The turmoil in the credit markets now emanating from the collapse of the housing bubble can be understood in the light of the theory of the business cycle developed by Ludwig von Mises and F.A. Hayek. These authors showed that credit expansion distorts the pattern of spending and capital investment in the economic system. This in turn leads to the large scale loss of capital and thereby sets the stage for a subsequent credit contraction, which is precisely what is beginning to happen now. (For the benefit of readers unfamiliar with the expression, credit expansion is the creation of new and additional money by the banking system and its lending out at artificially low interest rates and/or to borrowers of low credit worthiness.)
The genesis of the present problem goes back to the bursting of the stock-market bubble in the early years of this decade. In an effort to avoid its deflationary consequences, the bursting of the stock market bubble was followed by successive Federal Reserve cuts in interest rates, all the way down to little more than 1 percent by the end of 2003.
These cuts in interest rates were accomplished by means of repeated injections of new and additional bank reserves. The essential interest rate in question was the so-called Federal Funds rate. This is the interest rate that the banks that are members of the Federal Reserve System charge or pay in the lending and borrowing of the monetary reserves that they are obliged to hold against their outstanding checking deposits.
The continuing inflow of new and additional reserves allowed the banking system to create new and additional checking deposits for the benefit of borrowers. The new and additional deposits were created to a multiple of ten or more times the new and additional reserves and made possible the granting of new and additional loans on a correspondingly large scale. The sharp decline in interest rates that took place encouraged the making of mortgage loans in particular. The reason for this was the steep decline in monthly mortgage payments that results from a substantial decline in interest rates. The new and additional checking deposits were money that was created out of thin air and which was lent against mortgages to borrowers of poorer and poorer credit.
So long as the new and additional money kept pouring into the housing market at an accelerating rate, home prices rose and most people seemed to prosper.
But starting in 2004, and continuing all through 2005 and the first half of 2006, in fear of the inflationary consequences of its policy, the Federal Reserve began gradually to raise interest rates. It did so in order to be able to reduce its creation of new and additional reserves for the banking system.
Once this policy succeeded to the point that the expansion of deposit credit entering the housing market finally stopped accelerating, the basis for a continuing rise in home prices was removed. For it meant a leveling off in the demand for housing. To the extent that the credit expansion actually fell, the demand for houses had to drop. This was because a major component of the demand for houses had come to be precisely the funds provided by credit expansion. A decline in that component constituted an equivalent decline in the overall demand for houses. The decline in the demand for houses, of course, was in turn followed by a decline in the price of houses Housing prices also had to fall simply because of the unloading of homes purchased in anticipation of continually rising prices, once it became clear that that anticipation was mistaken.
This drop in the demand for and price of houses has now revealed a mass of mortgage debt that is unpayable. It has also revealed a corresponding mass of malinvested, wasted, capital: the capital used to make the unpayable mortgage loans.
The loss of this vast amount of capital serves to undermine the rest of the economic system.
The banks and other lenders who have made these loans are now unable to continue their lending operations on the previous scale, and in some cases, on any scale whatever. To the extent that they are not repaid by their borrowers, they lack funds with which to make or renew loans themselves. To continue in operation, not only can they no longer lend to the same extent as before, but in many cases they themselves need to borrow, in order to meet financial commitments made previously and now coming due.
Thus, what is present is both a reduction in the supply of loanable funds and an increase in the demand for loanable funds, a situation that is aptly described by the expression “credit crunch.â€
The phenomenon of the credit crunch is reinforced by the fact that credit expansion, just like any other increase in the quantity of money, serves to raise wage rates and the prices of raw materials. It thereby reduces the buying power of any given amount of capital funds. This too leads to the outcome of a credit crunch as soon as the spigot of new and additional credit expansion is turned off. This is because firms now need more funds than anticipated to complete their projects and thus must borrow more and/or lend less in order to secure those funds. (This, incidentally, is the present situation in the construction of power plants and other infrastructure, where costs have risen dramatically in the last few years, with the result that correspondingly larger sums of capital are now required to carry out the same projects.) In addition, the decline in the stock and bond markets that results after the prop of credit expansion is withdrawn signifies a reduction in the assets available to fund business activities and thus serves to intensify the credit crunch.
