Archive for February, 2012

The Boom, the Bust, and the Rate of Interest

Generations of Americans have been persuaded to believe America’s economy has been running amok for too long.  They’ve been told that capitalism failed and the powerful booms and busts are 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 on 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, homebuyers, 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 limited 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 in a free economy (without central bank intervention) such event 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 homebuyers 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 as demonstrated in the chart above – 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 represents a period of malinvestments 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 misinvestments 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 malinvestments 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 malinvestment; the crisis, which arrives when credit expansion ceases and malinvestments 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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The Fed’s Covert Bailout of Europe

By Gerald P. O’Driscoll Jr.
The Wall Street Journal

America’s central bank, the Federal Reserve, is engaged in a bailout of European banks. Surprisingly, its operation is largely unnoticed here.

The Fed is using what is termed a “temporary U.S. dollar liquidity swap arrangement” with the European Central Bank (ECB). There are similar arrangements with the central banks of Canada, England, Switzerland, and Japan. Simply put, the Fed trades or “swaps” dollars for euros. The Fed is compensated by payment of an interest rate (currently 50 basis points, or one-half of 1%) above the overnight index swap rate. The ECB, which guarantees to return the dollars at an exchange rate fixed at the time the original swap is made, then lends the dollars to European banks of its choosing.

Why are the Fed and the ECB doing this? The Fed could, after all, lend directly to U.S. branches of foreign banks. It did a great deal of lending to foreign banks under various special credit facilities in the aftermath of Lehman’s collapse in the fall of 2008. Or the ECB could lend euros to banks and they could purchase dollars in foreign-exchange markets. The world is, after all, awash in dollars.

The two central banks are engaging in this roundabout procedure because each needs a fig leaf. The Fed was embarrassed by the revelations of its prior largess with foreign banks. It does not want the debt of foreign banks on its books. A currency swap with the ECB is not technically a loan.

The ECB is entangled in an even bigger legal and political mess. What the heads of many European governments want is for the ECB to bail them out. The central bank and some European governments say that it cannot constitutionally do that. The ECB would also prefer not to create boatloads of new euros, since it wants to keep its reputation as an inflation fighter. To mitigate its euro lending, it borrows dollars to lend them to its banks. That keeps the supply of new euros down. This lending replaces dollar funding from U.S. banks and money-market institutions that are curtailing their lending to European banks — which need the dollars to finance trade, among other activities. Meanwhile, European governments pressure the banks to purchase still more sovereign debt.

The Fed’s support is in addition to the ECB’s E489 billion ($638 billion) low-interest loans to 523 euro-zone banks last week. And if 2008 is any guide, the dollar swaps will again balloon to supplement the ECB’s euro lending.

This Byzantine financial arrangement could hardly be better designed to confuse observers, and it has largely succeeded on this side of the Atlantic, where press coverage has been light. Reporting in Europe is on the mark. On Dec. 21 the Frankfurter Allgemeine Zeitung noted on its website that European banks took three-month credits worth $33 billion, which was financed by a swap between the ECB and the Fed. When it first came out in 2009 that the Greek government was much more heavily indebted than previously known, currency swaps reportedly arranged by Goldman Sachs were one subterfuge employed to hide its debts.

The Fed had more than $600 billion of currency swaps on its books in the fall of 2008. Those draws were largely paid down by January 2010. As recently as a few weeks ago, the amount under the swap renewal agreement announced last summer was $2.4 billion. For the week ending Dec. 14, however, the amount jumped to $54 billion. For the week ending Dec. 21, the total went up by a little more than $8 billion. The aforementioned $33 billion three-month loan was not picked up because it was booked by the ECB only on Dec. 22, falling outside the Fed’s reporting week. Notably, the Bank of Japan drew almost $5 billion in the most recent week. Could a bailout of Japanese banks be afoot? (All data come from the Federal Reserve Board H.4.1. release, the New York Fed’s Swap Operations report, and the ECB website.)

No matter the legalistic interpretation, the Fed is, working through the ECB, bailing out European banks and, indirectly, spendthrift European governments. It is difficult to count the number of things wrong with this arrangement.

First, the Fed has no authority for a bailout of Europe. My source for that judgment? Fed Chairman Ben Bernanke met with Republican senators on Dec. 14 to brief them on the European situation. After the meeting, Sen. Lindsey Graham told reporters that Mr. Bernanke himself said the Fed did not have “the intention or the authority” to bail out Europe. The week Mr. Bernanke promised no bailout, however, the size of the swap lines to the ECB ballooned by around $52 billion.

Second, these Federal Reserve swap arrangements foster the moral hazards and distortions that government credit allocation entails. Allowing the ECB to do the initial credit allocation — to favored banks and then, some hope, through further lending to spendthrift EU governments — does not make the problem better.

Third, the nontransparency of the swap arrangements is troublesome in a democracy. To his credit, Mr. Bernanke has promised more openness and better communication of the Fed’s monetary policy goals. The swap arrangements are at odds with his promise. It is time for the Fed chairman to provide an honest accounting to Congress of what is going on.


Mr. O’Driscoll, a senior fellow at the Cato Institute, was vice president at the Federal Reserve Bank of Dallas and later at Citigroup.

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An Outlook for the Dollar and Gold as Money

The dollar, inflation, and sound money….that’s what we’re concerned with today!  How are these subjects impacting our lifestyles, purchasing power, the way we live?  In this video Philipp Bagus, Assistant professor of Economics at Madrid’s Universidad Rey Juan Carlos and author of The Tragedy of the Euro, and Alasdair Macleod of the GoldMoney Foundation talk about the ongoing expansion of the money supply and persistent deficits.  Is the dollar gaining in value over the medium to long term?  Bagus – like so many Austrian economists – doesn’t think so.   So, what is the solution?  Nothing new under the sun, an idea that’s been proven the right option by history: sound money.  Bagus explains different ways to go about the introduction of sound money.  One way would be to back all the money in existence by gold, adjusting the price of gold accordingly.  Another would be to take away legal tender laws and have competing currencies.  However this would require the governments to impose dramatic reforms, which is partly why they will oppose such measures.  Watch this short educational interview.

An outlook for the dollar and gold as money

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