Tag: credit expansion policy

Geithner Admits – Austrian Economists Were Right All Along

Tim Geithner confirms what Austrian School economists have been blowing the whistle about all along:

Mr. Geithner: “But I would say there were three types of broad errors of policy and policy both here and around the world. One was that monetary policy around the world was too loose too long. And that created this just huge boom in asset prices, money chasing risk. People trying to get a higher return. That was just overwhelmingly powerful.”

Mr. Rose: “It was too easy.”

Mr. Geithner: “It was too easy, yes. In some ways less so here in the United States, but it was true globally. Real interest rates were very low for a long period of time.”

Mr. Rose: “Now, that’s an observation. The mistake was that monetary policy was not by the Fed, was not . . .”

Mr. Geithner: “Globally is what matters.”

Mr. Rose: “By central bankers around the world.”

Mr. Geithner: “Remember as the Fed started — the Fed started tightening earlier, but our long rates in the United States started to come down — even were coming down even as the Fed was tightening over that period of time, and partly because monetary policy around the world was too loose, and that kind of overwhelmed the efforts of the Fed to initially tighten. Now, but you know, we all bear a responsibility for that. I’m not trying to put it on the world.”

And I fully concur with this conclusion that follows in this WSJ article:

The Washington crowd has tried to place all of the blame for the panic on bankers, the better to absolve themselves. But as Mr. Geithner notes, Fed policy flooded the world with dollars that created a boom in asset prices and inspired the credit mania. Bankers made mistakes, but in part they were responding rationally to the subsidy for credit created by central bankers.

Another former Treasury official just confirmed the same:

The Fed helped to trigger the current financial crisis by keeping rates too low for too long, Taylor said.

“Low interest rates led to the acceleration of the housing boom,” he said. “The boom then resulted in the bust, with delinquencies, foreclosures and toxic assets on the balance sheet of financial institutions in the United States and other countries.”

Taylor said that though policy makers were well intended, they were mistaken in trying to “fine-tune” the economy after about a quarter of a century during which long and deep recessions had been avoided.

For more details see Credit Expansion Policy … always a good read for anyone who wants to understand the root cause of the financial crisis. Back in October 07 I concluded that article with:

As long as the central banks keep pursuing this policy, there is no need to be surprised when the next credit crunch occurs. Neither is there any need to be surprised about the fact that all countermeasures taken by the government will turn out to be utter failures that will accomplish nothing but aggravate the crisis. For if the cause of the problem has been too much government intervention, then more government intervention will only add to it.

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The Business Cycle

Note: To find out more about the differences between the consumption business cycle and the production business cycle read my newer post The Business Cycle Revisited.

All causes, effects and basic workings behind the Business Cycle have already been outlined by the theory of Credit Expansion.

This article shall elaborate on the detailed workings during the business cycle, from start to finish, divide it into phases, and establish a checklist for each phase during the cycle.

Phase 1: The Unhampered Market

The initial phase is a market system unhampered by central bank intervention. Consumers demand consumer goods. Entrepreneurs obtain savings money from capitalists in credit transactions and buy and combine factors of production and pay workers in order to produce those consumer goods. If the factors were withdrawn from less important uses and employed in more important ones, and on top of that there is still money left after paying interest to the capitalists, the entrepreneur earns a profit. Everyone who has earned money in this transaction, workers, capitalists, and entrepreneurs will then use part of the money earned and act as consumers which brings us back to the beginning. But with part of what they earned they act as capitalists and save it up for future consumption. Thus, as a whole,  part of their labor is available to  contribute to a stock of goods that are not consumed but rather aid in the production process, factors of production, via savings and investment. The more the immediate wants are satisfied over time, the lower the people’s time preference for present goods, and thus the more will people save, and the more capital will be available which increases the future output of goods per unit of labor. The unhampered market system, as a tendency, continuously provides for a rising standard of living for everyone who is involved. The government limits its scope to protecting the individuals on the market against aggression. It funds this activity via a minimal tax. Interest rates fully reflect the market participants’ voluntary time preferences, prices reflect voluntary value preferences.

