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Re-thinking the “Dual Mandate”

In 1977, Congress amended the Federal Reserve Act, instituting a policy guide commonly referred to as the “dual mandate.”[i] The “dual mandate” is typically conceived as a “balancing act” in which the Fed must employ the lever of monetary policy[ii] (primarily, interest rate manipulation through Open Market Operations) to achieve a balance between two seemingly dichotomous objectives: “maximum employment” and “price stability.”   Debate over Fed policy is typically framed as being between “Doves” who prioritize lower rates in order to achieve “maximum employment” and “Hawks” who prioritize “price stability” (presently defined by the Fed as 2% CPI).[iii]  In addition to being as unnatural and intellectually limiting as the linear “blue / red” political spectrum, the “employment / price stability” spectrum assumes, and reinforces, a Keynesian paradigm that does not reflect, and causes significant damage to, the real economy.

“Maximum Employment” versus “Sustainable Employment”

The notion of “maximum employment” as a policy goal has its roots in Keynes’ “General Theory of Employment, Interest and Money,” which, like Marx’s writings, posits that the function of the economy itself is not to allocate scarce resources according to consumer preference, but to ensure that everyone has something to do all day[iv] and is paid for it (even if this requires an overriding of consumer preference and/or misallocation or even destruction of resources).     Even if one accepts this value judgment, the notion that low rates actually do promote employment relies upon the Keynesian construction of the economy as an aggregate of investment plus spending plus government deficit spending plus net exports, and in which, generally, maximizing this aggregate maximizes employment (in the circular flow of funds model, one person’s spending being another’s income).   This construction, and the policy prescriptions upon which it is based, fail to consider the cross-purposes among these aggregates (i.e., the purpose of investment is to increase capacity to produce for future consumption). As such, efforts, informed by this misconstruction, to manipulate interest rates to turbo-charge both aggregate investment and consumer spending at a given point-in-time, can do so only by fostering longer-term instability in the aggregate measures, and employment, incomes and prices, in the form of the boom-bust cycle.

According to loan-able funds theory,[v] there is a natural rate of interest that serves as the price signal coordinating saving and investment activity – simply put, when society as a whole reduces its level of present consumption, it increases savings, in order to boost or maintain consumption levels in the future.   That increase in savings reduces the immediate consumer spending level, but also reduces firms’ cost of capital, which enables and induces an increase in investment in the capacity to meet that future level of consumption.   As Hayek pointed out, this is not a reduction of total demand (or employment), but merely a shift in time preference, and a reallocation toward the capital sector and away from consumer goods and services; it does not reduce employment but rather shifts it across sectors.

Keynesian macro policy does not eliminate this loan-able funds market, but simply attempts – in vain – to override it.   Artificially low interest rates are merely a distorted price signal that may (and in fact, is designed to) succeed in inducing an increase in consumer spending and decrease in savings, while also inducing an increase, through reduced apparent cost of capital, in capital investment.    In the short run, Keynesians may thus achieve their policy objective of boosting two of their aggregates (consumer spending and investment), but the gains are not sustainable, because the investment is based on an assumed future level and composition of increased future consumption that cannot happen, precisely because real savings have declined.   Often, even the present level of consumption is not sustainable because it too is financed by credit. Thus, while for a few months’ or years’ time, the Fed can, through sending a distorted price signal into the loan-able funds market, induce behavior that gives more people something to do all day, those actions, which would naturally be interconnected, become, by virtue of the same low rates, disconnected, and the boost in their aggregate level is unsustainable – an equally offsetting bust must occur.  The something is not actually in demand, thus will not be sustained.

Keynesians’ prescriptions for this dilemma basically amount to an attempt to re-inflate the bubble, which does nothing to solve the coordination problem. Even if it were possible, without a run-up in consumer and producer prices, to continue to inject fiat credit, at ever increasing levels, into the system, thereby bolstering aggregate spending and investment, the price signal would still be drowned out by the ever increasing level of static, and there would be nothing to coordinate production and consumption across time – eventually, the junk pile of mal-investments and resulting business failures would become so large that Keynesians, refusing to abandon their construct, would blame “catastrophic market failure” and demand government coordination of both spending and investment (e.g., massive public works projects and some mechanism to force consumers to buy what the government forced the economy to produce), thereby legislating the disconnect out of existence.   Even if that could be sustained, the result would be something along the lines of eight or nine bridges across the same river, and it is not clear what the ensuing prescription would be then (though politically, at this point, the disconnect between the supposedly equally “blue” concepts of the Keynesian paradigm and conservation of natural resources would likely become apparent).

