The Skyscraper Curse: And How Austrian Economists Predicted Every Major Economic Crisis of the Last Century
Chapter 3: Do You Have a Theory?
We don’t really know what starts the speculative bubbles. — Jesse Abraham and Patric Hendershott, “Bubbles in Metropolitan Housing Prices”
The Skyscraper Index was based on the most noteworthy business cycles of the twentieth century and can be explained using Austrian business cycle theory (ABCT). In contrast, there is no consensus within mainstream economics about business cycle theory. The Keynesians have several versions, but all are driven by psychology and changes in aggregate demand. This would include behavioral-finance economists such as Robert Shiller who believe that stock markets are irrational. There are also debt-cycle theories put forth by Irving Fisher, Hyman Minsky, and Joseph Schumpeter. There is the real business cycle theory (RBCT), which is associated with the Chicago school and embraces the role of external shocks, such as technological change. There is a political business cycle theory based on the election cycle, and there are even Marxist theories.
The problem with most business cycle theories is that they are really just descriptions of business cycles rather than economic theories of business cycles. Each description emphasizes particular features that are then elevated to the status of causal forces. Each stage of the business cycle is characterized by several features — for example, speculation, unstable supply of money, changes in aggregate demand, changes in social mood, and external real factors, or shocks. As a result, business cycle theories could be characterized as perspectives in which the economist has identified particular features of the economy to blame, along with their preferred remedies.
As such, business cycles are reoccurring sequences of varying length of expansions, downturns, contractions, and upturns in many types of economic activities such as production, employment, income, sales, housing starts, money, credit, and prices. Interest rates, inventories, fixed capital, and loans outstanding tend to be procyclical. Keynesian theories emphasize that business cycles must be fought with aggressive government policies, such as deficit spending, bailouts, public works projects, and monetary stimulus. Real business cycle theorists take the opposite approach and recommend a passive policy of letting the government and economy absorb the impact of external shocks.
Austrian business cycle theory has significant advantages over mainstream theories:
First, whereas mainstream theories find the cause of business cycles to be either psychological or technological, ABCT identifies a cause of the business cycle that is economic in nature — namely, artificially low interest rates, which start a chain of events that can be understood using simple economic tools, such as supply and demand.
Second, mainstream theories assume away the complexities of the real-world economy, while ABCT incorporates complexity in its analysis.
Third, ABCT incorporates the psychological and technological features of mainstream theories and shows them to be predictable rather than random and unexpected shocks.
Fourth, by identifying an economic cause of the business cycle, ABCT reveals a solution for ending the business cycle and the endless cycle of psychological and technological shocks and wasted resources.
For ABCT, the cause of the boom and subsequent bust is when the central bank reduces the market rate of interest below the natural rate of interest by increasing the supply of money and credit. The natural rate of interest is the market rate of interest set by savers and borrowers in the absence of intervention by the central bank and is adjusted for both risk and price inflation. This rate, therefore, signals the general time preference of society. Artificially low interest rates are not calculable because we cannot know what the natural market rate would be except by indirect measures such as the amount of open-market operations conducted by the Fed — that is, its net government-bond purchases. However, we can understand the impact of artificially low interest rates by looking at another, more straightforward, example of a government price control — in this case, a price ceiling set by rent-control laws. Such laws keep the rental rates on apartments artificially low. These laws lead to shortages of apartments, physical depreciation of apartment buildings, and misallocation of apartments. For example, with rent-control laws, you might find a large family occupying a one-bedroom apartment and a single individual living in a three-bedroom apartment due to the shortage of apartments. The key difference with artificially low interest rates in the loanable-funds market is that the Fed can make up for any deficiencies and prevents a shortage by printing money out of thin air.
Prior to Fed involvement, the amount of savings and borrowing are equal at the market-determined interest rate. Actual loan rates of interest vary from loan to loan based on the combination of the base rate, risk premium, inflation premium, and processing costs. After the Fed has reduced this rate to artificially low levels it creates a shortage of loanable funds, which it then corrects by buying government bonds from banks for cash. Banks now have more cash, which they can use to make loans. The direct consequences of this policy are to reduce savings, increase lending and debt, and lower lending standards so that individuals with lower credit ratings obtain loans and individuals with higher scores can obtain a larger amount of loans.
