What is a crack-up boom?

June 22nd, 2008

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In our previous article, Are we past the first stage of a crack-up boom?, we explained that much of the ‘prosperity’ that the Western world (more specifically, the English-speaking nations) experienced over the past several years was an illusion of monetary inflation (see our guide, What is inflation and deflation? to understand the true nature of inflation). As we are entering the second stage of the crack up boom, we must, as investors, learn how to read the economic signs.

So, for today’s article, we will turn to Chapter 9 of Human Action: A Treatise on Economics by Ludwig Von Mises. First, we will begin with a self-evident axioms and then work our way up to the more complex economic phenomena:

The deliberations of the individuals which determine their conduct with regard to money are based on their knowledge concerning the prices of the immediate past. If they lacked this knowledge, they would not be in a position to decide what the appropriate height of their cash holdings should be and how much they should spend for the acquisition of various goods. A medium of exchange without a past is unthinkable.

Clearly, some people may say this is laughingly obvious. But this is just the beginning of the economic method from the non-mainstream Austrian School of economic thought. Next, having established this self-evident axiom, we move on to the next axiom:

He who believes that the prices of the goods in which he takes an interest will rise, buys more of them than he would have bought in the absence of this belief: accordingly he restricts his cash holding. He who believes that prices will drop, restricts his purchases and thus enlarges his cash holding.

If you hear the boring and meaningless talk of central bankers, this will be what they call “inflation expectation.” Central bankers are desperate to control “inflation expectation” of the masses. Obviously, if the masses expect price inflation, then they will reduce their cash balance and buy more things to pre-empt it. There is an old-fashioned word for this: hoarding. Hoarding often exacerbate the economic rot (see Connecting monetary inflation with speculation).

As we can all observe, the ‘boom’ of the past several years was possible because of the low price inflation expectation that was made possible by the rise of Chinese manufacturing. As Ludwig Von Mises continued,

As long as such speculative anticipations are limited to some commodities, they do not bring about a general tendency toward changes in cash holding.

As long as speculative anticipations are limited to property (see The Bubble Economy) and stocks (e.g. the booming record highs on the ASX 200 just before November last year), the masses are generally comfortable. In fact, we argue that this make the masses (e.g. individuals with their property ‘investments’ and businesses with the ridiculous amount of borrowing) more reckless with regards to their cash holdings. The sub-prime crisis and the credit crunch is a fine example of the consequence of the widespread underpricing of risks in the global financial system.

The course of a progressing inflation is this: At the beginning the inflow of additional money makes the prices of some commodities and services rise; other prices rise later. The price rise affects the various commodities and services, as has been shown, at different dates and to a different extent.

This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation

As we said before, at this first stage, the masses were fooled into thinking that the asset price inflation was ‘prosperity’ and they failed to understand that the underlying cause was actually monetary inflation. During that time, prices have not yet fully adjusted according to the increase in the supply of money and credit.

There are still people in the country [world] who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services.

Today, the masses are slowly getting more aware of this price revolution. It may not be that clear for the fortunate few in Australia, but for the millions of poor starving Asians, Mexicans and Indians, this price revolution screamingly obvious.

These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and concomitantly increase their cash holdings. As long as such ideas are still held by public opinion, it is not yet too late for the government to abandon its inflationary policy.

We are at the crucial point whereby the masses are gradually losing hope that prices will one day stabilise and fall. In other words, using central bankers’ talk, inflation expectations are in danger of getting entrenched. This is the greatest fear of Ben Bernanke and all his other accomplices in the other central banks. The last stage of inflation occurs when:

But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against ?real? goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.

As we can hear very often in the media, high oil prices are blamed on speculators and the rising demand of China and India. There are fundamental supply and demand factors for the rise in oil prices. But oil price speculation is a sign that some among the masses are waking up to the fact that inflation is still an ongoing policy. Since oil (and we can say commodities in general) is a major root input cost for much of the activities that are going on in the global economy, it will soon result in consumer price inflation. Sustained consumer price inflation will be a very clear signal to the rest of the masses that inflation is a deliberate policy. When that happens, the die is cast. As Ludwig Von Mises wrote,

It was this that happened with the Continental currency in America in 1781, with the French mandats territoriaux in 1796, and with the German Mark in 1923. It will happen again whenever the same conditions appear. If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity of this thing will increase beyond all bounds. Inflation is a policy that cannot last.

