by Michael S. Rozeff
by Michael S. Rozeff
In a recent short article, I explained that capital flees from government's taxes and regulation. The other side of the coin is that capital is attracted by government's subsidies.
The attraction of capital to activities that are being subsidized diverts production and employment into activities where they would not otherwise have gone had people been left free to decide the allocation of capital. This redirection of capital invariably lowers social welfare.
Examples abound because subsidies take many, many forms. The government subsidizes leisure and penalizes work using welfare and unemployment benefits. (Human capital is attracted into these programs.) It subsidizes visits to doctors and hospitals with Medicare and Medicaid programs. It subsidizes alternative fuels, space flights, and the production of weapons of mass destruction, thereby attracting human and physical capital into the associated industries. It subsidizes wars, attracting human and physical capital into destructive activities. The list goes on and on because government is big, and government's main tool of social control is the subsidy.
Government subsidizes not only the production of certain items but also their financing. It shoots with a double-barreled shotgun. Government subsidizes loans. It often sees to it that there are low-interest loans available for selected activities such as making autos, attending college, agriculture, home buying, and so on. The list is very long.
The Federal Reserve, which is an arm of government, subsidizes the banking system. When the Fed buys bonds (or anything else), it provides banks with reserves that cost them nothing but which provide them the capability of making loans at interest. The system subsidizes bank lending and thus credit creation across the nation. This undermines other ways and means of channeling capital to borrowers, including capital markets.
Any government subsidy not only lowers social welfare but also creates production and financing imbalances. For this reason, every subsidy carries within it the seed of dislocations and unemployment. When subsidies ebb or are removed, the capital that has been unduly attracted to the subsidized activity must seek employment elsewhere. While the eventual result is healthy, the temporary transitional phase is often painful. If the subsidy for student loans is reduced, colleges and universities will experience a recession in demand. Some students will enter the job market. Some will borrow or obtain gifts from parents, who will then cut back on other purchases. The entire economy may not be noticeably affected, however. There will be no official "recession," but a partial recession in the education industry will have occurred.
A recession, as usually thought of, is a period of reduced business activity and higher unemployment that is widespread over the entire economy. One cause is the cessation or change in a subsidy or set of subsidies that have grown large enough to affect many parts of the economy. Recessions are temporary. If left alone, the capital, human and physical, moves toward other employment, and the recession disappears. Prolonged recessions are enabled and encouraged by government attempts to shorten them. They are prolonged when government restrictions of many kinds slow down and prevent labor mobility, discourage entrepreneurs from starting new businesses, prevent the unemployed from easily starting up new ventures, and prevent them from working at non-union jobs. Numerous business firms would hire more labor were it not for restrictions that they face that begin with the minimum wage and cover a vast range of other measures that act as taxes on their expansion.
If the recession is treated with more of the same government medicine, then any number of bad results can and will occur. If, for example, there are 2 million unemployed and government puts them to work building roads, social welfare will decline. Capital will be drawn from higher-valued uses into uses that society was not choosing. There will be too many roads, and not enough electricians or truck drivers or whatever other occupations would eventually be filled by the unemployed. The skills the unemployed learn will not be of as much value to them when the road building ceases as it would if they had spent the time in other jobs.
Another way to understand recessions is to begin with how production and employment work in a free market. Murray Rothbard gives a sound and clear explanation of production and the pricing of factors of production in Man, Economy, and State. The following is my simplified version of the process he explains there. Suppose we consider a single industry and good, which is the manufacture of pearls. These steps suggest how the industry reaches a free market equilibrium.
- The potential pearl consumers are willing to pay particular prices for particular quantities of pearls. These are unobservable.
- The pearl producers estimate what the consumers are willing to pay and how many pearls they will buy. They do not know these magnitudes for sure, but they have data from the past and other ways of predicting the future sales.
- The pearl producers hire (or rent) factors (land, labor, capital) to produce the pearls. They compete with producers of all sorts of other goods in hiring these factors. The production takes time, during which the land, labor, and capital have to be paid rental fees.
- In steps 2 and 3, the producers will pay for factors no more than what they think they can sell the pearls for to the pearl consumers. Since all producers of all products are doing the same, an economy-wide factor price and quantity demanded of the factors are established in the factor markets.
