Our next speaker is the Academic Vice President of the Ludwig von Mises Institute.
He's the editor of the quarterly journal of Austrian Economics, runs our summer programs, Rothbard graduate seminar, the Austrian Scholars Conference, Mises University.
But he's a professor right here, right down the street, I assume, at Pace University, professor of economics.
He is the author of a very big important book coming out called Money, Sound and Unsound.
Look for that very, very soon from the Mises Institute.
He's going to talk today about Can ABCT Explain the Overconsumption Boom?
Mr. Joe Salerno.
Thank you, Doug.
My title is Can ABCT Explain the Overconsumption Boom and ABCT refers to the Austrian Business
Cycle Theory.
Yeah, Paul.
It can.
Paul being Paul Krugman, the Supercainesian.
Okay.
Let me put my talk in historical context and by giving you a little bit of historical
insight and data about what has occurred in the most recent recession, one of the most
One of the most prominent features of the current recession, at least in the U.S., has been the exceptionally severe retail slump.
One indication of the severity of the slump is the sharp decline in retail and food service sales.
For example, for December 2008, the year-over-year decline in current dollar sales was 11.1 percent,
and from January through July of 2009, these year-over-year declines fluctuated between 8.5 percent and 10.5 percent.
The numbers themselves aren't important, except for two non-consecutive months during the recession of 1990-1991 in which monthly retail sales dipped slightly below zero on a year-over-year basis, one would have to go back to the 60-61 recession to find declines in current dollar sales during a recession, although nothing like the magnitude experienced during the current recession,
In the current recession, retail sales, or real retail sales, on a year-over-year basis have contracted by 8% or more for nine consecutive months, ending in May of 2009.
Overall, year-over-year retail sales were negative for 23 consecutive months, ending on November 1, 2009.
As of February, this past February, 2010, real retail sales and food service sales, seasonally adjusted, stood at about $167 billion, which was above its recessionary trough of 158, but far below the pre-recession peak, okay?
So we still haven't retained the retail sales that we had in October of 2007, which was the pre-recession peak.
Let me just give you the qualitative dimensions. I think it'll bring this home a little bit more clearly.
The current retail slump can be traced in the broad range of iconic American retailers
that have succumbed to bankruptcies, liquidations, or massive retrenchments since the recession began.
Chrysler filed Chapter 11 on April 11, 2009, followed by GM on June 1.
KB Toys, one of the largest U.S. toy retailers, sought Chapter 11 protection in December 2008
and announced that it planned to close all 460 retail outlets.
Circuit City, the second largest electronics retailer in the U.S. declared bankruptcy and closed all 575 of its stores.
We have mid-sized electronics retailers like CompUSA closed all of its stores.
Sharper Image, which is a novelty electronics retailer, also declared bankruptcy.
Linen and Things, the second largest home goods retailer in the U.S., filed Chapter 11 and is liquidating its 371 stores.
Fortunoff's leading jewelry and home furnishing chain in the Northeast filed for bankruptcy,
as did the mid-size furniture retailer Levitt and Bombay, both of which are liquidating.
So many more retail stores are scrappy expansion plans and proceeding with massive cuts.
The point of all that is to say, well, the Austrian theory of the business cycle is wrong,
because how could we have such a massive slump in retailing when the Austrian theory tells us that
In fact, what occurs during the boom is not too much consumption, not too much spending on yachts and luxury cars and so on, but too much forced savings, a term for the fact that banks inject credit to businesses which then spend money on capital goods industries.
So, we had an overconsumption boom, as I'll show you in a moment, as well as the normal business cycle.
The Austrian theory tells us that we were producing too many factories, we were drilling too many oil wells, we were spending too much on research and development, way up the chain of production during the boom, which meant that resources were taken away from consumption, that during a boom, consumption should be decreasing, not increasing.
So Krugman and others have said what the Austrian theory tells us is that during the so-called recession correction
We should have more consumer goods
We shouldn't have a retail slum
Everybody should be rushing out buying goods because the banks have stopped lending as much to businesses and businesses have stopped
competing for resources to expand capital goods factories
Sink, you know, oil wells and so on, sink drills into oil wells
So, is that true? Is it true that the Austrian business cycle theory, ABCT, cannot explain the consumption boom?
No, it's based on a fallacy. It's based on the fact that the mainstream economists, which I'll talk about in a moment, the macroeconomists, led by Krugman,
have never understood Austrian theory of the business cycle, have ignored it.
And now, because it is spreading among the intelligent layperson, among financial commentators and so on,
They are fearful that they'll lose their power and influence in the halls of government, in academia, and so on.