There is a much better and more logical construction than overriding the loan-able funds market – and that is letting the loan-able funds market work. Implicit in a long-run goal of maximum employment ought to be maximum sustainable employment. If, for example, the target class to benefit from Fed policy is blue collar workers, policy-makers would do well to consider the effect of the boom-bust cycle on the financial position of members of the this class, many of whom occupy positions in sectors that are far more “cyclical” than need be (e.g., low-to-moderately educated men who took construction jobs in the early 2000s, invested five years in a skill-set the demand for which was inflated by virtue of the Fed’s low rates, started families and took on mortgages based on their income levels in 2003-2005, only to be laid off in 2008, five years older, still in debt, with new families to feed and looking in vain online for construction jobs in between articles about tens of thousands of computer-related jobs that firms are unable to fill, but not financially in a position to take two years off and get an Associates’ degree in a computer-related field, or to take an entry-level computer-related position paying less than what home construction jobs paid back in 2005).

“Price Stability” versus “Price Reality”

The second mandate is “price stability.”   This sounds innocuous, and is often presented as the “Hawkish” side of the supposed dichotomy.   However, it too is based on a misconstruction of the economy.

Most people generally equate the term “inflation” with rising prices and equate the term “deflation” with falling prices, whether the shift is natural or not; some equate the term “inflation” with monetary expansion and the term “deflation” with monetary contraction.   There is a subtle yet important distinction. “Price stability” sounds like monetary stability, but it is not.   With a stable money supply, natural prices can fluctuate – prices are, after all, merely signals that transmit information to the market and thereby coordinate supply and demand.   Rising prices, for example, can indicate a reduction in resources, thus inducing conservation.   Similarly, falling prices can result from some technological (e.g., rail, automobile, internet, fracking) or political (e.g., end of the Cold War, GATT/NAFTA, trade liberalization in China) development, and thus signal a release of pent-up resources.   Such price shifts can be sector-specific, or could affect price levels generally. In either case, the use of monetary policy to attempt to override a naturally occurring price shift also, necessarily, negates the signal that this shift would send to the market, thus prevents market participants from understanding and reacting to the true situation.

At present, the natural price shift feared by interventionists is “deflation” or “excessively low inflation.”[vi]   Leaving aside the assumptions that go into a contrived measurement of the general price level, the fear of naturally falling prices is itself misguided.

The genesis of this fear is itself suspect, as examples of even a correlation between poor economic conditions and falling price levels are few and far between. In general, the tendency of a healthy market economy is for prices to fall with increases in productivity.   This was the case in the US for much of the 1800s, during which the economy produced its fastest rate of growth and most dramatic improvement in general living standards, including real wages (as nominal wages sometimes fell, prices fell faster).

The Great Depression, which was caused and prolonged by several factors none of which was a decline in prices, is nonetheless typically cited as the key (in fact, the only US) example of a period in which prices fell and, simultaneously, the economy performed poorly. This extremely loose[vii] correlation is relied upon to support the idea that “deflation” – defined as a general reduction in consumer spending and fall in the general price level – can cause a “vicious spiral” by discouraging or inhibiting capital investment, allegedly leading to mass layoffs, leading in turn to a further reduction in consumer spending, and so on.[viii]

The notion that falling prices would reduce capital investment relies upon two assumptions.   Exposing either assumption as a fallacy would disprove the purported causal connection between falling prices and investment, thus disproving the “vicious deflationary spiral” concept. Below, we expose both assumptions, and thus the “vicious deflationary spiral,” as fallacies.

The first assumption is that falling prices equate to falling profits.  There is simply no basis for this assumption. Business costs are prices, and a reduction in both revenues and costs would have no net effect on profit. Some input prices are “stickier” than others, but an inability to pass price shifts (in either direction) along would affect profit allocation along the supply chain rather than aggregate profit levels: one firm’s loss is its landlord’s or supplier’s or customer’s (typically temporary) gain, thus aggregate profits across the value-add chain would not, all other things being equal, grow or shrink with a shift in the general price level.   At worst, if wages were, as is often alleged, the “stickiest” price, business profits could, at least in the short term, shrink, primarily in the service sectors, but real wages would (as they did in the 1800s) rise, thus boosting both spending and saving (thus increasing the supply of loan-able funds), stopping any “spiral” in its tracks.

