The Economic Culture of Boom and Bust

0:00Well, seeing as Tom has used up some of my time, and as I'm the only thing standing between you and your lunch, I'll try to be brief. Several of our talks this morning have focused on war, problems with the warfare state, and I want to take us back to our discussions from yesterday and talk about the business cycle. And as we all know, the business cycle has very serious and harmful effects on the economy. My topic today is something a little different. I want to focus on the social and cultural effects of the business cycle. The relationship between social and cultural factors and economic factors is an interesting and complex one.

0:48It's widely recognized that social, cultural, legal, political factors are very important determinants of economic performance. Indeed, those are the primary determinants of economic performance, far more important than things like natural resource endowments, the weather, population density, and so on. However, what's less well known within the Austrian literature, certainly, is the degree The theory to which social and cultural factors are the result of economic activity, are affected by economic performance. It doesn't take much reflection to realize that this is true. We know that prosperity, for example, facilitates peace, intellectual and scientific development, the flourishing of literature and the arts, Whereas economic and financial distress brings about conflict, violence, and a general decline in social and cultural achievement.

1:50For instance, there's quite a bit of research in the social psychology literature on the effects of unemployment, the effects of recession, economic recession. Unemployment is associated with self-reported feelings of unhappiness, anxiety, stress, and so on, as well as observable manifestations like domestic violence, divorce, even suicide. Moreover, persistent unemployment is thought to lead to feelings of helplessness, despair, alienation, etc. And the most important consequence of recession, as I'll emphasize later, is the fostering of a general belief in society that the market has failed, that capitalism has failed, and that the sure hand of the state is required to rescue the victims, to provide a safety net, and so on.

2:47Now it turns out there's very little in the social psychology literature on the effects of inflationary booms. But the credit-induced boom that we study in the Austrian business cycle literature itself can have very important social and cultural consequences. Overconfidence, financial irresponsibility, an increase in time preferences, increased preference for present consumption as opposed to future consumption and even in extreme cases, such as hyperinflations, very serious changes in the larger social order itself. So let me spend a few minutes talking about booms, some of the social and cultural effects of booms, and then I'll conclude by talking about busts.

3:41I have to emphasize that by boom, I'm not talking about a general period of prosperity, secular economic growth, the overall level of well-being that we expect in a free market. I'm talking specifically about artificial booms, credit-induced booms, the inflationary boom that is the result of central bank intervention in the economy. Let's just briefly review the characteristics of the inflationary boom. Credit expansion, interest rates that are pushed below their natural or market rates of interest, increases in debt both at the personal and corporate level, over investment in the higher order goods or capital goods relative to the lower order or consumer goods, so malinvestment, and some form of price inflation.

4:33Now, how the price inflation manifests itself obviously differs from boom to boom. Sometimes it's reflected in higher prices for consumer goods. Sometimes a lot of the price inflation is channeled into the real estate market. Some of it can dissipate into the foreign exchange market and so on. However, persistent inflation is everywhere and always, we might say, a monetary phenomena as a result of central bank intervention. The overall result of these characteristics is what we might call an illusion of prosperity, an illusion of material prosperity. It's an illusion because it's artificial. It's temporary, right? As Mises, Hayek, Rothbard and others have shown, every such inflationary boom contains the seeds of its own destruction, will inevitably lead to the bust.

5:29to the Bust. I want to talk about two categories of social and cultural consequences of the boom. The first we might categorize as sort of general consequences of artificial prosperity, this illusion of prosperity. This would include intangibles like overconfidence, particularly among entrepreneurs, the belief that there are no trade-offs in life, we can accomplish whatever we want, pursuit of instant gratification, along with tangible manifestations such as higher fertility rates, higher school dropout rates, increased entry of women into the labor force, reduced scrutiny by investors of corporate activities. We could also talk about specific consequences of the mechanism by which the boom comes into being, namely credit expansion, lower interest rates, specific consequences of cheap and easy credit, such as increases in debt, increases in consumer debt, changes in housing patterns, and when accompanied by significant price inflation, we have reduced savings, what we might describe as a reduction in Prudent behavior more generally, potentially class conflict between debtors and creditors and in extreme cases a wholesale rejection of the traditional social order.

6:56So let me discuss both first the general consequences of artificial prosperity and then the specific consequences of credit expansion. The artificial boom, as mentioned, creates this sort of general feeling that things are good, that we have widespread prosperity. This sort of what we might call illusionary hubris manifests itself in several ways. It encourages irresponsibility on the part of entrepreneurs, unusual excessive risk-taking, entrepreneurship of course is intimately tied up with risk.