For consumers this means a greater debt burden and a reduction of future income because of less saving and interest income. For entrepreneurs this means a larger amount of borrowing. The lower interest rates also make longer-term investments appear more profitable relative to shorter-term investments. For example, low rates might induce a farmer to switch from growing corn, an annual crop, to growing apples, a multi-decade-length project. Lower interest rates induce foresters to let their trees grow longer, winemakers to let their wine age longer, and publishers to have larger print runs of their books. It also induces entrepreneurs to make production structures more roundabout.
The simplest example concerning roundabout production is of an isolated person who catches fish by hand and obtains one fish per day. If that person spends one day not fishing, but instead makes a net, that person could obtain three or four fish per day. Fishing by hand is direct production, while making the net and then fishing is more roundabout.
For a more modern example, let us examine the alternative ways we can communicate with each other. The most direct way of communicating with someone is to walk over to them and begin talking. A more roundabout method would be to first run a telephone line between your location and their location and use telephones to communicate. Using phones to communicate implies the prior existence of a vast variety of capital goods for the production of wires, phones, telephone poles, and so on. The amount and complexity of capital goods for cellular phone service is even more astounding. Phones are therefore more roundabout than the “walk and talk” method, but are much more productive. Austrian economists focus on this process of technological change. Investment in more roundabout production processes means that investors are investing in new ways of doing things that were previously on the shelf but were not feasible or in general use. Spending money on research and development is investment in new technologies to be available in the future. These technologies generally involve even more-roundabout production processes. In this manner, ABCT shows how the interest rate plays a direct role in the so-called technological shocks of the RBCT.
ABCT also tries to deal with the complexity of the economy rather than assuming it away. Mainstream theories generally have a mathematical model manipulating aggregate statistics such as consumption, investment, and government spending. The mainstream approach treats capital as a homogeneous factor of production that can be retooled and relocated with a wave of a magic wand.
In contrast, ABCT examines structures of production that span from the discovery of raw materials to the final product available for sale in retail stores. There are many stages of production in every structure of production, and each stage employs specific and nonspecific labor and specific and nonspecific capital goods. For example, an oil refinery contains a multitude of capital goods that are very specific to refining oil, but also capital goods such as pipelines and tanker trucks that are nonspecific capital goods because they can be used to transport many different things. To these, the entrepreneur adds very specific labor (e.g., petroleum engineers), nonspecific labor (e.g., truck drivers), and other inputs from previous stages of production (e.g., crude oil) in order to produce gasoline, a consumer good. Therefore, ABCT can show that nonspecific capital and labor can more easily be reallocated if conditions in the gasoline market deteriorate, but highly specific capital and labor are much more difficult to reallocate. Either the market value of oil refineries and the salaries of petroleum engineers must fall dramatically or they must remain unemployed.
The structure of production of all goods and services is highly complex. It is so complex that mainstream economics assumes it away. Even being complex, we can know some things about it and some things that affect it. The structure of production of a new product begins with a very short and direct structure. For example, with the invention of the automobile hundreds of small companies started making their own hand-fitted parts and assembling cars one at a time.
My first “portable” computer was built just for me by a computer technician using purchased parts, and it was the first one in town. This “portable” was the size of a suitcase that would barely fit in the overhead compartment of an airplane and weighed almost twice as much as a fully packed suitcase. Over time structures of production tend to get longer and the number of companies that sell the final consumer product often decreases.
For example, mass-produced interchangeable parts and the assembly line production technique for automobiles were introduced and quickly adopted. These technologies made production more efficient and increased the specialization of labor. They also made the structure of production more roundabout: machines had to be created to make interchangeable parts and assembly lines, technologies had to be created to replicate those machines, and so on. Today we find the structure of the automobile industry incredibly complex, with thousands of firms spanning the globe. These firms provide everything from computer graphics software to design new automobiles to the caps for the air valves on tires. Parts are transported to assembly factories, and then automobiles are shipped to auto dealerships. For mainstream economists the idea of perfect competition is the initial chaos of thousands of individual automobile companies, while for Austrians the whole process of the initial chaos evolving over time into a small number of mega-sized automobile manufacturers is competition. Mainstream economics’ ideal market form requires a large number of buyers and sellers, perfect information, a homogenous product, and several other conditions. For Austrian economists the only requirement for competition is no government barriers for entrepreneurs entering or exiting an industry.
