee is that fools “become”entepeneus duing the boom. Once we aggegate to the levelavailable in the data used hee, it is impossible to distinguish thisclaim fom the claim that entepeneus become fools. Howeve,we can come to some conclusions about changes in the “level of foolishness” held by those maginal entepeneus that ae having

a signicant impact on housing prices. Since we know that foolishentepeneus will pay moe attention to shot-tem ates, weshould expect that as entepeneus become moe foolish, they willtend to pay moe attention to shot-tem inteest ates. As a esult,the lowe shot-tem inteest ates ae, the lage the impact theywill have on housing pices.

These insights can be summed up by two statistical equations thatwill be estimated to demonstate that this pocess has been happening

to a signicant, measurable degree in the housing market.

Housing Prices = α + β11Year ARMRates + β

2Disposable Income + ϵ

1

β1

= γ1

+ γ21YearARMRates + ϵ

2

Our claims about housing prices imply that the coecient β1

should be less than zeo fo ou obseved sample. That is: thehighe inteest ates ae, the lowe housing pices will be, and vice

versa. At the same time, γ2 should be positive. Since β1’s magnitudegives us a sense of how lage an impact inteest ates have onhousing prices, and β

1is negative, as inteest ates ise, we would

expect β1

to decease in magnitude—that is, become less negative.




For that to happen, γ2 must be positive. When we combine thesetwo equations into a single equation fo estimation, we have:

ousingPrices = α + γ11YearARMRates+

γ2(1YearARMRates)2 + β

2Disposable Income + ϵ

To estimate this equation, I used Standard and Poor’s Case-Shiller 10-City Home Price Index for housing prices. One year

ArM ates come fom the monthly data collected by Feddie Macin their Primary Mortgage Market Survey. Disposable Income isincluded as a contol. Data on disposable income (measued in billions of dollas) come fom the Bueau of Economic Analysis.I used monthly data starting in January 1987 and continuingthough July 2010—so these data include both the small homepice boom and bust of the ealy 1990s and the moe ecent—andmore signicant—one throughout the 2000s.

Using standad least-squaes egession analysis,16 the following

esults ae obtained:

Parameter Estimate (Standard Error) P-Value

α 85.835 (24.486) 0.0005

γ1

-40.427 (7.703) 3.05 x 10-07

γ2

3.531 (0.616) 2.6 x 10-08

β2

0.018 (0.001) 1.64 x 10-83

R2 0.813

The rst point to note: none of the signs are a surprise. The coef -cient on β

1will be negative ove evey inteest ate in the data set

(the maximum inteest ate in the data set is 9.4 pecent—whichwould result in a β

1estimate of -7.236). The coecient on γ

2is

positive—which indicates that shot-tem inteest ates matte moethe lower they are. The coecient on β

2 , which is not pat of the

16 Fo those concened about whethe this type of analysis is stictly “valid,” theanalysis can be intepeted as uncoveing “conditional coelations” betweenthe seies.




theoy discussed in this pape, also has the sign one would expect.As incomes rise, house prices also rise. All of these are signicantlydierent from zero at any reasonable level of condence.

When it comes to intepeting the esults, the complexity of theequation makes a direct interpretation dicult for the most inter-esting point. So, just to choose a single point, suppose one-yeaadjustable rate mortgages are currently 5 percent. In that case, β

1

is equal to –22.772. So, othe things equal, an incease in motgageates of 0.1 pecent will decease the Case-Shille home pice index

by appoximately 2.277 points. Howeve, if inteest ates ae 4percent, then β

1is equal to –26.303, so an incease in motgage ates

of 0.1 pecent will decease the home pice index by appoximate2.630 points.

