4. Booms and Busts – the Austrians Were on the Right Track

Economic development around the world has been punctuated by many periods of what appear to be “booms” followed by “busts”. The booms are often characterised by relatively full employment in combination with sharply rising prices of some particular asset class, often housing or shares. This is often referred to as an asset bubble. The busts can be characterised by a sharp fall in the asset price that had previously been rising, combined with high levels of unemployment.

This chapter will explain the underlying causes of these phenomena. The ideas proposed here are inspired by, but not identical to, Austrian Business Cycle Theory, a collection of ideas proposed by the Austrian School of economics.

The Austrian School of economics

The Austrian School is so named because some of its early founders happened to be Austrian, though as time went on, its supporters came to be found all over the world. Indeed the current centre for promoting its teachings, The Ludwig von Mises Institute, is located in the US. Austrian economists could perhaps be described as the ultimate “free market fundamentalists”. Their answer to almost every conceivable economic issue is “leave it to the free market”. They assume this will naturally lead to a better outcome than would be achieved with any government intervention or regulation. This book does not subscribe to this view.

Before we get into the details of the boom bust cycle, it will be useful to tell a little tale which will serve as a analogy for more complex details to come.

The microphone and the speaker...

Imagine you are sitting in a theatre during the day, while a singer is preparing for a show later that evening. You look on stage and notice that there is a microphone, a powerful amplifier turned up to maximum and some large speakers. You also notice that the microphone is situated very close to the speakers. The singer's management is also sitting in the theater, there to ensure everything is running smoothly. The singer then walks up on the stage and approaches the microphone. Just as he's standing there, he has a little cough to clear his throat. The microphone picks up the sound of the cough, which then gets amplified and played through the speakers. This, now louder sound, gets picked up by the microphone, amplified, and out through the speaker again even louder. This cycles round getting louder and louder until it becomes a deafening screech which continues until one of the technicians rushes to switch off the amplifier altogether. Now imagine that you looked over to the management team and to your surprise, they were all busy discussing ways to avoid having the singer cough. "That screeching sound was horrible. Maybe we should get him some throat lozenges" says one, "maybe he could cough first and then go on stage afterwards" says another. The management clearly do not understand the problem. The screeching sound was caused by a phenomenon well known by sound engineers as feedback. The feedback can be reduced by simply repositioning the microphone further away from the speakers. The feedback mechanism needs some sort of "seed" sound to get it started but in order to understand the problem it is essential not to confuse the seed with the final screeching sound.

The boom

This section will describe the mechanics of the boom phase of the business cycle. This phase is often misdiagnosed because the high price of the asset concerned is usually driven by two components acting at the same time.

The seeds of an asset bubble

The seed of a boom is very often a clear and sustained rise in the price of some asset class (typically shares or houses), usually for a genuine fundamental reason to do with supply and demand. For the sake of argument, in the coming parts of this discussion we shall refer to this initial rise as being caused by “Reason X”. Employing our speaker-microphone tale as an analogy, reason X corresponds to "the cough". This is the first of the two components that drive the price rise. The second is more complex, and requires a little digression before it can be introduced.

Trading on margin and its cousin, the mortgage

The next ingredient in the recipe for creating bubbles, concerns a mechanism used by speculators known as trading on margin and an economically similar device, the mortgage. Trading on margin is a trick employed to make greater profits from a successful investment. It works as follows:

Trading on margin

Imagine a speculator is confident that the price of an asset is going to rise strongly over the next year. As an example, say that the asset is shares in General Motors. Let us also say that he has $1,000 to invest. The speculator can profit from this prediction by simply using his money to purchase the asset, wait a year, then sell up and pocket the difference. If the shares rose by 15% he would have a profit of $150. There is, however, a way to boost his earnings. What he can do is borrow some money for his investment. Say he borrowed $10,000 at 5% interest. Now he would have $11,000 to buy GM shares. One year later he can sell the shares for 15% more, i.e. $1,650. Now he has to pay the 5% interest on the loan. This will be $500. So the net profit over the year will be $1,150, far greater than the $150 without the loan. This method of magnifying your potential profits is a form of financial leverage. The degree of leverage is expressed as the ratio of the amount of loaned money to the amount of money the investor has available himself for the investment, so in this example the leverage is 10:1.

