A matter of interest – part 1

In the bank’s most recent report on the troubles currently afflicting the Ozzie mining boom, ANZ made the following pertinent observation:-

While most first-generation projects will be built, many projects plotted out on drawing boards in recent years will not come to fruition in the foreseeable future. In part, this is due to the reality that there simply would not be sufficient available capital or labour to complete them. Indeed, this report suggests that of the 950 projects identified as currently underway or proposed in Australia, up to two-thirds may not proceed in the planned time frame.

As we will argue below, this observation neatly encapsulates the key Austrian insight that the Boom ends – as Mises always insisted it does – due to scarcity and not to the development of some mythical state of widespread over-abundance.

It is through this developing scarcity that what we call ‘malinvestments’ are ultimately uncovered. By this expression we mean those undertakings which were launched on what is belatedly recognised as an unwarranted scale only because there was an inordinate increase in the availability to their promoters of what Fritz Machlup termed ‘created’ credit (something that went under the name of ‘fictitious capital’ in the even more descriptive, older parlance). The extent of such ‘malinvestments’ – and the intrinsic shakiness of their foundations – are revealed when the lack of any REAL capital corresponding to that fiction finally begins to bite, rendering moot the entrepreneurial calculations behind them.

The dearth usually shows up in the form of such threats to profitability as higher input prices, longer delivery times, and lower customer demand (this last arising since many prospective buyers will by now be facing their own, analogous strains). We Austrians talk here of there being a scarcity of complementary factors of production, rather than focusing on a supposed glut of capacity in the sector which is now seen to be struggling.

Typically, this revelation has a greater effect the higher up the chain of production we go (i.e., the further along a hypothetical line of processes stretching from the strip mall towards the strip mine) since here we tend to find that the output in question is both more specialized and less fungible than that which is created ‘lower down’ the productive structure and so nearer to its final apotheosis as a consumer good. The ‘higher order’ product has fewer alternative market outlets, if you will, and certainly enjoys less immediacy in the final realisation of its function in satisfying people’s needs. The path to completing its formation of value is much more tortuous; the release of the funds necessary to its success, and thus the vindication of its initial creation, more protracted.

Moreover, the purchase of said output is much more discretionary when of ‘higher order’ – since its uptake involves what is generally, if loosely, termed ‘capital spending’ on the part of others and this, of course, consists of both highly contingent and readily deferrable outlays and so is typically the first expenditure to fall victim to the effects of disco-ordination and faulty estimation being experienced elsewhere in the system. Furthermore, given that such disruption is, as we shall argue, to be laid at the feet of the faulty operation of the credit system, the greater the number of links in the chain between a good and its definitive contribution to consumer satisfaction, the more opportunity for credit-related problems to intrude.

Ultimately, it is not so much ‘over-capacity’ in mining (or housing, or solar panels, or diesel engines, or whatever is found to constitute the crisis of the day) that is the problem. Instead, what is being made manifest is the unfavourable constellation of costs and selling prices which has emerged because much of what is being built-out is not consistent with the overall schedule of desires of end-consumers and hence with the timely distribution of goods, services, labour, and land which these latter economic ‘sovereigns’ require for the fulfilment of these, their more urgent needs – both in the moment and over the entire course of the failing projects’ investment lengthy horizons.

A two-horse race to a one-horse town

To see why we assign such a key role to the interaction of money and credit in the propagation of mass, systemic error – and hence both to the boom and its ensuing bust – we must first insist on the distinction which is to be made between ‘created’ credit and what Machlup again termed ‘transfer’ credit. The former involves the synthetic generation of a disembodied accounting entry (or, else, a banknote or token coin of trifling intrinsic worth) which, no-matter how insubstantial its essence, nonetheless endows its new possessor with what is effectively a full quantum of new purchasing power. In contrast, the latter represents the recording of a voluntary, contractual surrender of an extant unit of such power by the lender (or vendor financier) in favour of the borrower so that the recipient can deploy it as he sees fit during some specified passage of time.

Since the former – the ‘created’ credit – adds an ability to spend which is unrelated to the prior production of goods or performance of service, it cannot fail to introduce an avoidable and highly regrettable degree of fluctuation in the process of exchange which is intrinsic to all of that material human activity which is conducted beyond the bare subsistence level of autarky.  The latter, ‘transfer’ credit, in contrast, merely passes from one party to another a claim upon the pool of available goods (or current services) which has been already made valid by dint of an antecedent contribution to that same pool.

