Boom and Bust (Part 2)
Many economists take it for granted that the attempts of the authorities to expand credit will always bring about the same almost regular alternation between periods of booming trade and of subsequent depression. They assume that the effects of credit expansion will in the future not differ from those that have been observed since the end of the eighteenth century in Great Britain and since the middle of the nineteenth century in Western and Central Europe and in North America. But we may wonder whether conditions have not changed. The teachings of the monetary theory of the trade cycle are today so well known even outside of the circle of economists, that the naive optimism which inspired the entrepreneurs in the boom periods of the past has given way to a certain skepticism. It may be that businessmen will in the future react to credit expansion in a manner other than they have in the past. It may be that they will avoid using for an expansion of their operations the easy money available because they will keep in mind the inevitable end of the boom. Some signs forebode such a change. But it is too early to make a definite statement.
Part I of "Boom and Bust" described the Austrian Theory of the Trade Cycle, or Austrian Business Cycle (ABC) theory, in order to pave the way for discussing the theory in the light of entrepreneurial expectations. If you are unfamiliar with the theory, a look at Part I, which includes links to many other resources, should prove helpful. Here, we shall examine the foremost objection to Austrian cycle theory, and see if the theory or the objection survives.
As Economist Richard E. Wagner of George Mason University says, in his working paper "Austrian Cycle Theory: Saving the Wheat while Discarding the Chaff": "...the primary criticism that has been advanced against Austrian cycle theory... is that the Austrian theory assumes that entrepreneurs are foolish in that they do not act rationally in forming expectations."
Wagner goes on to point out that "... a variety of occupations and businesses have arisen that specialize in forecasting the timing and extent of all kinds of governmental actions, including those of the central bank," so that, presumably, entrepreneurs have better information with which to form their expectations.
The idea of rational expectations entered into economic theory chiefly through the work of Robert Lucas. Justin Fox, in a Fortune magazine entitled "What in the World Happened to Economics?" explains Lucas' theory as follows:
He argued that if people are rational... they can form rational expectations of predictable future events. So if the government gets in the habit of boosting spending or increasing the money supply every time the economy appears headed for a downturn, everybody will eventually learn that and adjust their behavior accordingly... But the deductive logic of Lucas and other "new classical" economists led them to the stark conclusion that government monetary and fiscal policy should have no effect on the real economy.
As Austrian theory posits the central bank as the primary cause of the cycle of booms and busts that have characterized market economies for two centuries, it is easy to see why a wholesale acceptance of rational expectations theory entails a rejection of Austrian business cycle theory. I'll cite just one prominent example, from Gordon Tullock's article "Why the Austrians Are Wrong about Depressions":
The second nit has to do with Rothbard's [Tullock has decided to take a pamphlet of Murray Rothbard's as the canonical version of Austrian theory] apparent belief that business people never learn. One would think that business people might be misled in the first couple of runs of the Rothbard [Austrian] cycle and not anticipate that the low interest rate will later be raised. That they would continue unable to figure this out, however, seems unlikely.
What can Austrian theory say to this objection? If business people, aided by legions of "Fed watchers" and econometricians, can tell just what the Fed (or any other central bank) is up to, would we see a disappearance of the cycle?
To begin an examination of this question, I would like to recall the metaphor of the hyperactive pediatrician from Part I. Unsatisfied with how his patients were growing, the doctor kept administering doses of hormones that alternately sped up and slowed down that process. Let us imagine that we visit one of these patients after ten years of "treatment."
What do we know about this child's height compared to what it would have been without the treatment? Very little, I contend. The child might be taller than he would have been at his natural rate of growth, shorter, or even, by chance, exactly the same height. We might now that, at present, the doctor is applying growth-promoting hormones. But are they merely boosting growth up to where it would have been without the previous round of growth-retarding hormones, or boosting it above that?
Entrepreneurs are in a similar situation vis-à-vis the central bank and the natural rate of interest. When, exactly, could we point to a time when we saw this rate on the market? The Fed is always intervening, attempting to establish some rate. We might assume that, at least some of the time, this rate has been close to the natural rate, but how do we know which times? And even if we somehow did know that on, for instance, July 12, 1995, interest was at its natural rate, how could we relate that fact to what the natural rate should be now? And, while the Fed watchers might be able to tell entrepreneurs that the Fed is easing, they cannot say whether it is easing toward the natural rate of interest from some level above it, or past the natural rate from some level already below it.
Therefore, in regards to the interest rate level, we can see that the idea that entrepreneurs are committing clusters of errors by not somehow divining where the rate ought to be is to criticize them for lacking super-human capacities.
