Wednesday, October 21, 2009

The Origin of Economic Bubbles: The FED and the Business Cycle

Either you believe that money, prices, interest rates and the other phenomena which result from a market system are legitimate and meaningfully related to the real-world of material transactions that make up our economy, or you do not, and you might as well do away with the entire monetary system and arbitrarily erect something else to take its place. Most people have the good sense to reject the latter. But in the true spirit of the Progressivist/fascist movement that spawned it, the FED and its economic apologists try to have it both ways. They know full well that they are playing with fire in attempting to tamper with a system of such unbelievable complexity and upon which every one of us depends for our well-being, but in their arrogance they either think that they are up to the task or they do not care. Further, they know full well that their various tamperings are useful for achieving political ends and routing resources towards favored projects and individuals. The public seems perfectly happy to accept the fictitious storyline that central banking helps to alleviate the business cycle which would otherwise render the economy a disastrous manic-depressive roller-coaster ride. So everyone goes along, ostensibly to everyone's benefit. This thinking, the supposed political modification of reality so typical of statist movements throughout history and so prone to disaster, has led us to where we are today: a banking system that fails at basic accounting, and a money system far detached from the economy it is supposed to represent. Yet the present system has been with us for so long that it has acquired the air of legitimacy simply as a matter of familiarity. Few bother to question it. There are scant few better ways to find yourself lampooned as a crank, a nutcase, and a "conspiracy theorist" than to do so. Mostly it is left to grizzled world-weary soldiers like our own esteemed ΛΕΟΝΙΔΑΣ, political outsiders like Ron Paul, and ambitionless eccentrics like me. But reality intervenes in every system built on lies, the present system not excepted. Expanding the money supply does nothing to expand the resource base. It does, however, do much to distort the way it is put to use. The piper must be paid, and the boom must eventually be followed by the bust. This distortion, the boom followed by the bust, touched off and fed by the accounting lies of the fractional reserve system and central banking, is called the business cycle. Initiating the Business Cycle So far, we have gone through several explanations of the market distorting effects of monetary expansion and interest rate suppression, looking at the phenomena from several points of view. We saw that:
  • As new money enters the economy, it will increase prices in those markets which receive new money first. In the old days, we might see it in the prices of goods being offered for sale near a new gold mine rising much faster than prices distant to the mine. In our present system, monetary expansion occurs from a few specific points in the economy, the credit market and the banking system, and not across the entire economy as a whole.
  • Interest rate suppression causes unprofitable business ventures to appear profitable, initiating misguided entrepreneurial ventures. Thus, the types of goods that entrepreneurs are interested in purchasing with the new money will be driven up before other goods.
  • Monetary expansion and interest rate suppression act as a subsidy to debt markets, distorting the prices of debt instruments and making credit appear artificially cheap. In general, goods bought on credit will see their prices rise faster than goods which are typically not bought on credit. Buyers who purchase goods on credit will find that they have an advantage over non-credit buyers in the pricing competition of the marketplace.
It is important to recognize that these varying explanations are not descriptions different phenomena. They are really just different ways of saying the same thing. Monetary expansion and interest rate suppression are the same phenomenon under a central banking-fractional reserve system. Monetary expansion initiates this activity. But once the initial price distortions have taken effect, they begin having knock-on effects which can be even larger in scope than the initial distortion in credit markets. Downstream Effects of Price Distortions Like interest rates, prices are economic signals and direct the flow of money and resources in the economy. As prices increase in certain markets relative to others, we also expect to see capital and resources flow towards these new profit opportunities and away from the rest of the economy. In the old days, a boom-town attracted all sorts of business activity away from surrounding areas before promptly busting when the mine dried up. Today, the banking system and those in close economic proximit gobble up resources at the expense of those distant to the banking system. But this demand for resources results in further price distortions: the prices of the factors required to produce those resources being gobbled up by the monetary expansion. As prices rise in one market, thanks to the activities of entrepreneurs and other borrowers, still more profit seekers rush in to satisfy the new demand. Are entrepreneurs bidding up the prices of houses? Homebuilders rush to accommodate them, driving up the price of lumber and other building materials. Is lumber becoming dear? Timber companies begin bidding up the price of logging equipment. And so on it goes, from the initial round of bidding by the early recipients of the new money, on down to the late recipients. While such trains of events seem rather elementary (and they are) and not very interesting, there is a far more interesting and revealing net effect to the process. The overall effect can best be visualized with a symbolic representation of the production structure. The Production Structure Ultimately, all economic activities are undertaken with a mind towards consumption. Consumer goods are meant for direct consumption, while capital goods are used to produce consumer goods. Simple enough, right? Let's add one more layer. Subdividing capital goods, higher-order capital goods are used to produce other capital goods, while lower-order capital goods are used to produce consumer goods. Of course, there is actually a continuum of capital goods, but we'll just stick with this terminology. We can associate these