Checklist:

  • True GDP expands significantly
  • A continuous and slow decline of interest rates
  • A continuous and slow increase of the savings rate
  • A money supply growth of 3% or less
  • A continuous decline in the money prices of consumer goods

Phase 2: The Bank Credit Expansion

Now the central bank appears and prints additional fiat money. It goes out on the market and asks capitalists, or banks who act on the capitalists’ behalf, to sell the debt they hold at a price based on the interest payments and riskiness of the security. Capitalists won’t be interested in the exchange since they genuinely desire to hold the debt as a means of obtaining interest income. Hence the central bank needs to offer a higher price for the debt. As a result, the debt is sold at a higher price. It is sold to an institution that has not generated genuine savings but rather printed fiat money out of nothing.

Checklist:

  • Interest rates for the debt instrument types bought by the central bank begin falling a bit faster
  • Overall interest rates remain untouched
  • Banks accumulate excess reserves
  • True GDP keeps rising
  • The savings rate is still increasing

Phase 3: The Business Credit Expansion

The capitalists and banks whose debt has been bought by the central bank now hold cash again. They will thus loan out money again since their time preferences haven’t changed. But the entrepreneurs they previously loaned money to don’t need additional capital. Thus they will try to loan out money to others. They will try to find a borrower from whom they can expect the same interest rate as they were earning previously, or at least an interest rate that is only slightly lower. Since they realized a premium upon their previous sales of debt, they will still be able to earn more interest income per month if the interest rate for the total loan only drops marginally. Slowly the rate for loans on the broad market begins to drop. Bank profit from interest earnings begins to rise consistently. The central bank, again, buys up newly created debt from the capitalists which the capitalists, again, loan out. The activity is repeated.

Checklist:

  • Interest rates begin dropping faster across the board
  • Banks loan out excess reserves
  • Banks begin to report higher profits
  • The money supply growth rate accelerates beyond 3%
  • True GDP keeps rising
  • The savings rate keeps rising

Phase 4: Entrepreneurial Activity Expands

Would-be entrepreneurs, who up to now were unable to obtain loans from the capitalists, because interest rates indicated that not enough voluntary savings were available to bridge the temporary shortfall in consumption goods that comes with investment, are now under the impression that the market provides enough factors of production to complete the projects they had been planning. With the borrowed money, they will begin obtaining factors of production on the market.

Since no additional savings and thus factors of production have been added to the market, the prices for factors of production will rise slowly. The factors are withdrawn from other occupations where they were obtained for less money, but were fulfilling demands based on true market data. Salaries for employees in these new production lines will go up.

However, the overall market is not yet fully permeated by this new activity. Lots of the previous operations remain active. The overall mood is positive. The new entrepreneurs are convinced their projects will be successful. The employees withdrawn from other occupations are happy about the raise in salary. They have not begun spending this new money yet. Prices for consumer goods have not begun to rise yet so it appears as though their real income rises. Their example catches others people’s attention. They, too, begin looking for new occupations. The ensuing reduction of the supply of consumer goods will not immediately be reflected in market data. The prospect of new and better goods in the future entices the majority. The central bank keeps on buying up additional debt.

Checklist:

  • The ratio of entrepreneurs to workers on the market increases
  • The money supply grows more sharply
  • Interest rates bottom
  • Prices for factors of production slowly start to rise more noticeably
  • Stock prices begin to rise more sharply
  • Talk about new industries and businesses in the media increases
  • Business sentiment turns more optimistic than before

Phase 5: The Credit Acceleration

The perpetuation of the central bank’s purchases now impels capitalists to make riskier loans than before. The ability to load loans off at the central bank at a premium reduces the relevance of risk assessment. A broad market for risky loans emerges, the junk bond market. The rise in the price of factors of production is starting to become more obvious on their main market, the stock market. Especially the markets for risky loans and stocks and for loans and stocks for projects that yield output in the farther future will suddenly appear much more lucrative to capitalists.

Entrepreneurs believe that the goods to be produced in these projects will meet a demand and that enough basic consumption goods are available at a low enough price to justify expenditures for the new future products. Profit expectations of the new enterprises appear reasonable.  As a result stock prices continue to rise. More capitalists will enter this market and realize gains. Established businesses will also begin changing their strategy and embark upon riskier and longer term projects.