Another difference between Austrians and mainstream economists concerns the role of money. For the mainstream economists money is neutral and is similar to their view of capital. Money can be injected into any point in the economy and it will not cause disruptions, distortions, or redistributions of wealth. In other words, new money does not affect the real economy or relative prices. For them it only raises the so-called price level and reduces the purchasing power of money. In the mainstream view, new money seamlessly seeps throughout the economy without resulting in any relevant changes in demands, relative prices, or production.
In contrast, Austrians base their analysis on the real impacts money can have on the economy. Let us contemplate a doubling of the money supply in the economy, as Richard Cantillon did in 1730. He concluded that new money could not possibly be neutral and then gave several examples of new money and how it would disturb an economy and cause redistributions. His examples included the discovery of silver mines and a large number of wealthy immigrants moving into a nation with their money. He showed that new money changes prices and production to meet the new demands of wealthy mine owners, miners, and new immigrants.
Our example is a central bank that wishes to try an experiment with newly printed money. After carefully acquiring the names of all pickup truck and NASCAR enthusiasts in the economy, it credits each of their bank accounts with $10 million. Austrian economists would expect to see ticket prices for the Daytona 500 increase dramatically, and they might speculate about the introduction of a Daytona 1000, but mainstream economists would expect no change. Austrian economists would expect that the price of the Ford F-450, the most expensive pickup truck in the market today, would increase and that Ford would produce a larger quantity of such trucks and might even build a new assembly plant or even design more expensive versions of its line of pickup trucks.
The pickup truck and NASCAR enthusiasts, the Daytona 500, and the pickup truck producers would all gain relative to everyone else. However, when all the money was spent, what would happen to the new capital that the Daytona 500 and Ford have invested? Mainstream economists tell us that there would be no effect on incomes, wealth, production, and new products or that any such disturbance would only be short lived and unimportant.
In recent years, the Fed’s use of zero–interest rate policy (ZIRP) and quantitative easing (QE) has made it possible for hedge fund managers, Wall Street bankers, and bond dealers to become extraordinarily wealthy. As a result of this immense wealth, real estate prices in Manhattan have increased dramatically and many new luxury-condo skyscrapers have been constructed. The experience at art auctions also tells a similar story. The price of artwork of artists of the currently fashionable contemporary-art genre, such as Jean-Michel Basquiat, Christopher Wool, and Jeff Koons, has skyrocketed to millions of dollars, while the minor works of such famed artists as the impressionist Pierre-Auguste Renoir can be purchased for perhaps less than $100,000.
In reality, with conventional monetary policy there are some straightforward ways in which the economy is distorted by artificially low interest rates. There is more lending and investment and entrepreneurs tend to favor longer-term, more roundabout means of production. For example, in the current environment of extremely low interest rates, especially for large corporations, Amazon has found it profitable to use robots rather than employees to fulfill orders from customers, despite the low-wage environment. The most direct way to fulfill orders is to have employees read orders, retrieve products, and package the products for delivery. A more roundabout method would be to design and build robots to replace the employees; create software for the robots to fulfill orders; reorganize warehouses and order-fulfillment centers to operate with robots; and train some employees to maintain and interact with the robots.
To watch the robots move around Amazon facilities, one might get the feeling that the company is somehow cheating on its various competitors. Additionally, when one looks at the price of Amazon stock one might guess that the company is earning huge profits, akin to a worldwide monopoly. Sales in 2015 were an enormous $35.7 billion, up 22 percent over 2014. Profits were also up a staggering 125 percent at $482 million in 2015. However, that means they are only making about 1 percent profit on sales. Amazon has a market capitalization of $300 billion and a price-to-earnings ratio of over 500.1 In other words, investors cannot imagine anything going wrong for the company. Wilson2 reports that one analyst predicts the company will be worth $3 trillion in less than ten years.