7:45The nature of entrepreneurship in the Misesian sense is bearing of risk, trying to align factors of production in ways that will yield future benefits. Entrepreneurs are, of course, always taking risks. Sometimes they guess right, sometimes they guess wrong. Entrepreneurs who consistently guess wrong eventually cease to be entrepreneurs. That's the role of the profit and loss system. The general climate of prosperity that we find with a credit created or inflationary boom tends to distort the profit and loss mechanism, distorts these profit signals, right? Entrepreneurs can get away with risky activities that they would normally not be able to get away with. We only need to think about the dot-com bubble of the late 1990s, not of course talking about the wonderful benefits of the dot-com era such as Mises.org, as Jeff was talking about this morning, but some of the crazier schemes and ventures that are familiar to you.

8:46So entrepreneurs have sort of a feeling of invulnerability that leads them to engage in excessively risky behavior because the profit and loss mechanism, profit and loss signals are distorted. But Mises puts it this way in a 1946 essay. He says the wealth generated during an inflationary boom is, quote, a castle built on the sands of illusion. So entrepreneurs as well as consumers are given a sort of a detachment from reality. This overconfidence also manifests itself in consumer behavior. Consumers increase their spending. They tend to discount opportunity costs.

9:31They tend to ignore things like retirement planning, engage in day trading as they watch stock prices soar, and so on. and so on. You know, I might add that the famous book by Thorsten Veblen called The Theory of the Leisure Class, which was published in 1898, became famous in the 1920s during the boom that preceded the Great Depression. Veblen's book introduced the phrase conspicuous consumption that our left-wing friends often and used to describe the result of capitalism. But it was precisely the climate of the 1920s, the freewheeling, free-spending climate that was created by Federal Reserve policy, that made people take Veblen seriously.

10:22Social critics began to think, well, maybe this Veblen guy's really onto something. It sure looks like conspicuous consumption all around me. So had it not been for Fed policy, The boom leads to a rise in time preferences, greater discount of future rewards on the part of consumers. Buy now, pay later. Times are good. Newer is better than older. There's sort of a glorification of youth culture that we typically see during inflationary periods. This struck me, the contrast between this and what we found in prior, struck me just recently reading a biography of Joseph Schumpeter.

11:13And there was a passage that caught my eye on the way Schumpeter and young men of his generation behaved in the early 1900s. in the first five years of the 20th century, Mises of course being Schumpeter's Contemporary. Young men in that era tended to imitate old men. So young men would wear glasses even if they had perfect vision. They would walk kind of with a limp or a stoop to imitate their elders. This was a way of showing respect to the wisdom of the past. Nowadays, of course, it's completely reversed such that it's youth culture that drives social and cultural phenomena.

11:58One need only go to the mall and observe legions of soccer moms who dress like Britney Spears to realize how much times have changed.

12:14There are important tangible or observable measurable effects of the feeling of artificial prosperity. There's quite a bit of evidence suggesting that fertility rates rise during booms and decline during busts. The U.S. fertility rate actually at present is the highest it's been in about 30 years. Or I should say at the end of the, around the year 2000 when this data came, at the end of the 1990s boom, it was over, it was about 2.1 children per woman, which is substantially higher than it was in the 70s and the 80s. And there are a lot of theories about what factors affect fertility. One common idea that's probably not true is probably not the case that during a boom because the male head of the household has a higher income, women exit the labor force to have children.

13:14That's probably not the case because women, in fact, tend to enter the labor force at higher rates during booms, which suggests, one way to think about this in economist terms is that the women's labor supply curve is upward sloping. In other words, women are attracted into the labor force by the prospect of higher wages, not by the necessity to make up for the husband's lost income during a bust, for example. Economists would also say this fertility data suggests, or one way to interpret it, is that children are what we call a normal good. Meaning as your income rises, you prefer to consume more of this good. Parents, you may insert your own jokes here.

14:02Now, I want to be clear, I'm not saying that higher fertility rates are good or bad. I'm simply pointing out that using this as an example of how macroeconomic conditions can have important social consequences. And of course, the entrance of women into the labor force is another example of this. There's this huge literature on the effects of households in which both parents work, a generation of latchkey children and so on, and Increased Strain on the Family. Again, one needn't take the view that this is necessarily a bad thing to recognize that it's an important social or cultural consequence of what's going on in the economy.