It is not possible to determine from the outset which projects will be boosted more than others. If the government, for example, encourages home ownership via corresponding legislation and pushes home loans by itself, and if the central bank buys mortgage backed securities, it is rather likely that lending for the purpose of home ownership will increase and a housing bubble will ensue. But it is important to understand that such a housing bubble would only be one part of an overall reallocation of resources.

New would-be capitalists appearing on the market, who would usually have saved money and thus generated capital by abstaining from consumption no longer see their time preference reflected in the lower interest rates. Instead they will be compelled to buy stocks or houses as a means of wealth generation which at this point appears far more lucrative than loaning out money for less risky and shorter term projects. In addition they will be impelled to consume part of what they would have usually saved. Capital consumption as outlined in Savings and Investment ensues.

The number of resources withdrawn from the production of current basic consumer goods increases. Their employment in long term and risky projects increases. Meanwhile the true availability of savings has decreased. Production of basic consumer goods is neglected more and more as a result.

The additional money loaned and spent in salaries now visibly hits the market for consumer goods. The recipients of the money don’t save as much as the low interest rates indicated. And of the money they do save, part is diverted to risky or long term stocks. Due to higher consumption and less production, prices for basic consumer goods begin to rise slowly. The central bank begins to slow down its purchases of debt.

The entrepreneurs have gotten used to the easy access to credit. The overall sentiment will still be positive toward debt. Entrepreneurs will demand new credit once some of the initial loans are paid off. The lack of additional debt purchases from the central bank, coupled with the ever more prevalent shortage of savings will now cause interest rates to rise. Entrepreneurs will borrow money for more risky and longer term projects.

Checklist:

  • The junk bond market becomes more popular
  • Loans are being repackaged and sold at premiums
  • Profit expectations are revised higher
  • The savings rate peaks
  • The stock market soars
  • The money supply growth rate peaks
  • Interest rates rise
  • Prices of factors of production increase sharply
  • Prices for consumer goods begin rising slowly
  • True GDP peaks

Phase 6: The Credit Boom

Overall sentiment is very positive toward the projects that have been embarked upon. Factors of production are still priced based on the initial earnings expectations, meaning the expectation that their output would meet an expected demand. But the rise in consumer prices is no longer negligible. The raise in salaries is more and more put into relation with prices for consumer goods. Credit transactions will now take into consideration a significantly lower level of purchasing power, adding a premium to the interest. Interest rates begin rising more sharply. The rise of the prices of factors of production impels people to obtain them solely for the purpose of realizing a price gain and as a hedge against rising prices. Stock prices soar at an unusually high pace. Consumer prices rise more sharply. The central bank halts the credit expansion.

Checklist:

  • A euphoria emerges on the stock market, stock prices skyrocket
  • The money supply growth continues declining
  • Consumer prices rise more sharply
  • Interest rates rise further
  • The savings rate declines sharply
  • Stock prices peak
  • True GDP falls

Phase 7: The Credit Peak

Interest rates for loans keep rising sharply. The prices for factors of production increase which drives up cost for the new operations. The products they might at this point be launching are not the highest priority for the consumers. Due to a lack of immediate consumption products vis a vis  consumer demand, the prices for other consumer products begin rising sharply. Thus consumers need to cut back on extra consumption and confine their expenditures to basic consumer goods which are now more expensive. Thus revenue for the new operations falls. Rising prices and falling revenue will affect the profit of these operations. They will start to have problems paying interest to the capitalists and banks.

One by one, new businesses that produce less basic and more extra goods will begin defaulting on their loans and revise their earnings expectations down. First the riskiest ones, then the less risky ones. The capitalists will no longer extend additional credit. The market data now shows the capitalists and entrepreneurs what the true value and time preferences of the consumers are. Stock prices begin to fall, consumers refuse to change their consumption behavior while prices for basic consumer goods and commodities soar.

Resources need to be released from their current occupations. Since people will not immediately find new occupations, a rise in unemployment ensues.

