Gold News

How Booms Beget Inflation

Via malinvestments and economic misalignment...

THE MOST recent report from bank ANZ on the troubles currently afflicting the Ozzie mining boom made a rather pertinent observation, writes Sean Corrigan for the Cobden Centre.

According to ANZ:

While most first-generation projects will be built, many projects plotted out on drawing boards in recent years will not come to fruition in the foreseeable future. In part, this is due to the reality that there simply would not be sufficient available capital or labor to complete them. Indeed, this report suggests that of the 950 projects identified as currently underway or proposed in Australia, up to two-thirds may not proceed in the planned time frame.

As we will argue below, this observation neatly encapsulates the key Austrian insight that the Boom ends – as Mises always insisted it does – due to scarcity and not to the development of some mythical state of widespread over-abundance.

It is through this developing scarcity that what we call 'malinvestments' are ultimately uncovered. By this expression we mean those undertakings which were launched on what is belatedly recognized as an unwarranted scale only because there was an inordinate increase in the availability to their promoters of what Fritz Machlup termed 'created' credit (something that went under the name of 'fictitious capital' in the even more descriptive, older parlance). 

The extent of such 'malinvestments' – and the intrinsic shakiness of their foundations – are revealed when the lack of any REAL capital corresponding to that fiction finally begins to bite, rendering moot the entrepreneurial calculations behind them.

The dearth usually shows up in the form of such threats to profitability as higher input prices, longer delivery times, and lower customer demand (this last arising since many prospective buyers will by now be facing their own, analogous strains). We Austrians talk here of there being a scarcity of complementary factors of production, rather than focusing on a supposed glut of capacity in the sector which is now seen to be struggling.

Typically, this revelation has a greater effect the higher up the chain of production we go (i.e., the further along a hypothetical line of processes stretching from the strip mall towards the strip mine) since here we tend to find that the output in question is both more specialized and less fungible than that which is created 'lower down' the productive structure and so nearer to its final apotheosis as a consumer good. 

The 'higher order' product has fewer alternative market outlets, if you will, and certainly enjoys less immediacy in the final realization of its function in satisfying people's needs. The path to completing its formation of value is much more tortuous; the release of the funds necessary to its success, and thus the vindication of its initial creation, more protracted.

Moreover, the purchase of said output is much more discretionary when of 'higher order' – since its uptake involves what is generally, if loosely, termed 'capital spending' on the part of others and this, of course, consists of both highly contingent and readily deferrable outlays and so is typically the first expenditure to fall victim to the effects of disco-ordination and faulty estimation being experienced elsewhere in the system. 

Furthermore, given that such disruption is, as we shall argue, to be laid at the feet of the faulty operation of the credit system, the greater the number of links in the chain between a good and its definitive contribution to consumer satisfaction, the more opportunity for credit-related problems to intrude.

Ultimately, it is not so much 'over-capacity' in mining (or housing, or solar panels, or diesel engines, or whatever is found to constitute the crisis of the day) that is the problem. Instead, what is being made manifest is the unfavorable constellation of costs and selling prices which has emerged because much of what is being built-out is not consistent with the overall schedule of desires of end-consumers and hence with the timely distribution of goods, services, labor, and land which these latter economic 'sovereigns' require for the fulfillment of these, their more urgent needs – both in the moment and over the entire course of the failing projects' investment lengthy horizons.

To see why we assign such a key role to the interaction of money and credit in the propagation of mass, systemic error – and hence both to the boom and its ensuing bust – we must first insist on the distinction which is to be made between 'created' credit and what Machlup again termed 'transfer' credit. 

The former involves the synthetic generation of a disembodied accounting entry (or, else, a banknote or token coin of trifling intrinsic worth) which, no-matter how insubstantial its essence, nonetheless endows its new possessor with what is effectively a full quantum of new purchasing power. In contrast, the latter represents the recording of a voluntary, contractual surrender of an extant unit of such power by the lender (or vendor financier) in favor of the borrower so that the recipient can deploy it as he sees fit during some specified passage of time.

Since the former – the 'created' credit – adds an ability to spend which is unrelated to the prior production of goods or performance of service, it cannot fail to introduce an avoidable and highly regrettable degree of fluctuation in the process of exchange which is intrinsic to all of that material human activity which is conducted beyond the bare subsistence level of autarky.  The latter, 'transfer' credit, in contrast, merely passes from one party to another a claim upon the pool of available goods (or current services) which has been already made valid by dint of an antecedent contribution to that same pool.

It should go without saying that this passing of the baton has the potential to alter the specific choice of the object of its subsequent expenditure and, hence, that it can – and should – alter relative valuations between those items now feeling the force of less or more immediate demand, according to the varying preferences of debtor and creditor. But what it cannot do is to allow both parties to the transaction to turn up at the same time, in the same place, laying claim to the same share of an unexpanded endowment of goods, or an unenlarged capacity to perform service and thus create a shockwave of overbidding to ripple out through the whole Higgs field of money-goods interactions.

Conversely, since an effusion of created credit does allow precisely such a simultaneous expression of demands, it cannot do other than to sow the seeds for strife where there should only be a willing co-operation, by perverting what should have been a mutually-satisfying exchange of goods today for goods tomorrow (i.e., on either coupon or redemption day) into an unseemly Supermarket Sweep wherein both of those involved in the initial trade rush to fill their shopping carts, each striving to use his own version of this falsely duplicated means of purchase before his counterparty has a chance to pre-empt him.

Such a conflict will tend to resolve itself in a higher price being paid for the fought-over goods – with the associated drop in real living standards this entails all too frequently falling, not on the guilty parties, but on some unknowing innocent who turns up later only to find that the shelves are nearly bare and that what is left costs a great deal more than expected.

 'Inflation' is what we term such a social ill.

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Stalwart economist of the anti-government Austrian school, Sean Corrigan has been thumbing his nose at the crowd ever since he sold Sterling for a profit as the ERM collapsed in autumn 1992. Former City correspondent for The Daily Reckoning, a frequent contributor to the widely-respected Ludwig von Mises and Cobden Centre websites, and a regular guest on CNBC, Mr.Corrigan is a consultant at Hinde Capital, writing their Macro Letter.

See the full archive of Sean Corrigan articles.

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