Tuesday, June 12, 2012

The Malinvestments of the Previous Boom

The Austrian theory of the business cycle goes something like this: A recession is the period of adjustment for liquidating the malinvestments of the previous boom.

In other words, when you get an unexpected increase in the economy, people pile on, and make investment and consumer decisions that assume the good times will roll on forever.

It wouldn't matter if they just plowed their extra income into foolish projects.  Then, when things go south they would just adjust to the reduced income.  But typically, they borrow money to fund their projects.  Borrowing money is a way of anticipating your future income.  But what happens if your future income is not as large as you assumed?  The answer is simple: it is retrenchment, losses, poverty, and bankruptcy.  And because you fail to make payments on your debt you imperil your financial counterparties, your bank and your bondholders.

The Federal Reserve reports that Americans lost 40 percent of their family wealth between 2007 and 2010.  That is telling.  It says that the decisions that Americans made in the 2000s about the future were wrong.  The investments they made in houses, especially, turned out to be malinvestments, because they ended up not having the income to service their mortgages.  So it turns out that we are a lot worse off than we thought in the heady days of the real-estate bubble. (But there is hope.  The Wall Street Journal reports that foreigners are snapping up high-end apartments in Manhattan and Miami.)

So now we turn to the question of "stimulus" and Keynesian economics.  The Keynesians recommend that the government borrows and spends in order to jump-start the economy.  There is a point to that.  If you have foolishly let your car battery run down, then getting a jump-start will get your engine going again, and hopefully recharge your battery.  But if there is no fuel in the tank, then it doesn't matter how long you crank the starter, you ain't gonna get the car to start.  Eventually you will exhaust the battery on the other side of the jump-start cables.

That's the problem that southern Europe is facing.  It just can't go on paying all those government entitlements when the economy lacks the fuel to crank out the GDP and tax revenue that the government needs.

And that's the problem in the US as well.  President Obama wants to borrow money and forward it to state and local governments so they don't have to lay off government workers.  The problem is that today's government workers are very highly paid.  Writes Josh Barro for Bloomberg: "San Jose spends $142,000 per FTE on wages and benefits, up 85 percent from 10 years ago."

So the question is: Do you think that helping the city of San Jose continue to pay its full-time employees an average $142k per year is going to help the US economy?

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