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Volume 16, Number 12
Boom and Bust
by Jeffrey M. Herbener
With huge segments of the world economy mired in depression, can we conclude that
capitalism has failed or that the
market behaves irrationally? That seems to be the consensus among many commentators, so we
hear a wide range of calls
for government intervention to patch things up.
Monetarists are calling for more global interest rate cuts. Keynesians are recommending
all-out inflation. Clinton says we
need a new global financial "architecture." Others go further to say we need a new world central
bank. Still others say we
need ever more IMF bailouts.
But none of these measures deals with the underlying cause of the crisis, which is not the
market economy but its distortion
by central bankers. The basis for understanding this is the Austrian business cycle theory,
pioneered by Ludwig von Mises
in 1912. His theory, elaborated upon by Murray N. Rothbard, explains the boom-bust of the last
decade better than any
Rothbard called the central puzzle of the business cycle the "cluster of entrepreneurial
error." During the boom, most
entrepreneurs and investors appear to be geniuses, earning extraordinary profits year after year.
During the bust, their
fortunes are suddenly reversed, and they seem like dunces and suffer losses year after year.
Yesterday's profitable ventures
mutate into a mountain of malinvestments.
That's not how unfettered markets behave. Entrepreneurs base their decisions on prices
that accurately reflect consumer
preferences. Prices also reflect the opportunity costs (goods and services foregone) of the
resources needed to make these
goods. Entrepreneurs who accurately forecast the future state of markets and produce goods
whose value exceeds their
costs earn profits. Those with less predictive and productive skill earn fewer profits or suffer
Capitalists, or financial intermediaries acting on their behalf, lend funds to successful
entrepreneurs and withdraw or
withhold funds from unsuccessful ones. They thereby ensure that the entrepreneurs with
comparative advantages remain in
service while those without it fall back into the ranks of employees. In the unhampered market,
profits are as large as
possible and losses as small as possible.
Entrepreneurs earn profits by making good use of resources. But they must also face
changing consumer preferences, factor
supplies, technologies, and other conditions affecting profitability. As consumer demand shifts
away from one good to
another, the price and profit of the new good increase while the price and profit of the old one
decrease. With increasing
revenues, entrepreneurs producing the new good can increase their demands for factors and
expand production while those
producing the former, where revenues have diminished, must contract operations.
Since change is continual in the market, and not perfectly predictable, a spectrum of
profitability results. Some
entrepreneurs will earn a lot of profit, others a moderate amount, still others less, and some will
suffer losses of varying
amounts but each according to how well or poorly he satisfies consumer demand.
In a free market, there is no "cluster of entrepreneurial error" where the spectrum of
profitability is hugely skewed toward
one end or the other. That's because demand for goods is not unpredictably increased in every
sector at the same time,
causing profits everywhere. Neither is demand decreased everywhere at the same time, which (if
not predicted) leads to
losses everywhere. Yet, during the artificial boom, profits increase everywhere, and during a bust
everyone suffers losses.
Central-bank monetary inflation and credit expansion causes the boom and promises to
improve permanently the free
market by raising the profitability of operations across the entire economy. Higher prices, larger
profits, more production,
higher wages, larger incomes, more employment--this is the siren song of monetary inflation and
At first, central-bank monetary inflation seems to make good on its promise of perpetual
prosperity. Its open market
operations supply banks with a new stream of funds to lend, drive up bond prices, and push
interest rates below natural
levels. Flush with funds, banks lend to entrepreneurs who are eager to obtain credit at below
natural interest rates to pursue
projects whose profitability has been artificially inflated.
Entrepreneurs make more profit across the economy and fewer losses. They expand
production and employment by using
the borrowed money to bid more intensely for factors, especially capital goods. Since the
additional funds have not come
into the banks by shifting them away from other expenditures, revenues and profits need not fall
in other areas of the
economy to provide this stimulant to banks and borrowers of the expanded credit.
Because the central bank allows banks to hold only a fraction of the funds in their
checkable deposits as cash, money newly
created by the central bank can be lent and deposited over and over. This results in a "money
multiplier" effect. During the
boom, banks' balance sheets swell with loans on the asset side, balanced by checkable deposits on
the liability side.
On paper and in government statistics prosperity seems to reign. In truth, the boom is filled
with malinvestments and
misallocations. Al- though the practice of fractional reserves allows a magnification of monetary
inflation and credit
expansion, to the benefit of the banks in the boom, it results in a dangerous mismatch of the
maturity of assets and
liabilities. The swollen liabilities of checkable deposits are payable on demand to customers while
the matching assets of
loans are not recoverable on demand by banks.
Profits earned by entrepreneurs no longer correspond to the satisfaction of consumer
preferences. Instead they are
systematically distorted by the artificial spending stream fed by the central bank. Entrepreneurs
are misled by the credit
expansion into shifting the use of factors into activities considered less-valuable by consumers.
Some malinvestments and misallocations can be particular to the historical circumstances
of each business cycle. Cronyism
in some of the Asian countries and Russia, for example, channeled erroneous investments and
factor allocations into lines
which benefitted the politically-connected interests that had the inside track to bank loans.
