The Six Horsemen of the Financial Apocalypse
Mises points out the boom ends precisely when the entrepreneurs begin to experience difficulties in obtaining the increasing amount of financing they need for their investment projects: they have begun and which they begin to see threatened, turn to banks and demand additional loans, offering a higher and higher interest rate for them. Thus they start a "fight to the death" to obtain additional financing.
1. The rise in the price of the original means of production.
The first temporary effect of credit expansion is an increase
in the relative price of the original means of production (labor and natural resources). This rise in price stems from two separate causes which reinforce each other. On the one hand, capitalists from the different stages in the production process show a greater monetary demand for original resources, and this growth in demand is made possible by the new loans the
banking system grants. On the other hand, with respect to
supply, we must keep in mind that when credit expansion
takes place without the backing of a prior increase in saving,
no original means of production are freed from the stages closest to consumption, as occurred in the process we studied earlier, which was initiated by a real upsurge in voluntary saving.
Therefore the rise in the demand for original means of production in the stages furthest from consumption and the
absence of an accompanying boost in supply inevitably result
in a gradual increase in the market price of the factors of production. Ultimately this increase tends to accelerate due to
competition among the entrepreneurs of the different stages in
the production process. The desire of these entrepreneurs to
attract original resources to their projects makes them willing
to pay higher and higher prices for these resources, prices they are able to offer because they have just received new liquidity from the banks in the form of loans the banks have created from nothing. This rise in the relative price of the original factors of production begins to push the cost of the newly launched investment projects above the amount originally
budgeted. Nevertheless this effect alone is still not sufficient to end the wave of optimism, and entrepreneurs, who continue to feel safe and supported by the banks, usually go ahead with their investment projects without a second thought.
books, the only other work in Spanish on the topic is our article, “La teoría austriaca del ciclo económico,” which was published over twenty years ago in Moneda y Crédito 152 (March 1980), and which includes a comprehensive bibliography on the subject; and the series of essays by F.A. Hayek published as ¿Inflación o Pleno Empleo? (Madrid: Unión Editorial, 1976). Last, in 1996 Carlos Rodríguez Braun’s translation of Hayek’s Prices and Production (Precios y producción) appeared,
published by Ediciones Aosta and Unión Editorial in Madrid.
2. The subsequent rise in the price of consumer goods.
Sooner or later the price of consumer goods begins to gradually climb, while the price of services offered by the original factors of production starts to mount at a slower pace (in other words, it begins to fall in relative terms). The combination of the following three factors accounts for this phenomenon: (a) First, growth in the monetary income of the owners of the original factors of production. Indeed if, as we are supposing, economic agents’ rate of time preference remains stable, and therefore they continue to save the same proportion of their income, the monetary demand for consumer goods increases as a result of the increase in monetary income received by the owners of the original factors of production. Nonetheless this effect would only explain a similar rise in the price of consumer goods if it were not for the fact that
it combines with effects (b) and (c).
(b) Second, a slowdown in the production of new consumer
goods and services in the short- and mediumterm, a consequence of the lengthening of production processes and the greater demand for original means of production in the stages furthest from final consumption. This decline in the speed at which new
consumer goods arrive at the final stage in the production
process derives from the fact that original factors of production are withdrawn from the stages closest to consumption, causing a relative shortage of these factors in those stages. This shortage affects the immediate production and delivery of final consumer
74 In section 11 of chapter 6 we will see that our analysis does not change substantially even when a large volume of unused factors of production exists prior to credit expansion.
goods and services. Furthermore as the capital theory outlined at the beginning of the chapter explains, the generalized lengthening of production processes and the incorporation into them of a greater number of stages further from consumption invariably leads to a hort-term decrease in the rate at which new consumer goods are produced. This slowdown lasts the length of time necessary for newly initiated investment processes to reach completion. It is clear that the longer production processes are, i.e., the more stages they contain, the more productive they tend to be.
However it is also clear that until new investment processes conclude, they will not allow a larger quantity of consumer goods to reach the final stage. Hence the growth in income experienced by the owners of the original factors of production, and thus the increase in monetary demand for consumer goods, combined with the short-term slowdown in the
arrival of new consumer goods to the market, accounts for the fact that the price of consumer goods and services eventually climbs more than proportionally; that is, faster than the increase in monetary income experienced by the owners of the original means of production.
(c)Third, the rise in monetary demand for consumer
goods which is triggered by artificial entrepreneurial
profits that result from the credit expansion process.
Banks’ creation of loans ultimately entails an increase in the money supply and a rise in the price of the factors of production and of consumer goods. These increases eventually distort entrepreneurs’ estimates of their profits and losses. In fact entrepreneurs tend to calculate their costs in terms of the historical cost and purchasing power of m.u. prior to the inflationary process. However they compute their earnings based on income comprised of m.u. with less purchasing power. All of this leads to considerable and purely fictitious profits, the appearance of which creates an illusion of entrepreneurial prosperity and explains why businessmen begin to spend profits that have not actually been produced, which further increases the pressure of the monetary demand for final consumer goods.
