Posts Tagged ‘ABCT’

If the Australian economy ?booms? further, how is it setting the stage for a bigger bust later?

Wednesday, July 28th, 2010

Not long ago, the former Prime Minister of Australia, Kevin Rudd warned that Australia is facing a demographic crunch, which if not solved, will have grave implications on the Australian economy in the long-term. To put it simply, everything else being equal, Australians are getting older and older, which means that the Australian economy will not be able to continue increasing its production of goods and services. That means that the economic growth will slow, stagnate and eventually turn negative. On top of that, the Australian economy seems to have a problem with ?skills shortage,? which is threatening future economic growth (see Skills shortages shaping up as risk to economy).

Given that the Australian economy (as in most other modern economy) is a debt-based one, any slowing of growth will result in deflation, which is a complete show-stopping outcome (see Why is the modern economy so dependent on ever-lasting growth?).This demographic situation that Japan is already facing right now, and as we wrote in Currency crisis: UK, Japan and US, will be the first developed nation to face the consequences of the demographic time-bomb.

The easy solution is to increase the immigration intake, in order to fill the ranks of tax-payers, skilled workers and consumers so that the ?bicycle? economy can continue to stand (a bicycle has to move continuously in order to stop toppling).

Unfortunately, the idea of further population growth is an extremely unpopular among the electorate. Complaints, gripes and dissatisfactions related to the population issue (e.g. too much time in traffic jams, commuters crammed like sardines into trains and buses, poor-quality housing, rising power prices and climate-induced water shortages) are making the electorate fed-up. With the Federal election looming, no politician will want to be seen to support the idea of further population growth.

So, who is to blame for this? Since Australia is one of the least densely populated nations in the world, Australia should not be overcrowded in theory. But what happened?

The easiest target to place the blame on is the government, both on the Federal and State level. There is a chronic lack of investments in infrastructure, health, education, basic services and urban planning. Their symptoms include overcrowding, congestion, price inflation of basic services like utilities, rising youth unemployment.

But before we place all the blame on the government, what about the private sector? Businesses are warning politicians against the idea of cutting immigration levels, which will exacerbate the ?skills shortage? crisis.

But instead of blaming the government, let us thrust this provocative idea?could the ?skills shortage? crisis be at least partly due to businesses not investing in the training and development of its workers? There are some statistical and anecdotal indications (and you may even personally experience them):

  1. Youth unemployment rate in Australia is three times nation average
  2. Long-term unemployment continue to rise (see Growing structural unemployment in Australia)
  3. Discrimination against the unemployed job-seekers
  4. Discrimination against those who do not meet the stringent ?experience? requirements

If you look carefully at the above list, you will notice a commonality among them: the presence of a positive feedback loop (see Thinking tool: going beyond causes & effects with systems thinking) ? the disadvantaged job-seeker becomes less desirable as an employment candidate, which further disadvantages that job-seeker. Anyone in this situation will eventually give up in seeking employment, which results in him/her becoming long-term unemployed.

From some anecdotal observations, businesses (especially the small businesses which account for the majority of employment in Australia), on the other hand, have ?no time? to invest in training and development of its workers. Since they are flat out producing and making ends meet, such investments are considered dead monies that do not contribute to the bottom line. Furthermore, given the ?skills shortage,? they would not want to invest on their workers, only have them poached by other business. Again, there is a positive feedback loop here: lack of investments result in lack of growth in productivity, which in turn reduces the margins required for investments (see Another Achilles Heel of modern society- narrow margin), which discourages further investments, which result in further lack of growth in productivity.

As you can see by now, the easiest way out for the business sector is for the government to increase the intake of skilled migrants. That way, they can have the skills they require at the expense of others (those who trained the skilled migrants back in their home countries). That is why you will see them business industry leaders lobbying against the politicians? popular intention of cutting migration.

If for whatever reason, Australia does not fall into a deflationary recession, and pressure for the economy to increase its production of goods and services intensifies, we will see the ?skills shortage? crisis intensify. There will be further upward pressure on wages, which will increase the costs for businesses. Rising cost will place further pressure on the viability of some businesses, which will in turn increase the risk of business failures.

