Stop Blaming the Free Market for Modern Business Cycles – Eccentric Economics

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In the past few articles of my column, I have dedicated a great deal of energy to explaining the phenomena of business cycles. This has led me to author information regarding the causes of modern recessions, and how they are not only relevant, but inevitable if the Federal Reserve is to continue its policy of cheap credit and low interest rates to spur economic growth in the short run.

After the recession in the early 1990s, the United States was on its way to recovery after misallocations from the previous business cycle were corrected. However, in due time this manifested into another boom that began roughly in 1993, and from 1995-2002 the United States experienced a major boom that consisted of a mammoth increase in stock prices, particularly assets that were related to the internet. Due to the hefty investment in these internet related assets, this period was known as the Dotcom Bubble.

The noted commencement of the boom was when the company Netscape executed its initial public offering (IPO), with its share prices planned to be set at $12 and $14 a share, the market demand heavily outweighed this meager amount. In turn, the investment banking company Morgan Stanley raised the price to $28 a share for an essentially profitless company. By the time the shares were publicly traded, the stock was priced at $71. This appealing share value indicated the potentially profitable internet realm, with early investors being able to collect mass amounts of wealth.

Doesn’t this sound like the boom was a repercussion of the free market, contrary to the title of this article? Is the fault not to be laid at the feet of greedy investors? Not so fast.

In 1994, the IMF and US Treasury had to bail out Mexico due to issues that date back to the Plaza Accord, and in 1995 they had to bail out Japan during the Reverse Plaza Accord. For background knowledge, to accomplish the Japanese bailout, they had to artificially lower Japans interest rates compared to the United States. They intended to drive up the value of the dollar compared to foreign currencies to hinder inflation, which was coupled with increased liquidity due to the artificially lowered prices of imported goods.

Where did this increased liquidity go? The US stock market.

In July of 1995, the Federal Reserve ceased its tight credit policy, and decided to lower interest rates. Simultaneously, the NASDAQ composite saw a massive increase, with its index rising over 27% in less than a year. Alongside the decreased discount rate in the United States, Japan followed suit and lowered their rate to a meager half percent. This allowed investors to borrow the Japanese yen and reinvest to obtain a higher yield in the United States. This became a period of widespread wealth with impressively low unemployment rates, but as discussed in my previous article, this is not real wealth. It is a misallocation of investment and savings in the short run, which will have an inevitable bust in the long run.

The excess liquidity became noticeable in 1999, and the boom was in full speed. In 1990 alone, the NASDAQ rose to over 80%. Interest rates continued to decrease, and the cheap credit was given to those partaking in investing into the attractive internet assets. It is feasible to increase investment if consumption is forgone, but that was not the case during this artificial boom. Both investment and consumption saw increases, with a hefty decrease in real savings which naturally aided investment. These artificially lowered interest rates enticed investors to direct their newly obtained cheap credit toward the multitudes of internet companies, with many of them being anything but profitable.

In anticipation of a liquidity crisis, the Fed continued to lower the Federal Funds Rate. Personal savings continued to decline, while production of capital goods and other industries continued to expand. In due time, it was realized there were few scarce resources available to maintain the bubble. The NASDAQ faced a huge decline; with the decrease in the stocks of dot com assets taking a major hit. Although business investment decreased upon realization of this bust, consumer spending maintained strength at the aid of cheap credit for mortgages and auto loans. This ultimately brings us to another section in the boom and bust cycle, the financial crisis of 2008.

Alan Greenspan and the Federal Reserve found it necessary to increase the money supply and decrease the Federal Funds Rate, perhaps to combat the lingering effects from the 2001 recession. This attractive low rate attracted investors to an industry that withstood the 2001 recession, the housing market. This caused many investors to purchase homes simply for resale, invest in new construction, and allowed borrowers with low credit to become homeowners. The latter factor was supported by drastic measures set by congress in order to make housing more affordable for the less fortunate.