Some of the conventional disturbances caused by an increased money supply include a redistribution of wealth from savers to borrowers because borrowers obtain loans at lower rates, savers get a lower return on their savings, and the value of savings and debt is diminished by price inflation. The biggest beneficiary of this redistribution is the federal government, which has trillions of dollars of debt. The other primary redistribution from an increased money supply is the redistribution from people working for wages or living on fixed incomes to people with variable incomes, primarily but not exclusively in the financial sector.
Keynesian business cycle theories are based on psychological factors while real business cycle theory rests on external shocks such as technological change. ABCT incorporates both psychology and technology. With artificially low interest rates the economy will experience more investment and consumption. The price of assets will increase and unemployment will fall, even below the so-called natural rate of unemployment. Wages, incomes, and profits will all increase. During this boom Austrians expect the psychology of investors and entrepreneurs to be highly positive. Retirement stock accounts will increase substantially, variable-income workers in the service economy, such as waiters and massage therapists, will earn higher incomes, and novices will earn windfall incomes by endeavors such as flipping houses and day trading stocks. Given the above story about Amazon, it would also not surprise Austrians that a great deal of new technology would come about; in fact with ABCT it would be expected. The very nature of making an economy more roundabout implies new recipes for production and the introduction of new technologies. So there is a built-in rationale for a technology shock during a boom.
Every boom eventually peaks, and then the economy enters into a corrective phase, or bust. The reasons for transition are important and will be discussed, but for now let’s stick to our example of the bust phase; in light of the mainstream business cycle theories, this is largely just reversing aspects of the boom phase. The price of assets will fall, and the unemployment rate will increase above the natural rate. Wages, incomes, and profits will fall, and the incomes of service workers will decline. House flippers will flop. Naturally the positive psychology of the boom will disappear and the social mood will turn gloomy. Austrians expect this to happen. We would be very surprised if it did not happen.
In terms of technological change, it is hard to undo technology once it is introduced, so Austrians generally expect large losses where there had been the largest investments in new technology, the real estate related to that new technology, and the people who financed that new technology. Some RBC theorists argued that the financial technology used in the housing bubble was responsible for both the bubble and the bust. They blamed the new financial instruments, such as collateralized debt obligations, mortgage-backed securities, and asset-backed securities. For RBCT this financial technology was both a positive shock up to 2007 and then a negative shock. Indeed, the financial technology is the primary, but not only, reason why it was, after all, a housing bubble. Without these new financial products, Fannie Mae, Freddie Mac, the Community Reinvestment Act, and the tax advantages of homeownership, it would have been simply a generalized bubble throughout the economy, rather than specifically a housing bubble.
For now let us look first at the process of economic growth and contrast it with the business cycle in light of ABCT. It is important to know that true economic growth is dependent on the existence of increased savings. When people spend less of their income on consumption goods and save their money, they leave more resources in the economy to be used by others. As compensation, they will have more savings and interest income so that in the future they can increase their consumption beyond their income, or even forgo working altogether.
Entrepreneurs need savings, whether it is acquired through bank loans, the sale of stocks and bonds, or retained earnings from their companies. They need money to acquire capital goods, to hire labor, and to pay other expenses. Companies will use savings to maintain their capital from physical depreciation and they will invest in new capital goods that present better profit opportunities because of technological advantages. This will make the production structures more roundabout, efficient, and productive. More savings makes it possible to pay for things such as more employee payroll and inventories prior to the consumer ultimately paying for the final product. In other words, all the resources hired and used from the acquisition of raw materials to the final assembly and sale of consumption goods have to be financed in some way. More savings results in greater productivity and production.
Now let us contrast economic growth with the business cycle. Instead of an increased preference for saving and future income, now the lower interest rate and source of new loanable funds comes as a result of the monetary policy of the central bank. At the lower interest rate people will save less, not more. They will consume more. Investment will increase, particularly in longer-run, more-roundabout production technologies, but also for consumption purposes.
