EKIP– Expert Club for Economics and Politics A Different Opinion
Over the past 100 years, we have seen several distinct parallels between crises and construction, all of which have played out quite similarly. New York's Singer and Metropolitan Life skyscrapers were completed in 1908 and 1909, at the height of the Panic of 1907. In the early years of the Great Depression, New York City saw the reopening of 40 Wall Street (1929), the Chrysler Building (1930), and the Empire State Building (1931).
When Andrew Lawrence first presented his study in 1999 on the statistically significant correlation between the improvement of the record for the tallest building and a global or regional severe economic recession, his research was met with generally positive reception in the business media, but did not provoke in-depth discussion. The counterintuitive nature of the indicator at first glance puts it in the group of statistical curiosities such as the Super Bowl Index, which, although they can boast a serious success rate in predicting certain events, clearly do not show a causal relationship.
Over the past 100 years, we have seen several distinct correlations between crises and construction, which have proceeded in a similar fashion. The Singer and Metropolitan Life skyscrapers in New York were completed in 1908 and 1909, at the height of the Panic of 1907. In the early years of the Great Depression, the buildings of 40 Wall Street (1929), Chrysler (1930) and Empire State (1931) were reopened in New York. The now defunct World Trade Center towers (1972/1973) together with the Sears Tower (1974) in Chicago were completed at the beginning of the (impossible according to the Keynesian school) stagflation of the 1970s. The completion of the next record-breaking towers, the Petronas Towers in Kuala Lumpur (1997), coincided with the outbreak of the East Asian crisis. The currently tallest building in the world – Burj Khalifa in Dubai – was started in 2004 and opened in 2010, amid a global recession and falling real estate prices.
It is striking that the projects for the record-breaking skyscrapers are announced at the height of the construction boom and their construction begins when prices are high and unemployment is low. However, upon completion of the project, the situation is radically different – a sharp recession, accompanied by sharp changes in exchange rates, bank failures, mass bankruptcies and sometimes even social unrest. The latest edition of Lawrence’s article from 2010 completes the impressive series of predicted recessions, but again does not offer a theory that would explain the phenomenon. Dr. Mark Thornton took up this task and in 2005. presented an article[1] providing a theoretical justification for the indicator in the Austrian tradition.
Those familiar with the Austrian theory of the business cycle will notice the presence of familiar motives in the emergence of a construction boom, reaching its apogee in extremely ambitious projects, many of which subsequently turn out to be malinvestments. Due to its durability, real estate illustrates very clearly the importance of the calculator interest rate, with which future financial and non-monetary flows are estimated, regardless of whether the specific property is used for production or consumption. The deserted finished buildings and abandoned construction sites illustrate very clearly the accumulation of entrepreneurial errors in this sector, caused by the credit expansion. Skyscrapers are an extremely glaring sign of overly optimistic business plans, as well as the high prices of construction land. So the appearance of such projects around the zenith of speculative euphoria is at least logical.
The distortion of the interest rate systematically falsifies the monetary calculation of both entrepreneurs and households. In times of increased monetary expansion, the annual depreciation write-offs allocated to replace worn-out production facilities often lag behind the real costs needed for their future restoration. Thus, despite the apparent "paper" profits, a process of capital consumption is actually underway.
Similarly, households tend to overestimate their own financial position due to nominally increased incomes and/or prices of their own real estate. Thus, in addition to malinvestments (rather than overinvestments), credit expansion also induces overconsumption, which is the essence of the “Austrian” theory of the business cycle, when properly understood and interpreted[2].
In all the cases listed, the construction boom was preceded by a policy of “cheap money”, which reached certain people and institutions first. Unlike the mainstream, which preaches the neutrality of money[3], at least in the long run, for the “Austrians” the credit expansion provokes very real changes in the structure of production[4]. This view follows from the typically “Austrian” complex theory of capital, built on the works of Böhm-Bawerk, Hayek and others, and reformulated in our time by Roger Garrison[5]. Rejecting the highly simplified view of capital as a homogeneous mass, this theory allows us to recognize the importance of the relative prices of higher-ranking goods to each other, as well as to consumer goods.
Instead of talking about an aggregate mass of capital, the "Austrians" take the much more realistic view that the production structure consists of differently specialized, non-convertible, and complementary factors of production, the exchange ratio between them being expressed in relative prices. Even the relatively non-specific resources at the beginning of the production chain cannot change their use without significant costs, and the closer the production process approaches final use, the more specific (to the industry or even to the enterprise) the factors become.
Moreover, capital goods require complementary factors of production in various combinations to operate effectively. It follows that the structure of production is a complex and delicate system, not an amorphous mass that simply grows or shrinks. The only possibility of rational coordination of the structure with consumer preferences is expressed in free relative prices. In this number we must necessarily include interest rates, which coordinate savings and investment and hence the length of the production structure.