So they're lashing out at it based on very little knowledge of what it really is.
So let me just say a few words about what has caused the renewed interest in the Austrian business cycle theory.
Then I'll show you some pictures showing that, in fact, the Austrians do have an explanation.
The housing bubble and the financial meltdown has sparked a remarkable renewal of interest in Austrian business cycle theory.
Several high-profile media commentators and leaders in the financial community have employed ABCT in their interpretation of the current economic crisis.
They have been inspired to revisit the theory as a result of the abject failure of mainstream macroeconomists to foresee or even explain the housing bubble
and its subsequent transformation into a pandemic financial meltdown,
which has led to the longest recession since World War II.
Curiosity about the theory was reinforced by the fact that several economists
and financial commentators associated with the modern Austrian School,
some of whom are here, forewarned of an emerging housing bubble
and impending financial crisis during the Greenspan era, beginning in 2003.
During that era, the conventional wisdom was that the Federal Reserve system
had matters well in hand."
Mainstream macroeconomists have not, understandably, responded kindly to the sudden resurgence of interest in ABCT.
However, instead of openly subjecting the theory to scholarly analysis,
in the standard research forums of academic journals, professional conferences,
they have really sniped at it on their blog sites and in the popular press.
They don't even name Mises and Hayek and Rothbard.
They make snide remarks, sort of oblique remarks about this hangover theory, okay?
Everybody suddenly went crazy and spent too much and now things are turning around.
This is how they portray the theory.
And these critics include Brad DeLong of the University of California, Berkeley,
and the former Deputy Assistant Secretary of Treasury under Clinton,
as well as the super Keynesian Paul Krugman.
Now what I should point out is that the establishment macroeconomics profession
has been shaken to the core by events of the past five years.
Their sophisticated mathematical models failed to predict or explain the housing bubble, as I pointed out, and the subsequent recession.
As a result, modern macroeconomists have been forced to revert to policies of primitive Keynesianism.
These are the policies that wrecked our economy in the 1970s.
These are the policies of the new economics of the 1960s that was promised to us to abolish recessions.
What do we get? The worst decade of inflation and stagflation in American history in the 1970s.
Well, guess what? These policies are not working now either.
We are now supposedly in the recovery phase of the business cycle, yet payroll employment, aggregate hours worked, industrial production, retail and food service sales, real durables consumption and real private investment and stock prices are still far below pre-recession peaks.
All the Bush-Obama bailouts and stimulus programs have achieved are
a halting and artificial recovery that may yet lapse into a double dip recession.
I sort of see that coming with some of the data that's been released this past week.
Projected trillion-dollar deficits, an explosive expansion of the Fed's balance sheet,
and a whole raft of stifling, wealth-destroying new regulations on finance and business.
So it is now clear that modern macroeconomics is intellectually bankrupt.
It is a zombie discipline that is dead from the neck up, as Murray Rothbard was fond of saying.
Its leaders are becoming increasingly aware of this situation, and that is why now, after all these years,
they are suddenly lashing out at the Austrian business cycle theory.
So the Austrian theory is the only explanation of the business cycle that is based on sound economics,
and that can explain the boom-bust cycle in terms of human valuations, human choices,
and entrepreneurial mistakes caused by government policies.
So it's focused on individual actions, not on aggregates like consumption and investment and so on.
The more the public intellectuals, business leaders, financial commentators and other opinion molders learn about the theory,
the less likely that those with a vested interest in conventional macroeconomics will retain their influence and power in academia, business and government.
And that is why Krugman and his fellow macroeconomists fear the spreading knowledge and influence of the Austrian theory
and are doing everything in their power to discredit it.
Now, as Murray Rothbard once pointed out,
Austrians have one big advantage when debating with mainstream economists.
We know their stuff inside and out.
We are forced to learn it and regurgitate it in graduate school.
We read about it all the time in the newspapers and periodicals.
and we have to address it in our journal articles
in order to get them published in mainstream journals.
They, in contrast, know almost nothing about the Austrian theory.
So you have the advantage of surprise.
You can always ambush them with this stuff. It's great.
So now, they are very eager to find flaws with this new hangover theory.
So what did they do?
A while ago, Krugman read a book.
The book was by Gottfried Habeler,
with the former student of Mises. In that book is an overview of the Austrian business
cycle theory. Hobbler used to be an advocate of that theory in the mid 1930s, in fact wrote
a very good article on it. He later on, like some other Austrian economists, became influenced
by Keynesians. He became a right-wing Keynesian, as Rothbard would describe it. In fact, Mises
It was once asked, Professor Mises, do you know of any Ivy League economist who was an honest leftist?