What is the only way to avert hyperinflation? Very unfortunately, the only way is to abandon inflation as a policy (i.e. raise interest rates aggressively), which will be devastating to the credit market and worsen the credit crunch. The outcome will be severe deflation. When that happens, the word “depression” will appear in the media continuously. Do you think the masses will opt for a painful cleansing voluntarily? As we said before in A painful cleansing or pain avoidance at all cost?,

Even if Ben Bernanke is an Austrian economist, political pressure alone will do the job of forcing him to act otherwise. This is the Achilles? heel of democracy. The mob will scream at the Fed to bail them out by ?printing? money (i.e. pump liquidity into the economy in the form of cutting interest rates). Should the Fed refuse to comply, we can imagine the mob storming the Federal Reserve to demand the head of Ben Bernanke. Therefore, the Fed will have no choice but to acquiesce to the desire of the mob, whose aim is to avoid immediate pain as much as possible.

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  • Pete

    Wow great article! πŸ™‚

    I am not old enough to remember the recession of the 80’s with any kind of understanding, so a lot of this is harder for me to believe that it will actually happen. I can read about the depression in the 30’s, and recessions and wartime, but typically for me the world I have always known has been one of relatively decent financial security.

    The world hasn’t seen any large wars for quite a while (I don’t count Iraq or even Bosnia), so I tend to think that things now are so different to those in the past that it feels impossible for our lovely current way of living to ever be so drastically interrupted.

    I am pretty sure my ‘feelings’ are emulated throughout typical western society, as you have pointed out in your article(s). Maybe I should take a trip to Asia, India or Mexico to see things their way? Even now I still have people telling me to buy a house, or seeing many others that truly have no idea of what is going on in the global economy – sometimes I think a good 99% of people have no idea whatsoever.

    Please do not mistake my ‘feelings’ or limited history to be an indication that I do not agree with what you say. This is quite the contrary (no pun intended). I am pointing out that as you say, the masses (western) are fairly oblivious to these potential problems, myself being one of them.

    Questions:
    Do you think that the RBA is doing the right thing then? It has raised interest rates, although it has also bailed out financial institutions.

    So in a crack-up boom, will this be different to the times of Germany? There are so many fiat currencies out there, whats to stop Australia for instance adopting the Euro? (I bet there are many reasons). What about if people get sick of $USD, and start trading in Chinese Yuan instead? Or Reals? Is that possible? Due to our global trade system, that was not as highly developed in the time of Germany’s troubles, would that not alter the possible outcome when the crack-up ‘conditions are met’?

    A question on property: If the masses inflation expectations get high enough, and they rush to buy assets at any cost, would this make property prices soar even higher? Or…would this be curbed by interest rates or lack of credit availability? See I would think the prices would soar as housing is the ‘asset of masses’ – a fairly simple and needed asset that most people can understand.

    Another question on property: If the central banks do not put up rates to force a recession or at least reduce inflationary pressures, wouldn’t the banks just do it themselves anyway? In Australia the RBA has been increasing rates, yet the banks have also been increasing rates at times when the RBA has not. It seems to me that banks would take lending rates into their own hands, in hyperinflationary crisis, even if the RBA did not?

    Has the world ever seen an inflationary force of such global proportions before? Or one that even affected more than one country? (Ignoring the hyperinflationary French debts of the Germans).

    Well I hope some of these questions will generate some discussion, this is a very interesting topic indeed as it affects the nature of any future investments (or futility of investments).

    Thanks again for the article, it was an excellent read, I had been looking forward to it since Friday πŸ™‚

  • Pete

    Wow great article! πŸ™‚

    I am not old enough to remember the recession of the 80’s with any kind of understanding, so a lot of this is harder for me to believe that it will actually happen. I can read about the depression in the 30’s, and recessions and wartime, but typically for me the world I have always known has been one of relatively decent financial security.

    The world hasn’t seen any large wars for quite a while (I don’t count Iraq or even Bosnia), so I tend to think that things now are so different to those in the past that it feels impossible for our lovely current way of living to ever be so drastically interrupted.

    I am pretty sure my ‘feelings’ are emulated throughout typical western society, as you have pointed out in your article(s). Maybe I should take a trip to Asia, India or Mexico to see things their way? Even now I still have people telling me to buy a house, or seeing many others that truly have no idea of what is going on in the global economy – sometimes I think a good 99% of people have no idea whatsoever.

