In an attempt to side-step the political fallout from the recent stock market sell-off, George W. Bush told us that we were suffering from a hangover caused by the economic follies of the 1990s. While this was nothing more than a crude attempt to get the monkey off his back, it contains more than a grain of truth.
What the economy is suffering from is a Hayekian hangover. Friedrich von Hayek and other members of the Austrian School of Economics developed a comprehensive theory of the business cycle early last century. It reached a pinnacle in 1930-31, when Prof. Hayek delivered his famous lectures at the London School of Economics. Unfortunately, with the publication of Keynes' General Theory in 1936, Austrian cycle theory went out with the Keynesian tide. Austrian theory is in the process of being restored to its former sterling status, however. Indeed, it now receives a serious hearing, even in certain central banking circles. For example, in recent years, the Bank for International Settlements in Basel, Switzerland has repeatedly warned that the U.S. economy is in the grips of a classic Austrian business cycle. Accordingly, to comprehend where the economy has been and anticipate its future course, an understanding of Hayek and the Austrians is necessary.
For the Austrians, things go wrong when a central bank sets short-term interest rates too low and allows credit to artificially expand. Interest rates that are too low-lower than those that would be set in a free market-induce businesses to discount the future at artificially low rates. This pumps up the value of long-lived investments and generates an investment-led boom, one that is characterized by too much investment and investment that is biased towards projects that are too long-lived and too capital intensive.
An investment-led boom sows the seeds of its own destruction and is unsustainable, however. Indeed, on the eve of the downturn investors find that the loanable funds for investments are too expensive to justify commitments they made during the preceding monetary expansion. Some businesses engage in distress borrowing, profit margins collapse under the weight of too much costly debt, and-if that is not bad enough-many businesses are saddled with excess capacity, resulting from what turned out to be wrong-headed investment decisions. With that, the investment-driven boom turns into a bust. In short, artificially-created investment booms always end badly.
At present, the manifestations of a boom-bust episode litter the economic landscape. Bankruptcies are on the rise, with WorldCom representing the most spectacular example. In addition, many investment projects have been abandoned or curtailed. For example, a July 19th front page story in the Financial Times reported that the Securities Industry Association, an umbrella organization of investment banks and brokers, postponed an $8 billion investment to modernize markets.
A Hayekian hangover will vary in its duration and intensity, depending on the degree of the preceding over-investment/malinvestment binge, as well as the state of confidence that accompanies the downturn or hangover phase of the cycle. During this phase, a central bank's attempts to restart the economy by pushing interest rates down will-contrary to orthodox economic doctrine-only delay the required capital restructuring process and prolong the hangover.
If this hangover phase-working off excess capacity and transforming the capital structure to shorten the length of production processes-is not bad enough, the economy is vulnerable during this phase to what Austrians termed a "secondary deflation." If a general feeling of insecurity and pessimism grips individuals and enterprises during a Hayekian hangover, risk aversion and a struggle for liquidity (cash reserves) will ensue. To build liquidity, banks will call in loans and/or not be as willing to extend credit. Not surprisingly, banks are already scrambling for liquidity. During the past 17 months, banks have been cutting back on corporate lending, shunning especially industries like energy, textiles, steel and telecommunications that over-invested during the boom. Moreover, banks are charging higher rates and bigger up-front fees on most other loans, even to top-rated companies. Households, too, are liquidating assets to increase their cash positions and pay down debts. Indeed, they pulled $13.8 billion out of U.S. equity mutual funds in June. This scramble for liquidity will put a further damper on investment as well as consumption.
Several aspects of a secondary deflation are worthy of further comment. If the forces of a secondary deflation are strong enough, a central bank's liquidity injections can be rendered ineffective by what amounts to private sector sterilization. When people expect falling prices and a real deflation, their demand for cash will increase, soaking up liquidity injections. This has been the recent experience in Japan, where prices continue to fall in the face of year-over-year base money and yen note (cash) growth rates of 30 and 15 percent, respectively. While milder forms of a so-called secondary deflation don't result in real deflations, they do undermine economic growth and extend the life of Hayekian hangovers.
Even though the primary cause of a downturn is an over-investment boom, understood in the Austrian sense, Hayek acknowledged that a secondary deflation could ensue and that it could be best understood in Keynesian terms. This is particularly relevant in the current US context. Prof. Wynne Godley of Cambridge University made this perfectly clear in a July 16th letter to the Financial Times. He noted that in the first quarter of 2002, the household sector of the economy was in deficit by 2 percent of disposable income. Such a deficit, which is unusual, can be financed either by borrowing or by selling assets. With the sinking stock market, high debt ratios, and the current state of confidence, people could easily decide that it is time to put their financial affairs in order. If households' net savings were to revert to their long-term norms, personal consumption, according to Prof. Godley's calculations, would fall relative to income by 6 percent. In consequence, consumption, which has been holding the economy's head above water, would sink as investment has already done.
