Boom and Bust
[Part of an ongoing series on Austrian theory]
Imagine that you are a bus driver at the edge of a desert, about to take a busload of passengers across it. You have left all gas stations behind, and are now faced with a decision. There are a number of towns on the other side of the wasteland before you, each a different distance away. The farthest away of these towns also happens to be the closest to your final destination. You can try to reach any of them, but there is a trade-off: the farther away the town, the less the passengers can use the air-conditioning to alleviate the desert heat, as running the AC will use up the gas more quickly.
In order to make your decision, you look at your fuel gauge and determine how much gas you have. You tell the passengers that they must now make a trade off between comfort on the way and distance traveled, as the more air conditioning they choose to use, the faster the bus will consume fuel. Then you collect votes from the passengers on what temperature to keep the bus. You perform some calculations on mileage, speed, and fuel consumption, and pick the farthest city you can reach given the amount of gas you have and the passengers' vote on the use of air conditioning.
The passengers had to decide whether to cross the desert in greater comfort but arrive farther from their final destination, or in less comfort but with a closer arrival. The science of economics has nothing to say about the combination that they picked, other than that it seemed preferable to them at that moment.
However, also imagine that, before you began your calculations, someone had sneaked up to the bus and replaced the passengers' real votes with a fake set that choose a higher temperature, in other words, less fuel consumption. You made your choice as if the passengers would tolerate a temperature of, say, 80 degrees, whereas in reality they will demand to have the bus cooled to 70. Obviously, your calculations will prove to have been incorrect, and the trip will not come out as you had planned. Your plans will be overly ambitious. You will begin by driving as if you had available more resources than you really do, and end by phoning for help when the deception is revealed by the sputtering of your engine.
I offer the above as a metaphor for the Austrian theory of the trade cycle, which offers an explanation of why the economy swings through boom times and recessions. You, the driver, represent the entrepreneurs. The gas is the stock of capital goods. The trip across the desert is the next "round" of production. The passengers represent the consumers, and their choice on how much to use the air conditioning is analogous to how much consumers are willing to put off consumption today in order to save for the future -- their time preference for current consumption over future consumption. The ultimate destination is the satisfaction of as many wants as possible. And it is the central bank -- in America, the Federal Reserve -- that has sneaked up and tampered with the consumers' votes.
What the central bank tampers with is the outcome of the consumers' "votes" on time preference, which is the natural (originary) rate of interest. Consumers' time preferences tell us how much capital will become available through consumers' saving, or, in our metaphor, cutting back on the AC. When the central bank artificially lowers the rate of interest, entrepreneurs make their plans believing that consumers are willing to delay consumption and save more than they really are. As the bus driver, you think that the passengers are willing to endure the heat enough to reach Phoenix, but, in reality, they will force the bus to consume gas so rapidly that you should have planned only to reach Albuquerque instead. Your attempt to reach Phoenix will fail, leaving you "out of gas" in the middle of the desert.
The natural rate of interest, or that rate that would exist on the unhampered market, measures consumers' time preference because it reflects what borrowers must pay lenders to persuade the lenders to delay their own consumption. If I have $100, I could spend it today on a nice dinner with my wife. Or, I could lend it out for a year, at the end of which I could spend it on a somewhat nicer dinner. Exactly how much nicer a dinner I must expect to receive before I will lend the money is an expression of my preference for current consumption over future consumption. If I demand a rate of interest of at least 5%, this means that a $105 dinner next year is marginally more valuable to me than a $100 dinner this year. On the other hand, if my friend Rob demands 10% interest, he is demanding a $110 dinner. He values current consumption compared to future consumption more highly than I do.
At any particular rate of interest, the borrowers are those whose time preference is the opposite of lenders -- the higher a rate of interest I'm willing to pay on a loan, the more I prefer current consumption to future consumption. If I will pay 10%, then I prefer $100 for consumption today to $110 available for consumption a year from now. The net result of all lenders and borrowers expressing their time preference by offering and bidding on loans is the natural rate of interest.
This natural rate of interest tells entrepreneurs whether a particular investment is worth making or not. In an unhampered market, the natural rate of interest would be equivalent to what is termed, in finance, the risk-free rate of interest. Since entrepreneurs can earn this return on their money simply by lending it out, they will only undertake capital projects if they estimate that their return will be higher than the natural rate of interest. In terms of our analogy, it makes no sense to plan our trip with Phoenix as the destination if the consumers are only willing to turn off the AC (put off current consumption) enough to reach Albuquerque. For any project that returns less than the natural rate of interest, the consumers are indicating that they would, in fact, prefer that these resources be used for current consumption rather than being invested in this project.
Now, let us see how the activities of the central bank affect this relationship. We will use the Federal Reserve, the most powerful central bank in the world, and the recent Internet boom to illustrate what occurs.
As Dr. Frank Shostak points out, the Fed began a three-year long expansion in 1996: "After falling to a yearly growth of 1.6% in May 1996 the yearly rate of growth in the money base climbed to 15.2% by December last year." Meanwhile, the interest on the 30-year Treasury bond dropped from a high of over 7% to a low of 5%. The stock markets soared, especially the stocks of Internet startups. The "tech heavy" NASDAQ composite went from just over 1000 to 5132 during this period, rising over 80% in 1999 alone.
