Malinvestment and Overconsumption
We want to discuss the problem of forced saving as it seems to us that it is of particular relevance to the current "echo boom". Also, it complements what we have previously written about capital consumption and the pool of real funding. In Mises' rendition of the business cycle, we can find two different conceptions of the term forced saving. A classical boom based on credit expansion results in both malinvestment and overconsumption, as the accounting profits of entrepreneurs and capitalists in the higher order stages of the production structure, as well as the increase in wages of workers employed in them, leads with a very small time lag to higher consumption expenditures. Not only that, but the artificially lowered interest rate provides a disincentive to saving, so that consumption overall actually tends to increase relative to the pre-boom configuration of the economy. Consequently, resources are not only drawn toward the early stages of production (that are temporally most removed from the final goods production stages) as lower interest rates make these investment projects seemingly profitable, but also toward the late stages, which experience a surge in demand.
For a time, the economy will produce beyond its sustainable limit, as Roger Garrison explains in a highly recommended article on the topic entitled “Overconsumption and Forced Saving in the Mises-Hayek Theory of the Business Cycle”. According to Garrison, maintenance of machinery is neglected, the machinery will be used more intensively by running more hours than normally, workers will work longer hours and/or postpone retirement, and a greater proportion of workers will be drawn from the population, all of which will make this unsustainable production possible for a limited time period.
Garrison's article mainly deals with the different conceptions of the term "forced saving" employed by Hayek and Mises and the trade cycle as described by both of them. He concludes that Mises' explanation of the business cycle is the more plausible one. For Hayek, forced saving was essentially synonymous with malinvestment and he did not consider overconsumption a relevant feature of the boom, while Mises regarded forced saving primarily as the end result of the boom's twin features of malinvestment and overconsumption.
Looking at the different stages of the boom-bust sequence, at first, both malinvestment in capital goods production and overconsumption will co-exist (this is the part of the cycle that is politically highly popular, which explains why credit expansion is used as a tool to "goose" the economy over and over again). As time passes, resources continue to be bid away by the early stages of production, while the neglected middle stages whence these misallocated resources have been drawn from begin to yield a lower output of consumables, which effectively puts a stop to overconsumption. At that point "forced saving" sets in, as the prices of consumer goods begin to rise and distress borrowing on the part of entrepreneurs in the early stages puts upward pressure on interest rates. The frantic bidding for resources now moves on to bid away factors from the late stages of production as well, further curtailing the output of consumer goods. At the next point in this temporal sequence one finds both consumers and businesses in increasing duress – the liquidation of malinvested capital begins, and resources begin to be reallocated to the middle and late stages of production as the overambitious projects in higher order goods production falter. This is the bust, the period in which the economy returns to a configuration in accordance with the actual saving-consumption preferences of consumers.
As Garrison puts it, in this conception, the "forced saving" phenomenon is best described as follows: “Early in a credit expansion income earners consume more than they otherwise would have, while later, they are forced to consume less than they could have.”
The dynamics of credit expansion as graphically presented by Roger Garrison. On the left hand side is a 'Hayekian triangle' that represents the different stages of the production structure: capital malinvestment draws resources toward the higher order goods producing stages that appear more profitable due to artificially lowered interest rates, while overconsumption concurrently pulls resources toward the late (lower order goods) stages of the capital structure. On the upper right hand side we see the curve representing the production possibilities frontier (PPF, the sustainable combination of consumption and investment) that is determined by the volume of loanable funds provided by voluntary saving S in the lower right diagram. "S-aug" are the loanable funds consisting of 'savings augmented by credit expansion', D is the demand for loanable funds. The hollow diamond in the upper right diagram shows the unsustainable path the economy is temporarily taking toward a point outside the PPF, i.e., the credit expansion-induced boom. The arrow shows the entire path from boom to bust to 'secondary depression' (a movement of C+I to a point below the PPF).