The entry of new money into the monetary system has several effects. On the one hand, the new money is not magically distributed proportionally among all individuals, but flows first into certain places in the system, raising prices and, accordingly, incomes there, before reaching the other sectors. That is, some individuals have the advantage of buying goods at old prices with their newly acquired purchasing power, while the vast majority of others are confronted with higher prices long before their incomes increase.
Credit expansion does not create new resources, it simply enables some people to withdraw resources from competing uses by offering higher prices for them. Since the time preferences of the population have not actually changed (unlike the implicit information from the reduced interest rate), the new money that has come into the hands of the owners of the primary factors of production is quickly poured into consumption. This results in a simultaneous and unsustainable boom in both some of the early and late stages of the production structure. On the other hand, the artificially low interest rate does not correspond to the real time preferences of the population and misleads entrepreneurs about the availability of sufficient capital and the willingness to postpone part of consumption for the future.
Once started, credit expansion cannot be directly controlled by central banks, in the sense of which sectors the new money will be directed to. If it is poured into consumer goods, then the inflation of the currency will quickly be noticeable even through the (actually useless) consumer price indices. Since the first recipients of the new money are usually banking institutions, the newly emerging liquidity most often ends up in the form of loans to investors. There is no way to predict which sector exactly the new money will be directed to, as this decision depends on countless factors, "cheap" money can cause a bubble in stocks, real estate or other types of assets. The government policy of making every American happy with their own home, complete with the quasi-state Fannie Mae and Freddie Mac, greatly helped inflate the housing bubble in the US, later conveniently attributed to the greed of the bankers.
1967, p.38
2001
For me personally, the article is very interesting. I congratulate the author, especially for:
"It follows that the structure of production is a complex and delicate system, not an amorphous mass that simply either grows or shrinks. The only possibility for rational coordination of the structure with consumer preferences is expressed in free relative prices."
The above shows an understanding that the economy cannot be simply managed, because it is an extremely complex and subtle mechanism. This is why attempts at central management have a bad effect.
"In times of increased monetary expansion, annual depreciation write-offs allocated to replace worn-out production facilities often lag behind the real costs needed for their future restoration. Thus, despite the apparent "paper" profits, a process of capital consumption is actually underway.
..Similarly, households tend to overestimate their own financial position due to nominally increased incomes and/or prices of their own properties. Thus, in addition to malinvestments (rather than overinvestments), credit expansion also induces overconsumption,"
I would just add one more thing: monetary expansion also causes over-indebtedness and a decrease in the liquidity of companies and citizens. When money is cheap and can be easily taken from a bank, why not do it. If you don't do it, your competitor will do it and will come out ahead of you. Also, when money is cheap, why keep money that is not circulating (to be liquid). You simply pour everything you have into investments (if you are a company). And then, when the boom turns into a crisis, it turns out that you are illiquid, i.e. there is no money in cash. That is why in a crisis there is a process of increasing the liquidity of companies (i.e. they accumulate more money in cash).
"That is, some individuals have the advantage of buying goods at old prices with their newly acquired purchasing power, while the vast majority of others are confronted with higher prices long before their incomes increase."
This is the redistributive effect of inflation. Some become richer at the expense of others.
"Credit expansion does not create new resources, it simply enables some people to take resources away from competing uses by offering higher prices for them."
I am not convinced of the latter. I am expressing a personal opinion. If you pay attention to the phenomena during a crisis, you will see that new mines, new factories, etc. are opened. And during the expansion, everyone works very hard, they cannot even keep up with the orders. In my opinion, there is a creation of new resources. However, this is like making an engine run in turbo mode when it is not designed to work that way. Eventually it wears out and breaks down. In other words, the economy is not designed to work that way. If it were, there would be no need to force it.
The above view is not inconsistent with the fact that resources (old and new) are not being used properly (as would be the case if the amount of money were fixed).
"In this number, we must necessarily include the interest rates that coordinate savings and investments and hence the length of the production structure."
If I remember the standard developments well (I may have forgotten a lot), then according to them, money flows from lower-order productions (closer to the consumer) to higher-order ones (further from the consumer). Production flows in the opposite direction to money: from higher to lower levels.
I disagree with this model because money can flow not only up, but also down. For example, an iron mining company buys iron pillars for supports. The mining company is at a higher level than the manufacturer of iron pillars. But it gives the money for them and they flow down (and not up, as was described in what I read). In my opinion, the model is wrong.
I am also interested in whether the author shares the standard Austrian view that an economy can grow in the long run only if the interest rate is constantly falling. That is, that savings must constantly grow. I do not share this view (I adopted it from George Reisman's book). Austrian understandings ignore the fact that capital creates not only consumer goods, but also new capital. And the more capital you produce, the easier it becomes to produce new capital. In other words: when you have already produced one metal casting plant, you need fewer resources than before (people, effort, metal, etc.) to create a second one.
I also disagree with the so-called long processes and how and why they were more productive. In my opinion, the understanding in this regard is wrong.