Entrepreneurs do know, however, whether the Fed is currently easing or tightening. But here the knowledge that is most important to them is how long this policy will be pursued. Interestingly, in this matter the Fed has a motivation to act contrary to whatever expectations the business community forms. If businessmen feel the Fed will raise rates, and therefore they refrain from hiring, undertaking new projects, making new capital good orders, and so on, then the Fed, watching the statistics collected on new hires, capital good spending, etc., will be less likely to raise rates. If businesses, feeling an easy credit policy will continue, do expand operations, it becomes more likely that the Fed will tighten.
Furthermore, Wagner's point, mentioned above, that businesses have become better at watching the Fed surely must be complimented with the observation that the Fed has become better at watching businesses. Furthermore, the Fed has a legal advantage on the entrepreneurs, in that businesses (especially public ones) must by law reveal a great deal of information, while the Fed has been chartered to keep its proceedings secret. Entrepreneurs and the Fed have entered into a sort of card game, and it is hard to see how entrepreneurs can be faulted for not always guessing correctly which card the Fed is about to play.
We must also look at the issue of which entrepreneurs are most likely to first take advantage of easier credit, and in what position this will place the remaining entrepreneurs.
Let us, for simplicity, divide entrepreneurs into classes A and B. (This sharp division is not crucial to the analysis, as you'll see.) Class A entrepreneurs are those who are currently profitable, i.e., those most able to read the current market and anticipate the future state of the market. Class B are struggling, money-losing, or, indeed, unfunded "want-to-be" entrepreneurs, less capable at anticipating the future conditions of the market.
Now, let us go to the start of the boom. It is 1996, and Alan Greenspan begins to expand credit. To where does this new supply flow? The As are not necessarily in need of much credit. If they wish to expand, they have available their cash flow. In the state of the market prior to the expansion, they were the ones most able to secure credit. They quite possibly have been through several booms, and, being able to read the state of the market well, may suspect that they are witnessing the start of another one. They are cautious about expansion under such conditions.
The situation for the Bs is quite different, however. Their businesses are marginal, or perhaps non-existent. They have previously been turned down for funding. And, the Bs are those very entrepreneurs least able to discern that a credit expansion is underway.
Moreover, even if they could tell that this is an artificial boom, it might make sense for them to "take a flier" anyway. [See Roger Garrison's "The Austrian Business Cycle in the Light of Modern Macroeconomics" for a similar view.] As it is, they are either not capitalized, or on the verge of failing. If they ride the boom, they will have a couple of years of the high life. And who knows, their business just might make it through! Or, perhaps, they will build a sufficient customer base to be purchased, maybe even enough to retire on. They use the easy credit to expand or start their business. We should notice that the As are much less susceptible to this motivation -- they expect to be "living the high life" anyway, since their businesses are already doing well.
As the Bs create and expand businesses, the boom begins to take shape. However, we can see that the actual situation of the As has changed:
Of course, in order to continue production on the enlarged scale brought about by the expansion of credit, all entrepreneurs, those who did expand their activities no less than those who produce only within the limits in which they produced previously, need additional funds as the costs of production are now higher. (Mises, Human Action, XX.6)
Although the As suspect, correctly, that the expansion is artificial, they cannot afford to shut down their business for the duration. But, if they can't, they must increasingly compete with Bs for access to the factors of production. Take, for instance, the A company Sensible Software, Inc., and the B company, Dotty Dotcom.
Dotty Dotcom, flush with venture capital and an "insanely great business plan," is luring top Java engineers with salaries exceeding Sensible's plus stock options that could be worth millions after the IPO. (This is an investment in higher-order capital goods, as top engineers are needed chiefly for more complex projects, which typically can take one to five years to complete.) Sensible simply cannot afford to lose all of its best programmers to Dotty. It must bid competitively for them.
However, in order to do so, it must take advantage of the same easy credit that Dotty is using to back its bids, as at the natural rate of interest existing at the start of the boom, Sensible was already bidding up as much as it deemed marginally profitable for producer’s goods. So the A entrepreneurs, willy-nilly, are forced to participate in the boom as well. Their hope is that, in the unwinding, the basic soundness of their business and the fact that they have expanded less enthusiastically than the Bs will see them through, perhaps with only a few layoffs.
Or, take the case of a class A mutual fund manager who suspects that stock prices are artificially high. If he simply puts his funds in cash and attempts to sit on the sidelines, he's sunk. All of his customers will leave, and he'll never survive to see the bust that proves he was right.
The analysis of the bank side proceeds in the same fashion. It is precisely the marginal lenders, those with the least ability to evaluate credit risks, that have the least to lose and the most to gain from an enthusiastic participation in the boom, that expand credit first. Again, the sounder lenders are eventually sucked in as well, in order to compete.
