===== PAGE 1 =====

The Recession of 1990:
An Austrian Explanation

Arthur Middleton Hughes

In the misdirection of labor and the distortion of the structure of production
during past business cycles, it was fairly easy to point to the places where the
excessive expansion had occurred because it was, on the whole, confined to the
capital goods industries . . .

In contrast, the present expansion of money, which has been brought about partly
by means of bank credit expansion and partly through budget deficits, has been the
result of a deliberate policy, and has gone through somewhat different channels . . .

I do not doubt that in a sense we have today the same kind of phenomenon, but
the over-expansion, the undue increase of labor employed in particular occupa-
tions, is not confined to a single, clearly defined block such as the capital-goods
industries. It is now spread much more widely, and the distribution is much more
difficult to describe. It is a field I would wish some statistically minded economist
would investigate in order to show how the process operated in particular

countries.

Friedrich A. Hayek

hy do we have booms and recessions? The conventional Keynes-
ian view is that recessions are a failure of consumer demand.
Keynesians, however, are not entirely clear on why consumers
periodically act in unison to reduce their consumption. A more
logical answer to the question is the Mises—Hay~k theory of the business cycle.
The ideas of Ludwig von Mises and Friedrich A. Hayek, central to the Austrian
school of economics, suggest an entirely different approach to the business cycle
from what has become the conventional wisdom for the last 40 years. It is the

Arthur Middleton Hughes is an adjunct professor of economics at the University of Maryland.
"Friedrich A. Hayek, New Studies in Philosophy, Politics, Economics and the History of Ideas (Chicago:
University of Chicago Press 1978), p. 212-13.

Review of Austrian Economics 10, no. 1 (1997): 107-123
ISSN:0889-3047

107


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108 Review of Austrian Economics 10, No.1 (1997)

purpose of this paper to explore the Austrian explanation of the business cycle,
sometimes called the Austrian business cycle theory (ABCT), and to apply that
theory to the recession of 1990-1992.

The Structure of Production

The Austrian view of the economy differs substantially from that of Keynesians
or monetarists in their treatment of capital. Keynesians tend to lump the capital
accumulated by various industries throughout the country into an amorphous and
given “stock of capital.” Investment by business is treated in GNP analysis as a
single variable, regardless of the type of business in which the investment takes
place. Both Keynesians and Monetarists tend to deal with aggregates in explaining
business cycle theory whereas, as pointed out by James Clark and James Keeler,
“macroeconomic aggregates are not considered meaningful concepts by the
Austrians who are more concerned with relative changes among the components
of the aggregates.” In fact, the whole concept of the Gross National Product, as
defined in conventional economics today, leaves out of the analysis more than 40
percent of the industrial activity going on every year—the activities in the higher
stages of production.’

Austrian economists see the industry of any developed economy as a pro-
gression of activities from the most basic extraction of materials from the earth
(by means of mining, forestry, fishing, or farming), through the production of
semi-finished goods (such as lumber, steel, chemicals, and machinery), down to
the production and sale of final goods and services to consumers.

?John Maynard Keynes, The General Theory of Employment, Interest, and Money (New York:

Harcourt Brace, 1936), p. 245. “This does not mean that we assume these factors [including

© capital] to be constant; but merely that, in this place and context, we are not considering or taking
into Secount the effects and consequences of changes in them.”

3James Clark and James Keeler, “Misconceptions about Austrian Business Cycle Theory: A
Comment,” Review of Austrian Economics 4 (1990): 208-11.

In 1986, according to the Department of Commerce study “The Interindustry Structure of
the United States,” 43.8 percent of the output of all business units was of “intermediate goods”
(or capital goods requiring further work before they are ready for the ultimate consumer). The
remaining 56.2 percent were final goods, for purchase by individuals, governments, and other
businesses. This 43.8 percent representing intermediate goods does not show up in the Gross
National Product accounts at all, which treats capital as consisting only of the final goods purchased
by businesses.

Millions of Dollars Percent
Gross Intermediate Products $3,297,977 43.8
Gross National Product $4,235,116 56.2
Gross National Output $7,533,093 100.0

SFriedrich A. Hayek, The Pure Theory of Capital (Chicago: University of Chicago Press, [1941]
1975), chaps. 5 and 6.


