John Plender’s recent article in the Financial Times discusses the failure of diversification with regards to the current economic bust. I thought it was interesting because his thesis has an “Austrian” element¹:

A more fundamental point is simply that diversification cannot work well in a credit bubble because virtually all asset categories are driven up by leverage. Then when the bubble bursts, deleveraging affects asset categories indiscriminately.

I tend to agree that diversification cannot work well in a credit bubble, although I’m not sure “indiscriminate” is the appropriate way to describe the havoc wrought. When Plender says “indiscriminately”, what he means is that no amount of entrepreneurial insight was sufficient to avoid losses, and that only dumb luck could’ve kept investors above water.

But losses aren’t exactly “indiscriminate”, instead, effects of deleveraging ought to be strongly correlated with the amount of leverage, so highly levered “assets” should experience the largest losses; this much is elementary. Although not stated explicitly, Rothbard touches on the apparently “indiscriminate” nature of losses during the bust phase, while describing the “cluster of error” characteristic of capitalist boom/bust cycles²:

How, then, do we explain the curious phenomenon of the crisis when almost all entrepreneurs suffer sudden losses? In short, how did all the country’s astute businessmen come to make such errors together, and why were they all suddenly revealed at this particular time? This is the great problem of cycle theory.

Expanding on Hayek’s framework, Rothbard concludes that the eventual “bust” is “generated by monetary intervention in the market, specifically bank credit expansion to business,” and that the “’crisis’ arrives when the consumers come to reestablish their desired proportions [of savings and consumption]” and the banks can no longer credibly augment the money supply.

The last point is key: as long as the money supply can be continually and credibly expanded (i.e., no risk of hyperinflation), banks can continue to increase the amount of credit available, and business borrowers will remain “one step ahead”, able to bid prices ever higher, further exacerbating the eventual bust. At some point, however, credit is no longer issued in sufficient quantities or at the right time, and this is the point in time where the house of cards is revealed for what it is.

It’s of paramount importance to understand that although an economic “bust” destroys, dislocates, or otherwise consumes some real wealth through malinvestment, mostly, what’s happening is that the Ponzi-scheme illusion of wealth, credit, is being destroyed, and consequently every asset the “value” of which was determined (in whole or in part) by credit, needs to be reassayed.

Wherever economic growth is not driven by previous savings and capital accumulation, but instead mortgaged by future productivity, a “bust” is inevitable.

1. Plender, John. Investment and the crisis: an error-laden machine, Financial Times, March 2, 2009.
2. Rothbard, Murray N. How the Business Cycle Happens.

It is widely (i.e., it’s not just an Austrian or libertarian belief) and correctly held that it was an excess of spending that caused the current crisis: individuals were consuming far more “wealth” than had previously been created. They were using their homes as ATM, they were borrowing excessively because interest rates were artificially low and they were saving inadequately because yields were artificially depressed.

Some people argue that government spending must necessarily replace a perceived lack of consumer spending, a withholding of consumption that is deleterious to the economy as a whole. But individuals were spending far more than they had previously accumulated in the first place, indeed the pace of consumption was completely unsustainable! So, consumers spent too much, which caused all sorts of bad things to happen. When eventually this realization comes to light, consumers stop spending, at which time the mainstream economic ideology tells us that the only way out of the crisis is more spending — and that if only individuals weren’t so stingy with their funds, the government wouldn’t have to step in and make up the perceived lack of consumption spending.

They can’t continue spending at a pace on par with that of earlier this decade, because they weren’t spending in the first place, they were primarily borrowing. They were borrowing and consuming immediately. And at some point, the costs of servicing debt become so prohibitive that it’s no longer possible to keep borrowing, or even to keep consuming at the previous levels.

Keynesian economic policy suggests that governments should spend, in order to make up for a perceived lack of private consumption, but this couldn’t be more wrong: it wasn’t private spending that caused, e.g., the current crisis. It was private borrowing. And anyone who knows even the first thing about personal finance knows that it’s quite impossible to “borrow” one’s way to prosperity.

Fact: Governments don’t have any money, either.  So to whatever extent the government decides to “spend” its way out of a depression, you can be assured 100% of the way, that what the government is really doiing is “borrowing.”  And they’re using you as collateral.