[william.hardwick]

I am having trouble reconciling what I thought were the causes of the recent housing bubble with this passage by Murray Rothbard in America’s Great Depression. He seems to indicate that consumer loans cannot create a business cycle because they stimulate consumption. Wasn’t the housing bubble caused by excessive sub-prime loans to consumers (mostly in the form of mortgages)?

Installment credit is no more inflationary than any other loan, and it does far less harm than business loans (including the supposedly “sound” ones) because it does not lead to the boom–bust cycle. The Mises analysis of the business cycle traces causation back to inflationary expansion of credit to business on the loan market. It is the expansion of credit to business that overstimulates investment in the higher orders, misleads business about the amount of savings available, etc. But loans to consumers qua consumers have no ill effects. Since they stimulate consumption rather than business spending, they do not set a boom–bust cycle into motion. There is less to worry about in such loans, strangely enough, than in any other.

[jmherbener]

Consider the operation of the time market in the unhampered market economy. People with higher time preferences borrow from people with lower time preferences. The level of the rate of interest clears the market so that the quantity demanded and quantity supplied of present money are the same. The present money is allocated across the time market into consumer loans, producer loans, and the capital structure so that no further arbitrage profit arises. Only that portion of present money lent into production goes to capital projects across the capital structure. Consumer loans do not build up the capital structure, but merely transfer consumption from lower time preference people to higher time preference people. For example, let’s say that the people making consumer loans reduce their demands for clothing while people who borrow increase their demands for cell phones. Then the capital structure supporting the production of clothing (spinning cloth, growing cotton, etc.) will shrink while the capital structure supporting the production of cell phones (producing chips, touch screens, etc.) will grow. The overall capital structure will not be built up. Capital production will merely shift from areas with smaller demands to areas will greater demands.

The business cycle is inter-temporal mal-investment. Central bank monetary inflation and credit expansion increase the supply of credit beyond what people’s time preferences dictate. The increase supply of credit is arbitraged into the different areas of the time market so that no additional profit in shifting it is possible. That portion of the new credit going into producer loans and the capital structure allows entrepreneurs to lengthen the capital structure by building up capital goods in the higher and intermediate stages of production. The build-up of the overall capital structure proves to be unsustainable because it fails to satisfy people’s time preferences. The build up of the capital structure supporting the areas of production stimulated by consumer loans (housing, autos, etc.) is part and parcel of the overall lengthening of the capital structure.

[william.hardwick]

So, let me see if I understand this correctly in the case of the housing bubble. Because of the low interest rates and irresponsible housing policy, more houses could be purchased than otherwise would have been the case absent government interference. This, in turn, resulted in more producer loans in the industry, since the increased availability of consumer loans was signaling to lenders that it was a profitable market. But, the distortions in the capital structure only came about as a result of the producer loans, and the consumer loans were simply a catalyst.

[jmherbener]

Not exactly. The argument is that banks create credit out of thin air by issuing fiduciary media. If all the created credit went to mortgages, it would push mortgage interest rates down while other interest rates would stay the same. But then banks would earn more profit from additional fiduciary media issue by lending it into other loans types of loans. So banks arbitrage the create credit across all types of loans according to people preferences (and state interventions).

If all the created credit went into mortgages, then the capital structure would not be built up. Instead it would be expanded in those parts that support housing and would be shrunk in those parts that support other consumer goods.

The primary distortion of the business cycle called “lengthening the capital structure” comes about through producer loans and present money lent directly into the capital structure. The secondary distortion of the business cycle occurs in shifting production toward certain consumer goods bought on credit and away from other consumer goods. These two distortions are intertwined during the business cycle.

Because the effects in these consumer goods industries are secondary, the government’s efforts to boost their demand to boom time levels, even if it could be done, will not restore the economy to normalcy.

[william.hardwick]

I think I am understanding what you are saying, but I can’t seem to put it into context with the housing bubble and financial crisis.

In your opinion, what was the primary driver behind the financial crisis and how did it relate to the housing bubble? From my interpretation of what you are saying, it seems that the entire economy was distorted by the low interest rates as the capital structure was lengthened in many industries where it was not sustainable, but that doesn’t explain why housing was such a big part of the overall picture.

[jmherbener]

What industries are most affected vary from one cycle to the next. It depends on historical factors contingent to each cycle. It was radio in the 1920s, computers in the 1960s, dot.coms in the 1990s, housing in the 2000s. Historical work gives an account of the contingent factors.

Take a look at Tom Woods’s book, Meltdown.

The primary cause of business cycles is monetary inflation and credit expansion generated by a government supported money and banking system characterized by central banks and fractional-reserve commercial banks. Yes, the entire capital structure is distorted by monetary inflation and credit expansion. At the height of the bust, 15 million people were unemployed. the majority of them did not have jobs building houses before the bust. BLS data show that employment in construction and extraction occupations was around 5% of all employment in the U.S. in 2011.

http://www.bls.gov/cps/cpsaat09.pdf

Census Bureau data show that new single family house construction is only around 1/5 of total construction spending in the economy and total construction is a small part of overall production.

https://www.census.gov/construction/c30/pdf/privsahist.pdf

Housing construction is a small fraction of all production in the economy. Housing was a conspicuous, but not major, part of the recent boom-bust. In every cycle, the press draws our attention to a signature industry. By doing so, it draws our attention away from the more important aspects of the cycle.

[william.hardwick]

I remember reading in Prices and Production (by Hayek) that the capital structure is lengthened when the interest rate is held below the natural rate, and the natural rate tends towards the rate of profit. It seems to me that the industries that will have their capital structure most over-expanded during a boom are the industries with the highest rates of profit. Due to housing policy and lower lending standards, my assumption is that this was the case with the housing industry.

What I’m trying to better understand is, why were people like Peter Schiff able to predict the crash based mostly on developments in the housing market.

[jmherbener]

They used the housing market to identify the trigger setting off the financial crisis. This made sense in the recent boom-bust because the government’s fostering of mortgage backed securities channeled the credit expansion into housing. When the MBS market reached a peak it was an accurate indication of the unraveling of the entire financial boom.

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