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Hughes: The Recession of 1990 109

3 | Iron Ore Mining

Steel Production |
Sheet Steel Rolling Mill |
Automobile Body Stamping |

Automobile Assembly Plant |

Automobile Dealer |

Value of Output >

Figure 1. The Structure of Production

One big difference between the companies in different levels in the struc-
ture of production is the time that must elapse before their investments return
a profit: see figure 1. A retailer may add a distribution warehouse, and begin to
make a profit from it right away, in terms of having more stock on hand, fewer
back orders, or greater ability to satisfy the consumer.

A higher-stage firm, such as a coal mine or primary metal producer, often
has a much longer lead time. It may take five or ten years before a new plant can
be built, equipped with proper machinery, staffed with trained workers, and put
into full operation such that the profits from operations will begin to amortize
the original investment.

Austrian economists add to this another reason for the different impact of
interest rates on different levels of the structure of production. In the absence
of governmental interference, interest rates in the market are determined by
the interactions of the differing time preferences of borrowers and lenders
of money. Interest rates send valuable and important signals to market par-
ticipants. These signals have different meanings to industries depending on
where they are on the structure of production. Higher-stage industries are far
removed in time from the ultimate consumers. They must, as a result, use prices
and interest rates as important messages about the state of the market. Lower-
stage industries do not need these messages as much, since they meet daily with
the consumers and can judge demand directly. It usually takes a long time for
goods and services produced in higher stages to reach the ultimate consumer.
A bar of iron, for example, may go through dozens of stages before it emerges
as a rotor on a fan in someone’s personal computer. Someone has to pay the
interest charges on that piece of iron while it waits, in factory after factory, to
be transformed, finally, into something that a consumer would want to buy. Higher-


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110 Review of Austrian Economics 10, No.l (1997)

stage producers, therefore, without realizing it, must carry the burden of
subsequent interest charges which, if the interest rates increase too much, will
affect the sales of the consumer products made out of their output. Lower-stage
producers, who are closer to the consumer in time, do not have to carry the
same interest burden, and so are less affected by changes in rates.

Because of these dissimilarities, changes in the cost of capital result in very
different investment patterns. For a lower-stage industry (such as a retailer,
wholesaler, or food producer), the cost of capital is not as important, because the
interest charges do not have to be carried very long before the payout begins. For
a higher-stage industry, increases in the cost of capital often mean the difference
between undertaking a new project or not doing it at all.

Why Industries Differ in Capital Needs

To illustrate the difference, consider two different industries: a food retailer and
a primary metals manufacturer.

The food retailer is selling a perishable commodity. He has few warehouses.
Most of his capital is tied up in goods on display in his stores. Movement of stock
is brisk. If he were to add a new store, a warehouse, or additional trucks, he
would expect to build or buy them rapidly, and have them earning income within
a year or so of the purchase decision. If the interest rate is 8 percent, or 12
percent—it does not matter very much. At 12 percent, he may hesitate to build
a new store but he will still add to his truck fleet.

The primary-metal manufacturer has a very different attitude. Modern metal
extraction and production involves environmental questions, very elaborate and
expensive capital equipment, and many years of planning. A new steel, copper, or
aluminum plant may cost many hundreds of millions of dollars, and take 10 years from
site purchase to full production. Here, the interest rate is everything.

Suppose that the cost of a new plant is $200 million, and that it will pay a
return of $40 million per year when it is completed. At a market rate of interest
of 12 percent, such a plant would be worth $333 million. Time is money. How
long would it be before the cost of interest payments would drive the original
investment of $200 million up over $333 million? In other words, how much
time does the firm have to build the plant before the investment is no longer
profitable? The formula for the long term value (V) of an investment which yields
Y amount per year when the market rate of interest is (r) is:

V=Y/r
V=2%40/.12
V = $333


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Hughes: The Recession of 1990 111

The formula for the cost (C) including interest of an investment (I) for n
years at (r) rate is:
C=I(1+n"

Solving for n, the formula becomes:
n = Log(C/I) / Log(1+r)

The maximum time that an investor can afford to wait for his return is thus
based both on the rate of interest, and the value of the expected yield in relation
to his investment. His maximum time is when C = V, If we substitute the value
of the investment (Y / r) for C in the above formula, it becomes:

n = Log(Y/(I * r)) / Log(1 + r)

If the interest rate is 12 percent, the plant must be up and running in
four-and-a-half years, or the cost will exceed its market value.

n = Log(40/(200 * 0.12)) / Log(1.12)

n= 4.5 years.

