In his most recent post, Sebastian Dullien argues against the view that the subprime crisis is due to cheap money. To him, there is not much evidence in history. The logic of the hawkish argument, so Dullien, is unprecise. Greenspan for him is not the villain, but still the hero. The reader of this blog knows that my views on this matter significantly differ. But before I try to come up with some arguments against Dullien's point of view, I have to give him credit for his consistency and his steadfastness. For while less than a year ago most economists would have agreed with Dullien's view on the Greenspan era (which is more or less positive), all but a few (including Dullien) suddenly changed their view and argue as if they never had claimed the opposite before. It is indeed quite en vogue to blame Greenspan for the subprime crises and I also wonder when and how Bofinger (who is explicitly mentioned by Dullien), who had always suggested that the ECB is not as smart as the FED under Greenspan in fighting the possibility of deflation, became the hawk he now is. Indeed, all the power of Dullien's argument rests on the inconsistency and the arbitrariness revealed by shifts in the mainstream view. But in theory it is unfortunately Dullien who errs:
First of all, he fails to see that riskier finance is indeed accelerated by FED policies. He asks: "What exactly is the mechanism which drive banks who face lower interest rates to finance riskier business? (Was genau soll der Mechanismus sein, der die Banken bei niedrigen Refinanzierungskosten unbedingt in riskante Projekte treibt?)?" And he is essentially right. A lower rate of interest does not per se drive banks towards riskier investments. But if the lower interest is accompanied with a bail-out promise things look quite different. Banks in this case do not have to bear the full responsibility of their decisions; they do not have to face the consequences (and this does not refer only to the manager of banks, but much more to the owners). This, of course, explains the reshuffling of the bank investment scheme towards riskier business. They would have done so with the funds they controlled as well as with the additional funds created out of thin air. Moral hazard is real and if empirical evidence is not accepted in the face of the recent subprime crisis, I do not know what empirical evidence can settle at all. Thus, Dullien is right in claiming that lower interest rates motivates sounder (or better: less risky) business ["Eigentlich wäre zu erwarten, dass bei niedrigen Finanzierungskosten die Banken eher sicherere Projekte finanzieren würden: Gerade weil von der Finanzierungsseite kein Druck existierte, exorbitante Renditen zu erwirtschaften, hätte es eigentlich keine Notwendigkeit geben dürfen, große Risiken einzugehen."], but that argument is true only for the unhampered economy, that is, the economy without the government disburden decisionmakers from the consequences of their own choices.
Second, Dullien also does not see that government bonds are only alternative investments if the funds of the (global) economy are not directed to by such bonds in toto. Government bonds can only garantuee risk free terms because the government do not have to earn interest on the market. It is risk free because the interest are paid out of taxes by means of coercion. The existence of government bonds thus depends on people earning income on markets and they can only do so as long private investments take place and are dominant. Thus, even if the rates of government bonds would be higher than they actually were during the Greenspan years and thus attracted banks and other investors to purchase these titles, funds must have been employed dominantly in other investments. The problem of cheap money is not that investors do not finance government spending instead of private enterprises! The riskless world is utopia, because interest has to be earned by entrepreneurs facing an uncertain future! And we cannot buy it by purchasing government papers.
The most serious blunder in Dullien's reasoning you find here: Referring to the Saving&Loan crises of the 80's, Dullien argues that financial crises cannot be caused by a too low rate of interest because the same turmoils happening today happend in the 80s but with much higher rates of interest. What Dullien cannot see (due to the monetary theory of interest he employs) is that no absolute level of interest can ever tell us anything about its effect on credit expansion (and thus expansion of broad money). What matters is the relation between the money rates of interest and the expected profits (call it marginal efficiency of capital; call it the natural rate)! And as is well known credit expansion and nominal ballooning shifts expected cash flows and profits. But this is not a reflection of sound allocation of scarce resources, but simply inflation (defined as the increase of the money supply). Credit expansion outpacing the funds which consumers offer by foregoing consumption is always destabilzing and distorting, no matter if initiated at a higher or lower absolute level of interest.
Finally, Dullien offers a very bad picture of the stock market: if people expect something to happen, it happens. Period. But this is of course not true. Clusters of errors does not fall like manna from heaven. The stock market is the control market which regulates changes in the real capital structure of the economy. Contemporary economics is too focused on the manager and the firm. It is left to him, that is, to the insignificant man, to allocate resources by reacting to profit and loss. But no matter how significant a firm may be in respect to his specific industry, it is always insignificant in respect to the entire market economy. It is impropable that this relatively small entities can induce all the changes in prices which are supposed to communicate the changing perspectives of the many single manager throughout the economy. In any case, the adjustment process would be slow, too slow to fit the ever-changing pattern of consumer choices. The stock market is the place where anticipation of future trends are put to the test. It is indeed the very unpopular activity of the "Heuschrecke" which shows how decisions on stock market affect the real capital structure. But if this is the role fo the stock (or control) market, it is grounded in the economic problem: Wishfull thinking (and self-fullfilling prophecies) is unlikely to succeed in a world determined by the allocation of scarce means to alternative uses in which the stock market is simply the most important role. The purchase of stocks is limited by wealth and income! This wealth and income are real categories and cannot display the ballooning attributes which is implied by Dullien's treatment of the stock market. If I by a paper, I have to sell another (or a bond; or a car; whatever). Like in production, it is all about relative prices. If my anticipations are not met by the actual market process, I suffer a loss or am wiped out of the market. Stock markets are checked by consumers' choice on "real" markets!
But is Dullien not right about the expectation-driven, ballooning stock exchange? Is it not true that actual market processes indeed reveal such a tendency. YES! They do. But in identifying the nature of the stock market we know why this is so: because the wealth and income constraints are shifted from the outside, that is by increasing the supply of money (not accompanied by an increasing TFP). But in this case we are back at the beginning:
The recent subprime crisis is due to cheap money. Greenspan is partly responsible for this state of affairs. But this is also true for all advocates of cheap money which allowed for an institutional setting and an atmosphere which allowed Greenspan and his FED to do what they did. Dullien, therefore, is guilty too!
