The Free Market 16, no. 12 (December 1998)
With huge segments of the world economy mired in depression, can we conclude that capitalism has failed or that the market behaves irrationally? That seems to be the consensus among many commentators, so we hear a wide range of calls for government intervention to patch things up.
Monetarists are calling for more global interest rate cuts. Keynesians are recommending all-out inflation. Clinton says we need a new global financial “architecture.” Others go further to say we need a new world central bank. Still others say we need ever more IMF bailouts.
But none of these measures deals with the underlying cause of the crisis, which is not the market economy but its distortion by central bankers. The basis for understanding this is the Austrian business cycle theory, pioneered by Ludwig von Mises in 1912. His theory, elaborated upon by Murray N. Rothbard, explains the boom-bust of the last decade better than any alternative.
Rothbard called the central puzzle of the business cycle the “cluster of entrepreneurial error.” During the boom, most entrepreneurs and investors appear to be geniuses, earning extraordinary profits year after year. During the bust, their fortunes are suddenly reversed, and they seem like dunces and suffer losses year after year. Yesterday’s profitable ventures mutate into a mountain of malinvestments.
That’s not how unfettered markets behave. Entrepreneurs base their decisions on prices that accurately reflect consumer preferences. Prices also reflect the opportunity costs (goods and services foregone) of the resources needed to make these goods. Entrepreneurs who accurately forecast the future state of markets and produce goods whose value exceeds their costs earn profits. Those with less predictive and productive skill earn fewer profits or suffer losses.
Capitalists, or financial intermediaries acting on their behalf, lend funds to successful entrepreneurs and withdraw or withhold funds from unsuccessful ones. They thereby ensure that the entrepreneurs with comparative advantages remain in service while those without it fall back into the ranks of employees. In the unhampered market, profits are as large as possible and losses as small as possible.
Entrepreneurs earn profits by making good use of resources. But they must also face changing consumer preferences, factor supplies, technologies, and other conditions affecting profitability. As consumer demand shifts away from one good to another, the price and profit of the new good increase while the price and profit of the old one decrease. With increasing revenues, entrepreneurs producing the new good can increase their demands for factors and expand production while those producing the former, where revenues have diminished, must contract operations.
Since change is continual in the market, and not perfectly predictable, a spectrum of profitability results. Some entrepreneurs will earn a lot of profit, others a moderate amount, still others less, and some will suffer losses of varying amounts but each according to how well or poorly he satisfies consumer demand.
In a free market, there is no “cluster of entrepreneurial error” where the spectrum of profitability is hugely skewed toward one end or the other. That’s because demand for goods is not unpredictably increased in every sector at the same time, causing profits everywhere. Neither is demand decreased everywhere at the same time, which (if not predicted) leads to losses everywhere. Yet, during the artificial boom, profits increase everywhere, and during a bust everyone suffers losses.
Central-bank monetary inflation and credit expansion causes the boom and promises to improve permanently the free market by raising the profitability of operations across the entire economy. Higher prices, larger profits, more production, higher wages, larger incomes, more employment--this is the siren song of monetary inflation and credit expansion.
At first, central-bank monetary inflation seems to make good on its promise of perpetual prosperity. Its open market operations supply banks with a new stream of funds to lend, drive up bond prices, and push interest rates below natural levels. Flush with funds, banks lend to entrepreneurs who are eager to obtain credit at below natural interest rates to pursue projects whose profitability has been artificially inflated.
Entrepreneurs make more profit across the economy and fewer losses. They expand production and employment by using the borrowed money to bid more intensely for factors, especially capital goods. Since the additional funds have not come into the banks by shifting them away from other expenditures, revenues and profits need not fall in other areas of the economy to provide this stimulant to banks and borrowers of the expanded credit.
Because the central bank allows banks to hold only a fraction of the funds in their checkable deposits as cash, money newly created by the central bank can be lent and deposited over and over. This results in a “money multiplier” effect. During the boom, banks’ balance sheets swell with loans on the asset side, balanced by checkable deposits on the liability side.
On paper and in government statistics prosperity seems to reign. In truth, the boom is filled with malinvestments and misallocations. All—though the practice of fractional reserves allows a magnification of monetary inflation and credit expansion, to the benefit of the banks in the boom, it results in a dangerous mismatch of the maturity of assets and liabilities. The swollen liabilities of checkable deposits are payable on demand to customers while the matching assets of loans are not recoverable on demand by banks.
Profits earned by entrepreneurs no longer correspond to the satisfaction of consumer preferences. Instead they are systematically distorted by the artificial spending stream fed by the central bank. Entrepreneurs are misled by the credit expansion into shifting the use of factors into activities considered less-valuable by consumers.
Some malinvestments and misallocations can be particular to the historical circumstances of each business cycle. Cronyism in some of the Asian countries and Russia, for example, channeled erroneous investments and factor allocations into lines which benefitted the politically-connected interests that had the inside track to bank loans. Cronyism, however, is not a causal factor in the business cycle, but a sideshow to the main event.
