Legends of the Fall: The Real and Imagined Sources of Our Bubble Economy
Preface
The Foundation for Economic Education is pleased to announce that Richard W. Fulmer of Humble, Texas, is the winner of the second annual Eugene S. Thorpe writing competition. Mr. Fulmer holds a bachelor’s degree in mechanical engineering from New Mexico State University and for over 20 years has worked as a systems analyst in the energy industry. With Robert L. Bradley, Jr., he is the author of Energy: The Master Resource. His article, “Legends of the Fall: The Real and Imagined Sources of our Bubble Economy,” is published below.
We have for the better part of a century now lived in a world of fiat money, and fiat monetary systems are sophisticated versions of central planning. The belief system that supports them carries an inherent hubris that the planner’s vision of the future is sufficiently precise to chart the path of the chaotic interaction of variables that made up an economy. It is a recurring myth, with consistent historical outcomes. Mr. Fulmer’s paper goes directly to first causes and discusses the real estate bubble as a predictable consequence of our central- banking system.
One hundred eighty-two authors responded to FEE’s call for papers in competition for the 2009 Eugene S. Thorpe Award, and many wrote eloquently of multiple secondary causes. The unintended consequences of the Community Reinvestment Act? Fannie, Freddie, Ginnie, and assorted ill-conceived cousins? Zigging instead of zagging by our central bankers? Political opportunism and legalized graft? All surely true. Greed and other venal motives? Of course. But it misses the point to blame either human motivation or human error. The problem is systemic and foundational. It’s not what people do with or to the system—it’s the system itself.
The selection committee thanks all the contestants for their contributions. The rules allow for only one winner, but special recognition and honorable mentions are in order for several of the runner-up contributors. Erin Mundahl of Independence, Minnesota, wrote of government policies that disrupted the natural brakes on risk taking: “Free-market policies naturally limit risk exposure. Regulations which encouraged or even mandated an expansion of risk counteracted this natural limitation.” The risks were ultimately socialized to the taxpayers. The returns accrued to the congressional and bureaucratic elites that benefited both financially and politically. Government operates outside the confines of the natural constraints imposed by profit and loss, and grants political rewards based on the social choices valued by bureaucratic actors.
Charles N. Steele of Hillsdale, Michigan, observed that government not only did what it shouldn’t; government also failed to do what it should. A free market cannot function without the supportive infrastructure of the rule of law, and one of the legitimate functions of government is to prosecute criminal activity. Mr. Steele observes that “Deception, false representation of products, and failure to live up to contractual terms are not legitimate methods of competition in the free market. They are criminal activity, and the free market requires that such activities be policed.” Just so.
From Nero to FDR, emperors and their kin have listened to the sirens of monetary manipulation. The voices are enchanting and sing of wealth without work. But the ships of many states have foundered on the rocky shores to which such fantasies inevitably draw them. Real wealth creation cannot be manipulated; it results from increased efficiencies of resource allocation and production. A drunken Saturday night party may be fun while it lasts, but the Sunday morning hangover that follows is a predictable consequence of the shortsighted behavior that created it. Unless and until our system of monetary creation and control is redesigned to benefit from the power of market pricing mechanisms, we can expect the recurring cycle of boom and bust to continue.
Congratulations to Richard W. Fulmer on his winning article.
Karl Borden Professor of financial economics, University of Nebraska-Kearney Chairman, Eugene S. Thorpe Writing Competition Committee* * *
Businesses, competing for consumer dollars in a free market, must deal with the world as it is in order to survive. Politicians, competing for constituent votes, spin facts to recreate the world as they want it to be in order to gain support for their policies, hide mistakes, and shift blame. In this world of spun reality, the failure of government intervention provides the rationale for still more intervention. So spins the endless cycle in which legislatures create unintended consequences, condemn “market failure,” and demand further legislation. Government grows in crisis, even if it created the crisis.
Our current financial problems provide an illustration of this all-too-familiar pattern. In response to the housing bust, politicians hid behind long-discredited myths, moving swiftly to lay blame variously on Wall Street greed, oil speculation, investors’ animal spirits, deregulation, unrestrained capitalism, predatory lending practices, and, of course, the business cycle. Yet even a brief look at the facts reveals government intervention throughout.
