The 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.
Let us run through it and illustrate it with present day examples.
(1) 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.
If 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.
Last 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 u2018savings', enough said! It is just as well the Asians and Continental Europeans do that for those of us in the Anglo-Celtic world.
(2) 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. (ASIA!)
Part 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.
(3) Central bankers are the root cause of this problem with their false doctrine of the u2018stabilization' 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.
This point was recently conceded by Governor Bergstroem at the Swedish Riksbank, but it seems to elude the New Era coterie among the other BIS institutions.
(4) 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.
The 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 becoming choked.
Since 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.
(5) 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 its cost.
Once 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.
We 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.
In 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 u2018thinkers'. Austrians should be better prepared for the whirlwind.
Sean Corrigan writes from London on the financial markets, and edits the daily Capital Letter and the Website Capital Insight.