goods and their distribution with the division of labor. Some laborers are employed in producing consumer goods directly, while others labor to produce capital goods. If we represent the production structure with consumer goods near the bottom and capital goods further up, we get a wedding-cake looking structure like this: The further up the cake we go, the higher the order of capital goods we are representing. Production at higher levels fuels productivity gains at lower levels, as the capital goods produced at higher levels multiplies the productivity of labor at levels further down, but also robs the lower levels of resources, as resources are necessarily limited. The taller and steeper the cake, the higher the division of labor, which corresponds to a greater variety of economic processes and a higher degree of specialization. A high division of labor economy and a low division of labor economy might look like the following: Interest Rates and the Production Structure As the price distortions spread through the economy and resource allocation adjusts to these changing conditions, the net effect is for resources to be diverted from lower levels of the production structure to higher levels. Why? Because the prices of capital goods are driven higher by monetary expansion than consumer goods, and prices of higher-order capital goods are driven even higher than lower order capital goods. Higher-order capital goods benefit not just from easy credit, but also from higher profitability as these goods serve to produce other capital goods which are themselves being driven up in price. Remember? A visual representation of the effect of monetary expansion on the production structure would look like the following: Note that this is exactly the same effect that we described before when we said that lower interest rates cause an increase in the fraction of resources allocated to capital goods. Again, these are not separate phenomena, but different ways of explaining the same thing. You can look at it in terms of money flow and a response to price effects, or in terms of resource allocation in response to interest rates. Any way you want to slice it, lower interest rates and monetary expansion lead to a lengthening of the division of labor. Malignant Growth It does not matter whether the interest rate effect is in response to time preferences or money-printing, the effect is still to lengthen the division of labor and divert resources towards capital goods. A high-division of labor production structure results from both artificial interest rate suppression and naturally low rates set on the open market. So, once again it may be asked, if the effect is the same, what is the harm in suppressing interest rates? I can now give a fuller answer. First, in the instance of legitimately low interest rates, the capital structure corresponds properly to the time preferences of the economy at large. There really are plenty of resources available for economic growth and development because they really are being set aside by real savings and aren't all being consumed. Financial reality matches economic reality. Artificially diverting resources which consumers aren't willing to part with towards capital accumulation will eventually result in an economic backlash, as we now can see all too clearly. Suppression of interest rates results in a misallocation of capital by creating the illusion of profits through overly capital-intensive production strategies. In reality, actual time preferences will not support this capital structure. Secondly, this rather crude treatment of capital obscures its complexity and intricacy. We have treated it in a way that is overly homogenizing. In reality, capital is not homogeneous and serves very specific needs and purposes. By haphazardly allocating capital according to spurious price movements, the capital structure does not serve consumers efficiently. Not only is the capital structure mismatched in terms of the available resource base, the array and proportions of goods produced does not match the actual desires of the consumer. Manipulation of the money supply does lead to economic growth -- malignant growth. It leads to growth which has little to do with the actual needs and desires of society and little regard for the available resource base. In a flurry of economic activity, it incentives the allocation of resources inefficiently and towards destructive ends. Therefore, like a cancer, this malignant growth leads to economic decay. Manias and Bubbles Thus far, we have been talking about the general effects of a monetary expansion on the production structure of the economy. This might be described as a "general economic bubble." However, for various reasons these effects can also sometimes be quite focused to one market in particular, such as in our recent housing bubble. I am not entirely clear as to why one particular market gets singled out. Some have cited social or cultural reasons, such as in the case of the Dutch Tulip Mania or the single-mindedness of many Asian economies towards export bubbles at the expense of domestic development. I suppose one might even include the case of the American housing bubble. But at least in the latter case, there are clearly other contributing financial reasons. The housing bubble has attracted economic commentary ad nauseum, a lot of it of questionable merit, in my opinion. Most seems to have focused on the lack of regulation, fraud, and overzealous "financial innovation." I do not want to rehash too much of this, but only make a few simple points. In my opinion the single largest contributor to this bubble were the activities of Fannie Mae and Freddie Mac. No, not individual lending to people of questionable creditworthiness, stupid as that behavior is. I'm talking about the bulk of their activities, which were not only completely legal, but encouraged by the government and generally popular with the public. The entire purpose of these organizations was to expand the funds available to the housing market by buying up mortgages from banks and freeing up bank funds for more lending. Investors with Fannie and Freddie got favorable tax treatment and government guarantees for their investments. Interest rates on Freddie and Fannie debt were insanely low thanks to these subsidies, and the flood of money helped push down mortgage interest rates to ridiculously low levels. It seems to me that the primary cause of the housing bubble was that these policies helped drive an oversize fraction of the FED's monetary