Checklist:

  • Stock prices decline
  • Interest rates peak
  • Consumers complain about high prices for basic goods, such as gasoline or food
  • Business defaults increase
  • Commodity prices soar
  • Business sentiment turns less positive
  • The money supply growth keeps slowing down
  • Unemployment increases
  • True GDP continues to fall

Phase 8: The Credit Crunch

A general realization that the consumption demands were not in line with the actual amount of basic consumer goods available ensues. People will first of all begin consuming less, especially those who have been temporarily released from their occupation. Now the prices of consumer goods will reverse their gains begin falling sharply as well. The same realization reaches those people who are still occupied in more useful lines of production.

They will consume less and save more. More savings will be available. At the same time, as entrepreneurs still one by one liquidate their current failed operations, no additional credit is demanded. Existing loans are paid off or foreclosed upon. Businesses and consumers now rather want to consolidate their finances and save money so as to make available more productive factors for the production of basic consumption goods to get back to the level before the credit expansion began. A lot of money will initially be parked in very low risk debt securities, such as Treasuries. Their interest rates will begin falling first. Other debt securities will follow. The recipients of the money prefer to hold the cash until they are able to identify entrepreneurs who plan to produce more basic goods. Cash gains in preference to other goods.

The overall sentiment turns negative. Profit expectations are again revised down by the capitalists. They begin selling more of their stocks, factors of production are released from their current occupation and return to prices that truly reflect their usefulness to the consumers.

Checklist:

  • Stock prices crash
  • Commodity and consumer prices fall
  • The savings rate increases
  • Loan foreclosures increase significantly
  • Interest rates fall
  • Business sentiment turns negative
  • The number of bankruptcies increases
  • Unemployment increases
  • True GDP continues to fall

Phase 9: The Correction

Unless the government tries to counteract the processes that lead to a correction, in particular the liquidation of unprofitable operations, or attempts to perpetuate the process of credit expansion, prices will quickly return to levels where they represent voluntary value preferences. Otherwise the correction will also occur, but it will take much longer. Individuals have cut back on their consumption in order to save up money. The increase in savings lowers the rate of interest and thus indicates to entrepreneurs that a sufficient level of productive factors is available. Entrepreneurs identify operations that are profitable and obtain funds from the capitalists. They begin employing factors of production in these operations. The market returns to the unhampered state, albeit at a level of output and a standard of living that is lower than where it was before the credit expansion was started.

Checklist:

  • Stock prices bottom out
  • Interest rates bottom out
  • Consumer and commodity prices rise back to a certain level and then continue their slow long term decline
  • Unemployment declines
  • True GDP begins to rise again
  • Interest rates rise back to a certain level and then continue their slow long term decline

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Credit Expansion Policy

Objectives of Credit Expansion

Credit expansion is the policy where the central bank produces additional money in order to purchase debt from the government or from entrepreneurs, such as banks. In a system where gold is used as money there exist strict limits for money producers when it comes to credit expansion, due to the natural scarcity of the precious metal. In a fiat money system there are no natural limits on the amount of additional money produced. As a result, the interest rate for additional credit transactions drops.

The policy of credit expansion is broadly accepted as a measure to make people prosperous.

It is its declared objective to make credit abundant. New credit is said to spur business activity, capital becomes inexpensive, entrepreneurs can borrow more money for investments, commerce flourishes and soon all of society is permeated by the magical boon that the credit boom bestows upon it. Everyone is supposed to enjoy all the consumer goods they have been longing for under the stingy policy of tight credit.

This idea is based on the substantially flawed assumption that capital can be created out of nothing. Capital can only exist when factors of production are produced. Every investment necessitates the use of factors of production that turn out more or higher valued goods after a roundabout process rather than consuming fewer or less valuable goods immediately. Factors of production can only exist if people have generated savings. Savings are generated if one forgoes immediate consumption for the prospect of future consumption. Foregoing present consumption can only be feasible if one considers the future remuneration he gets in return more valuable than the immediate consumption he forgoes. This is what is called time preference. Time preference is expressed on the market in the form of interest rates.

This causality ensures that market interest rates always provide an indication of the time preferences of the individuals in that market, and hence the willingness to forgo present consumption of consumer goods for future consumption of goods created by new factors of production. While prices give entrepreneurs an indication as to which consumption goods are desired more and which less at a specific moment in time, interest rates provide a measure as to when they are desired or needed in the future. It creates an environment where entrepreneurs have an incentive to fulfill demands based on value preferences and time preferences at any given point in time.

