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How the Global Boom Might End

Mises Daily: Monday, December 11, 2006 by

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Currently, the wider world is undergoing an upswing of a kind perhaps unprecedented, but certainly not enjoyed since the golden age of hard money and classical liberal politics at the end of the nineteenth century.

Not only are teeming millions heading for the expanding cities of Asia, but industrial renovation is taking place all across the vast, former wasteland that lies to the east of the rubble that was the Berlin Wall.

Simultaneously, Latin America seems to be enjoying one of its all-too-rare episodes of genuine material advance, while they are turning oil into steel and concrete at a truly prodigious pace. Even some parts of perennially blighted Africa are swapping their mineral wealth for something more tangible than their dictator's Swiss bank account.

Thus, the process of secular expansion, which goes by the shorthand of "globalization," is rapidly changing the shape of our modern world, forging new trade routes and leading to a higher, more productive division of labor as it does.

Despite many flaws, a good part of this is undoubtedly real and enduring and is to be applauded for allowing at least some expression of their skills to an untold host of would-be entrepreneurs in places where such opportunities have been tragically few.

However, we must also bear in mind the grim caveat that, thanks to the interaction of political ignorance with our perverse financial system, a good deal of this is also not taking place on any sort of sustainable basis; that it will eventually undermine its own foundations and that it will occasion a good deal of loss when it does.

This is because, as Mises and Hayek taught us, a producer-led boom which has been launched on a wave of easy credit starts out on the shakiest of foundations.

Monetary laxity first makes itself felt by way of such artificially suppressed real interest rates that even as hurdle rates for entrepreneurs are lowered, investors switch what savings they still make into more speculative, longer-lived vehicles.

Some will also undertake investments while maintaining the same old consumption levels, bridging the gap by means of what appears to be a take-up of newly available consumer credit: others will simply consume more as easier terms are made available to them.

The first, as Machlup was quick to recognize, serves functionally as a hidden producer credit: the second directly implies that the net degree of abstinence will be further reduced — perhaps even reversed — once we take the relevant expenditures fully into account.

Thus, the ensuing search for yield is all too likely to translate into a self-fueling spiral of rising financial asset prices and a joyous euphoria of abandonment in capital and credit markets, the latter borne higher by its own boot-strapping effects in raising collateral values and the unrealized, notional net worth of asset holders.

A surge of new project financings, of increased bank lending, and enthusiastic venture capital will soon give rise to marked resurgence of business activity and reduced unemployment. Until costs begin to rise in proportion, the injection of new credit and the stimulation of new investment will also have the effect of boosting accounting profits at both the micro and the aggregate levels and will thus appear to justify the mass hysteria that this latest of "New Eras" will, by now, have unleashed.

Sadly, this gleaming superstructure will all be built on sand. The crucial flaw in its solidity will lie in the fact that entrepreneurs and their financiers have collectively mistaken the abundance of financial capital (which they themselves have largely created out of thin air) into thinking there must exist a correspondingly deep pool of physical capital and labor resources upon which they can draw without affecting their prices too adversely.

Alas! Such overheated conditions can only lead to an increased competition for these so-called "complementary factors" and here will emerge another confusing deviation from the viewpoint of the befuddled macroeconomic mainstream: viz., that we do not have to wait to enter the Promised Land of "full employment" before constraints start to chafe and returns start to fall.

In fact, as Henry Hazlitt made clear, it may only require that capacity is exhausted in one or two key areas for entrepreneurial plans to be disrupted and for economic distress to rear its ugly head amid inter-sectoral discord and conflict.

The areas that will first flag this crippling failing in the mutual consistency of overall business objectives are most likely to be those that have suffered from underinvestment in this – or, more likely, in a previous – cycle,  especially where these are also characterized by inelastic supply responses, long lead times, and a high degree of capital intensity.

