The following thoughts on the current economic and financial environment formed part of a recent commentary sent to our firm's clients. Users of the blog may find them of general interest.
In the Austrian description of the trade cycle, the lack of any generalized rise in the price of final consumption goods is never — repeat, never - to be taken as a sign of economic health or as a guide to the long-term viability of the upswing.
This is because the mere fact of such an absence tells us little or nothing about whether it might be masking the natural tendency for the productivity improvements we would expect during a period of entrepreneurial advance to lower the price of these goods, were it not for the overriding tendency of a widespread credit expansion to cancel this out.
That this is not an academic abstraction should be evident if we consider the case of, say, the technology sector where we find that the sticker attached to the first batch of any new gizmo generally contains a premium which only the most insistent status-seeker will be willing to pay. Thereafter, it is generally safe to assume that a subsequent increase in production volumes — as well as the workings of competitive imitation — will tend to deliver the same service at successively lower prices to the less impatient of us, once the hype associated with the launch subsides.
In the general case, therefore, when we try to value the enterprise which gives rise to such goods, we should build this schedule of decline into our estimates and we should therefore conclude that even the bare maintenance of profitability will require the delivery of one or all of the following: an ongoing lowering of costs, an expansion of sales volumes, or a steady stream of newly monetizable innovations.
Plainly, each of these would represent an economically beneficial outcome both for the producers and for the consumers of such goods.
Theoretically, too, in a world where new investment could only be financed out of genuine saving (whether this fund originated externally with an unconnected individual or internally in the form of the firm's retained earnings) the corollary that such savings would be economically scarce in a way they emphatically are not today would combine with the fact of benignly falling prices to curb the wilder fantasies of both the entrepreneur and his prospective backers, engendering a healthy discipline in the first and reinforcing a more prudent mindset among the second. It would thus severely curtail the opportunity for the contagion of the boom ever to take hold.
But, once we allow for the provision of an elastic bank credit which is subject to few practical restraints — and in spades if we then underwrite this laxity with a slavish central bank orthodoxy which regards falling prices as utter anathema, irrespective of the cause - the virtuous circle we have just described will soon be sundered in a thousand places.
No more will savings require a conscious decision to provide more for the future and to indulge ourselves less fully in the present for the gushing wellspring of credit will instead be able to conjure up the illusion of having our cake and eating it, too.
Moreover, the entrepreneur will soon realize — if often in an unarticulated fashion — that a concerted policy of monetary malfeasance has meant that final goods prices will no longer tend to fall as he and his peers perform their true function of earning profits by contributing most effectively to the ordered satisfaction of consumers' most insistently expressed desires. He will then become aware that his unending struggle to combat such a reduction by economising better (that is, by producing more and more service for less and less input) has started to reap him hitherto unlooked-for monetary gains, a windfall which is bound to stimulate his ambition to expand more rapidly. To do this, he will naturally have recourse to the very same, freely-available credit with which policy-makers intend to hold up the level of overall prices. Worse still, he may even begin to relax that struggle itself and instead come to rely upon the simple wager that his costs will rise less rapidly than will his selling prices.
The formerly virtuous circle will now have turned thoroughly vicious.
Already, here, we see the glimmerings of a system built upon the uncertain foundations of a fraud which does not consist of a violation of contract of the petty kind occasionally undertaken by a few unethical individuals, but rather of one rooted in the universal deceit of not trading like for like - one which, regretfully, even the most upright is unwittingly forced to practice when the calculus of exchange becomes perverted in this manner.
Though the resulting cycle may start out well enough — and certainly with enough promise to satisfy a politician's amoral sense of self-interest — it will deteriorate progressively from Alberich's first seizure of our own true gold to the economic Goetterdaemmerung which inevitably ensues from that theft.
Since genuine saving has fallen well short of releasing sufficient men and matériel to supply the needs of the investment boom, a struggle over such means soon becomes all too manifest. In this, the influx of credit can well be thought of as a crazed, command economy commissar issuing wholly incompatible orders willy-nilly and brooking no objections to his whim. The signalling ability of the price mechanism thus begins to be swamped and all sign of the relative degree of insistency of demand and scarcity of supply becomes obliterated, depriving entrepreneurs and investors of any means of navigation.
Now, the self-organizing harmony of the free market gives way to discord and strife. Those whose own productive efforts earn the other goods they wish to acquire come into conflict with those who can merely borrow the money for their purchase; while the entrepreneur no longer has to persuade cautious savers to risk their nest-eggs with him, but has only to surmount the trifling hurdle of completing the formalities with a banker who is all too eager to beat his competitors to the draw and create the necessary 'capital' out of thin air.
Annoyingly for the technocrats, the basic Keynesian con of tricking workers into selling their labour too cheaply (because are supposed not to comprehend that their money wages are rapidly depreciating) is, in practice, quickly rumbled by a hoi polloi far more savvy than the patronising, Bloomsbury set prescription assumes. Thus, the only part of the specious merit of inflationism which remains in force is exactly this mechanism for artificially fostering investment at the expense of end consumption via the first-use advantage of newly-created and selectively-granted credit — a phenomenon known (after Hayek) as 'forced saving'.
