Lesson 4 of 8
Why repeat the mistake
If the cheap credit is known to be temporary, the rational move is to take it and avoid projects that need it to last. Then errors would not cluster.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- The objection: a theory that credits entrepreneurs with foresight about markets cannot also assume they are systematically fooled by a policy that is public.
- The rational response to a temporarily low rate is to take the cheap credit and avoid projects that only pay if the rate stays low. That response breaks the mechanism.
- The best-known reply says a collective error need not require any individual to be irrational. The critic's counter is that it has to explain why the error takes this particular form.
This is the objection most economists reach for first, and the version given here is the strongest published one this course could obtain. It is aimed at a specific joint in the theory rather than at its conclusions.
The chain the objection attacks
- 1Credit expansionThe policy rate falls below the sustainable level
- 2Longer projects look profitableLower discounting raises the present value of distant returns
- 3Entrepreneurs act as if the rate will holdThis is the step the objection denies
- 4A cluster of errorsRevealed when the rate returns
The objection, at full strength
Caplan's essay concedes the first two steps without argument. Expansionary policy lowers interest rates in the short run, and lower rates make more roundabout projects profitable; he notes that any modern economist would accept both.
What he denies is that the stimulated investments tend to become malinvestments. Given that the low rate is unsustainable, why would a businessman compute profitability as though it will last. The rational response is twofold: make the investments that will still pay when rates rise, and refrain from those that only pay if they do not. If entrepreneurs follow that rule there is no systematic tendency for the reversal to produce errors.
He presses the point using the tradition's own commitments. The same authors who say entrepreneurs are selected for forecasting skill also say they cannot foresee a policy that is announced. And even if most managers use the current short rate mechanically, the long rate is available to anyone, and professional speculators in the credit market would have to make the same mistake for the long rate to be misleading.
Tullock makes the same objection more briefly, and adds that a well-informed business person interested in the matter could simply read the theory and anticipate what the government will do.
The reply, and what it does not settle
The reply this course could verify is Garrison's, reported in Caplan's own essay: macroeconomic irrationality does not imply individual irrationality. A person can rationally join a process they know to be ill-fated, as with a chain letter, provided they expect to get out in time.
Caplan accepts that such cases exist and denies this is one. His counter is that the chain-letter logic explains why someone takes the cheap credit; it does not explain why they would tie it up in exactly the long-lived assets that will be stranded when the rate returns.
Salerno's answer, in his comment on Tullock, is different: it is that the question has already been treated in the literature, and he names contributions by Mises in 1943, by O'Driscoll and by Garrison. This course did not obtain those, so it reports the pointer and not their content.
What a reader should take from this
The objection does not touch the claim that credit expansion changes relative prices. It touches the claim that the resulting pattern is a systematic error that keeps recurring.
A defender has two honest routes. Show that the information needed to avoid the error is not actually available at the time, which is a claim about what is knowable. Or show that the incentives facing individual firms make the error rational even when it is foreseen, which is the chain-letter route and needs to explain the specific form the investment takes. Both routes are live in the literature, and neither has closed the question.
Check yourself
Which step in the mechanism does this objection attack?
- That a lower rate raises the present value of distant returns
- That entrepreneurs act as though the temporarily low rate will persist
- That credit expansion lowers the market rate
Show the answer
Answer: B.
Caplan concedes the first and third and denies that the stimulated investments therefore tend to be errors.What is the chain-letter reply?
- That entrepreneurs do not read economics
- That a person can rationally take part in a process they know to be unsustainable, expecting to exit in time
- That the central bank conceals its intentions
Show the answer
Answer: B.
The reply is Garrison's and is reported in Caplan's essay. Caplan's counter is that it does not explain why the money goes into the long-lived projects.What does the objection leave untouched?
- The claim that credit expansion changes relative prices
- The claim that longer projects become more profitable at lower rates
- Both of the above
Show the answer
Answer: C.
The critics concede both. The dispute is about whether the resulting pattern amounts to a systematic, recurring error.Sources
- Caplan, 'Why I Am Not an Austrian Economist', an essay published on the author's university page at George Mason University, section 3.4: the concession of the first two steps, the argument that the rational response to a temporary rate cut breaks the mechanism, the appeal to long rates and professional speculators, and the report and rebuttal of Garrison's chain-letter reply.
- Tullock, 'Why the Austrians Are Wrong About Depressions', Review of Austrian Economics, volume two, 1987, opening section: the objection that business people would learn to anticipate the policy.
- Salerno, 'Comment on Tullock's Why Austrians Are Wrong About Depressions', Review of Austrian Economics, volume three: the reply that the expectations question has been treated by Mises in 1943 and by later writers, with the references given there.
What this leaves out
- This is a heterodox tradition. The mainstream account of the same phenomenon differs, and nothing here is a forecast or a view on any security.
- The works Salerno names as answering the expectations objection were not obtained for this course, so their arguments are not summarised here, only the fact that he points to them.
- The manager example is invented to show what the objection implies about behaviour. It describes no company and no decision that was made.