It should go without saying that this passing of the baton has the potential to alter the specific choice of the object of its subsequent expenditure and, hence, that it can – and should – alter relative valuations between those items now feeling the force of less or more immediate demand, according to the varying preferences of debtor and creditor. But what it cannot do is to allow both parties to the transaction to turn up at the same time, in the same place, laying claim to the same share of an unexpanded endowment of goods, or an unenlarged capacity to perform service and thus create a shockwave of overbidding to ripple out through the whole Higgs field of money-goods interactions.

Conversely, since an effusion of created credit does allow precisely such a simultaneous expression of demands, it cannot do other than to sow the seeds for strife where there should only be a willing co-operation, by perverting what should have been a mutually-satisfying exchange of goods today for goods tomorrow (i.e., on either coupon or redemption day) into an unseemly Supermarket Sweep wherein both of those involved in the initial trade rush to fill their shopping carts, each striving to use his own version of this falsely duplicated means of purchase before his counterparty has a chance to pre-empt him.

Such a conflict will tend to resolve itself in a higher price being paid for the fought-over goods – with the associated drop in real living standards this entails all too frequently falling, not on the guilty parties, but on some unknowing innocent who turns up later only to find that the shelves are nearly bare and that what is left costs a great deal more than expected. ‘Inflation’ is what we term such a social ill.

In discussions regarding our modern international monetary system – the ‘deficit without tears’ as Jacques Rueff memorably termed it – is a well-known phenomenon whereby the principal reserve currency issuer (currently, the USA) can buy without ever really paying, simply by issuing irredeemable IOUs – like Rueff’s much put-upon tailor – to those who have little choice but to accept them. The malign effects are both well-documented and much-debated, even among the macroeconomic mainstream. Yet, strange to say, this largely analogous and much more endemic business of lending-without-waiting with which we are here dealing is either completely overlooked, or else promoted as a positive blessing by that same, chronically inflationist church of the economically orthodox.

In a barter economy, where we have no identifiable means of exchange to confuse the issue, this temporal coincidence of demand claims would clearly be a nonsense. In order to acquire an axe head from you, I must give you an agreed number of beaver pelts: one is exchanged for the other. Even in a simple, face-to-face credit society, the same constraint must exist. If I lend you my horse, Aristotle, we cannot both hope to mount him and spur him, at one and the same instant, to gallop off to the diametrically-opposite towns of A and Non-A, as is permitted by way of the fractional-reserve deposit banking (or, the pure fiat money) system described above.

Being overly accustomed to dealing largely in money and its close substitutes, we often lose sight of the fact that they are supposed to constitute nothing more than a reliable and efficient means of facilitating benefit-enhancing exchanges of actual goods and services. In the standard economists’ telling, resort to this medium originally arose in order to circumvent the limiting effect of the ‘double coincidence of wants’ involved in barter (where I may only have beaver pelts to offer for my desired axe head, but you insist on receiving deer antlers instead).  Why this is important, of course, is that it removes a major obstacle in the path towards that richer division of labour which we all accept to be a major feature of our secular material advance.

In the other version of the origins myth, this one mainly propagated by the anthropologists and the archaeologists, the coincidence hindrance was first overcome by means of the extension of (transfer) credit from seller to buyer. Even here, however, money quickly found its competitive edge by offering a sure and convenient means of final settlement between an unlimited array of counterparties which obviated the need for much of that credit. Its superiority was evident over that of an arrangement which, as the etymology of the word suggests, requires the slow and careful establishment of a network of trust which may be severally inflexible, personally intrusive, slow in resolution, and tending to an excessive degree of commitment to one’s debtors and creditors, as well as being open to more subtle forms of either monopolist or monopsonist exploitation by one of the limited number of partners with whom one is constrained to deal.

Despite all these manifold advantages, we cannot pretend that the money has proved an unmitigated blessing to our species. Indeed, the histories of both commerce and of the organized banditry we call politics are in many ways tales of alternating monetary shortages and surpluses, of mints and manipulations, of competing standards and corrupted specie.

The introduction of money has brought with it a ‘double decision’ mechanism by separating our action in selling from its natural complement in buying all other non-money goods. Instead of swapping axes for pelts, we now first accumulate and then disburse money itself. Each time we make a sale this naturally affords us the option to hold more or less of that money for its own sake, (or, conversely, when we buy, to draw down a previously garnered store of that same money and thus obviating the need to sell). In this way, we introduce a kind of reservoir into the otherwise balanced and contemporaneous contraflow of goods and money.

