Pater Tenebrarum on Austrian Business Cycle Theory in Action

In an article titled “Season’s Beatings” Tenebrarum provides evidence that we may be in the final stage of the boom phase of the boom-bust business cycle.

Boom and Bust

If we think about crude oil, this is a sector that has evidently become a classical victim of price distortions due to loose monetary policy (in both the US and China in this case). Economic calculation was falsified as a result of extremely low interest rates and monetary pumping, with prices reflecting expectations of future demand that have failed to materialize. In the meantime, money supply growth in both the US and China has faltered. A slight tightening in monetary conditions was all it took to trigger a price collapse, thereby unmasking the boom as false.

It appears as though a similar miscalculation may have been made with respect to consumer demand more generally. As always happens during booms engendered by an expansion of money and credit, the production of capital goods has increased sharply relative to consumer goods production. Low interest rates normally suggest that savings are rising, i.e., that consumers are postponing consumption in the present in favor of saving and investment, so as to be able to consume more in the future.

4-Ratio cap vs. cons goodsBooms and busts illustrated by the ratio of capital vs. consumer goods production – click to enlarge.

However, if interest rates are manipulated by a central bank and suppressed below their natural level, then this signal is a false one. In reality, the real savings needed to support increased investment in production stages far from the consumption stage are lacking. As the boom progresses, too many consumer goods will be tied up in long-range production processes, while not enough will be released.

Eventually this inherently unstable situation comes to a head, usually indicated by the fact that upward pressure on market interest rates emerges, which will in due time stand the previous price distortions on their head (the increase in capital goods prices relative to consumer goods prices will begin to reverse). As you can see below, upward pressure on market rates is indeed emerging, especially at the short end of the yield curve:

5-two-year note yield2 year note yield, weekly – click to enlarge.

Once the reversal in the price structure can no longer be denied, a bust will be at hand. The distorted production structure is then found to produce too many goods that are actually not in demand, and too few of those that are. A complete rearrangement of the capital structure will become necessary at that point, which inevitably includes the liquidation of malinvested capital that is too specific to be profitably transformed, along with the liquidation of unsound debt associated with such malinvested capital.

Some partially finished investment projects will have to be abandoned, due to a lack of resources to actually finish them. However, at first there will be a scramble for scarce funds, as some entrepreneurs will desperately attempt to finish such projects to avoid a complete write-off. At the same time, demand for additional capital will still emerge in industries in lines that are tied to already finished early stage investments which wouldn’t have been undertaken had the real situation been known, but which after writing off sunk costs can still be operated at break-even or a slight profit. Thus competition for scarce capital (scarcer than originally thought) will heat up ahead of a bust, intensifying the pressure on market rates further and hastening the bust’s arrival.

The economy may actually be quite close to the tipping point, as evidence of its weakening continues to emerge. The evidence in its entirety is not yet indicating a recession, but merely a sharp slowdown. Every recession is preceded by a sharp slowdown, but not every sharp slowdown turns into a recession. Much will depend on future trends in monetary conditions and the degree to which the economy’s pool of real funding has been exhausted.

One of the key aspects of Austrian Business Cycle Theory (ABCT) is that as the inflationary boom proceeds, the structure of production becomes ever more distorted. By distortion we mean that the structure of production deviates from that which would have occurred in an unhampered market economy. Longer term projects receive more funding than that warranted by the preferences of consumers. Such longer term projects are in the capital goods sector of the economy rather than consumer goods. While Austrian school economics is not an empirical theory, nevertheless, this distortion should be manifest in the capital to consumer goods ratio. Indeed, this is what we see in the first chart above.

It is worrisome that the chart shows higher highs and higher lows. This indicates that recessions have not been allowed to do their vital function, cleanse the malinvestments so that the structure of production can reconfigure itself to reflect the most urgent wants of consumers. Such repeated failures to allow recessions to naturally play themselves out can only lead to ever more boom-bust cycles.

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