He thought for a moment, he says, yes, Gottfried Habler.
And he also said about Habler's book, which misrepresents the Austrian theory,
and was published by the League of Nations, when he was asked what he thought of it, he says,
it was commissioned by the League of Nations.
You know, what else is there to say?
Okay, so it's informative, but it misrepresents the theory in a specific way.
It says that the theory is a monetary over-investment theory, which means that, and I have a lot of stuff written here, I won't go into that,
basically means that when the Fed begins to expand the money supplier, any central bank, and depresses interest rates,
entrepreneurs then borrow more at the lower interest rates to invest in investment projects that they would not have invested in at the higher interest rates.
This is called for saving because the businesses get the money first and then begin to bid for labor, all sorts of raw materials and so on, against the consumer goods industries.
So you have an expansion in factories, in production of capital goods in general, in research and development and so on.
According to Hobbler, that means that the consumer goods industries now can produce fewer consumer goods because they can't pay the higher wages that are being paid
This is the new money that businesses have borrowed from the banks so workers
move over to the production of capital goods so according to Habler and Krugman
who that's all he read is simply that you get a fall in consumption there's no
consumption boom why should there be a consumption boom during the boom and
then after the boom what you should get is a huge consumption boom that is the
The banks cut back or stop lending money to those who would want to invest it.
They have less money then to spend to hire new labor and so on, and the labor, their
wages fall, they begin to be laid off, but people now, the money they have is more powerful
because new money is not being injected.
So consumers continue to spend on consumer goods in the same old proportions and it bids
gives back the labor and other raw materials and other, what we call, convertible capital goods.
Electricity is diverted away from producing new capital goods and machines and so on,
back to producing hamburgers and other things that consumers desire.
So you should have, during the Depression, people's living standards going up, more consumption goods.
That is the criticism. And let me just read in their own words some of the criticisms.
Very briefly, here's what Krugman says. He says,
Boom gets out of hand. Maybe excessive money creation or reckless bank lending drives it.
Maybe it is a matter of irrational exuberance on the part of entrepreneurs.
Now, he's giving you his account of the Austrian theory.
He goes on to say, whatever the reason, all that investment leads to the creation of too much capacity.
So far, so good. Here's the problem.
As a matter of simple arithmetic, total spending in the economy is necessarily equal to total income. Every sale is also a purchase, and vice versa.
So if people decide to spend less on investment goods, doesn't that mean that they must be deciding to spend more on consumption goods?
Implying that an investment slump should always be accompanied by a corresponding consumption boom.
So right now, as we're coming out of this recession, or during the recession, we should see more spending on consumption.
But we don't. To the extent that booms are driven by mistaken beliefs that investments have become more profitable, they are typically characterized by high, not low consumption.
And then I have some other quotes which I'll skip over.
Now the critics have a point if you take Hobbler's theory, which is at best incomplete, if you base yourself on Hobbler's theory.
In fact, as Mises and Rothbard have pointed out, there's something else that happens during the boom.
As prices go up, what we have is, in business, we see profits suddenly rising.
Now these are paper profits, as Mises has stressed.
They're fictitious profits, they're phantom profits.
Also, prices of capital goods go up.
Stock prices, which are titles of capital goods, they shoot up.
People feel wealthier, the stockholders feel wealthier.
Prices of houses shoot up.
Again, people's wealth is going up.
So, as Mises pointed out, what they do with these phantom gains, these phantom capital gains,
and these illusory profits, is to spend on consumption goods, okay?
They eat up their capital, they consume their capital, they don't reinvest enough,
because prices are going to continue to rise, to buy the same amount of capital equipment.
So, two things are happening during the boom.
One, you're getting malinvestment, bad investments,
in certain processes that should have never been started,
which the mainstream economists get,
but you also get, at the same time,
fewer and fewer capital goods available for those malinvestments.
So it makes things worse.
Why? Because you are getting more people spending
what they think are true profits on consumers' goods.
Let me give you a simple example from Fritz Machlub,
who also was a student of Mises, about capital consumption.
He says, a dealer bought a thousand tons of copper.
Now he's talking about Austria, which had a hyperinflation in the 1930s, in the 1920s.
He sold them as prices rose with considerable profit.
He consumed only half of the profit and saved the other half.
He invested again in copper and only got several hundred tons this time instead of a thousand,
because the price of copper had risen in the meantime.
Prices rose and rose. The dealer's profit was enormous.
He could afford to travel and to buy cars, country houses and whatnot.
His money capital was now a multiple of his initial one.
