 The title of my lecture this afternoon is Errors, Business, Cycles, and Government Stimulus. So I'm going to start off as any good Austrian economist does by looking at the data. As we know, our science should be data-driven and all of the... It's not a good joke. Okay, stop there. All right, so I actually want to look at a little bit of data because I think it will help highlight really the central point that I want to make here at the very beginning. All right, so here we have... This is the data on home prices as measured by the Case Schiller 20-City Composite Home Price Index. It gives us a rough idea of what home prices do over time. And we can see very clearly what we would call the housing bubble happening from about 2000 to right around 2006, 2007, being the peak where things slowed down and stopped. And then, as we all know, things collapsed shortly thereafter. So there's the data, and now here is my rendering of it, which is remarkably close to the real thing, which is shocking given my own artistic abilities. But what I want to point out is that point right there at this peak right around 2006. Because I think one of the great dangers whenever we start looking at the data is to forget what's actually happening. This is something where I think we as Austrians have an advantage and that we know the data isn't just data. What we're talking about here are house prices. And what is a house price? Well, it's an exchange ratio between a sum of money that people are willing to pay to buy a house and the house that people are willing to sell or what they're willing to accept in order to sell that house. So what is actually happening up here at the peak is not just that some data series reached a maximum, it's that there are actual people that have decided they're willing to pay these very high prices for houses. And there are people that are willing to sell to them, but there are people that are willing to pay very high prices for houses just before housing prices collapse. I want to suggest that this is pretty good evidence that error is a big part of business cycles. Because it's very hard for me to imagine what kind of story we could tell where these people that are paying these very high prices for houses are not, in fact, making errors. After all, okay, yes, we all have time preference. I'd rather have my house sooner rather than later. But I might be willing to wait a year to pay 20% less for the house, which we know is actually what happened over the course of this particular cycle. So if we saw this coming, if we actually knew what was coming with housing prices, odds are good we would not have paid that price for that house in 2006. I think Rothbard, I just picked up off of the table yesterday, Economic Depressions, They're Causing Cure. This also appears in a great little book, The Austrian Theory of the Trade Cycle and Other Essays. When I picked it up, it was free, so why not take another copy? So here we go. Rothbard says here on page 9 in this version says, Okay, in this case, the odd fact that needs explaining is this. How is it that periodically, in times of the onset of recessions, and especially in steep depressions, the business world suddenly experiences a massive cluster of severe losses? A moment arrives in business firms, or in this case homeowners, previously highly astute entrepreneurs in their ability to make profits and avoid losses. Suddenly and dismayingly find themselves, almost all of them, suffering severe and unaccountable losses. How come? I'm going to say here just as an English speaker, I hate the phrase how come. You can say why and it means the same thing and saves you four letters. How come? Here is a momentous fact that any theory of depressions must explain. So that's kind of our taking off point here. There's this huge cluster of errors where people are specifically paying too high a price for particular types of goods, specifically capital goods or these long range investments. As individual people, a house is probably the longest range investment that I'm going to make that's any kind of physical good. So why is it that people are overpaying for these things over the course of the business cycle? And it ends up that this idea that error is at the center of really trying to explain business cycles is nothing special to the Austrian school. You can really interpret a lot of the work of Robert Lucas, who is one of my favorite named economists. It ends up, this last name is my first name, it's great. I like to say I was named after Robert Lucas. He was named several years before I was. I don't think my parents had ever heard of him, but it's true I was named after he was named. Anyway. And one of the big points that he made in the New Classical Revolution was really pointing out that if people foresee what the results of a particular policy will be, they typically act in a way that will offset a lot of those results. Meaning, if we're going to get really these cyclical fluctuations where we have these booms followed by busts, it's really only unanticipated things happening that lead to this happening. And this has always, it ends up, been at the center of Austrian business cycle theory. All right, so then how do we think then about expectations in order to try to explain these clusters of errors? Now before I go too far, I do want to mention Dr. Holzman wrote a paper, I think it was about 15 years ago now, called Torta General Theory of Error Cycles. In this paper, he more or less says that what I'm going to be doing with the next 40 minutes is mostly nonsense. But, you know, he's not here, so I'll just kind of set him aside at the beginning and then we'll move on. But his claim, and I think it is useful to talk about it, he says that he really takes what he calls the essentialist theory of error. And what that means is that if we are approaching business cycles, as praxeologists that as we are studying human action, the application of means to attain ends, we really can't explain error because nobody sets out to make errors. Oh, I really want to be wrong about this. That's not really what we mean by error. Error is that I applied means to attain an end, but failed to attain the end that I tried to achieve. So we can't really analyze why people make errors if we're taking as given this action. It doesn't immediately follow. So what he suggests is that we should just take errors as given, we accept that they exist because foresight isn't perfect, and then we move on. He does suggest that as economists, we can identify certain