Tuesday, February 26, 2013

ABC

Brian Caplan lists several problems he has with the ABC. One of these issues he has is with the following "Proposition 3: Monetary expansion distorts the structure of production in an unsustainable way."

He clarifies his disagreement with the following, "The objection is simple: Given that interest rates are artificially and unsustainably low, why would any businessman make his profitability calculations based on the assumption that the low interest rates will prevail indefinitely? No, what would happen is that entrepreneurs would realize that interest rates are only temporarily low, and take this into account."

Brian Caplan would be correct if the market where 100% efficient all of the time, that is efficiency with respect to profit maximization. There are real examples of  this point on a regular basis. Look at the Federal reserve banks's chairperson. Many times the market reacts as a result of what he says as they did today. If the market where truly 100% efficient the market would already have know what he was going to say before he said it and would have fully priced it in, thus we would see no reaction to any statement the chairperson of the fed could say.

If the markets can't predict what the fed will do how can they predict interest rates? Perhaps it can still be done, there is no reason to doubt this but when consumers living in an inefficient world suddenly see mortgage rates on homes drop, on fixed rate 20 year loans below the long term "natural" rate, does that not qualify as a malinvestment? When the fed shifts monetary policy from just targeting short term rates to also longer term rates as it attempts to massage the yield curve would that not distort decisions? It may be that Mr. Caplan has a different opinion today and one has to wonder what a post financial crisis essay from him would look like.

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