Trading on margin is considered a high-risk strategy because if your prediction turns out wrong and the shares go down in value then potentially you can lose more than your original investment. This kind of investment strategy is less common among small individual investors but is almost routine among fund managers and other large institutions.

Note that for trading on margin to work profitably, the increase in the price of the asset must outstrip the interest rate being charged for the loan. So increases in interest rates will reduce the propensity for investors to employ this technique.

Getting a mortgage in order to buy a house for investment purposes has very similar economic characteristics to trading on margin. The investment in this case is the house. The investor’s contribution is the deposit and the remaining money is made up by the loan. If the price of the house rises at a faster rate than the interest on the loan then the profit that the householder can make on their investment can be far greater than that which they could make had they only been able to invest their original deposit.

Both trading on margin and buying houses as an investment can be summarised as follows:

People who are confident in the rising price of an asset may like to borrow money in order to invest it in that asset.

The word “may” in that sentence depends on how confident the investor is that the price of the asset will rise faster than the rate of interest on the money that needs to be borrowed. We can now make a more accurate summation of the situation:

People who are confident in the rising price of an asset may like to borrow money in order to invest it in that asset. The greater their confidence in the rise and the lower the interest rate, the greater the enthusiasm for this process.

There is one more key fact that needs to be considered here. In Chapter 1 we learned how loans create money. So we can further modify the summation as follows:

When people are confident that an asset can rise in price at a rate greater than the current interest rate, then fresh new money will be created for the purposes of purchasing those assets. The greater the confidence in the rise and the lower the interest rate, the greater the enthusiasm for this process.

Simple supply and demand will tell you that the more money there is chasing an asset, the higher the price will go. We can now state that:

More money being created for the purposes of purchasing this class of asset pushes up the price. This in turn creates more confidence that the price will continue rising.

This constitutes a positive feedback loop in the asset price. As discussed earlier, an asset bubble can get started when there is a sustained rise in the price of an asset for a fundamental reason. When people observe this rise for a long enough period, their confidence in its continued rise will grow. This will give people the confidence to trade on margin and the feedback loop can then kick in and the bubble will grow. Sadly so few people know of the feedback loop that many commentators will ascribe all of the rise to Reason X even though this was merely the seed.

Delusions of future wealth

With the steadily rising price of the asset class (rising at a rate faster than would be caused by Reason X alone) owners of that asset can foolishly believe that they will have greater wealth in the future than they will have in reality. The bubble is certain to burst. This delusion of future wealth leads to a wide variety of economic “errors”.

Economists from the Austrian school talk about “malinvestments” during the boom phase, though this gives too much emphasis on the investment decisions of entrepreneurs. The phenomenon is more generalised than that. The errors are being made by almost everyone. People’s spending decisions, their propensity to save, the types of business that will flourish, the types of business that will diminish or fail, as well as the investment choices of banks, will all be affected by the erroneous optimism about future wealth. So perhaps we should state that during the boom phase there will be a combination of malinvestments as well as “malspending”.

The bust

One can consider the price of an asset as being made up of two components:

1. a price based on the inherent desirability of the asset on its own merits

2. a premium over and above “Price 1”, based purely upon expectations that you will be able to sell the asset at a higher price at some future point.

During an asset bubble the second component will grow and grow while the first component may remain relatively unchanged. This is what we have seen time and time again, either in the form of unsustainably high share prices, house prices, or more recently, in the price of derivatives.

