The Austrian School on the Housing Bubble

We Told You So
Mark Thornton on the housing bubble.

The third view holds that there are changes in both real factors and market psychology during bubbles and that both are driven by the cause of the business cycle – the Fed. This view of bubbles is based on the Austrian business cycle theory (hereafter ABC theory). This is a minority view held by Austrian school economists. According to the ABC theory, if the Fed does follow a loose monetary policy, then a bubble can develop somewhere in the economy, whether it be in tulip bulbs, stocks, or real estate. If the new money is directed toward housing, a bubble will develop in housing. Austrian economists further emphasize that the additional resources allocated to housing are resources that are not available elsewhere in an economy, so that while more resources than normal are allocated to housing construction, fewer resources are available to other areas of the economy such as manufacturing, which will experience higher costs for its inputs such as labor and materials and will produce a proportionately smaller output. It is this mismatching of resources across industries and sectors that has to be resolved – painfully – in the inevitable bust or correction.

Among the Austrians who identified the housing bubble is economist Frank Shostak who defined a bubble as any activity that “springs up” from loose monetary policies. “In other words, in the absence of monetary pumping these activities would not emerge.” As a result of this pumping, a misallocation of resources develops whereby non-productive activities increase relative to productive activities...