At the same time, if nothing is done about the long-term unemployment issue, then there will be a further division between the haves and have-nots in Australian society as those who are currently and appropriately skilled and employed will enjoy higher income while those who are unemployed and/or underemployed will be become more so. As more and more unemployed join the ranks of long-term unemployed, it will result in more social problems and further increase in the budgets of the government through increased welfare payment.

On the other hand, if the immigration spigot is loosened to alleviate the ?skills shortage? crisis, it will lessen the upward pressure on wages but put upward pressure on the price inflation of essential services, which in turn will induce the RBA to increase interest rates further. For a country where households are highly indebted, rising interest rates and/or price inflation will further strain family budgets, which will further increase the risks of debt defaults. This situation is a classic illustration of the Austrian Business Cycle Theory. As we quoted Ludwig von Mises in The first step in an economic slowdown?mal-investment in capital,

It is customary to describe the boom as overinvestment. However, additional investment is only possible to the extent that there is an additional supply of capital goods available. As, apart from forced saving, the boom itself does not result in a restriction but rather in an increase in consumption, it does not procure more capital goods for new investment. The essence of the credit-expansion boom is not overinvestment, but investment in wrong lines, i.e., malinvestment. The entrepreneurs employ the available supply of r + p1 + p2 as if they were in a position to employ a supply of r + p1 + p2 + p3 + p4. They embark upon an expansion of investment on a scale for which the capital goods available do not suffice. Their projects are unrealizable on account of the insufficient supply of capital goods. They must fail sooner or later. The unavoidable end of the credit expansion makes the faults committed visible.

In the same way, if the Australian economy continues to ?boom,? entrepreneurs may not account sufficiently for rising price inflation (due to lack of infrastructure) or wage levels (lack of appropriately skilled labour). This will make many investment projects unrealizable (especially the mining projects). In fact, some businesses may even not be viable. For example, a recent survey found out congestion is affecting worker productivity and causing business owners to think of closing their businesses or move it elsewhere. These are symptoms that the economy does not have sufficient resources to maintain the current trajectory of growth. Eventually, more and more liquidation of mal-investments (e.g. projects, businesses, etc) will happen. Unfortunately, with the private sector of the economy highly indebted, this can trigger debt deflation. The end result will be a massive waste of unrealizable capital investments and projects. In 2007, we caught a glimpse of the effects of mal-investments?Owen Hegarty, former MD of Oxiana (today is called ?OZ Minerals?) said in a newspaper interview (see Rising metals price=rising mining profits? Think again!),

The cost increase at Prominent Hill makes Oxiana the latest resource developer to feel the impact of tight construction market conditions and cost increases in materials and equipment ? the so-called downside to the commodities boom.

…

“I think we’ve nailed it now,” Mr Hegarty said. “We’ve got that little bit of extra padding with the contingency (up from $75 million to $88 million) and we’re only 12 months away from commissioning. Being within the zone of a 30 per cent increase inside of 12 months is actually not too bad when compared with what other people are experiencing.

“Just about every second you turn around, the price of something else has gone up.”

From what we see, the Australian economy has hit a ceiling for which it is very hard to break through. For this reason, as Australian-based investors, we are looking into increasing our allocations to investments that have greater exposure overseas (note: this is NOT financial advice).

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Posted in Economics/Finance, Looking Forward | 5 Comments »

Jamming on brakes and accelerator simultaneously

Sunday, February 8th, 2009

A few years ago, we were chatting with our friends on the topic of personal finance and investments. Back then, it was a global financial bull market in which the savings (made compulsory by law in the form of superannuation) of millions of Australians were ploughed into ‘assets.’ Our friend’s attitude is that she will leave it all to the ‘experts’ and ‘professionals’ to invest her savings and would not want to bother herself with it. The prevailing thinking was that, as we described in The myth of financial asset ?investments? as savings (in February 2007),

… there are some who argued that if we include financial asset ?investments? such as home equity, pension and managed investment funds, stocks and so on, the savings rate is actually positive.

As we elucidated in that article, we had strong reservations on this fallacious idea. In essence, many people’s savings were (and still are) thrown into chasing prices of intangible financial assets, which hardly result in real capital formation. By chasing and bidding prices upwards, it gave rise to the illusion that ‘wealth’ had increased when in actual fact, there were no corresponding accumulation in capital goods (see The myth of financial asset ?investments? as savings to understand the meaning of capital goods). The global financial crisis (GFC) is a correction to this grand illusion.

