One of the most examined and discussed topics in all of economics is the infamous, dreaded business cycle. The pattern it displays is a familiar one: first a boom where the economy is strong, and then a sudden and unwelcome bust that severely weakens the economy. Despite the copious amount of literature on the subject, very little has been written about the “hinge” or “tipping point” of the business cycle, where the boom turns to bust. On its surface, this is quite surprising. After all, it is at the transition of boom to bust where the flow business cycle turns from good to bad. Even so, there is a significant dearth of understanding on this topic within the economics profession.
However, some schools of thought are more guilty of this oversight than others. The Austrian theory of the business cycle — which explains the business cycle through a structural and intertemporal misallocation of resources — does explicitly affirm that the bust comes about as a result of the calculations of the entrepreneur in light of higher interest rates. The usual story goes something like this: the boom is started when interest rates are artificially pushed below their natural levels by credit expansion (inflation through credit markets). These lower interest rates induce entrepreneurs to view long-term, more roundabout investments as being more profitable. They embark upon these investments, to their own eventual detriment. When interest rates are raised again, these investments are revealed to be unprofitable and must be abandoned. The result is the bust, where the losses from malinvestments are felt and reallocation of resources takes place.
Nothing about this is incorrect per se, but it is uncharacteristically vague and stilted for Austrian analysis. In this scenario, the entrepreneur is presented almost as an automaton that instantly and quickly responds to market signals. While this is consistent with the Neoclassical view of the entrepreneur (if only implicitly), the Austrian tradition — and specifically, the Misesian branch of that tradition — places a special emphasis on the subjective judgment of the entrepreneur in guiding the market process. It seems only in keeping with this tradition that the entrepreneur’s role in the tipping point of the business cycle should be further examined to understand precisely how the economy tips from boom to bust.
First, what characterizes the “bust” of the business cycle? In the Austrian theory, the bust is the necessary result of the mistakes made during the boom. Consequently, the seeds of the bust are sown during the boom. In other words, once the boom has started, the bust is unavoidable. Despite its inevitability, the bust is only realized once interest rates rise from their artificially low levels, and the economic calculation of the entrepreneurs is altered. Where once these investment projects looked profitable due to higher present values of future revenues and lowered cost of borrowing to finance the investments. When interest rates rise again, then the value of these future revenues fall while the costs of continued financing increase, these projects are no longer profitable. The only option, then, is to liquidate these investments, suffer the losses, and begin the process of recovery.
Clearly, then, the onset of the bust — as with the onset of the boom — is inextricably linked to the economic calculation of entrepreneurs. However, it is crucial to remember that while the comparative revenue/cost accounting of economic calculation is objective, the determination of those revenues and costs is a reflection of subjective entrepreneurial judgment. Whenever the entrepreneur examines any prospective business venture, he must estimate — to the best of his ability — future consumer wants and desires. However, the future is always uncertain. What may have been a successful product in the past may turn out to be unprofitable in the future. It is the task of the entrepreneur to navigate this uncertainty to provide the best products to consumers at the lowest possible cost. Crucially, this judgment also applies to the revenues and costs of any prospective investment project. These too are uncertain, and must be forecasted by the entrepreneur. The production of a particular good or service may in fact turn out to be more expensive than originally believed, or the may sell at a lower price than expected. The future will reveal which entrepreneurs were correct in their estimation of revenues, costs, and consumer desires, but these production decisions must be made in the present.
This component of judgment within an entrepreneur’s economic calculation is particularly important in the unique environment of the boom and bust. During the boom, the appearance of lower interest rates generates an increase in consumption at the same time investment projects are underway (this occurs because lower interest rates give the illusion of higher total capital values, making increased consumption appear feasible). This increase in total economic activity gives the illusion that the economy is much wealthier than it actually is, which creates a pervasive sense of optimism throughout the economy. It is precisely because of this false and unfounded optimism that many economists and political opportunists have been deluded into thinking the boom is good, and it is merely the bust that must be avoided. Much to their chagrin, however, the boom does not last forever, and this optimism is dashed upon the rocks of the bust.
Even so, entrepreneurs are not immune to the general sense of optimism that the boom foments. Along with the rest of the economy, they will become more confident in their investment decisions when they see the rest of the economy in a superficially strong state. This confidence will only build and grow the longer the boom is maintained. As a result of this optimistic, positive outlook, as soon as the errors in their investment decisions are revealed, entrepreneurs will at first remain confident and phlegmatic. In their minds, there is no cause for alarm. Sure, interest rates may be high now, but surely this is just temporary. While these investment projects may seem to be unprofitable now, surely this is only a short-run phenomenon and in the long-run they are still sound and productive. After all, the overall economy is still strong and has been for quite some time. Given some time, interest rates will fall once again and this setback will be nothing more than an unhappy memory.
Eventually, however, this confidence will begin to run out. As interest rates continue to rise rather than fall, the belief that the unprofitability of their investments is temporary will begin to wane. Unwelcome thoughts of giving up and abandoning their investments can no longer be avoided. Even at this point, however, some stubborn entrepreneurs may hold on, refusing to give up on investments that have consumed so much time and capital. Entrepreneurs are not immune to the Gambler’s Fallacy any more than the rest of us — especially when faced with potentially disastrous economic developments.