- The factor price and quantity demanded (demands derived from estimates of what consumers demand of pearls) are such that the discounted marginal value products (DMVP) of the factors across various products tend to be equated. This equilibrizing occurs because if the DMVP in emerald production exceeds that in pearls, there is an incentive to shift production into emeralds and out of pearls. Discounting is in the calculation only because it takes time before the product is sold to consumers and payment received; discounting is a present value calculation that takes into account the time value of money. The marginal value product refers to the worth of what a factor produces at the margin (when one additional unit of product is produced).
- The sum of factor prices paid to produce pearls (called the factor costs) tend to equate to the price that consumers pay for pearls. This is a second equilibrizing tendency. If this were not so, there would be an incentive either to produce fewer or to produce more pearls. If factor costs exceeded the price consumers pay, the business would be losing money and cut production back.
- In step 6, costs come to equal price. This is not because costs determine price. It is because price determines costs that can be paid to produce at that price.
- Capital gets paid the rate of interest in this process. It gets paid for "time," that is, deferring consumption and extending resources for the time it takes to produce the product.
- The remaining price that is paid (beyond paying interest on capital) is paid for labor and land factors.
The labor theory of value does not describe the equilibration. All costs are not reducible to labor costs. There are land costs and also time (capital) costs. Labor costs roughly account for 50—70% of all revenues of all producers in modern economies.
From the point of view of this model, recessions are economy-wide events in which production in many markets is discovered to have gone into products that find no ready markets at the prices that entrepreneurs had estimated would be paid. The mix of goods produced and/or their amounts do not match what consumers are willing to or able to buy at the pre-production estimated prices (steps 1 and 2 above). Unemployment of several kinds is one result. Unemployed goods (seen as excess inventories) appear. Prices drop so that these can be sold. This reduces business income. If the government has subsidized roadbuilding by drawing resources from society, and if society wants ice cream rather than roads, the ice cream manufacturers will discover that the purchasing power to buy the ice cream they have produced is lacking. If the government has printed money to pay the roadbuilders, then prices will rise and the rest of society will find that they do not have enough purchasing power to pay for all the goods that other manufacturers have produced.
The reduced business earnings, once they are seen or foreseen by stock traders, cause stock prices to decline. The longer and deeper the expected decline in earnings, the greater the stock price decline, all else equal. The recession raises both business risk and uncertainty. Investors demand a higher premium for investing in securities. That too reduces stock prices. At a lower scale of operations, operating leverage rises as fixed costs loom larger. Uncertainty rises because of the added uncertainties involved in the economy reaching a new equilibrium with a changed product mix and changed production. Producers do not know how long the adjustments will take or what their effects will be.
Unemployment of labor occurs as workers are laid off. It takes time for them to shift to industries that are demanding labor. Businesses take time discovering what lines of business may be profitable to pursue. They have unemployed capital goods on their hands. They take time changing over or adding to different lines of production that employ different kinds or mixes of capital goods.
The labor unemployment lasts for a while. Under ordinary circumstances, it dissipates by itself as businesses discover products that consumers will buy and then hire workers to produce those products. There is nothing that government can do to alleviate the process except to remove whatever prior interferences it had instituted that influenced the markets. If it provides unemployment insurance, it slows the transition to new employment. If it increases deficit spending, it withdraws capital from the private sector and slows the recovery. If it pumps up the money supply, it can reduce unemployment but at the cost of distorting production, adding fuel to another eventual recession, and diverting labor into jobs and production that have low social value.
Shifts from one line of business to another that are caused by shifts in consumer demand occur continually in market economies. They do not cause recessions unless the economy is undiversified and focused narrowly on only a few kinds of goods. A recession is something that affects many industries simultaneously. Its cause cannot be a shift away from cigarettes to cigars, or from bicycles to automobiles. It has to have a source that affects many industries at once. Something that distorts the relative prices (or costs) of the basic factors will do the trick (see steps 3—6 above). Something that causes many businesses to make errors in forecasting prices and quantities will do it.
Correlated errors are a sign of a cause that affects the whole economy. One such source is a previous excess of credit introduced by the central bank and banking system through their ability to create money and credit. Money maintains value as long as there is sufficient backing behind it. An excess of money means money being created and circulated that lacks enough backing. A clear signal of this is that the money loses value relative to goods, or that the prices of goods rise. A less clear signal is that prices of goods do not decline when productivity improvements suggest they should. Either signal means inflation is occurring. The clearest signal of a prospective problem in the existing system is an excessive rise in credit issued by banks.
Credit creation by the central bank in conjunction with the banking system is not a free market process. The following description applies to central bank credit creation.
