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The Boom, the Bust, and the Rate of Interest

February 20, 2012 | Comments: 0 | Views: 151

Generations of Americans have been persuaded to believe that America's economy has been running amok for too long. They've been told that capitalism failed and the powerful booms and busts were the result of the unrestrained wild market. Ask just about any banker what causes changes in the interest rates and I'm not sure you'll find one that will give you a close to accurate description of such event. Therefore, it is my desire to clarify the action that sets the interest rate in motion and its direct impact of the boom/bust business cycles that affect the world's economic climate.

According to Austrian economist, Murray Rothbard, "in the purely free and unhampered market, there will be no cluster of errors, since trained entrepreneurs will not all make errors at the same time." Conversely, when seasoned entrepreneurs commit errors all at the same time it is primarily due to factors that are unnatural. Let's take, for example, the past decade's real estate phenomenon. The first question is what could have enticed so many builders, home-buyers, and speculators to get involved at the same time? And the next question is why did most of them fail later, also at the same time? Were all these market participants lacking the experience of building, buying, and speculating? In other words, were all the people fools that knew little or nothing about real estate? It is obvious that I have just given the example of a boom-bust cycle which begs the question of what was at the root cause to provoke such devastating event? Conventional wisdom goes that it is the free and unregulated market that causes such imbalance. But is that true after all or could it be just a myth?

So, let us start with Newton's First Law of Motion that says "every object tends to remain in that state unless an external force is applied to it." We, humans, don't get sick just because. We may not see the virus, the bacteria, or other outside factors that find their ways into our bodies triggering the illness. Simply because we don't see them entering our bodies it doesn't mean it doesn't happen. The same goes for the seasoned businessman, who does not fail without an underlying cause, and the market, which does not experience drastic shifts without outside interfering elements. You may wonder what exactly are these elements and who manufactures them? Except for Austrian School economists, only a few other economists will admit that the central bank - with the government's approval - creates market distortions through monetary intervention - specifically bank credit expansion. And it is through such conspicuous credit expansion that the builder, the buyer, and the speculator all get in to take advantage - and to profit for individual gains - of such artificial phenomenon. Therefore at this stage we must emphasize that this is not a free market.

Now, let's analyze such process. Every economy has at each given time a given supply of money. This supply of money is used partially for consumption while another part is used for saving and investment in production capital. When consumption is low it allows savings to increase therefore an abundance in savings naturally leads to a reduction in the rate of interest. Conversely high consumption discourages savings and a free economy (without central bank intervention) would lead to higher interest rates. How much higher? Typically based on the proportion of consumption to savings. The higher the proportion of consumption to savings, the higher the rate. Such theory then clearly explains why an overheated real estate market would adjust on its own via the increase in interest rate. A rate increase would most likely discourage many buyers from buying and many builders from building.

But what happens when the market is tampered with and cannot balance itself according to natural laws? What if banks create money out of thin air to lend to businesses and people? This newly created money act as if the rate of savings has increased - implying consumption would have decreased. Yet in reality the savings have not increased and the consumption has not decreased. The rate of interest is being suppressed. But market participants are unaware the interest rate has been artificially lowered below the market level so they continue to expand their activities. Thus the builder builds more homes while more home-buyers and speculators enter the market, all of them bidding up the prices of real estate. A period of exuberance then follows when abnormal levels of prosperity are experienced. In the meantime consumption destroys savings and the currency's purchasing power is gradually being eroded. This is the market boom that almost always starts with a supply of abundant credit available at very low market rates.

If it was for no bank credit expansion the supply of money in the economy would have stayed unchanged. The decline in savings would have forced the interest rate to rise which in turn would have caused an inhibition of real estate prices. The market players would have been discouraged to continue their efforts in the real estate sector and the market would have gained its balance.

Expansion of money supply (money inflation) is thus at the root cause of market booms, busts, and economic depressions. The cautionary signals that would occur in an unhampered market - rise in interest rate - are concealed. The longer the banks' intervention in the money supply the more massive the boom and of course, its bust. During the early 2000's low rates gave real estate market participants the green light to proceed. The abundance of new bank credit prevented the recession that should have occurred after the collapse of the boom. Because a boom is a period of (mal)investments the healing of an economy takes the form of a recession or depression. Murray Rothbard describes the importance of such event in his book, America's Great Depression:

"In short, and this is a highly important point to grasp, the depression is the 'recovery' process, and the end of the depression heralds the return to normal, and to optimum efficiency. The depression, then, far from being an evil scourge, is the necessary and beneficial return of the economy to normal after the distortions imposed by the boom. The boom, then, requires a bust."

The clearing of wasteful (mis)investments does not have to take long in a free market. The best example is the Depression of 1920 at which time the economy recovered within one year. But when more market intervention is activated via monetary expansion the market's healing process is prevented. As a result, the interest rate that would normally have to rise ends up being suppressed. And even though the real estate market is still deflating, the inflation of new money induces bubbles in other market sectors. A true economic recovery cannot occur without purging of the (mal)investments and a complete stop in the monetary expansion. Therefore a true recovery cannot occur without a dramatic rise in the rate of interest. Finally, Mr. Rothbard concludes with:

"Thus, bank credit expansion sets into motion the business cycle in all its phases: the inflationary boom, marked by expansion of the money supply and by (mal)investment; the crisis, which arrives when credit expansion ceases and (mal)investments become evident; and the depression recovery, the necessary adjustment process by which the economy returns to the most efficient ways of satisfying consumer desires."

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Source: EzineArticles
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Article Tags:

Interest Rate


Credit Expansion


Boom Bust


Austrian Economics


Money Inflation


Economic Crises

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