Finally, the mainstream has come to recognise--albeit dimly--that the phenomenology of this cycle is not like the ones to which it has been introduced by its teachers. It is not about insufficient demand or money, nor it is a result of a technology shock. It is a story of malinvestment--resources misapplied due to bad interest-rate signalling from the Federal Reserve itself.
The mainstream still stutters about ‘overinvestment’ rather than the much more accurate ‘malinvestment’, and still largely fails to recognise the critical role of unbridled credit creation which was at the heart of the recent Boom and its subsequent Bust.
However, there is another issue at stake in the prevailing circumstances which is again missed by the Hierophants of Orthodoxy, but an understanding of which is absolutely vital to acquiring a grasp as to what is going on today and what the investment implications are of this.
The issue, put simply, is this: does stimulating consumption lead to the generation of a structure of production which will profitably and sustainably provide the desired goods to the consumers, alongside the means with which to buy them?
More pointedly, we need to recast this question to consider the negative side: can stimulating consumption disrupt, or even preclude, the generation of such a structure?
Having set out our thinking on this issue, we will then look at the vexed issue of an official policy which is geared to making savers despair of the value of their money holdings and of encouraging spenders to continue to squander their patrimony.
We need to step back a little to lay out a model of the economy somewhat different to the one most people have been given to consider: something we’ll call the Cone of Production.
In its simplest form, it shows how the division of labour is made so that men can work to provide that rich basket of ultimate consumer goods and services to the broad masses which is the defining triumph of free market capitalism.
At the left hand end of our diagram, we have raw material production, such as mining and refining. Next, we go through the area of capital goods, where we make not so much the things we wish to enjoy, but the tools with which we will fashion them. Successively, we then proceed through intermediate goods in general, and onto the distributive industries of wholesale, transport and retail, as well as those which center upon the provision of less tangible services to their customers.
The horizontal axis in this diagram is, in fact, a time axis (though we would be loath to include any determinate time intervals on this highly schematic layout).
The vertical, by contrast, we can intuitively grasp, should be widening, as jobs become less specialized, more labour, and less capital, intensive, and as the mass of products gradually swells as we move from barn, to grain elevator, to baker, to bagel stand.
This is only to say that there are more people driving taxis than designing them, or that more money is spent on potato chips than on chip fabrication plants.
What we can also think of the cross sectional area of the cone as measuring, therefore, is the flux of money flowing through the system--or of corporate (and, strictly, non-corporate business) revenue at each particular stage of production.
The slope of the curve must thus represent the amount of value added in a unit of time. More fundamentally, by imputation, the value of any higher order product (i.e. one located more towards the left hand apex) must represent a suitably discounted present value of its expected future worth as a consumer good.
In less technical terms, what this is saying is that no one buys a tool-die, or a metal-cutting lathe, for its own sake, but instead with an eye to the value of the range of consumer goods to which it ultimately gives rise.
Thus, starting from the right hand end, we can take the money clattering into the nation’s shop tills and work backwards to those factors of production--both human and physical--which participated at any preceding stage in the given consumer item’s manufacture, including all legal, marketing, packaging and delivery costs.
To make this rigorous, we should use a continuously compounding discount factor to accomplish this calculation, something which will give us a smooth, exponential curve.
This discount factor, since it depends upon how willing we, at the right, are willing to wait for a product to make its way along from the left, is a measure of our time preference, something which the Austrians categorize as the ‘natural interest rate’.
When we take into consideration that a man, working today to produce goods in the shops for next Christmas, will need to be fed for a year ahead of the point where his labour comes to its final consummation, we should also see that he needs the assurance that he himself can draw upon a stock of consumer goods throughout this period, or he will not willingly undertake the task.
That, in turn requires an act of forbearance--of saving--and the satisfyingly consistent inference is that a lower time preference (less material impatience, if you will) implies higher savings and thus the ability to support more workers further off to the left.
In other words, higher savings allow for more specialized, more capital - and skills -intensive work to be conducted, something which gives us a greater chance of heightening value productivity and of encapsulating innovation and inventiveness into the everyday round of production.
