This week's Economist suggests that America "might need a recession" (an "intriguing but unpopular thought"), and raises two important issues. Firstly, the utterly correct Austrian position that:
Delaying the correction of past excesses by pumping in more money and encouraging more borrowing is likely to make the eventual correction more painful.
All it does is "push" the bubble to a different part of the economy, without solving the underlying problem of there being too much air. Secondly, the typical concern that:
the Fed should not cut interest rates to bail out lenders and investors, because this creates moral hazard and encourages greater risk-taking
But why does moral hazard receive such attention? Sure, low rates will make borrowers behave in a different way. But the bigger issue might well be adverse selection - low rates influencing the type of borrower that takes out loans. Standard economic theory suggests that the marginal borrower will be the most risky, and thus the most exposed to future rate rises. Loose monetary policy entices marginal borrowers into the market, generating wider fluctuations.
If the adverse selection argument is true, we’d expect the downturns in subprime lenders to become especially prevalent, and evidence from America suggests that this is happening. According to Morgan Stanley, late payments rose from 7% in 2003 to 12.6% last Autumn, and HSBC’s bad-debt costs rose by 36% to over $10billion in 2006.
I wrote that in April, in an unpublished policy paper on the current housing market.
These issues are developed in a co-authored theoretical paper, "Heterogeneous Entrepreneurs, the Monetary Footprint, and Austrian Business Cycle Theory" which will be presented at the Southern Economic Association's annual conference, in November.
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