Putting the Hayekian horse back before the Keynesian cart, part II

The primacy of production

So, with all that in mind, we would be very much better off were we to start our macro analysis from the opposite end to the mainstream, making use of the following pair of what should be fairly unobjectionable assumptions, namely that:

a. for as long as they have an income, people will spend it (or that, saving it, they will temporarily transfer the spending power to someone else);

b. for as long as there are businesses who see the chance to make a return on invested capital, they will supply people not just with the goods they wish to buy, but also with the income which they require to pay for them.

From this follows the corollary that any episode of cyclical instability we may suffer — the overwhelming majority of which are engendered by the vagaries of the credit cycle, or by other forms of political disruption – will start with a diminution of business outlays as the widespread entrepreneurial error, fostered by mispriced financial capital and over easy money in the boom, begins to be revealed. In Hayek’s own words :

It is the decline in investment (or in the production of producers' goods) and not the impossibility of selling consumers' goods at remunerative prices, which characterizes the beginning of the slump. Indeed, it is the experience of all depressions… that the sales of consumption goods are maintained until long after the crisis; industries making consumption goods are the only ones which are prosperous and even able to absorb, and return profits on, new capital during the depression. The decrease in consumption comes only as a result of unemployment in the heavy industries, and, since it was the increased demand for the products of the industries making goods for consumption which made the production of investment goods unprofitable, by driving up the prices of the factors of production, it is only by such a decline that equilibrium can be restored.

Furthermore, we may presume that the first thing the individual business will restrict is its discretionary, below-the-line outlays on new equipment; that it will then be tempted to dip into its depreciation reserves to keep afloat; that next it will economise on re-orders of inventory and, finally, that it will begin to mothball plants and lay off workers. Incidentally, at any stage along this path, the struggling firm may try to bridge any gap in its cash flow by seeking to borrow money — on whatever terms it can — and thus tend to put upward pressure on short-term interest rates, unless the credit system is still so enthused with its own hocus-pocus that it is happy to extend yet more loans.

Hayek dealt with the first phenomenon in his paper Investment that raises the demand for capital (and thus gave a deductive, rather than an empty empirical explanation of the signalling ability of a negative yield curve), but even Hayek had not run across the ‘credit amnesia’ of almost indiscriminate lending to which the current institutional constellation of hedge funds, investment bank activity, and derivative innovation has given rise, helping to inhibit the appearance of such tensions and so to postpone the crisis.

An additional feature of the argument is that the pain will typically tend to be focused most intensely among higher-order (capital) goods manufacturers, since these are the most specialized, having the least flexible stock of physical capital (which therefore has fewer alternative outlets for its products), and because the orders given them by their customers are the most readily postponable of all outlays. It is only subsequently, as overtime is restricted, short-term work enforced, and the incidence of redundancies spreads that wage and salary incomes fall and so consumer industries begin to suffer, too.

Here we should add the caveat that the above schema describes the archetypal, business-led expansion which is centred on the undertaking of too many misconceived investments, of too long a duration of payback, and with what are intrinsically precarious economics since it is only the particular credit regime which enables them to take place even though they are in open conflict with voluntarily expressed consumer preferences for saving vis-à-vis current expenditure. If, however, a monetary stimulus of sufficient magnitude has been directed at some other sector, then the resulting hypertrophy will be more localised, though just as dependent on continuous hits to sustain its highs.

So, withdraw the dope and a severe spell of cold turkey will be the inescapable result, as in the US housing market — and its ancillary lifestyle industries — today; as also, for example, in the military-industrial complex in the early 1990s; and as will inevitably result if and when the Chinese authorities ever cease their quasi-Schachtian support of their favoured industries and force them instead to live in the cold, but ultimately invigorating climate of free market pricing and genuine capital accounting.

The search for a better yardstick

So much for the theory, but the question we must now address is that of whether we can put some numbers to all of this and, indeed, whether we can begin to fashion a better gauge of what is afoot than is afforded us by the likes of the GDP numbers which, as we have tried to persuade you, conceal as much as they reveal. As we will see below, the answer is a qualified “yes” (qualified because no aggregate measure can ever be more than suggestive of the intricate dynamics at work in the 21st century economy, anymore than we can make a detailed and accurate assessment of the health of a population simply through knowing its members average height, weight, and age).

The first place to start is to try to move beyond the GDP numbers and here we have the benefit of the Input-Output accounts, also compiled by the BEA (ironically, also by another central planning fanatic from Russia, this time Wassily Leontief). The beauty of these latter is that they attempt to set out a matrix of expenditure flows between broad economic sectors without the cross-cancelling which is practiced in the calculation of the former series.

If we perform a little indirect manipulation on the I-O data, we can derive an estimate of total business spending by making use of the Professor George Reisman’s insight (extended by Richard Johnsson) that the total resources available in a given period must equal total domestic production of both finished and intermediate goods, together with those which have been imported, these resources being used variously to add to stocks, as inputs to further processing, and for building new capital goods, furnishing exports, and serving as means for final consumption.