Central-bank monetary inflation and credit expansion cause a boom-bust cycle by distorting prices and profitability. They incite entrepreneurs across the economy to malinvestments and misallocations. With- out artificial credit-expansion, cronyism would result in higher profits for the cronies at the expense of lower profits or greater losses for the non-cronies. But it would not produce a business cycle.
The cronyism of the Japanese system was hailed as enlightened “government-business partnership” during the heydays of the 1980s. We were being told that America too must adopt this system or cede economic supremacy to the East. Now we know that half of all funds available for investing in Japan, nearly $1.75 trillion, were being held by the government-run, postal-savings system which “invested” funds in infrastructure boondoggles and “lent” funds to businesses that were too risky for private banks.
This is to say nothing of lifetime tenure for workers and government subsidies to companies to maintain employment and protect them from international competition. Nor were today’s critics of cronyism pointing to the “Asian Tigers” during their boom for having economies corrupted with political shenanigans. Even without the fuel of central-bank monetary inflation, a crony economy would be an inefficient producer and have stagnant or slow-growing standards of living.
Another sideshow often mistaken for the main event is bankers’ sudden loss of risk aversion. Increasing riskiness, however, is a necessary aspect of central-bank monetary inflation and credit expansion. Without such intervention, bankers properly balance their portfolios of loans, accepting additional risk only at higher interest rates, and extending loans to their most creditworthy customers for the projects most likely to generate profit. The additional credit created by central-bank monetary inflation will necessarily be extended to less creditworthy customers, both consumers and entrepreneurs, for projects less likely to be profitable.
Consumers, who could not obtain credit otherwise, are now able to entice entrepreneurs to satisfy their preferences by spending borrowed money. Individuals, who could not enter the ranks of entrepreneurs before, now find bankers willing to lend them start-up money. As a boom matures, bank portfolios are filled with loans that would not have been made, either for too much risk or too little return, in the absence of credit expansion. The longer the boom continues, the greater the errors within and emanating from banks.
Just as the boom builds outward from banks to the rest of the economy, with banks benefitting the most, the bust collapses inward to banks from the rest of the economy, with banks suffering the most. Now the balance sheets of fractional-reserve banks, swollen with loans and checkable deposits during the boom, suddenly collapse. Or rather, the value of their loans collapses initially, as the projects they lent to turn out to be unprofitable, leaving them with negative net worth; upon bankruptcy, their checkable deposits are liquidated.
Bankruptcy is made much more likely by the policy of fractional reserves. The checkable-deposit liabilities built up during the boom no longer have assets of equal value balancing them out once the crisis hits. Customers who know this have a great incentive to demand redemption of their checking accounts in cash, an obligation which fractional-reserve banks cannot fulfill even when the value of their assets is intact, let alone after their loans devalue.
Monetary deflation through bank failures is the other side of the coin of liquidation of bad loans. Liquidating the loans implies realizing the bankruptcy of the businesses that have taken out these loans. The monetary inflation and credit expansion of the boom are now reversed in the bust. The capital build-up of the boom must now be dismantled and factors reallocated into lines of activity made profitable by consumers.
Again, Japan is a case study. From 1985 to 1990, its economy was a powerhouse and the envy of the world. Encouraged by low interest rates, the largest six banks in Japan made $215 billion worth of real-estate loans. Since the bubble burst in 1991, commercial real-estate values have fallen 75 percent in six major Japanese cities.
Risky Japanese loans were not confined to real estate. Moody’s downgraded Toyota Motor Corp. debt from triple-A to double-A-1, leaving only nine Japanese companies with the triple-A rating (and five of these are being reviewed for downgrading). Mitsubishi, Hitachi, and Nissan all recently had their debt downgraded. Moody’s has even considered downgrading Japan’s triple-A, sovereign-debt rating.
It’s remarkable to consider that as late as 1993, Japan had the largest eight banks in the world, ranked by assets. Now, Japanese banks have the same share of the world market as they did in the early 1980s. In 1987, bank stock shares constituted 30 percent of all listed stock in Japan. Japanese banks currently make up only 12 percent of Japanese equity. One of the largest twenty banks in Japan and the world’s 67th largest in 1993, Hokkaido Takushoku Bank Ltd., failed last November.
Long-Term Credit Bank, ranked 14th largest in the world in 1993, had its debt rating reduced by Moody’s. Sumitomo Trust & Banking, number 16 in 1993, balked at a merger with Long-Term Credit Bank because of Long-Term’s bad debt, and rightly so, since Long-Term Credit Bank has now declared bankruptcy. Sakura Bank, number 5 in 1993, is now trading a price-to-book value of 0.81; that means investors think the bank is worth less than the value of its assets. Bad-loan write-offs have forced Sakura to plead for $2 billion in cash from its major shareholders to restore its assets and rebuild its net worth. Several other giant banks have seen their stock prices sink.
