Tag Archives: Booms and Busts

Today’s Distorted Production/Consumption Structure


As a general rule….people ask for advice only in order not to follow it; or, if they do follow it, in order to have someone to blame for giving it. –Alexandre Dumas

This l o n g post is critical in understanding our current investing environment.   I copied the entire post from www.acting-man.com because of its importance. Value investors seek bargains. We look at the particular shoe, car, asset, or business and seek to buy below what we estimate it to be worth. Outguessing the market or the economy is a hopeless task, nevertheless, one must be aware of distortions in order to normalize earnings–how would you have normalized earnings for housing stocks in 2005 and 2006, at the peak of a massive distortion?  Currently, we are making economic history with the current distortion of the country’s production structure.

Boom and Bust

Be aware of what that means for your investments! Read on.

Summary: Since this is a long post, let’s cut to the quick.  If interest rates are pushed below their natural free market rate (our time preference or how much do we consume today vs. save for tomorrow), then businessmen are fooled by how much real savings are in the economy to utilize or bid for. Say with a 5% loan we see in our spread sheets that building a factory would generate a nice profit, so we begin building our three-story building, but since there are not enough real savings in terms of bricks, steel, cement, as we build, the prices of those materials begin to rise. Now our building is no longer profitable because our input costs have risen or worse–there are no more bricks available to complete our factory. We abandon the project halfway through.  Look at the empty and uncompleted housing complexes outside of Las Vegas from the busting of the housing bubble in 2005/06 as a recent example.

Background: Structure_Production_Reconsidered (a full review after you have finished this post). For the fanatical student: Economic Depression Their Cause and Cure

The Goldilocks Illusion  May 11, 2015 | Author  Pater Tenebrarum

Why Market Participants Liked the Payrolls Report

Some people have wondered why the stock market reacted with such a big rally to last Friday’s payrolls data. After all, the report wasn’t much to write home about, especially if one  ponders the details. In addition, the already weak March payrolls data were revised lower to an even worse figure.

However, the report certainly did one thing: it kept the “Goldilocks illusion” alive. While jobs data are a lagging economic indicator and would likely be completely ignored in an unhampered free market (if anyone even took the trouble to collect them, that is), they are regarded as decisive for Fed policy. Few things illustrate more vividly that the central planners are driving forward with their eyes firmly fixed on the rear-view mirror.

The Fed has little choice though, since its mandate explicitly includes employment as one the things central bank policy is supposed to support (which it does mainly by fostering artificial booms and malinvestment of capital). The market’s focus on the jobs data has increased greatly in recent years as a result of this, which incidentally illustrates how utterly dependent the markets have become on a continuation of easy money policies by central banks.

The “Goldilocks” idea is that it is best for risk assets if economic data are strong enough not to signal recessionary conditions, but weak enough to keep ZIRP and monetary pumping going. Friday’s data point was presumably considered almost perfect in terms of this playbook.

SP 500

SPX, 10 minute chart: stocks bounce back to the upper end of their recent range

Normally the stock market is held to reflect the past successes or failures of listed companies, as well as expectations about their future performance. To some extent this is still the case, but as the market has come to increasingly depend on monetary pumping and the associated perceptions, this factor has diminished in importance.

We can indirectly discern this from certain data points, such as the fact that  the median stock has never been more expensive than today. This is a sign that intra-market correlations have greatly increased. However, it is actually impossible for such a large percentage of listed companies to be equally successful in terms of real wealth creation. Along similar lines, the strong rise in the Q-ratio (it is currently two standard deviations above the mean) is a strong sign that market valuations are driven by the “money illusion” rather than a rational assessment of value.

Q Ratio

A long-term chart of the Q ratio shows that loose monetary policy frequently distorts market valuations. If it tops out near its current level, it will be the second highest peak in history – click to enlarge.

What Will Shatter the Illusion?

Not everybody thinks that the “not too hot, not too cold” jobs data will keep the Fed from going through with its long-announced “policy normalization” plans. However, the conviction is growing that this will once again be pushed back to a later date. Here is an excerpt from  a Bloomberg report on the payrolls report that illustrates the current consensus on the topic:

“U.S. job growth rebounded last month and  the unemployment rate dropped to a near seven-year low of 5.4 percent, suggesting underlying strength in the economy at the start of the second quarter that could keep alive prospects for a Federal Reserve rate hike later this year.

Nonfarm payrolls increased 223,000 as gains in services sector and construction jobs offset weakness in mining, the Labor Department said on Friday. The one-tenth of a percentage point decline in the unemployment rate to its lowest level since May 2008 came even as more people piled into the labor market.

However, wage growth was tepid and March payrolls were revised downward, leading financial markets to push back rate hike bets. “We see this report as reducing concerns that weak first-quarter growth represents a loss of economic momentum,” said Michael Gapen, chief U.S. economist at Barclays in New York. Nevertheless, he said the bounce back was not strong enough to think the Fed could bump rates higher before September.

Considering that even most mainstream observers these days are usually admitting to the increasing importance of central bank policy to stock prices, it is slightly baffling that they almost never mention the money supply. The growth momentum of the money supply strikes us as the most important factor determining boom and bust conditions in the economy and the stock market.

As can be seen below, the annual growth rate of the broad US money supply measure TMS-2 (= true money supply) has slowed to approx. 7.4% in March. Historically this growth rate is still quite brisk. It also remains within the “sideways channel” within which annualized money supply growth has oscillated for more than two years. It also remains still well above the previous “bust thresholds” we have indicated on the chart. Therefore it isn’t sending a strong alarm signal just yet.

However, such thresholds are not a fixed magnitude. At what level precisely the boom-bust threshold will turn out to be depends to a large extent on contingent data and market psychology. Our hunch is that this threshold is higher than it used to be, mainly because the economy’s underlying performance continues to be quite weak compared to previous post WW2 era recoveries.