Savings, we might begin to glimpse, are what help us enrich ourselves.
Once we assume these conditions, all will be well in this ideal world where there are no more than local--and cumulatively offsetting--fluctuations between supra- and sub-optimal businesses to violate the smoothness of the curve.
Then, as we can see from the diagram, our capital goods producer pays for resources (materials, equipment and labour) to the tune of the area in the red disc and, a little while later, sells his product on to realize the slightly larger area shown in the nearby blue disc.
The difference between the two--a small ring around the circumference of the blue disk, typically, perhaps, some 5-10% of its total area--will represent the net income of the capital goods makers.
As this passes on down the chain, each successive intermediary, in turn, earns his own surplus and the sum of all those surpluses is simply the integral of those annuli--which neatly amounts to the total blue area of consumption at the extreme right end of this productive funnel.
In other words, everyone eats his own cooking and cooks his own eating. The system is closed and consistent.
There are a number of other features to notice in the diagram.
The first is that the standard GDP figures, to which so much misplaced emphasis are accorded, only count the light blue areas of our figure: namely, final consumption and a rather arbitrarily defined category of investment in fixed capital and inventory.
That this is arbitrary can be seen with the WorldCom-like recategorization of software as a capital expenditure, not an expense, a few years back, or by comparing the inclusion of houses (consumer durable goods) with the exclusion of boats, fridges and cars (also consumer durable goods).
But, quibbles aside, what the GDP method of accounting completely ignores is what goes on in the yellow portion at the core of the funnel, a volume which we can see, in reality, makes up a sizeable proportion of the cone - in fact, no less than $9 trillion dollars in today’s economy.
This oversight lies, in fact, at the heart of a great deal of the error committed by the mainstream and is this responsible for the damaging policy prescriptions they regularly seek to carry out.
In essence, a great many livelihoods rest here, in the business-to-business area, and, at every stage and continuously throughout time, the workers, owners, and managers of these enterprises are asked to make voluntary choices to contract, to maintain, or to expand their current activities.
Each one of them, too, must constantly be assessing whether he will be acting in what he sees as his own best interest by taking another set of inputs from those further to the left in our diagram and transforming them into a new set of lower order, more nearly finished, products, hopefully to be used again by his customers off to the right.
It is an absolutely critical observation that there is no automaticity in any of this, as the mainstream blithely assumes in its erroneous doctrine of ‘effective demand’.
Rather, each actor must repeatedly rethink the decision whether or not to save the greater part of his income (for gross savings are what a firm makes when it simply re-stocks its production lines, or offsets wear and tear on its equipment, while net savings are moves to add to either its fixed or circulating stock of capital).
That this is a genuine choice must always be borne in mind, for there is nothing which precludes the businessman, or his shareholders, from seeking instead to consume an increased proportion of their income at any point, in the pursuit of more direct, if, perhaps, less lasting, satisfaction.
Carrying this forward, it shouldn’t take a degree in mathematical topology to realize that we can build a solid with a much wider base (we can engage in more consumption) and yet shrink the rest of the cone, and so produce a higher GDP number on a smaller overall volume.
This new shape will be less revenue rich and less specialized. It will contain fewer niches for workers and entrepreneurs, and fewer outlets for capital. It will be one which is likely (though we haven’t demonstrated that rigorously here) to grow more slowly, while being more prone to the more obvious effects of monetary inflation.
Astute students of corporate performance will have realized that we have pretty much summed up what recent rounds of quarterly results, capital expenditure trends, and labour market developments have shown to be in train today, when we enumerate these deductions.
For now, let us leave any effects arising from credit conditions out of the equation and just look at what happens if there is a spontaneous raising of time preference on the part of the populace.
People will have less appetite for saving (the act of providing for goods tomorrow) and a greater desire for consumption (the appetite for goods today). The natural rate of interest will rise and the cone will become steeper and wider: less of a wizard’s hat and more of a coolie’s - which is rather fitting, if you think about it.