On the other hand, if the market rate of interest is 8 percent, the value of
the same plant that returns $40 million per year is $500 million. At 8 percent
per year, how long will it be before interest payments have forced an original
investment of $200 million up to $500 million?

n = Log(Y/(1 * r)) / Log(1l + r)
n = (log(40/(200 * 0.08)) / Log(1.08)
n = 11.9 years

So, at 8 percent they can afford to take a maximum of 11.9 years to build
the plant before it is no longer profitable. Most higher-stage investments take
longer than four-and-a-half years before they begin to pay dividends. Most
lower-stage investments take much less time than that.

What this tells us is that the market rate of interest means different things
to different segments of the structure of production. When rates go down, a
great many higher stage projects that were uneconomic at high interest rates
become at once feasible. When rates go up, many higher-stage long-term pro-
jects have to be scrapped. These simple rules do not apply to lower-stages of
production, simply because their payoff times are much shorter. They don’t have
to pay as much interest on their typical project. A lower stage producer is less
likely to embark on an investment project.


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112 Review of Austrian Economics 10, No.1 (1997)

Why the Money Supply is Expanded

Western governments since the 1940s, following Keynesian principles, have in-
creased their money supplies every year, thus leading to constantly-rising prices
believing that it was good for their economies. They have also found that inflation is a good
way to finance their governmental-spending programs without the need to increase
taxes—the increased spending also being a Keynesian prescription for achieving full
employment. How much increase in the money supply is the desirable goal? Keynesi-
ans and many monetarists would favor an annual increase of 5 to 6 percent per year.

A laissez faire system is doomed to wasteful ups and downs of the business cycle
and perhaps to long fits of stagnation. . . . Simple capitalism has been replaced
virtually everywhere by the mixed economy (a “welfare and managed economy”).
Everywhere in the Western world, governments and central banks have shown
they can win the battle of the lasting slump if people want them to . . . Just as we

. 7
no longer meekly accept disease, we no longer need accept mass unemployment.

The core of the Austrian macroeconomic theory is that government “fine
tuning of the economy,” through government-orchestrated expansions and con-
tractions of the money supply, are actually the cause of business cycles because of
the differing impact of the resulting interest rate changes on different stages in
the structure of production. Roger Garrison has pointed out that Mises and sub-
sequent Austrian theorists, influenced by Knut Wicksell, see a “distinction between the
natural rate of interest and the bank rate of interest” and recognize “that the bank rate
can diverge from the natural rate . . . The institutional setting in which the interest rate
reflects both the intertemporal preferences of market participants and the actions
of policy makers, then, figures importantly in the Austrian account of the artificial
boom and inevitable bust. Fritz Machlup accurately summarized the Austrian
view with the statement that ‘monetary factors cause the cycle but real phenomena constitute
it’. . . . The focus of the Austrian theory is on the actual market process that translates
the monetary cause into the real phenomena and hence on the institutional setting
in which this process plays itself out.”® Here is the way it works.

The Austrian Explanation of the Business Cycle

When the money supply is expanded, the cost of capital comes down. Industries
in higher stages find that many of their long-term projects are now feasible. They

Spaul Samuelson, Economics, 10th ed. (New York: McGraw-Hill, 1976), p. 332.

"Ibid., p. 345.

SRoger W. Garrison, “New Classical and Old Austrian Economics: Equilibrium Business Cycle
Theory in Perspective,” Review of Austrian Economics 5, no. 1 (1991): 91-103.


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Hughes: The Recession of 1990 113

begin to build new productive facilities which have long-term payouts. To build
these plants, they have to hire more workers which they pay with borrowed
money. The hiring of workers, and the competition for capital equipment and
resources, bids up the prices of goods and the wages of the workers, and increases
interest rates. The rising rates put more pressure on the government to ease up
credit by further increases in the money supply.

The increased money supply affects mainly the higher stages of production,
not the lower stages, because it is higher stages that depend on long-term
external capital infusion to undertake their development projects. Eventually, of
course, the expansion also affects the lower stages, as highly-paid workers spend
their wages on more consumer goods. A boom is in the making.

As long as the government keeps feeding the boom with more and more money,
the good times roll. Higher-stage industries undertake more and more costly projects,
and more and more workers move to those sectors. Their spending fuels the activities
in other sectors, and their absence raises the wages of those still remaining in these
sectors. Now all levels of production are competing for loanable funds. The game is up
when the monetary authorities finally become alarmed at the level of price increases, and
muster the courage to reverse their expansionary course, usually by raising the discount
rate or selling bonds on the open market.’ At this point, the good times come to an end.
The expanded spending by consumers tends to force the interest rates back up.