Money supply TMS-2, annual rate of growth


How much monetary pumping is required to keep assorted bubble activities on life support is unknowable. However, we can be sure that the economy is becoming ever more imbalanced and structurally weaker the longer strong monetary pumping continues. This is another reason to suspect that the “bust threshold” is likely higher than it used to be. Moreover, the lagged effect on economic activity from the peak money supply growth rates recorded in late 2009 and late 2011 has to be diminishing by now. As newly created money continues to ripple outward from its points of entry into the economy, the likelihood that “bad effects” become visible increases.

Currently there are two firmly established consensus opinions that are based on the irrational faith that  this time, central bankers somehow know what they are doing. One is the idea that strong economic growth is “just around the corner”, where it has been suspected to be lying in wait for the past six years. A corollary to this is the belief that the economy cannot possibly weaken to the point of entering an official recession.

A second, related conviction is that no “inflation problem” can possibly appear on the scene. Inflation problem in this case means: a noticeable increase in CPI. There are many good reasons for this consensus opinion. A number of contingent trends are helping to keep consumer prices in check. They comprise large consumer debt overhangs in nearly all developed countries, negative demographic trends, subdued wage growth (due to global labor arbitrage and tepid economic activity) and ongoing productivity growth in manufacturing (which seem to be waning lately). Moreover, in the post 2008 era, newly created money hasn’t primarily been borrowed into existence due to growing credit demand in the real economy. Instead it has entered financial markets more or less directly, as central bank debt monetization leaves major market participants with first dibs on new money.

All these trends affect demand for consumer goods, and even though we cannot truly measure their impact, some empirical confirmation is provided by related data points such as weak growth rate in retail sales. However, the demand side is only one part of the equation. Years of monetary pumping have left their mark on the economy’s production structure (KEY POINT!), and we want to briefly look at the problem from this angle.

The Balance between Production and Consumption

The chart below shows the industrial production index for capital goods (business equipment) compared to the production indexes of consumer goods and non-durable consumer goods. Given extensive global trade, domestic US consumer goods production has been partly replaced by imports, but the history of these indexes still conveys useful information.

capital goods vs consumer goods

Industrial production: capital goods vs. consumer goods and consumer non-durables

When interest rates decline, long-term projects that yield a consumable output only after a long period of time appear to become increasingly profitable. The decisive factors are firstly that the profitability hurdle declines as interest rates fall (for instance, it makes no sense to borrow capital at 4% for an investment yielding only 3%, but the situation obviously changes if borrowing costs decline to 2%), and secondly, that the net present value of long-lived capital goods increases sharply when they are discounted at a lower interest rate. The longer the time period involved, the bigger the effect will be.

As a result, factors of production will increasingly be bid away from the lower stages of the production structure (those closer to the consumer) to the higher stages (capital goods production) and the economy will become more capital intensive. In an unhampered free market economy, this is generally a positive development indicating a progressing economy. A decline in interest rates will signal that people are increasing their savings. Additional savings are a  sine qua non for a  sensible lengthening of the capital structure, as new long term investments need to be funded. If people are postponing consumption in favor of saving, this funding will in fact be available.

By increasing their savings, people are signaling that they prefer to be able to consume more or better goods in the future in exchange for lowering their present consumption. The creation of a more capital-intensive production structure will make this possible, as it will lead to greater output of consumer goods in the future (the quantity, and/or the quality of output my increase, and future output may also include goods that could otherwise not be produced at all). Interest rates and prices are the  signals indicating to entrepreneurs which types of investments make the most sense and to what extent the time structure of production can be lengthened.

Things become problematic though if interest rates are artificially suppressed by administrative fiat instead of declining due to an increase in savings. Economic calculation is falsified: relative prices are distorted, and the resources required to fund a lengthening of the production structure are in reality not available to the extent indicated by the interest rate signal. The investment activities of entrepreneurs will be misdirected – too much will be invested in the wrong lines, based on an incorrect assessment of consumer wants and the amount of real funding available for long term investment projects. Initially an economic boom is set into motion. Large accounting profits accrue and will be partly paid out in the form of dividends, stock buybacks and higher wages. However, at a later stage it will become obvious that many of these profits were actually illusory and that in reality, capital was consumed.

The people engaged in the production of capital goods need to be able to consume long before their own labor yields goods ready for consumption. They must eat, they need a place to stay, etc. The more factors of production are shifted toward capital goods production and away from consumer goods production, the more likely it becomes that not enough “free capital” in the form of consumer goods is available to support these long-term activities. Obviously, this problem can only be made worse by printing more money. KEY POINT!

The boom eventually expires because it turns out that many new investments can actually not be funded. Once this is recognized, a scramble to obtain the required capital commences, putting upward pressure on market interest rates. The distortions in relative prices that originally fired up the boom begin to reverse and malinvestments are unmasked as unprofitable – the bust begins. By looking at the ratio between capital and consumer goods production indexes, one can clearly discern boom and bust periods:

Boom and Bust

Not every bust necessarily results in an “official recession”. Sometimes the bust can be concentrated in just a few industries (like e.g. oil production and S&Ls in 1986-1988) – click to enlarge.

Let us reconsider the “CPI inflation” question in light of the above. If too many resources are devoted to capital goods production, the economy will over time tie up too many consumer goods relative to the amount it releases. The economy’s pool of real funding consists of two components: savings and consumer goods that become continually available from ongoing production activities. Although it is well known that many companies these days prefer to engage in financial engineering (mainly in the form of stock buybacks and m&a activities) rather than investing in capital, what counts are  relative proportions. If bottlenecks in the supply of consumer goods develop at some point, consumer prices may unexpectedly rise even if the currently tepid level of consumer demand remains unchanged.