expansion into this one single market. And not only were the FED's freshly printed bills flowing in, the American housing market attracted a fair share of overseas funds as well. Without such incentives, the inflationary effects would likely have been spread more evenly into other markets rather than focusing like a laser on this one in particular. It was as if all the inflation taking place across the entire globe were being funneled into one single market by our own Uncle Sam! What of these other activities, the fraud and "innovation?" Certainly, they weren't desirable, but these seem to me effects of the tidal wave of money flooding the housing market rather than the cause of the bubble and the later crisis itself. A sound financial spanking in the form of large losses at the hands of the market will tend to curtail the activities of people engaged in risky behavior, but if you can't lose no matter what you do thanks to a constant torrent of money, well, there doesn't seem to me to be a better way to encourage reckless stupidity. Blood in the water has a way of attracting the sharks, and easy money attracts fools and crooks. I doubt that most of this behavior would have taken place without the flood of money into the market. Better an honest money system than all the financial policing in the world. But that's just me. Bursting of the Bubble The bursting of the bubble occurs for precisely the opposite reason that the bubble inflated in the first place: the flood of money dries up. The stabilization of the money supply reveals unprofitable ventures for what they are as prices, no longer propped up by continuous flows of money, return to more appropriate levels. Bankruptcies ensue, and poorly allocated capital is "liquidated," making it available for new ventures more likely to succeed. Financial reality begins to realign itself with economic reality, and capital and other resources are realigned to better match the needs of consumers. As you might guess, the result is a fall in the price of capital goods relative to consumer goods, as a lot of capital goods tend to come on to the market all at once. Including human labor in the form of unemployment. Recession is a time of revaluation. In the old days, money was "bank notes" and those notes were backed by gold or silver held on reserve with the bank. Banks could inflate the money/banknote supply with the sleight of hand of fractional reserve banking in order to collect "extra" interest on the unbacked, counterfeit currency, but this was held in check by the fact that depositors could demand gold in exchange for their banknotes. In the back of his mind, the banker knew how much gold sat in his vault, and he would only allow the expansion to go so far. A bank run could destroy a bank in a single day. Business cycles of this time period tended to be very short and punctuated, as banks first expanded, then contracted to cover their positions quickly. Expansion of the monetary base, the gold supply, was generally a slow process dependent on the mining industry. Though economic cycles were more frequent, capital distortions overall were not able to get too far out of hand thanks to this important check on the system. Even under a central banking regime, where the central bank can defend member banks by increasing cash reserves, if the central bank is on a gold standard there are still checks on its ability to increase the monetary base. Nowadays, central banks can expand the monetary base at will, independent of the gold supply or anything else. They simply have to buy something. As a result, the central bank can protect the banking system from its own fraudulent expansion by simply increasing their reserves to defend them from runs. In consequence, it is not generally nervous bankers that end a boom. The booms are allowed to go on much, much longer. The present inflationary boom has been underway for decades. Price distortions are allowed to propagate for much longer through the economy, causing much larger distortions in the capital structure. We now have entire nations, such as China, with near monomaniacal devotion to industrial export, while nations like the US suffer from a festering tumor of a financial system and a withering manufacturing sector. Today, the biggest check on inflation by central banks appears to be the CPI. Well, that and the threat of political instability. Through the 80's and 90's, monetary inflation rippled through capital markets driving up stock prices with relatively negligible effects on the CPI. By 2006, the inevitability of price inflation as a result of the monetary expansion beginning as early as 1980 (and some might argue since 1960) had become apparent. The inflation had flowed through capital markets and was in the process of driving up wages. The stock market had failed to absorb new monetary increases after about 2000 and unemployment had been driven down to near full employment. Wages were on the rise and price inflation was imminent as newly printed money was now making it directly into deposit accounts of wage earners. Sensitive industries became flooded with money. Oil prices went through the roof. In late 2006, the FED began a campaign of monetary tightening, visible in the graph below: The monetary tightening is visible as a flattening out of the AMB beginning in late 2006. The scale of this tightening is better represented by a graph of the percent change in the monetary base, year over year. This is a kind of "first derivative" of the AMB, for those of you who are familiar with calculus. The closer it approaches zero, the less monetary expansion is going on: Aside from the temporary fluctuations near 2000 (a response to the 9-11 terror attacks and the bursting of the tech bubble), the slow tightening of the period 2003-2008 was far more than the market had seen since 1982. Even then, the monetary base was still growing marginally, jut not at the rate to which markets had grown accustomed. Contrary to the popular conception of monetary dynamics, even as the FED was "cutting interest rates" through late 2007 and 2008 it was not substantially expanding the money supply to do so. The FED was not being nearly as accommodating as most observers believed on the basis of rates alone. Markets were actually experiencing the nearest approximation of a true free-market with respect to interest rates and a stable money supply they had experienced in more than 20 years. They promptly collapsed. As the Federal Funds rate sat at near 2%, the money supply remained nearly flat. Such was