Think about it: Why is it that after the years of ‘prosperity’ (economic boom) the state of infrastructure is so poor and neglected that governments today have to spend billions in nation building to ‘stimulate’ the economy? After all these years of boom in ‘asset’ prices, wealth and prosperity, is that what our nation (including the US, UK and Australia) has to show for?

Where had all the money gone to?

Once you understand the Austrian Business Cycle Theory (see What causes economic booms and busts?), you will be able to see that limited resources in the economy are being mal-invested into wasteful and unproductive use. So, this bust is the period when mal-investments are in the process of liquidation (e.g. deflation in asset prices). Very unfortunately, governments are hell-bent in preventing this liquidation process and at the same time, trying to redirect resources into urgently needed area via central planning.

The governments’ actions are akin to jamming on the brakes and accelerator simultaneously. No prize for guessing what will happen to the car.

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Posted in Economics/Finance, Looking Forward, Market Observations | 4 Comments »

Are government bailouts good for the economy?

Wednesday, October 1st, 2008

Back in June last year (2007), we wrote in Epic, unprecedented inflation that

Today, the world is experiencing an unparalleled inflation of asset prices. This is the first time ever that the world is experiencing asset price inflation in all asset classes (e.g. property, bonds, commodities, stocks and even art!) and in all major nations (e.g. US, China, Japan, Australia, UK, Russia, etc). We will repeat this point again: never before had such a universal scale of asset price inflation ever happened in the entire history of humanity! Today, even artwork is also in a ?bull? market (if you consider artwork as an asset class)!

The implication is, as Marc Faber opined, this synchronised inflation will eventually lead to a synchronised deflation i.e. price deflation for all asset class in all major nations. This is something that contrarians have been warning all along (see Spectre of deflation in January 2007).

This synchronised monetary inflation leads to a mighty economic boom that mainstream economists called (and cheered for) the “asset-driven” growth. But again, we were sceptical about this kind of boom. As we explained back in November 2006 in How will asset-driven ?growth? eventually harm the economy?,

Thus, when housing prices [asset price in general] increased due to the increase in ?demand? for housing, the common people are misled into thinking that the value of housing had increased as much as the increase in its prices. That collective error in judgement resulted in the economy misallocating scarce resources into housing sector?in the case of the US, a significant proportion of the jobs created during the asset-driven ?growth? was related (both directly and indirectly) to the housing boom. Since economic resources are always scarce, any misallocation of it implies an opportunity cost on the other sectors of the economy. The result is a structural damage to the economy that can only be corrected through a recession.

The dark side of this boom is the dangerous build up of debt and leverage in the global economy. As we explained in January 2007 at Myth of asset-driven growth,

As asset price growth outpaces income growth by an ever-increasing margin, increasing issue of credit (i.e. the flip side of taking up of debt) is required to bridge the gap between the asset price and income. What is most often overlooked is that the uptake of debt, which is required for asset-driven growth, has to be serviced. There are two kinds of debt?investment debt and consumption debt. Investment debts are being used for investments that will generally add value to the economy by increasing its productive capacity. Thus investment debts are self-servicing loans?they will generate the necessary economic returns to make repayments possible. The problem with asset-driven growth is that much of the debts are consumption debts. Since such debts are acquired for consumption, they do not add value to the economy because they do not increase its productive capacity. As such, asset-driven growth magnifies the consumption debts of the economy, which will have to be serviced in the future. By deferring the burden of debt servicing to the indefinite future, it can only mean that the nation?s wealth will shrink in the future. Hence, asset prices cannot rise in perpetuality. Eventually, the weight of future debt servicing burdens dooms the bubble to collapse under its own weight.

For those who are new to this publication, these explanations are from the classic business cycle theory of the Austrian School of economic thought. Followers of the Austrian School will look at today’s financial crisis with a yawn because it is obvious to those who understands the Austrian Business Cycle Theory. To understand this theory, we highly recommend our guide, What causes economic booms and busts?.