75 It is important to underline the effect of the more-thanproportional rise in the price of consumer goods with respect to the rise in the price of original factors of production. Theoretically this is the phenomenon which has most escaped the notice of many scholars. As they have not fully comprehended capital theory, the analyses of these theorists have not accounted for the fact that when more productive resources are devoted to processes further from consumption, processes which begin to yield results only after a prolonged period of time, there is a reduction in the speed at which new consumer goods arrive at the last stage in the production process. Moreover this is one of the most significant distinguishing features of the case we are now considering (in which the lengthening of production processes is financed with loans the banks create ex nihilo) with respect to the process initiated by an upsurge in voluntary saving (which by definition produced an increase in the stock of consumer goods that remained
75 The additional demand on the part of the expanding entrepreneurs tends to raise the prices of producers’ goods and
wage rates. With the rise in wage rates, the prices of consumers’ goods rise too. Besides, the entrepreneurs are contributing a share to the rise in the prices of consumers’ goods as they too, deluded by the illusory gains which their business accounts show, are ready to consume more. The general
upswing in prices spreads optimism. If only the prices of producers’ goods had risen and those of consumers’ goods had
not been affected, the entrepreneurs would have become
embarrassed. They would have had doubts concerning the
soundness of their plans, as the rise in costs of production
would have upset their calculations. But they are reassured
by the fact that the demand for consumers’ goods is intensified
and makes it possible to expand sales in spite of rising
prices. Thus they are confident that production will pay,
notwithstanding the higher costs it involves. They are
resolved to go on. (Mises, Human Action, p. 553)
Furthermore, assuming the existence of a (constant) supply curve of savings, the decrease in interest rates will reduce savings and increase consumption. See Garrison, Time and Money, p. 70. unsold and which sustained the owners of the original factors of production while new processes of production could be completed). When there is no prior growth in saving, and
therefore consumer goods and services are not freed to support
society during the lengthening of the productive stages
and the transfer of original factors from the stages closest to
consumption to those furthest from it, the relative price of
consumer goods inevitably tends to rise.76
3. The substantial relative increase in the accounting profits of the companies from the stages closest to final consumption.
The price of consumer goods escalates faster than the price
of original factors of production, and this results in relative
growth in the accounting profits of the companies from the
stages closest to consumption with respect to the accounting
profits of companies who operate in the stages furthest from
consumption. Indeed the relative price of the goods and services sold in the stages closest to consumption increases very rapidly, while costs, though they also rise, do not rise as fast.
Consequently accounting profits, or the differential between
income and costs, mount in the final stages. In contrast, in the stages furthest from consumption the price of the intermediate goods produced at each stage does not show a major
change, while the cost of the original factors of production
employed at each stage climbs continuously, due to the greater monetary demand for these factors, which in turn originates directly from credit expansion. Hence companies operating in the stages furthest from consumption tend to
76 Hayek expresses the concept in this concise manner:
[F]or a time, consumption may even go on at an unchanged rate after the more roundabout processes have actually started, because the goods which have already advanced to the lower stages of production, being of a highly specific character, will continue to come forward for some little time. But this cannot go on. When the reduced output from the stages of production, from which producers’ goods have been withdrawn
for use in higher stages, has matured into consumers’ goods, a scarcity of consumers’ goods will make itself felt, and the prices of those goods will rise. (Hayek, Prices and Production, p. 88)
bring in less profit, an accounting result of a rise in costs more rapid than the corresponding increase in income. These two
factors produce the following combined effect: it gradually
becomes evident throughout the productive structure that the
accounting profits generated in the stages closest to consumption are higher in relative terms than the accounting profits earned in the stages furthest from it. This prompts entrepreneurs to rethink their investments and even to doubt their soundness. It compels them to again consider the need to reverse their initial investment of resources by withdrawing them from more capital- intensive projects which have barely gotten off the ground and returning them to the stages closest to consumption.77