The Growing Amplitude of Business Cycles

David Stockman recently  posted a chart from a BIS report that shows the amplitude of financial market cycles and business cycles in the real economy:


Financial market cycles vs. real economic cycles

This chart illustrates the fact that the increasing activism of central banks in recent years has led to a commensurate increase in the amplitude of business cycles, with boom and busts in asset prices becoming especially pronounced. Since stocks are titles to capital and real estate can be grouped with long-lived capital goods from an analytical perspective, this is in keeping with the distortions in the production structure discussed above.

We have mentioned that the current cycle differs slightly from previous cycles due to the fact that “QE” injects newly created money directly into financial markets. The firms selling securities to the Fed (i.e., the primary dealers) will use the funds they receive to purchase securities again. The sellers of securities in this second round of purchases will largely tend to do the same, and so forth. However, this doesn’t mean that new money will forever stay within the confines of the financial markets in a kind of closed loop. More and more of it will “leak out” over time.

For example, the purchase of expensive trophy properties by the rich generates commissions for real estate agents and profits for real estate developers. Rising stock prices may lead individual investors to sell a part of their investments to increase their consumption. Companies are issuing lots of bonds to take advantage of low rates and seemingly insatiable investor demand. Some of the proceeds are flowing back into the financial markets in the form of stock buybacks, but a large part is used to purchase capital goods, pay wages, invest in R&D, etc. In short, the enlarged money supply eventually ripples through the economy in a variety of ways.

Someone will always have to hold the additional cash balances, and while strong demand for money since the 2008 crisis has so far contributed to keeping consumer price inflation in check, this state of affairs cannot be taken for granted (the demand for money may actually have been egged on a bit by ZIRP as well, as savers of modest means likely feel they have to set aside more money in light of the lack of interest income). We can already see though that those with the largest amounts of cash at their disposal are treating it as a hot potato (hence the frantic bidding for expensive properties,  high end art works, etc.).


We can be certain that the vast expansion of the money supply in recent years has once again led to the erection of an unsustainable capital structure. Should money supply growth rates continue to falter, a bust is likely to arrive sooner rather than later, as investment projects that depend on monetary pumping to keep up the appearance of profitability will quickly turn out to have been misguided.

Moreover, the large amount of new money that has been created in recent years continues to move through the economy and the possibility that people will reassess their demand for cash balances cannot be dismissed, in spite of the contingent trends that are currently keeping a lid on consumer demand. This may become especially pertinent if the Fed reacts to the next bust by immediately kicking money supply inflation into high gear again. After all, the strong demand for money is  inter alia predicated on the belief that the inflationary policy of recent years isn’t going to continue indefinitely.


This article is actually a continuation of the “Echo Boom” articles we have published previously (see here for  part 1 and  part 2). In the next installment we will look at the relationship between “price inflation” and the stock market. This relationship is not as straightforward as is generally believed.

All in all we can conclude Goldilocks is treading on increasingly thin ice.

Charts by: BIS, St. Louis Federal Reserve Research, StockCharts, Doug Short / Advisorperspectives

New Course on BUBBLES, BOOMS and BUSTS

BUBBLESPlease join me in attending this course with a great teacher. See you in class!

He developed the “Skyscraper Index” to help identify the end of the boom.



Bubbles, Booms, and Busts

— with Mark Thornton

Cost: $59   Length: 6 Weekly Lectures
Dates: April 24, 2013 – May 28, 2013
Status: Upcoming

Click here to register for this course: http://academy.mises.org/courses/bbb/


This course will cover special topics in Austrian Business Cycle Theory, including the “Skyscraper Index,” the art of predicting downturns, and the causes of the housing bubble and burst that led to the 2008 financial crisis.


Lectures will be Wednesdays at 5:30 p.m. Eastern time.


All readings will be free and online. A fully hyper-linked syllabus with readings for each weekly topic will be available for all students.

Grades and Certificates

The final grade will depend on quizzes. Taking the course for a grade is optional. This course is worth 3 credits in Mises Academy. Feel free to ask your school to accept Mises Academy credits. You will receive a digital Certificate of Completion for this course if you take it for a grade, and a Certificate of Participation if you take it on a paid-audit basis.

Refund Policy

If you drop the course during its first week (7 calendar days), you will receive a full refund, minus a $25 processing fee. If you drop the course during its second week, you will receive a half refund. No refunds will be granted following the second week.

Mark Thornton

Mark Thornton is an American economist of the Austrian School.[1] Thornton has been described by the Advocates for Self-Government as “one of America’s experts on the economics of illegal drugs.”[2] Thornton has written extensively on that topic, as well as on the economics of the American Civil War, economic bubbles, and public finance. He successfully predicted the housing bubble, the top in home builder stocks, the bust in housing and the world economic crisis.

Thornton received his B.S. from St. Bonaventure University (1982), and his Ph.D. from Auburn University (1989). Thornton taught economics at Auburn University for a number of years, additionally serving as founding faculty advisor for the Auburn University Libertarians. He also served on the faculty of Columbus State University, and is now a senior fellow and resident faculty member at the Ludwig von Mises Institute.[3] He is currently the Book Review Editor for the Quarterly Journal of Austrian Economics.[4]

Prohibition studies

Libertarian organizations including the Independent Institute,[5] the Cato Institute,[6] and the Mises Institute have published Thornton’s writings on drug prohibition and prohibition in general. Thornton contributed a chapter[7] to Jefferson Fish‘s book How to Legalize Drugs. He has also been interviewed on the topic of prohibition by members of the mainstream press. His research and publications are the basis of the Iron Law of Prohibition which states that the enforcement of prohibition increases the potency and danger of consuming illegal drugs. [8] Thornton’s first book, The Economics of Prohibition, was praised by Murray Rothbard, who declared:

Thornton’s book… arrives to fill an enormous gap, and it does so splendidly…. The drug prohibition question is… the hottest political topic today, and for the foreseeable future…. This is an excellent work making an important contribution to scholarship as well as to the public policy debate.