The Effects of Credit Expansion

It is now necessary to examine what the process of credit expansion entails. The central bank that creates money does not own any capital, it does not create factors of production. The only thing it channels into the market is fiat money.

Before examining the purchase of credit instruments it makes sense to take an intermediary step and look at the simple purchase of consumption goods. For example, if it were to purchase houses with the newly printed money, its governing board could decide to supply the homes to all its officials. They will be able to enjoy the houses before their prices rises and hence they will not be available to other would-be buyers who would have purchased them at a lower price that would have represented their value preferences. The entrepreneurs selling the homes, too, benefit because they are the first ones to receive the new fiat money and get to spend it before other prices go up and before others get to spend it. Those who receive the new money later will suffer from the prices that have already gone up. While on the market, people can only buy goods when producing demanded goods in return, and while all transactions are based on voluntary exchange and value preference, the central bank does not act under these constraints. Its fiat money can be produced cheaply and the government enforces its acceptance and outlaws competition. Goods are hence violently withdrawn from those who actually produced demanded goods in exchange and end up in the hands of those who didn’t. Now, entrepreneurs will begin producing more homes, while withdrawing factors of production from other, more urgent, uses. If this plan were to be carried out to completion, at one point the majority of entrepreneurs would employ workers and resources in the production of houses for those who printed and enforced the money while a shortage of other demanded goods for all other individuals would ensue.

The equivalent, however, occurs in the sphere of time preference if the central bank purchases debt on the market. People who demand credit on the market issue credit instruments such as merchant bills, governments issue government bonds and bills. The credit instruments purchased by the central bank will go up in price after each additional purchase, interest rates drop as a tendency. Other providers of credit on the market whose time preferences were matched by the credit instruments offered will abstain from entering into the corresponding credit transaction. Now the central bank has withdrawn future money from the market that would have gone to those who were outbid by it in the process of purchasing the debt. They were not able to enter into a transaction that would have represented their time preferences.

On top of that, the interest rates for the loan contracts purchased drop below the market rate that represents actual time preferences of those operating in the market on a voluntary basis. This has the effect that the entrepreneurs’ assessment of time preferences is skewed. They think that present goods against future goods are valued less than actual voluntary time preferences warrant. Those roundabout projects, that were not being embarked upon, because interest rates indicated time preferences in favor of less roundabout projects (whose goods would be consumable earlier) now appear to be feasible. Entrepreneurs begin embarking upon more roundabout projects that yield an output in the farther future. At the same time they set aside those less roundabout projects which the market interest rates would have induced them to begin, had the credit expansion not taken place. The result is now precisely that consumers are again not supplied with products as desired as per their time preference.

The Credit Boom

Since no additional capital has been created via real savings, prices for factors of production used for the longer term will rise. The stock market, it being the main market for factors of production, will see a price increase, primarily in those stocks for businesses whose projects yield a later output. In particular, a lot of businesses incorporate, that are currently not producing anything, nor plan to produce immediately, but are rather aiming to turn out goods a few years down the road, after spending time on roundabout research and production processes. As a tendency, the labor force of society becomes employed in roundabout, long-term projects.

The same holds true if the credit instruments that are purchased are largely used to finance a specific consumption good, such as owning a home. By purchasing home credit instruments, the central bank will create an environment where many individuals who have not produced enough to exchange against a home will nonetheless obtain a home. Prices of homes will rise since the credit expansion has not at all expanded the amount of homes produced on the market. It is only after this initial expansion that more and more entrepreneurs will begin employing more and more workers in the home construction business.

The Credit Crunch

The labor force, however, at the same time represents the bulk of the consumers whom those products are intended to be produced for. But their time preferences have not changed in reality. While being employed in very roundabout projects and processes, they still desire present goods over future goods more strongly than the entrepreneurs expected based on the lowered interest rates. After the credit expansion is completed, consumer spending and saving habits will not be in line with those expectations. They demand more present products than are available and hence bid up their prices. Due to their shortage, an overall tendency towards rising prices for present consumption goods, such as food and gasoline, ensues. People will need most of their money to buy these consumption goods and hence cut back on spending it elsewhere or making it available in credit transactions. Market interest rates will now readjust in accordance with real time preferences again, based on real savings. They will move up to the market level again. Incorporation of companies with overly roundabout projects will decline. Some entrepreneurs, who are in the middle of overly roundabout projects will not immediately realize this. They will keep employing factors of production in these projects.

