Busts are not ‘inevitable’

There are those who can display a solid grasp of the oft–misunderstood mechanics of credit and money generation by banks and who are also well aware of the episodes of endemic mistakes this entrains in in our system. Yet, perhaps because they possess a certain ideological bent, many such commentators cannot seem to steel themselves to take the next step and admit that very little of this has anything to do with a free market, or that those mistakes are decidely not an intrinsic feature of what they like to call ‘capitalism’.

Investment errors typically take the form of ploughing too much money/credit into assets (real or financial, new or existing) to the point that one or both of the magnitude of their supply and the level of their pricing passes the point of being able to generate a sufficient schedule of cash flows to (a) fulfil any commitments incurred in their acquisition; (b) allow for the asset to be successively depreciated and, hence, potentially replaced at the end of its useful life; or (c) deliver a return which matches up to that prevailing on any other generalised outlet for our funds (which we could call the societal ‘natural rate’ and which strictly should be risk-adjusted for a fair comparison).

The first of these is a ‘hard’ loss, the second two are successively ‘softer’ ones, if you will.

In essence then, we either bubble up prices (of bonds, property, storable commodities, equities, etc.) or we build too much capacity (steel works, solar fabricators, shipyards, etc.).

Since there is nothing outside of this round which can be used as an absolute yardstick in judging such departures (elastic credit systems being subject to there very own Gödel’s theorem), it is all too easy to fall prey to special pleading of the ‘this time it’s different kind’, or to succumb to that transparent imperial cloth of ‘rational expectations’ (or, less pseudo- scentifically, the ‘wisdom of crowds’), or even to behave in that Three Wise Monkey manner of the post-Greenspan central bank and ignore what cannot be easily measured (financial excess) for what can (one’s pet version of a consumer price basket).

Along the way, the so-called ‘risk-free’ instruments are inflated with all those which are valued, with varying degrees of rigour, with reference to them, so lending even the inhabitants of the wildest fringe of the portfolio a certain specious respectability during the Boom.

Even when the Boom finally topples over into Bust, our burnt-finger risk-aversion, by triggering a rush for what are called ‘safe assets’, begins to transmute even these ‘havens’ into a lee-shore anchorage, by dint of driving up their price/down their yield and so sowing the seeds of the safety-first strategy’s own frustration, as surely as if we loaded far too many anxious passengers into the same lifeboat before launching it into the waves.

But – and here is my Austrian ‘but’ – though often used by adherents of other schools as a convenient shorthand for the financial aspect of this pathology, ‘malinvestment’ to us is a term usually – and I think usefully – reserved for the process of laying down too much capital in physical form, especially where that form is durable and functionally specific, thus, as we say, turning a monetary crisis into a real-side one and so drastically reducing its tractability and ease of remedy.

In this regard, to the extent we gauge the proportions wrongly, underinvestment (in means of production, not in financial claims, to be understood everywhere in the following) ‘shortens’, rather than preferentially ‘lengthens’, the interwoven skein of productive activities (i.e., it adds too few, rather than too many, more vertically specialized, end-consumer remote, highly-path dependent, and long-amortizing stages to the web). In this way, under-investment eventually gives rise to its own market – by leaving us with a mix of too many liquid assets – money supreme among them – alongside too few satisfied needs – in much the same way as was seen at the end of WWII in the USA.

Overinvestment – strictly, unbalanced, incoherent investment – alas, is a rather different kettle of fish.

A good part of the problem of the ongoing lethargy of some parts of the world economy – as well as of the dreadful prolongation of the slump in others – is that the Boomtime’s mania of ‘lengthening’ (plus its residential real-estate ‘broadening’) has still not been fully liquidated and hence the deadweight of the anchor-chain of past obligations (h/t Axel Leijonhufvud) continues to drag down both income-fearful debtors and balance sheet-falsifying lenders. This toxic combination has played a major role in impeding central bank efforts to reinvigorate that growth of ‘inside’, bank-created money and credit which they – to an Austrian, absolutely incorrectly – suppose to be the sine qua non of renewed economic expansion. (The other main impediment has been the central bank’s lunacy in destroying interest-bearing assets’ natural dominance over money and making so indistinct the difference between the two that it has greatly suppressed the urge to economise on one’s individual holdings of the latter).

