Michael B. Duff

Lubbock's answer to a question no one asked

A quick explanation of the current crisis

The current crisis was caused by monetary policy. That is, by how much it costs banks and businesses to borrow money. In the old days the supply of money was connected to a physical commodity. Money was backed by gold, so when banks started to run low on gold, they had to stop lending money. The economic growth charts looked like a mountain range, spiking up as banks lent money and diving back down when they stopped.

This was actually a healthy process. When money got tight, businesses that weren’t making a profit failed and went bankrupt. They sold off their land and equipment to other businesses and their workers got jobs at places that actually were making a profit.

And since the supply of money was finite, banks had to be careful about who they loaned it to. Only people with good reputations, with a proven track record of borrowing money and paying it back had access to credit.

Malinvestment

Then some economists came along and said we didn’t have to live with all these contractions in the market. We could sever the connection between money and gold and have a permanent credit boom. Those scary peaks and valleys on the growth chart could be replaced by one smooth line, forever sloping up. Banks would have lots of money to loan out and everybody would have access to cheap credit.

But this creates a problem. Not every loan is a good loan. Not all business ventures will make a profit. And when money is easy to come by, business owners can afford to take risks that they wouldn’t take in a time when credit is hard to get.

It would be better for everybody if failing businesses were allowed to go bankrupt, so their labor and equipment can be redirected to smarter things. But when money is cheap, businesses can delay the consequences of bad decisions and keep rolling debt over in hopes that things will magically turn around.

That’s where we are now. Decades of cheap credit have created bubbles of fake prosperity, brought about, not by real sustainable profits, but by shaky promises backed up by cheap money. “Innovators” on Wall Street have invented new ways to bet on the outcome of these loans, and many of them have committed outright fraud, lying about the quality of the mortgages people were betting on — pretending they were all good loans made to reliable people, when most of them were just crap.

Economic calculation at the Fed

In the days before we had a central bank, interest rates were determined naturally, going down when banks had excess gold in their vaults and spiking up when they started to run low. The money supply was finite, so banks knew exactly how much they had to lend and could predict approximately how much they could expect to get back. The finite nature of the money supply provided reliable information to everybody lending money and helped them set the price of credit accordingly.

Now interest rates are decided by central planners at the Federal Reserve. This same kind of central planning failed in the Soviet Union because without organic feedback from the market, there’s no way to calculate an appropriate price for goods and services. The bureaucrats have to guess. When the planners produce too much you get waste and surplus. When they don’t produce enough, you get shortages.

The same dynamic applies to interest rates. Without feedback from the market, there’s no way for economists at the Fed to know what the “right” interest rate is. They have to guess. It’s a fool’s game even when everybody’s honest, but the process of setting interest rates is also vulnerable to political influence and outright corruption. Politicians love low interest rates. When rates are low, it’s easier for governments to borrow money, and since borrowing is easier than raising taxes, politicians have a strong incentive to keep rates low.

Consumer spending and the Real Estate Boom

Low rates make it cheap for people to borrow money, but they also make it hard for people to save money. When savings accounts and CDs barely pay enough to keep up with inflation, investors have to put their money in riskier types of investments in order to get a decent rate of return.

For the past ten years that investment capital has been put into real estate. Republicans and Democrats got together and agreed on the idea of an “ownership society.” They set up programs that would encourage people to buy houses. The price of houses shot up and all these investors, driven out of safer things by low interest rates, decided that real estate would be a great place to put their money.

Housing prices exploded. The housing market became so lucrative, ordinary people started buying big houses and borrowing against the expected future value of their homes. They cashed out the value of equity they hadn’t actually paid in yet and used it to buy boats, cars and flat screen TVs.

Banks lowered their lending standards because, hey, what’s the worst that could happen? Worst case, the bank forecloses on the house and ends up with an asset that is skyrocketing in value. The risk to the bank was negligible, as long as those housing prices kept going up.

This created a giant short-term boom in the economy and made everybody think they were rich for a while. Governments, business owners and private individuals scrambled to keep up, hiring new people and changing their production schedules to build all this new stuff people were asking for. But this wasn’t true sustainable growth. This was a bubble caused by the availability of easy money and the response to low interest rates.

The appliance stores who hired new staff, the boat-builders who bought extra materials and the car dealers who started stuffing their inventories with high-end SUVs were all preparing for a future that never happened. Now the money from all those home equity loans has been spent, the mortgage payments are piling up and people are scared of losing their jobs.

The car dealers are stuck with lots full of cars that won’t sell, the boat-builders are stuck with warehouses full of materials they don’t need and the appliance stores are laying off employees that don’t have enough to do.

This buildup of inventory, labor and capital goods based on artificial market conditions is malinvestment — the inevitable consequence of a bubble.

Moral hazard

There’s plenty of evil and corruption at work here, but the root of the problem is moral hazard. That is, creating conditions that encourage stupid risks and reward people for doing stupid things. The auto and bank bailouts are prime examples of this.

If the free market was allowed to work, all these bankers who made bad loans would fail and go bankrupt, and the next generation of bankers would learn from their mistakes. But government won’t let them fail. Government is rewarding them for doing all these dumb things because the credit bubble has grown so big, a lot of people are going to lose their jobs when it pops.

The politicians don’t want to get blamed for the collapse of this giant monetary bubble, so they’re trying to delay it — desperately pumping money, credit and government stimulus into the economy to try and push back the collapse.

But all spending is not equally good for the economy. You have to invest in smart things that will produce profit in the long term. If your investments are not sustainable, the money is going to be wasted and the bubble will start to collapse again, as soon as the flow of new credit stops.

Playing musical chairs with government debt

Remember, all this stimulus money has to be borrowed from somewhere. When governments borrow too much, people start to doubt the government’s ability to pay that money back. When that happens the government can’t find people to buy its bonds anymore. It has to offer a higher rate of return and promise to pay the money back faster. That means the government has to use bigger and bigger percentages of its current income to pay interest on debt, restricting the amount it has to spend here and now. In extreme cases governments default, admitting that they can’t afford to pay back what they owe — filing the nation-state equivalent of bankruptcy.

That’s happening in Greece, Spain, Portugal, Ireland and Italy right now. These countries have borrowed way more than they can pay back and the rest of Europe is buying bonds to prop them up, even though they know those bonds will never pay off.

But Germany and France have big debt loads, too, and if they spend too much bailing out other countries, lenders will lose faith in them too. It’s like a huge game of musical chairs right now, with big countries bailing out smaller countries, federal governments bailing out state governments and state governments bailing out city governments, until finally someone says enough and admits that they can’t do it anymore.

Great Britain is starting to cut back on spending but it probably won’t be enough. Most of the other countries are still borrowing and spending like they always have, desperately trying to prop up this bubble and pretend that everything will be okay.

But this bubble has been growing for decades. Trillions of dollars have been invested in things that will never pay off. We have to get back to basics and redirect our resources into things that are going to make money in the long term.

That means a lot of people are going to have to change jobs. A lot of equipment will have to be sold off. And a lot of buildings are going to come down. The economy must be allowed to contract and regroup, so we can shift our focus to things that actually produce value for people, instead of just shuffling cheap credit around.

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Written by Michael B. Duff

July 9, 2010 at 10:02

Posted in Politics

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