In previous recession articles, I referred to recessions as a result of "vast shifts in customer preference" that cause temporary economic inconveniences which are inevitable in a period of comparatively large transitions. While being correct in the most general terms, this is, of course, a bit misleading since it leaves out of the picture why exactly these preference shifts started occuring in the first place. It could be that people all of a sudden decided to change their preferences, but that's unlikely on such a scale. The real culprit, at least in this recent case, seems to be central banking and centrally managed interest rates.
Let's start from scratch. Our current crisis originated in the housing market. A lot of people were unable to repay their mortgages and had their homes foreclosed; house prices started dropping since an increasing number of foreclosed homes were now up for sale. This created another problem: a number of homeowners used their homes as a "source of revenue", they hoped on ever-increasing homes prices and maxed out their mortgages whenever the speculative price of their home had risen. Now that house prices started dropping, their securities started melting away and other expensive consumer goods that had been leased with the expectation of ever-increasing housing prices had to be returned, thus decreasing demand and prices in these industries as well. Ensuing layoffs in affected sectors of the economy soon started spreading and recessionary tendencies became visible.
In other words, a good amount of people had been living well above their means for quite some time. How did this happen? Why did these people get a mortgage in the first place if their solvency was that unstable?
On a free market, credit is a finite good. The availability of credit is expressed by interest rates. If little to no savings (the foundation for sound credit) exist, interest rates are high: that way, scarce credit is directed to very profitable endeavors only that are able to generate enough revenue to pay back the considerable interest. As savings become more abundant, more credit can be given out for less interest and less profitable enterprises can make use of this tool as well. The least profitable enterprise is consumption. Consumption generates no monetary profit per definition because funds are being consumed instead of being invested. Thus, credit-financed consumption by a few (basically, what the United States had been doing in the last few years) is only sustainable to some extent in a society with an enormous savings rate (in case of the United States, the thrifty lender was mainly China).
A central bank with centrally managed interest rates shuts off this market-based process of interest rate creation. Interest rates are set by fiat ("according to leading economists' market estimates"). Because central planners are unable to imitate the effectiveness of a real market, central banking also has a political objective, namely to transform the "is" condition of the market into an "ought to" condition of what politicians would like to see. Wanna "spur consumption"? Just lower interest rates! Needless to say, this creates a lot of problems down the road once political planning collides with reality. To pick up our example of United States consumption, years of low interest and low personal savings rates created a vast debt bubble that popped once one of the most debt-laden sectors of the economy, the housing market, had started to crumble - in other words, once it had become obvious that the amount of debt circulating was not backed by a sufficient amount of savings or productivity, that there simply was a lack of funds that could not be compensated by an increase in debt because there was way too much of it already.
Saving money constitutes deferred consumption. Think of money as bricks. It's your decision whether you want to use all your bricks right now to build houses for yourself or put them into a bank to gain interest and to allow others to build houses with them. If a brick bank promises to loan out more bricks than it can reasonably expect to get in due time, any constructions that have already begun based on brick loans from this particular bank will eventually come to a halt. If the brick money system itself is based on not lending out bricks according to how many bricks are there, but according to how many bricks should be there or how many bricks a wise, but economically ignorant wizard estimates to be there, then all houses that have been planned based on this system will face a lack of bricks rather soon.
And then, to finally make the point I wanted to get to, you'll see these miraculous "vast shifts in customer preference" that I'd been talking about all along. When people realize there ain't enough bricks, they'll change plans and opt for alternative solutions. This will necessarily interfere with the schemes of those who had been calculating with central bank brick numbers, but ultimately, either there are enough bricks or not. If not, there's no point in pretending anything else. It will only delay recovery.
Now, recessions are not always the fault of central banks, but these banks notably increase the likelihood of far-reaching malinvestments. They are most likely to be blamed for our most recent recession. Accordingly, I considered it worthwhile to point out that "vast shifts in customer preference" do not need to be the result of "free market animal spirits", but can also be caused by the actions of state institutions.
Let's start from scratch. Our current crisis originated in the housing market. A lot of people were unable to repay their mortgages and had their homes foreclosed; house prices started dropping since an increasing number of foreclosed homes were now up for sale. This created another problem: a number of homeowners used their homes as a "source of revenue", they hoped on ever-increasing homes prices and maxed out their mortgages whenever the speculative price of their home had risen. Now that house prices started dropping, their securities started melting away and other expensive consumer goods that had been leased with the expectation of ever-increasing housing prices had to be returned, thus decreasing demand and prices in these industries as well. Ensuing layoffs in affected sectors of the economy soon started spreading and recessionary tendencies became visible.
In other words, a good amount of people had been living well above their means for quite some time. How did this happen? Why did these people get a mortgage in the first place if their solvency was that unstable?
On a free market, credit is a finite good. The availability of credit is expressed by interest rates. If little to no savings (the foundation for sound credit) exist, interest rates are high: that way, scarce credit is directed to very profitable endeavors only that are able to generate enough revenue to pay back the considerable interest. As savings become more abundant, more credit can be given out for less interest and less profitable enterprises can make use of this tool as well. The least profitable enterprise is consumption. Consumption generates no monetary profit per definition because funds are being consumed instead of being invested. Thus, credit-financed consumption by a few (basically, what the United States had been doing in the last few years) is only sustainable to some extent in a society with an enormous savings rate (in case of the United States, the thrifty lender was mainly China).
A central bank with centrally managed interest rates shuts off this market-based process of interest rate creation. Interest rates are set by fiat ("according to leading economists' market estimates"). Because central planners are unable to imitate the effectiveness of a real market, central banking also has a political objective, namely to transform the "is" condition of the market into an "ought to" condition of what politicians would like to see. Wanna "spur consumption"? Just lower interest rates! Needless to say, this creates a lot of problems down the road once political planning collides with reality. To pick up our example of United States consumption, years of low interest and low personal savings rates created a vast debt bubble that popped once one of the most debt-laden sectors of the economy, the housing market, had started to crumble - in other words, once it had become obvious that the amount of debt circulating was not backed by a sufficient amount of savings or productivity, that there simply was a lack of funds that could not be compensated by an increase in debt because there was way too much of it already.
Saving money constitutes deferred consumption. Think of money as bricks. It's your decision whether you want to use all your bricks right now to build houses for yourself or put them into a bank to gain interest and to allow others to build houses with them. If a brick bank promises to loan out more bricks than it can reasonably expect to get in due time, any constructions that have already begun based on brick loans from this particular bank will eventually come to a halt. If the brick money system itself is based on not lending out bricks according to how many bricks are there, but according to how many bricks should be there or how many bricks a wise, but economically ignorant wizard estimates to be there, then all houses that have been planned based on this system will face a lack of bricks rather soon.
And then, to finally make the point I wanted to get to, you'll see these miraculous "vast shifts in customer preference" that I'd been talking about all along. When people realize there ain't enough bricks, they'll change plans and opt for alternative solutions. This will necessarily interfere with the schemes of those who had been calculating with central bank brick numbers, but ultimately, either there are enough bricks or not. If not, there's no point in pretending anything else. It will only delay recovery.
Now, recessions are not always the fault of central banks, but these banks notably increase the likelihood of far-reaching malinvestments. They are most likely to be blamed for our most recent recession. Accordingly, I considered it worthwhile to point out that "vast shifts in customer preference" do not need to be the result of "free market animal spirits", but can also be caused by the actions of state institutions.
No comments:
Post a Comment