The Coming of the Recession

The inflating economy is like a giant pyramid scheme. As long as the government
keeps pouring money in, the system will keep going. Once the government stops,
a recession is inevitable.

The first to go will be the long-term capital projects. As interest rates go up,
new projects not yet started will be canceled. But many of those which are only
half finished will also have to be abandoned. One reason is that capital financing
is often obtained on a pay-as-you-go basis. As industries compute the payoff for a
project started when interest rates were 8 percent, which now must compete for
funds at 12 percent, they realize that the project is a loser. They cut their losses, and
abandon the enterprise. The workers are laid off, and often, much of the project is
a total loss. The reason? Because most capital goods (semifinished goods and
facilities) are specific to an industry, and have little general usefulness. It becomes
apparent that much of the expansion undertaken in prior years was really false
expansion, based not on a truly-growing economy, but on the government inflation

Mark Skousen, The Structure of Production (New York: New York University Press, 1990), pp.
300-1.


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114 Review of Austrian Economics 10, No.1 (1997)

14
[| GNP Increase

12

© 3 Money Supply
L
® 10
°
3 8 6 year average
a 4.1 percent
13 6
24
w
[-]
o 4
«
£
oO 2
[+]
[=]
EL]
0
2
@
o 2

4

1981 1883 1985 1887 1989 1991

Figure 2. Money Supply Increase versus GNP Increase 1981-1991
Source: Economic Report of the President 1992 M = M2

of the money supply. As workers are laid off in higher-stage industries, they
reduce their spending for consumer goods. The recession spreads.

The Recession of 1990

The process just described took place during the years from 1981 to 1992. From
1981 to 1986 (and earlier), the Federal Reserve embarked on a massive increase
in the money supply which averaged 9.6 percent per year while the GNP in real
terms expanded by only 2.6 percent. From 1987 to 1991, the money supply
increased by an average of only 4.1 percent per year while, the GNP increased by
about 2 percent.’ The dramatic drop in government money supply expansion is
shown by Figure 2.

The money supply expansion from 1981 to 1986 resulted in expanded bank
loans to higher-stage industries, while lower stage industries, at first, were unaf-
fected. As more workers were hired by these expandingindustries, and others received
pay increases and began to spend their pay on increased consumer goods, the lower-
stage-industry bank borrowing increased. Lower-stage capital expansion is based more
on anticipated consumer demand than upon the availability of capital. The precipi-
tous drop in government money supply expansion after 1986 ended the boom in
the higher-stage industries. This was the beginning of the recession—although
it did not show up for four more years.

10 Economic Report of the President 1992 (Washington, D.C.: U.S. Government Printing Office,
1992), pp- 300 and 373.


===== PAGE 9 =====

Hughes: The Recession of 1990 115

Index of Bank Loans % Growth Money Supply

“* Iron and Stee! ‘®° Primary Metals

12
250 >< Machinery £] Money Supply

10
200

All Manufacturing Industry
Index of Lang Term Bank Loans

150

100

1981 1983 1985 1987 1989 1991

Figure 3. Long-Term Bank Loans by Higher-Stage Industries 1981-1991
All Manufacturing Bank Loans = 100

Source: Quarterly Financial Report, Census Bureau and Federal Reserve

Figure 3 depicts long-term bank loans to higher-stage industries (repre-
sented by iron and steel, primary metals, and machinery) relative to total-long-
term bank loans to all manufacturing industries, superimposed on the annual
growth of the M2 money supply. Notice how two of these industries increased
their loans, in relation to all manufacturing loans, dramatically during 1982 and
1983. The increase was 250 percent in iron and steel and 150 percent for
primary metals. Machinery industries—much lower in the structure of produc-
tion than primary metals—increased their borrowing only slightly during the
expansionary period and were generally below industry averages thereaf ter."

The fact that the increases in higher stage borrowing from 1981 to 1985 were
based on the increased availability of capital funding rather than directly anticipated
demand for increased output is shown by the statistics on industrial production during
this period. The level of production in the iron and steel industry at the time was far

"The Quarterly Financial Report Program (QFR) of the Bureau of the Census publishes aggregate
statistics on the financial results and position of U.S. corporations based on an extensive sample
survey. The series began in 1947 and is issued in a 145-page book every quarter. Data are
extracted from IRS Form 1120 reports. Use of statistics such as these, which were gathered
for another purpose entirely, is bound to result in certain inaccuracies for analytical purposes.
Most corporations produce a product mix that does not easily fit into standard SIC (Standard
Industrial Classification) codes. The series is used as a basis for the analysis in this paper because
it is, basically, the only game in town. The categories covered by the data into which corporations
are divided include the following (these are a sample). The column headed “Long-Term Loans” .
represents long-term loans (due in more than 1 year) from banks in the first quarter 1982 as stated
in millions of dollars.


