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Symptoms of the Credit Crisis

The turmoil in the US subprime mortgage market has developed into an international credit crisis. It is eroding investor confidence in credit and credit-related products and, most important, raising concerns about the solidity of the banking sector, as evidenced by banks' elevated funding terms and diminished stock prices.

As a direct response to the credit crisis, the US Federal Reserve Bank first pared the Federal Funds Target Rate twice — by 50bp on September 18, another 25bp on October 31, and another 25bp on December 11 — bringing the official rate to 4.25%. The lowering of borrowing costs came despite the fact that the FOMC had been stressing "inflation risks" since early 2006.

Meanwhile, financial markets are speculating that the US central bank could cut rates even further. For instance, the level of the 2-year Treasury Bill rate, which has declined by quite a margin below the official interest rate, suggests that investors keep betting their money on forthcoming reductions in US Fed rates.

Figure 1: US interest rates (%), US S&P 500 index and gold (US$ per ounce)

In this context, it is interesting to note that the US dollar price per gold ounce rose from US$268 in January 2001 — when the US Fed started cutting interest rates — to close to US$800 in December 2007. In other words, the exchange value of the US dollar fell around 67% vis-à-vis gold — the world's ultimate means of payment. For comparison, the exchange value of the greenback declined 14% against US stocks (as expressed by the US S&P 500 index) in the same period.

The Cause of the Credit Crisis

The cause of the international credit crisis has a name: the government-controlled paper-money regime. This is the diagnosis when taking on board the theoretical insights provided by the monetary theory of the trade cycle (MTTC) as developed by Ludwig von Mises, one of the leading scholars of the Austrian School of economics. In his magnum opus, Human Action, Mises wrote:

The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.[1]

Mises foresaw that a government-controlled paper-money-supply regime, once established, would pursue a monetary policy of pushing down the market interest rate through credit and money expansion — driven by an ideologically rooted "anticapitalist mentality":

In the eyes of cranks and demagogues, interest is a product of the sinister machinations of rugged exploiters. The age-old disapprobation of interest has been fully revived by modern interventionism. It clings to the dogma that it is one of the foremost duties of good government to lower the rate of interest as far as possible or to abolish it altogether. All present-day governments are fanatically committed to an easy money policy.[2]

Mises predicted that once an economic crisis unfolds — which he saw as the inevitable consequence of a relentless increase in paper-money supply — the public would call for even lower interest rates, as such a policy would be seen as a remedy against recession and deflation. However, Mises said that such a monetary policy would ultimately end in the destruction of the exchange value of money:

The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market. But it could not last forever even if inflation and credit expansion were to go on endlessly. It would then encounter the barriers which prevent the boundless expansion of circulation credit. It would lead to the crack-up boom and the breakdown of the whole monetary system.[3]

The Market Interest Rate — Reflecting Peoples' Time Preference

Ever since, people have been unsympathetic, even hostile, to the interest-rate phenomenon. The interest rate is seen as an obstacle to output and employment gains. As a result, government authority over the money supply is preferred to a free-market money regime, as the former allows reducing the interest rate by way of increasing the money stock at the discretion of the central bank.

Such a lack of understanding of the very nature of the interest rate spells trouble. Mises stressed that the interest rate (or, as Mises put it, the "orginary interest rate") is a category of human action. In an unhampered market, it reflects peoples' "time preferences."[4] Because of scarcity, people value goods and services available today ("present goods") more highly than goods and services available at a later point in time ("future goods"). This is why present goods trade at a premium over future goods. That premium is the interest rate, or the "time preference rate."

The equilibrium market interest rate is an outcome of savers wanting to exchange present goods against future goods and investors willingly exchanging future goods against present goods in the "time market." Because of time preference, the supply of present goods (that is, the demand for future goods) is positively related to the interest rate, while the demand for present goods (supply of future goods) is negatively related to the interest rate.

Figure 2 A Declining Time Preference in the Time Market

The interest rate is neither the motive for savings nor a reward for abstaining from consumption. It simply expresses individual valuations of future against present goods. The interest rate varies according to peoples' degree of time preference. If, for instance, peoples' time preference declines, people will consume less out of current income and save and invest more. A declining time preference, other things being equal, would argue for a decline in the equilibrium market interest rate.

A falling time preference underlies economic growth: as peoples' time preference declines, a growing portion of current income is saved and invested, and thereby put to productive use. As a growing portion of present goods is devoted to production rather than consumption, the supply of present goods in the future can be increased.

To give an illustration, the market equilibrium interest rate is at point A in Figure 2, where savings (that is the supply of present goods) amount to S 0 and investment (that is the demand for present goods) amounts to I 0 . A decline in the time preference of the suppliers of present goods would move the savings schedule from S to S'. As a result, the new equilibrium interest rate is i 1 , where savings amount to S 1 and investment to I 1 . Point B marks a stable equilibrium: the interest rate i 1 reflects peoples' true time preferences, that is, their truly desired savings and investments.