After repeated transactions, he invested his whole capital, grown to an astronomical amount in money terms, in a few pounds of copper.
While he and the public consider himself a profiteer of the highest income, he has in reality eaten up his capital.
Let me give you one point that Mises makes. It's one quote from Mises, and then I'll show you some pictures.
Mises says this, he says it would be a serious blunder to neglect the fact that inflation also generates forces which tend toward capital consumption,
meaning turning your capital into present consumer goods, as I explained with the copper dealer.
One of its consequences is that it falsifies economic calculation and accounting, it produces the phenomenon of imaginary or apparent profits.
If the rise in the prices of stocks and real estate is considered as a gain, the illusion is no less manifest.
What makes people believe that inflation results in general prosperity is precisely these illusory gains.
They feel lucky and become open-handed in spending and enjoying life.
They embellish their homes, they build new mansions and patronize the entertainment business.
Does this sound familiar?
In spending apparent gains, the fanciful result of false reckoning, they are consuming their capital, okay?
Okay, so let me just finish what Mises says.
It is customary to describe the boom as an overinvestment. However, additional investment is only possible to the extent that there is an additional supply of capital goods, as, apart from the forced saving that we talked about, the boom itself does not result in restriction, but rather an increase in consumption, an increase in consumption, it does not procure more capital goods for new investment. The essence of the credit expansion boom is not overinvestment, but investment in wrong lines, malinvestment. So Mises and Rothbard, who I'm not going to quote here, continually refer
or to the Austrian business cycle as an overconsumption and a malinvestment theory of the cycle.
And let me just show you the dimensions of this. Where should I point this? Over here?
Here's the money supply to official Fed statistics.
A note that from 2000 or so until the latest point in time, the money supply more than
doubled.
It went from about $45 trillion to over $9 trillion.
So this, of course, as we know, is the genesis of the boom, so I don't want to spend too
much time on it.
Interest rates were pushed down to get us out of the 2001 recession.
They were kept down there at 1% for a while, and then Greenspan allowed, and the Fed raised interest rates, which didn't stop, but reduced the rate of increase in the money supply.
And now they're trying to get us out with some of the same medicine. Now interest rates are near zero.
Okay. Now look what happened during the boom. The Wilshire 5000, which is the broadest measure of equity investment in the U.S.
It's actually four hundred, sixty-seven hundred firms that are listed. But in any case, from around 2003, when we had eight trillion dollars of equity,
equity, to the top of the boom in 2007 when you have nearly 16 trillion, the assumption
is that we were twice as wealthy, but of course we're not twice as wealthy.
Much of that, if not all of it, is paper profit, paper capital gains.
When people feel that much richer, these stocks and their portfolio, what are they going to
do?
It's going to stimulate consumption.
They're going to begin to build a second house, they're going to begin to put in swimming
pools, they're going to go to upscale restaurants more frequently.
and so on and so forth. That's what we saw in the 1990s with a pause, with the 2001 recession, and then again in this past decade.
Okay, and this just shows that this is percentages, that at one point the Wilshire 5000, which is the index of total equity investment, was running at 20% increase year over year.
Now this is the overconsumption boom that accompanies that, those are percentages I think, and notice that real retail and food services are increasing at some point by over 5% on a year-over-year basis.
That's not supposed to happen based on the flawed and false rendering of the Austrian theory.
And this shows the monthly increase in spending, in real retail and food service sales, okay?
So there was a boom, and that's what explains the slump.
People realize, hey, I'm much poorer than I thought I was.
My 401k is a 201k now, right?
You know, the price of houses has fallen.
That's part of the story, too.
Okay, don't worry about that.
Here's housing prices.
The blue line is for 10 cities, 10 main cities.
The red line is for 20 cities.
It begins the index in 1907, it's around 52, it's a hundred in, right at the beginning of this decade, past decade, and it more than doubles, okay?
Once again, people are spending out of these false gains in their house on consumption, okay?
And this is, at certain points, the housing prices are rising at 15% year over year, 20% year over year.
These are unprecedented increases in real estate prices, which made people feel wealthier.
That's why corporate profits also jumped tremendously after 2002, which again, much of which were false.
That's why the personal savings rate fell down to 1%, dip below even 1%,
because people felt that they didn't need to save as much at a current income
because their wealth was increasing due to this falsification of accounting and capital accounting.
Okay, and that's really it.
I think what I've done is to defend the Austrian theory
and to show that the modern macroeconomists are just desperate to discover the theory.
But on the other hand, they're not enough of honest scholars
to read what the Austrians actually say about their theory.