    Please do not mistake my ‘feelings’ or limited history to be an indication that I do not agree with what you say. This is quite the contrary (no pun intended). I am pointing out that as you say, the masses (western) are fairly oblivious to these potential problems, myself being one of them.

    Questions:
    Do you think that the RBA is doing the right thing then? It has raised interest rates, although it has also bailed out financial institutions.

    So in a crack-up boom, will this be different to the times of Germany? There are so many fiat currencies out there, whats to stop Australia for instance adopting the Euro? (I bet there are many reasons). What about if people get sick of $USD, and start trading in Chinese Yuan instead? Or Reals? Is that possible? Due to our global trade system, that was not as highly developed in the time of Germany’s troubles, would that not alter the possible outcome when the crack-up ‘conditions are met’?

    A question on property: If the masses inflation expectations get high enough, and they rush to buy assets at any cost, would this make property prices soar even higher? Or…would this be curbed by interest rates or lack of credit availability? See I would think the prices would soar as housing is the ‘asset of masses’ – a fairly simple and needed asset that most people can understand.

    Another question on property: If the central banks do not put up rates to force a recession or at least reduce inflationary pressures, wouldn’t the banks just do it themselves anyway? In Australia the RBA has been increasing rates, yet the banks have also been increasing rates at times when the RBA has not. It seems to me that banks would take lending rates into their own hands, in hyperinflationary crisis, even if the RBA did not?

    Has the world ever seen an inflationary force of such global proportions before? Or one that even affected more than one country? (Ignoring the hyperinflationary French debts of the Germans).

    Well I hope some of these questions will generate some discussion, this is a very interesting topic indeed as it affects the nature of any future investments (or futility of investments).

    Thanks again for the article, it was an excellent read, I had been looking forward to it since Friday πŸ™‚

  • Hi Pete!

    Your questions require a long answer. We will write a follow-up article to answer your questions. πŸ™‚

  • Hi Pete!

    Your questions require a long answer. We will write a follow-up article to answer your questions. πŸ™‚

  • David

    Hi,
    This was a good article with an interesting response. The economic predictions of the articles on this site seems inevitable, but at the same time unimaginable (I was born in the USA in 1964 to a family that was on the professional side of middle class). The exact timing of when this will happen is not clear but it seems sooner rather than later. So I try to imagine this world I live in day to day going through what is sure to happen to the USD and the world that uses USDs as the reserve currency. It is really unimaginable what that world will be like, and what degree of law and order will exist in a world that is predicated on division of labor paid for in Federal Reserve Notes. How will commerce happen, how will the basics of government happen, how will a medium of exchange re-arise? If this happens with lightening speed, then in the summer that we be one thing, if the winter another. My comment/question is how do you plan, as a family, for an event that is this big and catastrophic and that could happen any day over the next 10 years, or take place “slowly” over months or years (or really is happening already at some rate)? Buying gold it seems is a good investment strategy, but not a complete preparation by any means. Thanks for all articles,etc.

  • David

    Hi,
    This was a good article with an interesting response. The economic predictions of the articles on this site seems inevitable, but at the same time unimaginable (I was born in the USA in 1964 to a family that was on the professional side of middle class). The exact timing of when this will happen is not clear but it seems sooner rather than later. So I try to imagine this world I live in day to day going through what is sure to happen to the USD and the world that uses USDs as the reserve currency. It is really unimaginable what that world will be like, and what degree of law and order will exist in a world that is predicated on division of labor paid for in Federal Reserve Notes. How will commerce happen, how will the basics of government happen, how will a medium of exchange re-arise? If this happens with lightening speed, then in the summer that we be one thing, if the winter another. My comment/question is how do you plan, as a family, for an event that is this big and catastrophic and that could happen any day over the next 10 years, or take place “slowly” over months or years (or really is happening already at some rate)? Buying gold it seems is a good investment strategy, but not a complete preparation by any means. Thanks for all articles,etc.

  • Temjin

    Another excellent article and some great questions there too Pete. It is a surprise to see how some of our views and feelings are quite shocking similar.