Stages of the boom-bust sequence: at point 1, both misallocation of resources and overconsumption occur. At point 2, overconsumption reaches its maximum, at point 3 forced saving relative to the maximum level of consumption begins, at point 4 the maximum demand for resources that are allocated to early production stages occurs, at point 5 the liquidation of malinvested capital begins. Points 6 to 8 are movements below the PPF, i.e., the "secondary depression"
Overall, this description of the trade cycle strikes us the most accurate one. We are leaving the phenomenon of the 'secondary depression' (a spiraling down of production and consumption below the production possibilities frontier) aside, except to note that this is a phenomenon mainly associated with ill-conceived attempts by the authorities to intervene during the bust. The fewer obstacles are put in the way of the adjustment process, the more likely it will be brief and succeed in quickly restoring the economy to a sustainable configuration. For example, the downward spiral of the Great Depression was initially mainly a result of Hoover's interventions. He kept wage rates artificially high on account of the erroneous idea that high wages would keep the economy going by supporting consumption spending. In addition, the introduction of the Smoot-Hawley tariff law derailed global trade and struck a blow against the international division of labor and the economic benefits provided by comparative advantage. Under FDR an inflationary echo boom began, which ultimately proved unsustainable (as soon as the credit expansion was stopped, the boomlet collapsed again). Regime uncertainty and a climate extremely hostile to business made even this intra-depression recovery period not much to write home about.
An Alternative View of Forced Saving
In his earliest exposition of business cycle theory in 'The Theory of Money and Credit', Mises also discusses forced saving in a different context. In this instance, he mainly refers to the redistribution of wealth actuated by inflationary policy. Since inflation/credit expansion tends to increase the real incomes and wealth of earlier receivers of newly created money to the detriment of later receivers, the question is whether the beneficiaries are more likely to save their additional income. Given that those who have first dibs on newly created money are as a rule members of strata of society that are already wealthy, whereas the late receivers and those who don't receive the newly created money at all are mainly wage earners and retirees, it can be argued that it is likely that additional increments of real savings will be created. Mises stressed however that these additional increments will never suffice to actually fund all the malinvestments of the boom (in other words, capital consumption cannot be averted).
Let us look at this phenomenon from the point of view of the late receivers: they are actually the ones forced to save in this situation; since their real incomes decline, they can consume less than they otherwise would. In other words, this group's claims on the pool of real funding will decline, which in turn enables the same pool to sustain a larger number of workers.
Are there situations in which this forced saving phenomenon occurs at a different point in the temporal sequence than in the classical business cycle described above? There is some evidence that this is the case; particular events in economic history suggest as much.
The business cycle is as a rule initiated by commercial banks expanding credit by lending to businesses. This does in theory not require a central bank – commercial banks employing fractional reserve banking can increase the amount of fiduciary media on the market on their own and thereby lower the market interest rate below the natural rate. In modern-day practice though, it is central bank policy that nowadays sets the process into motion and sustains it by accommodating the credit expansion. The central bank supplies reserves to the banks in order to keep short term interest rates near its 'target rate' whenever an increase in credit demand threatens to push the rate above the target.
The current echo boom is different: commercial banks are not starved for reserves. In fact, the rate of credit expansion on the part of commercial banks is declining (see this chart), even though they hold vast amounts of excess reserves due to 'QE' (note though that commercial and industrial lending has sharply increased since 2010 and is almost back at its previous high – the slowdown in total bank lending is mainly due to a decline in mortgage credit extended by banks and consumer credit growing at a much slower rate than in pre-crisis days). Nevertheless, there is plenty of money supply inflation, as the Federal Reserve's "QE" policy not only creates bank reserves, but also deposit money.
U.S. money supply TMS-2 (broad money supply) – up by 229% since 2000 and by approximately 81% since 2008.
