Wednesday, October 17, 2012

The Business Cycle is Caused by the Federal Reserve's Low Interest Rate Policy.

In a free market, interest rates are set by supply and demand.  Rates adjust up or down as the public changes its opinion on the premium one dollar in the future should have relative to a dollar today.

The meeting point of the supply and demand is the natural interest rate. The banks don't care what the rate is. They make money on the 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.

There is 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 embark on long term projects. The second scenario however is a disaster waiting to happen. 

In a free market where rates are low, that signals to an entrepreneur that there is a good deal of savings in the economy.  Rates are low precisely because of the abundance of capital.  That savings will be available to be spent upon the completion of the project.  In a Fed induced low interest rate environment however, borrowers are tricked by a false signal. The savings indicated by the low rates do not actually exist.  When the time comes to cash in on the investment the money was borrowed for, there will be limited power to purchase the goods than was anticipated on the outset.

Multiply the decision making process of one person by millions 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.  If the interest cost was too high, people would have taken a pass on the building the house, until there was sufficient savings. If the interest rate is low however, they will decide to go ahead with the project. 

Typically there is no analysis made as to why rates are low. People simply calculate whether they can make a profit by borrowing the money at the available price.  Even the savvy investors who know the situation is artificial often feel compelled to participate expecting they will be able to exit in time.  To the market as a whole unfortunately there is no possible salvation. The necessary savings simply doesn't exist.

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.  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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