Currently, we are in the bust phase of the business cycle. In this phase, we will see a much needed painful restructuring of the economy as wasteful and unsustainable mal-investments of the prior boom time get liquidated. Real-life example of mal-investment liquidations can be seen in this news article, Frozen-out expats return to Australia for jobs,

A generation of young Australian expatriates are being forced home from New York and London due to the tightening job market in the finance industry.

Painful as it is, liquidation of mal-investments is a necessary evil so that the global economy can get back on its feet towards a sustainable growth path. The manifestation of this painful process is deflation. The magnitude of the coming deflation reflects the monstrosity of the prior unsustainable inflation. The fact that the media is now murmuring about the infamous “D” word (Depression) shows that the massive boom of the past few years is a cruel illusion that fooled many, including many of the mainstream economists and government.

But what are the governments around the world doing? They are fighting this necessary evil by stalling the inevitable liquidation of mal-investments by the free market with bail-outs and even more attempts at monetary inflation! This will delay the long-term recovery of the global economy. How can they solve the problem with more attempts at inflation when inflation is the cause of it in the first place?

Should they ever succeed in their attempts at inflation, the end result will be as we described in Supplying never-ending drugs till stagflation:

Students of the Austrian School of economic thought will understand that indiscriminate ?printing? of money (i.e. [inflation]) will worsen the plague of mal-investments and structural damage in the economy. Like drugs, the more you ?print? money, the less effective it will be in stimulating economic growth (see What causes economic booms and busts?). Eventually, it will come to a point that the economy will not respond positively any more no matter how much money is being ?printed.? That is the nightmare of stagflation (low or negative real growth with sky-rocketing price inflation- look at Zimbabwe).

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Posted in Economics/Finance, Looking Forward | 10 Comments »

Why does the central bank (RBA) need to punish the Australian economy with rising interest rates?

Tuesday, March 4th, 2008

Today, the Reserve Bank of Australia (RBA) just announced yet another rise in interest rates. There are signs that this is hurting, as many people on the street (especially those who are straining under enormous debts) are screaming at the madness of the RBA for doing so. Many economists are worried that the RBA may accidentally tip Australia’s economic boom into a bust. Why is the RBA spoiling the party by raising interest rates?

Think about this: if raising interest rates is ‘bad’ and cutting interest rates is ‘good,’ then why don’t the RBA set interest rates to zero, thereby putting the economy into a path of eternal boom (plus runaway inflation)? For those who think this is a good idea, then this article will set to let you understand why this is a bad idea.

Now, at this point, we recommend that you read our guide, What causes economic booms and busts? because what follows will not make sense unless you understand the Austrian Business Cycle Theory (ABCT).

Back in February last year, in Where are we in the business cycle?, you can see that we already knew that Australia (and the US) was already at the top of the business cycle:

How can we restore the economy back to equilibrium and ensure that it remains in a firm footing for the future?

The first thing that has to happen is to increase our national savings. As we said in The myth of financial asset ?investments? as savings, we need to restore and rebuild our stock of capital goods to ensure our future prosperity. Already, the quality of our education, health, telecommunication and transport infrastructures are in decline and they are in need of repair and upgrade. This means that the only way we are going to achieve that is to reduce our current consumptions and cut down our debt. When that happens, the economy will slow down and many businesses and investments will fail as a result. Since most of the Australian (and the US as well) is made up of consumer spending, in which much of it is funded by debt, we can see that this remedy will be painful. If the consumers do not slow down and get their act together, we can expect the RBA to impose a restraint by raising interest rates.

The Australian economy was already running at full steam. Accelerating price inflation is a sign that there are insufficient resources in the economy to allow for all investment projects to succeed and all consumptions to carry on. If this trend is not arrested, the economy will run out of resources, resulting in a crash. Therefore, in order to put the economy back into a sustainable growth path, consumptions and investments have to slow down in order to allow for the economy to catch a breather for the rebuilding of its capital structure. The rebuilding of capital structure is necessary for the economy to replenish its resources for the future so that growth can continue down the track. Unfortunately, this rebuilding itself requires resources now. Therefore, current wasteful consumptions have to be curtailed and mal-investments have to be dismantled to make way for the rebuilding. The curtailment of consumption involves consumers spending less and saving more, while the dismantling of mal-investments involves retrenching workers, liquidating businesses, e.t.c. These involve pain for the people of Australia.