    Likewise, I am not old enough to experience ANY of the past “more serious” recessions. I was born in a wonderful, ever-lasting propersity with unprecendent financial security and wealth creation opportunities brought by the greatest credit boom ever. The day I become mature enough to experience the world, there was no such things as famine, war, financial crisis, whatever. Unfortunately, I see alot of my fellow friends of similar age who cannot see and comprehend beyond what they have already experienced in the recent past.

    I guess this is largely due to the inherent flaws of human beings with their cognitive biases. One such example is the recency bias that the editor has already explained. Where one would tend to treat recent data/experience with more weight than those in the past. This would explain why the majority of the people (especially YOUNGER ones) believe the world will see continue propersity forever and why the older generations (pre-boomers) tend to be more “pessimistic” than us younger people.

    At the end of the day, everyone is looking to create wealth and live comfortably. The cruel fact of life is that a great majority of these people will not achieve that if they continue to have the same believes as they currently have today.

    Anyway, another question I have is,

    Is another great depression an inevitable event that will occur sometime in the near future? Can it be AVOIDED or at least, the effect minimised with any sort of human intervention? My main concern would be that I am still in the early stage of my career and have not yet accumulate sufficient wealth to withstand any significant recession/depression. In fact, my parents would be the one who are most likely be affected and I am currently powerless to help them at this stage. So yes, I am hoping for some miracle that the great depression would not materialise.

    Thanks for the article again too.

  • Temjin

    Another excellent article and some great questions there too Pete. It is a surprise to see how some of our views and feelings are quite shocking similar.

    Likewise, I am not old enough to experience ANY of the past “more serious” recessions. I was born in a wonderful, ever-lasting propersity with unprecendent financial security and wealth creation opportunities brought by the greatest credit boom ever. The day I become mature enough to experience the world, there was no such things as famine, war, financial crisis, whatever. Unfortunately, I see alot of my fellow friends of similar age who cannot see and comprehend beyond what they have already experienced in the recent past.

    I guess this is largely due to the inherent flaws of human beings with their cognitive biases. One such example is the recency bias that the editor has already explained. Where one would tend to treat recent data/experience with more weight than those in the past. This would explain why the majority of the people (especially YOUNGER ones) believe the world will see continue propersity forever and why the older generations (pre-boomers) tend to be more “pessimistic” than us younger people.

    At the end of the day, everyone is looking to create wealth and live comfortably. The cruel fact of life is that a great majority of these people will not achieve that if they continue to have the same believes as they currently have today.

    Anyway, another question I have is,

    Is another great depression an inevitable event that will occur sometime in the near future? Can it be AVOIDED or at least, the effect minimised with any sort of human intervention? My main concern would be that I am still in the early stage of my career and have not yet accumulate sufficient wealth to withstand any significant recession/depression. In fact, my parents would be the one who are most likely be affected and I am currently powerless to help them at this stage. So yes, I am hoping for some miracle that the great depression would not materialise.

    Thanks for the article again too.

  • Sergey Stadnik

    In Russia during the hyperinflation of 80-90, Rubles instantly became a worthless paper, and US dollars became the currency of choice. It sounds weird, but it was actually easier to buy goods when paying $US then the national currency – sellers were accepting $US more willingly. So $US became kind of ‘value anchor’.

    It the new hyperinflation hits the world, starting with US. What’s going to become such an anchor: gold, oil, Chinese Yuan?

  • Sergey Stadnik

    In Russia during the hyperinflation of 80-90, Rubles instantly became a worthless paper, and US dollars became the currency of choice. It sounds weird, but it was actually easier to buy goods when paying $US then the national currency – sellers were accepting $US more willingly. So $US became kind of ‘value anchor’.

    It the new hyperinflation hits the world, starting with US. What’s going to become such an anchor: gold, oil, Chinese Yuan?

  • Pete

    Thanks Ed, you’re worth your weight in Reals! πŸ™‚

    It seems that there is a lot of common perceptions between us David and Temjin. The so called prosperity that we have known that has not been interrupted by any world wars, is typically the only world that we can relate to. As Temjin mentioned, this site’s explanation of recency bias is a good reason for these limited perceptions. Western civilisations seem to forget the fragility of life and security – all it would take is economic collapse, war, a nasty viral pandemic, or breakdown of government to take us straight back to the middle ages.

    I think western civilisations are in for a bit of a shock, when the countries we had been taking for granted (typically India and China) become more modern and stop giving us goods and labour at such cheap prices. The western world has entire industries and even economies that are built on the foundations of cheap imports. If Australia has hyperinflation, what will happen to our export prices? We’ll have to start asking for payment in Yuan instead(?), putting us at the mercy of the Chinese printing press. What a strange world this could turn out to be!

