Forget the Austrian School's logical explanation way back in the 1920s that central banks (such as our very own Fed) are ultimately responsible for boom-bust cycles in the economy.
Expansionary booms and their subsequent depressions are caused not by the Fed's monetary expansion, but by... well, there's really no easy way to say this: they're caused by you. And those irrational emotions of yours. How could you?
The argument that investor psychology has been the main culprit in history's economic manias and their subsequent meltdowns is quite common. It is found in books such as Charles MacKay's Extraordinary Popular Delusions and the Madness of Crowds (1841), John Kenneth Galbraith's The Great Crash of 1929 (1954), Edward Chancellor's Devil Take the Hindmost: A History of Financial Speculation (1999), and Robert Shiller's Irrational Exuberance (2000).
The government loves to blame its own screw-ups on private-sector "irrationality," because human "irrationality" is supposedly the ultimate reason for government's very existence: it must protect us from our wild, uncontrollable, passionate, murderous tendencies.
Perhaps, but isn't the government simply an organization of humans, just as the free market is? Isn't it just as human as any other organization that consists of human members? So what is the real distinction between government and non-government?
I don't dispute for one moment that human emotion can be humorously, and even dangerously, irrational. My day-to-day experiences with other people -- and myself -- are enough to convince me of that basic human truth. So how can I deny that investor psychology plays a critical role in economic manias and depressions? I can't. It most certainly does.
But to ignore the Fed's massive distortion of a key market signal, the interest rate, through its expansion of the money supply and lowering of the interest rate, and then to point the finger at "irrational exuberance" as the main component of economic boom-bust cycles, is like leaving all the windows in one's house open on a hot day, turning on the thermostat, and then blaming the thermostat for wastefully running the air conditioner non-stop. It mistakes a superficial cause for a far more fundamental one.
Investor psychology is powerful, but so are interest rates. They are both "forces" in economics. Leave the free market alone, and interest rates will rise in response to investor optimism fueled by affordable credit. Relatively quickly, the interest rates will rise high enough that optimism becomes tamed and reverses itself before anything resembling an economy-wide "bubble" ever has a chance to form. But as the optimism cools, demand for credit correspondingly drops, which causes interest rates to lower in response. This prevents capital investment from drying up completely, so pessimism does not cause a full-blown depression. Stability, not wild oscillation, is what results from this interplay: a balance between supply of and demand for credit, between future and present consumption, between optimism and reality.
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Let's not forget where the term "irrational exuberance" came from: Alan Greenspan, then chairman of the Federal Reserve. As you said, even government leaders are human, and the Fed is hardly going to be self-critical when there is such a wonderful scapegoat sitting right there, waiting to be blamed for all the chaos: the free market. When government sets interest rates at a level that's not appropriate for the free market, the inevitable result is economic distortion and chaos.
ReplyDeleteAs Demetri Martin pointed out the other day during his show, talking really loud is the next best thing to being right. The government is very good at "loud talking," and many ostensibly intelligent people believe the government is doing exactly what it should be doing. Why? Because the government said so.