That is why the RBA has to raise interest rates to ‘punish’ the economy. What if it don’t? Then the economy will crash, either in nominal terms (e.g. deflationary depression) or in real terms (e.g. hyperinflation)- see Recipe for hyperinflation.

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Posted in Economics/Finance | 1 Comment »

Example of mal-investments?dot-com bubble

Wednesday, February 14th, 2007

In our previous article, The first step in an economic slowdown?mal-investment in capital, we mentioned that one of the causes for slowdowns in the business cycle is the presence of mal-investments. Mal-investments will eventually have to be liquidated, resulting in a cyclical slowdown of the economy. In that article, we discussed about the structure of capital, which gives rise to the concept of mal-investments, which is unique to the Austrian School of economics. It should be emphasised that unlike other schools of economics, the Austrian School makes a distinction between overinvestment and mal-investment. It is the latter that is of primary concern in Austrian theory. Today, we will look at a real-life example of mal-investments and its effects.

During the dot-com bubble of 1996-2000, the NASDAQ flew from around 1000 to around 5000. Credit for ?investments? were abundant and plentiful. Any stocks related to the Internet were soaring well beyond its fundamentals. Spending on IT projects were mushrooming up everywhere; loss-making dot-com companies were floated; consumer spending, which were fuelled by the monetary print press (and not from sound savings), remained strong; Real-estates in the Silicon Valley sky-rocketed. Indeed, IT investments were running very high.

This is an example of a mal-investment.

Entrepreneurs, as a whole, invested as if all capital goods will be available at their disposal to ensure the success of all their plans. From the hindsight of today, it is clear that this was not true?there were shortages of programmers, network engineers, and technical managers. We recalled the days when a fresh IT graduate, who hardly had any experience and skills on the latest technologies, could fetch a salary of more than AU$50,000! Consequently, all the idealism of wealth through technology crumbled when reality sets in. As many IT start-up companies realised, the cost of staying in business was so prohibitive that eventually, a large number of them had to be liquidated. Today, only a few survivors remained alive. The resulting deflation of the bubble led to a recession (albeit the mildest one ever).

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Posted in Economics/Finance, History | 4 Comments »

The first step in an economic slowdown?mal-investment in capital

Tuesday, February 13th, 2007

In our previous article, The real story behind the phenomena of booms and busts, we mentioned that when the central bank finally raise interest rates, the economy will slow down as ?entrepreneurs will slow down their rate of investments, which means that employees will be laid off, projects cancelled, and cost being cut.?

Why would entrepreneurs have to slow down their rate of investments, which result in an economic slowdown? To answer this question, we have to understand that capital can be mal-invested. The reason why capital can be mal-invested is because it has structure, which is one of the key insights of the Austrian School which is not found in other school of economics.

What is the structure of capital?

Recall that in The myth of financial asset ?investments? as savings, we mentioned that capital goods are ?goods that help in the production of consumer goods?they increase the future productive capacity of the economy.? Capital goods that are directly used in the production of consumer goods are termed ?first-order? capital goods. An example of a first-order capital good is a sewing machine that is used to produce clothing for consumers. Capital goods that are used in the production of first-order capital goods are called ?second-order? capital goods. An example of a second-order capital good is the robot that put together the sewing machines in the assembly line. The third-order capital good are then used in the production of second-order capital goods and so on. Thus, capital goods can be arranged from the first-order up to the higher orders?this is the vertical structure of capital. Capital can also have horizontal structure. Some capital goods are complementary to other capital goods in the production of other goods. For example, computer software and hardware are complementary capital goods. In reality, the capital structure can be more complex?capital goods can play different roles in the horizontal and vertical chains simultaneously and may perhaps function as a consumer good at the same time.

As Ludwig von Mises said in Chapter 20 (Interest, Credit Expansion and the Trade Cycle), Section 6 of Human Action: A Treatise on Economics:

It is customary to describe the boom as overinvestment. However, additional investment is only possible to the extent that there is an additional supply of capital goods available. As, apart from forced saving, the boom itself does not result in a restriction but rather in an increase in consumption, it does not procure more capital goods for new investment. The essence of the credit-expansion boom is not overinvestment, but investment in wrong lines, i.e., malinvestment. The entrepreneurs employ the available supply of r + p1 + p2 as if they were in a position to employ a supply of r + p1 + p2 + p3 + p4. They embark upon an expansion of investment on a scale for which the capital goods available do not suffice. Their projects are unrealizable on account of the insufficient supply of capital goods. They must fail sooner or later. The unavoidable end of the credit expansion makes the faults committed visible.

