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 didn’t function 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.
Our man begins to watch the coverage of the accidents on TV. Breathless commentators are blaming the crashes on the irrational and reckless behaviour of drivers. He thinks: “That’s not fair. The drivers simply responded reasonably to a signal whose meaning they’ve long understood.” The irrationality that caused the crashes was not in the actors but in the traffic signals. When traffic signals don’t tell the truth, 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 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 behaviour is consistent with the other’s, thanks to the traffic-signal role of the interest rate.
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 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.
Like our drivers, borrowers were not irrational during the boom. They simply responded to an irrational signal. 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.”
Steven Horwitz is Charles A. Dana professor of economics at St Lawrence University. This article was originally published at The Freeman www.thefreemanonline.org