To reiterate the point, under such conditions, big-borrowing businesses can unfairly commandeer resources in quantities and at prices which do not genuinely reflect the particular allotment which would have followed had their distribution been solely reliant upon voluntary consumer preferences being faithfully transmitted up along the chain of production.
To take an extreme example of what this implies, consider the poor babushka queuing stoically for a few mouldy heads of cabbage while the Soviet planners who lord it over her boastfully unveil yet another new blast furnace, heedless of the truth that what the proletariat really wants is more investment in farm equipment, more frozen food factories and more efficient distribution networks. Again, think of what happens when the wartime economy forcibly harnesses the creative genius of a Henry Ford to churn out only engines of death rather than allowing him to thrive by offering more enablers of the better life.
Even if we draw back from such radical instances of collectivist compulsion, we should still be led to conclude that a policy of inflation is doomed to fail because, in extremis, the hungry man will gladly hand over his hammer in exchange for a hamburger and swap his shovel for a scoop from the stew pot. Though matters rarely come to this sorry pass in a modern, peacetime economy, the axiom still holds that the demand for consumer staples will always come to trump that for any other kind of good and when this long-suppressed drive reasserts itself - Take cover! — the storm clouds lowering over those running businesses far-removed from the immediate satisfaction of such wants are about to break and the coming deluge will sweep many of them away before it subsides.
We started this commentary by saying that an absence of increases in consumer goods prices should not be taken as carte blanche to continue heedlessly inflating. Conversely, however, the archetypal sign that this drearily repeated tragedy — this hubris and nemesis of boom and bust - is again nearing its ruinous culmination is when the prices of final consumer goods do, at last, start to rise more rapidly than those of higher order — intermediate, crude, or capital - goods. Once this juncture is reached, only a sufficiently large and unforeseen injection of new credit can give overstretched and inappropriately-positioned entrepreneurs the means to forestall a drain of resources into the short-term ramping up of the production of such pricier goods and so afford them some prospect of seeing their unduly longer-horizon projects through to completion, albeit that they are still acting in defiance of the principal of 'consumer sovereignty'.
If, however, the bankers have simultaneously become alarmed at the rise in consumer prices, this inflationary annealing may not be forthcoming. The urgent monetary stringency which follows (and which is often characterised by a negative yield curve) will then reveal that the buckling and twisting of the whole structure through 'forced saving' has multiplied and entangled a myriad dislocations in its matrix, leaving the fatally embrittled Boom susceptible at any moment to a catastrophic failure.
Being founded on nothing more than misplaced credulity and speculative self-delusion, once it does crack, the 'liquidity' born of easy money turns instantly from a sly Pandarus into a vengeful and eyeless Samson, pulling the whole temple of false prosperity down about its own ears in its dying spasm of retribution.
It is not inconceivable that this is the scenario with which we find ourselves confronted today, even though China's dominance of the key nexus of that productive upsurge we call 'globalisation' has long forestalled its full development, thanks to the Middle Kingdom's peculiar elevation of 'forced saving' to near godhead and to the lack of basic accounting rigour informing its investment choices. Not entirely fortuitously, the chronic, local imbalances which this spawned have long formed a precarious bridge between the sizeable, but complementary discrepancies which have simultaneously come to separate the two ends of the productive structure in the rest of the consuming world. Any narrowing of the former, therefore, will inevitably lead to a widening of the latter.
Because of this we must be attuned to the news that, in addition to the threat posed to further cheap Western imports by China's rising labour costs, its strengthening currency, its still-tentative central bank tightening, and its tweaking of export tax incentives — not to mention by the spectre of home-grown protectionism - Beijing may be about to reduce its runaway generation of forced savings much more directly than before.
If they are actually followed up (a conditional decidedly not to be underestimated), the latest announcements that state-owned enterprises will have their enormous retained earnings reduced through having to pay dividends to the various proprietary governments will not only make central bank policy more effective (since external funding will attain a greater relevance in corporate decision-making), but it will presumably divert funds away from the more sub-marginal kinds of what passes for investment and into that other sinkhole of exhaustive consumption which is public welfare. If so, a programme which has done so much to supercharge commodity prices and depress final goods prices will be much less dynamic in its operation from here on in.
Whatever China does or does not, it remains the case that as this credit boom — like every other of its type — reaches an inflexion point, the range of choices facing policy makers will run the following gamut:
- to attempt to truncate the approaching peak in the hope that this might lower the height of the precipice toward which the economy appears to be heading;
- to shore up the crumbling edifice of emerging entrepreneurial error with a further dose of inflation (a course only effective if labour does not manage to secure the majority of the proceeds to itself, as in the 'stagflationary' 1970s);
- to allow the boom to collapse under the weight of its own contradictions and only afterwards to attempt to alleviate the patient's suffering with a post hoc burst of further inflation;
- to stand back with Olympian detachment and let system purge itself of its worst excesses, however painful the experience.
