Published by the Foundation for Economic Education March 16, 2012 | Subscribe via RSS
Contributing editor Steven Horwitz is the Charles A. Dana Professor of Economics at St. Lawrence University and the author of Microfoundations and Macroeconomics: An Austrian Perspective, now in paperback. ... See All Posts by This Author
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Suppose on some sunny afternoon in a large city somewhere in the western world, a man discovers on awaking from a two-hour nap that several hundred car accidents had occurred in the city while he slept. He wonders why. First he considers the possibility that the weather was the cause, but the gorgeous afternoon sun pushes that thought aside. The odds of many hundreds of cars having simultaneous mechanical problems seems infinitesimally small, so he rules that out as well. He ponders the question further and eventually asks himself whether the drivers in that fair city just had a bout of group psychosis or mass delusion. The odds of that also seem pretty low.
As his brain slowly awakens, he stumbles across the likely culprit: Something must be wrong with the traffic lights. He concludes that the lights are not working, leaving the drivers to figure out how to negotiate the intersections on their own. Wouldn't that, he wonders, cause many accidents? He turns to his wife and suggests that explanation. She replies: "If you came to a traffic light and saw it was not working at all, wouldn't you slow down and proceed cautiously? In fact, after Hurricane Katrina didn't people in New Orleans just treat broken traffic lights like four-way stops, without explicit direction to do so?" Our fellow acknowledges his wife's insightfulness and continues to ponder.
Soon it hits him: It's not that the traffic lights were not functioning at all, but rather they were all green. If all the lights were green, drivers would have no reason to think the lights were not working and would proceed through every intersection — with the result being the hundreds of accidents. It strikes our fellow that not only do green lights mean go, they also mean that the cross-traffic has stopped. This is how traffic lights do their job of coordinating the plans of drivers on both streets.
Reckless Drivers Blamed
Our man begins to watch the coverage of the accidents on TV, where breathless commentators are blaming the crashes on the irrational and reckless behavior of drivers. He thinks: "That's not fair. They did not act irrationally; they simply responded reasonably to a signal whose meaning they've long understood." As he gets angrier about the blame being placed on the drivers, he realizes that the irrationality that caused the crashes was not in the actors but in the traffic signals. When traffic signals don't tell the truth, in this case that the cross-traffic has stopped, even the most rational, cautious drivers will get into accidents at intersections. He is stunned that the TV commentators can't see this. In despair he goes back to sleep, hoping it was all a dream.
Not only was it not a dream, it was the reality of the post-2001 boom that generated the financial crisis and Great Recession. The Austrian economist Israel Kirzner has long used traffic lights as an analogy for prices. In the case of the boom and bust, the key price was the interest rate. In a free market, interest rates and the banking system coordinate the plans of the cross-traffic of lender-savers and borrower-spenders. If saving increases, it means consumers are more willing to wait for goods. Their saving leads banks to offer lower interest rates, providing a traffic signal (and an incentive) for borrowers to borrow for longer-term projects that match the greater patience of consumers. If consumers are more impatient and save less, banks raise rates, leading borrowers to go more short term to match this preference. Each side's behavior is consistent with the other's, thanks to the traffic-signal role of the interest rate.
Central Bank Tampering
When the central bank intervenes, however, it turns all the lights green. Expansionary monetary policy provides loanable funds to banks, which enables them to lower rates as if there were more saving. However, that saving is an illusion; consumers have not become more patient. With lower rates, borrowers find longer-term projects more profitable and so divert resources to them and away from others. The problem, of course, is that consumers do not in fact wish to wait longer than they did before. So producer-borrowers invest in longer-term projects while consumer-savers continue to want relatively shorter term ones. This, like traffic patterns with broken signals, is not sustainable and will eventually lead to the economic equivalent of car crashes: the onset of a recession as this discoordination is revealed.
Of course robust economies can mask underlying discoordination for a fairly long time before it is revealed. A city suffering through a plague of all-green traffic lights sees a more immediate and visible result.