But look what happens to the higher order industries as this takes place and recall, when you do, that these are more specialized and tend to be more capital intensive. Also recognise that it is quite likely, too, that hard-to-adjust fixed costs will be higher in these firms, relative to the variable and more conformable costs of doing business.
Starting off with much the same level of costs (the red disc), they now find the market for their product has shrunk appreciably (the blue disc). They begin to make potentially solvency-threatening losses and, if this persists for any length of time, they will either move out of their current business, or be driven out of it.
Moreover, since this process will start much further down the curve than we have chosen to illustrate, each such firm, as it encounters a shrunken blue surface into which it can deliver its output, will attempt to contract its red surface to match its straitened circumstances – remember, businesses as producers can never really control the price at which they sell to their customers, but, as consumers of others’ output, like all consumers, everywhere in the chain, they do help determine the prices realized by their own suppliers.
Further, bear in mind that firms have a much higher discretionary component to their income than individuals and so changes here can be much more radical than at the rightmost extremity of the diagram. Firms don’t need feeding and clothing and don’t pay school fees. If firms must cut outlays, they can cut them - all the way to zero, if need be.
This in itself serves to focus the pain up into the shortening apex of the cone – that is, upon those least able to bear such sizeable shifts in the constituency of demand - but there is worse.
The Impact of Credit
The pernicious role of expansive credit now needs to be considered for its impact.
It is a central tenet of Austrian School theory that a period of credit inflation – always accommodated, if not predicated, by the central bank – is what gives rise to the Boom in the first place.
This comes about because the extra credit initially finds its way into bidding up the prices – and down the yields – of financial assets.
This lowers the cost of capital dramatically – whether in the form of debt or equity - and allows a rash of previously unfunded ventures to be launched and the majority of these are always prone to be found in the higher order categories of goods (technology is sexy, and New Eras seductive, after all).
Another reason for the concentration here is slightly more indirect. To the natural rate of interest which we have introduced, and which consists of people’s instinctive pricing of the passage of time, we must, in the real world, add two other factors: a compensation for the potential loss of the purchasing power of money and an added return commensurate with any increased risk specific to an individual business undertaking.
From all we have argued so far, we can see that higher order businesses must be deemed to be inherently more risky than lower order examples. They are more capital intensive, they are more specialized and thus less adaptable. Their lead times and forecasting horizons stretch further into a dimly-perceived and uncertain future. The value imputed to their output also passes through many more hands and hence is filtered through a greater number of layers of decision makers through the body of the cone, making it much more susceptible to large fluctuations.
This element of a risk premium in the discount rate might therefore be thought to be more elevated, the further left in the diagram we go, under normal circumstances (in fact, we have included exactly such behaviour in the equation which generated our curves).
But, come the Boom, and the bidding up of asset prices and down of yields tends to lead investors to extend out the credit spectrum, as well as to tolerate longer maturities. Risk premia therefore become squashed, often unrealistically so. Lower risk premia, combined with artificially lowered rates in general, means lower project finance hurdles over which to jump and hence more projects being rolled out than are warranted.
Moreover, there are fewer firms – as well as more visible ones – at the high end of the cone, so the money chasing into their securities can have more dramatic effects in the initial stages: an instability which becomes structural through the detrimentally slavish devotion to the fetish of ‘indexation’ practiced by most institutional money managers, who thus keep reallocating in favour of the winners, like punk gamblers betting more each time on the last winning number.
Thus, higher order firms will be disproportionately present in this dangerously ill-founded and inherently misdirected expansion – and these will rank highly among the ultimate victims of the Boom as a result.
Indeed, the very fact that these schemes were stuck on the drawing board before the Boom began should be enough to determine that they represent plans for using resources for less urgent, lower priority needs than those already in effect. In other words, these businesses were sub-marginal under the prevailing mix of consumer needs and capital possibilities and only easy credit allowed them a chance to compete for a ration of the nation’s ever scarce pool of resources.
