The big shift

The latest in California:

California Controller John Chiang, a Democrat, warned last week that the state was "less than 50 days away from a meltdown of state government."

While that's music to my ears in many ways, I wonder just how culpable California is in all this. Or for that matter the auto industry, the financial industry, and the housing industry. What if they are all ultimately caused by a fundamental shift in consumer preferences, i.e. a real business cycle? I think we are all aware of the shift in living patterns that has occured over the last decade or two. Sometime in the mid to late 1990s, the seemingly inexorable pattern of rich folks leaving the city for the suburbs started to reverse.

Understandably, this was not widely predicted, indeed it appears unprecendented at least in the US and Brittain. The car companies, domestic and foreign, lost this bet. Suburban homeowners and the suburban housing industry lost this bet. The financial industry, by facilitating these bets, also lost. States with a disproportionate share of suburban development, i.e. the sun belt states, lost this bet. Ultimately, this may the explain the downfall of the US as a car centric economy. Although non-car centric Europe has suffered just as much in the initial crash and aftermath, it remains to be seen who will emerge stronger.

Addendum: Offsetting this trend to some extent is politics. Many southern states, particularly Texas, are growing despite their car-centric infrastucture, because they have lower taxes and regulation.

Bubbles and banks, the never ending story

Tyler has a new paper in which he deflects blame for the financial crisis away from central banks and towards behavioral biases such as herd behavior and over confidence. See my comments there, but basically I'm wondering why we can't blame both. My dissertation is about trying to sort out the relationship between these factors. I intend to test in the lab and with simulations the idea that free banking better mitigates bubbles, including those arising initially from behavioral biases (what other kind is there?).

Vernon Smith explains Austrian Business Cycle Theory, without using the word Austrian

Don't know how I missed his article in the WSJ two weeks ago, but as always it's right on the money, so to speak:

Monetary policy, mortgage finance, relaxed lending standards, and tax-free capital gains provided astonishing economic stimulus: Mortgage loan originations increased an average of 56% per year for three years -- from $1.05 trillion in 2000 to $3.95 trillion in 2003!

By the time the Federal Reserve began to slowly raise the fed-funds rate in May 2004, the Case-Shiller 20-city composite index had increased 15.4% during the previous 12 months. Yet the housing portion of the CPI for those same 12 months rose only 2.4%.

How could this happen? In 1983, the Bureau of Labor Statistics began to use rental equivalence for homeowner-occupied units instead of direct home-ownership costs. Between 1983 and 1996, the price-to-rental ratio increased from 19.0 to 20.2, so the change had little effect on measured inflation: The CPI underestimated inflation by about 0.1 percentage point per year during this period. Between 1999 and 2006, the price-to-rent ratio shot up from 20.8 to 32.3.

The graphs comparing the last three real estate bubbles and the fed funds rate are compelling evidence that the Fed cannot escape blame.  

While I've always been a little skeptical of Austrian Business Cycle Theory, i.e. bubbles are created by the Fed's easy money policies, I've never been able to make much sense of the critiques.  Tullock, Cowen, and Krugman start and end with, what to me are absurd, neo-classical rationalist assumptions, namely that a) investors but not consumers are effected by interest rates, b) these two types are easily distinguished and do not effect each other, and c) investors are but a small minority of the economy.  They believe too much in the models.  Here's Tullock:

The end result of all of this is that we would anticipate that in an Austrian-style depression, there would be a good deal of unemployment in the capital goods industries, but this is, after all, a small part of the total industrial picture. Of course, such industries would not be able to buy as much in the way of consumer goods as they would otherwise, and this would add to the fall in prices which would have to be absorbed by other industries. Indeed, it would increase the bankruptcy rate. Because of the size of the capital goods industries compared to the rest of the economy, however, the forcing down of prices in other industries made necessary by this unemployment would once again cause bankruptcies but not unemployment. 

You're telling me the capital goods industries do not to some significant degree include or effect home owners or stock owners, or that either group constitutes a minority in the US?

Here is additional support for the Austrians.