The Monetary Cycle
Supply and demand regulate prices in a free-market economy. Increased borrowing (demand for loanable funds) or decreased saving (supply) leads to rising interest rates (prices). Conversely, lower interest rates stem from less borrowing, more savings, or both. More saving means that consumers favor future consumption over current spending. Banks, with rising deposits on hand, drop their interest rates to compete for borrowers. Capital investments deemed infeasible when interest rates were higher now appear attractive. Companies borrow to expand productive capacity, anticipating future rising demand made possible by rising present consumer saving.
Suppose, however, that the government intervenes to artificially lower the price of money. Reduced interest rates make saving less attractive and consumption more so. At the same time businesses, taking advantage of lower rates, borrow to fund expansion. Prices rise as consumers and producers compete for scarce resources—a sack of seed corn cannot be both eaten and planted. Sales increase and markets boom. Eventually, however, the central bank must raise interest rates to prevent inflation, and the boom goes bust. Businesses find that they have overinvested or invested in the wrong things.
Such malinvestment is an unsustainable allocation of scarce resources to create goods and services for which there is insufficient demand. A correction occurs when resources are reallocated to produce what people actually want. Corrections can be very painful as industries that overexpanded during the boom now downsize, shedding employees and suppliers. Avoiding the adjustments, however, simply postpones the pain. Resources often continue to be poorly invested, compounding the damage and making the inevitable correction that much more agonizing when it comes.
Boom and bust cycles nearly always result from monetary expansions that disrupt the price signals regulating an economy. Such expansions preceded Holland’s Tulip Mania in 1636–1637, the nineteenth-century banking panics in the United States, the Great Depression, the dot-com bubble, and the current housing debacle.
Ironically, these monetary cycles are called “business cycles,” as if they were an inherent part of the free market. Proponents of some business-cycle theories believe that, left unregulated, businesses will overproduce, creating a glut of unwanted goods. Factories must then reduce production or even shut down until the glut is eliminated.
Yet what mechanism would drive businesses in different industries across an entire nation to produce unwanted goods? How could, to cite the most recent example, home builders in California, Nevada, Arizona, Florida, and markets in between have simultaneously misread local demand to such an extent? A nationwide spike in greed? Irrational exuberance? Bankers’ bonuses? A simpler, more rational explanation is that they were misled by government policies that artificially inflated housing prices, giving the appearance of greater demand than was actually there. Overproduction is a symptom, not a primary cause.
The Housing Bubble
Early in the new millennium, the Federal Reserve slashed interest rates in response to the dot-com collapse and the 9/11 attacks. Other nations’ central banks soon followed suit. Now awash in liquidity, investors from around the world needed investments that would yield returns higher than the rate of inflation. Coincidentally, American local and federal policies—including land-use restrictions, preferential tax treatment, buyer subsidies, and regulations favoring low-income buyers—had made investing in residential housing more attractive than other options. Housing prices rose as homeowners upgraded and renters became owners.
Home loans were sold in the secondary mortgage market, which is dominated by the government-sponsored enterprises: the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae). Mortgages were then bundled into “packages” in order to diversify risk. Individuals and institutions worldwide purchased these packages as investments. “Derivatives” such as credit-default swaps (essentially insurance against bond or, in this case, loan failure) and other such securities created a “multiplier effect,” as these investment vehicles were based on other vehicles that were, in turn, based on mortgages.
The complex system that resulted was inherently unstable and was made more so by regulations that coerced lending institutions into making home loans to borrowers who could not afford to repay them. In addition, Congress encouraged Freddie Mac and Fannie Mae to buy trillions of dollars worth of these “subprime” loans, enabling lending institutions to engage in even more such dangerous lending with little (or reduced) incentive to vet borrowers.