A Rise in Paper Money Supply — Action that Spells Trouble

As noted above, in a free market the interest rate changes in response to changes in peoples' time preferences. However, there will be severe trouble if the market interest rate is artificially lowered through government interference. This is typically done by allowing commercial banks to increase the stock of money supply through lending.

Assume banks increase the supply of loans and money. The interest rate in the money market declines. Businesses make use of the artificially lowered interest rate. They invest in new equipment, hire additional staff, buy new raw materials, and build up inventories. They expand the production of investment goods relative to consumer goods. In fact, firms act as if savings had genuinely increased.

However, the increase in the additional demand for production factors is not accompanied by a rise in the economy's resources: the increase in the stock of money has not increased the amount of present goods willingly supplied in exchange for future goods. As a result, the money-induced increase in the demand for production factors bids up prices for scarce resources such as, for instance, commodities and wages.

All this takes place even though peoples' time preference has not declined. The truth is that the public does not want to save and invest more than it has prior to the increase in the stock of money. Sooner or later people can be expected to restore their actually desired consumption-savings proportions. They reign in the savings and increase their demand for consumption goods.

Figure 3 A Rise in Paper Money Supply in the Time Market

As people restore their preferred savings-consumption proportions, it is revealed that businesses invested too much in capital relative to consumption goods. The demand for investment goods falls short of producers' expectations, and the investment industry experiences a downturn.

To give an illustration, in Figure 3, point A marks the market equilibrium in which savings equal investment. Now assume that banks increase the money supply. The increase in the money stock (DM) moves the S to S' (with S' = S + DM). In the new equilibrium, point B, the interest rate, declines to i 1 , while savings rise to S 1 and investment expands to I 1 .

When moving from point A to point B, the economy enjoys a boom, due to money-induced additional investment. However, the new equilibrium — with a lowered interest rate, higher savings and investment and therefore overall output — does not represent a stable equilibrium in the sense that would correspond to peoples' true time preferences.

This is because in point B the interest rate i 1 is lower than peoples' time preference rate i 0 , brought about by an increase in money supply. Savings and investment are now greater than at point A. People would therefore want to return their original savings-consumption equilibrium, which would imply a move from point B to point A.[5] Such a shift represents the bust, following the boom.

The Crisis Entails Policies that Cause an Even Greater Crisis Later On

The ensuing economic contraction — the inevitable result of a government-sponsored lowering of the market interest rate — would, according to the Austrians, trigger further attempts at lowering the interest rate by way of a further increase in money supply. While such action might keep the boom alive for some time, it entails further malinvestment and inflation, and the costs of the final collapse of the artificial boom increase.

As Murray N. Rothbard put it,

Like the repeated doping of a horse, the boom is kept on its way and ahead of its inevitable comeuppance by repeated and accelerating does of the stimulant of bank credit. It is only when bank credit expansion must finally stop or sharply slow down, either because the banks are getting shaky or because the public is getting restive at the continuing inflation, that retribution finally catches up with the boom. As soon as credit expansion stops, the piper must be paid, and the inevitable readjustments must liquidate the unsound over-investment of the boom….[6]

Mises understood that the recurrence of boom and bust, the direct outcome of ongoing attempts to push the market interest rate below the originary interest rate, would actually increase inflation and ultimately lead to a destruction of the currency:

But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against "real" goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.[7]

Crises Erode Support for Capitalism

One of the major fears on the part of Austrian economists is that a crisis, once it unfolds, makes people draw a false conclusion about its cause. People would most likely become disenchanted with the concept of capitalism. They would want the boom to continue (the very source of the crisis), and would want to escape the bust (the necessary cleansing of the economic system from the preceding boom):

The boom produces impoverishment. But still more disastrous are its moral ravages. It makes people despondent and dispirited. The more optimistic they were under the illusory prosperity of the boom, the greater is their despair and their feeling of frustration. The individual is always ready to ascribe his good luck to his own efficiency and to take it as a well-deserved reward for his talent, application, and probity. But reverses of fortune he always charges to other people, and most of all to the absurdity of social and political institutions. He does not blame the authorities for having fostered the boom. He reviles them for the inevitable collapse. In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils which inflation and credit expansion have brought about.[8]

The Austrian School of economics not only suggests that the current credit crisis is a direct result of government-controlled paper-money-supply monopolies, which have embarked upon a policy of artificially suppressing the market interest rate; it also suggests that central banks will continue to respond to a monetary-induced crisis by a further increase in the stock of money, thereby increasing malinvestment and inflation.

All this might explain why the paper-money price of gold has been going up strongly in recent years — reflecting peoples' concern that the value of the currency is now in great danger. If this is the case, there should be little doubt that the free and peaceful societal cooperation as supported by the free market concept would be endangered as well. It is against this backdrop that Austrians argue that manipulating the interest rate — the inevitable outcome of a government money supply monopoly — is a recipe for disaster.