Economic bubbles

Thornton has also written on economic bubbles, including the United States housing bubble, which he first described in February 2004.[9][10][11] He suggested that the “housing bubble might be coming to an end” in August 2005.[12] His work on market bubbles has been cited by journalists[13][14] and other writers.[15][16] Economist Joseph Salerno noted that “Mark Thornton of the Mises Institute was one of the first to jump on this—to start writing about the housing bubble.”[17] Similarly, economist Thomas DiLorenzo has written that “[i]t was Austrian economists like Mark Thornton . . . who were warning of a housing bubble years before it burst.”[1] He also called the top in the housing market. He developed and published his Skyscraper and Business Cycle model in 2005.[13] His Skyscraper Index Model successfully sent a signal of the Late-2000s financial crisis at the beginning of August 2007. [14][15]

Political activities

Thornton has also been active in the political arena, making his first bid for office in 1984, when he ran for the U.S. Congress. He became the first Libertarian Party office-holder in Alabama when he was elected Constable in 1988. He was the Libertarian Party Candidate for the U.S. Senate in 1996 (also endorsed by the Reform Party) coming in third of four candidates. Thornton also served in various capacities with the Libertarian Party of Alabama including Vice Chairman and Chairman. In 1997 he became the Assistant Superintendent of Banking and a economic analyst for Alabama Governor, Fob James.[2]

Thornton has been featured as a guest on a variety of radio and internet programs and his editorials and interviews have appeared in leading newspapers and magazines.


Academy Courses

Fractional Reserve Banking and the Fed (Lesson in Booms and Busts)

Fractional Reserve Banking and the Fed

Prof. Joe Salerno’s Testimony to Congress on the problems caused by Fractional Reserve Banking and the Federal Reserve.  Fractional reserve banking causes term structure risk–customers can withdraw their money immediately but the bank creates loans at multiples of its customers’ deposits for periods longer than a day. Banks can create money out of thin air by creating these loans. Therefore, our system in buffeted by inflationary bubbles and debt collapses. Readers will learn why our financial system is infected with booms and busts. Prof. Salerno presents a solution to our Ponzi financial system. Transcript here:

Fractional Reserve Banking and The Fed_Salerno

Video of Austrian Economists’ testimony on Fractional Reserve Banking, including Prof. Salerno’s testimony (excellent): http://www.youtube.com/watch?v=jVm3Yzjq8zE

Sprott Asset Management on Economic Policy

The Solution is the Problem by Sprott Asset Management


….In today’s overleveraged world, greater deficits and government spending, financed by an expansion of public debt and the monetary base (“the printing press”), are not the answer to our economic woes. In fact, these policies have been proven to have a negative impact on growth.

No wonder bankers are reviled: http://nymag.com/news/intelligencer/encounter/jamie-dimon-2012-8/


The Freeman | Ideas On Liberty, http://www.thefreemanonline.org

Boom and Bust: Crisis and Response

by Gerald P. O’Driscoll, Jr.• March 2010 • Vol. 60/Issue 2

America has experienced a classic economic boom and bust, which I first chronicled in the November 2007 Freeman [1].

Ill-conceived policies to encourage homeownership channeled cheap credit into housing markets. Land-use and zoning policies restricted the supply of housing in key desirable markets. In The Housing Boom and Bust, Thomas Sowell of the Hoover Institution has shown how these policies brought about a crisis in housing and finance.

Others have told the story from a number of perspectives and with varying emphasis on different factors. My purpose here is to focus on the policy responses to the crisis and ask whether they have been helpful or harmful.


On October 3, 2008, Congress enacted the law creating TARP (the Troubled Asset Relief Program), which was authorized to spend up to $700 billion to purchase troubled assets from financial institutions. A little more than a month later, then-Treasury Secretary Henry Paulson announced that rather than buying troubled assets, the Treasury would use the money for capital injections into banks in return for preferred shares.

Regardless of one’s attitude toward bailouts generally, Paulson’s original plan was a recipe for disaster. To help the banks he would have needed to overpay for the assets to the detriment of the taxpayers. If he had paid then-current prices, accounting rules would have forced all firms holding such assets to write them down (not just those selling the assets). Financial institutions holding dubious mortgage-backed assets were desperately trying not to write them down because that might have threatened their depleted capital base. It is fair to say that Paulson failed to grasp the underlying problems at these institutions when he first proposed the program.

TARP became a capital-relief plan. It harkened back to the Reconstruction Finance Corporation (RFC) of the Great Depression. Under Jesse Jones and in conjunction with Franklin Roosevelt’s Bank Holiday, all the nation’s banks were examined and divided into the good, the bad, and the ugly. Call it his version of a “stress test.” Those deemed beyond hope were never reopened. Those troubled but salvageable were eligible for RFC capital injections. Jones also extracted resignation letters from senior management of institutions being bailed out. If he deemed existing management best suited to run the bank, it could stay. If not, it was replaced.

In comparison, Paulson’s strategy was “ready, shoot, aim.” Banks received government injections of money to replace depleted capital, with nothing explicit extracted in return. There were vague promises that banks would resume lending but there was nothing enforceable. The banks were stress-tested only after having received government funds. There were second and even third rounds of bailouts for some banks, indicating they had been weaker than thought. We know that at least one—CIT, a financial institution that received $2.3 billion in TARP money—should have been allowed to close. Instead it eventually filed for bankruptcy, and the taxpayer funds were lost.

Moreover, in what has become a national disgrace, existing management at bailed-out banks remained in place. The Bush administration failed to impose even the level of control exercised under FDR.

On the one-year anniversary of the announcement of Paulson’s reversal on TARP, I was asked by Newsweek for my assessment [2]. “It hasn’t done what [Paulson] said it would,” I said. “Yes, it saved some banks from going under, but did it restore the health of the banking system? Absolutely not.” I stand by that assessment today.

