Karl Case on Real Estate (and Banking)

On 3/31/09, me and a few dozen of my economics professor colleagues tuned in to a webcast by Karl Case, co-creator of the Case-Shiller Home Price Index. He told an interesting story of how the housing market came to be constructed, how home prices became collateral for all kinds of other assets, and how the smartest statisticians on earth could have been wrong about default rates on subprime mortgages, since they were deceived by a 30-year long real estate boom. I liked his story of the real estate bubble, though I think he missed the primary cause, the only logical reason why housing could become hideously overvalued: money creation.

I questioned him on the connection between fractional reserve banking and the housing bubble. His response showed how little he had thought about banking. "There's no need to destroy the entire credit system and bring lending to a halt," he replied.

I understand that response, for I thought much the same a few years ago, before I began to research the issue. Banks are a major conduit through which savings become investment. It is an economic necessity that such a conduit exists, but it is far from the only one. When corporations issue stocks or bonds, for example, savings become investment. (Assuming the corporation uses the money it raises for investment and not some other purpose.)

If we insist that banks are honest and do not permit them to engage in fraud, it does not mean that there will be no credit system and no lending. It simply means that lending will be done on a basis that is absolutely solid and does not involve the fraud and instability of the fractional reserve system.

The great American economist Irving Fisher showed this quite clearly in his 1935 book 100% Money. Murray Rothbard argues for the same thing in his article The Case for the 100% Gold Dollar. A full reserve system would not destroy banking, nor would it end credit. Banks would be restricted to lending only from bonds they would issue specifically for the purpose of investment. People who bought such bonds would know that they are taking a risk, sacrificing liquidity for a return. No lending from demand deposits (checking and savings accounts) would take place.

Full reserve banking would not end credit, it would simply make the credit system rational, functional, and morally sound.

Krugman vs. Austrian View of Booms and Busts

Robert Murphy has an interesting blog post on the Austrian economic explanation for booms and busts. Austrian economics is based on the writings of Carl Menger, Ludwig von Mises, Friedrich Hayek, and Murray Rothbard.

This post is a critique of a recent post by Paul Krugman, who seems to intentionally misunderstand the views of other schools of thought in economics. Is it so difficult to understand each perspective and give it a fair hearing before attempting to refute it?

It seems this crisis may offer an opportunity to test which of the predictions from these schools of thought end up being more accurate: the Keynesian view, as seen in Paul Krugman's writings, or the Austrian view. For example, Krugman writes:

Just a quick note on the new, pessimistic CBO budget projections:
1. These projections have no bearing on the case for a large stimulus now — none. Adding, say, another $600 billion to stimulus spending would, on net, add around $400 billion to debt a decade from now (net is less than gross because the stimulus expands GDP, which leads to higher revenues that partly offset the initial outlay.)

This is a testable hypothesis. We shall see if it is the case that spending another $600 bil actually results in an addition of (only) $400 bil in debt in a decade.

Just to be fair, let me throw in my own prediction: this crisis will be a severe test of the Keynesian faith in monetary and fiscal stimulus, for neither one is capable of solving the problem. All indications point to an inflationary recession and stagnation, much like the Japanese experience of the 1990s. Of course, Japan did not have the world's reserve currency. We do, and we're tempted to use that power to inflate away our massive debts. I predict we will do so, like Roosevelt did in 1933 when he essentially defaulted on US debt by suspending the gold standard and devaluing the dollar by 41%.

Rather than saying, along with Krugman, that debt doesn't matter, we ought to be recognizing that expanding the Federal debt burden to finance an economic stimulus is exactly the wrong direction. We ought to trim spending and cut taxes, and get out of the way of the inevitable economic adjustment to equilibrium.