Primus inter pares, we will find the industrial commodities sector and herein we should recognize the first signs of an explanation for the tendency of their prices to move about a generalized real decline in waves of 15-20 years, one based upon what has been called the "cobweb" theory of supply and demand.

What we mean here is that a period of unanticipated high demand for resources will eventually lead from cautious expansion through succeeding phases of (increasingly ill-timed) executive and investor enthusiasm until, at length, a crisis of overcapacity results when new supply comes on stream just as the overall business cycle turns downward.

Since the quantity of capital, marooned when the tide of fortune goes out, is both so large and so immobile, there is subsequently little enthusiasm for an outright dismantling of that capacity (especially where an expedient bankruptcy filing can both lift the burden of heavy dividend and interest payments and break labor covenants). So there will ensue a long period of high-grading, under-maintenance, exploration cutbacks, and deferred depreciation as the mine or well is run for so long as it barely exceeds the cash costs of its operation.

Meanwhile, of course, the cycle itself will turn; and demand, unnoticed, may creep upwards, even as shell-shocked miners and refiners run their operations at the lowest levels consistent with the generation of a positive cash flow.

At this early stage of the upswing, rather than looking too eagerly at new opportunities, this may be a time devoted to the repair and restoration, when a growing operating margin at last allows dud assets – for so long nursed in a state of denial — to be written down and the depreciation and degradation of old plant and obsolete equipment to be properly recognized on the balance sheet.

Moreover, the still-traumatized managers may well wish to restore their shareholders' faith, by paying out a good part of this extra income rather than risking a repeat of the whole sorry episode by using it to expand in a way these newly cautious souls would see as entirely premature.

Consequently, in this next cycle, their entrepreneurial antennae may well be dulled to the very real prospects opening up before them. Thus, as the investment community becomes breathlessly fixated on overbuilding some "industry of tomorrow" – such as, say, telecom or biotech – the outcome of a series of misread signals and of a schedule of a different kind of malinvestment will manifest itself not with the delivery of a glut, but in setting the stage for a shortfall in commodity output that may take some long while to rectify once it is finally seen for what it is.

Meanwhile, an excess of credit means that the effect of lower-than-warranted real interest rates, of shrunken risk premiums, and of higher-than-sustainable equity valuations tends to promote the purchase of capital goods. This occurs as, on the one hand, the lower hurdle rates will make all manner of pending, capital-intensive undertakings suddenly seem viable, and, on the other, the lowered discount rate will have the greatest impact on the worth of those durable assets that give off a modest but long-lived stream of income – much as a long-maturity, low-coupon bond will rally most in the same circumstances.

Here, too, a certain reinforcement may arise, for capital-intensive projects tend to be commodity-intensive ones, too, while a heightened demand for commodities is hardly likely to be satisfied without the aid of an increased complement of specialized capital equipment. After all, it takes a good deal more paraphernalia to open up a mine shaft than a mortgage brokerage!

However, the fact that all this boost to activity has not been predicated upon saving – i.e., upon a decision to forego consumption today in order to enjoy more or better consumption tomorrow – means that we will soon be caught burning the candle at both ends.

Since no one is voluntarily saving any more and since the increase in money incomes has been earned in the course of activities that do not yet give rise to more consumer goods on which to spend them, the inevitable consequence is that final goods prices begin to rise.

Where we have been led astray is in our collective timetabling of the delivery of sufficient consumer goods to meet income earners' demands. Artificially lowered interest rates – rates that therefore do not correspond to any increase in genuine saving and hence  are not matched by a pool of unutilized resources – lead to far too much effort being devoted to projects that will take a good protracted interval to mature into the goods and services  people need in their daily lives.

Yet, at the same time, each newly created dollar being expended on such projects will eventually end up in the hands of an employee, a shareholder, a creditor, or a tax recipient wanting such goods now and brooking no delay in their provision.

This is the point at which the less-specialized (or, if you prefer, the more-versatile) "factors" (people, machines, raw materials) will be bid away from work on the longer-horizon, slower-amortizing undertakings and will be enticed away instead into activities that seek to fulfil the mass of eager, would-be consumers.