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116 Review of Austrian Economics 10, No.1 (1997)

below capacity (estimated at about 63.5 percent from 1981 to 1985)" due to the
low level of orders. Lower-stage industries, closer to the consumer, showed no such
increased borrowing levels during this period of massive money supply increases.

With the benefit of hindsight, we know today that net shipments of steel mill
products would never regain their 1981 levels during the following decade. Why
did they expand their production? All that industry participants knew at the time
was that funding for expansion was available. Iron-ore production, much closer
to its direct customers than the iron and steel industry, did not invest in expan-
sion during the period, and, in fact, closed down several of its operating mines.’

When the massive money-supply increases came to an end in 1986, the iron
and steel industry collapsed. Prices of their product dropped every year as the
higher-capacity and more-efficient new facilities competed with the older plants
for what was essentially a disappointing demand.

For the copper industry 1981-1985 were turbulent years. They were years
of bankruptcies, shut down mines, laid off workers. But financing was available.

Long-Term Loans Long-Term Loans

All Manufacturing 74,129

All Durable 39,198 All Non-Durable 34,931
Stone, Cla 2,431 Food 7,364
Primary Metals 7,597 Textile Mill 1,824
Iron Steel 5,453 Paper 2,222
Non Ferrous 2,144 Printing & Publ 3,656
Fabricated Metals 4,575 Chemicals 5,238
Machinery 10,428 Indus Chem 2,346
Electrical 3,870 Drugs 352
Transport 4,627 Petroleum & Coal 6,919
Motor Vehicles 1,211 Rubber 1,737
Aircraft 1,802 Other Non-Durable 2,158
Instruments 1,296

Other Durable 4,373

Note: The figures do not add up to the total because they are a selection from a large
government survey. The selection of industries to illustrate this paper was a subjective one. The
statistics in the survey were not collected based on the stage of production. Every industry grouping
for which statistics exist is a combination of different heterogeneous companies making different
products. I picked the groupings (iron and steel, primary metals, food, textiles, rubber,
wholesaling, and retailing) because they seemed to, in general, represent examples of higher-order
and lower-order industries. They help to illustrate the Mises—Hayek trade-cycle theory. These
examples do not prove the validity of the theory, which is an apriori statement which does not
require empirical verification.

2 Minerals Yearbook 1985, United States Department of the Interior, p. 577. In 1982—the year
of the greatest long-term capital borrowing in the industry—capacity utilization in raw steel was
only 48.4 percent.

Minerals Yearbook 1985, p. 555-56, reports the following: From 1981 to 1985 US Steel
invested $300 million over four years to modernize its Pittsburg, California mill. Timken invested
$500 million in a new plant at Canton, Ohio. Tuscaloosa Steel built a new $75 million rolling mill
in Alabama. Great Lakes Steel spent $200 million to modernize its plant in Michigan. Wheeling-
Pittsburgh, in bankruptcy, began construction on a $50 million plant in West Virginia.


===== PAGE 11 =====

Hughes: The Recession of 1990 117

Despite massive losses in the industry, Standard Oil of Ohio invested $400
million to modernize Kennecott’s Utah Copper Division early in the period.
After serious losses, the plant was shut down entirely in 1985."

In looking at these figures, it is important to recognize that these numbers
are industry averages only. Inside each number are dozens, or hundreds or
thousands, of individual firms—some of which were borrowing heavily, others
of which may have been doing nothing in the way of external financing. When
the figures for an entire industry are shown to be at 270 percent of their previous
level, this must mean that some individual firms had really increased their bank
borrowing by a major amount. For primary metals, for example, bank loans in
the first quarter of 1981 were listed at $4,010 million. By the first quarter of
1982, their level was $7,597 million. Iron and steel had a similar increase: from
$1,832 million to $5,453 million. Machinery bank loans increased from $7,898
in 1981 to $10,428 millions by 1982.

But for iron and steel, and primary metals, the borrowing surge stopped after
1984. Thereafter, their bank borrowing was less, proportionately, than the level of
all manufacturing. The impact that money-supply increases produce on higher-stage
investments is well illustrated by the activities of these two industries.

