When did the bubble burst?

Yes, it’s been a while since I posted.  Seems not much to post on even though we are undergoing to the most radical transformation of our economy in history.  My thoughts have always been to develop this as a repository for comments and analysis from the Austrian perspective and not as some daily commentary on current happenings.  So, even though there is much to address, I don’t want to just add to the chatter out there.

I was asked the other day by a colleague “When did the bubble burst?”  I surmised that it burst at the time the real interest rate went positive.  I tried to explain it briefly, but that proved a daunting task.  So I will expound on that premise further.

Real Interest Rate

The Real Interest Rate is simply the rate of interest charged by banks for instance, minus the inflation rate.  Thus, if one is paid 5% on a $100 deposit, at the end of the year he will have earned $5 interest.  Thus his total deposit will now be $105.  If inflation (again, using the common definition meaning rising prices.  Austrians know the true meaning of inflation is artificial expansion of the money supply.  Higher prices are the result of inflation) is 3% then the original $100 will need to be $103 to retain its purchasing power.  Thus, of the $5 earned in interest, $3 were lost to inflation.

Thus, the depositor would have earned in actuality, only $2.  This is one of the many. many reasons why inflation is destructive for an economy and causes the gross misallocations of resources.  It not only destroys value but it distorts future decisions.

Money as a Commodity

The trap far too many people fall into (even notable Nobel laureates!!) is that money is money.  That the dollar one has in their pocket is the same as the dollar anyone else has in their pocket.  Not true.

This is because people typically only think of money in its functionary status: medium of exchange.  That is, we simply see money as what we use to acquire that which we desire.  And when one understand the money as commodity principle, then they will be able to see that people aren’t using money to acquire the goods and services they desire.  They are trading a less desirable good (money) for a more desirable good.  And it works in opposite as well.  The less desirable good (for example a car) is being traded for the more desirable good (money).

As Mises (and others) explained, money originated first as a commodity.  It was something that in itself was desirable. What made it “money” was that it held many other properties as well.

Money needed to be divisible into usable units, had to be durable, and had to be readily accepted by all.  Gold (and of course silver) had all of those qualities.  That is why in the ancient world gold coins from one empire were readily accepted by merchants in other empires.  And why not?  Certainly the imprinted likeness of some wannabe demigod generated no admiration among foreign peoples, but the metal certainly did.  It is also the reason trade flourished so well in the ancient world.  Gold is gold is gold.  Anywhere, everywhere, always.

Now, once one understands money itself is a desired good (which is one of the many reasons why our current fiat paper currency is such a disastrous system, as who wants worthless pieces of paper!!!) then we begin to understand money as a commodity.  Now, the other factor is price.  All commodities have a price, and for money, the price is the interest rate.

In fact, that is a basic concept in economics, interest rate as the price of money.  Just look at any introductory economics text and you’ll see a graph with a downward sloping demand curve for money, a vertical supply curve for money, IR on the vertical axis, and quantity of money on the horizontal axis.  This graph will differ not all from any other graph.  Thus, the interest rate is the price of money.

New or old money?

Since money is a good, one with a price, it begins to make clearer the understanding of when the bubble burst.

The money one currently possesses has a cost.  In other words, using the money one currently has means one must give up something.  Cash in the pocket has a cost too, it means that one forgoes any interest.  However, since most cash holdings are small, it’s negligible.  And, it also means one prefers greater liquidity.  But, consider the money in an account earning interest.  Using that money comes with a cost, forgoing the interest earned.

(This will apply too when one hasn’t any cash holdings earning interest.  In fact, as we’ll see, it has far reaching implications.)

And here is where it gets tricky.  Should one desire to make a purchase requiring using stored money, either investment or consumption, that purchase comes with a cost beyond the actual dollar amount.  If one needs to liquidate such holdings than they are forgoing the interest earned.  Now, that particular block of money has a cost.  That’s established.

So, let’s examine an example.  If one’s holdings are earning %5 interest when there’s 3% inflation, then the real interest rate is 2%.  This means that using the money costs 2%, and thus any use of such money must return greater than a 2% gain.  There would of course be risk premiums and the like, but for the sake of simplicity, we’ll leave those aside.

Now, what happens when the Fed pushes the interest rates below the market rate?  It lowers the price of money and makes new money cheaper than old money.  Whoa, how is some money cheaper than other money?  Isn’t it all the same value?

Remember, if the real interest rate is 2%, then using stored reserves costs 2%.  In other words, the price of that money is 2%.  But, when the fed lowers rates it lowers the price of new money only.  Thus, new money borrowed becomes cheaper than old money borrowed. (Notice in the graph below, the fed funds rate fell below 2% for a considerable length of time.)  And instead of liquidating assets, one would borrow the newly printed money.  Even if not “printed”, the newly expanded credit is the exact same thing.

What happens when the fed lowers the interest rate so low it becomes negative?  Picture a tsunami!!

What happened during the bubble?

Look carefully at the graph. From mid 2002 to late 2005, the inflation rate was greater than the interest rate.  Thus, during this time, the real interest rate was negative.

Right around the end of 2005, though the fed had been ratcheting up the interest rate for quite some time, the real interest rate went positive.  That was the proverbial straw.

Here’s a nice little excerpt from Wikipedia:

The United States housing bubble was an economic bubble affecting many parts of the United States housing market, including areas of California, Florida, Nevada, Arizona, Oregon, Colorado, Michigan, the Northeast megalopolis, and the Southwest markets. At the national level, housing prices peaked in early 2005, started to decline in 2006, and may not yet have hit bottom.

The market crashed right about the time the real interest rate turned positive.

Why?

As already discussed, when the price of new money is less than the price of old money, you acquire new money.  Thus one borrows from the newly created credit pool rather than dip into savings.  And if that’s not bad enough…

If one hasn’t any money in savings, one still borrows (excessively!!) as one is rewarded for doing so. Here’s why.

Recall that the real interest rate is the interest rate minus inflation.  Now, we tend to think of interest solely as what we pay when we borrow.  But savers are in essence the lenders:  first to the banks then indirectly to businesses, et al.  Simple analogy, but sufficient for this.

Again, if I earn 5% interest on $100 and inflation is 3%, I gain $2.  If the interest rate is 1% and inflation is 3%, then I lose $2 (as to simply keep pace, I’d need to have $103).  So, negative interest rates discourage savings.  As Homer Simpson says, “DOH!!’

But, how does it reward borrowing?  If I can borrow $100 at 1% and the inflation is 3%, I need only pay back $101, while to keep pace I’d need to repay $103.

In other words, while the lender loses $2, the borrower GAINS $2.  Thus the borrower gains simply by the act of borrowing.  Except, who’s going to lend money in this scenario?

Nobody will lend their money at all.  But the Fed will, via credit expansion.  So we ended up with a situation where the fed was funneling newly created money into a market whereby borrowing, for anything, was rewarded.  Not the result of the borrowing, i.e. investment and wealth creation, but simply borrowing for the sake of borrowing.

Imagine a world turned upside down, where one is rewarded for profligacy and punished for thrift.  Imagine a world where capital destruction creates gain, Bastiat be damned.  And for several years, that was the economic world that the fed created.  And when it began to be turned right side up again, well, things fell very hard.

The bubble burst almost precisely when the real interest rate turned positive.  Skidding to a halt came the entire system of asset inflation, borrowing against homes, and rewarding indebtedness.  The destruction of the past decade is only now slowly being revealed.

So, how do our masters of the universe, the Fed, plan on dealing with the current situation?

With 0% interest rates.  Because, as they say, what doesn’t kill you, probably just required more effort.

Or something like that.

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