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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