Ironically, of course, not only did the central banks’ prior criminal laxity give rise to the Boom, but their unimaginative appeal to the same medicine of artificially depressed interest rates is the thing which has deliberately limited the scale and pace of liquidation, recalculation, and title transfer from weak hands to strong, from loss-deniers to gain-chasers (outside the zero rate gambling halls of the Global QE-sino, that is). Hence it has both extinguished incentives to judicious risk- taking and crowded out many of what would otherwise have been a profusion of entrepreneurial opportunities to rebuild our irrevocably lost (but still not completely realised) loss of wealth.

Here we must record a strong exception to a comment made some while back by financial writer, Francis Coppola – one we cite here but as a ready example of a sentiment which is widely echoed in other quarters. This is her assertion that she is ‘… not convinced that investment would be any better directed without central bank support. Unless we become much, much better at pricing risk, malinvestment is an inevitable consequence of doing business.

Humans are, of course, all too fallible, but it is a guiding tenet of Austrian analysis that unless there is some gross distortion to be found in the economic continuum, individual mistakes tend to cancel out. Moreover, while none of us denies that entrepreneurs are similarly mortal in their constitution, we would almost define the members of the class as they who tend to be a touch more far-sighted and more readily adaptable to changing business conditions than the rest of us poor salarymen.

Furthermore, we would argue that, under a functioning market system which operates within a clear framework of stable property rights and benign institutions, the entrepreneurial dynamic is that of a non-zero sum, wealth-creating, self-stabilizing arbitrage. As part of this, there unfolds an evolutionary process in which a demonstrable success in serving us, the consumers, is rewarded with the transfer of a commensurately greater command of resources, favouring the better and penalizing the worse examples of an entrepreneurial population which is thus subject to a relentless and pitiless mechanics of selection.

It is to this largely co-operative version of Darwinism, this multi-agent process of search for more profitable combinations of time, energy, human and physical resources which that we look to find the crucial emergent behaviour which slowly but surely raises material standards for us all.

Under such conditions, I put it to the reader that malinvestment is not at all inevitable, rather it is a gross aberration.

If you can broadly accept these premises, it will surely not raise too many further objections if, as an Austrian, I point you toward the assertion that the kind of mass delusion which afflicts so many entrepreneurs in the boom is only possible if the signals which they derive from the market as to the nature of those exploitable gaps which may exist between attainable supply and expressible demand are not swamped in a howling of intervention-derived noise. This implies that for entrepreneurs to mutate, en bloc, from equilibrium-seeking (but never attaining) agents of negative feedback and positive gains into the germs of a viral plague of self-aggravating, loss-breeding speculation needs something very toxic indeed to be introduced into their medium.

In fact, the one and only trigger is to bring about a state in which the cost of financial capital is pushed too low for too long. Such a sustained divergence from what is appropriate can only occur with the complicity – if not, indeed, the active agency – of  that very central bank, the absence of whose ‘support’ Ms. Coppola seems to doubt would make little difference to the case.

I would also argue that after the house of cards has tumbled, entrepreneurs’ supposedly depressed ‘spirits’ (as marked by their stubborn reluctance to over-leverage once more) are not so much the result of some irrational group hysteria but rather of the wholly justified apprehension that since both policy and politics aee striving mightily to delay a full reckoning of our past follies, their undeserving, evergreened, zombie counterparts will continue yet awhile to depress their prospective returns through what is effectively an exercise in state-sanctioned, bank-enacted, unfair competition. Worse, they darkly suspect that any profits they do manage to garner in these least auspicious of circumstances will be subject to both confiscatory (and possibly retrospective) taxation and to blame-deflecting, populist opprobrium.

It is to this malaise that we can attribute the lowered ‘marginal efficiency of capital’, not to some technological hiatus or ‘secular stagnation’. And it is at this door, too, that we can lay the blame for the anaemic recovery, not at that of some fetishistic desire to hold money for its own sake in a supposed ‘liquidity trap’.

No. The truth is that it takes some spectacularly bad government and some avowedly perverse applied economics to turn a Thomas Brassey into an Ebenezer Scrooge.