Now, we return to our original question: why do entrepreneurs have to slow down their rate of investments? Based on our new understanding capital structure, it is more accurate to say that entrepreneurs not only have to merely slow down their rate of investments, they may even have to liquidate their investments due to their errors in judgements. As the economy booms, entrepreneurs make plans and invest in the belief that the economy’s capital structure will provide the necessary higher-order and complementary capitals in the future. What happens when capital are mal-invested, leading to an unbalanced structure of capital in the economy? The entrepreneurs’ plans will fail, which mean they will have to liquidate their investments. When that happens en masse, it will result in what we see as layoffs, cancelled projects and so on.

How would this work out in real life? Stay tuned!

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Where are we in the business cycle?

Friday, February 9th, 2007

Yesterday, in our article, The real story behind the phenomena of booms and busts, we asked this question. Today, we will look at the indications of where we may possibly be in the business cycle in Australia (which is applicable to the US as well).First we look at the November 2006 Statement of Monetary Policy from Reserve Bank of Australia (RBA):

What does seem clear, however, from several sources of information, is that the economy is operating with very limited spare capacity.

Clearly, as in the metaphor we gave in What cause booms and busts? Introduction to the Austrian Business Cycle Theory, the bus is running low on fuel i.e. the economy is reaching its limit of productive capacity. This is also the same situation that the United States is facing right now. Further down the statement:

Demand in some sectors has been especially strong over a number of years, reflecting the growth of the domestic and international economies. If firms cannot bring new factories or mines immediately on line when capacity constraints become binding, they may decide to hire more labour to work their existing production processes more intensively. This would lead to strong employment growth, but also a fall in the growth rate of average labour productivity because only relatively modest additional output can be produced by hiring more labour without additional capital.

To cope with the strong demand, businesses are forced to increase output. Unfortunately, the effectiveness of the existing capital stocks in the economy is reaching its limit and the only way to increase production further is to employ more labour and pressure the existing employed workers to produce more. As the statement says, without complementary capital, these extra labours are constrained in its effectiveness in increasing output.

Recently, we read in this news report, Consumer confidence ‘lowest since 2003’, ?dragging sentiment down in the half was a sharp 14 point fall in the quality of life rating to 25.5 points… But (they are) finding it more difficult to achieve due to the demand for longer working hours and more intense competition in the job market.? Anecdotally, many of us are feeling the increasing strain of work. Though Australia may be experiencing the lowest unemployment rate, it comes with a cost at our quality of life. Worse still, according to our personal experience, we can feel that price inflation is more pronounced lately.

With the economy struggling to increase output and the money supply still growing, we can expect price inflation to still remain a threat. But price inflation has been quite benign during the past few years. Why is it so? As in the United States, price inflation has been ?controlled? by importing of goods from China. As we said in The Bubble Economy, the rise of the Chinese economy?s productive capacity has a disinflationary effect on prices worldwide. But such low inflation can only be achieved at the cost of incurring a ballooning trade deficit?our imports exceeding our exports. But make no mistake about it: we cannot always rely on the Chinese to save us from price inflation by blowing out our current account deficit even further. So, the greatest danger to Australia?s economy right now is price inflation. As we said in The real story behind the phenomena of booms and busts, if interest rates persistently remain out of sync from the natural rate of interest for too long, we can run into the danger of hyperinflation.

How can we restore the economy back to equilibrium and ensure that it remains in a firm footing for the future?

The first thing that has to happen is to increase our national savings. As we said in The myth of financial asset ?investments? as savings, we need to restore and rebuild our stock of capital goods to ensure our future prosperity. Already, the quality of our education, health, telecommunication and transport infrastructures are in decline and they are in need of repair and upgrade. This means that the only way we are going to achieve that is to reduce our current consumptions and cut down our debt. When that happens, the economy will slow down and many businesses and investments will fail as a result. Since most of the Australian (and the US as well) is made up of consumer spending, in which much of it is funded by debt, we can see that this remedy will be painful. If the consumers do not slow down and get their act together, we can expect the RBA to impose a restraint by raising interest rates.