institutions that are inherently erroneous, that is where the end that they are supposed to achieve cannot possibly be attained by the means that they're trying to use. He points to things like fiat money as an example of this. But then he calls the rest of us, myself, in this camp, but if I'm in a camp with Mises, I feel pretty good. He specifically points to Mises as having what he calls a consequentialist theory of error. What we're trying to do is suggest that there are conditions under which errors become more likely, and that we can understand the Austrian business cycle theory in this way, and that during the boom, we created conditions in which entrepreneurs are more likely to fall into errors that eventually get revealed, say right here in 2006, and then things end up falling apart as we realize our means are not suited to attain our ends. So with all of that set aside, let's just go ahead with the consequentialist approach. Now I first want to point out three different approaches in the mainstream to expectations and error. The first approach is the approach of perfect foresight. Perfect foresight suggests that errors simply do not exist, that people can foresee perfectly, and any choice they make, they in fact know exactly what the consequences are going to be, regardless which option they choose. Now to be fair to the mainstream, I don't know of any mainstream economist that actually suggests that this is true in any real sense, but it's the kind of thing where it's a convenient assumption to make, make some of the math easy here and there, so occasionally we do see that. So perfect foresight is one option. Another, which I think is far more common, and it's certainly one that I dealt with a lot in graduate school, is rational expectations. Rational expectations suggest that not that we know everything about the future, but that we know everything that can be known about the future, and there are, of course, there are some random things that may happen where we don't know exactly what will happen, but we can at least know what the probability distribution is. So I can say if I roll this die a million times, that on average I'm going to add everything up, divide, and get three and a half, so I understand the structure of the probability distribution, but at the same time, if you ask me to roll the dice here in Vegas one time, the odds that I'm going to lose are fairly high. Not because I don't understand the probability distribution, but because I don't know what specific draw I'm going to get on this specific roll, and that's kind of the view of rational expectations. We understand the way the economy works, we understand the probability distributions, but sometimes these unexpected things happen, and we get a bad draw, and as a result we end up with error. And there's another view, which is adaptive expectations, which I think is probably the most realistic of these three, and suggests that our expectations are formed based on what we've seen in the past. So we see past data, when we look at that past data, we develop ideas about how different things connect, and as a result we act on those expectations, which may or may not actually be right. We could actually form expectations about the future that are totally wrong, because the data can sometimes, in a sense, lie to us, or the unexpected can't happen. So these are three different ways of approaching expectations from the mainstream view. Now when we look at the Austrian literature and how do we explain error, I think there are a few different explanations out there. There's just kind of a general explanation around that just says that, well, foresight is difficult, we know this is true, there are certain things that are difficult to foresee or perhaps impossible to foresee ahead of time, and as a result we sometimes end up with people making errors, we might end up with lots of people making the same kind of errors, and we can therefore end up with business cycles. I don't think this is a very good argument, because in the end the problem with the business cycle is not just that people are making a bunch of errors, it's that people are making a bunch of the same types of errors. After all, if we're just making errors, some people are going to overvalue housing, some people are going to undervalue it. One would think that on the whole there's no particular reason to believe we'd see a housing bubble if we're just making errors, but if there's something in the economy that's leading us to systematically overvalue housing, then we might be able to get an explanation of business cycles. So we need to have some explanation why foresight is not just failing, but failing in a very specific way that we're overvaluing particular types of investments, these long-term investments, the early stages of production and the like. Another explanation comes from Walter Block, at least he's one person that I've seen suggest this, and he suggested in the Austrian theory really central to it we know is the low interest rate that comes from the Federal Reserve or the banking system introducing new money through credit markets, this process of credit expansion. That's what Block would point out, is that these low interest rates in effect act as bribes to make a specific type of error. Specifically when interest rates go down we know there are sectors that are more interest rate sensitive, especially in the early stages of production or on the consumer side, things like housing, this very long-term investment. So we're being bribed into starting those particular types of investment. And I think there is something to this argument, but I think we can go a bit further. I think there is more of an explanation. Another argument that I've seen, I'm as Carillion Dempster's argument, which if you sat in on my Game Theory lecture you already know how I feel about it. In the boom, at Carillion Dempster they try to give a game theoretic result suggesting that entrepreneurs, while it may be that all of us collectively if we all invest in the boom we create this unsustainable boom that's going to collapse. Each of us individually plays so little role and actually has a good reason to participate in the boom. So we end up with the boom anyway despite the fact that we could have prevented it in a sense if none of us had invested in the early stage of the boom leading to the overvaluation. I want to say about one of my other troubling points about this argument is I think it does fairly well explaining why somebody that's Austrian-informed might go