14:47Other tangibles. There's evidence that teenagers tend to drop out of school during the boom and go back to school during the bust. Again, on average, labor force participation rates for 16 to 19 year olds are substantially higher during periods of expansion than they are during periods of contraction. The data seem pretty conclusive in this sense. If we think it's desirable that teenagers be in school rather than be in the workforce, we might be alarmed about this, but we might not necessarily think that. Another important consequence that has a tangible, consequence of the boom that has a very tangible manifestation. So we might call sort of a greater tolerance for shady practices within the private sector.

15:38The whole corporate accounting scandals, Enron, Worldcom, Global Crossing and so on, I think reflect this in the following sense. Keep in mind that what brought these controversial episodes to light was not some government investigative committee that discovered that irregular accounting practices were being used. Rather, it was the market that discovered this. It was the rapid decline in the share prices of these firms that made the Fed start thinking about it, that put the SEC onto the trail that, oh, gosh, there must be something funny going on here we need to investigate. So markets are very good at providing feedback to managers and entrepreneurs on all aspects of their business, including how they account for things.

16:27Accounting is complicated. Some accounting practices are appreciated by investors, some are not appreciated and discounted. Investors, of course, have the option, have the ability to show their disapproval for management practice by selling their shares, by getting out of the stock market and so on. In the artificial boom, financial markets tend to be much more forgiving. So investors didn't pay as close attention to what was going on in these companies as they otherwise would because of the general rise in stock prices, which made people happy. Concrete result of these scandals, of course, has been a result that is promulgated by the media, encouraged by the media and the state, of course, is that business can't be trusted.

17:15businessmen are out to take advantage of investors and that's why we need powerful benevolent regulators and so on to protect small investors and to protect the public at large. Well I mentioned that there we can also identify specific consequences of the means by which the artificial boom comes into existence namely credit channels, expansion of credit, reduction of interest rates. What are some of these manifestations? Increase in consumer debt, consumer debt levels reached all-time highs in the 1990s and of course excessive debt goes against the teachings of almost all cultural religious traditions virtually all of which recognize thrift and moderation as virtues as manifestations of self-discipline and of course I'm not I'm not offering a condemnation of credit markets of debt but simply pointing The real estate boom that typically accompanies or often accompanies credit expansion has important implications for demographics, for housing patterns, where people live, who people live with, who they live near.

18:36As you know, the real estate and construction sectors, like other interest rate sensitive parts of the economy, are particularly volatile during the boom-bust cycle. We often see real estate expansion, which can temper the effects of price inflation in consumer goods, by the way. We saw it in the 1920s, we saw it in the boom of the 1980s, and in the most recent boom in the 90s. The thing to keep in mind about expansion in the real estate and construction markets is that by its nature, real estate development is less mobile, less easily reversible, more durable than some other kinds of investment.

19:23A housing development that has begun during the boom cannot easily be returned to its previous state once the bubble bursts. So things like the growth of suburbs, urban sprawl, etc., all of these are associated, are consequences of credit expansion. And again, I'm not claiming that we shouldn't live in suburbs or that cities shouldn't be sprawling, only pointing this out as an effect. Now, when the credit expansion is accompanied by significant price inflation in consumer goods markets, we have even more important and typically harmful consequences. Like artificially low interest rates, price inflation provides an incentive to borrow and a disincentive to save, promotes a tendency toward instant gratification, can lead to class conflict between debtors and creditors as Mises pointed out all of us are creditors almost all of us are creditors in some sense if you have a bank account you're at least a gross if you have a savings account you're at least a gross creditor the unevenness in the rise in prices can cause conflicts within society remember how the Austrian Austrian style credit expansion works some segments of the economy receive the new credit first

20:51and those and the monetary expansion channel constitutes leads to a transfer of real wealth from those sectors that receive the new money last to those individuals in those sectors that receive it first so there are some at least short-term beneficiaries and some who are some losers through this process and the monetary transmission mechanism introduces conflicts of interest among groups of consumers and business people And of course, in the case of hyperinflation, the consequences can be much more severe. And here I would recommend the very interesting piece by Paul Cantor in the review of Austrian economics in 1994, where he interprets Thomas Mann's story, Disorder and Early Sorrow, in terms of the German hyperinflation, in terms of Austrian business cycle theory.

