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Positive Economic Commentary

The US Economy: A Textbook Austrian School Business Cycle?
March 30, 2001

Friedrich Hayek (1899-1992), a Nobel Laureate in economics, was one of the "all stars" of the Austrian School of economics. One of Hayek's claims to fame is that he predicted in February 1929 an impending business crisis in the U.S. What did he see then that led him to this prediction? If Hayek were alive today, what might he be predicting now for the U.S. economy?

One of the basic tenets of the Austrian School is that any government interference with markets will lead to distortions and inefficiencies in an economy. It is impossible to know a priori the needs, preferences and time schedules of all the different consumers and producers in an economy. Austrian economics sees the interactions of consumers and producers in free markets as the process resulting in new and improved ways of organizing productive resources. Prices guide the decisions of consumers and producers. If inefficiencies and distortions in the allocation of productive resources are to be minimized, then the markets in which prices are determined must be free of government interference.

Nothing terribly radical here. This is what most Econ 101 students are taught. But what does tend to separate the Austrian School from mainstream neoclassical economics is the Austrians' belief that the price of current consumption versus future consumption, that is, the interest rate, also must be allowed to be determined in a market free of government influence. Because central banks either directly or indirectly influence interest rates, the Austrian School sees central banks as major mischief-makers in an economy. The Austrian theory of the business cycle is premised on the misallocation of productive resources caused by central banks' interference in the free market determination of interest rates.

Interest rates, as mentioned above, are the prices guiding each of us in our decision on how much to consume today versus tomorrow - our decision on how much to save. The higher the interest rate, the higher the price of current consumption versus future consumption because by consuming more today, we are giving up more consumption tomorrow. Each of us has a different preference for current consumption versus future consumption. For example, in general, children have a higher preference for current consumption than do middle-aged adults. Children have little concept of tomorrow. Middle-aged adults, who are thinking about their retirement years, would likely have a lower preference for current consumption. Therefore, it would take a higher interest rate to get children to forgo more current consumption - save more - than would be the case for middle-aged adults. The point is that time preferences differ from person to person, and can not be known by any central planner, including any central banker.

Interest rates are determined like any other price - by the interaction of supply and demand. Think of saving as the act of supplying resources today. When one saves, he transfers current resources or the means to acquire current resources to someone else. One is willing to make this transfer on the basis of a promise by the borrower of these current resources to return to the lender resources in excess of what were lent. Assuming that the borrower of current resources is acting in good faith, the borrower believes that he can use those resources in such a way so as to produce enough future goods and services to pay back the lender and have some left over for himself to consume, too. "Haggling" takes place until an interest rate is determined that matches the quantity of current resources offered for transfer with the quantity demanded. Fritz Machlup, a member of the Austrian School, termed this lending of current resources "transfer credit." Spending power or command over current resources is being transferred in a free market setting from one party to another. The lenders are voluntarily giving up consumption today in anticipation of consuming more in the future. Will there be more goods and services available for consumption in the future? Yes, if those resources lent today are used to produce capital goods, which will allow for greater future output of consumer goods. The interest rate determined in a free market without government interference is the price that balances saving with investment.

Enter central banks. Central banks are essentially legal counterfeiters. They can figuratively create credit out of thin air. When a central bank purchases a bond or makes a loan, it is allowing someone to acquire current resources without necessitating anyone else to transfer control over resources to the borrower. So, central bank credit was termed "created credit" by Machlup. The means to acquire the use of current resources is created by the central bank, not transferred or given up by some other party. Actually, central banks work through agents to create this credit, the agents being depository institutions such as commercial banks and savings banks. By the creation of credit, central banks disturb the balance between voluntary saving and investment.

The borrower makes no distinction between transfer credit and central bank created credit. "Parts is parts," as the fast-food chicken commercial goes, and credit is credit. By creating credit, the central bank forces the interest rate structure lower than what it would have been. This encourages more borrowing for investment purposes than would otherwise occur. A capital spending boom is spawned. This, in turn, causes resources to be bid away from the current production of consumer goods and directed toward the production of capital goods. But households have not voluntarily given up their claims on currently-produced consumer goods and services, as would have been the case if this investment boom were being financed with transfer credit (i.e., voluntary credit). Moreover, the labor that has been bid away from the current production of consumer goods to the production of capital goods sees its income rising. This will lead to even greater demand for currently-produced consumer goods. Thus, the producers of current consumer goods will want to hire more resources, including labor, in order to meet the higher demand. This will result in the prices of resources being bid up. But the higher cost of resources will begin to impinge on the cash flows of businesses engaged in the lengthy production cycles of capital goods. These businesses will seek additional financing in order to keep the production process going. This will tend to push interest rates higher, which will further jeopardize the profitability of capital goods. The economic downturn will then begin. The downturn can be delayed by the central bank holding down interest rates through the creation of even more credit. Eventually though, this cumulative process of credit creation will lead to higher inflation, which will induce the central bank to start eliminating credit rather than creating it.

To the Austrian School, then, the central bank disturbs the balance of economic nature. The central bank creates investment booms. But isn't investment a good thing for the economy? Doesn't it increase the long-term growth potential f the economy? If investment results from free market outcomes, yes. But if it results from market interference by the central bank, then, according to the Austrian School, malinvestment occurs. That is, unsustainable investment projects are undertaken. The Austrians would probably point to the Japanese experience of the 1980s as an example of malinvestment. You may recall that the Japanese investment boom was fueled by central bank credit.

What about the recent U.S. economic expansion? If Friedrich Hayek were alive today, would he say that it conformed to his Austrian School theory of the business cycle? One of the hallmarks of an Austrian School business cycle is an investment boom. Included in investment would be residential construction. The Chart 1 below shows just how big an investment boom we have experienced in this expansion. As a proportion of real GDP, real fixed private investment in 2000 was 19.0% -- the highest percentage in the history of this series, which dates back to 1929!