Although there is plenty of lending to corporations – in fact, corporate debt is at a record high – the current echo boom is not characterized by overconsumption. Not only is there plenty of anecdotal evidence to that effect from the earnings reports of listed retail chains, there is also the fact that the real incomes of households have been under severe pressure since the 2008 crash. The real incomes of wage earners have stagnated in the period between the Nasdaq crash and the bust following the housing boom in 2008, and have declined sharply ever since (there has been a slight improvement since the trough in 2011):
Median household incomes since 2000, nominal and real.
A different view of the same phenomenon is provided by the following chart which shows the decline in real wages of different quintiles of wage earners. Note the fact that those earning the least (the first and second quintile) are suffering the biggest declines in their real income, a typical effect of inflationary policy.
Declines in real wages by quintiles between 2009 and 2012: the poorer strata of society are harmed the most by inflationary policy.
We can conclude that the echo boom hat started in 2009/10 differs from previous credit expansions in that forced saving has been a feature throughout. Note that the shifting of resources from lower order stages of the capital structure to higher order stages is well underway: as we have previously discussed, the ratio of capital to consumer goods production is close to a record high (see this chart).
The Weimar Inflation Example
A similar phenomenon could be observed – to even greater extremes – in the post WW I inflation in Germany that culminated in a crack-up boom and hyperinflation in 1922 to 1923. Immediately after the war, unemployment was very high, as soldiers returned home and industry had to be retooled from war production to peacetime production. By 1922, unemployment had practically disappeared (note though that a lot of employment was provided by nationalized enterprises such as the railways, as a kind of "make work" program). In this period, economic activity and employment were strongly inversely correlated to the exchange value of the German mark. Whenever the currency strengthened, economic activity would decline and unemployment rise and vice versa. As the inflation progressed, wage earners and those depending on fixed income suffered a strong decline in their real incomes. As Constantino Bresciani-Turroni writes in "The Economics of Inflation" with regard to the forced saving this decline in real wages created:
“The inflation profoundly altered the distribution of social saving. It is true that at first a certain mass of "forced saving" was created. But it cannot be said that these savings became available to the most productive firms and to those entrepreneurs who were most able to employ rationally the capital at their disposal. On the contrary, inflation dispensed its favors blindly, and often the least meritorious enjoyed them. Firms socially less productive could continue to support themselves thanks to the profits derived from the inflation, although in normal conditions they would have been eliminated from the market, so that the productive energies which they employed could be turned to more useful objects.”
Germany, 1920 to 1922: real wages and the unemployment rate both fell sharply, while the dollar, wholesale prices, and the cost of living all increased markedly.
The effects of the inflation were quite perverse. A lot of energy and effort was squandered in speculation and the enabling of speculative activity. Many jobs were created in administrative functions, essentially unproductive work, as companies attempted to keep their book-keeping and all sorts of planning up-to-date with the effects of the inflation as well as the constantly changing and fiendishly complex regulatory and taxation backdrop. Businesses did of course not care about efficiency, as labor was extremely cheap in real terms. Inflation had thoroughly falsified economic calculation as it later turned out. Higher order industries, especially iron, steel and coal production experienced an enormous expansion. Huge vertically integrated and totally inefficient industrial conglomerates were formed by the largest companies in these sectors. More and more capital goods were produced and plants expanded, but these expansions were all focused on quantity instead of quality. Bresciani-Turroni notes that in terms of production methods, industry often regressed and the decline in consumer purchasing power even led to the re-adoption of previously discarded technologies:
“The inflation exercised contradictory influences on the structure of production. On the one hand the exceptional profits of certain industries and the decline of the real rate of interest stimulated the demand for capital goods; but on the other hand the low wages deterred many entrepreneurs from improving their machinery, which remained old and inefficient, compared with that of other countries.
The diminution of the purchasing power of vast numbers of consumers caused in some spheres a retrograde movement in methods of production. A curious example was the reappearance in the streets of Berlin of old and rickety carriages in the place of the taxis which had become too expensive for the public.”