Losses may be taken in the short-run to maintain these unsound investments, but these losses cannot be taken indefinitely. The liquidations will start with firms that are the least able to take such losses, such as those that are relatively illiquid or barely profitable as it is. They will abandon their projects, selling off whatever they can and dumping the rest for scrap to recoup as much of their investment as possible. Whatever funds cannot be recovered have to be taken as a loss. As these losses are realized and publicized, a broader sense of panic will begin to set in. Upon seeing other firms having to abandon their investment projects, a systemic effect begins to take place. As firms take losses on their investments, their weakened financial position will negatively impact their stock value, as well as introduce the possibility that they will no longer be in a position to repay bonds and other short-term debt. This, by extension, places other firms that hold that stock or debt in a weakened financial state, which creates a stronger incentive for them to cut any unprofitable ventures — including their now-failing investment projects. The result is a spiral where the liquidation of some firm’s investments quickly snowballs into the liquidation of malinvestments more generally. At the bottom of this deadly spiral lies the bust, where the economy begins to realign prices with consumer desires, reallocate capital, and start the long road to recovery.
The bust wrecks not only the economy, but the psyche of the entrepreneur class. Where they had previously been so confident in their investment decisions, that confidence has now been thoroughly shattered. Those entrepreneurs who have avoided bankruptcy are now more cautious and wary than ever before. The scale and scope of their business operations will be severely reduced, as their risk tolerance is now much lower than during the boom. They will also be much more hesitant to expand their operations or embark upon longer production processes. The result of this risk-averse psyche is that the length of the bust is prolonged and the recovery process more sluggish and lethargic.
To quickly summarize, the bust is brought on by rising interest rates, which reveal the malinvestments of the entrepreneurs, and when their confidence in these investments runs out the losses are realized. Whereas the rise in interest rates is fairly easy to objectively observe, it is much more difficult to measure something as abstract as entrepreneurial confidence. Is there any way for us to predict when this confidence will collapse and the bust will arrive? Unfortunately, no. However, this doesn’t mean that we are completely blind regarding the timing of the bust.
Depending on the institutional factors and market conditions at hand, we can expect a relatively shorter or relatively longer interim period between the rise in interest rates and the chaos of the bust. While some of these measures could hasten the onset of the bust, the vast majority are directed towards fending it off for as long as possible in an attempt to avoid the pain of realizing malinvestments.
The first of these potential bust-delaying tactics is what might be labeled the “camaraderie effect”. Whenever businessmen and industry leaders can feel that the happy times of the boom have abruptly ended and the bust is on the horizon, they may try to band together in order to prevent the coming crash. None of them want the broader economy to collapse, so they may try to help out their fellow firms to endure through the hard times in hopes of staving off a general crisis. These types of measures may include friendly low-interest loans to struggling businesses (this is especially likely in the banking sector), handshake agreements to not call on each other’s debt and risk a general collapse, and larger firms buying out smaller, struggling firms to avoid bankruptcy (such as Bank of America did with Merrill Lynch in 2008).
However, all of these efforts merely delay the inevitable. Economic realities come for us all, and the reality of the bust is that the more roundabout production processes that have been started cannot be finished. No amount of gentlemen’s agreements or sweetheart loans will remedy that underlying fact. These efforts of camaraderie may delay the onset of the bust by temporarily preventing the marginal firms from collapsing under the weight of their malinvestments, but they will never avoid it altogether.
Another of these tactics is what may be labeled the “bailout effect”. If businesses believe that the government will bail them out if the economy crashes, then they have much less incentive to realize their losses now if the government or central bank will buy up these “toxic assets” at face value later. The result is that firms weighed down by these malinvestments will simply hold onto these investments for as long as possible in the hopes of avoiding reaping the fruit of their errors Of course, not all businesses will be able to take advantage of the bailouts, if they do come. Some investments will have to be liquidated for the bust to arrive before any bailouts will ever be considered to “save the day”. As mentioned above, those first to jump the investment ship will be the illiquid and marginally profitable firms, leaving larger and more profitable firms as those who are able to enjoy the bailouts and avoid losses.
Insofar as any firms are bailed out of their malinvestments, this does not avoid the bust. All it does is transfer costs of the bust and the pain involved in the subsequent economic realignment to the taxpayer. As politically convenient as this might be, it is economically disastrous. Reimbursing the entrepreneurs for their malinvestments prevents — or at least, postpones — the post-bust readjustment process. Rather than capital and labor being moved from the higher-order to the lower-order goods, the removal of their malinvestments allows them to remain where they are at in the production structure. Eventually, those entrepreneurs in the higher-order goods will feel pressure to move down into producing lower-order goods. However, as long as credit is cheap in the aftermath of the bust, they may be able to survive by continually issuing debt. The popular term used to describe companies in these situations are “zombie companies”, and this economic environment is very similar to that which prevailed after the 2008 Recession.
These and other bust-delaying tactics all have the same effect: preventing the necessary readjustment process of the market and elongating the period of suffering that adjustment will bring. Similar to the boom-infatuated economists, any bust-delaying entrepreneurs have an inverted view of the business cycle. The bust is painful, but it is necessary.
The tipping point, while perhaps the most neglected aspect of the business cycle, is one of its most integral pieces. It is in the tipping point where so many monumental decisions are made — whether the bust will be accepted and malinvestments liquidated, or if the inevitable crash will be delayed and postponed for as long as possible. Ultimately, the outcome is the same. The only difference is the pain involved along the way. If the bust is not dragged out and allowed to naturally reallocate resources, then the economy will quickly be on its way towards economic growth once again. Poorer than before, but firmly on the path of recovery. Alternatively, if the bust is delayed and every measure is taken to soften the blow, there is no greater folly. The pain itself is not avoided, but only spread out or transferred to someone else (as in the case of taxpayer bailouts). Furthermore, as the attempts are made to reinflate the boom, the seeds are sown for the next crisis. Then, the tipping point is not from boom to bust, from the boom to a perpetual economic purgatory. In such a state, the only hope for sustained, real economic growth is a complete repudiation of interventionism and allow the market process to run its natural course.