Essential Financial Crisis Reading

In preparation for my talks in Moscow and St. Petersburg on the financial crisis and the risks of protectionism, I did a lot of additional reading, focusing on serious scholarship and insight into why the asset bubble caused a worldwide recession and a crisis of the financial system, rather than on religion. I found the papers in the special “Causes of the Crisis” issue of Critical Review especially helpful. The editor, Jeffrey Friedman, really did a great job. His own article was quite good at tying together a great many threads. I recommend the issue highly. (I understand that it will be coming out soon as a book, as well. There is a blog on the issue here.)

Note: Jeff and I had a healthy debate on the nature of libertarianism some years back. Click here for “Debate on Libertarianism.”

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8 Responses to “Essential Financial Crisis Reading”

  1. I finally read the “religion” post. W/o commenting on the merits of Wood’s book (which I haven’t read) the argument that artificially low rates led to malinvestment in longer run projects isn’t so easily dismissed. The Austrian story has people accumulating more debt today b/c of a longer time horizon. Whether one defines residential housing as capital or consumption isn’t material. The Austrian theory doesn’t specify what sectors will boom, nor is it one of general overinvestment.

    I don’t think the crisis can be understood w/o appreciating the role of artificially low interest rates in stimulating sectoral malinvestment. Stanford’s John Taylor doesn’t either:

  2. Charles, I evidently did not make my point clearly enough. The issue is not whether housing can only be conceptualized as capital or as a long-term durable good, nor do I believe that artificially low interest rates played no role (they played, it seems, a quite large role). It’s that Woods offers a religious account of how a crisis has to unfold, based on quotation of sacred texts and on a conceptualization of capital that does not easily encompass houses, viz., “lengthening” or “deepening” of the capital structure, understood as a lengthening of the round-about means of production.

    According to Woods, here’s how a credit-induced boom unfolds: “As the company works towards completing its projects [TGP: in this case, for Woods, it is “home construction”], it will find that the resources it needs, such as labor, materials, replacement parts – called by economists ‘complementary factors of production’ – are not available in sufficient quantities. The pool of real savings turns out to be smaller than entrepreneurs anticipated, and thus the complementary factors of production they need wind up being scarcer than they anticipated. The prices for these parts, labor, and other resources will therefore be higher than entrepreneurs expected, and business costs will rise.” I have not seen any evidence that the collapse (or near collapse) of the financial system came about in this manner, rather than through the very process that John Taylor (and others) have identified, namely, distrust of the solvency of financial institutions because they held so many toxic assets, i.e., securitized mortgage-backed securities the risk of which was not well priced or signaled to investors. Moreover, according to Woods, “If Austrian business cycle theory is correct, we should expect the most significant declines to be in the capital-intensive industries in the higher-order stages of production.” He applies that to the Japanese economy in the 1990s and cites a 2002 article by Ben Powell in the Quarterly Journal of Austrian Economics on “Explaining Japan’s Recession.” Note the words, “If Austrian business cycle theory is correct….” It suggests that if that is not what happens, Austrian business cycle theory is not correct. So, did we see “the most significant declines in the capital-intensive industries in the higher-order stages of production”? Is that what happened in the current case? Was the crisis a rippling out of the process he describes? Is it the case that the crisis was due to overinvestment in the “home construction” industry? (“Artificially low interest rates misdirected enormous resources into home construction.” P. 75) Was a collapse of the “home construction” industry the source of the problem, rather than, perhaps, the collapse of a financial house of cards built on a speculative bubble?

  3. Mathieu Bédard

    I didn’t think a simple comment would have such an impact and I have people coming to me asking about it, so I’m going to correct my above statement. We like to exaggerate in Marseille; I have ‘unwrapped’ the book, I have gone quickly through a couple of articles. What I haven’t done is an active reading, taking notes, rewriting parts in my own words in my notes, etc. Before you’ve seriously done that you can’t go around saying you’ve read an article, because you would be held accountable on having acquired it’s content. That’s part of the scholarly reading process and I haven’t done that with any of the articles in there yet unfortunately. It’s not a statement about how I value this book, it’s not a statement about how relevant I think it is, it was a comment on the irony of me being excited for this issue but being busy elsewhere on some other articles that aren’t necessarily better but that require my attention now. That’s all there is to it.

  4. OK, fair enough. I haven’t read Woods, but from this summary he sounds way off.

    I do think the ABCT does help explain the Great Recession (your earlier post seemed rather dismissive of this), but it’s certainly not the straightforward simple story above. IMO too many Austrians and their critics are defining capital in physical terms, instead of seeing it as subjective plans…which is perhaps why Woods focuses on expansion of the home construction industry as central, instead of the willingness of homeowners to take on increased debt as his example of a shift in the time structure. They also are failing to try to incorporate modern financial innovations.

    I note, though, that theories that omit capital specificity, time structure, and uncertainty over these dimensions really make little sense, and seem to rely either on ad hoc irrationality or unforeseeable black swans. But theories that include them are Austrian, to me.

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