The artificial expansion of credit and money is never more than a short-term solution, and often not even that. In fact, today there is no doubt about the recessionary consequence that the monetary shock always has in the long run: newly created loans (of money citizens have not first saved) immediately provide entrepreneurs with purchasing power they use in overly ambitious investment projects (in recent years, especially in the building sector and real-estate development). In other words, entrepreneurs act as if citizens had increased their saving, when they have not actually done so.
… and the consequences of this misdirected investment are inevitable. Yet these Austrian-school economists were not the only Jeremiahs.
Selected articles from The Economist, some of which are subscription only:
- In the shadows of debt — Sep 21st 2006:
For most regulators, the safest thing you can have to protect against such shocks is liquidity, and this has been abundant for years. But as the old adage goes, a banker is someone who lends you an umbrella when it is sunny and asks for it back when it starts to rain. Liquidity in the debt markets has an annoying habit of disappearing just when you most need it.
- Beware the bubbles — Jun 30th 2005:
Looking ahead, the BIS argues that policymakers need to modify their current policy frameworks in order to prevent the build-up of imbalances in future. Targeting inflation is not enough. Central banks also need to take more account of the increase in debt and exceptional rises in asset prices. Thus interest rates should be raised to curb excessive credit growth even if inflation remains tame. Regulatory policy could also be adjusted in a discretionary way over the cycle. Banks could be encouraged to build up more capital during booms, which would help to avoid excessive lending, and then be allowed to reduce their capital in bad times to cushion the economy from a credit crunch. During a rampant house-price boom lenders might be told to reduce the amount they can lend as a percentage of the purchase price of a home or to shorten repayment periods—the exact opposite of what tends to happen now.
- Building the American dream…or nightmare? — Feb 18th 2005:
Fannie Mae likes to say that “Our business is the American dream”. Homeownership is undoubtedly popular with Americans and their politicians. But if the Fed chairman is right, these two dream-builders should be keeping financial regulators awake at night.
- A remedy for financial turbulence? — Apr 15th 2004:
What might be done to make financial crises less common? The answer depends on the causes of financial meltdown. Governments bring some crises on themselves by pursuing fiscal and monetary policies that are inconsistent and unsustainable. Such self-defeating policies may be the symptom of deeper flaws in the body politic.
- In the long run we are all broke — Nov 20th 2003:
If governments are to avoid going bust, politicians will have to grasp the nettle. They must cut back on the over-generous promises they have made to their citizens, above all in pensions and health care. And they must do so sooner rather than later. Delay means that future generations of pensioners will find themselves short-changed through an abrupt cut in benefits. Given due warning, they could take steps to protect their incomes in retirement.
- Design flaws — May 29th 2003 :
Banks have an incentive to lend as much as possible when property prices are rising, but then to pull out when prices fall, exacerbating both the boom and the bust. Rising house prices lift the market value of collateral on banks’ existing loans, so they are willing to lend more, pushing prices higher. Higher prices also lift the value of banks’ own property holdings and hence their capital, which encourages them to relax their lending standards. If prices fall, this process goes viciously into reverse, and a credit crunch can amplify the impact of falling prices. Property booms are much more closely linked with credit growth than stockmarket booms.
- Feeling the crunch — Jan 30th 2003:
Banks’ cosy relationships with business have kept many inefficient firms alive for too long; today’s tighter credit partly reflects more rational behaviour. However, the timing is awkward, to say the least. If credit stays tight, more bankruptcies and bad loans are probable. These could in turn induce banks to become stingier still. German banks are in better shape than Japan’s were at the start of the 1990s. But Japan has shown how credit crunches can be lethal in economies that are so dependent on bank finance.
- Doors now closing — Oct 24th 2002:
“TWO months ago, I would have said the chances of a credit crunch were too small to measure,” says the head of syndicated loans at a big American bank. “Now, they are better than evens.”
- The deadliest sin — Feb 14th 2002:
Part of the explanation is that even risky companies have kept borrowing right through the global slowdown. Normally, says Bill Cunningham of J.P. Morgan Chase, the financial markets punish overextended firms at the start of a recession, as a credit crunch rations borrowing among the strong and mercilessly deprives the weak. This time, however, the Federal Reserve cut interest rates so quickly and so deeply that the money has kept flowing. By the end of last September, American companies had combined debts of $4.9 trillion, 6.6% more than they owed at the same point in 2000.
