Tom Burger looks at economic events from the Austrian Business Cycle Theory perspective, and in doing so, sees more pain ahead, current optimism notwithstanding.
Unintended Consequences
Unfortunately, however, we can also now see that the housing mania produced a horrific number of unintended consequences: millions of non-performing mortgages, high home foreclosure rates, escalating personal bankruptcies, collapsing mortgage backed security valuations, corporate insolvencies, bank failures, government seizures, rising unemployment, and emergency government expenditures in the multiple trillions of dollars. These cascading disasters caused a recession which, by many measures, has already become the worst since the Great Depression.
It is axiomatic, however, that things always look darkest at the bottom. There aren’t many right now, but a few optimists are noting that this has already been a relatively long recession, that some production statistics can’t get much lower, that commodity prices are beginning to rebound, and that the stock market wants to rally. Since optimism about the US economy has been a winning bet for a long time, a few smart, experienced analysts are thinking that we may have already seen the bottom.
I recognize that the optimists could be right, and I hope they are. It would feel so good to believe that our economy is mending, that jobs will soon be more plentiful, that retirements will be bountiful, and that Americans will continue to enjoy a very high measure of freedom and personal liberty. I look forward to the day when that is my view. For now, however, there are still some major issues that leave me convinced that more unintended consequences will plague us for at least a few years.
A Big Boom Means a Big Bust
We have lived through a huge credit expansion boom, one for the record books. Every major currency in the world is now a "fiat currency" not backed by any commodity — and therefore each currency is limited in quantity only by the issuing government’s sole discretion. It is also true, I believe, that every banking system in the developed world is a fractional reserve system. With fractional reserve banking and fiat currencies, the potential for global monetary inflation (i.e. injecting more money into the economy) is greater now than at any previous time in history. This potential, together with widespread acceptance of inflationary economic doctrines, gave us what was perhaps the biggest, broadest, and most dangerous credit expansion in world history.
Why do I say a credit expansion is dangerous? It comes from my understanding of the Austrian Business Cycle Theory (ABCT) and the simple observation that government actions are becoming wilder, more expensive, and more out of control with every passing week. In my opinion, the ABCT is the key to understanding risks in this environment because it alone has permitted economists and analysts to anticipate and explain major economic busts. For example, Ludwig von Mises anticipated the Great Depression in the late 1920s, when one of America’s imminent economists was saying the economy was on a "permanently high plateau." Similarly, Peter Schiff and other Austrian-influenced analysts predicted the current crisis even as our mainstream economists were still maintaining that the economy was strong and the banking system solvent.
The ABCT is a rich, multidimensional theory based on microeconomic analysis of price incentives; it’s a bit too complex to fully explain within a blog post. The essential point, however, is that monetary inflation, usually a credit expansion, creates an artificial economic boom. The inflation lowers interest rates below the free market level and distorts relative prices within the economy. As a direct consequence, entrepreneurs initiate many projects that cannot be profitably completed — Austrian economists call these "malinvestments." See The Trouble with Credit Expansions for a bit more ABCT insight.
When the credit expansion inevitably slows, the many malinvestments are revealed and the bust phase begins. The bust is inevitable because it is simply the necessary process of liquidating bad investments, converting assets to their next best employments, and reallocating labor and other resources to their best uses. When markets have been left to their own devices, this corrective process has never taken longer than a couple of years. It is just a matter of logic, however, that longer and more extreme booms will accumulate more malinvestments and the corrective process will therefore adversely impact more people and probably take a longer time.
Given the size and global scope of our preceding boom, I have to believe that we will see a lot more malinvestments come to light before this recession is over. It’s impossible to know where all of these bad investments will turn up. If a human being could know these things, then a planned economy might be practical — but nobody can know how the economy should be structured or exactly where it might be maladjusted. There are, however, some additional malinvestments already coming into view. For example, according to some specialists such as Andy Miller, most commercial real estate operations will experience a major downturn — a sure sign of preceding malinvestment.
So, the scope and size of the preceding boom strikes me as one important reason for not jumping on the optimists’ band wagon just yet. Unfortunately, however, there is another reason which seems to be much more significant.
Government Actions Will Prevent a Recovery
Our government, and most other governments around the world, have made one thing perfectly clear: they are not going to accept the natural market corrections that would lead to a rapid, market-based reallocation of resources — and therefore an economic recovery. Our government officials do not like the market solution. They do not want to see large businesses failing, they do not want asset prices falling, they do not want a large number of home foreclosures. Our government officials engineered the inflationary boom and they liked it very much. Now they want to "get credit flowing again."