Cronyism, however, is not a
causal factor in the business cycle, but a sideshow to the main event.
Central-bank monetary inflation and credit expansion cause a boom-bust cycle by distorting
prices and profitability. They
incite entrepreneurs across the economy to malinvestments and misallocations. With- out
cronyism would result in higher profits for the cronies at the expense of lower profits or greater
losses for the non-cronies.
But it would not produce a business cycle.
The cronyism of the Japanese system was hailed as enlightened "government-business
partnership" during the heydays of
the 1980s. We were being told that America too must adopt this system or cede economic
supremacy to the East. Now we
know that half of all funds available for investing in Japan, nearly $1.75 trillion, were being held
by the government-run,
postal-savings system which "invested" funds in infrastructure boondoggles and "lent" funds to
businesses that were too
risky for private banks.
This is to say nothing of lifetime tenure for workers and government subsidies to companies
to maintain employment and
protect them from international competition. Nor were today's critics of cronyism pointing to the
"Asian Tigers" during
their boom for having economies corrupted with political shenanigans. Even without the fuel of
inflation, a crony economy would be an inefficient producer and have stagnant or slow-growing
standards of living.
Another sideshow often mistaken for the main event is bankers' sudden loss of risk aversion.
Increasing riskiness, however,
is a necessary aspect of central-bank monetary inflation and credit expansion. Without such
intervention, bankers properly
balance their portfolios of loans, accepting additional risk only at higher interest rates, and
extending loans to their most
creditworthy customers for the projects most likely to generate profit. The additional credit
created by central-bank
monetary inflation will necessarily be extended to less creditworthy customers, both consumers
and entrepreneurs, for
projects less likely to be profitable.
Consumers, who could not obtain credit otherwise, are now able to entice entrepreneurs to
satisfy their preferences by
spending borrowed money. Individuals, who could not enter the ranks of entrepreneurs before,
now find bankers willing to
lend them start-up money. As a boom matures, bank portfolios are filled with loans that would
not have been made, either
for too much risk or too little return, in the absence of credit expansion. The longer the boom
continues, the greater the
errors within and emanating from banks.
Just as the boom builds outward from banks to the rest of the economy, with banks
benefitting the most, the bust collapses
inward to banks from the rest of the economy, with banks suffering the most. Now the balance
sheets of fractional-reserve
banks, swollen with loans and checkable deposits during the boom, suddenly collapse. Or rather,
the value of their loans
collapses initially, as the projects they lent to turn out to be unprofitable, leaving them with
negative net worth; upon
bankruptcy, their checkable deposits are liquidated.
Bankruptcy is made much more likely by the policy of fractional reserves. The
checkable-deposit liabilities built up during
the boom no longer have assets of equal value balancing them out once the crisis hits. Customers
who know this have a
great incentive to demand redemption of their checking accounts in cash, an obligation which
cannot fulfill even when the value of their assets is intact, let alone after their loans
Monetary deflation through bank failures is the other side of the coin of liquidation of bad
loans. Liquidating the loans
implies realizing the bankruptcy of the businesses that have taken out these loans. The monetary
inflation and credit
expansion of the boom are now reversed in the bust. The capital build-up of the boom must now
be dismantled and factors
reallocated into lines of activity made profitable by consumers.
Again, Japan is a case study. From 1985 to 1990, its economy was a powerhouse and the
envy of the world. Encouraged by
low interest rates, the largest six banks in Japan made $215 billion worth of real-estate loans.
Since the bubble burst in
1991, commercial real-estate values have fallen 75 percent in six major Japanese cities.
Risky Japanese loans were not confined to real estate. Moody's downgraded Toyota Motor
Corp. debt from triple-A to
double-A-1, leaving only nine Japanese companies with the triple-A rating (and five of these are
being reviewed for
downgrading). Mitsubishi, Hitachi, and Nissan all recently had their debt downgraded. Moody's
has even considered
downgrading Japan's triple-A, sovereign-debt rating.
It's remarkable to consider that as late as 1993, Japan had the largest eight banks in the
world, ranked by assets. Now,
Japanese banks have the same share of the world market as they did in the early 1980s. In 1987,
bank stock shares
constituted 30 percent of all listed stock in Japan. Japanese banks currently make up only 12
percent of Japanese equity.
One of the largest twenty banks in Japan and the world's 67th largest in 1993, Hokkaido
Takushoku Bank Ltd., failed last
Long-Term Credit Bank, ranked 14th largest in the world in 1993, had its debt rating
reduced by Moody's. Sumitomo Trust
& Banking, number 16 in 1993, balked at a merger with Long-Term Credit Bank because of
Long-Term's bad debt, and
rightly so, since Long-Term Credit Bank has now declared bankruptcy. Sakura Bank, number 5
in 1993, is now trading a
price-to-book value of 0.81; that means investors think the bank is worth less than the value of
its assets. Bad-loan write-offs have forced Sakura to plead for $2 billion in cash from its major
shareholders to restore its assets and rebuild its net
worth. Several other giant banks have seen their stock prices sink.