Now, we don’t just find ourselves in a chicken farming Boom. We have the possibility of a fully-fledged mania, for one of the most destructive of all currents is that firestorm which develops in an asset-credit vortex whereby money chases an asset and forces up its price, increasing speculative demand for it and, at the same time, improving the value of the existing holders’ collateral. That then provides both motivation and means for another round of borrowing and buying, ratcheting prices – and indebtedness - higher at each turn.
There is nothing to guarantee that the focus of all this activity is actually adding to real value, rather than merely to the kind measured with the rapidly-shrinking ruler of money’s worth.
What it certainly cannot conjure out of thin air either is the complex capital array needed to see the start-up’s, or new business division’s, product through to a finished and wanted consumer good. It did not originate in a voluntary shift to more saving – signalling relative satiety with the basket of goods on offer today and hence the possibility of a latent, higher desire for new goods in future – nor can it help assure that any such production as is completed will be viable.
All that this frenzy of misplaced activity can wreak is contained in the lesson of the last two and a half years, and it should serve to tell us what the awful consequences of such a grand folly can be.
Is Consumption the Answer?
But we are not addressing the pathology of the Boom-Bust cycle here for its own sake: we have done that often enough and at length – both during its final soaring ascent and all through the hurtling decline since.
Rather, since what we have been considering here are the effects of enhanced consumption on the Cone of Production, let us briefly consider what consumer credit does to its structure, before marrying the two parts and trying to assess whether a policy of unrestrained consumption can ever be the answer to a bust which had its roots in a misguidedly lengthened cone.
To recap our earlier conclusions, accumulating more capital per head of the populace is what leads to progress, whereas destroying capital can only make us poorer, and a shift towards consumption is – a priori - a shift towards the latter.
In the case which we looked at in detail, we only considered a spontaneous shift towards higher time preference (a more intense appetite for immediate goods and services) without worrying about credit effects. So, now, let us allow consumers to borrow ever more freely as well.
While businesses are all too fallible – and can often be run as engines of ill-deserved gratification for their managers and bankers – the ostensible purpose of business borrowing is for reproductive purposes; that is, it is aimed at using the extra resources it can now command in such as way as to give rise to enough extra income to service, amortize and, one day, discharge the debt so incurred.
Used irresponsibly, or contracted in the midst of a miasma of monetary expansion, this can be damaging, but it is not the credit itself, but its misuse, that is the evil. Corporate credit is like fire – useful when controlled, but the source of an inferno, if unchecked – but corporate credit, when the funds have previously been saved, is as legitimate a form of capital as shareholders’ or proprietors’ equity.
Consumer credit, on the other hand, has few redeeming features, since it is aimed squarely at the pleasurable extinction of those things for which one has not already offered up a compensatory creation of value through work, or the use of one’s assets.
The best consumer credit can do is to promise proper payment out of future contributions, but this is merely to indulge a spoilt child, doling out treats today on the pledge of good behaviour tomorrow.
Imagine a business given a special subsidy to enable it to buy in supplies and to pay for labour ahead of its rivals. Very soon, this business would begin to crowd all other businesses out of the chance of making the returns they require.
It would bid up costs – of materials, services and labour - and it would, no doubt, have an increasingly insistent first call on such genuine capital, as well as such extra created credit as was available, so depressing the chances of investment elsewhere in the cone.
Consumer borrowing can be thought of as exactly such a subsidy.
Indeed, we can see this process clearly at work if we use our new-found perspective to re-interpret what the latest NABE survey was telling us about costs being the worry, not credit availability. More corroboration comes from a recent NFIB small business survey where, when asked to rank their most pressing problems, whereas fully two-thirds cited issues of costs, taxes and regulation, only 25% cited matters related to demand and competition, and a risible 2% cited credit issues.
Consumer credit, moreover, has been actively encouraged by the authorities, whether through exhortation (remember ‘Shopping for America’, in the wake of the WTC attack?), through lowering rates with the aim of making money holdings as unattractive as possible, or through the disingenuous promotion of the housing bubble as a means of building ‘equity’ (in fact, just another asset-credit spiral) – equity, no less, which is then to be withdrawn and spent via cash-out refis and dedicated lines of credit!