What Does Government Stimulate?

The fiscal response to the crisis of the Bush/Obama administrations has been to spend their way out of the recession. In the process the nation’s debt has skyrocketed. There are deficits and debt as far as the eye can see, and our children’s future has been mortgaged. The 2009 fiscal deficit was double that of 2008. It is running at 10 percent of GDP, and former Fed governor and Bush adviser Larry Lindsey estimates deficits will run at 7 percent of GDP for a decade.

Because of the work of Milton Friedman and his monetarist followers, countercyclical fiscal policy fell under a cloud. First, they argued that recessions are difficult to forecast and we only typically know we have entered one after the fact. The monetarists also argued that fiscal policy was subject to the cumbersome legislative process and thus could not be quickly implemented. Once spending began, its effects were only felt slowly. All this wisdom was forgotten in the panic of the Bush administration and then more so in the Obama administration.

The Economic Stimulus Act of 2008, passed in February of that year, mainly sent $100 billion in checks to households in early summer to stimulate consumption and jump-start the economy. As Stanford economist John Taylor, author of Getting Off Track, has shown, the money did nothing and the economy slid into recession later that year. Any economist worth his salt knows that temporary government cash infusions will likely be saved and at best have transitory effects on spending.

Undaunted by that failure, the Obama administration decided to up the ante on the theory that there had just not been enough fiscal stimulus. It replaced billions in spending with trillions in spending: the stimulus package added on to TARP. In the next section I also discuss Fed spending masquerading as monetary policy.

What is the record? It appears that the recession may have ended in the third quarter of 2009. That would make it less than one year in duration–not atypical in that sense. Most of the Obama stimulus money has yet to be spent. (Recall Friedman’s arguments on fiscal policy.) It may be good electoral politics to claim credit for a still-nascent recovery. But it is poor economics. More likely, the self-adjusting forces of the market have been at work.

Clearly, nothing the government has done has been able to lower the unemployment rate. GDP is an abstraction; being out of work is a reality. In October the unemployment rate exceeded 10 percent. (It fell back to 10 later.) A broader measure of unemployment exceeded 17 percent. These numbers put the flesh on the skeleton of policy debates. More ominously, we now are seeing indications that wage rates are falling. As the Wall Street Journal reported [3], Professor Kenneth Couch of the University of Connecticut estimates that displaced workers returning to work will on average take a 40 percent pay cut.

Double-digit unemployment rates and double-digit wage cuts are depression statistics. In what way is government spending “stimulating”? In an editorial the Wall Street Journal concluded that “no matter how hard or imaginatively the Administration spins, the reality is that the stimulus has been the economic bust that critics predicted it would be.”

Indeed, the labor story helps us to see the dark side of stimulus spending. A good chunk of it has gone to state governments to support bloated budgets in the face of collapsing revenues. Those fiscal transfers are being done, at least in part, to placate public-sector unions, which want to protect the incomes and pensions of their members.

Fiscal stimulus has failed. What about the monetary variant?

Monetary Stimulus

The Fed’s response to the crisis has drawn mixed reviews among free-market economists. Some approve of the Fed’s easing in 2008–09 as a response to an increased demand for money (falling velocity). Nearly all market-oriented economists are disquieted by the explosion of the Fed’s balance sheet as it takes on more and more assets of dubious quality. It will be extremely difficult for the central bank to dispose of such assets when it inevitably comes time for it to tighten. The Fed will likely suffer losses, and such losses impact the taxpayer. (The Fed’s surplus is paid to the Treasury.)

Many economists have been critical of the Fed for its targeted-credit policies, which amount to credit allocation. They favor one sector at the expense of others, and constitute fiscal policy rather than monetary policy. The Fed’s leadership is dismayed at its loss of approval by the general public and fears calls for greater political oversight. But the backlash is of the Fed’s own making.

In the end its fortunes are tied to the economy’s. Most Americans do not know the technicalities of monetary policy. But Fed Chairman Ben Bernanke has taken an active and public role in defending the policy response to the crisis (under both Bush and Obama). Under Bernanke the Fed has promised much and delivered little.

Just as Americans fear the spending and budget deficits, many understand that easy money helped get us into the crisis. Now Dr. Bernanke has prescribed the strongest dose of cheap money ever administered. How can the elixir that caused the boom cure the bust?

The Bernanke Fed is engaged in a policy of reflating (re-inflating) the economy: stimulating money demand to restart economic growth. It justifies the policy on the basis of Professor Bernanke’s own research that shows the evils of deflation. But what prices is he trying to prop up? All prices? Even in hyperinflations, some prices fall. Is he trying to prevent downward adjustment in wages? As suggested above, wage rates in hard-hit sectors may be falling at double-digit rates. Is he preparing for double-digit price inflation? If so, gold is underpriced at $1,000 an ounce.

Astute observers increasingly fear that what is being reflated is another asset bubble. At present, the asset bubble is concentrated in commodities (such as gold, copper, and oil) and Asian real estate. In what is known as a carry trade, global investors are borrowing dollars at low interest rates to invest in property in cities like Hong Kong and Singapore. Instead of bringing prosperity to Americans, the Fed’s policy is fueling speculation. Instead of production in the United States, the Fed’s easy money is creating paper wealth for Asian property owners.

The rise in commodity prices is perhaps most ominous. The U.S. economy remains weak and unemployment elevated. Yet Americans are already paying higher prices for gasoline. They are facing the prospect of renewed inflation and economic weakness: stagflation. That would be an updated version of the economy of the 1970s. The Fed is thereby impoverishing Americans. Is it any wonder many are calling for a reconsideration of its role?

A version of this article previously appeared on TheFreemanOnline.org on Nov. 23, 2009.

