In previous blogs I’ve explored the possible causes of boom and bust cycles, in particular the origins of the Global Financial Crisis. I recently came across Dr Mark Skousen’s book The Structure of Production. He explains how modern macroeconomics is flawed as it ignores the structure of production and time. He advocates a microeconomic approach to macroeconomics, where the vertical structure of production, which captures the full production process from raw inputs to final consumption, is analysed in addition to the traditional aggregated horizontal view.
He discusses how different segments of the economy react to changing interest rates. As a general rule, the further a segment is from the retail sector or consumer end of the production line the more sensitive it is to changes in interest rates, as these segments generally involve large investments in capital, with long life spans. This includes property and engineering construction, infrastructure and R&D. They also tend to be the most volatile sectors throughout the business cycle.
Skousen explains how the Keynesian approach to economic policy tends to perpetuate the boom and bust cycle as it ignores the time preference of consumers. Consumers make a decision about what portion of their income they’re willing to save, in other words how much current consumption they’re willing to forgo in order to increase future consumption. Aggregate private savings are then diverted to the business sector for investment. The greater the level of saving, the lower the interest rate and the more available funding the business sector has for expanding operations and investing in capital. As interest rates fall, the profitability of longer term projects increase. This investment drives the expansion of future consumption and economic output.
An issue arises when interest rates are artificially lowered, via expansionary monetary policy. A mismatch occurs between saving and investment as consumers haven’t changed their preferences. The ratio of consumption versus savings remains unchanged. The gap between investment and saving is filled by expansionary monetary policy. As interest rates fall businesses are encouraged to commence longer term projects and invest in capital, and as a result the economy expands. Employment and incomes increase, which leads to increased consumer demand. Since consumers haven’t adjusted their preferences, demand will rise. As this scenario plays out there may be pressure on central banks to raise interest rates as increased consumer demand ultimately stimulates inflation.
Businesses and sectors closer to the retail end of the production line will face increased profits as consumer demand rises. And as a result may compete for labour with the more capital intensive end of the production line, which may lead to cost pressures. Those sectors that have invested in longer term and longer term projects will find that the profitability of these projects will fall as demand for their output wanes and interest rates, if inflation becomes an issue, rise. Ultimately longer term projects will be put on hold, unemployment will rise and incomes will fall. The boom cycle goes into reverse and an economic downturn emerges.
He also explains how GDP is a misleading representation of the economy. It is the sum of final output and excludes intermediate goods to prevent double counting. A more accurate view of economic activity is gross output, which incorporates total spending, the sum of spending on intermediate and final goods. Consumption represents 70% of GDP, however it only represents 30% of gross output, while business and capital spending represents 70% of gross output and only 30% of GDP. Thus business and capital spending have a much greater importance than GDP figures portray.
This theory makes a lot of sense to me, particularly when you consider the situation in the US at the moment. The Fed has kept rates low for an extended period, not just since the GFC but prior. This has without a doubt created distortions in the structure of the economy and a consumer society that spends way more than it saves. As I’ve discussed in previous blogs, China and the emerging world has aided this consumption through financing government debt and the export of cheap goods. This theory really drives home the fact that you can only use expansionary policy to a certain extent before it distorts an economy and creates dangerous imbalances.
Now the Fed is struggling to raise rates and put an end to quantitative easing. Each time the Fed attempts to prepare the market for a future rate rise, confidence falls. This week is a perfect example. The bond market went into a frenzy, yields dropped by more than they did in the 2010 flash crash and then recovered before closing. This was in response to less than positive data and the anticipated end of quantitative easing. Bond yields in Australia fell due to global financial market volatility, deflation threats in Europe and the prospect of US interest rates not being raised for some time.