Lower-Stage Industry Long-Term Borrowing

Contrast this higher-stage borrowing and capital spending with the bank bor-
rowing of lower-stage industries during the same period (1981-1991). Food,
rubber, and textiles are industries that are much closer to consumers than are iron
and steel and primary metals. We could have also looked at petroleum, drugs and
motor vehicles as representative of lower-stage industries, but for special demand
reasons, one could argue that the 1980s were not typical years for these groups.

Drugs were affected by the growth of the Medicare and Medicaid programs
which began to be important during this period. American motor vehicles were
competing heavily, for the first time, with the Japanese. Petroleum is a vertically-
integrated multi-national industry with high capital investments in higher-order
(drilling) and lower-order (refineries and gas stations) goods."

"Minerals Yearbook 1985, p. 320-26. Newmont Mining closed their Superior Mine in 1985, taking
a $40 million loss. Despite this, they planned to invest $71 million to open a new San Manuel Mine. In
1985, the Burro Chief Copper Company completed a $15 million program to double their operations.
Phelps Dodge planned on a $90 million investment at their Morenci Mine in 1985.

131¢ is easier to describe the concept of higher-stage and lower-stage industries than to obtain
statistics on them. Logging obviously comes before sawmills which come before drying kilns.
Most businesses are involved in many different activities in which the stages overlap. Statistics
are not collected based on the structure of production.

The best government source which provides a breakdown relevant to the structure of


===== PAGE 12 =====

118 Review of Austrian Economics 10, No.1 (1997)

Index of Bank Loans 9% Growth in Money Supply
170 12
150 10
130 8
110 6
80 4

70

* Rubber * Food =X Textiles i:l Money Supply

“10
1981 1983 1985 1987 1989 1991

. Figure 4. Long-Term Bank Loans by Lower-Order Industries, 1981-1991

All Manufacturing Bank Loans = 100
Source: Quarterly Financial Reports 1982-1992, Census Bureau, and Federal Reserve.

50

Figure 4 depicts the long-term bank borrowing of three lower-stage industries
during 1981-1991 as contrasted with total long-term bank lending to manufactur-
ing industries during the period and the growth in the money supply. Our three
lower-stage industries illustrate the Mises—Hayek theory. During the period of
money supply expansion from 1981 to 1984, they generally maintained their bank
loans virtually unaffected by the expansion of loanable funds. Towards the end of the
expansion period, textile and rubber industries began to undertake long-term
projects that pushed them up to 170 percent and 200 percent of industry averages
by 1986. By 1987 consumer spending had driven even food industries to compete
for bank-loan funds at a very high rate.

Notice that the peak borrowing for food and rubber came after 1986—at a time
when the money-supply growth rate was being drastically curtailed. Why was
that? The previous expansion in higher-stage industries produced an increase
in consumer spending which pushed lower-stage manufacturers to borrow to
expand their facilities to meet it."

of production is a survey done every 5 years by the Department of Commerce, called the
“Interindustry Structure of the United States,” based on work by Wassily E. Leontief, whose
first tables were prepared for 1919, 1929, and 1939. It provides a rough guide to understanding
the position of the industries in the QFR, although not a definitive one.

18Erom 1981 to 1986, real consumption spending in 1987 dollars increased by 19.7 percent,
whereas real GNP increased only 15.7 percent in the same period. Consumers were trying to
restore their spending patterns after the recession of 1982.


===== PAGE 13 =====

Hughes: The Recession of 1990 119

500 - 14
-=— All Manufacturing —+ lronand Steet ¥ Food [] Money Supply

12

400
10
a]

2 3
a 300 @
S 8 3
m 6 =
gE 200 a
3} 5
=
& 4 g
5 3
= 100 2
5 [7]

2
B <

0

1981 1983 1985 1987 1989 1991

Figure 5. Long-Term Bank Loans to Industry 1981-1991
Source: Quarterly Financial Report 1982—1992 and Federal Reserve 1981=100.

Figure 5 puts the entire period into perspective. It shows total dollar
borrowing by all manufacturing industries adjusted for inflation—the pro-
ducer’s price index. As you can see, long-term bank borrowing by manufacturing
industries increased steadily from 1981 to 1991."7 The dramatic reduction in
money supply increases in 1987 did not affect the total borrowing level at all—in
fact the average annual increase in borrowing after 1986 was higher than before
1986. What did change was the distribution of that borrowing. Before 1986,
most of the increase was led by higher-stage industrial borrowers, represented
here by iron and steel. After 1986, the increase in total borrowing was fueled by
lower-stage industries, represented here by food.