Article printed from The Freeman | Ideas On Liberty: http://www.thefreemanonline.org

URL to article: http://www.thefreemanonline.org/features/boom-and-bust-crisis-and-response-3/

URLs in this post:

[1] I first chronicled in the November 2007 Freeman: http://www.tinyurl.com/npnog4

[2] I was asked by Newsweek for my assessment: http://www.newsweek.com/id/222321

[3] As the Wall Street Journal reported: http://online.wsj.com/article/SB125798515916944341.html

The Freeman | Ideas On Liberty

Subprime Monetary Policy

by Gerald P. O’Driscoll, Jr.• November 2007 • Vol. 57/Issue 9

In recent years monetary policy has been conducted so as to create an expectation that the Federal Reserve will bail out investors when asset bubbles deflate. Investors have come to bank on the Fed’s backing of risky ventures. The recent crisis in the subprime mortgage market is at least partly the outcome of this new approach to monetary policy. That crisis has already had widespread ramifications for homeowners and investors.

Government programs and policies often serve to insulate individuals from the full consequences of their actions. For instance, subsidized federal flood insurance leads individuals to build more homes in flood plains than would otherwise be the case. The public naturally feels sympathy for homeowners who are the victims of flooding, and supports more assistance for those caught up in these dreadful situations. The “help” often exacerbates the problem, however, by removing incentives for homeowners to rebuild on higher and drier land. The general public wonders why the catastrophes appear more frequently. Pundits ascribe them to global warming, and nature is blamed for the effects of manmade policy.

Since the 1930s the federal government has insured bank deposits. That scheme inherently reduced the vigilance of bank depositors toward their banks, removing constraints on risk-taking by the insured depository institutions. The situation became acute in the 1980s and 1990s, when unconstrained risk-taking by banks and thrift institutions led to a series of banking and financial crises. Eventually the deposit-insurance system was reformed and banking put on a sounder basis. Now we are in need of a reform of monetary policy.

Crisis in the Mortgage Market

Last February the popular press discovered subprime mortgage loans (see box) when two major originators of such loans, HSBC Holdings PLC and New Century Financial, disclosed increased loan loss provisions. HSBC is a globally diversified financial company. While it was a large lender in the market, the aggregate amount of its subprime loans was not a significant portion of its total portfolio.

New Century Financial fared much less well because of the concentration of its lending in this risky category. Its stock price collapsed after problems surfaced the previous February, and the company eventually declared bankruptcy.

Other lenders in the subprime market experienced difficulties. Fears of a housing collapse and even an economic recession grew as investors gauged the size and extent of the problem in the mortgage market.

The crisis was foreseen by many. For more than a year before the bust, bankers, analysts, and even regulators knew they had a mess in the making. As John Makin of the American Enterprise Institute observed, the lending practices in the subprime market were “shoddy and absurd.”

Lewis Ranieri, former chairman of Salomon Brothers, echoed those comments: “We’re not really sure what the guy’s income is and . . . we’re not sure what the house is worth. So you can understand why some of us become a little nervous.” Ranieri helped pioneer the bundling of mortgages into marketable securities (“securitization”), so he should know!

The collapse of the subprime mortgage market is the latest in a series of financial bubbles whose existence reflects, at least in part, moral hazard in financial markets. Moral hazard is the outcome of explicit or implicit guarantees to investors. At one time, deposit insurance was a major culprit. Today, monetary policy is fostering moral hazard.

Moral hazard occurs when some action or policy alters the behavior of individuals in a counterproductive way. Specifically, a policy intending to mitigate risk causes individuals instead to assume more risk. For example, a poorly designed policy insuring against fire could lead individuals to diminish resources devoted to fire prevention. In that case, the insurance would increase the probability of the insured risk occurring. (Of course, well-designed insurance policies should reduce risk. And in competitive markets, that is what normally happens.)

Earlier financial crises were the effects of deposit insurance and bank-closure policies that effectively insulated depositors and even other bank creditors from risk in the event of the failure of depository institutions. In an October 2002 speech to economists in New York, then-Fed Governor Ben Bernanke described the savings-and-loan crisis of the 1980s as “a situation . . . in which institutions can directly or indirectly take speculative positions using funds protected by the deposit insurance safety net—the classic ‘heads I win, tails you lose’ situation.” After an intellectual and political battle of more than a decade, the deposit-insurance loophole was sealed.

To better understand moral hazard, consider the case of a gambler going to a casino. If he bears the losses, his bets will be constrained by that risk. If someone were to guarantee him against loss, but allow him to keep the profits, the gambler would have an incentive to make the riskiest possible bets. He gains all the profits but bears none of the losses. One might designate such a system as “casino capitalism.” Current Fed policy has encouraged casino capitalism in the housing market.

Monetary policy can generate moral hazard if it is conducted so as to bail investors out of risky and otherwise ill-advised financial commitments. If investors come to expect that the policy will persist, they will deliberately take on additional risk without demanding commensurately higher returns. In effect, they will lend at the risk-free interest rate on risky projects, or at least at a lower rate than would otherwise be the case. Too much risky lending and investment will take place, and capital will be misallocated.

Money and Prices

To simplify a complex theoretical issue, an ideal monetary policy is one that facilitates and does not distort economic decision-making by individuals. Market prices play a critical role in that process by signaling to everyone the relative scarcity of goods and urgency of ends.

Austrian economist and Nobel laureate in economics F. A. Hayek characterized the price system as a communications mechanism for transmitting information about economic values. By communicating that valuable information, the price system helps coordinate economic activities. In its simplest formulation, prices tend to bring about equality between supply and demand in each market.

As with any communication system, it is desirable to filter out “noise,” extraneous signals that interfere with communication. Money is indispensable to price formation, but money can generate noise along with information. The ideal monetary policy is one in which there is no noise, only valid price signals. The best possible monetary policy would maximize the signal-to-noise ratio.

