The Vicious Cycle

Many discussions of the current economic situation are wrapped around the effects, yet do not address the causes. Everyday we are engulfed in reports of the “sub-prime” crisis, foreclosure, insolvent banks, etc. Most of the blame has been successfully shifted on the victims and not the perpetrators. Sub-prime fallout, bank collapse, and the recession are not the fault of capitalism and the free market. They are a direct result of monetary and fiscal policy that sets out to defy the laws of economics at every turn. Such policies create business cycles of boom and bust, much like we are seeing now. But what is the cause?

The short answer is that we are in the downward turn of the business cycle. The business cycle is the product of poor policies that are thrown upon the economy by monetary in fiscal authorities. Such policies only take into account intentions, and never potential results, which very rarely match the stated intent. In the 1990’s the cry was that everyone has a right to own their own home, everyone has a right to go to college, etc. regardless of their ability to repay any loans taken. These intentions were turned into policy, created by the legislature, enforced by the executive, and aided by the monetary authority. The end result of these seemingly well-intentioned policies? The current crisis is the result, and we probably have further to go. But what specifically occurred to get us here? The newsletter discusses tax increases and trade deficits. Could that have been it? The suggestion is put forth that the FED had a role in the crisis. True, but what specifically?

 The bottom line is that credit was expanded irresponsibly to those who did not deserve it. At last year’s meeting in Omaha, Berkshire Hathaway vice-chair Charlie Munger referred to these borrowers as the “overstretched rich and the undeserving poor.” Essentially, these were borrowers that had no chance of ever paying back the loans, ever, whether they were sub-prime, student, or otherwise. Amid all of the massive credit expansion, rates came down, as money seemed more available. People began to borrow and borrow and spend and spend. The stock market soared. Prices for new homes inflated beyond their true value. Banks enslaved a new generation of student borrowers with easy credit for tuition and whatever else they wanted. People began investing their money in things they had no idea about. Enron, Pets.com, JDS Uniphase, etc. became “hot stocks.” On paper, everything looked great. Accountants showed that profits were high, and demand increased. Demand for more employees rose as capital good prices inflated. Happy days were here again!

 But you know the rest of the story. Reality started to set in. Consumption started to plateau. The credit expansion began to cease and onetime capitalist Alan Greenspan began to slowly and steadily ratchet up rates. The market began to slide. Prices for consumption goods began to outpace wage growth, and demand remains high. Creditors begin to lend out less money, slowing down the purchase of new homes. The slowdown of new home buys creates losses for homebuilders. With new losses they begin to shower pink slips on all excess employees hired to fill the demand in the run up. Worker layoffs mean that less is consumed. Consumer retailers begin to show losses, and some even go out of business when people realize they can get a loan to finance that 55 inch plasma TV they wanted. Companies that rode up the waves disappear from existence, such as Pets.com and Circuit City. Banks experience more defaults. Defaults mean that banks do not have the money to pay depositors whose money has been loaned out to create cheap credit. Many once mighty financial institutions are toppled to the ground. Some cease to exist, and others become property of the state. The end result is recession then perhaps depression.

 What happens next sets the whole cycle up for yet another run. Monetary and fiscal authorities, under pressure from the electorate, set out to “fix the economy.” They set out to “improve things” with bailouts, higher taxes, and stimulus packages. The bailouts come to financial institutions who assisted in the downfall, and corporations that make inefficient cars no one wants to buy. What is the end result? The malaise is prolonged. The perpetrators become the heroes as they shift blame to everyone else but themselves, particularly the victims: sovereign consumers in a free market. The bureaucrats get more and more power to fiddle with the laws of economics, which remain impervious to artificial intervention. In spite of that truth, they will continue to inflict misery, all the while supported by those who believe government bureaucrats have the power to override the laws of economics and human nature. The consumer will be the ultimate victim. Ask anyone who lived through the 1930s or 1970s. Sadly we join them, and are now able to tell a similar story.