Japanese banks now suffer from carrying, by private estimates, over $1 trillion in bad debt,
$600 billion of which is
officially admitted. The largest six banks hold $131 billion in bad debt. And according to Japan's
Agency, more than one-tenth of all good debt has higher than normal risk of default. $256 billion
of this high-risk good
debt is held by Japan's nineteen largest banks. For 1997, Japan's top banks made 0.24 percent
return on portfolio assets,
making them the least profitable banks of any developed area. In the U.S., the banks' return was
more than five times
greater at 1.33 percent.
The Japanese debacle has been repeated around the world. Allowing for the unique
circumstances that will make the
situation play out differently in each country, central banks and fractional-reserve banking
systems have flooded their
countries with money and credit. The result is a worldwide financial crisis and bust.
Now that central banks have created an international crisis, the best policy is to let the
market work. Only entrepreneurs
operating on an un-hampered market can restore economic health. Only they know how to
reorganize production, reallocate
factors, liquidate malinvestments, and reconstruct the capital structure in the best way. The bad
loans should be liquidated,
that is, sold at a discount to entrepreneurs who will specialize in their collection. The bankrupt
banks and companies should
be liquidated, sold to entrepreneurs who best know how to reallocate their assets, and the funds
distributed to creditors.
Does a laissez-faire policy mean cruel hardship? No, since a laissez-faire policy would have
prevented the boom and thus,
the crisis and bust. It should have been adopted before the cycle began and its adoption now will
prevent cycles in the
future. Liquid- ation is the least-painful way to deal with the government-created bust. The more
quickly this is done the
sooner the economy can return to normal.
If the government, perversely, tries to forestall liquidation, then the depression will linger on
indefinitely. In Japan the
government has made liquidation difficult with various regulatory hurdles and unfavorable tax
treatment. Almost the entire
stock of bad loans remains on the books of banks making them financial zombies, unable to
conduct normal business and
unable to perform their crucial social function. The result is the paralysis of production.
A central bank policy of reinflation only leads to another wave of misallocations and
malinvestments. Open market
operations is a clumsy tool for repairing existing misallocations and malinvestments. A bank that
receives an infusion of
funds from the central bank will not use them to liquidate or renegotiate existing bad debt, but
seek out new borrowers. It
will lend to the most credit-worthy customer it can find instead of the least creditworthy one, i.e.,
the customer who cannot
pay what it already owes the bank.
When the Bank of Japan in- creased bank reserves in an effort to reinflate, banks, already
burdened with loads of bad debt
of domestic consumers and entrepreneurs, took the additional reserves and lent them to
businesses in Asia, especially South
Korea, exacerbating the boom there. The Bank of Japan's reinflation policy has piled foreign bad
debt upon domestic bad
debt and led to the devaluation of the yen. Banks have responded by further retrenchment; they
make fewer loans at home
and abroad. In the first quarter of 1998, their overseas lending fell by $244.3 billion.
A policy of bailout, even if it can be tailored to liquidate bad debt, creates moral hazard,
making the next boom-bust cycle
more extreme. If it goes to bail out distressed and bankrupt businesses, then the money is wasted
entirely since these are the
very operations that need to be contracted. Japanese banks are right to refuse to extend more
loans for real-estate projects or
to steelmakers like Toa Steel, which has declared bankruptcy under the burden of $1.82 billion of
debt. The 30 trillion yen
($207 billion) bailout fund for banks proposed by the Japanese government will be money wasted
prolonging and extending
malinvestments. Moreover, bailouts are usually financed by more central-bank inflation and thus,
result in further
malinvestments and misallocations.
Japan will also try a 17 trillion yen ($128 billion) stimulus package. But, fiscal policy leads to
more misallocations and
malinvestments as the liquidated projects and unemployed factors are, at best, channeled into
areas consumers do not value
as highly as those selected by entrepreneurs. To favor fiscal policy as a palliative to the bust, one
must favor the political
expenditures of bureaucrats over the economic expenditures of entrepreneurs. The
malinvestments must be liquidated and
the misallocated factors reallocated.
All calls for people to consume more and save less or cries against "oversaving" are
counterproductive. The problem in
Japan is not "oversaving" or lack of fiscal or monetary stimulus. The problem is that the
government refuses to let the
market work. By refusing to allow bankrupt institutions to fail, it has forestalled the liquidation
process necessary for
recovery. Until it permits liquidation, the Japanese economy will remain moribund.
Some good can result from the recession and depression in Asia and elsewhere. It serves as a
model case of how credit
manipulation by central banks, combined with fractional-reserve banking, creates economic crisis
and causes human
suffering. Restoring the market economy and sound money is the only way out.
* * * * *
Jeffrey M. Herbener is professor of economics at Grove City College and senior fellow of
the Mises Institute.
Further reading: Ludwig von Mises, The Theory of Money and Credit (Indianapolis, Ind.: Liberty
1980); Murray N. Rothbard, America's Great Depression (New York: Richardson & Snyder,