Monetary noise comes about when policy changes the value of money. In economies on gold or silver standards, the discovery of new sources of the precious metal can set in motion forces leading to an expansion of the money supply and the depreciation in the value of money. In modern times, money is created by printing it, or through expansion of bank liabilities. In nearly all developed countries, the rate of that expansion is (or can be) controlled by central banks.

Changes in the value of money create monetary noise because investors and ordinary individuals mistake changes in money prices for changes in relative prices. For instance, during inflation prices will rise just to reflect the increase in money and not necessarily because there has been a shift in preferences.

Current monetary policy is much improved from the record of the late 1960s, 1970s, and early 1980s. That was the era of double-digit inflation and sky-high interest rates. In a December 2002 speech to the Economic Club of New York, then-Fed Chairman Alan Greenspan put monetary policy in historical context:

Although the gold standard could hardly be portrayed as having produced a period of price tranquility, it was the case that the price level in 1929 was not much different, on net, from what it had been in 1800. But, in the two decades following the abandonment of the gold standard in 1933, the consumer price index in the United States nearly doubled. And, in the four decades after that, prices quintupled. Monetary policy, unleashed from the constraint of domestic gold convertibility, had allowed a persistent overissuance of money. As recently as a decade ago, central bankers, having witnessed more than a half-century of chronic inflation, appeared to confirm that a fiat currency was inherently subject to excess.

Some scholars have suggested that money influences not only the prices of consumer goods and wages, but also asset prices. They argue that money can work its mischief without showing up in consumer goods inflation. Widely used price indices, such as the consumer price index (CPI), do not include asset prices. A stable price index of consumer goods would thus not be a good measure of the value of money. Professor Charles Goodhart pointed to the two-decade experience of Japan, in which consumer prices were stable while asset prices fluctuated wildly. He asked rhetorically what the meaning of “inflation” is in such a context.

Goodhart argued that at least one category of assets figures so large in consumer purchases that it cannot be ignored: housing. Rental prices and housing prices do not always move in tandem. Home prices are affected by monetary policy in a number of ways, most notably through interest rates.

If asset prices are not incorporated into measures of inflation, their movements will not be action-forcing events for policymakers. Fed chairmen will wring their hands about “irrational exuberance,” but will be powerless to do anything until the effects of asset-price changes are manifested in undesirable changes in current prices and output.

The Greenspan Doctrine

The new moral hazard in financial markets has its source in what can be best described as the Greenspan Doctrine. It was clearly enunciated by Greenspan in his December 19, 2002, speech, in which he made an asymmetric argument leading to an asymmetric monetary policy. He argued that asset bubbles cannot be detected and monetary policy ought not in any case to be used to offset them. The collapse of bubbles can be detected, however, and monetary policy ought to be used to offset the fallout.

Two months earlier Ben Bernanke had made a similar argument. He endorsed the Greenspan Doctrine, arguing against the use of monetary policy to prevent asset bubbles: “First, the Fed cannot reliably identify bubbles in asset prices. Second, even if it could identify bubbles, monetary policy is far too blunt a tool for effective use against them.” Since Bernanke is now Fed chairman, it is reasonable for market participants to assume that the Greenspan Doctrine still governs current Fed policy.

Wrong Question

The two men were surely asking and answering the wrong question. They were implicitly treating bubbles as solely the consequences of real shocks or disturbances. (An example of a real shock is a technological innovation leading to productivity gains and higher future expected profits in a sector.) They asked whether monetary policy should be used to offset the effects of real shocks and concluded that it should not. The latter is the correct answer to the question they each posed.

A different question would be whether monetary policy should be conducted so as to create or exacerbate asset bubbles, which would not have occurred or would have been milder absent the assumed monetary policy. The answer to that question is surely no. Consider Bernanke’s apt characterization of moral hazard in the context of the deposit-insurance crisis: “When this moral hazard is present, credit flows rapidly into inelastically supplied assets, such as real estate. Rapid appreciation is the result, until the inevitable albeit belated regulatory crackdown stops the flow of credit and leads to an asset-price crash.”

Bernanke could have been talking about the subprime-mortgage market. That bubble and collapse cannot, however, be blamed on deposit insurance. First, deposit insurance is no longer systematically mispriced and banking supervision has improved. Second, the majority of mortgages are no longer made by insured depository institutions. Yet something generated the moral hazard that enabled shoddy underwriting of subprime mortgages to persist for years.

The Greenspan Doctrine helped create moral hazard in housing finance. The Fed announced that it will take no action against bubbles, but will act aggressively to offset the consequences of their collapse. In effect the central bank is promising at least a partial bailout of bad investments. The logic of the old deposit-insurance system is at work: policymakers should protect investors against losses, no matter their folly. Or, in Greenspan’s own words: monetary policy should “mitigate the fallout [of an asset bubble] when it occurs and, hopefully, ease the transition to the next expansion.”

In the present context, the “next expansion” could also be rendered as “the next asset bubble.” If the Fed promises to “mitigate the fallout” from “irrational exuberance,” then it is rational for investors to be exuberant. Investors may be at risk for some loss, as with a deductible on a conventional insurance policy, but losses are still being mitigated.

Rate Cut in 2000

The Fed cut the Fed Funds rate sharply after the bursting of the stock market bubble in March 2000. In the eyes of many, the Fed cut rates too far and held them down too long, fueling not only a vigorous economic expansion but also the housing bubble. In his December 2002 speech, Greenspan was at pains to deflect any argument that the Fed was inflating a housing bubble. “To be sure,” he acknowledged, mortgage debt was high relative to household income [remember the date] by historical norms. But “low interest rates” were keeping the servicing requirements of the mortgage debt manageable (emphasis added). “Moreover, owing to continued large gains in residential real estate values, equity in homes has continued to rise despite very large debt-financed extractions.”