I am not going to recount the many familiar Treasury and Fed programs employed, but they are all aimed at dropping interest rates, increasing bank reserves, keeping lending institutions in business, and encouraging or coercing those institutions into lending more money. The scale and expense of these programs started out as breathtaking and have now moved on to the point where I have lost all feeling in my extremities — these government actions and power grabs have left me totally numb.
Our government interventions are increasingly undermining the market forces which are responsible for the productivity that we know markets deliver (see Laissez Faire Capitalism would have Prevented the Crisis). Bailouts are impairing profit and loss motives, government takeovers are putting non-producing bureaucrats in charge of production, "toxic asset" purchases are distorting financial asset prices and misallocating trillions of dollars. The far below market interest rates and unlimited government finance for selected firms is ensuring more malinvestments and capital consumption on a gigantic scale. The low interest rates are also harming retirees and savers of all ages — and distorting the country’s capital formation process. The planned "stimulus" expenditures will divert entrepreneurial attention from the important business of meeting the most urgent consumer needs to the strictly political task of meeting the government’s needs.
This government attempt to "get credit flowing again" is in reality an attempt to pick up the credit expansion where it ran out of steam. But consider the situation in 2009: the Fed itself reports that bank credit issued this year is running about 9% above the incredible volume of credit issued during 2008. What possible sense can we make of these people who refer to that massive, ongoing bank credit as having "dried up"? Our government officials, and their economists, obviously fail to understand that businesses are failing because real resources are inadequate to support all the bubble activities started during the preceding boom. See The Trouble With Credit Expansions for a better understanding of this point.
Whether the government can somehow rekindle the credit expansion, or not, we are now experiencing massive monetary inflation that will continue to distort relative prices, but in new ways and with consequences that are still difficult or impossible to anticipate. What we can absolutely count on, however, is that additional malinvestments will be revealed whenever the Fed’s massive money printing operations begin to slow.
We know the Fed’s printing will end. As Ludwig von Mises said, an inflationary process will stop either when the monetary authority comes to its senses, or, if not, when the currency is destroyed in a hyperinflationary catastrophe, a "crackup boom," he called it. Inflation is a serious scourge, one that has inflicted misery on countless victims throughout history. This is not hyperbole. I find the following Henry Hazlitt comment to be absolutely chilling, especially when I think about how many of these characteristics we have already experienced firsthand.
"It [Inflation] discourages all prudence and thrift. It encourages squandering, gambling, reckless waste of all kinds. It often makes it more profitable to speculate than to produce. It tears apart the whole fabric of stable economic relationships. Its inexcusable injustices drive men toward desperate remedies. It plants the seeds of fascism and communism. It leads men to demand totalitarian controls. It ends invariably in bitter disillusion and collapse."
Henry Hazlitt, Economics in One Lesson, page 176
In the space of one decade, I believe U.S. leaders have in one giant leap brought us perilously close to the conditions described in the Ayn Rand quote on the sidebar, which I repeat below for emphasis:
"When you see that trading is done, not by consent, but by compulsion — when you see that in order to produce, you need to obtain permission from men who produce nothing — when you see money flowing to those who deal, not in goods, but in favors — when you see that men get richer by graft and pull than by work, and your laws don’t protect you against them, but protect them against you — when you see corruption being rewarded and honesty becoming a self-sacrifice — you may know that your society is doomed."
Ayn Rand, Atlas Shrugged, page 413
First with the Bush administration, and now the Obama administration, we are watching economic leadership operating with just the barest pretense of knowledge, to use F.A. Hayek’s memorable phrase. Our government’s crisis management methods are tragically ill-advised and certain to lead to larger, less tractable crises than we now face. Consider [last] week’s rather odd diplomatic development: European Union President Mirek Topolanek, from the Czech Republic, publically said that the U.S. stimulus program is the "Road to Hell." How in the world, I wonder, did the United States of America elect leadership that is so far to the "political left" of the European Union and the Czech Republic?
It pains me a great deal to draw this conclusion, but our government is determined to prevent a recovery — and that is the second major reason why I can’t see a near term recession bottom. First we have to see sanity return to Washington, D.C.
(Note: the immediately preceding post, The Trouble with Credit Expansions, provides a little more insight into the Austrian Business Cycle Theory.)
