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Thursday, March 15, 2012

The Parable of the Broken Traffic Lights

Bad signals.

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.”

Find a Portuguese translation of this article here.

  • Steven Horwitz was the Distinguished Professor of Free Enterprise in the Department of Economics at Ball State University, where he was also Director of the Institute for the Study of Political Economy. He is the author of Austrian Economics: An Introduction.