As Austrians we are always looking for evidence to lead us to the next bubble. I think most of us are on high alert after a decade of easy money, stock price inflation, and ever decreasing bond yields. However, identifying the specific bubble sector(s) ahead of time is extremely difficult (unless you are Mark Thornton). ...
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As Austrians we are always looking for evidence to lead us to the next bubble. I think most of us are on high alert after a decade of easy money, stock price inflation, and ever decreasing bond yields. However, identifying the specific bubble sector(s) ahead of time is extremely difficult (unless you are Mark Thornton). This notwithstanding, one industry seems to me to display all of the signs that it is in the midst of an Austrian business cycle theory (ABCT) bubble. That industry is whiskey (or whisky) production.1
Let’s review what makes whiskey production especially susceptible to expansion during the credit fueled boom and therefore likely to undergo a violent contraction during the inevitable market correction.
Whiskey Has a Long Production Process
“As implied by standard calculations of discounted factor values, interest-rate sensitivity increases with the temporal distance of the investment subaggregate, or stage of production, from final consumption.”
Whiskey production can be one of the longest production processes in the entire economy. Planning whiskey production is extremely difficult, even if you assume a perfectly stable, hard money economy. Even moderate quality whiskies need to be planned years in advance. The youngest whiskey that can be legally labeled as bourbon must be barrel aged for at least 2 years, but most middle shelf bourbons are aged for 4, 6, or 8 years. Scotch whiskey has even stricter requirements; to be labeled Scotch the whiskey must be aged for a minimum of three years, but it is rare to find a moderately rated Scotch aged for less than 8 years. The most popular Scotches are aged 12, 14, and 16 years while the most luxurious whiskies are aged as long as 25 or even 50 years. Compound this with losing 2 percent of volume per year aged to the “angel’s share” and you are in a very difficult entrepreneurial situation. The entrepreneur has to accurately predict the demand for his product 12 years in the future so he can invest the correct amount of resources now in order to produce an adequate supply for that demand. The only chance one has to perform this economic calculation efficiently is to have accurate interest rates. Even a small distortion in the interest rate will have a dramatic effect on the profit/loss expectations for a product you are expecting to sell in 12 years.
It’s Highly Capitalized
“Capital goods industries will find that their investments have been in error: that what they thought profitable really fails for lack of demand by their entrepreneurial customers. Higher orders of production have turned out to be wasteful, and the malinvestment must be liquidated.”
Whiskey production may not be what comes to mind when reading the often referenced “capital goods industry.” Nevertheless, whiskey production is very dependent on highly specific capital goods and distilleries generally have a high level of vertical integration (often mandated to do so by government regulations). In some cases they harvest raw materials like peat from the distillery’s land (peat production probably warrants its own Austrian analysis), and they don’t sell the product until it is nearly in the customer’s hand decades later. This can be best illustrated with a brief summary of the whiskey production process.
The distiller-entrepreneur will first need to determine the recipe, this will determine the proportion of grain, corn, rye, or barley that must be acquired based on the predicted preferences of the customer years later. Once the ingredients are acquired malting begins where the barley (for example) is steeped in water on the malting floor to start the germination. This process involves monitoring the germination of the barley until the sugar content is within the target range. Once the barley is ready it is dried out in a kiln where peat is burned in order to add flavor and stop the germination. The malted barley is then ground down and water is added, this is referred to as the mash. It is then allowed to ferment into a beer like substance called the wash. The wash is subsequently transformed into whiskey by distilling it in copper pot stills. The distiller-entrepreneur then needs to decide how long to age this clear, harsh whiskey and in what type of cask. A popular combination would be an oak cask that was previously used to age sherry, aged for 12 years. During this 12 years the cask sits in an enormous dunnage warehouse. Once the maturation is complete, the whiskey is sent through a strict quality assurance program, bottled, labeled, and distributed all over the world. At this point the distiller has finally sold his product. So in short, the distillery needs peat harvesting equipment, malting floors, kilns, copper pot stills, thousands of casks, dunnage warehouses, land, and a lot of time.
The whiskey industry suffers from another disadvantage because of the specificity of the capital goods required. When the inevitable market adjustment occurs, the large amounts of capital that the company invested in during the boom is virtually impossible to liquidate because it has no other uses. This will make it very difficult for highly leveraged distilleries to stay afloat after the bust. Contrast that with a labor heavy industry like restaurants in which, economically speaking, labor rates are essentially a rent that can be scaled back immediately. Consider Diageo, the corporation that owns many popular whiskey brands, it has a market cap of around $96 billion, but only employs around 30,000 employees. On the other hand, Yum Brands, the owner of many large fast food businesses has a market cap of $35 billion and employs 90,000 employees. The restaurant business could potentially have an easier time scaling back operations — via cutting staff — when the contraction hits because they are not tied down to highly specific capital.
Production of Luxury Goods
“Households financed their increased spending on boats, luxury autos, upscale restaurant meals, pricey vacations etc., through fixed-dollar debt. The increase in value of home equity and 401(k) plans also reduced saving out of current income, and the personal saving rate plunged from over 4 percent immediately after the recession of 2001 to less than 1 percent during 2005.”
ABCT tells us that the major price fluctuations occur in the higher stages and leaves the lower stages relatively unaffected. However, empirical data and common experience tells us that luxury goods may be an exception. During the boom, the public’s time preference did not change, but they found more money in their pocket. This encouraged increased spending. During the 2000s boom, we found that this extra spending was directed largely toward luxury items, whether it be houses, cars, or vacations.
While the distiller-entrepreneur is planning the quantity of whiskey to supply, a major data point to consider is the current demand. In a sound economy the entrepreneur would see low interest rates and it would entice him to invest in higher production to be released in the future. Inherent in that signal is the knowledge that consumers are curbing consumption now to fund their increased spending in the future. Moreover, if the entrepreneur sees low interest rates while current consumption in his industry is booming despite the higher savings, this has a compounding effect on predictions for the future. In other words, if business is booming now while people are saving, imagine the height of demand for the whiskey in 12 years when consumers’ time preference shift toward consumption spending!
Unfortunately, in the current economy, over investment (or malinvestment) is occurring now, squandering the resources that are expected to be available to fund the consumption in the future. During the contraction, when unemployment will rise, it stands to reason some of the first items to drop off a household’s budget will be discretionary luxury items, like $100 bottles of whiskey. This will cause the demand for whiskey to plummet at the same time the supply is exploding. This could spell disaster for the hundreds of new distilleries that have been started in the last decade.
Massive investment has entered this industry in response to rising prices. Unfortunately, solid economic theory is telling us that this investment is probably in error. However, I am not advocating any financial advice. I know for myself whiskey would be one of the last things to drop off my budget during hard times. It’s possible that distilleries can sell off a portion of their inventory to weather the storm. Or maybe this is a real industry boom; maybe whiskey has so engrained itself into modern culture that demand will never really drop off and all of this investment was undertaken with undistorted signals. If there is one thing that Austrian economics teaches us, it is that predictions are often futile. The dynamics of the market are based on each individual making thousands of decisions a day. Predicting the timing, location, or extent of future economic events will likely end up embarrassing in hindsight. I guess all we can do is wait and pour ourselves another dram.
- 1. The spelling "whiskey" or "whisky" often depends on the place of origin, Ireland or Scotland, respectively. But as this is an American publication, we will use the generic American spelling "whiskey" to denote all types.