    The idea of a crack-up boom is quite intriguing, especially for the idea that it’s impact is very quick. As this article mentions, I have noticed that the flow on effects of inflation or economic manipulation (eg RBA rate rises) seem to be quite slow. This is ever more evident in the Australia housing bubble, where people still believe prices will soar (BIS Shrapnel?), or particularly in the US housing bubble, where prices and market sentiment seemed to hold on far beyond what I thought they could. It appears that the cascade effect of the credit crisis meltdown is slowly gaining momentum, though Australian’s seem to be ignorant of the similarities between here and the US, and the impact the US has here.

    A side note, for all the BIS Shrapnel haters: is there perhaps an irony that they may be ultimately correct? Maybe house prices will go up, in an inflationary sense? I don’t condone their report at all, it is a detriment to society to publish anything that would give people reason to perpetuate our housing bubble. It appears that any form of social responsibility for financial institutions or advisors has since been substituted for the idea of increased profits.

    Sorry, filling up this article with rants again. This is a great topic for discussion, cheers πŸ™‚

  • Pete

    Thanks Ed, you’re worth your weight in Reals! πŸ™‚

    It seems that there is a lot of common perceptions between us David and Temjin. The so called prosperity that we have known that has not been interrupted by any world wars, is typically the only world that we can relate to. As Temjin mentioned, this site’s explanation of recency bias is a good reason for these limited perceptions. Western civilisations seem to forget the fragility of life and security – all it would take is economic collapse, war, a nasty viral pandemic, or breakdown of government to take us straight back to the middle ages.

    I think western civilisations are in for a bit of a shock, when the countries we had been taking for granted (typically India and China) become more modern and stop giving us goods and labour at such cheap prices. The western world has entire industries and even economies that are built on the foundations of cheap imports. If Australia has hyperinflation, what will happen to our export prices? We’ll have to start asking for payment in Yuan instead(?), putting us at the mercy of the Chinese printing press. What a strange world this could turn out to be!

    The idea of a crack-up boom is quite intriguing, especially for the idea that it’s impact is very quick. As this article mentions, I have noticed that the flow on effects of inflation or economic manipulation (eg RBA rate rises) seem to be quite slow. This is ever more evident in the Australia housing bubble, where people still believe prices will soar (BIS Shrapnel?), or particularly in the US housing bubble, where prices and market sentiment seemed to hold on far beyond what I thought they could. It appears that the cascade effect of the credit crisis meltdown is slowly gaining momentum, though Australian’s seem to be ignorant of the similarities between here and the US, and the impact the US has here.

    A side note, for all the BIS Shrapnel haters: is there perhaps an irony that they may be ultimately correct? Maybe house prices will go up, in an inflationary sense? I don’t condone their report at all, it is a detriment to society to publish anything that would give people reason to perpetuate our housing bubble. It appears that any form of social responsibility for financial institutions or advisors has since been substituted for the idea of increased profits.

    Sorry, filling up this article with rants again. This is a great topic for discussion, cheers πŸ™‚

  • Hi Sergey!

    It’s interesting to hear from your first hand experience of hyperinflation. If the US dollar becomes worthless paper, our bet is that gold will become the money of choice. See What if the US fall into hyperinflation?.

    David, Temjin & Pete:

    We will continue to answer each of your questions as the days goes by. Please be patient with us.

  • Hi Sergey!

    It’s interesting to hear from your first hand experience of hyperinflation. If the US dollar becomes worthless paper, our bet is that gold will become the money of choice. See What if the US fall into hyperinflation?.

    David, Temjin & Pete:

    We will continue to answer each of your questions as the days goes by. Please be patient with us.

  • Biospeculator

    Economists of today are trained in the experiences of hyper-inflation as occurred in Latin America and parts of Africa and Asia in the 70s-90s.

    There are benefits to inflation. Right now the U.S. govt has a lot of debt and the economy has a lot of nominal obligations ( e.g. govt pensions, contracts etc. ) that are unsustainable. Inflation would inflate these away and inflate away the real burden of these misobligations. Otherwise the rest of us will have to be working our lives for those who ( through govt favoritism and inertia ) got a really good deal