Many businesses finance their production processes (their rentals of land, labor, and capital (step 3)) by means of credit. With credit made more widely available (although its basis in money lacks sufficient backing), the cost of financing production falls. Businesses that were rationed out of the market prior to the central bank stimulus find that loanable funds are available to them. Businesses in general are induced to produce more product if they believe that their prospective profit margins are rising. They believe this because they observe that their cost of capital has declined.
This point is a great divide in economic theory. It is of critical importance for the Austrian trade cycle theory. The Misesian point, which is that the central bank's money creation depresses the real rate of interest, is denied by economists who believe there is no money illusion. They believe that since the money creation is destined to raise prices, the rate of interest will immediately rise to reflect the anticipated price level increase. This is rational expectations applied to the money market. Irving Fisher, having studied the connection between prices and interest rates, did not believe this. Mises didn't believe this. Like Fisher, he argued that money rates first fell and only rose when the actual price changes influenced expectations. Experimental evidence in support of Mises and for money illusion is provided here. Even when a person overcomes his own money illusion, he cannot predict what others persons will do, and therein lies the core of a persistent money illusion. The strongest argument presented by Mises is, I believe, the following, and it operates along similar lines:
"The price premium could counterpoise the effects of changes in the money relation upon the substantial importance and the economic significance of credit contracts only if its appearance were to precede the occurrence of the price changes generated by the alteration in the money relation. It would have to be the result of a reasoning by virtue of which the actors try to compute in advance the date and the extent of such price changes with regard to all commodities and services which directly or indirectly count for their own state of satisfaction. However, such computations cannot be established because their performance would require a perfect knowledge of future conditions and valuations. The emergence of the price premium is not the product of an arithmetical operation which could provide reliable knowledge and eliminate the uncertainty concerning the future. It is the outcome of the promoters' understanding of the future and their calculations based on such an understanding. It comes into existence step by step as soon as first a few and then successively more and more actors become aware of the fact that the market is faced with cash-induced changes in the money relation and consequently with a trend oriented in a definite direction. Only when people begin to buy or to sell in order to take advantage of this trend, does the price premium come into existence."
A rational expectations theorist would argue that "people will learn," and then they will impound inflation expectations more rapidly into interest rates and negate the efficacy of the Fed's policies. Perhaps they will learn to some extent in a context of repeated trials with unchanged conditions. But that does not characterize real-world economies and markets. They are forever changing. If there is central bank money creation, no one ever knows who will take down the money, when this will happen, what they will use it for, and how it will eventually affect prices. Furthermore, computation of a price level is extremely difficult. For this reason, interest rates can be driven down by a central bank's money creation.
Given then that businesses expand under the stimulus of credit creation by the central bank and banking system, and let us remember that this is not a free market scenario, the effects of these expansion decisions across different industries are not uniform. Those firms that require and use relatively more credit benefit more from its lowered cost and greater availability. Firms that are more capital-intensive in production benefit more as well. These types of firms expand more.
Duration is a financial measure of the sensitivity of a good's value to a change in capital cost. The values of assets and liabilities of long duration are more sensitive to credit costs than those of shorter duration. Thus, long-term bonds fluctuate more in value for a given interest rate change than short-term bonds. Long-lived capital goods fluctuate more in value than short-lived capital goods.
Since easier money and credit affect the values of the long-duration assets and claims relatively more, they benefit relatively more from the increased credit flows. More credit therefore flows into the long-duration assets and claims like airplanes, factories, land, houses, and stocks. The effects of all this across factor prices, product prices, assets, liabilities, and securities are complex. No two companies have exactly the same mix of short- and long-term assets and liabilities. The durations of the two sides of the balance sheet vary greatly across firms. The responses of managements are hard to predict. This complexity is again the reason why a rational expectations model will fail to capture the reality of the credit-induced business cycle.
Greater use of financial leverage accompanies the boom. More firms expect profits from investing in long-term assets since the prices of this class of assets rise the most. By financing them with the cheapest debt, which is short-term debt, the credit creation encourages a duration mis-match: borrowing short and lending (or buying) long. This practice violates the standard and conservative financing rule, which is to match the maturities (or durations) of loans with the maturities (or durations) of the assets they finance.
It suffices to say that the U.S. has had two credit booms in the last 13 years. The first was centered in technology and other stocks. That bull market ended in 2000. The second focused on housing and other real estate. That bull market ended in 2005 for housing, with effects on stocks and other securities extending to the present.
Each of these episodes is associated with central bank money creation followed by banking system credit creation. Each has been followed by recession when neither the price structure nor the credit structure could be sustained.
October 21, 2008
Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.
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