How the Fed Causes the Business Cycle.

In a free market, interest rates are set by supply and demand.  If there are a large numbers of savers, the banks adjust their rate paid to lenders down and as a result can offer rates to borrowers at a low level.  If there is a relative reluctance to save, banks will try to attract lenders by offering a higher interest rate.  The higher rate forces banks to charge a correspondingly high rate of interest to borrowers.

The free market balances the supply and demand for the desire to hold the money.  The meeting point is the natural interest rate.  The banks don't care what the rate is.  They make money on the relatively narrow spread between the lending and borrowing rates.  Their real profit comes from lending more money then they take in through the magic of fraction reserve money creation.  See here for more.

Let's say you're thinking about borrowing money to invest in a long term project.  It doesn't matter what industry it is in.  It could be a housing project or an internet company start-up.  Let's pick housing.  You analyze the price of money, i.e. the interest rate, and calculate your cost to borrow the money for the duration of the project.

If the interest cost is too high, you'll take a pass on the building the house.  If it is low, you'll decide to go ahead with the project.  To you there is no analysis made as to why rates are low.  You simply calculate if you can make a profit by borrowing the money at the available price.

There is however a major difference between a low rate caused by free market forces and one set there artificially by edict of the Federal Reserve.   The first scenario is a healthy environment to build the house because the savings actually exists to purchase the house upon completion.  The second scenario however is a disaster waiting to happen.  You are tricked by the false signal of artificially low interest rates.  The savings indicated by the low rates do not actually exist.

Multiply your decision making process by millions of people and you can clearly see how the Federal Reserve is behind the boom bust cycle.  When the artificially low rates kick off the decision to build houses or other capital projects, the economy does in fact see increased activity.  The Fed appears to have successfully ended a recession with its low interest rate policy.  In fact all it has done has set the economy off on an unsustainable boom which will always be followed by a bust.

The process repeats with each round of the business cycle getting more and more dramatic.  The last two rounds have ended in a mania as the price of internet companies and housing respectively were bid up to the astounding levels only to come crashing back down during the bust phase of the cycle.  As an individual the best you can hope for is to be early in the process and sell the house or other project before others realize the false market signal.  To the market as a whole unfortunately there is no possible salvation.  The savings necessary to purchase the projects simply don't exist.  The real pain and suffering caused by the Fed fixing market prices for interest does exist however and like the severity of the cycle is only getting worse through time.

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