Japanese banks now suffer from carrying, by private estimates, over $1 trillion in bad debt, $600 billion of which is officially admitted. The largest six banks hold $131 billion in bad debt. And according to Japan’s Financial Supervisory Agency, more than one-tenth of all good debt has higher than normal risk of default. $256 billion of this high-risk good debt is held by Japan’s nineteen largest banks. For 1997, Japan’s top banks made 0.24 percent return on portfolio assets, making them the least profitable banks of any developed area. In the U.S., the banks’ return was more than five times greater at 1.33 percent.
The Japanese debacle has been repeated around the world. Allowing for the unique circumstances that will make the situation play out differently in each country, central banks and fractional-reserve banking systems have flooded their countries with money and credit. The result is a worldwide financial crisis and bust.
Now that central banks have created an international crisis, the best policy is to let the market work. Only entrepreneurs operating on an un-hampered market can restore economic health. Only they know how to reorganize production, reallocate factors, liquidate malinvestments, and reconstruct the capital structure in the best way. The bad loans should be liquidated, that is, sold at a discount to entrepreneurs who will specialize in their collection. The bankrupt banks and companies should be liquidated, sold to entrepreneurs who best know how to reallocate their assets, and the funds distributed to creditors.
Does a laissez-faire policy mean cruel hardship? No, since a laissez-faire policy would have prevented the boom and thus, the crisis and bust. It should have been adopted before the cycle began and its adoption now will prevent cycles in the future. Liquid- ation is the least-painful way to deal with the government-created bust. The more quickly this is done the sooner the economy can return to normal.
If the government, perversely, tries to forestall liquidation, then the depression will linger on indefinitely. In Japan the government has made liquidation difficult with various regulatory hurdles and unfavorable tax treatment. Almost the entire stock of bad loans remains on the books of banks making them financial zombies, unable to conduct normal business and unable to perform their crucial social function. The result is the paralysis of production.
A central bank policy of reinflation only leads to another wave of misallocations and malinvestments. Open market operations is a clumsy tool for repairing existing misallocations and malinvestments. A bank that receives an infusion of funds from the central bank will not use them to liquidate or renegotiate existing bad debt, but seek out new borrowers. It will lend to the most credit-worthy customer it can find instead of the least creditworthy one, i.e., the customer who cannot pay what it already owes the bank.
When the Bank of Japan in- creased bank reserves in an effort to reinflate, banks, already burdened with loads of bad debt of domestic consumers and entrepreneurs, took the additional reserves and lent them to businesses in Asia, especially South Korea, exacerbating the boom there. The Bank of Japan’s reinflation policy has piled foreign bad debt upon domestic bad debt and led to the devaluation of the yen. Banks have responded by further retrenchment; they make fewer loans at home and abroad. In the first quarter of 1998, their overseas lending fell by $244.3 billion.
A policy of bailout, even if it can be tailored to liquidate bad debt, creates moral hazard, making the next boom-bust cycle more extreme. If it goes to bail out distressed and bankrupt businesses, then the money is wasted entirely since these are the very operations that need to be contracted. Japanese banks are right to refuse to extend more loans for real-estate projects or to steelmakers like Toa Steel, which has declared bankruptcy under the burden of $1.82 billion of debt. The 30 trillion yen ($207 billion) bailout fund for banks proposed by the Japanese government will be money wasted prolonging and extending malinvestments. Moreover, bailouts are usually financed by more central-bank inflation and thus, result in further malinvestments and misallocations.
Japan will also try a 17 trillion yen ($128 billion) stimulus package. But, fiscal policy leads to more misallocations and malinvestments as the liquidated projects and unemployed factors are, at best, channeled into areas consumers do not value as highly as those selected by entrepreneurs. To favor fiscal policy as a palliative to the bust, one must favor the political expenditures of bureaucrats over the economic expenditures of entrepreneurs. The malinvestments must be liquidated and the misallocated factors reallocated.
All calls for people to consume more and save less or cries against “oversaving” are counterproductive. The problem in Japan is not “oversaving” or lack of fiscal or monetary stimulus. The problem is that the government refuses to let the market work. By refusing to allow bankrupt institutions to fail, it has forestalled the liquidation process necessary for recovery. Until it permits liquidation, the Japanese economy will remain moribund.
Some good can result from the recession and depression in Asia and elsewhere. It serves as a model case of how credit manipulation by central banks, combined with fractional-reserve banking, creates economic crisis and causes human suffering. Restoring the market economy and sound money is the only way out.
Jeffrey M. Herbener is professor of economics at Grove City College and senior fellow of the Mises Institute.
Further reading: Ludwig von Mises, The Theory of Money and Credit (Indianapolis, Ind.: Liberty Classics, [1912] 1980); Murray N. Rothbard, America’s Great Depression (New York: Richardson & Snyder, [1963] 1983).
