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.
I see the same ambiguity in a Forbes interview with fellow GMU prof Todd Zywicki. Greenspan says that the Fed isn’t to blame for a housing bubble:
As Fed chairman, [Greenspan] had only lowered short-term interest rates, he argued in the Wall Street Journal,
not the long-term rates on which mortgage prices are based. “No one, to
my knowledge,” Greenspan huffed, “employs overnight interest
rates–such as the Fed Funds rate–to determine the capitalization rate
of real estate.”
So far, Greenspan sounds like he’s just echoing the arguments of critics of Austrian Business Cycle Theory – such as myself. But here’s Zywicki’s reply to Greenspan:
“What Greenspan overlooks,” Zywicki says, “are adjustable-rate
mortgages. ARMs are really sensitive to shorter-term interest rates.”“Look
at the data going back to nineteen-eighties,” Zywicki continues. “When
the spread between regular mortgages and ARMs is less than about 150
basis points, people tend to take out regular mortgages. But when that
spread widens, they switch to ARMs.“What Greenspan did was artificially drive down the prices of ARMs,
widening the spread. Low interest rates on ARMs enabled ordinary
Americans to get bigger mortgages than they would otherwise have
believed they could afford. That pushed up home prices. And that created the updraft that brought in speculators.”
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.
My preferred story, in contrast, is just that once in a century, we get a once-in-a-century economic disaster. These disasters are hard for anyone to foresee, no matter how smart he is. The trick is just to keep the rarity of such disasters in perspective, stay calm, and let things get back to normal.
Sigh.
READER COMMENTS
Freedom Thinker
Apr 10 2009 at 1:21pm
And let a good crisis go to waste? Are you mad? It’s hard to let it go on by when politicians are jumping up and down saying the sky is falling, the media is in tow screaming the sky is falling, and therefore your neighbor is screaming the sky is falling.
Watch Master and Commander, that is what I thought leadership was supposed to be, calm in the storm, calm in the face fire, but alas I guess I was wrong. Never let a good crisis go to waste.
Steve Miller
Apr 10 2009 at 1:30pm
The situation right now is that people are blaming the greedy banana sellers, the roofers, and the government for failing to adequately regulate the banana and roof industries.
What’s wrong with Zywicki pointing out that people’s behavior, idiotic or not, was an unintended consequence of the banana subsidy?
Greg
Apr 10 2009 at 1:34pm
So you’re saying it’s basically a market failure, like Tyler Cowen did with the banana fable? Doesn’t that mean that we should consider government intervention to prevent or address the market failure? I’m not saying regulation is the answer, given public choice issues, but it should be in the consideration set. The question is whether the cure is worse than the market failure, or vice versa.
I also think there are limits to the banana analogy. What if the government subsidized dogs? Some percentage of dogs bite people. In that scenario, the government bears some responsibility for the increase in dog bites because that’s a foreseeable externality of having more dogs. The problem with the banana story is that no one really stores bananas on their roofs. If it were customary to do so, then the government would have to take some blame for banana roof collapses. Are you arguing that the mortgage connection is as implausible as banana roofs? That strikes me as hard to accept.
Overall, I’m a little confused. You’re saying Greenspan wasn’t at fault for the mortgage bubble, but that the stimulus is a bad idea. I get the latter point on the basis of macroeconomics. However, if you’re speaking from a public choice perspective, this seems contradictory. Either they’re both bad, or both ok. How do you reconcile that?
English Professor
Apr 10 2009 at 1:38pm
I think Robert Barro says that crises like this one come, on average, twice a century, not once.
dWj
Apr 10 2009 at 1:47pm
I live in an apartment building. I’ve bought a couple extra bananas, but nothing out of line, but my neighbors are piling bananas on the roof like mad.
The Snob
Apr 10 2009 at 2:17pm
Amazing, lower the price of ARMs relative to fixed mortgages, and people buy more of them?
There was a post last week or so comparing the dot-com bust which had a notional loss of $10T to this one, which seems to have done far more real-world damage despite being notionally much smaller in scale ($3T). It does raise the question of whether debt/leverage bubbles should be taken much more seriously.
Caliban Darklock
Apr 10 2009 at 2:33pm
I chose not to buy bananas and store them on my roof, but to rent bananas from someone storing them on his own roof. I get just as many bananas, but when the roof collapses, I don’t have to pay for it. Indeed, it’s the owner’s problem how to keep supplying me with bananas per our contract.
Wm Tanksley
Apr 10 2009 at 4:42pm
I don’t see that at all. Specifically, you seem to attribute any incapability to perform a task to being “so clueless”, and I believe that there are many other possible sources. My preferred explanation is that large-scale economics is extremely complex, and prone to failure modes brought about by common human failures.
This does mean that failures are darn near inevitable, so in that point I largely agree with you.
Tom
Apr 10 2009 at 5:52pm
Instead of subsidizing bananas, supposed the government fixes the price of bananas below the market price of bananas. This is more like what the Federal Reserve does. The Fed fixes the Federal fund rate below what the rate of interest would be if it were market based.
With a below market price of bananas, the quantity of bananas demanded would exceed the quantity of bananas supplied. At this point Bryan Caplan and Tyler Cowen would say, “Look! People are clueless fools. They are buying more bananas than the market is willing to supply at that price. The government is not to blame. People are habitually buying too many bananas causing the banana market to careen to the edge of disaster. It happens every time. The government sets the price below the market price and guess what, people buy too much of the good resulting in a shortage. Why don’t people and business ever learn in this story? This must be a flaw in the argument of price fixing, because people and businesses would surely learn to not purchase too many bananas.”