Thus, we believe that Australia (and the US as well) is at the top of the business cycle. For investors, we have to bear in mind that we are now probably at the cyclical top. If we assume that the current trend of companies? profit growth will extend indefinitely into the future, we will be in for a nasty surprise.

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The real story behind the phenomena of booms and busts

Thursday, February 8th, 2007

Today, we will explain how the business cycle of booms and bust comes about. If you have not already read What cause booms and busts? Introduction to the Austrian Business Cycle Theory followed by What cause booms and busts? Explanation of Austrian Business Cycle Theory metaphor, please do so because what comes next will not make sense without the background understanding of these two articles.

First, we revisit the thought-provoking question that we first asked in What cause booms and busts? Introduction to the Austrian Business Cycle Theory: How can the central bank know the ?right? price of money when it decides the level of interest rates? The truth is, it does not and the outcome is less than ideal as it sets interest rates at levels other than ones the free market would have chosen.

Let us suppose that interest rates are decided by market forces. How would it be decided? As expected, the fundamental economic law of supply and demand determines the level of interest rates. As consumers seek to defer their consumption to the future, they increase their savings rate. This increase in the supply of money from savings pushes down the interest rates. Conversely, as consumers seek to increase their current consumption at the expense of the future, they decrease their savings rate, which decrease the supply of money for savings, which in turn pushes up interest rates. On the side of the entrepreneurs, their demand of capital, which is supplied from the consumers’ savings, will lead to an equilibrium level where supply equals demand. This equilibrium level is the natural rate of interests.

Now, what happens if the central bank interferes with market forces and set the interest rates below the natural rate? The outcome would be that the demand for capital (from entrepreneurs) will exceed the supply of capital (from consumers). The only way to bridge this gap would be to increase the supply of money (that is, ‘printing’ of money). When that happens, through the fractional reserve banking system, the amount of credit in the financial system will be increased multi-fold. Consumers will spend more than they would have if the interest rates had been higher. Entrepreneurs would invest more than they would have if the interest rates had been higher. The outcome would be ‘greater’ economic activity.

But there is one problem with this state of affairs?there are finite amount of resources for the economy to work on in order to keep up the rate of production with the increased investment and consumer demands. Thus, for a time, the economy can be stressed to increase its rate of production, but ultimately, it will meet its limit. At this point in time, the boom part of the business cycle is coming to a halt. This is what is happening to Australia right now as the Reserve Bank increasingly uses the phrase “capacity constraint” to describe the economic situation.

If the interest rates are still kept artificially below the natural rate, the outcome will be price inflation as the artificially induced demand far outstrips the economy’s capacity to produce. If left unchecked, the result will be hyperinflation. Thus, the central bank will have to raise interest rates to curb the excess demand. Consumers will cut their consumption as their debt becomes more expensive. Entrepreneurs will slow down their rate of investments, which means that employees will be laid off, projects cancelled, and cost being cut. At this point, we have come to the bust part of the business cycle.

Thus, the adjustment of interest rates by the central bank does not ?smooth out? the peaks and troughs of the business cycle. Instead, such interference of the interest rates is the cause of the business cycle.

Now, where are we in the business cycle?

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What cause booms and busts? Explanation of Austrian Business Cycle Theory metaphor

Wednesday, February 7th, 2007

In our previous article, What cause booms and busts? Introduction to the Austrian Business Cycle Theory, we introduced the Austrian Business Cycle Theory (ABCT) with a metaphor. Today, we will explain the meanings of the metaphor from the book, Economics for Real People.

As we all know, since we live in a world of scarcity, the economy has a finite amount of resources (e.g. land, capital, labour, technology, raw materials, etc) to produce the goods and services that consumers want. Thus, the gas in the bus represents all the available finite resources in the economy.

The economy is always producing goods and services. Thus, the trip across the desert represents a period of time of economic activity.

In any economy, there is a class of people called the ?entrepreneur.? They are the business people who take risks by anticipating what consumers may want in the future and create the products and services that meet these anticipated needs. A very good example of an entrepreneur is Henry Ford who introduced the motor car to the world. In the metaphor, you, the bus driver, represent the entrepreneurs in the economy.