The situation today is essentially similar to all previous episodes of the boom-bust business cycle launched by credit expansion. The only difference is that in this case, the credit expansion fed an expanded demand for housing and, at the same time, most of the additional capital funds created by the credit expansion were invested in housing. Now that the demand for housing has fallen, as the result of the slowdown of the credit expansion, much of the additional capital funds invested in housing has turned out to be malinvestments. In most previous instances, credit expansion fed an additional demand for capital goods, notably plant and equipment, and most of the additional capital funds created by credit expansion were invested in the production of capital goods. When the credit expansion slowed, the demand for capital goods fell and much of the additional capital funds invested in their production turned out to be malinvestments.
In all instances of credit expansion what is present is the introduction into the economic system of a mass of capital funds that so long as it is present has the appearance of real wealth and capital and provides the basis for sharply increased buying and selling and a corresponding rise in asset prices. Unfortunately, once the credit expansion that creates these capital funds slows, the basis of the profitability of the funds previously created by the credit expansion is withdrawn. This is because those funds are invested in lines dependent for their profitability on a demand that only the continuation of the credit expansion can provide.
In the aftermath of credit expansion, today no less than in the past, the economic system is primed for a veritable implosion of credit, money, and spending. The mass of capital funds put into the economic system by credit expansion quickly begins evaporating (the hedge funds of Bear Stearns are an excellent recent example), with the potential to wipe out further vast amounts of capital funds.
As the consequence of a credit crunch, there are firms with liabilities coming due that are simply unable to meet them. They cannot renew the loans they have taken out nor replace them. These firms become insolvent and go bankrupt. Attempts to avoid the plight of such firms can easily precipitate a process of financial contraction and deflation.
This is because the specter of being unable to repay debt brings about a rise in the demand for money for holding. Firms need to raise cash in order to have the funds available to repay debts coming due. They can no longer count on easily and profitably obtaining these funds through borrowing, as they could under credit expansion, or, indeed, obtaining them at all through borrowing. Nor can they readily and profitably obtain funds by liquidating the securities or other assets that they hold. Thus, in addition to whatever funds they may still be able to raise in such ways, they must attempt to accumulate funds by reducing their expenditures out of their receipts. This reduction in expenditures, however, serves to reduce sales revenues and profits in the economic system and thus further reduces the ability to repay debt.
To the extent that anywhere along the line, the process of bankruptcies results in bank failures, the quantity of money in the economic system is actually reduced, for the checking deposits of failed banks lose the character of money and assume that of junk bonds, which no one will accept in payment for goods or services.
Declines in the quantity of money, and in the spending that depends on the part of the money supply that has been lost, results in more bankruptcies and bank failures, and still more declines in the quantity of money, as well as in further increases in the demand for money for holding. Such was the record of The Great Depression of 1929-1933.
Given the unlimited powers of money creation that the Federal Reserve has today, it is doubtful that any significant actual deflation of the money supply will take place. The same is true of financial contraction caused by an increase in the demand for money for holding. In confirmation of this, The New York Times reports, in an online article dated August 11, 2007, that “The Federal Reserve, trying to calm turmoil on Wall Street, announced today that it will pump as much money as needed into the financial system to help overcome the ill effects of a spreading credit crunch.… The Fed pushed $38 billion in temporary reserves into the system this morning, on top of a similar move [$24 billion] the day before.†In addition, the print edition of The Times, dated a day earlier, reported in its lead front-page story that “the European Central Bank in Frankfurt lent more than $130 billion overnight at a rate of 4 percent to tamp down a surge in the rates banks charge each other for very short-term loans.â€
Thus the likely outcome will be a future surge in spending and in prices of all kinds based on an expansion of the money supply of sufficient magnitude to overcome even the very powerful impetus to contraction and deflation that has come about as the result of the bursting of the housing bubble.