The second assumption is that, even if falling prices did cause investors to expect a decline in nominal profit, this would discourage or inhibit capital investment.   This too is a fallacy in that it is based upon the notion that businesses invest in order to maximize nominal rate of return on capital. Businesses do no such thing.   As any first year Corporate Finance text explains (typically in Chapter 1), firms and investors invest based on a comparison between the internal rate of return on capital and the weighted average cost of capital (IRR versus WACC).[ix]   If the decline in prices were to result from or coincide with a decline in spending, this would necessarily correspond to an increase in savings, which would increase the supply, thus reduce the price, of investable funds. Thus, all other things being equal, even if a firm’s IRR were to fall, so too would its WACC.   All other things being equal, then, falling prices do not reduce capital investment.

Thus, in those few cases in which a recession features a decline in investment, the decline must be a function of all other things not  being equal. For example, the investment decline could be a function of below-hurdle IRR driven by some other input to capital budgeting models, such as a higher beta applied to a historically volatile cost of equity, or perhaps firms’ mistrust of the model itself, both of which might be expected following a series of credit-expansion-driven mal-investments.   The decline could also be a function of further government intervention, such as a tariff or tax hike, or crowding out of the capital markets through an increase in sovereign borrowing.

It could also be that the natural rate of interest is – as a result of prior, debt-financed, mal-investments brought about by prior interest rate manipulation – higher than the artificial, manipulated interest rate now targeted by the Fed.   If this is the case, then the market-directed higher rate of interest would, if allowed to manifest itself, encourage an increase in savings (and debt repayment), which would replenish the supply of real capital to lend and invest, eventually bringing the interest rate, and WACC, back down (and bringing the future capacity to consume back up).   Thus, the true dichotomy is, as with the employment mandate, between the medicine and the natural cure.

We have now shown that central bank efforts to override the market signal over the short term, allegedly to maximize employment and stabilize prices, will actually have the opposite effect of preventing the market from achieving either of these objectives on its own. We would be better served with a “dual mandate” of “maximum sustainable employment” and “price reality,” both of which the Fed would best pursue by abandoning Open Market Operations altogether, and allowing interest rates to be set by the market, as a function of the supply of and demand for savings.

[i] Source: Federal Reserve Bank of Chicago web site:

[ii] Federal Reserve Board web site:

[iii] Source: Federal Reserve Board.

[iv] Here there is a distinction, though unimportant to the fallacies underpinning the “dual mandate,” between Keynes and Marx, in that Marx would also include a requirement that the activity be meaningful in some way, while Keynes was generally happy enough to pay people to dig ditches and fill them up again, as it would provide them with incomes, the expenditure of which would serve in turn as someone else’s income, and so on.

[v] Originally advanced by Wicksell.

[vi] Source: New York Times editorial.

[vii] See “Deflating the Deflation Myth,” Mises Daily, April 2, 2014:

[viii] See “Deflation” definition on Investopedia web site: See also: “Why is Deflation Bad?” New York Times, August 2, 2010.

[ix] Any first-year Corporate Finance textbook explains the basic concepts of capital budgeting.   There are other approaches to capital budgeting but these reflect different ways of viewing the same equation – for example net present value of future cash flows using WACC as the discount rate.


Austrian Business Cycle Theory, Interest Rates and Housing – the Mechanics of the Last Great Credit Bubble

When Ludwig von Mises’ treatise, “Human Action,” was published in 1949, Austrian Business Cycle Theory (“ABCT”) was focused on the supply-side (credit expansion distorting inputs to what the corporate finance sector would later quantify and label “WACC vs. IRR”).   This was because the supply side – primarily, commercial lending and investment – was the primary channel through which central bank credit expansion flowed into the economy.   Subsequent innovation in consumer credit has made ABCT more, not less, relevant, as interest rate fluctuations now both reduce apparent WACC and boost baseline sales (and, with baseline sales, projected IRR).  The 2000s housing bubble is a recent example. As the below timeline illustrates, central bank credit expansion distorted the signals relied upon on both the supply and demand side, by lenders, investors, home-buyers, homeowners, builders and workers alike. This enabled and induced a series of mal-investments that often compounded each other,[i] causing the biggest boom-bust cycle of all time, the effects of which still dominate the financial world, and are still felt by tens of millions of people.

In Q101, Alice and Alan buy a home.   A&A receive the median household income of $42,228.[ii]   Applying a 33% payment-to-income ratio, A&A can afford payments of $1,173. FRM and ARM rates are equivalent,[iii] and like 90% of borrowers, A&A opt for an FRM.   At 7%, A&A qualify for a loan of $176K. With 80% financing, their price point is $221K.

