and von Mises:
In the Shadow of the Storm
last five years have mystified policy makers, hedge fund managers
and central bankers alike. They do not pose such a mystery to followers
of the Austrian theory of the Trade Cycle.
us run through it and illustrate it with present day examples.
By artificially depressing the cost of capital, credit expansion
distorts the process of evaluating consumers’ preferences for current
goods over savings which may be used for the purchase of future
goods. Left to itself, this latter, inescapable factor determines
the natural rate of interest which any entrepreneur must guess he
can exceed by the return on his new business if he is to discharge
his debts to those who provide his capital and retain the surplus
which is his profit.
over-plentiful provision of credit distorts this rate of return,
entrepreneurs en masse can be gulled into making investments based
on inherently false premises. Essentially, they bid away factors
of production (materials, land, labour) from their existing uses,
initially boosting prices (and revenues) in the production sector.
However, no new saving has, in fact occurred, no-one has become
sated with the existing supply of goods and services, there is no
surplus. Thus, those enjoying enhanced incomes as a result of the
entrepreneurs’ optimism instead enter a competitive auction for
those old consumption goods, raising their price (and incidentally,
restoring the natural rate of interest). This means that many among
the wave of investments will prove to be unprofitable and the new
businesses will fail, or will need to be restructured and their
historic costs written off. The price of productive goods, especially
in areas where they are so specialized they cannot be redeployed
easily, will fall in price or become worthless.
year’s BIS report admitted that the cost of capital had been maintained
at too low a rate in at least one major centre for too long this
decade. Greenspan, in his back-handed way, contended in his infamous
Boca Raton speech last autumn that a host of new opportunities had
opened up which had exceeded the cost of capital for five successive
years! This is a logical impossibility in a free market, but might,
instead, be something to do with the fact that MZM, for instance,
has risen 53% in the same period, of course. As for ‘savings’, enough
said! It is just as well the Asians and Continental Europeans do
that for those of us in the Anglo-Celtic world.
The only – temporary – escape from this outcome is to deploy even
more monetary expansion and thus pile layer upon layer of such malinvestments.
This is the true definition of inflation, not the latter-day commonplace
of a rise in some crude aggregate price index, but a watering down
of standards of valuation via the credit system. Indeed, it is possible
that such prices may fall as the supply-side effects of the credit
expansion bring more goods on stream at first. It is also possible
that one nation may opportunely benefit from a previous trade cycle
bust in other parts of the globe and its consequent liquidation.
of the reason this escape from the bust is only temporary is a simple
arithmetical one: debt contracted in this phase, whether directly
via bank borrowing or securities issuance, or indirectly by encouraging
others to contract debt to buy ones’s equity, while maintaining
consumption, compounds up with each new infusion of credit. At some
stage, revenue streams from the new enterprises must be sufficient
to meet both expanded interest payments and principal redemptions
or amortizations, else default looms large.
Central bankers are the root cause of this problem with their false
doctrine of the ‘stabilization’ of prices ( in practice today an
even more lax standard than that proposed by those misguided champions
of the approach in the early part of this century, who would have
viewed even 2-3% chronic inflation with horror). However, in such
an instance, relatively mild increases in such barn door measures
as CPI can act as a dangerous blind to what is being wrought in
the economy at large.
point was recently conceded by Governor Bergstroem at the Swedish
Riksbank, but it seems to elude the New Era coterie among the other
Finally, however, the demand for credit becomes more and more insistent
as debt is sought to service debt. Borrowing both accelerates and
becomes more price insensitive. Rises in indexes of consumer goods
prices are most likely to appear at this stage, as all the new purchasing
power is concentrated on the same old range of goods and services,
many of which have not had their supply enhanced either in volume
or productivity because of the misallocation of resources throughout
the cycle. If asset markets are also in disarray at this point,
as is all too likely, one possible prior outlet for the increase
in monetary substitutes is removed, making the flight into real
values all the more urgent.
recent rise in a broad range of price indexes is indisputable whether
it be recorded by CPI, ECI, unit labour costs, GDP deflators (most
signally, ex-computers) or the personal consumption deflators. Borrowing
is also an ever present, though with credit spreads exploding to
levels reminiscent of the early 90s New England banking crisis and
even the late 80s S&L debacle, bank balance sheets are bearing
the strain, not capital markets where securitization channels are
the end of March, Commercial and Industrial loans to the tune of
$32 billion have been extended by banks and real estate loans of
$40 billion have been contracted. Overall, bank assets have expanded
by $131.4 billion in just seven weeks, about 25% faster than GDP
itself, and 15% more than in the whole of the first quarter.
At this stage either a complete breakdown in the monetary system
takes place or the banks (and particularly the supposed inflation-fighters
at the Central Banks) begin to rein in liquidity, as well as raise
this occurs, recession is now almost an inevitability and the effects
will be most magnified in the higher and more specialized orders
of production, where long lead times and intensive capital usage
drastically increase vulnerability. Given that, in the modern economy,
the input/output sector, these higher orders of production, the
B2B chain is around twice measured GDP, 2˝ times private GDP and
three times consumption, the knock-on effects are all too foreseeable,
once this occurs.
might just be seeing glimmers of this in the Durable Goods numbers.
Overall capital goods orders, with a 21% annualized drop, have suffered
their worst start to a year since the recession of 1991, if we except
the weather and GM-strike disrupted Winter of 95-96. Further, Electrical
goods orders have had the worst four months in the 42-year record,
as the hangover from Y2k turns into an order drought.
a global economy which has forgotten the virtue of thrift in favour
of pledging an uncertain tomorrow against gratification today on
a scale heretofore undreamed of, the sense of impending resolution
is tangible. The effects of that denouement could well be more painful
and protracted not to mention inexplicable to the mainstream
‘thinkers’. Austrians should be better prepared for the whirlwind.
May 31, 2000
Sean Corrigan writes from London on the financial markets, and
edits the daily Capital Letter and the Website Capital