Credit-rating agencies, members of a cartel created by the Securities and Exchange Commission, gave unrealistically high ratings to packaged debt containing subprime loans. Basel II, an international banking accord, similarly understated the associated risks and encouraged banks to hold mortgage-backed securities by requiring them to keep smaller cash reserves to back such instruments than it required for traditional loans. Implicit government support for Freddie Mac and Fannie Mae and the “Greenspan put” (an unstated Federal Reserve policy of injecting liquidity into the economy in response to any serious difficulty) encouraged investors to take risks in the belief that the government would cover any losses.
Speculators exploited zero-down loans and “adjustable-rate mortgages,” intended for disadvantaged home buyers, and began “flipping” homes (buying houses only to quickly resell them at a profit). In some cases, houses were built strictly as investments—built to be sold and sold again, not to be occupied. Such overbuilding could not be sustained and, when the Federal Reserve raised short-term interest rates—contracting the money supply—the bubble burst. The value of investments based on bundled home mortgages quickly plummeted.
Mark-to-market accounting rules enforced by the Securities and Exchange Commission (SEC) compounded the problem. SEC rules required financial instruments to be valued at current market prices, amplifying the effects of both boom and bust. Mortgage-based securities, overvalued when housing prices soared, became undervalued as the panic grew and financial institutions saw their assets become virtually worthless almost overnight.
The key intervention and primary cause of the entire cycle of events, however, was the Fed’s initial monetary expansion. Government policies all but dictated that the resulting boom would be concentrated in residential housing and that the eventual bust would be far worse than it would otherwise have been. Even without these policies, though, a boom would still have occurred. Perhaps it would have been concentrated in another sector of the economy; or perhaps there would have been a general rise in capital investment. Either way, once the Federal Reserve triggered the expansion, a boom was inevitable. And, because the boom was artificial (that is, the credit expansion was not based on real savings), a bust had to follow.
Government control of a nation’s money supply guarantees boom and bust cycles. To illustrate this, imagine a car with some very special features. Its windshield is frosted so that the driver cannot see where he is going, and its side windows are just clear enough to allow him only a vague idea of where he is. The rear window alone affords an unobstructed view. Finally, the steering linkage is on a 30-second delay. The car will not change course until half a minute after the driver turns the steering wheel.
Now imagine trying to drive such a car. You steer a straight course as long as you see the highway stretched out behind you in the rear view mirror. When the road curves, you realize it only after the fact. You turn the wheel to get back on the highway, but nothing happens. So you turn the wheel some more. Again, nothing happens, so you turn the wheel still farther. Suddenly, the steering kicks in, and the car veers wildly. Desperately, you swing the wheel in the other direction, but the car continues turning the other way. What follows is a series of violent overcorrections ending in a crash.
Trying to regulate a nation’s money supply works about the same way. Central bankers cannot see into the future. They see only dimly where they are, and it is only in hindsight that their vision is clear. The impact of adjustments they make to the money supply may not be fully felt for a year or more. Such a system, like our car, is inherently unstable.
In response to the bust the Federal Reserve has moved quickly to re-inflate the economy, just as it had done after the dot-com collapse. The result is being termed a “recovery,” but more likely it is another overcorrection, the beginning of yet another boom and bust cycle, and a further misallocation of scarce resources. We cannot spend our way into prosperity. Production, not consumption, creates wealth.
The Road Back
We face two basic issues: How do we recover from the current recession, and how do we stop monetary boom and bust cycles? The answer to both is to increase economic freedom.
Our immediate problem stems from an imbalance between money and goods and from resource misallocation resulting from government interference with the market. The money-goods balance can be restored by shutting off the federal money spigot. This requires reining in government spending (which competes with the private sector for scarce resources), cutting taxes, and freeing markets. Correcting the misallocation of resources requires eliminating the policies that favor residential housing over other consumer needs.
The longer-term problem of taming boom and bust cycles can be addressed only by eliminating the Federal Reserve’s money monopoly. Repealing legal tender laws (which grant a monopoly on the creation of media of exchange to the Federal Reserve) would free Americans to choose forms of money that both meet their needs and maintain their value.
Before any of this can happen, though, the myth of the “business cycle” must be dispelled. Legends are luxuries we cannot afford. Reality is not optional.