4. The Ricardo Effect.
In addition, the more-than-proportional rise in the price of
consumer goods with respect to the increase in original-factor
income begins to drive down (in relative terms) the real
income of these factors, particularly wages. This real reduction
77 Sooner or later, then, the increase in the demand for consumers’ goods will lead to an increase of their prices and of the profits made on the production of consumers’ goods. But
once prices begin to rise, the additional demand for funds
will no longer be confined to the purposes of new additional
investment intended to satisfy the new demand. At first—and
this is a point of importance which is often overlooked—only
the prices of consumers’ goods, and of such other goods as
can rapidly be turned into consumers’ goods, will rise, and
consequently profits also will increase only in the late stages
of production. . . . [T]he prices of consumers’ goods would
always keep a step ahead of the prices of factors. That is, so
long as any part of the additional income thus created is spent on consumers’ goods (i.e., unless all of it is saved), the prices of consumers’ goods must rise permanently in relation to those of the various kinds of input. And this, as will by now be evident, cannot be lastingly without effect on the relative prices of the various kinds of input and on the methods of production that will appear profitable. (Hayek, The Pure Theory of Capital, pp. 377–78; italics added) In an environment of increasing productivity (such as the one experienced during the period from 1995 to 2000), the (unit) prices of consumer goods will not rise significantly, yet the (monetary) amount companies closest to consumption bring in in sales and total profits will soar.
5. The increase in the loan rate of interest. Rates even exceed precredit- expansion levels.
The last temporary effect consists of an escalation in interest
rates in the credit market. This rise occurs sooner or later,
when the pace of credit expansion unbacked by real saving
stops accelerating. When this happens the interest rate will tend to return to the relatively higher levels which prevailed prior to the beginning of credit expansion. In fact if, for instance, the interest rate is around 10 percent before credit expansion begins and the new loans the banking system creates ex nihilo are placed in the productive sectors via a reduction in the interest rate (for example, to 4 percent) and an easing of the rest of the “peripheral” requirements for the granting of loans (contractual guarantees, etc.), it is clear than when credit expansion comes to a halt, if, as we are supposing, no increase in voluntary saving takes place, interest rates will climb to their previous level (in our example, they will rise from 4 to 10 percent). They will even exceed their pre-credit-expansion level (i.e., they will rise above
the originary rate of 10 percent) as a result of the combined
effect of the following two phenomena: (a) Other things being equal, credit expansion and the increase in the money supply which it involves will tend to drive up the price of consumer goods, i.e., to reduce the purchasing power of the monetary unit. Consequently if lenders wish to charge the same
[W]ith further progress of the expansionist movement the rise
in the prices of consumers’ goods will outstrip the rise in the
prices of producers’ goods. The rise in wages and salaries and
the additional gains of the capitalists, entrepreneurs, and
farmers, although a great part of them is merely apparent,
intensify the demand for consumers’ goods. . . . At any rate, it is certain that the intensified demand for consumers’ goods
affects the market at a time when the additional investments
are not yet in a position to turn out their products. The gulf
between the prices of present goods and those of future goods
widens again. A tendency toward a rise in the rate of originary
interest is substituted for the tendency toward the opposite
which may have come into operation at the earlier stages
of the expansion. (Mises, Human Action, p. 558)
interest rates in real terms, they will have to add (to
the interest rate which prevails prior to the beginning
of the credit expansion process) a component for “inflation,” or in other words, for the expected drop in the purchasing power of the monetary unit.
81 (b) There is another powerful reason interest rates climb
to and even exceed their prior level: entrepreneurs who have embarked upon the lengthening of production processes despite the rise in interest rates will, to the extent that they have already committed substantial resources to new investment projects, be willing to pay very high interest rates, provided they are supplied with the funds necessary to complete the projects they have mistakenly launched. This is an important aspect which went completely unnoticed until Hayek studied it in
81 As Ludwig von Mises wrote in 1928: The banks can no longer make additional loans at the same interest rates. As a result, they must raise the loan rate once more for two reasons. In the first place, the appearance of the positive price premium forces them to pay higher interest for outside funds which they borrow. Then also they must discriminate among the many applicants for credit. Not all enterprises can afford this increased interest rate. Those which cannot run into difficulties. (See On the Manipulation of Money and Credit, p. 127) This is Bettina Bien Greaves’s translation into English of the book published in 1928 by Ludwig von Mises with the title, Geldwertstabilisierung und Konjunkturpolitik. The above passage is found on pp. 51–52 of this German edition, which contains a detailed explanation of all of Mises’s theory on business cycles. It was published before Prices and Production and the German edition of Monetary Theory and the Trade Cycle by Hayek (1929). It is odd that Hayek almost never cites this important work, in which Mises formulates and develops the theory of the cycle, which he
only had the opportunity to outline in his book, The Theory of Money and Credit, published sixteen years earlier. Perhaps this oversight was deliberate and arose from a desire to convey to the scientific community the impression that the first attempt to develop Mises’s theory was made by Hayek in his writings on Monetary Theory and the Trade Cycle and Prices and Production, when Mises had already covered the topic very thoroughly
in 1928.
