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Burning Down the House

December 3, 2002

Corrigan heads Capital Insight, a financial consultancy. He was interviewed at the Mises Institute prior to his lecture on the "What Happened to Recovery?" You can listen to the audio of his speech here, and follow his charts and research here.

MISES.ORG: It seems like the Austrian story of the boom is getting out there.

CORRIGAN: My sense is that many Austrians have described the process of the boom very well. The literature deals very elegantly with how unwarranted credit expansion leads people en masse to misjudge the capabilities of an economy. The result is malinvestment which leads to overbuilding in capital-intensive industries. In today's modern institutions, this leads to a share price boom, company floatation, and all the symptoms we saw in the upswing of the late 1990s.

In retrospect, this process has become better understood by the masses. Even the Wall Street Journal has picked up on this. They still miss the key element, namely that it has to be the elastic credit which fuels this process. It is this elasticity that brings about an asset-credit spiral that sucks more and more people in. It becomes effectively a firestorm in the end. More credit is available, prices go up, that makes more collateral available, that makes the asset look more attractive, the banks lend more money, and round and round we go.

MISES.ORG: To think that the Austrian cycle theory was only recently considered outmoded.

CORRIGAN: When, in fact, in today's extremely fast and liquid markets, the credit-creation process of the Austrian cycle becomes more and more exacerbated. Nowadays it is not just narrow money but nearly everything these days in financial markets is a money substitute of some form or other. We have clearing mechanism, netting mechanisms, we have derivatives, and great deal of leverage. So now, a small amount of money, however narrowly defined, can exert an enormous impact on asset prices.

As we know, once prices go up, everyone wants to buy because things are going up. We might even know that there is no underlying income in these companies. We just buy them because prices are going up.

So it is true that the process of the boom, and what went wrong—the symptoms, if you will—are much better understood. The link to credit creation is not as widely understood, but we are getting there. Greenspan, for instance, has been coming in for some unwanted criticism. This is not something he is used to.

MISES.ORG: But also, in your work, you have closely tracked the unfolding of the bust.

CORRIGAN: Austrians have given far less attention to the process of the bust. For ordinary people looking after savings, and for people in financial markets trying to make decisions, the critical thing is not the pathology of what happened. It is the prognosis of what might happen in the future, as the bust unfolds. This is very unclear, and the Austrian literature is somewhat lacking in this respect.

In the main literature, we get the boom and the collapse, and then most authors try to glibly say that in the hopeful case when government does nothing, prices and costs become more equilibrated, wages have adjusted, financial capital is written off, and therefore physical capital which still persists can be better used. Therefore, we have come down so far that the only place we can go is up again. All of this is clearly stated.

But in today's world, the liquidation is never allowed to take place. Every single fiber of government and central bank policy is designed to avoid the liquidation. The literature is quite unclear about what will happen in this case. Rothbard, I think, said that new credit creates another boom on the back of the ruins of the old boom. But there is no clear guiding path. Richard Strigl deals with it a little bit. He says that we never quite liquidate the previous boom, and that seeds of another boom are always coming through. Some of Hayek's work deals with the concept of capital consumption, which is very relevant to where we are today.

MISES.ORG: You find his triangle of production stages to be useful, then.

CORRIGAN: Yes, but I tend to think of it as a cone, because we have a flux of goods and services moving through these cones and they have to go through each successive stage. The cone gets over- lengthened in the boom. We put too many resources in capital intensive industries, far way from the end point of consumption. There are not enough resources to see these profitably all the way from their inception through to their consummation in individual consumption. We then have a shortening process as this boom is being eradicated and collapsing in on itself.

Today's economy tries to overcome this by fostering consumption at any expense. Debt-led consumption, credit-created consumption, spending consumption: these stretch the cone the other way, shortening it as fast as the higher industries try to keep up and find a foothold. It's as if the cone is closing up even as business is trying to get back on the surface.

In this process, we therefore must be eating what we did not cook and burning what we did not plant in the forest. We must be consuming capital. We are taking the assets that remain to us today and monetizing and spending them, or we must be borrowing against tomorrow's income and thereby alienating what may come in the future, but which may never come because this process is so destructive.

As business tries to reorganize itself, the structure of production is changing faster than they can adapt. To move people and skills and fixed capital, some of which may be very specific, to the industry in which it is best employed can be problematic. This whole instability of credit and interest rates and foreign currency parities is hugely detrimental to the process. We are at the stage here in which it is clear from the financial market evidence that while nonfinancial corporate profits have stabilized in the last four to five months, they stabilized at levels which are in current dollars where they were before the boom started.

But this new stability is an uneasy one. It does look, insofar as we can judge aggregate statistics, like these companies are not replacing old capital and they are not investing new capital. The depreciation levels against the fixed-investment levels are at the narrowest margin that we've seen in fifty years. In addition, where companies have reported profits recently, when we strip out the one-off gains that they are still trying to book, any profitability has come at the expense of cost cutting, both on capital expenditure and on the payroll. So clearly, these companies are trying to adjust to the fact that the useful capital stock has shrunk.

At the same time, we're encouraging everyone to go out and buy cars at zero percent and houses with the lowest mortgage rates in 40-odd years. We are encouraging people to consume ever-more capital, today's and tomorrow's. The debt will have to be paid for at some point.

MISES.ORG: In real estate in particular, Freddie and Fannie were just approved to accept higher-end mortgages.

CORRIGAN: Yes, Fannie is particularly bad in this way. But both Freddie and Fannie are doing everything possible to encourage more debt. They have online mortgage applications. You can even get an online appraisal of your house.