Most traditional economists looked on the years from 1986 through 1988 as
being boom years. They overlooked what was happening in higher-stage industries.
What was going on in iron and steel, for example was this: LTV Corp., Wheeling-

From $60.5 billion in 1981 to $197.2 billion in 1991, in current dollars. Quarterly Financial
Report J the Bureau of the Census, 1982-1992.
18 4 finerals Yearbook 1989 (Wshington, D.C.: United States Department of the Interior Burcau
of Mine’s, 1989), vol. 1, pp. 523-24. U.S. consumption of iron ore from 1980 through 1986 tells
the story (p. 554):

Thousands of Metric Tons

1980 91,983
1981 97.903
1982 57.203
1983 63,050
1984 68.450
1985 66,049

1986 57 513


===== PAGE 14 =====

120 Review of Austrian Economics 10, No.1 (1997)

Millions of short tons Cents per pound

100 27
28

80
25
60 24
3

40 2

22

20

21

“%] Consumption -¥- Prices

1981 1982 1983 1984 1985 1986 1987 1988

1989

Figure 6. Iron and Steel Consumption and Prices
Source: Minerals Yearbook 1989

Pittsburgh Steel Corp. and Sharon Steel Corp., were all forced to. file for bank-
ruptcy following the collapse of steel demand in 1985 and 1986. This collapse
accelerated the reduction of U.S. steel-making capacity, and triggered a major
restructuring of the iron ore and steel industries on both sides of the U.S. —Canadian
border."

Figure 6 shows what happened to steel prices after the Federal Reserve
stopped inflating the money supply. Consumption of steel failed to regain its
1981 levels in the subsequent decade.

The situation in copper was quite different, but illustrative of the same basic
problems. Coinciding with the United States money-supply increases which
began in 1981, the U.S. copper industry began a major inventory increase to 275
percent of 1979 levels by 1983. Beginning in 1984, inventories began to fall
drastically every year until 1988, until they reached an average of about 14
percent of 1981 levels by 1989."

In figure 7, we contrast long-term borrowing of all manufacturing, retailing,
and wholesale firms. Retail borrowing took a nosedive from 1981 to 1982—re-
cession years—and stayed down all during the period when the Federal Reserve
was inflating the money supply. Retail borrowing only accelerated in 1987—af-
ter the inflation of the money supply was over! Why? Because retail firms borrow

"Minerals Yearbook 1989, p. 359. Despite this buildup of inventory from 1980-83, world
consumption of copper was almost flat from 1980 to 1989. The buildup, therefore, cannot be
ascribed to increased demand (p 352).


===== PAGE 15 =====

Hughes: The Recession of 1990 121

—— All Manufacturing + Retalling * Wholesaling EJ Money Bupply

500 14

12
400 °
+]
2 10 g
x 300 8 i

o

£ 6 =o
3
KS] 200 z
g 4 3
Ss 2
Ss 100 ®
x 2 3
° <

0
1981 19883 1985 1987 1889 1991

Figure 7. Bank Loans to Manufacturing, Retailing, and Wholesaling
Source: Quanerly Financial Report 1982-1992 and Federal Reserve 1982 = 100, adjusted for Producers Price Index

to meet immediate customer demand. Higher-order firms borrow when financ-
ing is available on attractive terms.

In the later stages of the boom, consumer spending competes with and
overtakes all other types of activity. It is at this point that unused higher-stage
capacity materializes because, as Hayek says, “We are unable to use the fixed plant
to the full extent because the current demand for consumer’s goods is too urgent to
permit us to invest in current productive services in the long processes for which (in
consequence of ‘misdirections of capital’) the necessary durable equipment is
available.””® In the last part of the decade, retail use of loan funds, secured to meet
expanding consumer spending, dwarfed the growth rates of manufacturing and
wholesaling borrowing activities. In a contest, lower stages always win.

The data assembled here provide an illustration of the working of Austrian
business cycle theory,” namely, that business cycles are caused by government
inflation of the money supply, leading to excessive borrowing by higher-stage
industries. This borrowing produces a boom which must come to an end when

20F A. Hayek, Prices and Production 2nd ed. (New York: Augustus M. Kelley, [1935] 1967), p. 96.