Like its hydrodynamic equivalent, this reservoir can be a source of stability, cushioning people from the vicissitudes of life, but it can, on occasion, add to rather than dampen oscillations when heightened unease increase money’s safe haven appeal and optionality or, conversely, when distrust of its continuing value is excited. By altering the proportion of money which remains in active circulation, hence by changing its effective scarcity, our actions can exert a wider and arguably a less predictable influence on economic relations – one which can become subject to positive feedback, if sufficiently disturbed from the norm – than we could otherwise achieve in the course of our simple, direct intercourse with our immediate suppliers and customers.

Such states of ‘monetary disequilibrium’ which are said to be brought a out by rapid shifts in the size of people’s desired holdings of ‘real cash balances’ offer a rich field for economic theorizing and the search for methods to mitigate their putative ill-effects have given rise to an even more lush jungle of proposals regarding the shape of the institutions, the regulatory framework, and the kinds of policy interventions for which one should aim. Needless to say, a de-politicization of money, a simple insistence upon the observation of property rights and the existing laws of contract, a withdrawal of the crutch of corporate welfare from the banking system, and a refrainment from further interference do not feature highly on this list.

Lowering the Boom

Since monetary influences can be so all-pervasive; since ‘money’ itself is so widely accepted (otherwise it would not even be a money, however ethereal its form), it has been hard even for princes and popes to resist the counterfeiter’s urge to procure the fruit of another’s labours through offering him a fake version. In our own, more populist, more Progressive, era it has been similarly easy for our elected rulers to convince themselves that to practice such a swindle is to promote the greater good by providing the state’s many placeholders and pensioners (all of whom share an equal franchise with the pigeons they are plucking, as Candidate Romney was indiscreet enough to point out) with a living for which they will reward their political benefactors-by-proxy with their votes. Add to this the irresistible, if intellectually jejune, conclusion that all periods of bad business are characterized by slack sales, idled workers, and falling prices – and hence by a perceived ‘lack’ of money – and there has always been a persistent thread of opinion that it is far, far better for money to lose its value through over issuance than it is for it to gain value through under supply. Inflation therefore becomes endemic to our way of thinking.

In all this, it is easy to neglect the truth that, once present in readily-divisible quantities which reach beyond a certain functional minimum, additions to the supply of money become not only redundant but, since money usually serves also as the universal unit of economic calculation – the numeraire – a uniquely debilitating influence. It is bad enough having far more bandwidth than is needed to convey the given traffic of useful information, but once the excess starts giving rise both to spurious signals and to a howling cacophony of noise and so scrambles the coherence of the message it is supposed to carry, more can easily end up being far, far less.

But the evil of monetary over-issue is not just confined to a rise in the prices of goods and services which takes place in a largely unpredictable and highly unsystematic fashion, so that we lose track of what is truly more scarce and what more abundant. Beyond this, it also renders accounting for profit and loss highly problematical, especially when this must take place over a passage of time during which the inflationary virus has been wreaking its havoc with market values. If we are happy, as many are, to attribute the commercial revolution of the Quattrocento and the liberation of humanity from the bounds of feudal superstition which that era ushered in to the arithmetical innovation of double-entry book-keeping, we must recognise this inflationary falsification as a further plague.

We can go yet further for monetary over-abundance cannot fail to spill over into the markets for assets – indeed, in the modern age, it will probably be felt here first. In so doing, it inflates the price of claims on prospective future income, lowering the implied rate of discount intrinsic to them, and so it insidiously persuades entrepreneurs that the present has suddenly become so well supplied with actual capital means that a greater call that heretofore can be made upon their provision without any adverse impact upon their price or fear for future availability. Thus it is that far too many of humanity’s inveterate commercial optimists convince themselves that many, more ambitious, longer-term projects than before can be undertaken with no heightened risk of failure, but rather with an enhanced opportunity for gain.

Take the act of deciding upon the launch of a new or expanded line of business. Obviously the entrepreneur will make his best guess as to the stream of revenues he may gather and will set these off against his estimates of what it will cost him to achieve them. To the extent he needs outside funds to accomplish this, the interest rate payable on these is, of course, one of his principle costs. More fundamental still, he has to apply some form of discount to this putative schedule of flows of cash, both into and out of the firm, in order to compare their aggregate, time-normalized sum to that of the initial outlay he must make, if only to measure the opportunity cost of this against all alternative uses of the funds at his disposal.