Like our drivers, borrowers were not irrational during the boom. They simply responded rationally to an irrational signal. The source of that irrational signal was the Federal Reserve System. The next time a friend blames the boom and bust on irrational investors, you might recall our protagonist’s city and say: "The irrationality, dear friend, is not in our markets but in our government, that is, the central bank."
Excellent analogy!
Excellent analogy!
Good analogy, however the central bank is private! I only wish the government reacted as though they knew that. How many heads of the Federal Reserve Banks are in financial difficulty? Not a one…
Good analogy, however the central bank is private! I only wish the government reacted as though they knew that. How many heads of the Federal Reserve Banks are in financial difficulty? Not a one…
Well said. Keep up the great work!
Well said. Keep up the great work!
A very good analogy.
Prices are the most wonderful communication tool designed by man. Discipline provided by profit and loss results in the best use of scarce resources.
Government has absolutely stepped in the way of the pricing system of almost every market – but especially in the most important market (via enabling of the Fed), the price of money. Of course, government has also stepped in the way of allowing the discipline of profit and loss.
The result, as identified in this analogy, is mixed signal sent to market participants. For the drivers, this results in numerous accidents.
In the market, the result is wasted resources – a destruction of wealth. When central banks play make believe (there is more available to borrow than supported by real savings), the result is both long term goods and immediate goods are destroyed.
This can only result in a reduction of the standard of living. We have seen signs of this reduction in the west for the last forty years. It will only get worse.
A very good analogy.
Prices are the most wonderful communication tool designed by man. Discipline provided by profit and loss results in the best use of scarce resources.
Government has absolutely stepped in the way of the pricing system of almost every market – but especially in the most important market (via enabling of the Fed), the price of money. Of course, government has also stepped in the way of allowing the discipline of profit and loss.
The result, as identified in this analogy, is mixed signal sent to market participants. For the drivers, this results in numerous accidents.
In the market, the result is wasted resources – a destruction of wealth. When central banks play make believe (there is more available to borrow than supported by real savings), the result is both long term goods and immediate goods are destroyed.
This can only result in a reduction of the standard of living. We have seen signs of this reduction in the west for the last forty years. It will only get worse.
Dick – The Federal Reserve has never been a “private” entity anymore than employer provided healthcare is “private”. The Federal Reserve has been owned by the largest bankers (not banks) in the world in combination with the Federal Government. Read the book “Creature from Jeykle Island” and you will see the Fed was never meant to be “private”. It was always meant to pay for the promises of Washington.
Dick – The Federal Reserve has never been a “private” entity anymore than employer provided healthcare is “private”. The Federal Reserve has been owned by the largest bankers (not banks) in the world in combination with the Federal Government. Read the book “Creature from Jeykle Island” and you will see the Fed was never meant to be “private”. It was always meant to pay for the promises of Washington.
The Fed is private in the same sense that all businesses in a fascist economy are private. The “owner” who must follow the orders of others in running “his” business is owner in name only. Private ownership of all businesses in the US is rapidly becoming nothing more than a legal fiction.
The Fed is private in the same sense that all businesses in a fascist economy are private. The “owner” who must follow the orders of others in running “his” business is owner in name only. Private ownership of all businesses in the US is rapidly becoming nothing more than a legal fiction.
You are all actually off here. The Fed is private, yes, but not like other private organizations. Each district bank is “owned” by the banks in that district. But their “ownership” is not something like stock that they can transfer. Banks and bankers are NOT, repeat NOT, getting wealthy because they “own” the Fed. That’s just factually wrong.
It’s true that bankers benefit by the actions taken by the Fed, but that is NOT because it’s “private” or they “own” it. It has to do with the way monetary policy is conducted, which often does, LIKE EVERY OTHER AGENCY, work to the benefit of those it supposedly regulates.
People have to get away from this argument that the Fed is “private” like it was Apple or some other business. IT IS NOT. You make it HARDER to make GOOD arguments against the Fed when you make bad ones like that.
Take an hour: http://vimeo.com/8040669
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