Home > Macro/Monetary Theory, Uncategorized > The Anatomy of a Bubble

The Anatomy of a Bubble

 Keynesians and progressives (along with Marxists) hold some combination of the beliefs that interest is immoral and lower interest is better for the economy because it increases investment.  Recall the words of Keynes.

Interest to-day rewards no genuine sacrifice, any more than does the rent of land.  the owner of capital can obtain interest because capital is scarce, just as the owner of land can obtain rent because land is scarce.  but whilst there may be intrinsic reasons for the scarcity of land, there are no intrinsic reasons for the scarcity of capital. An intrinsic reason for such scarcity, in the sense of a genuine sacrifice which could only be called forth by the offer of a reward in the shape of interest, would not exist, in the long run, except in the event of the individual propensity to consume proving to be of such a character that net saving in conditions of full employment comes to an end before capital has become sufficiently abundant….

The justification for a moderately high rate of interest has been found hitherto in the necessity of providing a sufficient inducement to save.  But we have shown that the extent of effective saving is necessarily determined by the scale of investment and that the scale of investment is promoted by a low rate of interest, provided that we do not attempt to stimulate it in this way beyond the point which corresponds to full employment.

This highlights a key difference between them and us.  A classical economist would tend to observe a positive price for something (like the lending of capital) and take this to indicate that there must be some “genuine sacrifice which could only be called forth by the offer of a reward.”  Keynes, on the other hand, assumes that there is no such sacrifice and therefore that it would be beneficial to create a giant quasi-governmental organization with the power to manipulate the entire economy in order to eradicate this seemingly inexplicable phenomenon.  Of course he is confusing capital with money.  It’s true that it is possible to print money until the money rate of interest is zero.  The problem for Keynesians is that this does not necessarily cause the rate of interest on capital to become zero. 

This is because creating money does not create more capital, it creates a higher demand for capital at a given price.  To see what I mean imagine you own a business and you borrow money to invest in producing some good.  You will do this until the marginal return on investment is equal to the interest rate (both in money terms).   This means that when interest rates are lower, you will invest more because there will be some projects that are productive enough to pay the lower rate of interest but not the higher one as long as you hold all other things equal.  So the Keynesians would like to “stimulate” investment by lowering the interest rate.  The problem is that all other things do not remain equal.

When you see the lower interest rate, you borrow more money (the money supply increases) and you use it to invest in your business.  But the “capital” that you invest consists of real goods which you buy with the money you borrow.  And these real goods have alternate uses.  The reduction in nominal interest rates doesn’t make anyone else any more willing to forego the other uses of those real goods (if it did, this would lower the real interest rate) so when you use this borrowed money to purchase capital it drives the price of these real goods up.  Furthermore, if you actually expanded investment you would produce more in the future and if everyone produced more in the future, the price of your output would be lower.  In other words, you would see short-run inflation, then long-run deflation and if everyone predicted this accurately, the equilibrium amount of deflation would bring the Fisher equation into balance with the new lower nominal rate and the same real rate as before.  Because, the real rate wouldn’t change, investment wouldn’t change, and this policy would have no effect on production (although the bankers would end up with some wealth that they didn’t have to begin with).  This is the same phenomenon I have been trying to describe for a while now.

So if they are going to “stimulate” investment, they have to do something to drive the expected real interest rate down, not just the nominal rate.  The way they go about this is quite simple: they just come out and tell us that they will keep prices steadily rising.  “Trust us, we know what we’re doing” they say.  Now you’re a producer and you believe that inflation will be 2% and you are looking at a nominal interest rate of 2% and you say “wow I can borrow at a real rate of 0%, Keynes’ dream has finally been realized, we’ve overthrown the rentier class at last.”  So you undertake all projects that you expect to yield a positive real return.  In your rush to borrow more and increase investment you drive prices up for a while which fulfills the Fed’s promise of inflation.

After a little while, though, the loans come due and you have to find some money to pay them back.  Your plan was to sell the resulting produce of your investment to get this money but lots of other people borrowed back then to invest and produce goods and their loans are now coming due as well so there are a lot of goods out there chasing that money and prices are in danger of falling.  If this were to happen you would not be able to pay back your loan and a wave of defaults would sweep the economy.  But have no fear, the Fed will prevent this from happening by lowering the interest rate some more which will cause more borrowing, investment, and inflation keeping prices high enough for you to carry on.  Let’s say they lower it to 1%.