Thus it is, of course, that a lowering of the rate of generally accepted rate of interest makes his challenge seem a less daunting one: our man will not only have less to pay out on any hired capital he requires, but the possibility of earning a greater return in some other fashion (e.g. by entrusting his own wealth to a second entrepreneur instead of acting the part himself) will be correspondingly lessened. Just as it is with the familiar arithmetic of the bond market, the influence of changes in this interest rate will be greater, the more temporally dispersed are the cash flows, i.e., the longer the foreseeable timespan between the moment when the entrepreneur makes his first investment and the day when he has fully recouped its worth (and, hence, has also paid off any external debt he may have incurred in its making).

But, having reckoned with all this on our own spread sheet, or having seen it laid out in the 10-k taken from someone else’s, what we must never forget is that such calculations are not simply an abstract pecuniary calculation, but that the various entries represent the estimated purchase costs and selling prices of actual, real goods and services. If our hero misjudges the margin between the two, all may be lost. Yet – whether he recognises this or no – his reckoning is intimately bound up with the information which the interest rate is conveying with regard to the likely relative abundance of his inputs and the relative demand for his outputs over the entire investment horizon of his project.

What is not to be overlooked is that the applicable rate of interest is not some abstract entity, utterly variable according to the whim of the banking system, but rather is one of the fundamental ratios prevailing in the vast, interconnected topology of exchange – in this case, between the value put on goods available at once and on those only accessible at some future date.

Moreover, since the ultimate goal of all productive undertakings is to satisfy the desires of the end-consumer, the definitive set of goods which one wants in the present – and so the one from which the prices of all preceding goods are therefore imputed via discounting over the relevant stretch of production time – is the set of end-consumer goods. This is made most evident in the height of the wages the entrepreneur must offer to his workers who labour, in the first instance, in order to feed, house, and clothe themselves and their families with such end-consumer goods and who will thus measure the worth of their pay against what it will buy them in the shops. No less will the ampleness of the entrepreneur’s own rewards, as well as that of the ones accruing to his shareholders and earmarked for his creditors be tested against that same benchmark.

It is less obvious – though no less important – that not only must the workers, employers, owners, and creditors of all those upstream suppliers of his be equally satisfied (or else they will try to charge him more for his inputs), but also so must their peers downstream (or else they will seek to pay less for his output). The more urgent such folk perceive the demand for their daily bread to be, the less favourable will be conditions for all those not involved in reaping, milling, and baking it.

Since the new undertaking we are here considering makes neither a matured contribution to the production of bread, nor yet has had time to give rise to the kind of other goods for which the bakers will be willing to exchange a few of their much-prized loaves, all those involved in the scheme will have to rely on a nourishment which has been spared from the needs of those who are already fully integrated in to the overall pattern of production and exchange and who therefore can either fabricate their required ration or trade for it. Hence the importance of an interest rate which accurately reflects the size of this pool of real savings – the scope of this ‘subsistence fund’, as it used to be called – and hence the fatuity of trying to stimulate investment by encouraging exhaustive, end consumption, rather than production and saving.  

Even before we confess that the outline we have presented here of a good passing through a succession of processes akin to a linear chain of fire-buckets – or perhaps along a well-ordered, unidirectional assembly line – paints far too simplified a picture of who sells what to whom and hence of exactly where any given business lies on what we call the ‘structure of production’, we should already be acutely aware of just what an impossible task the business leader faces, of just how much dispersed knowledge he would need to acquire (and constantly update), were he to have to calculate all this from scratch. Confronted with an insuperable computational task, it is just as well that our man should be able to rely on the levels – and more importantly the ratios – of the prices generated in the market to encapsulate all that he needs to know. It cannot be emphasised too strongly that the interest rate is a key example of such a ratio and that it should therefore not be the subject of gross manipulation, either by the state itself or by state-sponsored deposit bankers acting under its aegis.

It might also be noted, in passing, that if we take this idea of a near infinite complexity of calculation seriously, we must recognise how hopeless is the attempt made by those who would presume to plan not just a business, or an industry, but an entire economy. In applying their crude macroeconomic theories of the humours to its interwoven and interacting wonders, these leeches are unlikely ever to do much to improve the health of the dynamic, adaptive organism they are each purporting to treat, but only to occasion it harm.

Continue to Part 2.

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