ahead and invest in 2002. Okay, we know that this housing boom is eventually going to collapse. It's certainly true, but at the same time there is money to be made in the intervening four years. But it's very difficult using this argument alone to explain 2006. At this point now there is no longer any individual incentive if I have a good foresight about what's going to happen in the future. There's really no longer an individual incentive to go ahead and invest in this overpriced house that I know is overpriced when I know that the turnaround is coming very soon. So I think this game theoretic argument by itself isn't going to work very well. We have to have some other explanation. So my favorite explanation here. This is not original to me by any means. I first saw this argument made by Baxendale and Evans. I've also written a little bit kind of adding on to giving some credence to what they suggest. And what they say is that just like capital is heterogeneous, that it does different things, we also have heterogeneity amongst our entrepreneurs, specifically in regard to entrepreneurial quality. So it's not just that we have good entrepreneurs and bad entrepreneurs, or that we just have entrepreneurs as a kind of amorphous glob. Rather we could rank our entrepreneurs from people at the top. So I might point to somebody like Peter Schiff, who seems to be very good at having good foresight about where markets are going to hit and when. I can predict the collapse of the housing bubble with astonishing detail. So some people are very good entrepreneurs at the cream of the crop or at the top of the spectrum of entrepreneurial quality. Then there are other people, I might put myself among them, that are toward the bottom in terms of quality of entrepreneurship. That is our foresight is not very good. Now, again, this is an empirical question, so to present some data, I have one account, it was the account that I started when I started college. I put a couple thousand dollars into it, and that was 15 years ago now. I now have one dollar and 19 cents in that account. I believe when I was in college, the best predictor, a company would go bankrupt, was that I would buy it a few months ahead of time. One after another, I'd buy this company and went bankrupt. I'd buy another company, went bankrupt. But another company went bankrupt until finally I did literally only have the one dollar and 19 cents that didn't quite divide evenly into the shares I was buying. So I have that account, I keep that account to remind myself where on the spectrum I fall. How much should I consider starting a business? And I'm probably not. I just lend my money out at interest. That's something I can do. So you have this range of entrepreneurial quality. Some people are at the top, some people, me, are at the bottom. And typically what happens through the market process is we know through profit and loss are you have people like Peter Schiff, they make good investments, these investments pay a return. As a result, they acquire more capital and have a greater command over the real economy thereby. So we have the people at the top are continuously acquiring additional command over the economy. Then we have people at the bottom, like me, who invest a couple thousand dollars, managed to turn it into $1.19. And over time have less and less control over the economy as we don't have the resources to command very many resources in the economy. So typically what would happen is that we have some spectrum of people up here at the top that are the people that actually regularly earn profits and actually would convince people to give them money to invest for them and the like, they would actually attract the financial capital they need in order to have command over resources in the economy. Meanwhile, the rest of us have established track records showing that you should not, in fact, give us money to invest under any possible circumstance or lousy entrepreneurs. And as a result, people don't give us money to invest. So for the most part, what we see is good entrepreneurs are running the economy and the economy runs very well. They have good foresight. I don't have to put in an order for wedding race markers years ahead of time so they know it's coming. They saw it coming. I just walk into Staples. I pick up the wedding race markers which really meant somebody years ahead of time knew that I would need it, which is kind of crazy. But somebody did that and was very good at it and they're the people that command the economy because of the profit and loss system. So why does this go wrong in a business cycle? According to Bax and Dale and Evans, what happens is we know that we have this credit expansion and what it does, it does a couple things. One of the very important things that it does is that it increases the amount of financial capital available. Which means now it's not just the very top people that get capital. It's also a few people here below. People that could not previously get loans or what have you to make investments now find it is possible. After all, there's more money available in the banking system. We have to find more people to lend too. We've already lent all of the best investors so we've moved down the list of loans. Now I add to their argument and I suggest that what really happens as we approach the peak of the business cycle is that this gets even worse. So if you've read Peter Schiff's writings that toward the peak of the business cycle he definitely did not want to own a house. So he was shopping for some place to live. They were showing him houses and he said, no, this is crazy. I'm not buying a house. I'll in fact go across the street where I'm going to pay rent for this apartment this is actually less than my house payment would be across the street and it's a nicer place. The housing bubble was just so bad I think in California where he was living that it just made absolutely no sense to him especially knowing that things were going to collapse. So we have the Peter Schiff's of the world say this is not going to continue I need to get out. The closer we get to 2006 the more of these people try to get out. At the same time we know the Federal Reserve is continuously putting more and more money into the capital flowing in. It's going to have to go to somebody if the banks want to make any money with it. It's not just going to sit in the vault. It does now. We have enough doubt about people's abilities but at the time no we need to make sure we lend it out so it gets invested. So what