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July 16, 2007

Like the Clinton Boom the Bush Boom Will Also Crash
by Gerard Jackson

Judging by my emails there are a lot of worried and confused people out there. Basically most readers want to know why I'm "so sure that another recession is inevitable" and "Why can't the good times keep on rolling". I need to make it clear that in predicting another US recession I am not laying out a time table. In a sense, I have predicted a recession in the way most people predict rain, i.e., according to their experience of how the sky looks before it rains. They cannot give you the exact time, and in fact it might not even rain. Economics is similar in the sense that it is a qualitative and not a quantitative science, meaning that it concerns itself with trends rather than econometric forecasting techniques that generate 'precise figures' that have no real roots in the economy.

(Hayek referred to the qualitative approach as one that rests on "pattern predictions". Hayek's view is not confined to the Austrians. John Elliott Cairnes [1825-1862] explained why the mathematical approach to economics is doomed to fail, The Character and Logical Method of Political Economy, Harper & Brothers, Publishers, 1875 pp. 87-120).

Austrians are always confident that there will be no "New Era" or "plateau" because orthodox economics refuses to accept Austrian breakthroughs on monetary theory, capital and interest. The Austrians have explained that money is not neutral and that using credit expansion to force interest rates below their market level causes the economy to boom while creating malinvestments. These are investments that are not justified by genuine market conditions.

So if economics is qualitative what should we be on the look out for? Well, once certain symptoms appear, then we know that a bust is beginning to emerge. One of the symptoms is not necessarily a stratospheric stock market -- that is a boom symptom -- but other symptoms that tend to be neglected because orthodox economics cannot account for them. Now the real cause of confusion over the current economic situation is largely the fault of Keynesian economics plus a lack of knowledge of economic history. Ignoring the past -- and that includes the history of economic thought -- has, for example, misled two generations of economists into believing that tight labour markets cause inflation and falling productivity.

Not so. During the 1920s America had very tight labour markets along with 'stable prices' and high productivity. (It's generally overlooked that most of productivity gains occurred in the first part of the decade). Nevertheless, the country still collapsed into a severe depression. When it comes to the "Roaring Twenties" mainstream economists reject the idea that the period was one of inflation. But if we accept the Austrian view of defining inflation as a monetary expansion then the 1920s was a highly inflationary period, one in which Reserve bank policies inflated credit by artificially lowering interest rates. The price level remained stable because rising productivity prevented it from rising. Therefore the great majority of economists pooh-poohed the idea that America was experiencing an inflationary boom.

The usual effect of 'cheap money' policies is to cause a stock market boom. When that boom goes off the boil then that's the time to worry. However, some argue that these rises in stock prices are only reflecting expectations of a rise in profits. This is clearly not always the case. It is also true that a rapid increase in share prices does not portend an imminent crash. Peter Bernstein reminds us that when the Dow Jones Industrials returned to their 1929 level in 1955 many sold, believing that a crash was imminent. They were wrong. (Against the Gods: The Remarkable Story of Risk, John Wiley & Sons, Inc., 1996 p. 174).

These investors seriously erred in their judgement of the stock market trend. This is called drawing the wrong lesson from history. Historical facts have to be interpreted, not parroted or treated as a crystal ball. What these investors overlooked is that the American economy of 1955 was much more capital intensive and productive than in 1929 and that is why the share prices were justified. In other words, income streams justified the share valuations.

During the latter part of the Clinton years it was noted that the rise in the share market was largely based on a narrow range of stocks the rise of which caused the index to conceal the generally poor state of affairs for most other stocks. Unlike the mid-'50s American manufacturing in general was not enjoying a boom. Now I say in general because Austrian thinking would lead one to predict that one of the symptoms of a classic boom-bust situation is a contraction of manufacturing in the higher stages of production, even as manufacturing close to the point of consumption seems to be doing well.

Some feel that the Clinton boom could have been saved if only consumption had expanded. This is the old fallacy that has it that consumption drives the economy. It's business spending that drives the economy, not consumers. What happened in Clinton's term is exactly what any Austrian would predict. The additional money eventually found its way to consumers. This in turned raised the demand for consumer goods at the expense of the higher stages of production. Mainstream economists then found themselves baffled by the phenomenon of booming consumption while manufacturing contracted.. (Frederich von Hayek, Profits, Interest and Investment, Augustus M. Kelley, Publishers, 1975 pp. 8-15 and Fritz Machlup, The Stock Market, Credit and Capital Formation, William Hodge and Company, LIMITED, 1940, pp. 177-178).

In early 1999 the National Association of Purchasing Managers' Survey stated that manufacturers purchasing plans were at the highest level since November 1997. Yet it should have been clear that this statement did not square with the evidence of companies like Caterpillar who were laying off workers, plus anecdotal evidence that many manufacturers higher up the production structure were being squeezed. Moreover, the survey did not square with earnings and share prices. The broadly based Value Line Composite Index, consisting of 1,500 companies and thus more influenced by smaller stocks, fell by 7 per cent from April 1999 to the following March.

What matters is not surveys but real forces. With respect to the Bush boom, I cannot say at this stage when the boom will collapse. I can say with certainty that such collapse can be forestalled by significant injections of credit into the economy. But eventually a point would be reached where the Fed would have no choice but to use the monetary brakes to wring inflation out of the economy.

Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes economics editor.

Copyright © 2005-2008 Gerard Jackson

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