the level of fear in financial markets at that time. When the CPI begins to show inflation, the central bank tightens. But it takes a very long time for this particular statistic to show inflation. In the meantime, and it can be a very long time, capital markets absorb the greatest effects of the monetary inflation. They are not held to account until the FED hits the brakes. Capital misallocations build up unchecked. The Illusion of Prosperity All of this may seem a tremendous distraction to the question we initially set out to answer: do we face inflation or deflation? But now we come to the crux of all this discussion. The FED is in a bind like never before. By inflating the money supply, it has managed to create price distortions that have lasted the better part of three decades. By propping up housing prices, stock prices, and rendering a general climate of easy financial security and investment profitability, it has created an illusion of immense wealth which is simply a fantasy. The promise implied by present price levels and the values of pensions, retirement accounts, and promised social security payments is spectacularly overblown and unrealistic. An entire generation has come to believe that it will easily retire in splendid comfort. Worse, it has caused such tremendous real capital distortions that the market stands hardly a chance of meaningful recovery any time soon. The crisis is not limited to the US, either. With the US dollar as the reserve currency, and further, with central banking and its penchant for inflation the dominant monetary system throughout the world, these capital distortions span the entire globe. This is a global financial and economic crisis unprecedented in human history. There is exceeding political pressure to maintain the illusion, not just in the US, but throughout the world. Without continuous inflation, capital prices will fall and the massive correction begins. In the long run, we will be able to appropriate resources more readily towards efficient, sustainable economic development, but in the short run, our artificial world will come crashing down around our ears. We won't get to pretend we are rich any longer, and it will appear that the FED and the government have ripped our cherished images of idle bliss right from our fingertips. Yet if the inflation continues, distortions worsen and price inflation eventually destroys us, a la Germany of the 1920's or today's Zimbabwe. In short, by now we realize that inflation isn't primarily an economic problem but a political problem. The FED is in charge of it. If we're going to try to predict what the FED is going to do, we must understand the situation it faces, and the way it understands the world to function. The FED believes that its models are correct, that CPI is inflation, and that through "proper" monetary management, it can maintain the status quo. It is therefore highly likely to try. However, its models are not correct, and it cannot succeed. Eventually it will fail, though we cannot say for certain how long that will take. But by understanding the business cycle, how the FED responds to economic data, and how the economy responds to FED policy, we can better predict what is likely to happen down the road. Conclusion If you are like me, at some point in reading and thinking about all of this you have had something like the blue pill/red pill moment from The Matrix. Most of what we have been over sounded to me like plain-old common sense when I first heard it, as if it were all something that should have been obvious in the first place. But for some reason, I had to have it spelled out to me in black and white, and the implications, if true, turn the world on its head. Strange how that can happen, isn't it? While it is true that America's "free-market system" is far more productive, flexible, and resilient than those of lesser freedom throughout the world, which is to say that "it is better for the freedom that it has," it should be quite clear by now that the economy we see before us is something of a sham. Our economic freedom in many ways simply becomes a way for our activities to more quickly conform with the monetary forces exerted by central banks. The economic distortions caused by central banking are immensely, immensely powerful. Though I am a defender of free markets, I now find myself questioning ostensible capitalists who criticize those who lament such effects as outsourcing, "the forces of globalization," the massive growth of the "pink collar" and financial industries at the expense of American manufacturing, and the like as though these effects were actually the result of the free market. I'm convinced that they are not. They are the result of the free-market adjusting itself to the coercive efforts of central banks, which are in turn acting in accordance to crass political pressures and delusional economic theories. They are the warped constructs of a global economic bubble, they don't actually work, and they are destroying our way of life even as they maintain the illusion of prosperity. Though I am a staunch defender of capitalism, I must at this point admit that I'm not sure that I have any clue whatsoever as to what capitalism actually looks like. I'm not sure that anybody does. Maybe it doesn't look like Hummers and Wal-Mart and Made in China. Maybe it looks like something completely different. I don't know. At any rate, with respect to the inflation-deflation debate, the point is this: monetary inflation produces the business cycle, and this go-round the FED has created a catastrophe. By lengthening the business cycle far beyond anything we have ever seen, it has produced one of the most spectacular economic bubbles in the history of mankind, with, of course, the help of fellow central banks across the globe. In 2006, it decided to pop the bubble, but did not visibly succeed until 2008. It now has a mess on its hands. There is a widespread perception of wealth and prosperity which is simply false, though the FED and Washington are likely to do everything in their power to maintain appearances for as long as possible. However, this is in vain, and eventually the truth must be broken to the public in some fashion. It is clear that we are headed for impoverishment as the mess is sorted out, though it is not entirely clear at this point what form the impoverishment will take, or how long the illusion of prosperity can be propped up. Next time, we will wrap things up with the final verdict!

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