Another outcome will almost certainly be the enactment of still more laws and regulations concerning financial activity. Oblivious to the essential role of credit expansion and of the government’s role in the existence of credit expansion, the politicians and the media are already attempting to blame the present debacle on whatever aspects of economic and financial activity still remain free of the government’s control.
It probably is the case that at this point the only thing that can prevent the emergence of a full-blown major depression is the creation of yet still more money. But that new and additional money does not necessarily have to be in the form of paper and checkbook money. An alternative would be to declare gold and silver coin and bullion legal tender for the payment of debts denominated in paper dollars. There is no limit to the amount of debt-paying power in terms of paper dollars that gold and silver can have. It depends only on the number of dollars per ounce.
To be sure, this is an extremely radical suggestion, but something along these lines will someday be necessary if the world is ever to get off the paper-money merry-go-round of the unending ups and downs of boom and bust, accompanied since 1933 by the continuing loss of the buying power of money.
Copyright © 2007, by George Reisman. George Reisman is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. His web site is www.capitalism.net.
{ 26 comments }
I suspect James Grant and Bill Bonner are going to see a surge in popularity. Ah, the gold standard. With Ron Paul it would be possible; but when in our collective american history have hard-money men been particularly successful in politics? (at least in the last 160 or so years….)
creation of new and additional money by the banking system and its lending out at artificially low interest rates
Realistically, the Fed isn’t going anywhere so I’ll dispense with the day dreams of others, and ask simply this; what is artificial and once that is established, what is real?
does this help??
“Let us begin with Clinton’s “prosperity.” Yes, during the late 1990s, unemployment was low, and the stock market was booming. The problem was that this boom was driven by unwarranted expansion of credit by Clinton’s new political ally, Federal Reserve Chairman Alan Greenspan, and was in no way sustainable.
In fact, by 2000, the boom already had run its course, and the markets were showing weaknesses. Moreover, the massive number of new regulations the Clinton administration placed upon business activities–especially on the environmental front–were sure to become even more burdensome once a slowdown hit the economy, and would also impede any recovery.
That the boom was driven by the Fed’s credit expansion is obvious. The figure above demonstrates money growth from 1983 to 2000, and we can see that growth in M2 and M3 was especially steep, particularly after the 1994 elections when the Republican took both houses of Congress.
Even more telling is the growth of debt from 1995 to 2000, as household debt rose by 46.4 percent, corporate debt by 62.8 percent, and state government debt by 19.5 percent. For households, mortgage debt rose by an astounding 94 percent during that period.[i]”
http://mises.org/daily/1019
i guess an artificial interest rate is one where due the the ‘rapid’ expansion of fiat currency the cost of borrowing is driven lower than it would have been without a rapid expansion of fiat money.
or one where the government has so much control over it.
others may be able to elaborate better.
Real interest rate = the rate determined by the voluntary exchange of individuals
Artificial interest rate = anything else
If I own a mortgage with a bank that goes bankrupt due to other bad loans, what (generally) happens to the loan? Does the loan vanish? Does the outstanding amount of the loan get called in immediately by creditors? Does the outstanding amount of the loan get transferred to another bank?
Thank you to anyone who can shed light onto this scenario.
Yes, I understand the market.
But I’m looking for something more quantifiable than a vague artificial.
Could the Fed be ran by a simple computer program that adjusted the rate within a narrow window as the various influencing factors vacillated?
Should there be a set % rate to remain unmoving except for the most extreme circumstances?
