In the Austrian theory of the boom-bust cycle, monetary intervention, specifically the expansion of bank credit, causes a “cluster of errors” in business investment throughout the “orders or production”. In the economy some of the money is spent on consumption with the remainder being saved and invested throughout. The proportion of consumption to savings and investment is based on the population’s time preferences, the less present preference the public has, i.e. the less consumption, the lower will be their time preference rate and therefore the lower will be the pure interest rate. This low preference will reflect a greater proportion of investment to consumption, a lengthened structure of production (in terms of the furthered allocation of funds in industries far from the consumer), and a buildup of capital with lower loan interest rates. As new money created by banks via the Federal Reserve’s expansion pours into the loan market, it lowers the loan rate of interest, because the supply of funds in relation to the rate of profit in business and the purchasing power of the currency is raised, business takes advantage of the cheaper money and invests in what they believe to be more profitable production lines.

But if the increase is due to credit expansion instead of a change in time preferences; as the new money streams through the economy and trickles down to the consumer by way of higher wages, rents, and basic inflation. Business will need to gamble on whether the new excess of funds were due to a real change in time preferences, which will result in justified credit expansion, or artificial money growth resulting in the public allocating their newly inflated money base into their old time preferences, thereby creating “clusters of errors” of business investment that’s not justified by time preferences. The Federal Reserve under Alan Greenspan claimed that the economy can absorb the expansion by using the funds to further productivity and raising the rate of profit and thereby the purchasing power of the dollar. However as the banks allocate their newly inflated monetary base into areas of the economy with higher rates of return…to riskier recipients…the flow of capital would neglect the lower orders of production, i.e. commodity markets.

Under the direction of the Fed, and with the use of derivatives, banks transfer the increased loan risks throughout the economy, however the risk is just that…transferred not eliminated…and it comes to a question of who is it transferred to…stronger hands or weaker hands? As time passes by and the economy realizes that time preferences have not changed enough to justify the broadened allocation of funds…reflected by the lower (neglected) orders of production receiving inflationary pressures by the inflated “higher orders of production” and the consuming public.

Today it looks as if the “higher orders of production” receiving the excess funds are the financial markets itself. The private equity & hedge fund industries are inflating the stock market by bidding up companies to quickly extract years worth of value and future earnings. Several sectors of the stock market are overvalued…reflected by its capitalization rates vs. the yield curve. “Low order sectors” such as consumer goods, commodity, and food and beverage providers (close to consumer sectors) are so highly valued that not only is there no risk premium but there is in some cases what would appear to be risk discounts, relying on earnings growth in the near future or higher interest rates. On the other side of the pivot, if the fed raises interest rates or cuts the money supply, it would put recessionary pressures on the economy as tightening an already weakening and bloated economy is troublesome. That is not to say every sector or every stock is bloated. But the amount of debt created liquidity that has propped up the financial markets is in my opinion unsustainable unless Schumpeter’s creative destruction ever steps up to the level that the Fed believes our businessman should be at, or if foreign time preferences shift to much higher levels, to where they will step up the acquisition of capital goods from us, without so, the over-priced sectors of the market will need to adjust for reality…the bust part of the cycle.

A unique situation to our chapter in history is the leadership derivative exchanges have on general prices. The Crude Oil market at the NYMEX currently has listed, or open interest of, about 955 million bbls of oil for the front 12 months, and in which time the consumption of oil in the US alone is almost 10 times that figure. Yet the industry uses the quotation as its basis. One contract of Crude Oil is 1,000 bbls at around $66/bbl, but margin requirements are only about 10% or $6,600 per contract. So for a mere $660 million one can control 100,000,000 bbls of oil or over 1 day of world consumption. This is similar to what the hedge fund Amaranth Advisors accomplished, before they imploded. Amaranth controlled enough Natural Gas to supply the entire United States for several days. The price inflation, while building up that massive position, heavily impacted the end users of Natural Gas, as did the deflation after their demise. The volatility adds risks and businessman respond by accounting for them with price hikes or market avoidance. Once the error in the market reveals itself…either that the large budget for inputs were artificially high, and an excess in corporate profits are present, or that the futures market proved to be incorrect (in its pricing), following more of a momentum based technical trade pattern than the realistic relationship of supply and demand the market compensates the owners of capital with higher wages, that are invested through different time preferences…confusing as to whether they’re one time wage gains or recurrent payroll increases. Also, this is demonstrated by a speech Greenspan gave in 2005 praising the financial markets for “opening up credit” to the sub-prime mortgage market and that the extension of financial services to that sector will benefit all…as it did with higher house prices and equity buildup, yet when the market realized that the extension and price inflation was overdone…by way of sub-prime borrows being sub-prime borrows unable or unwilling to service their debt, the market pulled back.

The bottom line is this, in my opinion, it’s not a sign of strength that the credit cycle is peaking at 5.25% or around that, and with capitalization rates so low, basically no risk premiums, T-Bills discounted to the Fed Funds rate, and continued talk of policies that should increase risks…ethanol is more risky than petrol as agricultural production is more volatile and weather dependent than petroleum’s volatility based mainly on transportation risks. More and more inefficient centralization through government or patrons of the stock market will mark more errors that will need to be liquidated at some point in the future. Yet as history shows, more of it has to do with perception rather than reality. Recession and depression could be a good thing…it liquidates the inefficient participants in the economy, while deflation lowers the cost of living, cost of business, opens up opportunities, fixed income groups are ruined during inflationary times…and so they receive a total benefit during deflation. On the other hand, people can exaggerate reality and cause panics and stints of unwarranted ruin, resulting in a question of time preferences.

Boston Properties (BXP) serves as a fine example of time preference. The company is a real estate investment trust that I bought in August 2001 to take advantage of strong fundamentals in the high end office market. Today the capitalization rate on its FFO (funds from operations) is about 3.8%, illustrating that either time preferences have lengthened, that the market will demand much more office real estate and if not built rental rates will go up. Or that credit expansion caused an abundance of liquidity in the debt markets, allowing for inflation and leaving investors wanting tangible assets for protection, meaning market demand does not warrant an inverted cap-rate to treasurys and the disequilibrium (“error”) will need to correct one day.