The most commonly government mortgage assistance program was the FHA, which in the past demanded the borrower put 20% down in order to close. In 2004, Congress reduced the required down payment to a mere 3%, and made rules and regulations that demanded they give out loans and mortgages to risky recipients. Additionally, the Community Reinvestment Act that was passed under the Carter administration encouraged lenders to allow lower income applicants borrow was expanded and regulations pressured banks to offer these loans to the less wealthy applicants. Finally, the Department of Housing and Urban Development began to enact legal repercussion to banks that would not easy up on their tight lending practices.

These practices consisted of various selling methods such as sub prime mortgages, no down payment, and among other schemes, that would help low income new homebuyers in order to meet government standards. Naturally, these companies would only lend to those with good credit backgrounds. Instead, the government mandated that banks only use three particular bond rating companies, instead of allowing them to seek private rating companies. In this action, the government restricted data, which distorts price signals, thus causing the investors to not know the actual value of the mortgages. Speculators and other investment companies would then purchase a collective of these mortgages, without knowing their actual value. Again, naturally, they use bond rating companies before they invest, but these new mortgages had little to no data.

In addition to the private lenders offering lower standard lending, government sponsored “hybrid companies,” Fannie May and Freddie Mac, were required to offer affordable loans to low income families and individuals. In due time, upon realization of the resale capability of these mortgages, they began to purchase these mortgages from private lenders. Since they had ties to the US treasury, it was easy for them to finance this extensive growth.  Due to the attractiveness of the government backing these two hybrid companies, many investors placed money in Fannie Mae and Freddie Mac. This boom caused a massive increase in demand for homes, causing widespread construction products, and an increase in the prices of existing homes.

In due time, the interest rates began to increase and the leniency of credit began to cease to prevent hefty inflation, and the bust phase began to commence. There was a reduction in the demand for property, with investors now being stuck with these artificially high priced homes. Those who purchased their homes with variable interest rates could no longer afford the payments, and in due time people started defaulting on their mortgages. Furthermore, as expected, this mortgage boom had a spillover into other industries, with the stock market seeing tremendous gains. However, as always, this boom must come to an end.

This delay of payments spread to the stock market in early 2007, with financial institutions being unable to recover their losses, and began liquidating causing a substantial decrease of prices.  Companies had to reallocate scarce resources to their properly designated sectors, which reflected an initial misallocation of those resources. Among these reallocations are increased unemployment for laborers i.e. home construction, and liquidating investment in earlier stages of production.  Note in the below graph, as the prices for homes began to decrease, so did the demand for construction workers. This reflects a misallocation of labor into an industry in which there was no real demand for. 

The point of this article was to illustrate the forces behind modern business cycles, and how they originate from monetary policies set by the Fed, supplemented by programs set by regulators. It is simply not factual to pin these recessions on private companies and investors. It is nothing more than a cop out, using the market as a scapegoat for irresponsible monetary policy. Could these companies and investors suppressed their greed and instead not seek to obtain profits? Sure, but that’s not the point.

The point is, they would not have initially pursued these risky investments if the market conditions weren’t constructed as they were.  There were false market signals sent to these investors which enticed them to direct money to sectors and assets they otherwise would have strayed away from if their investment was originated in genuine savings. Instead, artificially low interest rates tricked investors into unprofitable exchanges that appeared profitable, and government policies pressured lenders to allow risky borrowers purchase homes they could not afford. Summarily,  the boom and bust cycles of the 90’s and 2000’s can be traced to fiscally unsound policies set by the Fed and the government, with the market and its economic actors being their misled victims.

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Logan Davies

Logan Davies is a Regional Manager in the Banking Services industry, and the director of the non-profit organization, Voluntaryism in Action. He graduated from Middle Georgia State University with a degree in Business Administration. He is the father of a loving son, an avid outdoorsman, firearm enthusiast, and unwavering supporter of liberty.