In Q203, Brenda and Ben buy a home. B&B receive the median household income of $43,318 – 2½% more than A&A’s income in 2001.[iv] Applying a 33% payment-to-income ratio, B&B can afford payments of $1,203 – only a $30 increase.   But ARM rates have dropped 300-350 bps, despite a falling savings rate.[v] This has happened because the Federal Reserve has, through Open Market Operations, purchased, with fiat credit, securities on the open market, in order to implement its target overnight rate of 1%, a 425 bps drop.[vi] At an ARM rate of 3¾%,[vii] B&B qualify for a loan of $260K, translating into a price point, with 80% financing, of $324K. This is 46% higher than A&A’s price point just 9 quarters earlier.   Borrowers take out ARMs in much greater numbers,[viii] and home prices, predictably, are bid up at the fastest rate in a generation.[ix] 

With no prepayment penalty in the US, existing homeowners can refinance at the new rates and values.   15 million households refinance in 2003, versus 2.5 million in 2000.[x] Refinancing enables existing homeowners to reduce monthly payments or take cash out, at up to 80% loan-to-value, with “value” determined based on the price that B&B paid for a “comparable” home within the preceding twelve months.[xi] There is no limit to the number of times that one purchase can serve as the “comp” to support the valuation for a refinance, and there is a refinance “boom-let” whenever rates plunge. In 2002-2003, hundreds of millions of dollars of paper equity is created, then monetized, then used to pay down credit cards and fund home improvements and everyday consumption.[xii] As a result, total US home mortgage debt more than doubles, with over 1/3 of new originations structured as ARMs at artificially, and then-historically, low interest rates.[xiii] By Q2 2004, prior to, and without the aid of, any large-scale shift in underwriting or lending metrics, there is already a massive bubble that must end in a future day-of-reckoning, and it is entirely the result of central bank credit expansion.[xiv]

Despite the leveraging-up, the mortgage delinquency rate plummets – having never in decades fallen below 2% for more than two consecutive quarters, it falls below 2% in Q103 and remains below 2% through Q306.[xv] This is primarily the temporary result of cash-out refis (debt proceeds servicing debt) and temporarily lower payments on ARMs. Delinquency rates, collateral value trends and debt service ratios are the fundamentals used by banks to approve credit and determine lending standards, and in 2004-5 these ratios all appear to be moving in the right direction. Banks take these ratios at face value, failing to understand how the ratios have been temporarily distorted by credit expansion.   Banks shift lending thresholds according to that misinterpretation.  Credit spreads decline and ARMs now feature rates only 100-150 bps higher than comparable-tenor Treasury rates. They make more “exotic” loans[xvi] and more loans to borrowers with low credit scores.[xvii] RMBS investors read the same ratios and make the same misinterpretation and mal-investment as the banks.  

Also responding to low rates and rising prices are homebuilders.   Most private housing developments are financed at floating, Prime-based rates with interest-carry. Builders’ cost of capital is thus directly a function of Fed policy, and it has been reduced dramatically. Builders, like banks (and many economists), misinterpret rising home prices and home improvement spending as signals of increased real demand.   Home construction and employment increase dramatically[xviii] as homebuilders’ “WACC vs IRR” inputs are distorted on both sides of the equation.   Over a million workers who might otherwise have continued their education and/or pursued other jobs not related to the artificial boom (e.g., in technology) take construction jobs that will disappear in 2008 – a personal mal-investment of time and training.[xix]   Countless others take jobs in other real estate-related fields. They make further personal decisions and obligations (marriages, children, mortgages, car loans) informed by their boom-time incomes.   For builders and construction workers, the dynamic is a textbook example of ABCT, without any new or “exotic” features to cloud the matter.