detail in 1937.82 Hayek demonstrated that the process
of investment in capital goods generates an autonomous demand for subsequent capital goods, precisely ones which are complementary to those already produced. Furthermore this phenomenon will last as long as the belief that the production processes can be completed. Thus entrepreneurs will rush to
demand new loans regardless of their cost, before being forced to admit their failure and altogether abandon investment projects in which they have allocated very important resources and with respect to which they have jeopardized their prestige. As a result, the growth in the interest rate which takes place in the credit market at the end of the boom is not only due to
monetary phenomena, as Hayek had previously thought, but also to real factors that affect the demand for new loans.83 In short, entrepreneurs, determined to complete the new more capital-intensive stages
Bank Credit Expansion and Its
Effects on the Economic System 373
82 See F.A. Hayek, “Investment that Raises the Demand for Capital,” published in Review of Economics and Statistics 19, no. 4 (November 1937) and reprinted in Profits, Interest and Investment, pp. 73–82. 83Hayek himself, in reference to the rise in interest rates in the final stage of the boom, indicates that: [T]he most important cause practically of such false expectations probably is a temporary increase in the supply of such funds through credit expansion at a rate which cannot be maintained. In this case, the increased quantity of current investment will induce people to expect investment to continue at a similar rate for some time, and in consequence to
invest now in a form which requires for its successful ompletion further investment at a similar rate. . . . And the
greater the amount of investment which has already been
made compared with that which is still required to utilise the
equipment already in existence, the greater will be the rate of
interest which can advantageously be borne in raising capital
for these investments completing the chain. (Hayek, “Investment
that Raises the Demand for Capital,” pp. 76 and 80)
Mises points out the boom ends precisely when the entrepreneurs begin to experience difficulties in obtaining the increasing amount of financing they need for their investment projects: they have begun and which they begin to see threatened, turn to banks and demand additional loans, offering a higher and higher interest rate for them. Thus they start a "fight to the death" to obtain additional financing.
6. The appearance of accounting losses in companies operating in the stages relatively more distant from consumption: the inevitable advent of the crisis.
The above five factors provoke the following combined
effect: sooner or later companies which operate in the stages
relatively more distant from consumption begin to incur heavy accounting losses. These accounting losses, when compared
with the relative profits generated in the stages closest
to consumption, finally reveal beyond all doubt the serious
entrepreneurial errors committed and the urgent need to correct
them by paralyzing and then liquidating the investment projects mistakenly launched, withdrawing productive resources from the stages furthest from consumption and transferring them back to those closest to it.
In a nutshell, entrepreneurs begin to realize a massive
readjustment in the productive structure is necessary. Through
this “restructuring” in which they withdraw from the projects
they began in the stages of capital goods industries and which
they were unable to successfully complete, they transfer what
is left of their resources to the industries closest to consumption.
It has now become obvious that certain investment projects
are unprofitable, and entrepreneurs must liquidate these
and make a massive transfer of the corresponding productive
resources, particularly labor, to the stages closest to consumption.
Crisis and economic recession have hit, essentially due to a lack of real saved resources with which to complete investment projects which, as has become apparent, were too ambitious. The crisis is brought to a head by excessive investment (overinvestment) in the stages furthest from consumption, i.e., in capital goods industries (computer software and hardware, high-tech communications devices, blast furnaces, shipyards, construction, etc.), and in all other stages with a widened capital goods structure. It also erupts due to a parallel relative shortage in investment in the industries closest to consumption. The combined effect of the two errors is generalized malinvestment of productive resources; that is, investment of a style, quality, quantity, and geographic and entrepreneurial distribution typical of a situation in which much more voluntary saving has taken place. In short, entrepreneurs have invested an
85
In the words of F.A. Hayek himself:
The crux of the whole capital problem is that while it is
almost always possible to postpone the use of things now
ready or almost ready for consumption, it is in many cases
impossible to anticipate returns which were intended to
become available at a later date. The consequence is that,
while a relative deficiency in the demand for consumers’
goods compared with supply will cause only comparatively
minor losses, a relative excess of this demand is apt to have
much more serious effects. It will make it altogether impossible to use some resources which are destined to give a consumable return only in the more distant future but will do so only in collaboration with other resources which are now
more profitably used to provide consumables for the more
immediate future. (Hayek, The Pure Theory of Capital, pp.
345–46)
inappropriate amount in an inadequate manner in the wrong places in the productive structure because they were under the impression, deceived as they were by bank credit expansion,
that social saving would be much greater. Economic agents
have devoted themselves to lengthening the most capital intensive stages in the hope that once the new investment processes have, with time, reached completion, the final flow of consumer goods and services will increase significantly. However the process by which the productive structure is lengthened requires a very prolonged period of time. Until this time has passed, society cannot profit from the corresponding rise in the production of consumer goods and services. Yet economic agents are not willing to wait until the end of that more prolonged period of time. Instead they express their preferences through their actions and demand the consumer
goods and services now, i.e., much sooner than would be possible were the lengthening of the productive structure to
be completed. |
