The Boom, the Bust, and the Rate of Interest

Generations of Americans have been persuaded to believe America’s economy has been running amok for too long.  They’ve been told that capitalism failed and the powerful booms and busts are the result of the unrestrained wild market.  Ask just about any banker what causes changes in the interest rates and I’m not sure you’ll find one that will give you a close to accurate description of such event.  Therefore, it is my desire to clarify the action that sets the interest rate in motion and its direct impact of the boom/bust business cycles that affect the world’s economic climate.

According to Austrian economist, Murray Rothbard, “in the purely free and unhampered market, there will be no cluster of errors, since trained entrepreneurs will not all make errors at the same time.”  Conversely, when seasoned entrepreneurs commit errors all at the same time it is primarily due to factors that are unnatural.   Let’s take, for example, the past decade’s real estate phenomenon.  The first question is what could have enticed so many builders, homebuyers, and speculators to get involved at the same time?  And the next question is why did most of them fail later, also at the same time?  Were all these market participants lacking the experience of building, buying, and speculating?   In other words, were all the people fools that knew little or nothing about real estate?  It is obvious that I have just given the example of a boom-bust cycle which begs the question of what was at the root cause to provoke such devastating event?  Conventional wisdom goes that it is the free and unregulated market that causes such imbalance.  But is that true after all or could it be just a myth?

So, let us start with Newton’s First Law of Motion that says “every object tends to remain in that state unless an external force is applied to it.”  We, humans, don’t get sick just because.  We may not see the virus, the bacteria, or other outside factors that find their ways into our bodies triggering the illness.  Simply because we don’t see them entering our bodies it doesn’t mean it doesn’t happen.  The same goes for the seasoned businessman – who does not fail without an underlying cause – and the market – which does not experience drastic shifts without outside interfering elements.  You may wonder what exactly are these elements and who manufactures them?  Except for Austrian School economists, only a few other economists will admit that the central bank – with the government’s approval – creates market distortions through monetary intervention – specifically bank credit expansion.  And it is through such conspicuous credit expansion that the builder, the buyer, and the speculator all get in to take advantage – and to profit for individual gains – of such artificial phenomenon.  Therefore at this stage we must emphasize that this is not a free market.

Now, let’s analyze such process.  Every economy has at each given time a given supply of money.  This supply of money is used partially for consumption while another part is used for saving and investment in production capital.  When consumption is low it allows savings to increase therefore an abundance in savings naturally leads to a reduction in the rate of interest.  Conversely, high consumption discourages savings and a free economy (without central bank intervention) would lead to higher interest rates.  How much higher?  Typically based on the proportion of consumption to savings.  The higher the proportion of consumption to savings, the higher the rate.  Such theory then clearly explains why an overheated real estate market would adjust on its own via the increase in interest rate.  A rate increase would most likely discourage many buyers from buying and many builders from building.

But what happens when the market is tampered with and cannot balance itself according to natural laws?  What if banks create money out of thin air to lend to businesses and people?  This newly created money act as if the rate of savings has increased – implying consumption would have decreased.  Yet in reality the savings have not increased and the consumption has not decreased.  The rate of interest is being suppressed.  But market participants are unaware the interest rate has been artificially lowered below the market level so they continue to expand their activities.  Thus the builder builds more homes while more homebuyers and speculators enter the market, all of them bidding up the prices of real estate.  A period of exuberance then follows when abnormal levels of prosperity are experienced.  In the meantime consumption destroys savings and the currency’s purchasing power is gradually being eroded.  This is the market boom that almost always starts with a supply of abundant credit available at very low market rates.

If it was for no bank credit expansion the supply of money in the economy would have stayed unchanged.  The decline in savings would have forced the interest rate to rise which in turn would have caused an inhibition of real estate prices.  The market players would have been discouraged to continue their efforts in the real estate sector and the market would have gained its balance.

Expansion of money supply as demonstrated in the chart above – money inflation – is thus at the root cause of market booms, busts, and economic depressions.  The cautionary signals that would occur in an unhampered market – rise in interest rate – are concealed.  The longer the banks’ intervention in the money supply the more massive the boom and of course, its bust.  During the early 2000’s low rates gave real estate market participants the green light to proceed.  The abundance of new bank credit prevented the recession that should have occurred after the collapse of the boom.  Because a boom is a period of malinvestments the healing of an economy takes the form of a recession or depression.  Murray Rothbard describes the importance of such event in his book, America’s Great Depression:

“In short, and this is a highly important point to grasp, the depression is the ‘recovery’ process, and the end of the depression heralds the return to normal, and to optimum efficiency. The depression, then, far from being an evil scourge, is the necessary and beneficial return of the economy to normal after the distortions imposed by the boom. The boom, then, requires a bust.”

The clearing of wasteful misinvestments does not have to take long in a free market.  The best example is the Depression of 1920 at which time the economy recovered within one year.  But when more market intervention is activated via monetary expansion the market’s healing process is prevented.  As a result, the interest rate that would normally have to rise ends up being suppressed.  And even though the real estate market is still deflating, the inflation of new money induces bubbles in other market sectors.  A true economic recovery cannot occur without purging of the malinvestments and a complete stop in the monetary expansion.  Therefore a true recovery cannot occur without a dramatic rise in the rate of interest.  Finally, Mr. Rothbard concludes with:

“Thus, bank credit expansion sets into motion the business cycle in all its phases: the inflationary boom, marked by expansion of the money supply and by malinvestment; the crisis, which arrives when credit expansion ceases and malinvestments become evident; and the depression recovery, the necessary adjustment process by which the economy returns to the most efficient ways of satisfying consumer desires.”


