There is a considerable Austrian literature on the unsustainable boom driven by credit expansion. When the boom ends, a depression begins. The depression is a transitional period of reduced production that lasts until entrepreneurs restructure capital and labor into sustainable uses. During the depression, there is unavoidable unemployment of both people and productive assets. The recovery is marked by an increase in production and the employment of resources that were idle during the bust.
What happens during a depression? Should we expect it to end, or can an economy remain stuck at the bottom? Is “stimulus” required to start the recovery? The British Austrian economist “W.H.” Hutt In The Keynesian Episode: A Reassessment, provided a coherent theory of the downturn and recovery, driven by the market price system. Hutt incorporated the ideas of coordination through entrepreneurial forecasting and Say’s law to answer these critical questions.
If prices adjust to balance supply and demand, how can there be so many unemployed resources, both capital and labor? If entrepreneurs are reasonably good at forecasting, why should many business firms fail at more or less the same time? Mises’s Austrian theory of the business cycle identifies the banking system issuing excess credit leveraged on deposits as the cause. The interest rate does not accurately reflect the scarcity of savings. The system as a whole sets off in a direction that would only make sense if there were more complementary labor and capital goods than exist in reality. Entrepreneurs set out to produce the wrong mix of capital goods of different types.
The depression begins as some producers, somewhere in the supply chain, inevitably suffer losses. In some cases the inputs they need are not available in quantity and at a price that was expected; shortages and bottlenecks of scarce inputs drive the prices up. In others cases, the demand for their products is not what was expected. Planned allocations are found to be misallocations; continued progress in the same direction is unsustainable. Some businesses will experience losses, others fail entirely. Inventories must be marked down and even sold at a loss. Hutt used the term “discoordination” to describe the state of affairs. The first wave of unemployment comes at this point, as some firms realize their mistakes.
An example of this is the notorious 90s tech bubble incarnation of pets.com. They were unable to economically ship heavy items such as bags of pet food. According to Investopedia, “Given the choice between ordering online and waiting for delivery or walking into the nearest store to buy the product and take it home immediately, the majority of people preferred the latter.” Today, most people prefer the former. Delivery times are almost as fast as going to the store, and the ease of home delivery predominates over driving, parking, and lugging a heavy bag of cat food back and forth to your car. The present success of this sector is due to the build-out of complementary capital in the form of logistics and transport systems to move the goods. The complementary infrastructure to get the products to the customer did not exist in 1999. Considerable savings and capital investment over the intervening years were necessary to make this business feasible today.
The productive assets that were used for loss-generating activities during the boom were wasted. These resources had alternative uses. If more of the wrong thing was produced, then somewhere else, fewer goods that people did want and could pay for were not produced. Entrepreneurs in other industries were not able to expand as they otherwise would have, because they could not hire the labor or obtain the capital goods that were diverted into malinvestment. The office space, machinery, energy and workers were otherwise engaged. We can not say for sure what those industries were, but some neglected sectors such as tobacco products, gold mining, and energy boomed during the collapse of the dot-com bubble. Other firms were able to take advantage of the surplus of unemployed financial analysts and tech workers to grow.
The recession brings to a halt those projects that should never have been started in the first place. But the impact of the recession is not limited to the industries where the misallocation took place. There is a secondary impact as the bubble unwinds. Hutt explained that “unemployment is infectious.”1 A self-reinforcing cycle amplifies the downturn. The feedback is driven by two reinforcing principles: inflexible prices and Say’s law.
Say’s law is a modern term for principles that originated in the general glut debate. This was a historical controversy between two explanations of the post-Napoleonic war depression in England. Thomas Malthus blamed an overproduction of goods in general (a “general glut”); or, when looked at from the other direction, the purchasing power of the public could not keep up with production of goods and services.2 He advised what we would now call a “stimulus package.” Unproductive consumption should be encouraged to make up the difference.
James Mill, Jean-Baptiste Say, and David Ricardo responded that there can never be such a thing as a deficiency of demand. The power to demand is derived from production. Everyone has the role of both a producer and a consumer. A good offered for sale constitutes a demand for a different good. When this is understood, it is obvious that demand as a whole and supply as a whole are only different ways of looking at the same thing—the two sides of the totality of market exchanges.