Notice that this analysis adds to the explanation of the radical difference between an artificial boom and a savings-led expansion. In the latter, the A entrepreneurs are able to sense that the consumers really *do* desire a lengthening of the production process and an increased investment in capital goods. Therefore, they are eager to take advantage of the increased savings. There is no reason to turn to the B entrepreneurs to find takers for the new funds.
Of course, entrepreneurs exist on a gradient, and there is no sharp A/B division. This was introduced only to simplify the discussion above, but the fundamentals remain unchanged under a more realistic assumption.
Another malinvestment from the boom, in addition to the intertemporal one, is the interpersonal one -- Bs are those that society least wants to have capitalized! One of the corrective forces operating to bring on the downturn is the fact that capital must be wrested back from the Bs and into the hands of those who can better satisfy the desires of the consumers.
This factor, it seems to me, fits well with our experience of real booms and busts.
For example, an architect I worked with was quite aware, two years ago, that we were in a "boom phase." He told me stories of witnessing a previous wipe out in Connecticut real estate in the late eighties. He expected another, and yet he had expanded his business anyway. There were simply jobs that he couldn’t afford to turn down coming his way.
Meanwhile, with the established builders in my area so busy, new builders have been popping up everywhere. Many of these people really should not be in the business. As Roger Garrison said to me, in commenting on this article:
In lectures more so than in print, I have often referred to the "marginal loan applicant" in explaining it all (your Class B entrepreneur). At the operational level, the relevant margin is the creditworthiness of the borrower and not an eighth of a percent difference one way or another in the rate of interest.
The idea that the Austrian cycle is caused by systematic, foreseeable errors on the part of entrepreneurs to a great extent depends, as Wagner points out, on confusion between individual choices and aggregate outcomes. Certainly, an omniscient socialist planner in perfect control of the economy, and who had by some miracle solved the calculation problem, would not choose to misalign the time structure of capital. But in a market economy, as Wagner says, "The standard variables of macroeconomics, rates of growth, levels of employment, and rates of inflation, are not objects of choice for anyone, but rather are emergent outcomes of complex economic processes."
I'd like to introduce one last metaphor to clarify this point. Picture a small town centered on a village green. This is an ordinary town in every way, except that the town council has acquired an odd ability and has chosen to use it in a most curious way. Somehow, the council has devised a way to extract 10% of every resident's cash holdings every evening at midnight. No effort to hide cash from the council is of any avail. In a redistributionist fantasy, the council has decided that it will deposit this pile of cash in the middle of the green every morning at six, available to anyone who wants to grab some.
In the aggregate, it is obvious that this activity cannot make the town better off. In fact, as everyone will now be spending time trying to grab back as much cash as they can, the town will be worse off. By chance, some less-well-off residents may occasionally make out well, but as time goes on, the net effect of the lost productivity will tend to punish them as well.
Still, it is not an error on the part of residents to plop down on the green at 5:55 every day. They are subject to a phenomenon that they cannot control, and each of their micro-level decisions lead them to participate despite the fact that, at the macro-level, this activity cannot make them better off. There is only one error necessary to generate this wasteful activity, and that is the error of the town council's foolish policy.
We must extend the bus driver metaphor from Part I. There, we had a single bus driver, representing "the entrepreneurs," driving a single bus, representing "the economy." The passengers (the consumers) had voted on a level of air-conditioning for the trip, but the Fed had replaced their vote with its own.
To handle the issue of expectations, we need to have many buses crossing the desert, each with its own driver. The drivers are competing for passengers, who will, to a great extent, board a particular bus based on the combination of comfort and distance the driver offers them. The drivers, while knowing that they do not have the passengers' real preferences on air conditioning, do not know what those preferences are, or how the temperature they have been handed actually relates to those preferences.
In addition, as the supposed air-conditioning preference (the interest rate) is lowered, it lures more drivers into the business, many of whom are not really qualified, but perhaps have no better shot at "making it" than to attempt the desert crossing anyway. Perhaps, after all, they will get across!
It is clear that the situation is far from optimal. Whenever the Fed has set a supposed demand for air conditioning (current consumption) that is too far below the real one, many buses will fail to make the crossing. Recovering from this ("sending out the tow trucks," we might say, or liquidating the failed investments) creates additional costs itself, and exacerbates the situation. But it is hard to see why the bus drivers are to blame.
Foreseeable errors on the part of entrepreneurs are not a primary component of the Austrian theory of the trade cycle. Of course, error is a key part of the theory -- the central error being the conceit on the part of the central bank that it can manipulate the interest rate away from the natural rate without untoward consequences.