The U.S. is already in the grips of a Hayekian hangover and the seeds of a secondary deflation are threatening to sprout. Two factors make the threat of a secondary deflation more likely with each passing day: the war on corporate America and the war on terrorism. Past corporate shenanigans continue to be uncovered with alarming regularity. In response, the Congress, in a fit of demagoguery, has declared war on corporate America. This has further panicked investors, shattered confidence, increased risk aversion and set off a scramble for liquidity.
Will Washington's warriors, armed with new legislation and regulations, put a stop to corporate malfeasance? Probably not. After all, the Securities and Exchange Commission has been around since 1934, and as Prof. George Stigler of the University of Chicago has convincingly shown, it has failed to have much effect on the flamboyant falsehoods that on occasion appear in prospectuses and company accounts. If Congress is serious about protecting investors and rooting out malfeasant corporate executives, it should remove the impediments and lower the costs of mounting hostile takeovers by repealing the Williams Act of 1968. The threat of hostile takeovers (more competition) is the only way to remove the protective cocoons that envelop corporate crooks and incompetents.
Perhaps the most underrated factor undermining confidence is the war on terrorism. Among other things, the war effort has diverted the Bush administration's attention away from virtually all things economic. In consequence, the administration does not have a consistent and plausible economic game plan. And without a game plan, economic confidence suffers.
In addition, there are longer-term consequences. The U.S. is engaged in a war with an elusive enemy and a very uncertain outcome. The only certainties are that this war, as it is being prosecuted, will have a very long duration and will consume meaningful resources. The diversion of those resources toward a war effort will be a drag on the economy.
The medium-term (approximately the next five years) economic consequences of the war on terrorism are analyzed in a recent study, "Economic Consequences of Terrorism," published by the Organization for Economic Cooperation and Development (OECD) in Paris. According to the OECD, the war will affect the international economy through three primary channels: a transformation of the insurance industry, depressed trade due to higher transportation costs, and increased government spending on security. It is important to stress that the OECD study is ultra-conservative. Specifically, it assumes that there will be no further terrorist success stories and that there will be no pre-emptive strikes against the likes of Saddam Hussein.
The insurance industry suffered windfall losses estimated at $30-58 billion from the September 11 terrorist attacks on the U.S. Even though no insurers were forced into bankruptcy, their capital bases took a big hit and many saw their solvency ratios go to extremely dangerous levels. In consequence, insurers have reduced their coverage and raised premiums by 30 percent on average, with potential target structures such as chemical and power plants and "iconic" office buildings paying even more.
Many insurers used the terrorist attacks to rationalize government intervention and government assistance. Some countries-such as Spain, the UK, France, South Africa, and Israel-have already introduced government mechanisms to insure against the risk of terrorism. Though these interventions were introduced as temporary measures to be subsumed by the private sector at a later date, many have persisted well beyond their original mandates. In this vein, the United States has proposed a "Terrorism Risk Insurance Act" to absorb excessive losses for the insurance industry. That bill has been read twice in the Senate and referred to the Committee on Banking, Housing and Urban Affairs.
International trade will suffer due to increases in transportation costs. The fear of a terrorist incursion through porous (i.e., trade-friendly) borders has resulted in demands for additional checks and searches at ports and land borders. Thus, "compliance costs"-the cost of collecting, producing, transmitting and processing required information and documents-will likely increase by 1 to 3 percent of the value of traded goods, up from their current levels of 5 to 13 percent. Since international trade is quite sensitive to increases in transportation costs-the elasticity of trade flows with respect to transportation costs is estimated at -2 to -3, meaning that a 1 percent increase in the cost of trading internationally reduces trade flows by 2-3 percent-the war on terrorism promises to put a big drag on international trade.
In addition, delays in shipments and other distortions to trade flows resulting from new regulations will disrupt just-in-time supply chain management techniques developed over the past decade. As a precaution against interruptions in the supply chain, firms may begin to carry larger inventories, requiring new infusions of working capital. If inventories climb to their "pre-just-in-time" levels, the additional carrying cost is expected to reach 0.7 percent of US GDP.
Increased defense spending is also a foregone conclusion. According to the OECD, higher levels of government spending will erode the post-Cold War "peace dividend" and impact the economy through three channels. First, since increased military spending will most likely be financed through new debt issuance, long-term interest rates will rise. Second, reallocating capital from the private sector to the public sector will reduce labor productivity. Third, the trend of fiscal consolidation observed since the end of the Cold War is likely to be undermined, leading to negative impacts on long-term expectations.
If you add the lack of a U.S. economic game plan, the war on corporate America and the war on terrorism to a Hayekian hangover and the precarious state of corporate and household confidence and finances, you have the increasing likelihood of a secondary deflation and a double-dip. And if that short-term prospect isn't gloomy enough, consider what promises to be the legacy of George W. Bush's first term: a ballooning of the modern regulatory state, one that will far surpass the dreadful deeds inflicted during the Nixon years. For a sobering account of where that will lead us, there is nothing better than Prof. Hayek's 1944 classic, The Road to Serfdom.
This article was published in Friedberg's Commodity and Currency Comments, v. 23, no. 4, July 29, 2002. The original version was presented as the Inaugural Friedrich von Hayek Lecture, The International Life & Annuities Forum, Southampton, Bermuda, June 26, 2002.