So it does appea that home pices become moe sensitive to shottem inteest ates as shot tem inteest ates fall. Seeing that shot-term rates are so inuenced by the credit expansions that breed the boom-bust cycle, we can take this inceasing sensitivity to shot-tem

ates as a sign of inceasing entepeneuial foolishness.By means of compaison, we can pefom the same egession,

but using inteest ates on 30 yea motgages fom the PimayMotgage Maket Suvey (which epots inteest ates on newlyissued 30 year xed rate mortgages, whether these are newmortgages or renancing), giving these results:

Parameter Estimate (Standard Error) P-Value

α -17.498 (43.37) 0.6853

γ1

-12.196 (8.936) 0.1734

γ2

1.194 (0.521) 0.0225

β2

0.020 (0.001) 1.25 x 10-48

R2 0.805

These esults suggest that the impact of 30 yea inteest ates is

quite small relative to the impact of 1 year interest rates. In fact, γ1’sestimate is not statistically signicantly dierent from zero at anyeasonable level. At heat, this suggests that long-tem inteest atesdo not seem to have a big impact on the changes in the housing pices




we have seen ove the past 25 yeas o so, but shot-tem inteestrates do have a signicant impact. Since roughly half of the last 25yeas of housing pices wee obseved duing a housing boom and bust, it is easonable to view this evidence as suppot fo the idea thatsome capital pices (in ou case, housing pices) have been heavilyimpacted by shot tem inteest ates, despite the fact that theseinteest ates ae heavily distoted by the inteventions of cental banks. Since entrepreneurs appear to be more inuenced by theseshot tem ates the lowe they fall, entepeneus do become moe

foolish (o moe fools become entepeneus) as inteest ates fall.

concLuSIonS

Austian business cycle theoy—like all tue business cycletheoies—is essentially a theoy of clustes of eo (see Hulsmann[1998]). Some citics—and even such famous advocates as Ludwigvon Mises himself—have suggested that a wold in which ente-preneurs are not fooled by credit expansion is conceivable. In fact,

entepeneus have evey eason to ty to avoid eos, and theprot-and-loss system does a reasonable good job—under normalconditions—of soting out eo-pone entepeneus fom thosethat are wiser. Over time, the same prot-and-loss system will takecontol of esouces away fom entepeneus that waste esoucesin thei eos and will give contol of esouces to entepeneusthat ae bette at anticipating futue maket conditions. Thispocess is hampeed duing a business cycle. Wise entepeneusunderstand that interest rates are articially and temporarily low

and look fo a way to avoid the inevitable bust. Fo example, pioto the cisis, they may sell thei (tempoaily ovevalued) factoiesand stocks to those who ae ovevaluing them. The entepeneuswho buy these factoies—and build new ones as well—ae peciselythose entepeneus who do not undestand that the boom willcome to an end. They foesee a “pemanently high plateau” inthei maket, not ealizing that the “plateau” is only as high as itis because inteest ates ae being held to an unsustainably lowlevel. Theefoe, while nomal maket conditions would esult

in fools losing thei status as entepeneus, by the end of theAustian boom only (entepeneuial) fools ae willing to investin the booming industries. In the terms of Evans and Baxendale(2008), the “maginal entepeneu”—who is the one that plays




the decisive ole in capital makets—is of lowe quality duing the boom than in nomal times. Cedit expansion makes moe fundsavailable fo lowe quality entepeneus, and, at the same time,the knowledge that the boom will end in a bust esults in elativelyhigh quality entepeneus eventually exiting the maket, futhefeeing esouces fo foolish entepeneus to contol.

This pape has suggested that housing maket data fom the past25 yeas povides a easonable demonstation of this tendency.Despite the facts that housing is typically a long-tem investment,

and that long-tem inteest ates ae less distoted by monetaypolicy, housing pices have been moe esponsive to the moedistoted—and seemingly less elevant—shot-tem ates. Not onlydo shot-tem inteest ates seem to matte moe statistically, butthei impotance gows as inteest ates fall. Put anothe way: home- buyers are more inuenced by interest rates when interest rates areunusually low. This suggests that people making investments inhousing do, in fact, get moe foolish as inteest ates fall. Despitethe fact that vey low inteest ates must eventually ise (esulting in

falling housing pices), people ush in to buy when inteest ates aelow. Anecdotally, people have also tended to use moe adjustable-ate motgages duing the ecent housing boom. This suggestsanothe laye of foolishness that was not exploed in this pape—notonly ae investos in homes buying when pices ae tempoailyhigh because of low inteest ates, but they ae also buying usingmotgages that will get moe expensive as inteest ates ise.17