Taking these options in reverse order, the fact that the last full-blown instance of the laissez-faire course being followed was arguably during the short, sharp Harding recession of 1920-21 shows how far we should weight our bets against it being pursued again today.
In contrast, the 'mopping-up' policy is exactly the kind of indulgent parenthood most notoriously practiced by Alan Greenspan throughout the course of the Tech bubble and while his tenure still overlapped with the developing phase of the subsequent housing fiasco. As these recent examples should themselves make plain, however, this is only really practicable when dealing with an asset boom (widely, but erroneously regarded as 'good' inflation). It is much less applicable to a fine, old-fashioned rise in end-consumer prices — a condition for whose prolongation there is typically much less popular support.
These same two examples should also show how pernicious the 'hair of the dog' approach can turn out to be, for few would argue that the threat of mass household bankruptcy across the Western world has its roots anywhere but in the panicky, post-Tech monetary relaxation. As Albert Hahn once remarked: "there is nothing so dangerous as inflation without 'inflation'".
If we can here adopt the (slightly sniffy) stance that the second of our choices — the administration of ever-increasing doses of stimulus to the point that the currency itself disappears into a vortex of worthlessness — is the sort of thing which nowadays only a despot like Mugabe, or some desperado of a Latin American Presidente would hazard, then we can quickly move on to the first case, that of a prophylactic central bank pre-emption.
The cynic might here argue that the experience of the last four years has ruled this out in practice in no less convincing a fashion than the others we have already discounted. But this would not be entirely fair for, by their own narrow prescriptions, central banks have not, thus far, had much of the necessary grist to begin the contentious business of turning their monetary mill. In general, indices of final goods prices have, after all, been moderately well-behaved (at least, by our lowered standards) - a happenstance we can partly ascribe to the China phenomenon explained above.
Remember that the prevailing central bank orthodoxy is that both food and energy prices should be ignored when setting short-term interest rates. Bear in mind also that central bankers insist on misapplying the term 'inflation' to its effect (higher prices) rather than to its cause (too much money) and that they then choose to disregard whole swathes of those prices when they do rise — even if these are the very ones which tend to hit the forgotten man's pocket the hardest. Given this, it is not a cause for wonder that the standard recipe they follow does tend to diminish the chances that they will be called upon to take any timely steps whatsoever.
Insulated in this way, the bankers can remain 'vigilant' and issue regular, stern declarations of anti-inflationary resolve while still avoiding the need to do something concretely unpopular now in the hope of achieving what can only be an unquantifiable increment to well-being sometime in an uncertain future.
But here we come to a possibly crucial irony for commodity investors, for the prices of final goods are currently showing clear signs of upward pressure in any number of countries and one of the key factors here has been the upward spike in food prices. That spike is, of course, not just due to the fabled enrichment of Asian diets, but also because of the endemic degree of extra scarcity occasioned by the largely political biofuel factor — an influence whose potency has this year spread from bioethanol (primarily affecting corn) to biodiesel (and hence is being felt by various oilseed crops as well).
Adding to this has been an expressed reluctance on the part of the oil producers and refiners to commit even more tens of billions of dollars to removing the worst of today's price-raising bottlenecks in an environment of rapidly spiralling construction estimates (a link to rising metals prices, among others) and when Washington, Brussels, and Beijing are insisting that, henceforward, we reduce the potential market for the new plants' output by burning food instead of fossils in ever greater proportions, irrespective of the economic, or even the energetic, rationale behind that decision.
Faced with all this, one gets the distinct impression that some central bank council members are becoming a little hot under the collar as the awareness dawns that their much-vaunted 'credibility' will be irredeemably challenged if they ignore all of rampant credit growth, indiscriminately soaring asset prices, rising fuel prices and rising food prices.
Add in the possibility we have mooted that, one way or another, the cost of goods sourced in Asia may also start to increase and this discomfort is likely to resolve itself in a much more determined pull on the reins before too long.
As Bundesbank chief, Axel Weber, warned readers of the FT in May: "The sources of inflation risks have shifted from the external side to the domestic side. In a situation where we see some endogenous upwards dynamics [in] inflation due to excess demand in the economy, we cannot give the all-clear on monetary policy. If necessary we also have to move into a territory that is portrayed as being restrictive if that is needed to control inflation.
If all the changes we have considered do come to pass — if China really edges away from 'wild investment' and towards greater domestic consumption; if final goods prices continue to rise more rapidly in the West; and if this induces a belated burst of central bank activism — it is likely to trigger an archetypally Austrian, producer-led bust.
Then, once the central banks have finally succeeded in upsetting the applecart - and after the ensuing period of turmoil - all thoughts will again turn to the question of how long it will be before they respond to the spillage by issuing copious reams of newly-printed payment orders, each made out to those whose job it will be to restack the fruit in the shortest possible order.
At that point, the cycle can begin anew - different in its specifics, no doubt, but also horribly familiar in its overall form.