So as interest rates keep going down prices keep going up and everyone manages to pay off their loans and life is good.  But wait a minute!  Now nominal interest rates are 1% and you are expecting 2% inflation…. This means that you don’t even have to produce anything to make money.  You can take out a loan and just buy something and hold on to it, then sell it when the loan becomes due and you will have some money left over because its price will increase at a greater rate than the rate you have to pay on the loan.  All you need to do is find a durable good and someone to give you a loan.  So what could you buy…?  I know, how about stocks?  Or you could buy real estate, there are lots of government programs to help you get a loan for that.  And there’s always gold….

So did you ever wonder what was going on at the Fed in 1928-29?  Well according to Milton Friedman’s authoritative account:

The stock market boom produced severe disagreement within the System on policy, generally oversimplified as a difference between the Federal Reserve Board and the Federal Reserve Bank of New york.  The question at issue between the Board and the New york Bank in 1928-29 had provoked controversy as far back as late 1919, when the Bord, at the Treasury’s behest, refused to sanction increases in the discount rate and instead urged the Banks to use “direct pressure–in the language of the 1929 and later annual reports–to prevent overborrowing by member banks.  The question arose again in October 1925, when Walter W. Stewart, surprisingly in view of his presumed authorship of the Tenth Annual Report (for 1923), seems to have recommended direct pressure.  Governor Strong disagreed, pointing out that direct pressure could not succeed in New York unless the Federal Reserve Bank refused to discount for banks carrying speculative loans, and that it would mean rationing of credit, “which would be disastrous.”  in May 1928, Adolph Miller, the economist on the Board, demanded that the presidents of the large New York banks be assembled and warned that speculative activity must be reduced, although a few months later, he was no longer in favor of such a warning.

Both the Board and the Federal Reserve Bank of New York agreed that security speculation was cause for concern.  The difference was about the desirability of “qualitative” techniques of control designed to induce banks to discriminate against loans for speculative purposes.  The Tenth Annual Report section on “guides to credit policy” had emphasized the impossibility of controlling the ultimate use of Reserve credit, and other reports had repeatedly noted the same point.  Nevertheless, the view attributed to the board was that direct pressure was a feasible means of restricting the availability of credit for speculative purposes without unduly restricting its availability for productive purposes, whereas rises in discount rates or open market sales sufficiently severe to curb speculation would be too severe for business in general.  The Board’s unwillingness to approve a rise in discount rates was partly, no doubt, a reaction to the severe criticism the System had suffered for the 1920-21 deflation.  The board’s view prevailed until August 1929, when it finally permitted the New York Bank to raise its discount rate.  Bu then the New York Bank believed the time might have passed for such action.

The collapse of 1920 (remember the Fed was created in 1913) was caused largely by a commodity bubble.  They knew the same thing was happening again in the stock market.  Their problem was that the obvious solution to this (raising rates) would have burst the bubble so they were trying to use the approach that progressives always turn to once their distortion of a market starts to cause unintended consequences: “direct pressure.”  They tried to ration credit by arbitrarily deciding who could get loans and who could not (death panels anyone?) 

So of course, this bubble can’t go on forever because, just as before, eventually the loans that people used to drive the prices of these goods up have to be paid back.  At that point, the borrowers have to liquidate their positions and the prices collapse.  In 1920 the bubble was in commodities, it was the stock market in 1929 and again in 2001.  In 2008 it was housing and here are quotes from two different stories in the Wall Street Journal on April 11, 2011

The task has become even more daunting recently because companies and individuals [in China] have been hoarding commodities of all types–from cotton and copper to cooking oil–betting that prices will rise.  With little insight into the stockpiles, analysts tend to overestimate China’s real strength of consumption.In China’s three dozen largest cities, prices have shot up by about 50% over the past two years, according to Dragonomics Research, a Beijing consulting firm.  Ordinary Chinese have become real-estate speculators, figuring that real-estate prices can only go up.  State-owned industries are also big speculators, using loans they received from state-owned banks in late 2008 to fight the global recession to invest in urban real estate.

Here is what gold has been doing over the last 5 years.

Oh, if only there were some way that we could set the interest rates to simultaneously prevent unwanted speculation and also coordinate saving and investing in such a way as to achieve the efficient amount of each and not blow up these inflationary bubbles that eventually burst and harm the poor working class……

History shows again and again how markets point out the folly of men.  Godzilla!

  1. June 21, 2013 at 3:44 pm

    I and my friends watch the football game clips at YouTube always, as they have in fastidious quality The Anatomy of a Bubble | Free Radical.

  1. December 27, 2011 at 12:29 am

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