The tricky question is how long this humbling will last. Perhaps it is just a normal part of the business cycle—a credit crunch delayed by a year because of the Fed’s sharp cuts. Then again, maybe it is the start of something more permanent. Big firms have been adding to their borrowings for decades, squeezing out greater returns for their investors by adding to their financial risks. But shorter technology and product cycles, continuing deregulation and fiercer global competition also keep adding risks to the business environment. Investors may have begun to decide that they do not want to bear the extra financial risks after all. If that is the case, more and more companies may be forced into the most effective debt-reduction method of all: the bankruptcy courts.
- An old economy crunch — Oct 11th 2001:
The good news, though, goes only so far. As part of the latest exam, banks had to scrutinise all their loans and regrade those that had become riskier, which, given the slowing economy, should mean most of them. They will thus have to put aside more capital, and cut lending. Customers may then experience a credit crunch.
- The party’s over — Jan 25th 2001:
The urge to borrow has been exacerbated by the growing habit of handing out stock options as incentives to senior employees. These are supposed to align the interests of a firm’s managers and its shareholders, but in reality they do no such thing. Holders of options—unlike shareholders—have every reason to bet the firm, because they share in any upside but not in most of any downside. If things go wrong, they simply refrain from exercising their options.
Bond investors were the first to spot that all was not well. Banks have taken much longer; indeed, in the past two years, they have been filling the gap left by choosier bond investors. Only now that their bad loans have started to mount have they reined in their lending. Suddenly credit is no longer so cheap and plentiful; instead, America is seeing the first signs of a credit crunch. This does not bode well for the country’s stockmarkets, which have already come off their highs.
- Destructive creation, What happens when the good times come to an end? — Jan 25th 2001:
It is a banking truism that the worst loans are made at the best of times. This survey has argued that, in America at least, companies’ financing arrangements seem to assume that the good times will continue to roll. But all good things must come to an end. The American economy cannot continue to grow forever; indeed, it is starting to slow. Stockmarkets still appear to think that Mr Greenspan will perform yet another miracle, and keep the economy growing at just the right pace to keep inflationary pressures at bay without bringing it to a halt. Perhaps he will. But there is a risk, a big risk, that the excesses of boom times will make a bust more likely.
- Hubble, bubble, asset-price trouble, Central banks should pay more attention to rising share and property prices — Sep 23rd 1999:
Mr Greenspan’s confidence that he can use monetary policy to prevent a deep recession if share prices crash exposes an awkward asymmetry in the way central banks respond to asset prices. They are reluctant to raise interest rates to prevent a bubble, but they are quick to cut rates if financial markets tremble. Last autumn, in the wake of Russia’s default and a slide in share prices, the Fed swiftly cut rates, saying it wanted to prevent a credit crunch. As a result, share prices soared to new highs. The Fed has inadvertently created a sort of moral hazard. If investors believe that monetary policy will underpin share prices, they will take bigger risks.
- Crunch time, again? — Aug 5th 1999:
Last year’s credit crunch was ended by the Federal Reserve, which cut interest rates three times in a couple of months to boost liquidity and signal to investors that it stood ready to do all that was needed to sustain the credit markets. Today, the Fed is in a much trickier position. Recent inflationary warning signs in the American economy would normally be reason enough for the Fed to raise interest rates again at its August policy meeting. On the other hand, the recent widening of spreads would normally cause it to stay its hand, to see if the situation deteriorates further.
So, what might we conclude?
- Credit expansion causes problems.
- These problems should have appeared at least twice in the last decade.
- Additional credit expansion was used to postpone a financial reckoning.
Now, the left are presently cock a hoop to varying extents. They may be well-intentioned, but we had better stand ready with the arguments in defence of freedom and we had better figure out how to redefine the rules for money and credit.
Listening to Austrian-school economists might be a start: they are quite capable of explaining how the current system creates boom and bust while widening economic inequality. Now there are two issues we would all like to address.