21:45This story tells the day in the life of a history professor in Germany between the wars during the hyperinflation and it sort of describes how things become completely absurd. Hyperinflation led to what Cantor described as a detached sense of reality or a hyper-reality to go along with the hyperinflation. The young had the authority and the prestige, the old were denigrated. Instead of saving, housewives struggled to spend as much money as possible. In Cantor's phrase, hyperinflation led to a kind of hyperreality in which nothing has a fixed meaning. Society spun out of control. The great German economist Wilhelm Rippke called inflation a moral disease.

22:34He said, inflation is a moral disease leading to a disorder of society. And there's quite a lot written by Mises and others on the social harm of inflation. Okay, well that's the boom. What about the bust? The case is a little more obvious here. Remember that we're not talking simply about unemployment per se or a firm that goes out of business. We're talking about the cluster of errors, the systematic persistent business failure and widespread unemployment that constitutes the bust. I referred earlier to this social psychology literature, actually quite a few economists working on this too.

23:21There are surveys of happiness across various countries where respondents are asked to rate how happy or unhappy they feel on a 1 to 10 scale, something like that. And then these ratings are associated with various social, economic, cultural factors to try to determine what makes people happy, what makes people unhappy. And not surprisingly, unemployment is associated with unhappiness, and there's data suggesting that unemployment leads to increase in substance abuse, domestic violence, divorce, even suicide. and Suicide. There's a recent NBER paper by Justin Wolfers at the Stanford Business School who finds that not only unemployment itself but also volatility in unemployment, cyclical unemployment has very harmful social psychological effects. So this suggests that it's not just being out of a job that's bad but this recurring pattern of employment, unemployment, employment, Unemployment that characterizes the business cycle that is a further source of trouble.

24:36It's well known that philanthropic activity is curtailed during a recession, charitable giving tends to track the business cycle pretty closely, and I might add that community organizations, religious organizations, charitable groups are also susceptible to the overinvestment problem or malinvestment problem that private businesses are susceptible to during the business cycle. So charitable and religious groups may initiate a new program during the boom phase and then be unable to continue that program, have to abandon it in midstream during the bust. Of course this can have very serious effects on the recipients of aid or those to whom such a program is targeted.

25:26The most important consequence of the boom-bust cycle is this, as I mentioned before, is this feeling among the public that capitalism is unstable, that the free market is unreliable, that it's subject to these periodic periods of crisis and only the sure hand of the state can protect us. In other words, that government is necessary not only to run the economy, to steer the economy, but to control all aspects of social life, education, health, welfare, the arts, and so on. The Great Depression is perhaps the quintessential example. I mean, almost all of us were educated, were taught growing up that Roosevelt saved capitalism from itself, The Great Depression proved that unbridled capitalism, dog-eat-dog capitalism doesn't work and that a new form of capitalism, a social market economy, a mixed economy and so on, is necessary.

26:40Robert Higgs, of course, has brilliantly shown that during periods of crisis like depression and, more importantly, war, Those are the periods when government tends to grow the most, and of course it doesn't shrink back when the crisis is over, as we know. Politicians are all too eager to help out those who are suffering from economic recession, to provide a safety net, to offer social and humanitarian services, typically crowding out private providers of such services, churches, religious organizations, other charitable groups, and so on. You know, sort of the manifestation of this attitude that the state has to run things is, you know, it's in almost every news report about Iraq or about what's going on in other parts of the world.

27:25I remember just a few weeks ago when listening to National State Radio, NPR as some people call it, when Charles Taylor was finally ousted from Liberia and all the pundits were talking about, Now that Charles Taylor isn't running the country, who is going to run the country? Will it be this group? Will it be that group? Who is going to run Iraq? Paul Bremmer can't run Iraq forever. At some point, some other perhaps indigenous government body has to run the country. The phrase just sort of rolls off these commentators' tongues. The idea that maybe the country can run itself is considered beyond the pale. I think David Gordon was I was talking about the Constitution this morning, and when I read about the struggle to draft the Constitution for Iraq, I wanted to reply, why don't we just give them ours, since we're obviously not using it.

28:20So, to conclude, I would urge my fellow Austrians to investigate further, to investigate this area further. There's very little Austrian literature on social and cultural consequences of monetary policy. But I hope that this brief overview shows that there are some potentially very serious consequences of the boom-bust cycle, which is all the more reason to return to laissez-faire, to establish sound money, to abolish the institution of central banking altogether.