Bubbles

res_v_nonres

This is a graph of investment since 1980.  I picked these years in particular as they represent an unprecedented level of economic growth and prosperity.  In addition, after the 1981-82 deep recession, the next twenty five years were marked by rapid growth punctuated only by two very shallow, very short, recessions.  

As we head into the second year of the current deep recession, it is prudent to look back and examine a few things.  First, let’s look at this graph.

Data is available at http://www.bls.gov under the NIPA tables, table 5.3.5 Private Fixed Investment by Type

Notice that for the period prior to 2002, non-residential investment never exceeded 30% of all investment.  Then, suddenly a huge upswing in residential investment, which is of course marked by a huge decrease in non-residential.

This is a particular principle known in economics as trade-offs and opportunity cost.  One dollar spent on residential investment cannot be spent on non-residential.  

Why do firms invest?  Contrary to the Keynesian lunacy of animal spirits, they invest when the opportunity cost of holding cash exceeds investment, or conversely, the cost of investing is lower than the cost of liquidity.  Period.  The interest rate provides the balance.

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The business cycle is an investment cycle.  Firms can only invest when there are available funds from savings to borrow.  The greater the demand for funds, the higher the interest rate.  Notice that the business cycles, i.e. recessions, are very susceptible to changes in investment.  What happens is this: as firms invest more and more, the cost of investment increases (this is called the law of increasing opportunity costs).  Ultimately, the cost of investment rises above the cost of holding cash reserves, and thus investment falls.  As investment falls, firms have to clear out inventories, use less resources (e.g. labor) in production, and wait until the cost of investment lowers again.  

However, when the Fed artificially lowers interest rates below their natural level through monetary creation, then funny things happen in the marketplace.

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The precipitous increase in the money supply, beginning in the mid 1990’s, drove interest rates to artifically low levels.  Bring the fed funds rate, with such celerity, down to 1% was the beginning of the bubble.  However, what made the move even more dangerous was the fed’s (Alan Greenspan’s) decision to hold the rate there long after the recession.  Thus, investment was terribly skewed.

As the first graph illustrates, this skewing is evident in the dramatic rise in residential (housing) investment.  This meant that specifically, non-residential investment, which is productive, was diminished at the expense of residential investment, which is specifically not productive.

Refer to the Savings/Investment graph.  How is it possible that investment could exceed savings?  The answer is rather simple actually.  When the fed (Alan Greenspan) continues to create artificial money through the credit creation process, the markets are flooded with money.  This surplus of available funds, which did not come from savings, lowers the interest rate, thus lowering the cost of investment.

However, as mentioned earlier, this is a skewed cost as it does not reflect the true cost in terms of resources and the market.  This can only go on for so long.  Eventually, inflationary pressures mount and the fed is pressured to control inflation.  Thus, they raise interest rates.  This causes the bubble to burst.

cpi

And of course in the first graph we see a marked decline in residential investment, as determined by a return to previous percentages.  Nonetheless, the damage was done.  All those homes diverted resources away from non-residential productive investments and left a huge pool of unsold homes.  

The corollary to all this is the rapid asset inflation that also arises from artificial credit expansion.  Along with that, the artificial credit created millions of new buyers, driving up prices, forcing a multitude of creative financing schemes, all underwritten by the government agencies Freddie and Fannie.  But that’s for another time. 

As Bastiat observed with the broken window, what is unseen is the shoemaker.  He never knew he lost out because of the baker’s son.  Likewise, we do not know all the productive investment that never happened due to the housing bubble.

This much is certain: the liquidation will not be easy, and it will not be brief.  Hope and change all you want, there is no stimulus that can fix this.  Quite to the contrary, the more done, the worse off we’ll be.

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