There is a subterranean literature on the fringes of the mainstream press about how the appraisal process in home loans has been corrupted in this boom. The appraiser is paid if the loan goes through. Therefore, the potential borrower or purchaser or even the vendor can prod the appraiser to give a higher evaluation, just to get the deal done. Even with the inflation in prices that we've seen, it's worse than it looks because the house values aren't there in the first place.

MISES.ORG: Sounds a bit like the relationship between auditors and corporations.

CORRIGAN: Inflations corrupt people, one way or another. Whether it is through peer pressure or the pressure of commercial business, people are pushed to cut corners.

MISES.ORG: Does anyone really believe that all this credit-fueled consumption will help?

CORRIGAN: We have this curious cognitive dissonance at work. People are borrowing hand over fist to buy houses and re-mortgage their houses to maintain their standard of living. This means that they must, somehow, have adopted an inflationary psychology. On the other hand, everybody is terrified that the Fed is going to allow the economy to lapse into deflation, that is, allow prices to go down. This schizophrenia pervades the whole of the economic debate, from the man in the street to the top traders on Wall Street. And nobody seems to be able to rationalize, clearly, what the differences are.

At the Fed and the Treasury, you have this Keynesian view that the economy operates like a toilet. You pull the handle and it empties, and then the water automatically fills back up. The view is that if consumers empty the stores of stuff, the stores will fill up again, and everyone will make money. So they don't understand the intricacies and complexities of what goes into a modern economy. To use another analogy, they believe that so long as the fire is burning in the house, the logs will be put on it. They don't seem to consider the possibility that you can be burning the furniture and, indeed, the house!

MISES.ORG: What are the prospects for deflation?

CORRIGAN: It's true that we have such an unsupportable pyramid of credit on such a miniscule base of real income. The idea that there could be a cascade of debt default and asset fire sales is a real possibility. And yet the Fed and central banks around the world—excluding somewhat the European central bank—have clearly said that they will do anything to prevent deflation.

The Fed has changed the rules under which they can inject liquidity into the system. The Fed has made several overt statements of intent that, if necessary, it will buy anything—corporate securities, mortgages, physical assets—it will conduct a "money rain" if it has to.

MISES.ORG: You are thinking in particular of the statement by Fed Governor Ben Bernanke.

CORRIGAN: Yes. He said: think of it this way. If we were alchemists, we could create more gold and drive the price down as low as we wanted. He continued on to say that the Fed has that alchemy in the printing press. This is the central bank that is supposed to be the guardian of stable money! It's unbelievable. But, in my view, it would take a real crisis for the Fed to resort to unlimited money creation by whatever means necessary.

There's a statement in that egregious book of hagiography called Maestro in which it is said that Greenspan is prepared to take emergency measures, as when a fire-truck drives down the wrong way of a one-way street in order to put out a fire. In other words, he'll do what it takes. We saw this in Mexico, Asia, and the dealings with Long Term Capital Management. We saw it on September 11, when it was strongly rumored that mutual funds were offered credit lines by money-center banks and by the Fed, so that the funds wouldn't have to sell all their stocks. Whether or not this is true, I can't say. But senior people in financial markets give it credence.

As for the short term, the Fed does have a very serious problem to deal with. Somehow or other, we need to get the monetary value of our liabilities in line with the monetary value of the real income we can produce. There is a huge disparity now. A great wedge has been driven between the two. The problem can be addressed through inflation or deflation. We know which the central bank will choose.

MISES.ORG: Many have compared the current state of the US with that of Japan.

CORRIGAN: There are some differences. The Japanese banking system got itself tied up with the land boom. It wasn't so much a share price inflation as it was a land collateral inflation. Remember the tales of the day when the real estate of the Emperor's garden was said to be worth more than Canada. While we may not necessarily value Canada all that highly, this is something of an unreality.

The Bank of Japan has been accused by the Fed of acting too timorously in the aftermath. But the BoJ has disputed this vigorously. The Bank points out that the collapse would have happened whether it had warned people or not, and, in addition, there are rules and regulations and regimes and constitutionality questions involved that might have prevented substantial intervention. Of course in Japan, the crisis was entrenched not just by the monetary policy but by the rigidities of the Japanese economic system.

The Japanese come in for some undue criticism now. They have made great strides. The total of the debt involving corporate bankruptcies over the last four years is $670 billion. That's about 4% of GDP every year for four years. That is much higher than the US economy has managed, even with the somewhat easy regime of Chapter 11. So the Japanese are tackling their problems. It's just that the problems are so enormous and so entrenched. Obviously, as in any country, politics intrudes to take short-term measures that prove detrimental: witness the way the Bush administration has handled this.

MISES.ORG: As one of the first to predict the bust, have you been basking in glory?

CORRIGAN: Of course not. Immediately after the bust came, we had a long period of denial. First we were told that technology had abolished the business cycle. Then it was said to be merely a dot com bust, but then it was a telecom bust as well. Then Greenspan was to give us a soft landing. Then we were to have a V-shaped recovery. Then the recovery was to be U-shaped. Suddenly it began to look W-shaped. And now, everyone is consumed by the fear of deflation.

Remember that all the predictions come from the same people who thought the boom could last forever. To know what's ahead, you are far better off reading books on Austrian economics than listening to the latest forecasts from economists, which are made with rulers and a couple of debatable assumptions.

MISES.ORG: Thank you, Sean.


Sean Corrigan is a principal of www.capital-insight.com, a London-based economic consultancy. See his Mises.org Articles Archive, or send him MAIL. See also the Study Guide on Business Cycles.


Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.

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