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Comment by Richard W. Fulmer on 25 March 2010:
There is another feature that comes standard in most countries with “Richard’s wreck” (my automotive model of the central bank): power assists on both the accelerator and the brakes. These assists multiply the force the driver puts on either pedal by a factor that can be only roughly known in advance.
The effect of these “multipliers” is analogous to the impact that the fractional reserve banking system has on actions taken by a central bank. Fractional reserve banking amplifies both credit expansions and contractions. (http://en.wikipedia.org/wiki/Fractional_reserve)
Comment by Joseph Concordia on 26 March 2010:
I question your statement: “Production not consumption creates wealth”. Typically wealth flows to the ownership of industry when industries prosper. “Wealth”, the accumulation of asset portfolio values, is disproportionately distributed to the ownership demographic, while “wages”,i.e. income for services rendered are are collected by workers. Wages are not wealth. Certainly for industries to prosper consumers must buy their product.
Since the owners are a minority and the workers are a majority, spending for consumption by workers is critical. If there is no income at the worker level where would the money come from to buy the products of industry? Owners buying their own product? Producers only produce the amount of product they can sell. It is consumption that drives production and ultimately produces wealth. If a producer manufactures too much he suffers an inventory expense problem, if he makes too little he suffers a loss to the competition by his out of stock situation. Consumption is clearly the driver and good knowledge on demand is one key for success.
Business cycles are endemic, but boom and bust cycles are not necessarily so. Suitable monetary policy reduces the possibility for the boom and bust. It may not eliminate them, but it is the best way to deal with the problem. Economies left to their own devices will distribute wealth to the owner class to the harm and deprivation of the worker class. This has been the lesson of history throughout the world and the subject of essays by economists over the ages. Only in America where a democracy opened opportunity for less privileged to share wealth has that problem been solved. It is reflected in the standard of living in the USA that is the envy of the world, and the upward mobility of thousands who came here with nothing in their pockets seeking opportunity and found it here.
Comment by Richard W. Fulmer on 26 March 2010:
Mr. Concordia,
Thank you for your post. You have zeroed in on a fundamental difference between the Keynesian and Austrian economic models.
First, I agree that production and consumption are inexorably tied together. After all, the only reason to produce a thing is to consume it. However, wealth is not the result of consumption; it is the result of producing more than is consumed. Wealth is the accumulation of unconsumed production goods – the result of deferred consumption.
If the Marxian/Keynesian economic model is correct, then markets can never be in balance because workers never earn enough to buy back everything that they produce. GM workers, as Henry Hazlitt pointed out in “Economics in One Lesson,” don’t earn enough to purchase every Cadillac they build. General gluts (that is, the simultaneous overproduction of all products), therefore, must always exist. Yet we know that this is not the case. Gluts, such as the current housing glut, occur episodically rather than continuously. We must therefore look for a sporadic cause (or causes) rather than for one that exists everywhere and at all times.
When gluts do occur, they appear to be centered in specific areas rather than affecting every product. For example, even though housing sales have slowed significantly, iPhones are still flying off the shelves. Our “root cause,” then, in addition to being able to explain episodic gluts must also explain why there are gluts of some goods but not of others.
Austrian economists point out that bubbles (the precursors to gluts) tend to be concentrated in goods that are sensitive to interest rates such as capital goods and housing. This supports the theory that bubbles are created by credit expansions. When the central bank artificially lowers interest rates, projects that take time to complete (and that therefore depend on the time value of money) now appear to be feasible. Once such projects are underway, however, the central bank can pull the rug out from under them by raising interest rates. Long-term investments that made sense when interest rates were low are suddenly no longer profitable, and the bubble bursts.
Say’s Law (http://en.wikipedia.org/wiki/Say's_law) explains why general gluts cannot occur in a free market economy (which, admittedly, we don’t have in this country). His explanation is based on the fact that, in a free market, goods and services are produced for the purpose of exchanging them for other goods and services. For example, a farmer produces surplus corn (i.e., corn over and above that which he and his family will eat) to exchange for a cobbler’s surplus shoes, a blacksmith’s surplus horseshoes, and so on. The farmer’s surplus corn is his claim on what the others produce, just as what others produce is their claim on his corn. Goods and services are, in effect, demands on the production of others. In Say’s words, “supply creates its own demand.”