happens? Well, there it is. So these people at the top at least some of them the really really good ones that Peter Schiff's drop out so they're not in the market anymore as entrepreneurs we want to continue giving loans we have to take the money that would have gone toward those people and give it to people even further down the list. So what we'll see happen then during the business cycle is a systematic decrease in the value or not value but in the quality of entrepreneurs. So normally the economy is run by people that really know how to run an economy that have good foresight can know what people want and so on and so forth but when we have this monetary expansion happening we first draw in people that have low enough quality they would not normally get funds but secondly because all the high quality people leave we draw in even more people that really make a lot of mistakes to the point where even I it ends up can get a mortgage. It's true, it's kind of crazy. Anyway, so what happens? We're drawing in a different set of entrepreneurs so the way that I would answer Rothbard's question in a sense it's not that we have all of these entrepreneurs that normally do a really good job but then suddenly become idiots because of the business cycle it's quite different. In fact what happens is we have a bunch of idiots out there that normally can't be entrepreneurs they can't get the funding for it but thanks to the monetary expansion and thanks to the fact that the good entrepreneurs are getting out now idiots can become entrepreneurs so it's not that entrepreneurs suddenly became stupid it's rather the stupid people so I suggest this may be a somewhat better explanation for why we see a lot of errors happen in this case and then add to it the low interest rate incentives we can see exactly the types of errors that are going to be made as described in Austrian business cycle theory so let's talk a little bit about the role of capital in Austrian theory in a sense repeating a lot of what Professor Garrison has already said as we know the Austrian theory of the business cycle is really all about these distortions that happen in the business cycle that happen in the capital structure we have these artificially low interest rates driving people toward investing in these long production processes in the capital goods that specifically support those processes and as we know drawing from Mises capital is not all the same capital is not this amorphous blob rather it takes the form of very specific goods as I like to say no matter how large the McDonald's is it will never be able to produce a car for you a huge deep fryer will not produce a car it's the wrong type of capital you have to have the right type of capital to produce the right thing so for producing in various industries focused on things that make sense to invest in if interest rates are low and then interest rates stop being low suddenly these investments don't look good anymore we have all these very specific capital goods that have specific uses that are no longer actually going to be useful since we don't actually want to produce the things that they are specifically designed to produce kind of the analogy that I like to make is we can imagine if the government created the subsidy system where they were subsidizing lead baseball factories giving huge amounts of money to anybody that produced lead baseballs we can imagine that as a result of this we'd have some politically minded entrepreneurs say okay I can grab some money let's start producing lead baseballs so we start building factories installing machinery all designed around melting lead and putting it into a baseball form and then we try to sell it find out nobody wants to buy it but fortunately thanks to the subsidy the government just buys it all up and we're good as soon as the subsidy stops though we know our business is in trouble in fact it's very similar here if we push down interest rates some businesses look like they make a lot of sense we start adopting these sorts of businesses we see that interest rates are going to correct okay if we're these types of people down here that see what interest rates are now but don't account for what they're going to do in the future then we start making investments in the equivalent of lead baseball factories it ends up as we know from Austrian theory interest rates can't stay low forever they eventually have to go back up when they go back up these investments just like the lead baseball factory stop making sense with the result being we have a bunch of capital that is now no longer useful it cannot be used to fulfill the desires that consumers actually have so when the collapse comes what we're really doing is revealing that these capital goods were in fact mistakes we should never have invested in these things to start with so what then happens in the crisis crisis these things get revealed we abandon the lead baseball factories and we end up if we look at the economy see lots of lead baseball factories sitting empty and everybody gets depressed and I take a drink of water to save my thirst believe it or not that also happens during booms I still drink water alright so anyway so we have all of this it looks like idle resources and start getting itches we have people that were trained to make lead baseballs now they find out they can't find a job at least not one that pays as well as their old lead baseball job we have all these factories that are designed to make lead baseballs that are sitting empty man if only there were a way if only there were something we could do and sure enough that's what people start calling for we know as soon as the recession hits where we have the crisis things start collapsing unemployment rates go up and people start saying well we have to do something which is a very interesting sentence to deconstruct what do I mean by we I don't think I've ever been part of the we that was intended in this sentence we does not mean I personally need to go out and do something about the state of the economy what it really means is that people in Washington are in the government governing authorities so say the Federal Reserve or in Congress or the President they really need to do something but we live in a democracy so we're the government well they need to do something in Washington they need to pass some kind of policy that are going to get these people re-employed okay right so and something what is the something a lot of the time we don't necessarily care as long as there's some promise that it's going