The classical economists did not suggest that any production at all, of anything, creates the power to demand. Businesses must produce things that people want, and are willing to pay for. Even a good that can only be sold at a loss still provides the seller with some revenues. But when there are mistakes in production, not as much power to demand is created as was used up. If a good has no value to anyone, or perhaps creates greater liabilities than it can be sold for, then it does not contribute to demand at all. As Mises observed many years after the original controversy:
With regard to economic goods there can never be absolute overproduction…. With regard to economic goods there can be only relative overproduction…. The attempts to explain the general depression of trade by referring to an allegedly general overproduction are therefore fallacious.
Hutt applied Say’s law in reverse to the process of unemployment. Unemployed workers pause in their contribution to supply and so lose their power to demand. Workers not only demand consumer goods, but indirectly all of the higher-order capital goods required to produce them and the chain of services such as marketing and retailing that bring them to the consumer. The loss of demand for consumption goods ripples up the supply chain. As supply slows down, by Say’s law demand weakens as well. The sales revenues of firms in other industries decreases, and they may have to lay off workers as well. As these second-order layoffs decrease supply, they further decrease demand in a chain reaction.
Hutt explained the process this way:
[T]he individual firm is working at low pressure because other firms are working at low pressure. Each is inactive because the general power to consume has fallen; and the general power to consume has fallen because of and in proportion to the general decline in the activity of production.3
And:
In a situation in which widespread layoffs of men are occurring, and physical assets are being thrust into idleness, the withholding of supplies … appears as a sort of evaporation of demands or as a sort of redundancy of excess of supplies, not as a withholding of supplies. Keynesian teaching accepts that appearance as reality.4
Hutt’s language might sound superficially like the Keynesian circular flow in which the spending of one party is the income of another. Hutt would agree that there is an interdependence between all participants in the market. We are all consumers and we are all producers. The interdependence is through production. As each consumer-producer stops producing, he loses his power to demand, and therefore to consume. Hutt would agree with Keynes that demand is depressed, but not for lack of consumption.
The reinforcing nature of rigid prices contributes to the depressionary feedback cycle. “Each group of producers in pricing itself out of the market, priced out others also.”5 In a recession, “the self-aggravating process under which prices in key activities come to diverge still further above market-clearing levels can get almost completely out of hand.”6
Demand is lacking because production is not taking place. Production is depressed because firms can or must no longer accept the losses that result from producing the wrong things. But it takes time for entrepreneurs to figure out what the right things are. In many cases a different set of people will make the decisions about what to produce for the economy to recover than the ones who drove up the boom. Some assets need to change hands in bankruptcy. Prices must fall, but the new bids for capital and labor will come from a different set of firms producing a different mix of goods than during the prior boom.
Must the disruption of production go on forever? Is there a bottom to the valley? The depression exists so long as the market for capital goods and idle labor does not . Once a place is found for the assets within the price system, production, and therefore supply, will resume. Prices must be restructured—mostly lowered—to enable the idle resources to be brought back into use. At each stage of production, costs must fall more than prices to give clear profit opportunities to entrepreneurs. This may be on top of a general deflation affecting all prices due to an increase in money demand, or, in the days before the Fed, a contraction of money supply.
During the depression, Hutt explained, revenues are lower than during the boom. This means that businesses derive less revenue from each unit of labor and of capital. Yet as Hutt emphasized, any valuable productive resource has some use, somewhere, at some price. The equilibrium price theory, in which labor earns its discounted marginal value product, still applies, but the expected revenues are lower, and so the wage that a business can pay for the same work is lower during the depression than it was in the boom.7
[Businesses] are justifiably pessimistic, faced with low prospective yields. Hence the market-clearing prices of potentially profitable inputs are very much lower at that moment than they are destined ultimately to be.8
Hutt explains why the transition from recession to recovery is not instantaneous: “[I]n the course of entrepreneurial decision making, what we now call ‘market signals’ need time to be observed, and acted upon.”9 Many factors can influence a fall in demand for particular products. It can take weeks or months for a firm to determine that a fall in demand is not temporary, that they have more inventory than needed and price cuts will be necessary. Firms will to some extent try to wait it out, to avoid the costs of laying off and then rehiring and retraining competent employees.
