Mises Daily Articles
Economic Crisis and Paradigm Shift
Neoclassical economists usually explain their disdain for the Austrian School by saying that, although their theories may seem to be logically and correctly constructed, they lack predictive power; that is why, according to the positivist view, they must be ruled out as "nonscientific."
The current global financial crisis, described in an incomplete manner as the "subprime crisis," has shown, however, that neoclassical theories are not only descriptively false, but also completely incapable of predicting events. In contrast, the Austrian School's theories, as I will shortly show, not only maintain their realistic approach but also have an important predictive power.
The current crisis fits perfectly with how Austrian economists have explained these events since the beginning of the 20th century. This is easily demonstrated by reference to what might be called the "orthodox version" of the Austrian business-cycle theory (ABCT), as Professor Jesús Huerta de Soto has elaborated it on his book Money, Bank Credit and Economic Cycles.
I do not agree with every point elaborated in this book, but in order to avoid accusations of retrofitting the theory, I will present it without revision or qualification. Even with these exceptions, the traditional Austrian theory is able to explain the main facts of the current crisis, and, being available to all professional economists, it should have enabled them to anticipate and explain this crisis with far greater success than they have had. The sequence described by ABCT is as follows:
Banks grant new loans on a massive scale and the interest rate drops.
After 9/11, first the Federal Reserve and then the European Central Bank (ECB) a few years later, undertook an aggressive credit-expansion policy that led them to keep interest rates at extremely low levels for some years. Thus, the Fed went so far as to keep them at 1% from June 2003 to June 2004, and the ECB at 2% for more than two years — from June 2003 to December 2005.
Credit expansion drives malinvestments in projects far from consumption which were not profitable before the credit expansion.
The new credit was infused through both consumers and producers. The former decided to mortgage themselves on a massive scale in order to purchase homes that, before interest rates were pushed down, were not affordable. These consumers would have decided, for example, to rent their homes, or possibly to continue saving for a later purchase. Producers generally decided to carry out leveraged buyouts of stocks in order to change managerial control or reduce costs of capital. As in the case of the mortgages, these leveraged buyouts would not have been profitable before interest rates dropped.
Capital goods rise in price.
House prices rose by 40% on average between 2002 and 2006. Real-estate prices rose more in these five years than they had in the entire decade of the 1980s (when prices rose by 38%). In Spain, in that same period, average prices rose by 65%.
Prices climb on the stock market.
Between 2003 and 2006, the Dow Jones Index climbed by 45%, the S&P 500 by 55%, and the IBEX 35 by 125%.
The capital structure is artificially lengthened.
Between 2003 and 2006, 4,627,000 new homes were built in the United States. Also, companies displayed a widespread trend of leveraged buyouts of stocks, trying to arbitrage between two different ownership structures distinguished by such descriptors as "Inc." and "L.L.C." in company names.; Since the debt-service burden was reduced, they could finance the transaction with a lower profit expectation. Thus, for example, the average ratio between Debt/EBITDA (how many years of profits are needed to pay off the current debt) went from 4 in 2001 to 5.5 in 2006.
Large accounting profits appear in the capital-goods sector.
Nonfinancial-company profits in the United States increased by 65% between 2003 and 2006, and the profits of many construction companies increased even more: Meritage Homes Corporation (136%), Cetex Corporation (131%), Lennar Corporation (128%), and DR Horton Inc. (97%).
The capital-goods sector demands more workers.
In the United States, the building industry did not significantly absorb the labor force (because it was not the only sector where credit expansion flowed in) and its share only increased from 6.1% to 6.7% between 2001 and 2006. However, in Spain, where the credit expansion flowed into this sector on a larger scale, the labor force in the building industry went from 11.1% to 12.4% between 2000 and 2005.
At some point the rate of growth in credit expansion ceases. The interest rate climbs. The stock market crashes.