As many economists have pointed out, “If something cannot go on forever, it won’t.” When the price of an asset class has been rising steadily for some initial period, many people may assume that it is bound to continue rising and they will merrily invest in the asset, thereby raising prices in the bubble. But there will eventually, possibly years after the start, come a point where the price of the asset becomes so obviously unsustainable that more and more people begin to become skeptical that it can go any further. At some point the skeptics will begin to outnumber the “believers” and the prices will turn around. As soon as this starts to happen then the aforementioned “Premium over Price 1” will vanish. The positive feedback loop then acts to accelerate the price change in the opposite direction, i.e. people see the prices falling and they no longer want to hold on to the asset so they sell, or at least are reluctant to buy. This signals prices to go down... and so on and so on.

An end to the rise at some point is guaranteed but there will always be some event that people will claim was the cause, even if it was merely the straw that broke the camel’s back.

At this point let’s remind you of the two phenomena discussed earlier:

• Borrowing causes money creation (via fractional reserve banking).

• Speculators like to borrow in order to invest in assets that they think will rise in price (trading on margin).

Obviously the price of the assets involved in the bubble are no longer expected to rise; quite the opposite, they are expected to fall. We now need to introduce the corollary to these phenomena:

• Paying back loans/defaulting causes money to disappear out of existence.

• Speculators who had recently been doing a lot of borrowing will now no longer have that desire. Indeed speculators whose investments have fallen in price dramatically may default on their loan repayments.

You should be able to see now that this scenario will naturally lead to a significant shrinking of the money supply. Indeed when the stock market bubble preceding the Great Depression burst, the money supply shrank by around a third. A big drop in the money supply has a whole host of bad side-effects, which we will come to later.

The faulty brakes on the positive feedback loop

Mainstream economics might suggest that there are natural brakes on the feedback loop that would prevent any runaway asset price boom from developing too far. The idea would be as follows:

A natural braking mechanism

1. If the money supply (due to all the trading on margin or mortgage lending) started growing too fast then this would show up as high inflation.

2. Governments instruct their central banks to use interest rates to keep inflation to a reasonably low level, commonly 2%.

3. If inflation started to rise then central banks will raise interest rates and it will become expensive to borrow money and the speculator’s trick of borrowing money in order to invest will no longer be so attractive.

4. Asset prices will start to level off and the boom will be over before it has barely got started.

Step 2 of this braking system should sound familiar to you. It has been, and still is, an extremely popular policy implemented by governments throughout the world. Unfortunately there is a problem with this...

Why the brakes don’t work very well

In practice this braking mechanism is flawed. The critical problem is the assumption that an increase in the money supply will directly lead to an increase in CPI inflation. If this assumption is incorrect then it may be possible for the money supply to increase without triggering significant immediate inflation and therefore without giving central banks the signal that they need to raise interest rates. It is indeed possible for CPI inflation to remain relatively low even when the money supply is increasing at a rapid rate. If the newly created money is being used for trading assets involved in the bubble that are not measured within the scope of the CPI then the CPI may appear to be relatively stable.

Higher prices in one sector do not quickly lead to higher prices in all sectors

Now you may argue that the higher prices of any specific asset class (shares, housing etc.) will soon feed into the rest of the economy and will cause more generalised price rises that will be picked up by textbook inflation measures. This is because the rises in these prices will eventually lead to the newly rich investors spending their money on everyday items like the rest of us, thereby signalling that prices should rise. But this process can be subject to very long delays. If, for example, the price rises are in shares, working to the benefit of a pension fund, then the bulk of the rise in prices is scarcely being spent in to the rest of the economy at all. There may some leakage in the system in as much as the flow of newly retiring people will gain, but the vast bulk of money sloshing around in the pensions system will remain doing nothing other than trading back and forth between different shares. Similarly, when wealthy investors, banks and hedge funds see that they are onto a good thing with a skyrocketing investment, the last thing they want to do is sell up and take the profit. They have a big incentive to leave their money in the system for as long as possible.