Keynes’s counterargument is that, in any reasonably advanced economy, exchanges do not take the form of barter, but are carried out using money as a “medium of exchange.” Money does not have to be spent right away, but can be hoarded instead. Suppose, in our example, the farmer exchanges his corn for dollars, then puts those dollars in the bank rather than buying shoes and horseshoes. The exchange was not completed, and the cobbler and blacksmith are left with gluts.
Austrians reply that the bank will lend the farmer’s money to someone who will use it to purchase goods and services – either for current consumption or to expand production in the hopes of increased future consumption.
Keynes would counter that, while this is true in normal times, there are times (such as during the Great Depression) in which banks are afraid to lend and businesses are afraid to borrow. In such times, the government must step in and become the “spender of last resort,” creating the demand needed to “prime the pump.”
Austrians have several responses. One is that government cannot spend anything that it hasn’t first taxed or borrowed from someone else. Any demand or jobs that government spending creates in one area must, therefore, come at the cost of lower demand and fewer jobs in another. Government cannot create demand, it can only redirect it. Another response is that banks are afraid to lend and companies afraid to invest in times of market uncertainty. And often it is government action, and the threat of government action, that creates such uncertainty.
We have seen, both in 1920 (http://www.thefreemanonline.org/featured/the-depression-youve-never-heard-of-1920-1921/) and in 1987, sharp economic downturns reversed very quickly in the face of (thanks to?) government inaction. We have also seen a downturn in the 1930s that was extended for years even though (because?) government energetically worked to “solve” the problem.
Thanks again for taking the time to write.
Comment by Steven Hankin on 14 April 2010:
I have read many explanations, including your own, as to the causes for the recent economic recession. Nowhere do I see any blame attributed to our faulty corporate ownership model. That is, I submit that large, widely held (i.e., publicly traded) corporations represent a faulty ownership model under which neither the shareholders nor the executives running the corporation take the long-run perspective of an owner. The original shareholders have provided the equity, but in actuality have no ownership control (or even an interest in exercising such control). The executives typically control the corporation, but have no substantial equity investment in the corporation. This is all made possible and facilitated by: (1) the SEC which serves to provide shareholders with the illusion that their investment in such large public traded corporation is protected and (2) the corporate law (particularly, Delaware Corporation law), that effectively cedes control of the corporation to its executives.
This is a continuation of my previous comment. …. and (3) the corporate tax law, with its double level taxation of the corporation and the shareholders, has induced most widely held corporations to retain their earnings (i.e. paying no dividends), and this serves to further separate the shareholders from the investment made in the corporation’s business. In my opinion, this has created a “moral hazard” with regard to the actions of the executives.They are effectively rewarded with a share of the profits and yet they do not share in the corporation’s losses. That is they do not have adequate “skin in the game.” In the case of those corporations involved in the financial sector (investment banks, commercial banks, mortgage companies and insurance companies), taking financial risks is part and parcel of their business. This fact allowed the executives of these financial companies to bet “the farm,” in order to generate large profits without having the appearance of changing their corporate business model.
Steve Hankin
Comment by Richard W. Fulmer on 15 April 2010:
Steven,
I agree that the principal-agent problem (http://en.wikipedia.org/wiki/Principal-agent_problem) contributed to the debacle, but I do not believe that it was a root cause.
We had an upside-down “pyramid of debt” with the pyramid’s apex, consisting of home mortgages, forming the pyramid’s “base.” While this inverted pyramid was inherently unstable, it would not have collapsed if the mortgages supporting it were solid.