Thus, if a producer credit boom wastes scarce real capital by channelling it to over-ambitious, or fundamentally flawed, business ventures (what we call malinvestment’), consumer credit burns capital on the altar flames of a fatalistic self-indulgence.
Ask yourself this, if the end of the Boom has already necessitated a painful shortening of the productive structure, how can fostering individual habits of profligacy and material gluttony – which only serves to shorten the cone yet further – be of any assistance whatsoever?
It should be apparent that floundering, post-Bubble entrepreneurs are striving to secure a foothold somewhere in a structure revealed to be not as rich and supportive of higher-order processes as had been believed. It should also be an ineluctable conclusion that mobilizing the masses to force the cone into an even steeper, more truncated form, is only to be moving the ground from under those companies anxious to swap the quicksand of the Boom for the bedrock of relative certainty once more.
What is the Answer?
So, what is the prescription?
Well, if credit-led over-consumption drags everything to the mouth of our cone, and if the secular trend of capital accumulation is what, at root, ensures progress, surely we should be telling people to emerge from denial, to recognise the real degree of loss occasioned in the Boom, and to begin to under-consume – i.e. to save.
Yes, some goods will go begging when first offered – they will even fall in price (GASP!) to reflect this. To condemn that is to castigate veracity in expressing their place in individuals’ freely compiled lists of preferences.
Yes, some companies will fail, but if they are not viable under true free market conditions, they are merely locking up scarce capital in decidedly less than optimum undertakings. If the advice to winnow them out is fit for Japan, it is surely fit for the Anglo-Saxons, too.
Finally, yes, the banks and the other multifarious financial intermediaries will, like the State itself, not reap quite so much of the handsome, if rotten, fruit of credit expansion. Some of the more egregious of them may also fail, but the more sound survivors will be the ones best suited to act wisely in future. As for the State, it will just have to be more honest about how much of our labour it would conscript to pay for its guns and other peoples’ butter.
Far from being a bane, in truth, none of these consequences is more than an act of preparing the groundwork for future, more stable, increases in genuine earned prosperity.
Of course, we then want such savings as we do make to be channelled by sound financial intermediaries, acting on wise and prudent principles of stewardship, to companies with realistic aspirations, run by open and honest managers.
The cynics among us may grunt that such a combination is hardly to be found, but just because it is a labour to ferret it out, doesn’t mean we should despair of its existence and, more to the point, a continuation of the present flawed, chronically inflationary and morally hazardous financial system is not likely to be conducive to such rare blooms seeding themselves among the weeds of monetary and ethical corruption.
But sermonizing aside, does this represent any more of a way out than the current ruse to provoke just enough inflation to maintain headline billing for our great debt-asset Ponzi scheme for another period ‘in the short run’?
The flip answer is to recall the old Irishman’s response, asked, as he sat smoking his briar at a country crossroads, by a lost and benighted traveller: ‘Could ye tell me the way to Skibereen, please?’ Pushing up his cap to scratch his hoary old head for a moment, the old man looks the fellow up and down and drawls: ‘If Oi was after getting there, Oi wouldn’t be starting from here!’
There are no easy choices. Huge – perhaps unprecedented – imbalances, record indebtedness perched atop still-overblown asset prices, the ire of powerful vested interests, and a blind dedication to a whole pharmacopoeia of quack remedies and misdiagnoses stand in the path to recovery and regeneration.
But, after eighty years of increasingly ubiquitous and unabashed central bank-led inflationism, one which financed two industrial-scale, and a host of lesser, slaughters, two monumental booms, and one Great Depression, might it not be time to refer the patient to a more sympathetic, traditional doctor to see if he can effect a cure, before our current debt-fuelled consumption leads us to such a state of exhaustion and enervation that we risk another such Depression and--almost inevitably--a new and more horrible global conflict?
The voices of political and intellectual inertia may cry a resounding, No!, to such an imprecation and Rome may fall again, as a result.
But, at least you will not now have to wonder why the consumer not only didn’t save the day, but may well have lost it for us.
