Can Skyscrapers Predict a Recession?
In 2005, Dr. Mark Thornton published an essay titled, “Skyscrapers and Business Cycles,” in the Quarterly Journal of Austrian Economics. In it, he discussed the usefulness of what is now known as The Skyscraper Index, and its ability to predict the onset of recessions. Without getting too deep into the nuts and bolts of economics, I would like to present this concept to you, and demonstrate that it is a useful tool for not only studying past fluctuations in the business cycle, but for predicting future fluctuations as well. I shall conduct this discussion by first explaining the theory behind the index, going into its practical implications and finally, presenting some of the empirical evidence supporting and detracting from the index.
In order to properly understand the implications behind the Skyscraper Index, it is necessary to understand how business cycles occur and what causes them. Simply put, the business cycle is the periodic pattern of recessions and expansions that an economy experiences. When there is an expansion, unemployment decreases, household incomes rise, and the overall level of business activity increases. During recessions however, unemployment increases, household incomes decline, and business activity begins to slow down. This is the nature of the business cycle, and its causes have puzzled economists since the study of macroeconomics was first introduced nearly a century ago. While some economists argue that downturns in the business cycle are caused by decreases in the overall demand for goods and services, others argue that the business cycle is actually driven more by the supply-side of the economy. Both of these views hold merit, and both provide accurate assessment of specific historical recessions, but both groups miss or, marginalize a key factor in what causes these cyclical fluctuations: credit expansions. (1) Credit expansions are the process of increasing the total amount of savings by artificial means. Savings, it should be remembered, are the result of frugality on the part of the individual consumer, of their preference for future goods over present goods. And it is only through an increase in savings that the overall supply of financial capital (2) can grow, therefore allowing for the economy as a whole to grow. An increase in the supply of capital allows the economy to grow by driving down interest rates. (3) It should be remembered that interest rates, like any other price, respond to the laws of supply and demand. Thus an increase in the supply of savings will lower the interest rate. This makes the pursuit of certain projects that had previously been unprofitable, more tenable for businesses to pursue. It also makes more long term, or capital-heavy projects cheaper due to the lower cost of borrowing the necessary funds. As a result of this the economy expands, more people are employed, more goods and services are produced and thus available for the consumer to purchase, and workers generally see an increase their wages. Overall the economy as a whole is wealthier than it was previously.
The trouble begins when the government, usually seeking to correct a recession, or decrease unemployment, seeks to artificially increase the supply of savings. This artificial increase usually comes in the form of the Federal Reserve buying assets, usually referred to as “Open Market Operations.” This process works by the Fed going to—say, a bank—and offering to buy treasury bonds or other financial assets off the bank in exchange for cash. The Fed usually offers pretty good rates to such banks, so they will rarely pass up the opportunity to sell off usually low-yield, short-term assets for cash, which they can then loan out and turn a profit on. What this process in effect does, however, is increase the amount of reserves banks possess in excess of real savings, thus driving down rates of interest banks offer on loans. This has the same effect as an actual increase in savings: projects that had previously been deemed unprofitable are now rendered profitable. This leads to what is referred to as malinvestment, that is, investment in unsustainable business investments. Credit expansions tend to lead to an overall increase in business activity as wages increase, machinery and equipment industries see a boom in demand, and the prices of consumer goods increase. This period of the business cycle is known as the expansion or “boom” phase. But booms necessarily have a finite lifespan. As Ludwig von Mises pointed out, “The boom can last only as long as the credit expansion progresses at an ever-accelerated pace.” (4) Thus, when the boom period eventually ends, interest rates are bid back up, some projects are abandoned, and others are liquidated as companies attempt to attain cash to cover their liabilities. Meanwhile, inventories are thrown on the market at dirt cheap prices, again as companies scramble to save themselves from insolvency. Workers are either fired, or see their wages decrease. Overall, unemployment increases, incomes decrease, and the economy enters into a recession. This phase is known as the “bust.” And it is this cycle of boom and bust which is illustrated by the Skyscraper Index.