Effectively, since selling prices have gone up in this sector, real factor costs – wages, for example – must have locally fallen: ergo, more employment will be offered and on better terms here than in the now less-favored lines of work.

It is at this critical juncture that — if no further intervention to re-energize it by injecting yet more credit into the system occurs – the great ocean roller of the boom is likely to topple over and crash.

Certainly, this may be the point where the dreaded omen of a negative yield curve may appear as misled entrepreneurs, strung all along the chain from the malinvested higher-order goods, now clamor for short-term credits.

Given its topicality, we must here interrupt the chain of reasoning to insist that the inverted curve loses its significance if it is not being driven from the short end, but if it is rather a side effect of the indiscriminate rush for longer-maturity, riskier instruments on the part of leveraged speculators and mercantilist central bankers (the first of whom may be using lower yielding foreign currency borrowings to finance their exposures, while the latter – printing up the wherewithal as needed – have effectively no carry costs at all!).

Be that as it may, the stringency on the short-term money market may arise because hard-pressed businessmen want to join the bidding war for the factors they so urgently need to complete the transformation of their wares to saleable final goods, factors for whose reward their own cash flow is now far too meager to encompass.

Alternatively, it may be that they wish to finance a store of unsold inventory, being unwilling, just yet, to admit defeat and to clear it out at whatever disappointingly lowly price the market will currently bear.

Anxious to salvage anything they can from the wreckage of their plans, the struggling producers will be willing to pay interest not merely up to the level of their expected profit, as before, but even up to the full extent of their (foregone) depreciation allowances as well – a phenomenon Hayek termed as "investment that raises the demand for capital."

Assuming no fresh influx of funds, short-term money rates will soar as the desperation mounts and as error-stricken businessmen seek to unblock the stream of products now languishing, uncompleted, on an idled assembly line whose workers have all been tempted away to better-paid work serving beers in the bar across the road from the factory.

Inevitably, then, the fatal divide between entrained investment and the ex ante desire to save will all come to reveal the false premises on which the boom was launched.

With costs rising and selling prices falling for all those firms suffering the effects of this excruciating dislocation, discretionary spending will be cut – especially that earmarked for new capital outlays – business services deemed "non-essential" will be curtailed and, finally, redundancy notices will be issued.

Thus will end the investment boom and then – and only then – will the malign influence of rising unemployment and falling incomes be felt on a consumer sector that has thus far been positively humming along to the tinkle of cash registers as boom-swollen incomes are spent.

The recession has now truly arrived, though not, you will note, from any lack of "effective demand," but rather due to a surfeit of defective – that is, mutually incompatible – demand.

Pessimism abounds that we are on the cusp of just such a revulsion today — fears that may or may not turn out to be real.

Whatever the case, we can surely comfort ourselves with the thought that this wholly avoidable evil is unlikely to be able to send the spreading advance in the methods of production and distribution reeling into headlong retreat.

Booms are not forever
For it would take a very severe train of events, rich in protracted and perverse political stupidity, to induce the new Asian city-dweller to hand in the keys of his well-equipped apartment; to leave his shiny new car undisturbed in its parking place; and to pack all his movable possessions back onto a hand cart, ready for the long-weary trundle back to the communal farm and out of modernity.

Human aspiration, guided and served by entrepreneurial insight, can cure a multitude of self-inflicted economic ills and we should realize that realizable aspirations have perhaps never been higher, nor the population of potential entrepreneurs larger than they stand today.

So — even if the current cycle is about to turn — it will surely complete the revolution and move upwards once again and possibly faster than we might expect, thanks to the benign self-interest of the millions of new Asian and East European entrants into our complex, highly interconnected, global economy.


Sean Corrigan is Chief Investment Strategist at Diapason Commodities Management. Send him mail. See his articles. Comment on the blog.