Reducing saving and increasing consumption and debt makes consumers less wealthy and puts them in a more precarious economic position. Investing in more-roundabout production processes also puts entrepreneurs in jeopardy. For example, instead of two entrepreneurs developing two new factories for the production of new advanced computer chips, four such projects are proposed and financed at the artificially low rates. The entrepreneurs study their projects, which are not identical but are very similar, in order to determine where to construct such factories and what are the best places to find construction workers, engineers, scientists, and factory workers. Also, what are the best sources of the very-specific capital goods, such as chip-making machines and clean-room technology? With existing chips selling better than expected due to increased consumption in the economy and promises of a new advanced chip on the way and financed at low interest rates, the stock price of these companies goes much higher. With such activities happening in many industries, the economy is booming.
Now we turn our attention to supply and demand issues as the entrepreneurs start running into some unforeseen circumstances. With twice the normal number of factories under construction, the price of land best suited for the factories is higher than expected. The availability of labor — first construction workers, but eventually the engineers, scientists, and factory workers — is less than anticipated and therefore wages and benefits are higher than were projected. The demand for the advanced chip-making machines and clean-room technology is also much higher than anticipated, so their prices are also higher than expected. Because there are four factories instead of two, the cost of all four projects will be higher than anticipated. Some components of the projects could be ordered in advance to avoid such cost increases, but not all them.
As the factories come online and start producing, other problems arise. The industry-wide supply of advanced computer chips is much greater than the entrepreneurs originally anticipated. As a result, the price of such chips falls and is lower than anticipated when the projects were initiated. The result of having undertaken four projects instead of two is that prices and revenues are lower than anticipated. Computer chips can be sold in advance too, but such hedging provides only short-term protection.
The overall demand for such an advanced computer chip is also likely to be adversely affected by the artificial interest rates. Recall that artificial rates increased consumption and reduced saving. This means that consumers were busy buying things such as the previous generation of smart phones and other chip-containing products, but now they have less savings and more debt. If half of your intended consumer base now has $10,000 in credit card debt and only $100 in their checking accounts, there is going to be a reduced demand for new chip-containing gadgets. This means fewer chips sold and even lower prices. The central bank can try additional doses of artificial credit, but it cannot print resources. It can only create more malinvestments and greater consumer debt. Notice that if there is a general glut of production capacity in an economy the result could be price deflation, the bogie man for mainstream economists.
With market-determined interest rates, an increase in the demand for loans by chip-making companies and entrepreneurs more generally would result in higher interest rates. When the interest rate is determined by the central bank, there is nearly a perfectly elastic supply of loans at the policy interest rate.
You can see the impact of artificially low interest rates today in the boom in higher orders of capital goods: the record-setting stock markets and general weakness in goods of the lowest order, consumption goods. Central bankers have feverishly used their one tool of money printing, but that has only created asset bubbles, malinvestments, and relative weakness in the Consumer Price Index, which is what ABCT expects. Once central bankers give up and put away their tool, asset prices will crash, malinvestments will be revealed, and consumer prices will be relatively strong.
Some might wonder here about the Austrian view of entrepreneurs. How can the same people who can figure out such amazing ways of improving the economy and its structures of production be fooled, repeatedly, by the Fed? Yes, Austrian economists do view the entrepreneur as a critical player in the economy, but entrepreneurs are not omniscient and we expect them to fail on a regular basis, constrained and controlled by competition, the system of profit and loss, and their capitalist backers. Engelhardt shows how easy credit conditions provide low-quality entrepreneurs access to credit that they would not have access to under tighter credit conditions.
In a nutshell, ABCT warns that artificially low interest rates create malinvestments and a boom or bubble in the economy. This necessarily sets the stage for a recession, bust, or economic crisis when the cluster of entrepreneurial errors is revealed. This is an economic business cycle theory, although it anticipates and incorporates the technological shocks and psychological instability of the competing mainstream theories. ABCT shows us how the biggest policy errors by the central bank result in economic crises and skyscraper curses and more entries in the Skyscraper Index.