Then there is a class of people called the ?consumers.? Basically, consumers enjoy the fruits of the economy?s production of goods and services?they ?consume? resources of the economy. The passengers in the metaphor represent the consumers of the economy. As we said before in The myth of financial asset ?investments? as savings, there is a need to make a choice ?between producing consumer goods for current consumption or capital goods which will help in producing future consumer goods.? In the metaphor, the choice to use how much air-conditioning for comfort represents the choice of the consumers in how much they want to consume now at the expense of saving for future consumption.

In the economy, the entrepreneurs will borrow capital to engage in investment spending in order to fulfil what the consumers may want or need in the future. The speed of the bus represents the amount of investment spending to undertake.

Finally, the bogey man who tampered with the passengers? survey results is the central bank, which sets the interest rates. Please note that we are not accusing the central banks of any misconduct?they happened to fit the villain in our choice of metaphor.

So, how do all these fit into the explanation of the business cycle? Stay tuned!

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What cause booms and busts? Introduction to the Austrian Business Cycle Theory

Tuesday, February 6th, 2007

What causes the business cycle of booms and busts? According to popular belief, the business cycle is due to the collective mood of the consumers, which drives investments and spending. That is why Wall Street is so fixated on the readings of consumer confidence. Central banks, on the other hand, hope that by adjusting a lever called the ?interest rates?, fluctuations of the economic cycle can be smoothed through the resulting influence on investments and spending. Hence, it may seem that the Fed?s policy of ultra-loose monetary policy (of exceptionally low interest rates) several years ago not only prevented a recession, but created further economic growth.

But according to the Austrian School of thought, the control of interest rates is the very action that creates the business cycle. Thus, the Fed did not avert a recession several years ago. Instead, they merely defer it. Worse still, the extent of the coming recession is proportional to the excess of the prior artificially induced boom. By deferring a necessary recession and engineering a synthetic economic boom, the Fed is setting the stage of an even more severe recession down the track.

Before we introduce the Austrian Business Cycle Theory, let us ask a thought-provoking question: If we generally let market forces set the price of things (e.g. stocks, consumer goods, bonds, real estates, etc), then why is it that the price of money (interest rates) should not be chosen by the market? Does the central bank know better than the market to set the ?right? price of money?

Now, here comes the introduction to the Austrian Business Cycle Theory to explain the phenomena of booms and busts. For this, we will use a metaphor from this book, Economics for Real People:

Imagine that you are a bus driver, at the edge of a desert, about to take a busload of passengers across it. You have left all gas stations behind. Your destination is a town on the other side of the wasteland before you. You are faced with a trade-off: the faster you try to reach the town, the less the passengers can use the air-conditioning to alleviate the desert heat. Both higher speeds and higher air-conditioning settings will use up the gas more quickly. And since, in our luxurious bus, each passenger has his own temperature control for his seat, you, the driver, cannot control the total amount of air conditioning used on the trip.

In order to make your decision, you look at your fuel gauge and determine how much gas you have. You tell the passengers that they must now make a trade-off between comfort on the way and speed travelled, as the more air-conditioning they choose to use; the faster the bus will consume fuel. Then you collect statements from the passengers on what temperature they will keep their seat. You perform some calculations on mileage, speed, and fuel consumption, and pick the fastest speed at which you can travel, given the amount of gas you have and the passengers? statements about their use of the air-conditioning.

The passengers had to decide whether to cross the desert in greater comfort but arrive later at their final destination, or in less comfort but with an earlier arrival. The science of economics has little to say about the combination that they picked, other than that it seemed preferable to them at that moment of choice.

However, also imagine that, before you began your calculations, someone had sneaked up to the bus and replaced the passengers? real choices with a fake set that chose a higher temperature, in other words, one that makes it seem they will use less fuel than they really will. You will make your choice on travel speed as if the passengers will tolerate an average temperature of, say, 80 degrees, whereas in reality they will demand to have the bus cooled to an average of 70 degrees. Obviously, your calculations will prove to be incorrect, and the trip will not come out as you had planned. The trip will begin with you driving as if you have more resources available than you really do. It will end with you phoning for help, when the sputtering of your engine reveals the deception.

Stay tuned for the explanation of this metaphor!

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