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Critique of Austrian Economics

Victor Aguilar

posted on 07 April 2014

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On signing the American Dream Downpayment Act of 2003, George Bush boasted:


"Rising home values have added more than $2.5 trillion to the assets of the American family since the start of 2001.  The rate of homeownership in America now stands at a record high of 68.4 percent.  Yet there is room for improvement.  The rate of homeownership amongst minorities is below 50 percent.  And that’s not right, and this country needs to do something about it."


From the ADDI website:  "ADDI provides downpayment, closing costs, and rehabilitation assistance to eligible individuals. The amount of ADDI assistance provided may not exceed $10,000 or six percent of the purchase price of the home, whichever is greater…  Individuals who qualify for ADDI assistance must have incomes not exceeding 80% of area median income.”


Basically, ADDI assures that recipients do not have any skin in the game.  If they like their McMansion, they can make their monthly payments; if they tire of having to hold a job for this purpose, they can just walk away and lose none of their own money.


In 2004, when I wrote Critique of Austrian Economics, I observed that the Austrians were strenuously arguing that interest rates go down during booms and up during busts, which Paul Krugman derisively called the Hangover Theory, claiming instead that exogenous shocks – Damn those Iranians! – cause busts and the government responds by lowering interest rates.  In the meantime, the econophysicists were spinning elaborate theories based on interest rates measured in increments of 0.0001%.


They were all wrong.  As I wrote in my 2004 Critique, "This idea, that bank loans redistribute wealth from one class of people to another, is a fundamental departure from the classical view that banks merely divide the world into those who are willing to borrow at x% but not at x.1%, without any regard to who those people are, their class or their importance to the government."


Yet, without exception, every journal referee singled out the following passage as exaggerated and recommended against publication on grounds that I was talking about a housing crisis that existed only in my own mind:


"An easy counter-example is cycle effects occurring when new money is loaned to consumers.  In the 1990s, banks would make consumer loans up to 125% of the equity in people’s houses.  Today, foreclosures are skyrocketing and the streets are lined with ‘We Buy Ugly Houses’ billboards."


That was Spring 2004.  What those referees failed to understand is that it is possible to have a crisis and a boom simultaneously; prices were galloping upward AND foreclosures were skyrocketing.  The galloping prices had inspired people – former renters turned real estate moguls – to leverage the purchase of multiple houses.  At the time I was writing this paper, I visited a strip club where a 19-year-old girl sat on my lap and boasted of the three – soon to be four – houses she owned.  I thought, “When strippers own four houses, it is time to get out of real estate.”


It was the collapse of these chimerical real estate empires that drove the foreclosure boom I mentioned in my paper.  People with one house were using it like an ATM machine and had no fear of foreclosure – yet.  The AVERAGE price was still rising and it was these averages that the referees pointed to when denouncing my groundless fears of a problem in housing.