I honestly don’t have a dead-set opinion for or against the Fed, but I know what makes fools out of the planned-economy types is that there are simply too many factors to a dynamic, free economy. So if we constrict the Fed to a single rate, or some kind of pre-programmed formula, might we fall into the same trap as a planned economy that thought to “fix†or “manage†the economy through a well defined set of parameters?
Or the opposite; we get rid of the Fed, national banking, et cetera and return to extreme boom and busts?
I have opinions on what might be a fix, but I haven’t finished the answers.
Matthew:
Someone would most likely be able to buy your debt, but your assets would be toast.
Cool huh? . . .
Ray G,
Nothing is vague about:
“Artificial interest rate = anything else”
You say you know what makes fools out of the “planned economy types” yet you are postulating various schemes for planning the economy. What gives?
When have we gotten extreme booms and busts without central banks, fiat currency or fractional reserve banking? None of these would exist (or would at least be punishable as fraudulent) if governments didn’t prop them up.
I think maybe you should start with some basic books about money first and start working your way up to “finishing the answers”.
Ray, have you head of Monetarism? I do not mean to be condescending when I ask this – I am just curious, because it bears huge resemblance to what you outlined.
should be: heard
Out of curiosity, does anyone have an estimate for the value, in terms of dollars per ounce, of gold if gold(and silver) were declared legal tender for ‘payment of debts denominated in paper dollars?’ That is, let’s say as of January 1, 2007.
Surely, the mass of unpayable mortgage debt is only half the problem. What brought the hedge funds undone was the ingenious repackaging of this debt into CDOs and “corporate bonds” which the funds mopped up with gusto. After all, debt instruments have been one of their safest sources of income in the past so what could possibly go wrong now? The unexpectable happened. Like any market, these exotic bonds had the potential to crash and they did. The reason is irrelevant. The notion of maintaining order in the markets and controling booms and busts by whatever means is an illusion. Isn’t it patently obvious that the more the Fed interfers to maintain a desirable economy the more it contributes to the very volatility it has tried to prevent? Markets are an expression of human nature, accept it.
Douglas MacArthur put it this way, “There is no security on this Earth. Only opportunity”.
Peter, that is precisely what they cannot accept. It gets in the way of their paternalistic/controlling mania.
RayG:”But I’m looking for something more quantifiable than a vague artificial.”
I don’t think any Austrian has every quantified the natural rate. That’s partly due to the idea that such quantification is futile. But monetarists developed a workable quantification of natural rates of employment and GDP which I think might apply to interest: those rates in which prices neither rise nor fall.
That definition will take some adjustment to make it fit Austrian theory, because the price indexes we use are flawed. They contain basically consumer and producer goods and leave out assets such as housing, stocks, etc. Then you have to add in the effects of productivity increases. So here might be a rough workable quantification of the natural rate of interest: that interest rate at which a broad index of prices, adjusted for productivity increases, neither rise nor fall.
Keep in mind that prices will naturally fall if the money supply is held constant, because production will naturally increase with an increase in the population and capital accumulation. They naturally will fall even farther with increases in productivity. So you have to adjust the current price indexes for these factors.
Close to 500 billion USD was injected by CB’s world wide. Clinton is allready making herself popular by suggesting to give Fanny Mae and Freddy mac a higher cap for buying the default mortgages. Stuff the junk bonds in the black hole.
Thanks to Dr. Reisman for his clear, exacting and illuminating discussion of today’s downturn in the business cycle.
I have a question regarding the power that the Federal Reserve has to prevent a deflationary meltdown. My question concerns what I assume to be the vast value of the unierse of financial derivatives–financial contracts between institutions and individuals designed to facilitate leveraged speculation. I read recently that the total value of futures contracts today is rapidly nearing $350 trillion dollars. Because there are many other forms of derivative contracts, relating to debt and currency speculations, many of which have no public market, I can only guess that the total value of all financial derivatives approaches a much larger number, perhaps as much as 1,000 trillion dollars.
