Remember the Fable of the Banana Subsidy? Government subsidizes bananas. People buy a ton of bananas and store them on their roofs. The bananas weigh so much that their roofs collapse. Then people say, "It's the government's fault!" - which is true in a sense, but also misleading.What charitable interpretations of this story are out there? I can think of a few:
I see the same ambiguity in a Forbes interview with fellow GMU prof Todd Zywicki...
If you pay attention, you'll notice that Todd's making a Banana Subsidy argument. The government cut interest rates, and then... banks started offering loans to people who wouldn't be able to pay them back - and borrowers accepted.
Maybe Todd's story is right. If he is, the Fed made a terrible mistake. Unfortunately, for Todd's story to work, we also have to admit that business and consumers are so clueless that they're habitually on the edge of disaster.
- If low interest rates are liable to undergo a sudden runup, previously economical investments may go bad. But this raises a question: if a sudden increase in short term interest rates is so likely, why isn't it priced into long term interest rates at the beginning? For this explanation to work, the change has to be in large part unexpected, or at least uncertain. As an example, even if all investors admit that a reversal of the current global "savings glut" will take place sometime in the next 50 years, the exact time is unknown, and anticipation of this change plays only a small role in current interest rates, despite the fact that it may cause serious dislocations whenever it happens. (I'm not sure I believe this story, but it's at least vaguely plausible. I should repeat, however, that it has very little to do with what happened in our current financial crisis.)
- Downward movement in the real interest rate allows new classes of consumers to borrow economically, for new purposes (i.e. housing). Since these marginal consumers have little established borrowing history, it is difficult to evaluate their risk. Still, even if lenders appropriately internalize this uncertainty, they may think that it is profitable to engage a new base of consumers. The financial troubles come when they are wrong in the aggregate. (Their errors can be highly correlated.)
- Elaborating on #2, as a decline in real interest rates makes homebuying at high prices more economical for a new set of consumers, housing prices are driven up. This process does not happen overnight, however, and limited knowledge about the new consumer base means that no one knows when it will stop. Prices rise in anticipation of future increases. Misreading speculative runups in price as further evidence of strong fundamentals, investors continue to pour money into the market until the ultimate crash. This is a classic bubble. (The extent to which it can be a rational phenomenon, however, is severely limited.)
Possibility #1 suggests that low interest rates themselves can be risky, assuming they're based on an unstable financial arrangements. Possibility #2 explains how low interest rates can lead to a higher chance of massive risk mispricing, and possibility #3 helps to explain how they can trigger a "bubble." Note, however, that all these explanations depend on more than low interest rates. The real problem is the change in interest rates, which acts as a threat in case #1 and as a trigger for mispricing in #2 and #3.
Needless to say, it's important to know whether low interest rates themselves lead to asset bubbles and instability, or whether rapid changes in interest rates are to blame. The policy implications are very different, and I want to hear better explanations from neo-Austrians who blame the Fed for private banks' massive failure to price risk.