What then ae the consequences fo Austian business cycle

theory? First, Austrian business cycle theorists need not fear theallegations of ational expectations citiques. As has been noted byGaison (1986), Austians should not be ovely concened aboutthese citiques fo a simple eason: ational expectations appeasto be a false assumption. This pape adds to the evidence fo thatfact. Investors in housing markets do not take into full account thelikelihood that inteest ates will ise when they ae unusually low.Second, this pape povides evidence that the eos that occued

17 As noted by an anonymous efeee, it is also possible that thee wee policychanges that made adjustable ate motgages moe attactive. This would lead toan inceased use of these motgages. Howeve, given how histoy played out, ahomebuye with good entepeneuial foesight would know that such motgageswould eventually end up being a losing poposition once ates ose.




duing the ecent business cycle have esulted fom an inceasinglevel of “foolishness” among entrepreneurs. Part of this eect arises because the cedit expansion povides esouces to entepeneuswho could not have secured them before. Another part of this eectaises because wise entepeneus have a good eason to leave amaket that is tempoaily ovevalued, especially as the cisis neas.If anything, the more “fragile” theory is one resting on rational expec-tations. The ational expectations citique against Austian businesscycle theoy only eally woks if all—o at least an ovewhelming

majoity of—entepeneus ae “ational” in the vey stict senseimplied by rational expectations theory. Introducing a reasonablehandful of less “ational” entepeneus into the mix allows fo theconclusions of Austian business cycle theoy to take hold—the“aveage entepeneu” is of lowe quality in the cedit-expansion-driven boom than in normal times. If, on the other hand, we startwith entepeneus of heteogeneous quality as suggested by Evansand Baxendale (2008), intoducing a easonable handful of pefectly“ational” entepeneus will have little impact. Thoughout the

boom, ational entepeneus should move towad sidelines.18

Natually, we cannot ule out, a pioi, that some day ente-preneurs will all come to understand the distorting eects of monetay policy so well that they cease to be fooled by expan-sionary monetary policy. In fact, someone who wants to see societyescape fom business cycles as we know them should hope fothe day in which all business cycle theoies cease to be elevant.Howeve, ecent expeience has shown us that business cycle

theoies ae still equied if we want to undestand the economy asit actually operates. Recent experience has also conrmed that the business cycle opeates vey much like Austian busincess cycletheoy suggests.

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Altig, David, Lawence Chistiano, Matin Eichenbaum, and Jespe Linde.2004. “Firm-Specic Capital, Nominal Rigidities, and the Business

Cycle.” Working Paper.

18 The esult suggests that Alexande Pope’s dictum applies to business cycles—“foolsush in whee angels fea to tead”!




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Cowen, Tyle. 1997. Risk and Business Cycles: New and Old Austrian

Perspectives. London: routledge.

Evans, Anthony J., and Toby Baxendale. 2008. “Austian Business CycleTheoy in Light of rational Expectations: The role of Heteogeneity,the Monetay Footpint, and Advese Selection in MonetayExpansions.” Quarterly Journal of Austrian Economics 11, no. 2: 81–93.

Fiedman, Milton. 1969. “The Monetay Studies of the National Bueau,

44th Annual Report.” In The Optimal Quantity of Money and OtherEssays (pp. 261–284). Chicago: Aldine.

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Quarterly Journal of Austrian Economics 1, no. 4: 1–23.

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Tullock, Godon. 1987. “Why the Austians Ae Wong about Depessions.”Review of Austrian Economics 2, no. 1: 73–77.

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Expansionary monetary policy and decreasing entrepreneurial quality

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