If we then deduct profits and depreciation from the total — for both corporate and non-corporate enterprises — we have an estimate of total above-the-line expenditures made in a given period, while adding back reported net additions to inventories and gross fixed investment furnishes us with one for below-the-line outlays in turn. Hence we have at last a handle on total business revenues or conversely — realising that one man’s income is another man’s outgo — for total business expenditures. A further cross-check can be made with aggregate figures available on the IRS website for above-the-line items. A close correspondence (r-squared = 0.996) is observed¹.

To provide a concrete example of this, estimates for 2005 (the latest year for which full figures are available) show that while nominal GDP was around $12.5 trillion — 70% of that, as per the cliché, being comprised of personal consumption expenditures — in comparison, Gross Domestic Output (GDO) was approximately $22.9 trillion, while imports amounted to close to $2 trillion, meaning that total resources were of the order of $24.9 trillion. Subtracting profits plus depreciation of $2.1 trillion to give us above-the-line costs, then adding back investment totalling $1.3 trillion, we arrive at a final figure of just over $24 trillion for total business expenditures — a number no less than 2 ¾ times that of the final consumption outlays on which so much attention is normally directed!

If we compare figures across the last thirty-five years, we find (as per the following table) that, as we would expect, not only are annual business outlays far greater in magnitude, but also that they are far more variable than those made by consumers.

In fact, using the quarterly ‘Financial Statements Statistics of Corporations by Industries’, compiled by the Ministry of Finance, we can perform a similar exercise (with much less work, to boot!) for Japan.

Here, too, we find that, for 2006, total corporate business expenditures came to Y1,475 trillion while the sum of personal consumption, residential real estate investment, and government outlays were only just above a three-tenths of the size at approximately Y420 trillion. Confirming the US observations, we also see that Japanese productive outlays are also much more inconstant than are their exhaustive counterparts.

In summary, it should no longer be a matter of controversy that, given both the theory that productive expenditures enjoy primacy over consumptive/exhaustive ones and this empirical corroboration that they do, indeed, fluctuate far more violently, if we are to be effective in our attempts to gauge the status of the economy, we should monitor the former, rather than the latter.

As a case in point, a glance at the late Tech-Telecom bust shows that, far from being a ‘mild’ recession (as the standard, GDP-based analysis suggests), in terms of business activity, 2001 witnessed the most severe collapse suffered in at least three decades, whether measured in terms of the absolute decline in either nominal or real expenditures; as the percentage deceleration (the second difference) from the preceding year’s result; or as the start of the only two-year consecutive period of contraction seen in the record.

The discrepancy between this and the GDP numbers are not too hard to find — they lie in the enormous sale of fiscal and monetary stimulus which was brought to bear to offset this, giving rein to the full doctrine of ‘driving a fire engine the wrong way own a one-way street’ (as Bob Woodward² termed the unconstitutional approach to any systemic crisis adopted under Alan Greenspan’s chairmanship) and of enacting the ‘lessons’ the Fed thought it had learned from its study of both the 1990s BOJ and the 1930s Fed .

Far from congratulating the authorities for their wise paternalism, however, it should be realized that — like all such attempts to forestall the consequences of economic folly — this display of Militant Keynesianism only served to disguise and displace the consequences of the previous boom, it did not nullify them in any permanent sense whatsoever. The most obvious sign that we have belatedly been presented with some of the bill for this stay of execution comes in the shape of the sizeable retrenchment taking place in a housing sector which was one of the main outlets for the contracyclical stimulus it required.

Here, accompanied by a hypocritical display of post officio caution on the part of the man directly responsible for the problem, a genuine and wholesale destruction of capital is being revealed both to homeowners and to those holding securities against the collateral of their property. As a rough sense of the scale of this, consider that the transaction-weighted decline in the average price of both new and existing homes has amounted to just over 6% since last summer, theoretically implying a $1.2 trillion notional pullback in aggregate housing stock values, to be added to the loss associated with the one-third fall in principal value endured by some of the lower ABX indices of mortgage-related bonds, as well as the recent decline in equity values this has helped trigger.

Even this does not give the full reckoning, for if Austrian School reasoning tells us anything, it is that the losses are actually incurred during the boom itself, as a result of the widespread distortion of entrepreneurial calculation and of the tsunami of rash and insupportable investments to which persistently overeasy credit inevitably gives rise.

1. A further cross-check can be made with aggregate figures available on the IRS website for above-the-line items. A close correspondence (r-squared = 0.996) is observed.

2. Maestro: Greenspan's Fed and the American Boom, Bob Woodward, 2001

Sean Corrigan

Sean Corrigan is Chief Investment Strategist at Diapason Commodities Management (Lausanne and London)

Copyright © 2006 - Copyright © Diapason Commodities Management - Sean Corrigan