21 As Friedrich Hayek said in Monetary Theory and the Trade Cycle (New York: Augustus M. Kelley,
[1933] 1966). “The corroboration of statistical evidence provides, in itself, no proof of correct-
ness. A priori we cannot expect from statistics anything than the stimulus provided by the indication
of new problems. In thus emphasizing the fact that trade cycle theory, while it may serve as a basis
for statistical research, can never itself be established by the latter, it is by no means desired to
deprecate the value of the empirical method. On the contrary, there can be no doubt that trade
cycle theory can only gain full practical importance through exact measurement of the actual course
of the phenomena which it describes.” pp. 31-32.


===== PAGE 16 =====

122 Review of Austrian Economics 10, No. | ( 1997)

10 14
~~ Consumer Prices Money Supply
12
8
The Fed's worries came to

2 a head right about here. 10 po
Qo a
=
a 6 8 3
[+]
E [9]
2 z
& a
Oo 4 8 e
£ =
££ @

~
(&] 2 »
5 > §
E ©
a -<

1981 1983 1985 1987 1989

Figure 8. The Fed Loses Its Nerve
Source: Bureau of Labor Statistics and Federal Reserve

the inflationary activities stop—as they must, when the government can no
longer continue to stoke the monetary fires with more and more monetary
expansion. The end of the boom leads to a crack-up and a recession.

The recession did not begin until 1990, but the seeds were planted in
1981-1986, with the money supply expansion. The recession was triggered in
1987 when the Federal Reserve lost its nerve to continue the inflationary spiral.
What caused the Federal Reserve to alter its policy so drastically in 1987?

1987: The Fed Lost Its Nerve

Why the Federal Reserve alters its policies is always a matter for speculation. It
is seldom one single thing that is crucial. The Fed worries about inflation,
deficits, the money supply, interest rates, and unemployment. But certainly a key
concern in the past 20 years has been the value of money, as represented by the
consumer price index.

Figure 8 shows one key variable—the consumer price index—against the
annual growth rate of M2. The Fed pursued a high inflation policy for 6 years.
During all of these years, prices were flat or falling. Then, in 1986, prices began
to climb. Eight years previously, in the fall of 1979, the Federal Reserve changed
its policies dramatically when it decided to clamp down on double-digit inflation.
Its actions produced the recession of 1982, and a halt in the inflationary spiral. Price
increases from 1982 through 1985 were held to a flat 3.8 percent per year. The shift
was welcome news for the public and for businessmen generally When price


===== PAGE 17 =====

Hughes: The Recession of 1990 123

increases in 1986 dropped to a low of only 1.1 percent, there was rejoicing in all
quarters. But while the Fed leaders were happy about the price levels, there was
real concern about the growth of the money supply. Even the non-Austrian Fed
economists realized that the country would have to pay for the excessive growth
in money at some point. The year 1987 looked like that point.

Consumer price increases, led by medical costs due to Medicare and Medi-
caid, began to zoom up. When the 1987 rise passed the 3.8 ceiling and kept on
rising, the Fed lost its nerve. It put the brakes on money supply increases in a
drastic way, and kept them on for the next 5 years. Some would point to this
decision and say that the recession of 1990-92 was caused by Fed actions in
1987. That may be true. But Austrians know that that is not the whole story. The
actions which led to the recession really took place from 1981-86. Once the
money supply was inflated during this period, the actions of 1987-1991 were
inevitable, and so was the recession.

During the time between 1987 and 1990, the public was unaware of the time
bomb ticking away. Life went on as usual. New businesses were formed at an
expanding rate, and business failures were on the decline. Corporate profits from
1987 to 1989 rose by 31 percent. Consumer prices rose by 4.4 to 6.1 percent.
Mortgage debt rose by 48 percent from 1986 to 1990, and consumer credit rose by
22 percent in the same period.” None of the standard signals showed to Keynes-
ian economists any sign of the impending recession, for one very simple reason:

they were looking in the wrong place.

Conclusion

Deficit spending and money-supply expansion do not eliminate recessions. They
cause recessions. This fact will never be understood unless economists and
government policymakers stop trying to micro-manage the economy, and start
studying what their actions are doing to the structure of production. Heavy
inflation of the money supply followed by sharp cutbacks change the rules right
in the middle of the game for millions of businesses in the economy.

For the last 40 years, government expansionary policies have stimulated
industries to create false and untenable investments. These policies are followed
by government corrective actions that destroy those same projects—waste the
billions of dollars invested in them, and throw millions out of work. Business
cycles are not an essential feature of market capitalism. They are the result of
government interference with the market.

22 Economic Report of the President 1993, pp. 411, 433, 434, 447.