Chart 1

If created credit is another of the hallmarks of the Austrian cycle, then the recent U.S. cycle certainly meets this criterion. As a proxy for created credit, I am using the M3 money supply. As the Chart 2 below shows, growth in M3 had been in a steeply rising trend from1994 through 1998. At the same time that created credit has been rising rapidly, the private sector (combined personal and business) saving rate -- the source of transfer credit -- has been in steady decline. The private sector saving rate fell to 13.0% in 2000 -- the lowest since 1947. (I don't include so-called government saving because governments do not save in the true sense of the word. To save means to defer consumption of part of what you produce. Because governments do not produce anything, but rather spend or consume what the private sector produces, governments cannot, by definition, save.)

Chart 2

To show created credit relative to transfer credit, I have divided that year-to-year dollar change in the M3 money supply by the yearly flow of private sector saving. These data are plotted in Chart 3 below. In 2000, created credit was 44.7% of transfer credit -- the highest since 1973.

Chart 3

The Austrian School business cycle model predicts that resources will move away from the production of consumer goods into the production of capital goods. The current U.S. cycle seems to conform to this. In the past five years, growth in business equipment production has outpaced growth in consumer goods production by 7.7% on average -- the widest differential in approximately the past 50 years. This is shown in the Chart 4 below.

Chart 4

The investment boom, with a lag, creates an increased demand for consumer goods as workers' incomes rise, this according to the Austrian School. In fact, there was a marked increase in the growth of consumption expenditures starting in 1998, as shown in the Chart 5 below. Notice also, that in most previous cycles, consumption is strongest early in the expansion, then moderates as the expansion ages. This cycle is very different in that respect, and is consistent with the Austrian model.

Chart 5

Source: Bureau of Economic Analysis/Haver Analytics

With the increased demand for consumer goods but with resources having been diverted to the production of capital goods, the Austrian model predicts that the prices of consumer goods and services will rise relative to those of capital goods. As Chart 6 below shows, this is what has been happening in recent years. In the past five years, consumer inflation has outpaced capital goods price inflation by 2.2 percentage points. This is the widest gap in almost 50 years. Most likely, consumer goods price inflation would have risen even more above that of capital goods had there not been so much excess productive capacity for the production of consumer goods abroad.

Chart 6

The bidding for labor between the capital goods producing sector and the consumer goods producing sector pushes labor costs up relative to sales revenues, which results in slower profit growth. This is exactly what happened in 2000, as shown in Chart 7 below.

Chart 7

In the later stages of a classic Austrian School business cycle, the lifeblood of the investment boom, cheap credit, starts to dry up. That is, the cost of credit starts to rise because the central bank increases its policy interest rate in an effort to prevent or contain goods and services price inflation or in an effort to deflate the asset price bubble it has created. As shown in Chart 8 below, the Fed started raising the overnight funds rate in the second half of 1999 and corporate bond yields rose in sympathy. In addition to the central bank tightening up its terms for the creation of credit to the economy, private lenders begin to price in higher risk premiums in their loan rates due to the increased leverage of businesses. Chart 9 below shows that commercial paper credit quality spreads have ballooned in recent months and that the percentage of banks tightening up their terms of lending to business borrowers has shot up, too.

Chart 8

Source: Federal Reserve Board/Haver Analytics

Chart 9

If central bank created cheap credit is the catalyst for the investment boom, then the weaning of that cheap credit in conjunction with slower profit growth is the catalyst for the investment bust. And bust, it appears to be for business equipment investment, as shown in Chart 10 below. For the first time since 1991, business equipment spending actually fell in the fourth quarter of last year. And the further decline in price-adjusted shipments of nondefense capital goods excluding aircraft in the three months ended February suggests a further drop in business equipment spending in the first quarter of this year.

Chart 10

Starting in January of this year, the Fed started cutting its policy rate again in an effort to avoid an economic bust. Late last year, the expectation that the Fed would revert to an easier credit policy led to a speedup in M3 money supply/created credit growth. (See Chart 11.) The Fed is likely to drop the funds rate further in the months ahead. Will this prevent an economic bust? More likely, it will just postpone it. More and more created credit is needed to prevent the bust. But, as shown in Chart 12, consumer inflation is now trending higher. So, the Fed runs the risk of ratcheting inflation higher if it creates ever more credit to prevent the economic bust. If Hayek were alive today, he would most likely take the other side of any bet saying that the Fed can print us out of this economic predicament we find ourselves in today.

Chart 11

Source: Federal Reserve Board/Haver Analytics

Chart 12

Source: Federal Reserve Board of Cleveland/Haver Analytics

In sum, the behavior of the US economy in the past five years seems to fit the description of a textbook Austrian School business cycle about as tightly as the glove fit O.J.'s hand. The dot.com investment frenzy and the miles of empty bandwidth smack of what the Austrians refer to as malinvestment. Much of this malinvestment would not have taken place had the Fed not created as much credit as it did in recent years. According to the Austrians, increased doses of created credit now will only postpone, at best, the inevitable liquidation of these malinvestments that must take place in order to set the stage for a new business expansion based on the solid foundation of saving, or transfer credit. Rather than the Fed printing more money, a policy option the Austrians would recommend to encourage saving and profitable investment is a cut in marginal income tax rates. This might not eliminate an economic downturn, but it would mitigate the severity of a downturn.

Paul Kasriel
Head of Economic Research

The information herein is based on sources which The Northern Trust Company believes to be reliable, but we cannot warrant its accuracy or completeness. Such information is subject to change and is not intended to influence your investment decisions.

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