Is the American boom beginning to crack?

By Gerard Jackson
web posted February 1999

Waiting for America's recession has been a bit like Waiting for Godot. Unfortunately every credit fuelled boom ends in recession, and I fear America's recession is a lot closer than many probably realise. Though no one can really predict the actual timing of a recession one can look out for certain danger signals. It looks very much as if those signals are beginning to flash for the US, even though consumer spending seems to be telling a very different story. Therefore, let us begin with the vital role that consumer spending is alleged to have played in fuelling and prolonging the boom. Consumer spending as an engine of economic growth is the great economy fallacy of the age. To expose this fallacy is to paint a different and somewhat grim picture of the American economy.

It ought to be patently obvious that one cannot consume what has not been produced. In other words, consumption follows production and is its raison dêtre. In turn, it is the existence of capital goods, i.e., machinery, factories, power stations, etc, that makes the production of consumer goods possible. The more capital goods we accumulate the greater the quantity, quality and range of consumer goods and services that can be produced at lower real prices. Now it is axiomatic in economics that opportunity cost is the true cost of anything; meaning that what we sacrifice to obtain any object or goal is its true cost. If I choose world trip to a car than the real cost of the trip is the car and its forgone services. It follows that whatever is consumed cannot be invested. Hence economic growth is forgone consumption, which is commonly called savings.

For the first time since the depths of the Great Depression America's personal savings are negative while real consumption has steadily increased. This means two things: (a) nothing is being put away for capital accumulation and (b) personal debt levels must be rising. Regarding the disastrous collapse in savings, some have argued that the so-called 'wealth effect' has encouraged people to spend and that this spending will keep recession at bay. Whether people cease saving because they feel wealthier is neither here nor there. What matters in this respect is the source of the spending. There can be no doubt that the Fed's easy money policy has considerably expanded credit. It is this credit expansion that has fuelled the boom and thus consumer spending by raising nominal incomes and funding the disturbing rise in household debt. Therefore, when the party comes to an end consumer spending will drop.

But why must the party stop? Because nothing is for nothing. The Fed's credit expansion has set loose economic forces that it does not even acknowledge, let alone control. By using credit to stimulate output it has misdirected production by distorting interest rates. A lot of companies embarked on projects that market condition cannot justify because easy credit misled them into thinking that demand justified the investment. Unfortunately for them, though the credit was there the savings were not. Why? When people save they indirectly shifts resources from the production of consumption goods to capital goods and it is this process that increases future output. On the other hand, reducing savings means directing more resources to current consumption, which lowers investment and future living standards. The logic of this reasoning leads us to conclude that what America needed was an increase in savings and not consumption. Instead, the country literally ceased saving. And this will certainly aggravate the recession, despite the fallacious claims of Keynesians.

Now these companies used the credit to hire labor and buy goods and services. These expenditures translated into incomes which were spent on consumption. But as we have seen, the effect of raising the demand for consumer goods is to direct resources away from investment. These firms now find their cost rising as they compete for resources against rising demand for consumer goods. The effect has been falling profits, output and rising layoffs. (Even if the savings ratio had not collapsed this phenomenon would still have arisen but it would have been less intense.) This explains why employment has started to fall in manufacturing while still expanding in consumer or consumer related industries. This sectional employment fall, I believe, is one of the danger signals.

This Austrian explanation has been given additional weight by the so-called 'mystery' of the country's capital utilisation. According to the current orthodoxy when the NAICU (non-accelerating inflation rate of capacity utilisation) exceeds 82 per cent inflation begins to rise. (NAICU is obviously a version of the discredited Phillips curve). Observers are bothered because utilised capacity is only at 80 per cent even though unemployment has fallen to 4.3 per cent and expansion has continued unabated. One explanation is that a global downturn has subdued American capacity despite rising employment. But this cannot explain the general 'softness' that is now beginning to afflict a number of American manufacturing industries. It now becomes apparent that this situation is explained by the consequences of misdirected production finally making themselves visible. The emerging profits squeeze, rising layoffs and the capital utilisation 'conundrum' suggest that 1999 will be the economy's crunch year.

Another danger signal, and one greatly commented on, is the stock market boom. Excess credit is much like excess water, it must find an outlet. Every credit boom I know of eventually triggered a stock market boom that inevitably resulted in a speculative frenzy, sometimes causing stock prices to reach stratospheric levels, much like Wall Street today. Shares are titles to capital goods. It follows, according to economic theory, that the discounted anticipated earnings of those shares determine the value of the companies that issued them. Now does anyone really believe that the massive gains in stock prices are justified by future earnings? Or that price earning ratios of 32 are justified? Take, for example, Amazon whose shares traded at $US9 in May 1997; they reached $US320 this month, a 3,455.6 per cent rise, even though the company has never made a profit. This makes the South Sea Bubble look positively tame in comparison.

Now all economic activity is speculative. It cannot be otherwise in an uncertain world. But there is speculation and speculation. The latter is what we are witnessing on Wall Street. It has been fuelled by the Fed's easy credit policies and is now being driven by a "quick-buck" mentality that knows it is playing musical chairs, with very few chairs but a lot of players. This explains trading volumes. Large daily share turnovers in certain companies strongly suggest that speculators are aiming at short-term profits before the boom busts. (The whole thing reminds me of "Tulip Mania."*). That the Fed realises monetary expansion is responsible for this situation was admitted by Greenspan when he pointed to the effects of the "flood of liquidity" into the US economy.

When the necessary economic adjustments are finally made people will once again blame a stock market crash for the recession. And once again they will be wrong. In July 1929, about five months before the October crash, the American economy had already shown distinct signs of an emerging depression: manufacturing was slowing down, output was falling, layoffs rising and capital utilisation was declining. Sound familiar? Yet, despite the lessons of history and the groundbreaking work of the Austrian school of economics, commentators will still blame any recession on a stock market crash, especially if they are Clinton supporters.

* See Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay, first published in 1841. This book is still in print.

Originally published in The New Australian.

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