After a few years of the asset price boom, the accompanying inflation in consumer and producer prices cannot be ignored, and from mid-2004 to 2007 the Fed gradually raises rates.[xx] The rest of the story is well-known: the spiral reverses itself.   Home prices, no longer bolstered by credit expansion, stop rising. The increased pace of building produces excess supply, and now prices start to fall.  ARMs re-set, generating payment shock. Troubled borrowers cannot refinance at higher rates and are too leveraged to sell at the new, lower prices. Delinquencies spike. “Underwater” borrowers become “strategic defaulters.” Delinquencies soar. RMBSs become worthless.  Securities “derivative” of these underlying mortgages become worthless.   Trading units leveraged up by the same math as the homeowners (flat income stream covers more debt) fail as rates rise and defaults increase – (financial firms’ leverage is high, but the crash has to happen regardless of leverage, as a result of the crash in the underlying mortgage market).   Credit markets freeze. Major banks fail. Builders and other real-estate-related firms fail. Millions of workers, primarily in boom-related sectors, are laid off, and, having spent 4-5 years working construction, lack the skills needed to fill openings in sectors such as technology. In turn, many of them default on their loans, and spend less than at the peak of the boom. The same economists who saw increased real demand in 2003-4 now misread the situation as being a matter of “insufficient aggregate demand.” The financial crisis and Great Recession are the necessary outcomes of the unnecessary – and unsustainable – boom that originated in the loose central bank policies of the early 2000s.   

[i] My analysis ties the boom and bust to rate policy, not government home-ownership promotion or “Wall Street Greed,” both of which are problems worth studying in their own right, but both of which had been omnipresent for decades prior to the 2000s.

[ii] Source: US Census Bureau.

[iii] Source:

[iv] Source: US Census Bureau.

[v] Source: NPR:

[vi] Source: US Federal Reserve web site   Of note, the ECB follows a similar rate path, generating bubbles in real estate markets featuring floating or adjustable rate mortgages with long amortization periods (e.g., Spain, Ireland).

[vii] Source:

[viii] ARM market share rises dramatically, exceeding 33% for purchase mortgages, and 38% for all mortgages, by 2005. Source: NY Fed.

[ix] The median new home price rises from $175M in 2001 to $221M in 2004. The average new home price rises from $213M to $274M. Both median and average prices peak in 2007 at levels fully explained by the above-calculated increase in purchasing power.   Source: US Census Bureau web site -

[x] Source: US Department of Housing and Urban Development, Office of Policy and Research, “An Analysis of Mortgage Refinancing, 2001-2003,” November 2004.

[xi] Ibid.

[xii] Ibid.   It is worth noting that, according to circular flow theory, in which one person’s spending, even of borrowed funds, is another’s income, this should have marked the dawn of a long period of widely shared prosperity.

[xiii] US Federal Reserve web site:

[xiv] This is not to suggest that this day of reckoning, now seen in the rear view mirror as being obvious, was recognized at the time by those who had the data. See:

[xv] US Federal Reserve web site:

[xvi] Note that, for the first several years of any 30 year loan, there is minimal amortization, and that the crisis occurred only a few years after the ramp-up of “exotic” lending; thus the oft-cited interest-only and modest negative amortization provisions in many late-bubble loans, while “exotic” in form, are more of a red herring than a smoking gun, as such terms typically have a 10-15% effect on payment level, vs. a 30-60% effect from the rates. The rates were set at the central bank-manipulated index plus a standard margin. “Predatory lending,” then, primarily meant exposing borrowers to the Fed’s volatile rate policy.

[xvii] Not only were such loans made in response to a declining overall delinquency rate, they were made possible by the expansion of credit. There had never been regulatory prohibitions of loans to borrowers with low scores – the prohibitive factor had, prior to the 2000s, always been pricing, reflecting the limits to the supply of credit.   One effect of increasing the supply of something is to reduce its price, and loans to people with poor credit scores were more likely to be made, and to cash-flow, in the high single digits in the 2000s than in the double digits at which such loans would have been priced in earlier periods.

[xviii] Housing starts data 1999-2005,

[xix] The US Dept. of Labor estimates that 1.2-1.7 million construction jobs in existence in 2005 were solely the result of bubble-related demand  Source: US Bureau of Labor Statistics web site: Of note, including the further positive feedback of inflated credit fueling the temporary increase in jobs and incomes would further strengthen the argument for the housing bubble as an example of an ABCT-described credit bubble.   Note that we are referring to a growth in employment as a negative – the combination of increased household spending and boom-sector job creation are to Keynesians very real – “increased investment and spending, thus increased job creation,” thus a positive, in their circular flow diagram – to Austrians, these represent a the mirage of prosperity – an unsustainable boom or bubble, as the spending cannot be propped up forever, and the investment is made in production of something for which consumers are not in fact saving up to purchase.  This is why, after the crash, Keynesians call for a reinflation effort, to try to support demand growth to the pre-crash level that they still believe was real, while Austrians oppose such measures on the ground that the previous consumption level was not sustainable at it was achieved with borrowed funds – indeed, the housing bubble was created partially in response to the collapse of the bubble.