18 thoughts on “The Boom, the Bust, and the Rate of Interest

  1. The BEST most COMPREHENSIVE explanation I’ve read of how fluctuations in the countries interest rates occur. I would be honored if you would let me re post this on my blog, tributing and trackbacking to yours, of course.

    • Thank you, William! Dr. Paul is the one that inspires me. I have so much admiration for him, first because of his wealth of knowledge in economics, and of course because of his integrity, his courage to stand up to the powerful establishment.

  2. Excellent piece Carmen. I always read your Blog with much interest. You hit the nail on the head always. More power to you.

  3. The chart in your post blows a hole in what is written. from 1985 until about 2009 the rate of money growth is practically a straight line. There was no massive increase of of money into the system until the system was almost to the point of world wide collapse. If you idea of low interest rates caused inflation and booms, tell it to the Japanese who had there interest rates were near 0 for over a decade. No boom, they staid in a huge bust. The people with cash in a depression are the upper1%. They prosper and suck up real estate and other assets for pennies on the dollar while the lower 95% loses almost everything. You may call that a healing process, but the 95% calls it unfair if not evil. And it certainly goes against the teaches of Jesus, and most any religious icon.

    • Larry, When credit expands it inflates prices in certain economic sectors. The world would have not collapsed if the banks that acted in a hazardous manner would have been allowed to fail. Rescuing them encourages moral hazard. Interest rates per se don’t cause booms, it is the expansion of money supply that suppresses the rates and gives wrong signals to entrepreneurs. It is not my idea, it is the basis of Austrian economics. If you have a desire to learn about free market economics I encourage you to read Ludwig Von Mises, Henry Hazlitt, or Murray Rothbard. A great place to start would be the site that is full of incredible articles written by some of the sharpest minds in the world economics. Thanks!

  4. Outstanding, Carmen.

    I might suggest clarifying: “When consumption is low it allows savings to increase therefore an abundance in savings naturally leads to a reduction in the rate of interest.”

    Why does this occur? When there is more savings available, the banks must lower their interest rates to entice people to borrow, since they are already less pre-disposed to consume. More savings in the economy means there is more opportunity for price competition in loans, in other words.

    This is obvious to some, but to those still breaking out of the mechanistic econometric framework of pseudo-economics, the connection isn’t always immediately clear.

    My compliments 🙂

    • Bill, excellent clarification, thank you. The law of supply and demand playing its role in the price of money, I guess. And thank you for taking the time to read and comment, your contribution is highly welcomed;-)

  5. @Larry: “from 1985 until about 2009 the rate of money growth is practically a straight line. There was no massive increase of of money into the system until the system was almost to the point of world wide collapse.”

    Say what? The money supply quadrupled over this time frame.

  6. “No boom, they [the Japanese] staid in a huge bust.”

    Negative. The Japanese had a monstrous PROPERTY bubble. It burst. And then prices continued to fall for over 10 years. Think about that. In Japan, where they’re living on top of each other. Prices fell for 10 years AFTER it crashed.

    They created so much funny money, and mucked with the system so much after it crashed, that Japan has remained in malaise for two decades. Japan, as well as the rest of the world, is desperately in need of black coffee (market-driven interest rates and a cessation of money printing) and a day of bed rest to let the hang over happen.

    Instead, they keep pounding the hair of the dog in the belief that the party mood will kick in again.

    • Bill, you are right. There can be no bust without a boom. The bust typically is commensurate with the degree of its boom. The Maestro should have allowed the tiny to a full bust, and the healing process would have not impacted as many people. Instead he “solved” the problem by inflating the Real Estate bubble (I believe some money found their way in the commodity market, too, but certainly not like in real estate). And boy, did he inflate…

  7. “The people with cash in a depression are the upper1%. They prosper and suck up real estate and other assets for pennies on the dollar while the lower 95% loses almost everything. You may call that a healing process, but the 95% calls it unfair if not evil.”

    The evil part was the boom that suckered everyone in. Carmen is providing the insight that people can use to prevent themselves from being suckered by a phony boom.

    Instead, you argue that she is wrong for advocating the healing process (which involves a massive amount of liquidation). She’s informing us what happens when we let central bankers and govts control the price of money. We can either be informed and steer clear of phony, credit-induced booms, or we can continue to let this bogus destruction of capital wreak havoc on our prosperity.

    Nobody welcomes a hangover, or wishes it on anyone, but what do you tell someone who has pounded so much alcohol they can’t stand up? Drink some more?!

    • I like the analogy, Bill! It appears to me that as a nation we’re still in denial (granted a few have been awaken by Austrian school or by their own common sense). Politicians would rather keep us drunk so they can get re-elected;-)

  8. Pingback: Financing Apartment Buildings « Commercial Finance

  9. Carmen thanks for linking me here and let me be frank with you; you certainly do not disappoint! The manner in which you present the relationship between cycles and interest rates is so concise and elegant that even to me, an individual with a meager background in economics, I didn’t have to scratch my head like a clueless baboon after reading it. Yay! :p

    Much kudos to you for creating this masterpiece!

    • Cheng, thank you for reading, for caring, and for your kind words. Economics does not have to be that complicated… And I honestly believe that the Austrian Business Cycle should be taught in schools all over America (and the world). This is stuff that does matter. Best wishes;-)

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