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Thursday, June 18, 2009

The limits of demand

When we did the AGD study, a few of you mentioned that you were interested in knowing where I part theoretical company with Rothbard. I never did get around to answering that question until now, with this suggested alteration of his version of the Austrian business cycle. I should be quite interested in hearing where my logic breaks down, if it does.

The conventional Austrian business cycle theory rests upon the expansion of bank credit causing a shift in investment to capital goods from consumer goods, which creates malinvestment that is exposed when when consumption patterns revert to the previous norm. The subsequent contraction is brought about by the liquidation of those malinvestments. My two problems with this middle step are (1) it doesn't apply as well to an information and service economy as to an industrial manufacturing economy even though we see the same pattern of expand-malinvest-contract in both, and, (2) I see neither evidence nor logical rationale for insisting that consumption patterns must return to their previous form in order to trigger a contraction.

I suggest the cycle can be better understood if we broaden our perspective when looking at the middle phase of the cycle and consider how the expansion of bank credit will also lead to malinvestment for reasons that are not dependent upon the shifting production ratio between capital goods and consumer goods by utilizing a price-based variant of the Keynesian acceleration principle. This begins with recognizing that the obvious causal connection between increased bank credit and price distortions, since cheap credit permits consumers to purchase goods at prices they could not otherwise have afforded; this is what cheap credit is expected to do and is the reason loan consolidations and other forms of consumer credit are advertised on television. The easy availability of cheap credit permits the purchase of houses, college tuitions, and cars by a much broader range of buyers than would otherwise be the case, so as the law of supply and demand dictates, an increase in the availability of debt will lead to an increase in demand which will necessarily drive the price of those goods being purchased by debt higher relative to the price of goods not being purchased by debt.

As these debt-purchased goods rise in price, more potential suppliers become interested in entering the market while existing suppliers ramp up their manufacturing capacity. This increase in production capacity requires additional investment in the capital goods that produce them. But it's not necessary to insist that consumers will revert to their old consumption patterns, instead, it's enough to note that although consumption patterns are altered in the short term, there is a material limit to the extent they can be altered that the continued increase in capital investment must eventually exceed. Once that limit is exceeded, the inevitable contraction begins, exacerbated by the fact that the excessive production has increased supply far beyond the furthest limits of demand, causing prices to decline even faster than the shift in consumption patterns would dictate. This may sound very similar to the acceleration principle described by Paul Samuelson, but it is rather different because it does not rely on any mechanistic production assumptions or a fixed capital–output ratio. It merely requires postulating three things: (1) the availability of debt increases prices, (2) there is a finite limit to the maximum consumable quantity of every consumer good available, and (3) money used to purchase debt-enabled goods cannot be used to purchase other goods that are not debt-enabled.

Both the recent housing and automotive booms are examples of what for lack of a better term I will call the Austrian acceleration principle. Bank credit expansion increased the demand for both houses and cars, (among other things), as first lower interest rates, then subprime and Alt-A mortgages, expanded the pool of home buyers, while at the same time, the plethora of low-interest leasing options vastly increased the number of potential car buyers. Consumption patterns were drastically altered. The percentage of homes purchased as second and even third residences didn't only increase in the U.S.A., but in every country where a housing boom took place. Whereas the number of vehicles per household had remained flat, at 1.8, from 1998 to 1994,2 that rose to 2.3 per household by 2008 with nearly 35 percent of U.S. households owning three or more vehicles. But the number of houses and cars a consumer can afford to own is limited, so the expansion cannot continue indefinitely. In the meantime, the consumption patterns have been shifted towards the debt-enabled purchase houses, cars, and ancillary products and away from whatever the consumers had been buying before. The best efforts of the financial institutions to expand the enlarged demand base finally fail, and then the contraction begins.

It must be understood that this is very different from the Keynesian concept of underconsumption. There is no shortage of consumption, in fact, the problem is rooted in the credit-based creation of consumers that cannot truly afford to be purchasing the consumer goods they are buying. It should be obvious that in the real world of economic scarcity and finite resources, there will always be material limits on consumption. Once the artificially enhanced demand limits are reached, or even worse, consumers cannot afford to service their debt on the goods they previously purchased, the boom will come to a hard and fast end.

Rothbard asserts that the Keynesian acceleration principle only explained fluctuations in specific industries, not general economic depression, and even declares it to be wholly invalid because it does not take prices into account. But, as I have already noted, prices are an integral part of this Austrian variant on the concept so that aspect of Rothbard's criticism does not apply. As for the matter of specific industries versus the general economy, my response is to point out that bank credit does not expand at the same rate throughout the economy as a whole, but is concentrated in the specific sectors upon which the financial institutions are focused regardless of whether they are capital or consumer goods. This is why the initial contractionary signs that precede a general depression tend to be seen first in the price movements of the sectors in which the credit expansion was concentrated before spreading across the entire economy.

1 Comments:

Blogger Jonathan Swinghammer August 19, 2013 11:03 AM  

There is one issue that I think may impact the analysis you are forwarding here. The contraction itself starts with a decrease in the amount of credit inflation caused by central banks in response to price inflation. This causes positions to no longer be sound because they only made sense with lower interest rates. The obvious example being the large homes being built awaiting buyers who could get loans with no money down and no jobs at ARM rates that were artificially low. Because capital good investment tends to be low margin anyway and only makes sense when there is a lot of savings in the economy (under a free market signaling a longer time preference in general and thus a lower interest rate) these positions become insolvent very quickly and people who were funding their operation on credit are exposed and have to either liquidate or hold on (which is probably going to make matters worse).

In our credit based world things get worse when loan failures start cascading through the system and result in margin calls and bank failures.

Getting back to the consumption pattens though for a moment. The reason that prices were rising is because rates were artificially low signaling not greater time preference but instead greater preference for spending. We all saw this when people took out HELOCs to buy big screen televisions or whatever. The shift was really just a decrease in capital goods spending relative to consumer good spending where there was legit demand. We saw this as people stopped buying big homes and continued their love of all things Apple.

I hope this makes some sense. Maybe this is how you see it and I just misunderstood you. This was a very interesting writeup. Thanks for sharing it.

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