I understand that not all derivatives are malinvestments, and that it isn’t possible to distinguish with certainty malinvested derivative investments, as opposed to derivatives contracts that would arise on a free market to facilitate various kinds of trade. But since entering into and holding a derivatives contract requires capital, I am sure that the exponential growth in derivatives since 1980 is an offshoot of monetary inflaton and its implicit promise of bailout for any player too big to fail. In short, much a today’s huge derivatives empire is malinvestment.
If this empire were to crumble as prelude to possible collapse, I wonder if the Fed’s powers would be sufficient to turn back the tides. I worry about this mainly because of the numbers involved: hundreds and hundreds of trillions of dollars. The Fed deals in hundreds of billions.
Perhaps Dr. Reisman would care to comment, here, or perhaps in some future article.
Again, many thanks for this wonderful explanation of the current business cycle.
Mark: “My question concerns what I assume to be the vast value of the universe of financial derivatives…”
I’m not Dr. Reisman by a long shot, but I have an opinion on the matter. The stock market and derivatives market are zero-sum games. For each and every loser a winner must exist. So a meltdown in the derivatives markets will not hurt the economy in general. A large decline in the stock market or the derivatives market will hurt those who were long (owned assets) but will enrich by exactly the same amount those who sold at the right time. Unfortunately, the Fed seems to think the stock market should be a win-win game, with no losers.
However, if people borrow to invest in derivatives or stocks, then a crash could cause credit for those to dry up, as the defaults on mortgages have caused credit to dry up in the mortgage industry.
What I don’t understand is why the Fed (and the financial press generally) are so concerned about bond liquidity, making sure that banks can sell their bonds for “full value” in short time. It seems so inconsistent. Homes, after all, are illiquid, and people who have to sell quickly typically have to suffer a huge “fire sale” price cut as they sell to someone who specializes in that sort of thing. So why does the Fed ensure “home liquidity” by buying foreclosed homes? Like the mortgage market, that too would prevent recessions from cascading. Yet I’m supposed to believe banks can’t bear the indignity of selling their bonds at a discount to a hedge fund?
“I’m not Dr. Reisman by a long shot, but I have an opinion on the matter. The stock market and derivatives market are zero-sum games. For each and every loser a winner must exist. So a meltdown in the derivatives markets will not hurt the economy in general. A large decline in the stock market or the derivatives market will hurt those who were long (owned assets) but will enrich by exactly the same amount those who sold at the right time. Unfortunately, the Fed seems to think the stock market should be a win-win game, with no losers.”
This is totally wrong.
Real profits make real increases in values of companies. So win win is possible in a totally free market with free market currency like gold.
However if you get win win with inflated prices then you have a problem.
ktibuk: “So win win is possible in a totally free market with free market currency like gold.”
I think you misunderstood my post. I meant that the stock market and derivative markets are zero sum, not the economy. A free market economy is win-win; both sides in a transaction win. Something similar could be said of the stock market if you consider that each transaction is free, so both the seller and the buyer get what they value most. So in value terms, yes the stock market is win-win. But in absolute dollar terms, every monetary gain in the stock market has to have a corresponding loss. When the market rises, every person who sold before the rise misses out on a potential gain that the buyer actually gets.
But my main point was that a falling stock market doesn’t cause a net loss of wealth, nor does a rising stock market create a net gain, because it is zero sum.
Virtually ANY computer could run the Fed better than the Fed is now run. Any computer not plugged in, that is.
I’ve got a paperweight that could do it . . .
RogerM: I think I understand what you’re trying to say, but what you actually said is still in error: it’s possible for EVERYONE to invest in the stock market, and be better off, in their judgment, than the alternatives. What I think you mean to say is that “Buying securities in an attempt to beat the market index is a zero-sum game” — for each dollar that does better than the market, another does worse. Would you agree with the above?
Person: “for each dollar that does better than the market, another does worse.”
Yes, I agree with that.
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