However, when they announce their new earnings expectations they will have to take into consideration the fact that most consumers will not have enough money left to purchase their products. They will have to let the capitalists know that their capital will not yield the return expected. This will cause a downward pressure on the prices of those factors of production used for overly roundabout processes. Correspondingly the prices for shares in such companies decline. They will be sold at prices that reflect true time preferences again. However, the time that resources have been employed in overly roundabout projects has been wasted. The true yield of their output did not match the capitalists’ expectations. The capitalists have suffered a loss.

Some of the factors of production and workers will have to be released from their current employment and need to be employed in new lines of production where they contribute towards the production of more urgently demanded consumer goods. Flexible resources will be aligned accordingly and the supply of those goods will increase again and hence their prices will drop back to market levels. Other resources however, which are fixed and specific to one particular project and are merely half finished may be forever lost, in particular this will be the case for huge construction or manufacturing projects that involve the erection of factories, machinery, etc. which have turned out to be useless. A credit contraction will occur and the money supply will be reduced to lower levels in a healthy deflationary process which induces people to save and spend as time and value preferences mandate. The market, once again, returns from an inflationary, regressive resource misallocation to progress and a move toward market equilibrium.

Depending on the amount of excess credit channeled into the market and depending on the duration of the credit expansion, the repercussions can be anything between mild and disastrous.

It is a fact that the correction of the allocation of labor and other factors of production is highly unpopular with the populace. As a rule, individuals, in particular entrepreneurs from businesses employed in unprofitable lines of production, will be in favor of continuing the credit expansion. The positive term “correction” will be replaced by the unpopular word “recession”. A prudent government should not fall for this fallacy. If the process of readjustment is not hampered with, the problems caused by the credit expansion will be within limits. The market will quickly recover, albeit, at a level that is less desirable than where it could have been at without credit expansion. If, however, the government doesn’t allow for the correction to occur, the misallocation of factors of production will be kept up and aggravated until it all culminates in a devastating collapse.

Conclusion

The objective of credit expansion, namely to ensure that more capital is generated in order for the market to provide more of what consumers demand, fails. In fact, it has the opposite effect. It skews the entrepreneurs’ judgment and makes them align resources to produce products that consumers are not demanding and makes them use factors of production for processes that turn out products later than consumers are demanding them while withdrawing them form those production processes that would have been in compliance with consumers’ time preferences.

Historical Relevance

The policy of credit expansion has been pursued by governments time and time again. It has become prevalent in the United States under President Woodrow Wilson after the establishment of the Federal Reserve Bank under the Federal Reserve Act during the Christmas Holiday of December 1913. Since then, it has caused major credit booms and crunches in the form of asset booms and subsequent crashes and economic booms and subsequent recessions. In particular this has been the case in the years of 1929, 1987, and 2001, and will be visible in 2008 and the following years. It has always precipitated precisely the effects outlined above. Its workings and effects have been fully explained by this theory of the business cycles. No one has ever refuted the correctness of this theory.

Yet, to date economists and politicians appear completely riddled as to what causes booms and crashes. It is claimed to still be a matter of discussion amongst experts. It has been attempted to impute it upon humans’ greedy nature and natural exuberance. Whenever a crisis emerges the pundits, experts, central banks and politicians will try and regulate the market to stave off the impending crunch. They forget or don’t have the intellectual capacity to understand that it has been their own policy that has caused the crisis in the first place.

As long as the central banks keep pursuing this policy, there is no need to be surprised when the next credit crunch occurs. Neither is there any need to be surprised about the fact that all countermeasures taken by the government will turn out to be utter failures that will accomplish nothing but aggravate the crisis. For if the cause of the problem has been too much government intervention, then more government intervention will only add to it.

Update: I refined the process and added much more detail in the post The Business Cycle.

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