Wealth became ever more concentrated in the hands of a quite small number of powerful industrialists who promptly proceeded to misallocate the resources that became available to them. They were continually painting economic horror scenarios that would allegedly strike if the Reichsbank were to ever stop its inflationary policy. However, there finally came a phase when they could no longer rely on forced saving to provide them with new capital (voluntary saving was practically non-existent at that point).
As domestic prices spiraled ever faster upward in 1923, it became customary to adjust wages much faster to prices than previously. Since unemployment was very low by 1922, the bargaining power of wage earners increased. Moreover, the government introduced laws that required a more rapid adjustment of wages to expected price increases. Unemployment immediately began to rise concurrently with the increase real wages. By late 1923, the currency had arrived at the point of complete repudiation – it could no longer serve as a viable medium of exchange. Unemployment had risen sharply as well. None of the alleged 'benefits" of the inflation were in evidence anymore.
September 1922 to November 1923: unemployment rates closely follow developments in real wages. By late 1923, the German mark was de facto repudiated.
After the monetary reform of late 1923, the extent to which capital had been malinvested in the higher order goods industries became fully evident. A great part of these investments had to be written off as completely worthless. The balance sheets of companies were reconstituted on a gold basis and revealed vast losses. Furthermore, what was interpreted as a 'shortage of liquid working capital' at the time, was due to the enormous change in the composition of the stock of capital goods in the economy (i.e., there were abnormally large stocks of higher order goods and a greatly diminished stock of middle and lower order goods; similarly, the plant for producing the former had been greatly expanded compared to the latter). Many of the large industrial conglomerates and cartels that were formed during the inflation years experienced serious crisis conditions and most fell apart again into their constituent parts. Almost immediately the so-called "stabilization crisis" saw capital move into the previously neglected parts of the capital structure, with consumer goods industries reviving strongly relative to the capital goods industries (within the first "crisis" year of 1924, employment in consumer goods industries rose from 2.2 million to 2.8 million). Interest rates rose sharply as well, unproductive companies went bankrupt and many expansion projects were stopped.
Beer consumption during and after the inflation period: the consumer comes back – click to enlarge.
As an aside, although banking activity increased sharply during the inflation period, mainly to aid in speculative transactions on the stock exchanges and foreign exchange markets, commercial banks were among the biggest losers of the inflation period. When they drew up their balance sheets in gold terms after the monetary reform, the bulk of their capital was found to have been wiped out.
The Weimar inflation period is an extreme example of an inflationary business cycle financed by a central bank, characterized by forced saving on a large scale and massive capital malinvestment. It is a very interesting case study precisely because it went to such extremes and occurred in an industrially developed nation.
We are not trying to suggest that the current situation is necessarily going to lead to a similar outcome (i.e., a hyperinflationary crack-up boom), even though it cannot be ruled out. Every slice of history is unique and there were additional factors involved in the Weimar inflation that we haven't discussed. After all, the Reichsbank could have stopped the process much earlier, but for a variety of reasons chose not to.
We are only pointing out a few interesting fundamental parallels: a credit and money supply expansion due to direct central bank action as opposed to one that is led by commercial banks, declining real wages and the associated increase in forced saving, and the development of a boom with investment increasingly concentrated in the capital goods sectors of the economy similar to what occurs in a classical credit expansion induced boom. One sense in which the example of the Weimar crack-up boom may be regarded as a useful template is the likely outcome of forced saving diminishing, which should eventually lead to an increase in unemployment (note that the decline in real incomes has reversed since 2011). Also, once the central bank's inflationary policy ceases or pauses (we are currently assuming that a voluntary pause is in the offing), the extent to which resources have been malinvested and squandered will be discovered and another major bust can be expected to take place.
Charts by: St. Louis Federal Reserve Research, Roger Garrison, Doug Short, Real World Economics Review, Constantino Bresciani-Turroni