to do something to create jobs as if there's a shortage of jobs anybody who wants a job by the way I have lots of work to do in my yard my garden which I've told you about before is in a horrible state at the moment it could use quite a bit of weeding I will happily pay you 15 cents an hour there's plenty of work the problem is that I'm not willing to pay something you're willing to accept so that's part of the adjustment process that has to happen if we want to convince people that they actually have to work they have to start realigning their expectations about what jobs are going to pay and specifically the jobs they're qualified to do are going to pay but we know people are hesitant to do this especially if there's some promise the government might be able to get me a job paying what I was used to so what then happens I like to look at what happened during 2008 really as kind of a model of the way the government stimulus typically will work so there's a call we have to do something we put together some kind of stimulus program and what we're really interested in is we want to create jobs that's the thing we say we're not really interested in creating jobs itself it ends up creating jobs it's fairly easy and doesn't necessarily result in a whole lot of permanent waste in the economy but I can after all say pay somebody to watch TV at home and write reviews or something like that if they were going to be unemployed anyway okay it's not really a huge waste of resources when I'm unemployed I want to watch TV anyway we're not really changing the way resources are being used but we're providing an income and that's really what people want they want an income not a job I will happily if anybody wants to relieve me of my job but still provide my income I'll happily make that step and I think most people would because leisure plus income is better than work plus income anyway what people actually want is income but we associate that with the job so okay we have to create jobs but we don't want to have these jobs like paying people to watch TV at home one that's a really difficult political sell and secondly even politicians have this sense that the economy at heart is about producing things they kind of miss that it's about producing things that people want but it's about producing things so we see even when the government is trying to have these stimulus programs to create jobs they do things that economically make more sense than they really should do if they were just trying to create more jobs, if that makes sense the story is told from Milton Friedman that he was visiting I believe it was India and he saw these people by the side of the road digging trenches as part of this work program and they were using these shovels and he said to the government official that was showing him around he said well you know you could invest in this backhoe you could dig this trench much much more quickly use a fraction of the manpower you'd need and it's actually going to be fairly cheap for you to do this so that would make sense and the official said to him oh well no this program is not about that it's about creating jobs Milton Friedman turned to him and said well then why aren't they using spoons because we even understand even a government official doesn't want to use spoons to dig the trench we need to at least have the appearance of productivity so what then can we do to make it appear productive as we are doing this stimulus one thing we could do is look around for shovel ready projects shovel ready is a great phrase shovel ready meaning that we have pretty much everything set up we've done all the steps we need to get to the point all we need is just a little bit of government money and then we can get this thing off the ground so we look for things like we say well we just came off a housing boom well that means we have lots of construction equipment sitting around what else could we do with this construction equipment we could repair roads and bridges crumbling roads and bridges being one of my favorite phrases from President Obama we need to repair our crumbling roads and bridges it ends up we already have people trained to do construction we already have all this construction equipment that was being used before it's not all necessarily good for roads and bridges but a lot of it is so we can bring that back in we have all of these empty lead baseball factories we have all of these people trained to make lead baseballs all the government needs to do is buy up a bunch of lead baseballs and we're going to end up having lots of production not necessarily production of much value but we're going to see lots of production people are doing jobs and we already have all the resources we need to make this happen so what does that suggest then if we have governments and I would suggest this is the kind of government we have that at least wants the appearance of productivity with its stimulus they're going to be very tempted to use the capital that is available and is going unused but as we know from what we just said about errors about capital the capital that's available and is unused is precisely the capital we should never have invested in in the first place so what happens then they come in with a stimulus now all these businesses that had failed or at least were on the verge of failure and that should have failed if we're going to free resources to do something that consumers actually want done get locked in those old positions because government steps in and says ok we'll pay you to keep doing what you were doing so step in we bail out the banks close or that would be disastrous bank closure it's horrible so we can't let that happen we want to make sure we save all of these jobs and banks maybe fire an executive here or there or replace them with somebody else but for the most part we want to make sure people don't leave the financial sector we don't want to lose too many jobs there we don't want people to lose their jobs in construction we don't want people to lose their jobs here there so we try to lock people in those old positions but the result is really only that we end up locking resources exactly in those places that we have now had revealed to us are erroneous that are not in fact creating much value ok so that's pretty much the point that I wanted to make if we think about it seriously and really what it means, what is the signal we're getting once things turn around what does that say about the types of stimulus that the government begins to offer us thank you very much