Economists from the Austrian School prefer to define inflation purely in terms of money supply growth. If this was the standard measure, and central banks had been instructed to use interest rates to keep that measure low, then none of the recent asset bubbles would have occurred, at least not to anything like the same degree.

The central banks never got a signal to raise interest rates

In relation to the recent sub-prime housing crisis, as mentioned earlier, a variety of central banks were instructed to target a CPI inflation rate of 2%. The CPI did not measure house price inflation in any way, not even mortgage repayments. So for years interest rates were set too low and people were taking out ever larger loans (creating new money) to buy houses. The price of houses inevitably went higher and higher. The majority of house buyers/owners did not spend much of the increased price of their houses into the rest of the economy. Sometimes the reverse would happen. People were straining so hard to join/stay on the housing bandwagon, spending so much of their income on mortgage repayments, that they would spend an ever decreasing fraction of their income on “normal” consumer goods, i.e. the kinds of things that would be measured by the CPI index. The result was that the government were blind to the creation of this bubble. They would “explain” the rise in house prices purely in terms of a shortage of housing or on increasing numbers of immigrants. Indeed the availability of some reasonable sounding explanations was part of the problem. The fact there were factors that would and should have led to some rise in house prices served only to fool so many politicians and economists into thinking that these factors explained all, or almost all of the rise.

Psychological effects of a boom–bust cycle

Some people seem to assume that asset bubbles are something that only concerns bankers, but this could not be further from the truth. Asset bubbles do a huge amount of harm to the real economy. The supposed good effects of the “boom” phase are more than offset by the bad effects of the “bust”. We would all be far better off if there was no bubble at all.

Bad things happen on the way up...

When an asset bubble is in full swing, large numbers of people have unrealistically optimistic expectations of their future wealth because their investments appear to be growing in value at a galloping pace. They will develop corresponding patterns of spending/saving/borrowing. If the upswing of bubble happens over a long period then the economy will have gradually migrated to serve this pattern. Sectors catering to people under the delusion that they have great future wealth will have grown and will now be employing too many people. Industries catering to people with realistic expectations about their future wealth will have shrunk and will now be employing too few people. The industry involved in the bubble itself will be the most distorted of all. So if, for example, the bubble was in housing then obviously there will now be far too many builders, real estate agents and mortgage brokers. Whatever asset the bubble is in, the financial services sector will have become bloated with the profits from these excessive loans.

... and even worse things that happen on the way down

People’s behaviour in the aftermath of an asset bubble is, not surprisingly, the opposite of what it was on the way up. The delusion about future wealth has now been corrected. People’s patterns of spending/saving/borrowing will inevitably change. The sector involved in the bubble will be hit hard. The correction of this situation clearly involves the opposite migration of workers to that which occurred on the way up. Workers need to move away from both the sector involved in the bubble and the sectors over-manned due to the unsustainable patterns of spending/saving/borrowing. They need to migrate toward the rest of the economy, especially those sectors which became undermanned as a consequence of the distorted signals.

Unfortunately, unless we live in a “planned” economy where government dictates what jobs we have, the only way that this migration can take place is to allow the excess workers in the unsustainable sectors to lose their jobs and then be absorbed by the rest of the more conventional economy. This is a painful process but there is no way to avoid it. Unfortunately short-sighted governments, egged on by bad economists, will not realise what needs to happen and they will attempt to “prop up” or subsidise those unsustainably large sectors of the economy, with invariably bad results. Propping up unsustainably large sectors must, by definition, harm the process of getting more workers into the undermanned sectors. So there is a danger of ending up in a situation in which a too-small group of people producing goods that we all need have to subsidise a too-large group of people whose job it is to produce goods or services that nobody wants any more. Governments will describe this “propping up” as “saving jobs”, whereas all that is happening is the prevention of the economy from correcting itself.

And the story does not end there. There are additional problems that emerge after the bursting of an asset bubble, which we will come to in the next chapter.

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