It’s The Structure Of Prices & Capital, Stupid

Teaching Hayekian monetary eoonomics to a new generation of central bankers:

[Hayekian] economics, has enjoyed a .. revival in the last decade, most prominently at the Basel, Switzerland-based BIS, which has few formal banking duties but is an important talking shop (it is sometimes called the “central bankers’ central bank.”) The BIS’s leading [“Hayekian”] is a Canadian, William White, the head of the bank’s monetary and economic department .. In a 2006 paper Mr. White wrote that under [Hayekian] theory, “credit creation need not lead to overt inflation. Rather…. the financial system … create[s] credit which encourages investments that, in the end, fail to prove profitable.” This leads to an “an eventual crisis whose magnitude would reflect the size of the real imbalances that preceded it [because] the capital goods produced in the upswing are not fungible, but they are durable. Mistakes then take a long time to work off.” He argued that in recent decades, “financial liberalisation has increased the likelihood of boom-bust cycles of the [Hayekian] sort.”

.. “Virtually no one foresaw the Great Depression of the 1930s, or the crises which affected Japan and Southeast Asia in the early and late 1990s, respectively,” it begins. “In fact, each downturn was preceded by a period of non-inflationary growth exuberant enough to lead many commentators to suggest that a ‘new era’ had arrived.”

It notes that “the prices of virtually all assets have been trending upwards, almost without interruption, since the middle of 2003 .. There seems to be a natural tendency in markets for past successes to lead to more risk-taking, more leverage, more funding, higher prices, more collateral and, in turn, more risk-taking… [S]uch endogenous market processes … can, indeed must, eventually go into reverse if the fundamentals have been overpriced.”

Apart from financial imbalances, the report argues the world economy also displays dangerous misallocations of capital. In its “recent rates of credit expansion, asset price increases and massive investments in heavy industry, the Chinese economy also seems to be demonstrating very similar, disquieting symptoms” to Japan in the 1980s. “In the United States, it is the recent massive investment in housing that has been unwelcome from an external adjustment perspective. Housing is the ultimate non-tradable, non-fungible and long-lived good.” In other words, the U.S. could be stuck with a lot of houses that are hard to sell to each other and impossible to sell to foreigners, and won’t need replacement for a long time.

What does the BIS say central bankers should do? Essentially, relax their single-minded focus on price stability, and tighten monetary policy when “a number of indicators — not just asset prices but also credit growth and spending patterns — are simultaneously behaving in a manner that indicates increasing exposures.” In other words, when easy credit is fueling excesses, raise interest rates to end the party ..

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