Buoyed by the stellar stock market returns, consumers built massive additions to their houses, and took trips they otherwise would not have taken. Real estate, especially in the "dot-com areas" such as Silicon Valley and New York City, soared in price.
However, the Fed knows that such a boom cannot be sustained indefinitely without leading to ever-increasing rates of inflation. Last year, the Fed began raising interest rates to check the progress of the boom. As the Fed's actions began to take effect, the malinvestments of the boom period began to be revealed. Internet startups shut down for lack of funds. The stocks of other high tech companies crashed -- Amazon.com from a high of 113 to a current 30, Qualcomm from a high of 200 to 62, Red Hat from a high of 151 to a low of 18. Peter Eavis of TheStreet.com reports: "In the past month, Chicago’s Bank One and Charlotte’s First Union, among the nation’s largest banks, have reported billions of dollars in losses as they repair missteps, all committed in this boom." Meanwhile, all around my town I see large construction projects abandoned after being only 10 or 20% completed.
James Cramer, writing in the June 26th New York Magazine, hit the nail on the head with his diagnosis of the downturn:
The Federal Reserve, in its desire to stomp inflation, has raised rates to the point where business is faltering throughout the country… That means that many companies that had been thinking we were in for boom times have simply gotten it wrong.
It is important to note that the Austrian theory does not imply, as some have interpreted it, that we are witnessing the results of "overinvestment." Austrians do not contend that the Fed really has put more gas in our car! Since the Fed produces no capital goods, this obviously could not be the case. Rather, we suffer from malinvestment, as we have spent time and resources on projects that we cannot actually complete, and which we would not have undertaken if we had had an accurate reading on our gauge. As Mises put it, " A further expansion of production is possible only if the amount of capital goods is increased by additional saving, i.e., by surpluses produced and not consumed. The characteristic mark of the credit-expansion boom is that such additional capital goods have not been made available." (Human Action, XX.6)
Differentiating overinvestment from malinvestment is only possible because of the key Austrian insight that capital has structure, and it is this structure, much more than the neoclassical concept of the "amount" of capital, that is important to the economy's smooth functioning. The Austrian concept of complex orders of capital goods interlocked in complementary structures stands in stark contrast to, for instance, the neoclassical Cobb-Douglas function, where a single variable, Kt, stands for the "capital stock at the beginning of the year." (This definition is from Miller and Upton's Macroeconomics: A Neoclassical Introduction.) If you have any doubt about which model better reflects economic reality, consider whether you would prefer to live in an economy like America's, with a rich variety of complementary capital goods, or another economy with the same "amount" of capital goods in its "Kt variable," but with the capital consisting entirely of machines for kneading pizza dough.
The distinction between the amount of capital and the structure of capital explains why (besides simple lying) the Soviet Union was able to report impressive macroeconomic statistics for capital goods production while still being an economic disaster. The Soviet planners were able to direct the economy to produce large amounts of capital goods without being able, in the absence of any basis for economic calculation, to achieve a sensible capital structure.
Another analogy for the process by which the Fed "manages" the economy would be that of a hyper-active pediatrician, who never feels that the children under his care are growing at the "right" rate.
The body grows by a process we do not consciously control, based, in ways we only partly comprehend, on genetic makeup, nutrition, rest, exercise, and so on. Each cell responds to its own local conditions, and the net result of all of these responses is the body's overall rate of growth. Similarly, each individual in the economy makes local decisions based on his unique circumstances, the net of which is the overall state of the economy. By using this analogy I do not mean to contend that the economy is "really" some sort of organism, only that the process of economic growth is in some ways similar to that of organic growth.
The Fed, the pediatrician of our analogy, feels it can improve on this natural state. It doesn't alter any of the real inputs to this process, such as capital currently available or the willingness to save. Instead, it fidgets with the economy's "hormonal levels" by adjusting the interest rate. When it makes credit easy, the economy's apparent growth speeds up. In fact, what has occurred is that certain visible manifestations of growth have accelerated, while other, equally necessary but less visible growth processes have suffered as a result. Without the necessary "nutrients" being present, this sort of "growth" is built on a foundation of sand. The "bones" weaken and cannot support the body. The central bank, fearing a collapse, then tries to reduce the rate of growth through tightening credit. This in no way undoes the damage done during the period of credit expansion, but, rather, adds a new set of distortions to those already present. Of course, once the central bank has engaged in credit expansion, it is foolish to blame it for reining in the boom. The only alternative is eventual economic collapse in what Mises called "the crack-up boom," or hyperinflation and the breakdown of the exchange economy.
Hopefully, this piece has given those unfamiliar with the Austrian theory an understanding of how it explains the trade cycle. With these basics at hand, in the next piece in this series we will proceed to examine the challenge to Austrian theory presented by the "rational expectations" school of economics.
"The Macroeconomics of Capital Structure," from Time and Money, Roger Garrison.
"Keynesian Confusions," David Gordon.
"Goodbye, Japanese 'Miracle'," Jeffrey Herbener.
"Originary Interest," from Human Action, Ludwig von Mises.
"Credit Expansion," from Human Action, Ludwig von Mises.
"The Anticipation of Expected Changes in Purchasing Power," from Human Action, Ludwig von Mises. (This section describes the "crack-up boom.")
"Can the Stock Slide Be Stopped?," Llewellyn H. Rockwell, Jr.
"Can the Boom Last?," Hans F. Sennholz.