hb -
Gene Callahan ... has just finished a book, Economics for Real People, to be published this year by the Ludwig von Mises Institute.
economicsforrealpeople.com
economicsforrealpeople.com
Chapter Thirteen: Times Are Hard
On the causes of the business cycle.
"...We must also look at the issue of which entrepreneurs will first take advantage of easier credit, and in what position this will place the remaining entrepreneurs.
Let us, for simplicity, divide entrepreneurs into classes A and B. (This sharp division is not crucial to this analysis, as you'll see—it is merely a device to simplify our picture.) Class A entrepreneurs are those who are currently profitable, i.e., those most able to interpret the current market conditions and predict their future. Class B are struggling, money-losing, or, indeed, unfunded "want-to-be" entrepreneurs, less capable at anticipating the future conditions of the market.
Now, let us go to the start of the boom. It is 1996, and the Fed begins to expand credit. To where does this new supply flow? The As are not necessarily in need of much credit. If they wish to expand, they have available their cash flow. In the state of the market prior to the expansion, they were the ones most able to secure loans. They quite possibly have been through several booms, and, adept at interpreting the state of the market, suspect that they are witnessing the start of another one. They are cautious about expansion under such conditions.
The situation for the Bs is quite different, however. Their businesses are marginal, or perhaps non-existent. They have previously been turned down for funding. And, the Bs are those very entrepreneurs least able to discern that a credit expansion is underway.
Moreover, even if they could tell that this is an artificial boom, it might make sense for them to "take a flier" anyway. As it is, they are either not capitalized, or on the verge of failing. If they ride the boom, they will have a couple of years of the high life. And who knows, their business just might make it through! Or, perhaps, they will build a sufficient customer base to be purchased, maybe even enough to retire on. They use the easy credit to expand or start their business. We should notice that the 'A's are much less susceptible to this motivation—they expect to be "living the high life" anyway, since their businesses are already doing well.
As the 'B's create and expand businesses, the boom begins to take shape. However, we can see that the actual situation of the 'A's has changed:
Of course, in order to continue production on the enlarged scale brought about by the expansion of credit, all entrepreneurs, those who did expand their activities no less than those who produce only within the limits in which they produced previously, need additional funds as the costs of production are now higher. (Mises, Human Action)
Although the most skilled entrepreneurs suspect that the expansion is artificial, most cannot afford to shut down their business for the duration of the boom. But if they can't, they must increasingly compete with Bs for access to the factors of production. Take, for instance, the A company Sensible Software, Inc., and the B company, Dotty Dotcom.
Dotty Dotcom, flush with venture capital and an "insanely great business plan," is luring top Java engineers with salaries matching Sensible's while throwing in stock options that could be worth millions after the IPO. (This is an investment in higher-order capital goods, as top engineers are needed chiefly for more complex projects, which typically can take several years to complete.) Sensible simply cannot afford to lose all of its best programmers to Dotty. It must bid competitively for them.
However, in order to do so, Sensible must take advantage of the same easy credit that Dotty is using to back its bids. At the market rate of interest existing at the start of the boom, Sensible was already bidding as much as it deemed marginally profitable for producer goods. So the A entrepreneurs, willy-nilly, are forced to participate in the boom as well. Their hope is that, in the downturn, the basic soundness of their business and the fact that they have expanded less enthusiastically than the Bs will see them through, perhaps with only a few layoffs.
Or, take the case of a class A mutual fund manager who suspects that stock prices are artificially high. If he simply puts his funds in cash and attempts to sit on the sidelines, he's sunk. All of his customers will leave, and he'll never survive to see the bust that proves he was right. He will continue to invest in stocks, perhaps keep a bit more money in cash than usual, and watch carefully for signs of the turn.
Our analysis of the banks proceeds in the same fashion. It is precisely the marginal lenders are those with the least ability to evaluate credit risks, that have the least to lose and the most to gain from an enthusiastic participation in the boom. They will expand credit first. The more sound lenders are eventually sucked in, in order to compete. This problem is compounded by the tendency of the International Monetary Fund, central banks, and other government bodies to jump in and bail out large investors when they get in trouble. (This is the moral hazard problem we mentioned in Chapter Nine.) We've already mentioned the Mexican loan bailout and the bailout put together after the collapse of Long Term Capital Management as two prominent examples. If you are promised all of the upside of making a risky loan, should the project being funded succeed, but are protected on the downside by the likelihood of a bailout, you are much more likely to make the loan!
This A/B division of entrepreneurs adds to the explanation of the radical difference between an artificial boom and a savings-led expansion. In the latter, the A entrepreneurs are able to sense that the consumers really do desire a lengthening of the production process and an increased investment in capital goods. Therefore, they are eager to take advantage of the increased savings. There is no reason to turn to the B entrepreneurs to find takers for the new funds.
Of course, entrepreneurial ability exists on a gradient, and there is no sharp A/B division among entrepreneurs. This was introduced only to simplify the discussion above, but the fundamentals remain unchanged under the more realistic assumption...."
Regards, Don |