If the process takes longer, Hutt blamed mainly sellers for not accepting the changed reality. They are pulled by inertia toward keeping the memories of the boom. For a business that was not in the epicenter of the misallocations during the boom, this may be a good strategy. Demand for everyday products, housing, clothing, and transport will return to its former levels. Demand for the exemplars of the worst excesses of the boom may be permanently gone.
Seen in a clear light, can houses in two dozen coastal cities really be worth 20 or 50 percent more each year for six years running, from 2000 to 2008? Or like Pets.com, failures in one bubble may become economic years later, when substantial savings and investment have been realized to create the complementary capital goods that were missing the first time around.
Anything that impedes the market price system will slow the recovery: “[S]uch things as subsidized unemployment compensation and the maintenance of wage rates under private coercion or governmental edict…. Welfare activities often have deplorable effects; but worst of all … subsidize the “occupation of being unemployed.”10
[A]t wages rates equal to the “marginal prospective product” all labor is immediately employable. And I argued further that in the reemployment of labor (through pricing for market clearance) in any particular sector “will set in operation the required ‘groping’ process; this process will lead, in subsequent periods, to a rise in labor scarcity; and that scarcity will, in turn, result in the entrepreneur being forced to offer real wage rates which correspond to labor’s rising realized marginal product.”11
The adjustment will happen more rapidly to the extent that the sellers of inputs (labor and inventories in the supply chain) will accept price cuts. Lower costs, in the face of lower prospective demand will create the possibility for a profit margin even in the depths of the depression. Entrepreneurs who are rationally pessimistic require a greater margin of safety.
Even when matters are at their worst, even when entrepreneurs generally fear that if they provide jobs for the unemployed, they might connect vocover their additional costs … they might still be prepared to shoulder the risks if only labor were generally prepared to accept wage rates which equated with labor’s temporarily low marginal prospective product.12
With profit margins opened up by lower costs, entrepreneurs tentatively begin to employ more of the idle resources. And then, Say’s law operates in the forward direction. The newly employed workers, or those who stayed in their jobs are able to produce, and to supply. This supply constitutes a demand for other noncompeting products, which contributes to the recovery of output in other industries:
[Keynesians do not understand that the fall in the rigid asking prices of idle resources] does not always mean that prospective yields are bound to rise in [the same industry]. Yields will tend to rise for all noncompeting industries.13
Rigid prices can be caused by sellers being unsure of how to adapt to the fall in demand for their products. Hutt explained that it can take some time for a firm to determine if a decline in business is temporary or of a longer duration, and to estimate the best selling prices for their inventories under worse market conditions than expected when the inventories were acquired. Longer established firms may try to hold on to their employees to avoid the cost of laying off and rehiring.
Institutional arrangements that prevent prices from falling serve only to prolong the adjustment period, or prevent it from happening at all. In Britain at the time of Keynes, there were efforts as a matter of policy to maintain nominal wages at or above their boom-time levels. In the American Great Depression, the National Recovery Administration sought to prevent both wage and price adjustments. The inability of these regulated markets to clear by lowering prices kept them stuck in surplus. Unemployed workers, by not producing, withdrew their power to demand other goods from other industries, prolonging the depression.
Say’s law shows that when production is impaired, demand is weakened—only because the supply is not forthcoming. The Keynesian program of “stimulating” consumption can only make the process worse by squandering scarce consumption goods. Putting idle resources to work with stimulus only slows the process of price adjustment. The consumer’s ability to pay comes from his own production. What is needed is coordination through the price system so that all willing labor and useful resources may be used for the greatest contribution to supply. Production must be reorganized in such a way that scarce labor and capital are used to supply things that people want.
1. W.H. Hutt, The Keynesian Episode: A Reassessment (Indianapolis, IN: Liberty Fund, 1980), p. 52. Hereafter cited as KER.
2. Malthusian thinking was later resurrected by Keynes as the basis for his theory of “macro economics.
3. KER, p. 150.
4. W.H. Hutt, A Rehabilitation of Say’s Law (Athens: Ohio University Press, 1974), p. 8.
5. KER, p. 59.
6. KER, p. 55.
7. Murray N. Rothbard, Man, Economy, and State, with Power and Market, 2d scholar’s ed. (Auburn, AL: Ludwig von Mises Institute, 2009), chap. 7.
8. KER, p. 162.
9. KER, p. 53.
10. KER, p. 54.
11. KER, p. 284.
12. KER, p. 55.
13. KER, p. 151.