If the government set the price of something lower than the market price, is the proper response to absolve the government of responsibility and blame the consumer for not having self control to buy only that quantity of bananas that supplier are willing to supply? But that is what is going on here with the Fed. The Federal Reserve sets the short-term interest rate too low and it signals to demanders of savings that there is more actual savings in the economy than there actually is being supplied. That is, the quantity demanded of actual savings exceeded that quantity supplied. Unlike bananas, however, the Federal Reserve can create credit out of thin air, so the effect of a shortage of actual savings is harder to understand than is a shortage of bananas.
The next step in Tyler’s banana subsidy story makes no economic sense at all. Why the hell are people storing bananas on their roof? There is no economic logic behind this at all. When the government set the price of gasoline below the market price, which caused the gasoline lines during the Carter administration, who was buying gasoline to store on their roof? The part of roof caving in is complete non-sense and has no economic reasoning.
Troy Camplin
Apr 10 2009 at 6:42pm
Grr. I sent essentially this idea to the Wall Street Journal. I think Greenspan’s manipulation of interest rates is exactly what caused the housing bubble.
Steve Sailer
Apr 10 2009 at 7:41pm
Of course individuals and businesses were clueless about the ability of marginal homebuyers in California, Arizona, Nevada and Florida to pay off their huge new mortgages or to find greater fools willing to pay even more to move into their rapidly Hispanicizing states.
Not being clueless is racist!
Joe
Apr 10 2009 at 9:30pm
Steve,
I thought we had put the minority loan story to bed?
Adam Ruth
Apr 10 2009 at 11:31pm
I think it is this combined with the tax incentives for mortgage interest. Without that second factor, the bubble could have been anywhere else or spread around more.
baconbacon
Apr 10 2009 at 11:37pm
At the heart of the ABCT is the concept of mis allocated resources which sets up a scenario where there are few, if any, good choices to be made. Taking the bananas as an example: The government subsidizes bananas- so you have a choice either grow bananas and collect or pay for others to grow bananas through taxes. Easy choice so many people grow bananas, they grow more than anyone wants to eat- so what do they do with them? If they put them on their roofs and they collapse you laugh at them- what idiot puts a thousand pounds of bananas on their roof? Why not let them rot in the field? Then you blame the ‘market’ when the rat population explodes and disease runs rampant, but what is implicit when you say these things is that there is some apparently unspoken way in which all these banks could have made good decisions and avoided this whole mess. Looking at the entire economy how could the majority of banks avoided making these loans? The fed lowers interest rates to record lows which drives the costs of buying a home down so everyone buys and refinances. Great for the banks right? They expand, hire more workers to carry the volume, but its a one time thing. There is no systemic growth so now the banks have fewer prime borrowers left but they still have to cover the costs of their employees, depositors and inflation or their investors dry up, the cost of borrowing goes up and they lose even more money. The industry has no good choices as a whole, if yo can describe how a majority of banks could make good decisions under the policies of the fed without losing money and without creating a huge incentive for a couple of them to jump in and reap the rewards of monopoly pricing then you have an argument for not putting bananas on your roof. If the alternatives are no good either then the only conclusion can be that you need to stop subsidizing bananas.
j
Apr 11 2009 at 3:40am
Bananas is a bad example. Bananas cannot be stored on the roof, they rot. Bananas are stored in refrigerated rooms with little oxygen, which is expensive. Governments do not subsidize but tax bananas. People are not totally stupid, when it is raining, they tend to move under the roof. Your model presumes that they stay out under rain (maybe moving up more bananas to the roof).
Carl Jakobsson
Apr 11 2009 at 11:19am
The Fable of the Banana Subsidy is (intentionally?) misleading; it argues that austrians believe investors are extremely stupid, while they only believe investors are moderately stupid. A better analogy would be:
Government starts to (or raises) subsidies for bananas. Investors buy more banana-plants and those industries buy more capital goods. After a few years the goverment stops giving away subsidies, because voter support for it has decreased. As a result, the banana industry suffers a downturn.
Now, it doesn’t seem misleading to call this banana-bubble a govermental failure.
Sheldon Richman
Apr 13 2009 at 9:57am
Bryan, aren’t you leaving all the moral-hazard devices out of the story? The local banks were protected. Fannie and Freddie were protected. The big banks had reason to think they were protected. FDIC put depositors to sleep. Marginal borrowers figured they could refinance. The once-in-a-century argument isn’t an argument at all.
Vangel
Apr 13 2009 at 9:15pm
Sorry Bryan but your subsidy argument is not entirely sound. Whether we like it or not real human beings are not always blessed with good judgement and will respond to artificial signals sent by the manipulators of the marketplace if the manipulation lasts long enough.
The same is actually true of institutions run by intelligent men and women due to structural factors. For example, CEOs of banks that saw the Fed’s actions for what they were and avoided taking large risks wound up with poor performances in comparison to their peers. For their effort they either lost their jobs or saw their companies got taken out by competitors who could use higher valued shares.
The real world is full of men and women who did what they should instead of what they must. Most of them are not praised for their great judgement but are seen as losers who just didn’t have what it took and lost their positions to those that did. You might think of that the next time you discuss the Banana Subsidy.
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