How wrong the Fed chairman was! If Greenspan was not worried about interest rates resetting, why should mortgage bankers and homeowners worry? It would have been reasonable to read into the chairman’s musings an implicit guarantee of continued low rates. A homeowner is certainly entitled to bet his home on the come if he wants. Should the central bank encourage such behavior?

Monetary Policy for a Free Economy

In his 2002 speech to the Economic Club of New York, Greenspan spoke disapprovingly of a policy that permits prices to nearly double in two decades. At current CPI inflation rates, however, prices will double in less than three decades. If inflation were to rise to 3 percent and remain there, prices would double in 24 years. That is not much progress against inflation, and surely we can expect better.

In a vibrant market economy with technological innovation and ever-new profit opportunities, the monetary policy that maintains true price stability in consumer goods requires substantial monetary stimulus. That stimulus will have a number of real consequences, including asset bubbles. These asset bubbles have real costs and involve misallocations of capital. For example, by the peak of the tech and telecom boom in March 2000, too much capital had been invested in high-tech companies and too little in “old-economy firms.” Too much fiber-optic cable was laid and too few miles of railroad track were laid.

By 2002 the Fed was worried about the possibility of price deflation and introduced a strong anti-deflationary bias. A tilt to stimulus was understandable at the time. A continued bias against deflation at any cost, however, will produce a continued bias upward in price inflation. The inflation rate begins at the positive number. With the bursting of each asset bubble and the fear of deflationary pressure, Fed policy must ease. The Greenspan Doctrine prescribes a stimulative overkill that begins the cycle anew. The Greenspan-era gains against inflation will then prove to be only temporary. His doctrine will be the death of his legacy, a legacy that already includes a housing bubble and its aftermath.

Article printed from The Freeman | Ideas On Liberty: http://www.thefreemanonline.org

Why California is bust


Video Lecture on Stock Market Booms and Busts

Are Booms and Busts Inherent in the Market Economy?

In this excerpt from a lecture at Liberty Classroom, Jeffrey Herbener says no.

Excellent lecture on the stock market’s booms and busts during the 1920s to 1960s. Worth viewing or downloading.


Interesting Lessons on Economics: The Cause of Booms and Busts

The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.

–Henry Hazlitt


Booms and Busts

Short two-to-three-minute videos on the causes of booms and busts:

The history of booms and busts: http://www.learnliberty.org/content/history-economic-booms-and-busts

The Myths of the Great Depression: http://www.learnliberty.org/content/top-3-myths-about-great-depression-and-new-deal

Govt. response to the 2008/09 Financial Crisis: Manipulation fails. http://www.learnliberty.org/content/2008-financial-crisis-government-response

Occupy Wall Street

I sympathize with the Occupy Wall Street protestors in their grievances against crony capitalism, government corruption and corporate welfare. Unfortunately, many of these protestors do not understand economic principles. More government intervention doesn’t solve problems caused by government control and interference in the free exchanges between individuals under a rule of law.

A short video on Occupy Wall Street Protestors: http://www.learnliberty.org/videos/occupy-wall-street-capitalism-professors-response

Ludwig von Mises on the First ‘Occupy Wall Street’

In his book Bureaucracy, Ludwig von Mises discussed the German youth movement that occurred in Germany the decade before the First World War. The similarity with OWS is quite remarkable:

In the decade preceding the First World War Germany, the country most advanced on the path toward bureaucratic regimentation, witnessed the appearance of a phenomenon hitherto unheard of: the youth movement. Turbulent gangs of untidy boys and girls roamed the country, making much noise and shirking their school lessons. In bombastic words they announced the gospel of a golden age. All preceding generations, they emphasized, were simply idiotic; their incapacity has converted the earth into a hell. But the rising generation is no longer willing to endure gerontocracy, the supremacy of impotent and imbecile senility. Henceforth the brilliant youths will rule. They will destroy everything that is old and useless, they will reject all that was dear to their parents, they will substitute new real and substantial values and ideologies for the antiquated and false ones of capitalist and bourgeois civilization, and they will build a new society of giants and supermen.

The inflated verbiage of these adolescents was only a poor disguise for their lack of any ideas and of any definite program. They had nothing to say but this: We are young and therefore chosen; we are ingenious because we are young; we are the carriers of the future; we are the deadly foes of the rotten bourgeois and Philistines. And if somebody was not afraid to ask them what their plans were, they knew only one answer: Our leaders will solve all problems.

It has always been the task of the new generation to provoke changes. But the characteristic feature of the youth movement was that they had neither new ideas nor plans. They called their action the youth movement precisely because they lacked any program which they could use to give a name to their endeavors. In fact they espoused entirely the program of their parents. They did not oppose the trend toward government omnipotence and bureaucratization. Their revolutionary radicalism was nothing but the impudence of the years between boyhood and manhood; it was a phenomenon of a protracted puberty. It was void of any ideological content.

If you want a concise, clear lesson on economics you can view the 3-hour video: 10 lectures on each chapter of Economics in One Lesson by Henry Hazlitt


The book in pdf: http://www.fee.org/pdf/books/Economics_in_one_lesson.pdf

To grasp why understanding economics is critical view the errors of Prof. Milton Friedman on the Federal Reserve. Professor Friedman praised Alan Greenspan’s reign at the Federal Reserve while completely ignoring the distortions in the economy in 2005.

Milton Friedman on Charlie Rose: http://video.google.com/videoplay?docid=-2963837673813979186#

How a bad economic theory leads to a false interpretation of economic performance. An Austrian discusses Milton Friedman’s monetary theory: http://www.youtube.com/user/misesmedia#p/u/5/DMR-r0nrk60

The Importance of Critical Thinking

If you understand the lessons from Economics in One Lesson, you will see many false premises and the errors in logic here:

Thomas Friedman, the columnist for the New York Times is daft. How can innovation in one part of his essay cause human suffering while in another paragraph innovation will improve lives?