To get at the underlying causes, we need to answer the following questions:
1. Why was the pyramid so large?
2. Why was the pyramid based on residential loans?
3. Why were so many of the loans bad?
4. Why did so many people around the world believe that the securities based on these loans were safe?
The size of the pyramid stemmed from the Fed’s easy-money policy and that of other nations’ central banks. The money had to flow somewhere, and Federal policies directed it to the real estate market. Many of the home loans were bad because the government coerced banks and other lending institutions into making loans to people who could not afford to repay them. In addition, Congress demanded that Freddie Mac and Fannie Mae buy trillions of dollars worth of these subprime loans, enabling lending institutions to make more such loans with no incentive to vet borrowers. Investors were blinded to the risks by government-sanctioned credit rating agencies that gave the mortgage-based securities triple-A ratings. Furthermore, investors believed that the Fed would save the day in the event of problems.
Comment by Fred Foldvary on 20 April 2010:
The business cycle is not a myth, but historical fact. Austrian theory only half explains it.
Comment by Richard W. Fulmer on 21 April 2010:
Mr. Foldvary,
You’ve left us hanging. What is the half that Austrian Theory doesn’t explain?
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Comment by Joseph Concordia on 10 October 2010:
Mr. Fulmer: Further to my note of 26 March and your comment. It is interesting you describe wealth accumulation as result of deferred consumption. I agree completely that is so, intrinsically that says savings equals wealth. However, that is only true from the side of the consumer, not the producer. Unsold production is a decrease in wealth for the business owner. His cost of production is not returned, his added cost for inventory is increased. Any business that regularly overproduces and undersells targets will eventually go out of business as he lowers his price to dispose of inventory.
Your contra-positioning of the Keynesian vs Austrian economic philosophy is rife with the explanations of Adam Smith on how the world works. The problem with that is that the world is a very different place now compared to the time of Adam Smith. When the majority of people were producers, i.e. farmers or guild craftsmen there was some credibility to the notion that if everyone worked in his own self interest things would be fine. In the world today, particularly the western world, where ownership of production is in the hands of a select few and the majority of people are consumer customers there is a very different dynamic. Producers,working in their own interest have great power and consumers have little opportunity to leverage their own interests. Ergo the need for government to intervene to provide balance via regulations, progressive taxation, and monetary control. Government is the only agency mandated to serve public good. They don’t necessarily do it all the time in optimum ways, but they do move directionally that way. Commercial business is charged with making profit for itself. It has no intrinsic mandate for public welfare. Certainly some companies do contribute to the public welfare, but only where their self interests are served. A USA without a rational government to regulate the economy and an unfettered corporate franchise to exploit would be a disaster for the majority of citizens.
Comment by Richard W. Fulmer on 13 October 2011:
Mr. Concordia,
Industries exert enormous influence over the government agencies created to regulate them. Often, they even seek regulation in order to fix prices or shut out competitors. Reformers, believing that this problem (known as “regulatory capture”) is due to an imbalance of power, often seek to remedy the situation by increasing the authority of the regulatory agency. Such measures will likely serve only to solidify the positions of those companies that already dominate the regulated business.
Industry sway over government agencies is a natural result of the incentives inherent in the regulatory process. No one has more incentive to lobby regulatory agencies than do the companies they regulate. And regulators’ self-interest gives them a powerful incentive to listen.
There is also the “revolving door” phenomenon whereby personnel leave industry for jobs with government agencies and vice versa. Some see this as proof of corruption, but there is a simpler, less sinister, explanation. When an agency is created to oversee a business, one of its first needs is employees with knowledge of that business. Where can it go for such people but to the industry itself? Similarly, when government employees retire and wish to begin second careers, where can they go other than to the business about which they have spent their professional lives learning?
(Adapted from: http://www.thefreemanonline.org/featured/regulatory-failure-by-the-numbers/)
Comment by Andy C on 16 November 2011:
“Unsold production is a decrease in wealth for the business owner. His cost of production is not returned, his added cost for inventory is increased.”
NO!
Why would any inventory go unsold? Yes, if the consumer chooses to consume less and save more then the value of inventory may go down, but it is a fallacy to say that the value will go to zero. Any money not spend on consumption goods (and thus reduces the value of consumer goods) is spent on investment goods which produces capital stock (Read: WEALTH) for the future.
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