First created by Dr. Andrew Lawrence in 1999, the Skyscraper Index demonstrates the correlation between the onset of recessions and the height of newly constructed skyscrapers. That is, when the business cycle is in the boom phase, the number of new building projects tends to increase. Dr. Thornton identified three effects of the credit expansions that drive the “boom,” the first being the reduction in the relative price of land and capital. When interest rates are reduced, the cost of owning land is reduced as well. This is because investors earn less on interest accruing to the money they have saved. Thus, the cost of taking those savings and investing them in physical assets, such as land, is lowered. As well, the actual cost of borrowing is reduced, therefore making it cheaper for firms to borrow funds to construct increasingly ambitious building projects. The second effect of credit expansion is the effect it has upon the size of firms. A decrease in the cost of borrowing incentivizes firms to increase production, and invest in more long-term projects. This causes firms to extend their operations over an ever larger area, and to buy up new facilities at which to pursue such long term projects such as product development, and higher yield production processes. All this serves to increase firms’ demand for land, therefore pushing up rents and land values. And it is this increase in the price of land that, in part, pushes firms to construct increasingly taller buildings, as height becomes cheaper, relative to the width of buildings. The third and final effect of a credit expansion is its impact on technology. As buildings get taller, builders and suppliers have to devise new and inventive ways in order to properly construct them. As a consequence a great deal of capital is turned towards the development of these new technologies, and engineering processes. It is perhaps worth noting that of all the effects identified by Thornton, the subsidy that booms provide to technology seems to be the sole beneficial one. However as a whole this process, like all others associated with artificial booms, are necessarily harmful to the overall state of a nation’s economy. As a result of the boom, scarce resources are squandered, and investments eventually lose their value, workers see their wages and salaries rise and then fall. The end result of this process is a wide collection of devalued, underutilized goods of varying natures, and impoverished workers and entrepreneurs.
Finally, I would like to consider the empirical evidence presented by Thornton in his essay of the index’s validity. Thornton notes in his article that, in line with his theory, there are periods when new, record setting skyscraper construction projects were being undertaken prior to the peak of the business cycle, and the resulting bust. He notes that the earliest instance of a skyscraper inducing business cycle comes in the early 1900s with the construction of the Singer Building, which was the tallest building in the world upon its completion in 1908. The construction of the Singer Building coincided with the Panic of 1907, which Thornton attributes to being caused by a combination of seasonal factors relating to fall harvests, and credit manipulation on the part of the National Banking system. (5) The next period of note comes during the Great Depression where,
Three record setting skyscrapers were announced during the late 1920s, when the stock market boom was being matched by booms in residential and commercial construction. In 1929, the skyscraper at 40 Wall Street was completed at 71 stories, followed by the Chrysler Building in 1930 at 77 stories, and the Empire State Building in 1931 at 102 stories. Clearly, there was a capital-oriented boom in the construction of ever-taller buildings before the Great Depression. (6)
This information, combined with further data he presents regarding the 1970s boom in skyscraper construction which coincided with the era of stagflation, and the similar booms that occurred in the 1980s and 90s, according to Thornton seems to vindicate that the Skyscraper Index is a worthwhile tool to help predict the business cycle. As a final note, the index, like all macroeconomic theorems, should be taken with a hefty dose of skepticism. And while Thornton’s argument and the data he presents provide a convincing argument, there is by no means a consensus among macroeconomists that the Index is a good indicator of the business cycle. Indeed, Thornton devotes the last section of his paper to discussing when the index is faulty, or fails to predict the onset of the business cycle. (7) As well, further empirical research on the matter has yielded a slightly different conclusion than the one that Thornton comes to. While the height of skyscrapers is related to movements in the business cycle, their height does not predict the business cycle. Rather, the business cycle can determine the height of skyscrapers. (8)
However, notwithstanding these objections, the Skyscraper Index still yields valuable information on the business cycle, both in predicting its effects, and in illustrating the patterns inherent in fluctuations in economies. If someone wants to understand the business cycle, the answer lies not just in charts and spreadsheets, but right outside their window.
(1) I do not claim originality with this theory. The idea that business cycles are caused by government manipulation of the supply of credit originates in the writings of Eugen von Böhm-Bawerk, William Stanley Jevons, Ludwig von Mises, Friedrich von Hayek, Lionel Robbins, and Fritz Machlup. Many of these thinkers fall into what is now known as the Austrian school of Economics, however, many of their ideas are shared by members of the Real Business Cycle school, Public Choice school, and the New Classical school as well.
(2) “Savings” and “capital” are synonymous in this instance.
(3) Interest rates serve a multitude of purposes in the economy, however in this instance it solely refers to the price one pays for the use of capital, paid to the lender that compensates them for the risk of lending, the time value of money, and inflation.
(4) Ludwig von Mises, Human Action: A Treatise on Economics, Volume II, ed. Bettina Bien Greaves (Indianapolis, Liberty Fund, Inc., 2007), 555.
(5) Mark Thornton "Skyscrapers and Business Cycles," The Quarterly Journal of Austrian Economics 8, no.1 (2005): 55.
(6) Ibid., 56.
(7) Ibid., 70-72.
(8) Skyscraper Index," Wikipedia, accessed January 21, 2018. https://en.wikipedia.org/wiki/Skyscraper_Index.