Causes of Slow and/or Unsustainable Recovery

Causes of Slow and/or Unsustainable Recovery

In a comment on Malinvestment and Regime Uncertainty, Dick Fox wrote:

“Professor, I am a little confused. The first part of your paper concentrates on the fact that policies have hindered investment, but then at the end of the paper you imply that artificially low interest rates are artificially directing spending to the early stages of production. It seems to me that your description of the impact of government policies attacking business are hindering investment more at the early stages of production. Are these forces working against one another?”

I’ll try to clarify some below:

Factors that contribute to slow recovery:

1. Boom-bust cycle creates malinvestments:

Microeconomic problem – resources need to be moved from where they are less intensely needed to where they are more intensely needed:  Solution is flexible prices with resource mobility.

Complications: Non-homogenous capital goods and labor services – some resources may not be easily transferable across stages of production of location.

Significant malinvestment and over consumption can cause capital destruction and/or waste – reducing production possibilities below what they might have been sans boom.

2. Reaction to bust could create “secondary deflation’ or secondary depression:

Hayek 1970s (See Hayek 1979) recommend preventing  the secondary deflation, however Salerno (2012 A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis) argues:

My third refinement of ABCT is to link the so-called “secondary deflation” to the pervasive malaise and waning of “animal spirits” among the mass of entrepreneurs that occurs when the recession reveals their cluster of miscalculations and errors and saps their confidence in their ability to identify and calculate profitable investments. I argue that the secondary deflation is not the result of an incidental monetary contraction that depresses some arbitrary price level; rather it is a reaction to and correction of the relative price distortion caused by the extreme overbidding of factor and asset prices during the euphoria of the boom. When allowed to run its course, this relative price adjustment inevitably re-establishes a natural interest rate sufficiently high to stimulate capitalists and entrepreneurs to dishoard cash and actively seek out investment opportunities. When stunted by “quantitative easing” and fiscal deficits driven by stimulus programs, the entrepreneurial malaise becomes chronic, and economic stagnation ensues.

These are issues of recovery from any boom-bust cycle and there is a third contributing factor to a slow recovery – a poor policy reaction to the crisis which creates:

3. Higgs’s Regime Uncertainity – Inappropriate policy reaction and/or rhetoric which creates uncertainty about the future of property rights and returns on investment. Hinders recovery even if relative prices are adjusting. Affects all stages, but probably more impact on earlier stages.

There is a second issue, related to your question on low interest is where  I should have been more clear about a shift of emphasis in the discussion. The shift is toward factors impeding a healthy recovery and sustained growth – a growth path consistent with tastes, preferences and resource availability.

  1. Regime uncertainty also operates here.
  2. Stimulus- both monetary and fiscal which misdirect production – see Especially Hayek 1979 and Ravier Rethinking Capital-Based Macroeconomics. Artificially low rates, may even in the face of regime uncertainty, marginally increase investment relative to what it would have been sans low rates, but while such spending may like fiscal stimulus, especially stimulus which has more impact on consumption and later stage investment (Garrison’s induced investment), appear to increase employment,but it will do so at the cost of increased instability and potentially higher employment later.

As described in Cochran (2011 Capital in Disequilibrium: Understanding the “Great Recession” and the Potential for Recovery): “Recovery must be driven by a revival of investment, but to return to real stability and sustained growth the new pattern of investment must be in line with resource availability and time preferences. According to Hayek (1979, p. 42), this is not likely to be achieved by “subsidi­zation of investment” or “artificially low interest rates.” Hayek (1939) argued that while such a policy may result in a temporary increase in production and employment, the ultimate result is a new period of boom and then bust.”

Reference

Hayek, Friedrich A. 1979. Unemployment and Monetary Policy: Government as Generator of the “Business Cycle.” San Francisco, CA: Cato Institute.

Comments

  1. Thank you, Professor. I do agree with your analysis but I would add the following (and there might be more).

    Concerning the malinvestments, if the money supply is artifically increased even after the malinvestment there comes a point at which the malinvestment will not sustain itself even though additional money is injected into the system. Becaused money is introduced to the economy through loans, borrowers become over-extended to the point where no matter the quantity of money or the interest rate there are no qualified borrowers. Any additional money will then flow to hard asset such as gold or collectibles, and also into excess bank reserves.

    This is clearly where we are now. Any QE increases the price of gold and excess bank reserves. Banks are blamed for not loaning the money but they actually have no one to loan it to.

    The concerning an interest rate being held artifically low, we see the destruction of savings. Bonds cannot be used to raise funds because the interest rates are so low they do not attract investment. Money tends to flow to equities because that is the only source of returns. But additionally this creates another incentive toward malinvestment because there is excess money available at low loan rates so interest sensitive segments of the economy boom while other segments are starved.

    In truth our current stagnation is directly linked to government policies intended to stimulate the economy. Japan has tried the same technique for over 20 years and has had nothing but stagnation. The US is following the same formula, as is Europe.

    But that does not even touch the fiscal problems with subsidy and mandate. But perhaps that is a discussion for another time.

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