From 2004 in the United States and 2005 in the euro zone, interest rates started to rise from 1% to 5.25% in 2006 and from 2% to 4% in 2007, respectively.
By January 2008, the Dow Jones Index had already decreased by 5%, the S&P 500 by nearly 6.5%, and the IBEX 35 by nearly 13%. Stock-market volatility had increased, as demonstrated by "Black Monday" (January 21), when stock prices decreased by about 7% in just one day.
Consumer goods prices grow faster than wages, in relative terms.
In the United States, the average inflation rate was 2.3% between 2002 and 2006, whereas wages per hour increased by an average of 1.9%. In Spain, the difference was even larger. Average annual wages went up by 2.2% between 2002 and 2006 and the Consumer Price Index (CPI) by 3.2%.
Accounting profits appear in the consumer sector (demand increases).
Accounting profits of the main consumer-goods wholesalers continued to rise between 2005 and 2007 or maintained virtually constant, despite the economic crisis.
Wal-Mart, for example, earned $10,267,000 in January 2005 and $11,284,000 in January 2007. Costco Wholesale Corp. gained $1,063,092 in September 2005 and $1,082,772 in September 2007. Target Corporation suffered a slight dip from $3,198,000 in 2005 to $2,787,000 in 2007.
In the last quarter of 2007, the profits of these companies fell by about 2% with regard to previous quarters, but they remained solid compared to the losses that construction and other heavily leveraged companies suffered.
The capital-goods sector sustains heavy accounting losses.
As already noted, nearly all the big construction companies mentioned above have sustained losses since June 2007: Meritage Homes Corporation ($175,128), Cetex Corporation ($771,792), Lennar Corporation ($758,057) and DR Horton Inc. ($873,900).
Workers are laid off in capital-goods industries.
In the United States, employment in the building industry drops marginally, from 6.72% to 6.7%. This development is much more visible in Spain during 2007, where unemployment in this sector increased by 20%.
Bank defaults mount. Marginally less solvent banks face serious difficulties. Credit crunch.
In early 2007, nonperforming loans in the United States skyrocketed to almost 14% of the so-called subprime mortgages. In Spain, during the 3rd quarter of 2007, nonperforming loans were at 0.63% of all mortgages; although this is a very low figure, it is higher than at any time in the previous five years.
The current situation is precisely this: we face a credit crunch stemming from the creation of bad debt by the banking system (based on hyperabundant money) and the central banks. The recession seems to be inevitable: malinvested assets will undergo a severe adjustment due to the sale or the repossession of assets on a massive scale, which is necessary to repay the debt.
Neoclassical economists, and specifically monetarists, have brought us here. Keynesian theory fell apart in the 1970s, and now monetarism has followed. The Austrian School is the only remaining source of credible analysis and sound economic policy.
If financial and business communities do not want to sacrifice themselves in an ever-intensifying cycle of monetary chaos, they should start to listen to the Austrians; as should the media as well. For some people, unfortunately, intellectual conceit and convenient ignorance are more powerful forces than honesty and prosperity.
There is always a bubble someplace. In a world of fiat currency and fractional-reserve banking, where money is effortlessly multiplied and pyramided, the sequence of boom and bust become inevitable, like the sequence of the seasons. In this system, the government cannot prevent the expected corrections anymore than it can prevent the onset of winter. The strong housing market has all the makings of being the next bubble — in particular high leverage and unsustainable price increases.
Moreover, the Bank for International Settlements (BIS), in its report of June 2007 (no. 77) resorted to Austrian theory (although it did not mention it) to point out several worrisome elements in the world economy:
The problem at the moment is that the allocation of resources in all three countries has been moving resolutely in the wrong direction. In China and Japan, investment is still in large part focused on export markets.… In the United States, it is the recent massive investment in housing that has been unwelcome from an external adjustment perspective. Housing is the ultimate non-tradable, non-fungible and long-lived good.
The Wall Street Journal, however, recognized the reasoning: