In this post, DragonLZ asks a very important question:

What was so much better back in 2003 that justified the incredible bull market that lasted four and a half years, from March of 2003 until October of 2007?

A related question that DragonLZ could have asked is what was so great about Zimbabwe in 2007 that caused it to have the best performing stock market in the world?  But we’ll get back to that.

Little does dragonLZ know that he is at the start of journey that leads to Mises, Hayek, and the Austrian School of Economics, for it is that very question that only the Austrian School can answer.  As he pointed out, there isn’t a very good economic reason why the market kept going up and up.  We agree.  So what did happen?  Here is the Austrian School answer, known as the Austrian Business Cycle Theory (ABCT):

Excessively low interest rates exacerbate the boom and bust cycle

These low interest rates cause an increase in the available funds (business capital.)  From these funds, malinvestment occurs as companies take on projects that would not be justifiable under a system of free market interest rates.  (Rates higher than the prevailing rate.)  This expansion can occur because the Fed (or any central bank) holds rates too low for too long, or through unchecked fractional reserve banking.  If it persists long enough, economic activity can BOOM, but it is an illusion.  Many of the projects are unsustainable, excessively risky, and pull resources away from more efficient alternative uses.  In other words, economic activity gets distorted.  The result is a predictable crash.

Do you think the Fed’s rates don’t have an impact on economic activity?  Then why do they bother manipulating them?  Ask Krugman.

From this most recent boom/bust to the dot.com boom/bust all the way back to the late 1920′s boom/bust…. and guess what…. the panic of 1819, the inflationary boom/bust of John Law’s Mississippi System and the Tulip Bubble before them…

Every single one has the same characteristics.  Easy money at the beginning, resources drawn into sectors that wouldn’t normally justify it, unsustainable development due to scarcity, and it all comes crashing down as entrepreneurs miscalculate risk.  The lyrics from the famous Hayek-Keynes Rap Video explain it better than I can:

The place you should study isn’t the bust
It’s the boom that should make you feel leery, that’s the thrust
Of my theory, the capital structure is key.
Malinvestments wreck the economy

The boom gets started with an expansion of credit
The Fed sets rates low, are you starting to get it?
That new money is confused for real loanable funds
But it’s just inflation that’s driving the ones

Who invest in new projects like housing construction
The boom plants the seeds for its future destruction
The savings aren’t real, consumption’s up too
And the grasping for resources reveals there’s too few

So the boom turns to bust as the interest rates rise
With the costs of production, price signals were lies
The boom was a binge that’s a matter of fact
Now its devalued capital that makes up the slack.

Whether it’s the late twenties or two thousand and five
Booming bad investments, seems like they’d thrive
You must save to invest, don’t use the printing press
Or a bust will surely follow, an economy depressed

And that’s how the Austrian School knew that we were headed for trouble.  The Fed had merely reinflated with cheap credit, which Austran scholars knew was unsustainable.  Another bust was sure to follow, worse than the bust which preceded it.

So the story continues, and this is why we urge caution once again.

However, it is foolish to view the Austrian School as anti-stock market.  Nothing could be further from the truth as the following quote shows:

One time, during Mises’s seminar at New York University, I asked him whether, considering the broad spectrum of economies from a purely free market economy to pure totalitarianism, he could single out one criterion according to which he could say that an economy was essentially “socialist” or whether it was a market economy. Somewhat to my surprise, he replied readily: “Yes, the key is whether the economy has a stock market.” That is, if the economy has a full-scale market in titles to land and capital goods. In short: Is the allocation of capital basically determined by government or by private owners? – Murray Rothbard

Now look at this Austrian School examination of the Fed and the stock market in May 2009.  Pretty consistent with what I have been saying all along. This rally is built on cheap money.

This is very dangerous.  Consider that the best performing stock market in the world in 2007 was Zimbabwe.  I’m surprised dragonLZ didn’t ask us why that was justified.  You can see now that it was for the same reason.

While I don’t want to disparage other bloggers that may have libertarian leanings and an affinity for sound money, without an Austrian School perspective on the boom/bust cycle they may sound like PermaBears to the untrained ear.  But just like me, they want economic growth. We all however would just prefer it to be sustainable.

Neither 2003-2007, as dragonLZ pointed out, nor 2009 was sustainable.

NEW YORK – The stock market has had one of its most turbulent days ever. The Dow Jones industrials plunged nearly 1,000 points in half an hour amid concerns that Greece’s debt problems could halt the world financial recovery.

The only problem with this statement is that there never was a recovery, there was merely an artificial stimulus of money and credit from the Federal Reserve and government with the intention to keep unsustainable ventures from failing. A short-term high is all we’ve had over the past couple years, nothing else. The more that the government and Fed prevent the markets from correcting and allocating money to productive areas of the economy, the worse the inevitable bust will be on the U.S. and world. This is only the beginning.

The Dow has managed to recover two-thirds of its losses and close down 347 at 10,520. But all the major indexes lost 3 percent in a day that recalled the market turmoil of the 2008 financial crisis.

http://bit.ly/bdW8zM

There is a buzz going through the Interwebs. Deflation is back, they say.  The core CPI numbers declined for the first time since 1982, down 0.1%

I’m going to discuss 5 topics today so let’s dive right in.

1  Why Deflationists are always wrong.
2. Why deflation, in normal circumstances, is a great thing.
3. Why the CPI is a useless statistic
4. A realistic assessment of current price levels
5. Why the Federal Reserve wants you to worry your poor little head about a 0.1% drop in price.

Why Deflationists are always wrong

According to deflationists, falling prices are right around the corner.  The inflationists, on the other hand, predict rising prices but often say that the rise may not come for some time.  You won’t hear a deflationist predicting prices falling by massive amounts.  They can’t tell you how long it will last or how severe it will be.  You never hear the term “mass deflation.”
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Yesterday Barack Obama unveiled his new financial regulatory proposals. These include greatly expanding the scope of the Federal Reserve’s regulatory duties, creating a government agency to “protect consumers” from the financial industry, and increase government control over many investment and financial outlets.

The first problem with this proposal is that it completely disregards how this bubble and bust came about. “Lack of regulation” did not cause the bubble or the pain we feel today. In fact, it was the federal government and Federal Reserve who were actually encouraging banks and lenders to lower their lending standards to riskier customers. The government was pushing lower lending standards in the name of equality and the right for lower income families to own a home.

In Obama’s plan banks would be forced to hold the mortgage-backed securities they create and sell to investors, with the belief that they will be more conservative with their loans if their own money is on the line. The problem with this is that it ignores how mortgage-backed securities, or the secondary mortgage market, came about. For those who don’t know, the secondary mortgage market is where a bank sells a loan it made with a customer to another business, relieving the bank of the responsibility to maintain that loan. The business buying those loans from banks may hold them in its portfolio or group them into mortgage-backed securities and sell them to investors.

This market started with Fannie Mae and Freddie Mac, two government-sponsored enterprises (GSEs) created in 1937. Fannie and Freddie have enjoyed special privileges and treatment since their creation. They created the secondary mortgage market to give banks the opportunity to give more loans (and thereby sell them to Fannie and Freddie) and therefore give more people the chance to borrow money to buy a house.

In the 1990s, the Clinton administration continually pressured Fannie and Freddie to buy riskier mortgages from banks. This would encourage banks to sell mortgages to lower income individuals regardless of the increased risk of foreclosure involved. In 1999, after pressure from the federal government, Fannie Mae lowered some of its previous standards so it could buy riskier mortgages from the banks.

We often hear today that it was greed, deception, and lack of regulation that pushed subprime mortgages onto the market, when in reality these risky loans were being openly encouraged by the federal government. The mortgage bubble would not have been possible had it not been for Fannie and Freddie and the special government treatment they have received since their creation. Any government agency involved in the housing market (in both the Clinton and Bush administrations) was pressured to lower mortgage standards, allow lower income individuals and families to get loans, and ignore the extra risks and consequences.

The very reason why many politicians didn’t want equal treatment and oversight for Fannie and Freddie was because they thought it would take away the GSEs’ ability to “commit” to riskier customers. The government was pushing “affordable housing” by lowering mortgage standards in any way possible, rejecting the market’s natural rates of risk, and ignoring the risks involved with increased loans to people who clearly couldn’t afford them.

No one in government pushing these practices believed they were adding to an unsustainable and deadly bubble, and no amount of government regulators would have had the nerve to ignore what Congress, the President, and the Federal Reserve were all pressing for. The push for decreased mortgage standards for lower-income people gradually spread into decreased standards for the mortgage industry as a whole. Subprime mortgages were not the only portion of the mortgage market that crashed, many “prime” mortgages faced high foreclosure rates because of the spillover of decreased lending standards.

Obama’s plan assumes that forcing businesses in the secondary mortgage market (mainly Fannie and Freddie) to own part of their own mortgage-backed securities will solve the problem. If the government suddenly has to jump into the secondary mortgage market to ease and control the industry, why are we not simply allowing Freddie and Fannie to compete on the free market, suffer the consequences of unreasonable practices, and go bankrupt if necessary? Instead of allowing Freddie and Fannie to fail because of their poor practices, the government nationalized the two corporations last year. The secondary mortgage market would not have been possible had it not been for the government’s unending support for Fannie and Freddie. Rather than look at the root cause of the problem, Obama is taking an issue that the government essentially created and sustained and using it as an excuse to increase government regulatory power.

People rarely ask how banks suddenly got the money and ability to loan to people who obviously should not have gotten loans. In response to the bursting tech bubble and weak economy, then-Federal Reserve Chairman Alan Greenspan lowered the Fed’s interest rate to 1% for a full year starting in 2003. Greenspan kept rates artificially low for one purpose: lower rates mean banks can borrow more money, which they can loan out to more people (who otherwise couldn’t have gotten those loans) who will go out and spend those dollars. Lower interest rates encourage spending, borrowing, and discourage saving; if they are held at artificially low levels that money will drift to areas that it never would have gone before. By keeping rates at unsustainable and artificially low levels, the Fed gave banks the money and opportunity to loan cash to people who otherwise never could have gotten it (i.e. subprime mortgages).

The Federal Reserve’s easy money and cheap credit policy played a huge part in giving banks the chance to take advantage of their lowered lending standards. Lower lending standards coupled with the artificial credit from the Federal Reserve put the subprime mortgage market in full gear. Without the Fed, the banks could not have gotten that cash in the free market. It is frightening that the practices employed at the Fed, which were so instrumental in causing today’s mess, are now being looked upon as the solution. The leaders of the Fed are the very people who ignored the bubble forming from their own policies.

In 2005 Ben Bernanke said that rapidly rising housing prices “largely reflect strong economic fundamentals.” At the same time Greenspan said the housing market was merely experiencing “froth,” not a bubble, and would only correct in local markets. Why in the world would we want to give more power to the Fed and the people who manage it when they continually ignore the consequences of their easy money policies and denied for years that the housing bubble was unsustainable and irrational? Why are we listening to the people who helped create the problem, ignored the problem for as long as possible, and suddenly feel they have all the answers that will lead to massive economic damages if not put into place?

The fact that they see the same policies that brought us into this mess as the perfect solution should caution everyone about their judgment. Artificially low interest rates and cheap credit may boost the economy in the short-term – even for a few years as it did after the tech bubble burst until 2007 – but they will guarantee another bubble of this magnitude and a more disastrous bust several years down the road.

Because of the policies endlessly pursued by the Fed and the government over the past year (artificially low interest rates, bailouts, increased intervention) do not be surprised to see excessive malinvestment in the years ahead, a period of artificial wealth (just as the tech and house bubble “wealth” proved to be nonexistent after their respective bubbles popped), and a painful collapse.

Obama’s new regulatory plan is nothing more than a continuation and massive expansion of the exact policies that brought us to this point. More government and central control will not solve problems that they themselves were strongly supporting when the economy seemed to be in great shape. Obama’s plan simply hands buckets of gasoline to the arsonist watching the fire he started.

In the midst of the constant economic meddling we have grown accustomed to, it astonishes me when mainstream “economic experts” such as Ben Bernanke, Tim Geithner, and Nobel Prize winner Paul Krugman simply say that “bubbles happen.” It is commonplace, they say, for bubbles to appear and the role of government and central powers is to step in to prevent its popping. Essentially they are saying that the market created the problem, but it is too dangerous to let the market to correct itself; therefore new regulations and interventions must come into play to solve the problem.

The first flaw with this theory is that bubbles are not just created by accident. It is not the natural course of a strong economy to be either constantly on the upswing of a boom or the downswing of a bust. It is not the natural course of a currency to depreciate over time. It is not the natural course of prices to consistently increase. Yet over the past several decades, it seems that the economy is always on the verge of “overheating”, “deflating”, “slowing”, nearly any term you can think of.

It’s become a mainstream belief that too much economic growth and productivity is a bad thing, and will lead to a terrible recession. The Fed raises interest rates to slow growth, but subsequently lowers rates dramatically when the economy begins to slow down to make sure it doesn’t halt too much.

Through the laws of supply and demand, which people generally seem to think they understand, prices should go down over the long run, not up. In recent history, ever since the Fed came into existence and the gold standard was diminished, general prices are increasing due to the rapid expansion of the money supply. It is vital to realize that it is not prices that should go up, and the currency that should go down, but rather the currency that appreciates value and the prices that fall.

Even in the 19th century, probably the closest thing to a real free market in recorded history, the government’s intervention managed to create numerous financial panics. The U.S. had two central banks during the century that, along with various acts by Congress, played a large role in cheapening credit to artificial levels and encouraging unsustainable speculation. During the Civil War period the U.S. adopted both a fiat monetary system and income tax, which contributed to the 1873 panic. Escalated government intervention, central planning, and behind-the-scenes manipulation have been the natural trends of all countries throughout history, and they have never worked.

Bubbles are not created by voluntary, personal exchange that you have in a free market. Today, bubbles are created when interest rates and credit are constantly manipulated (by the Federal Reserve) beyond or below their natural levels, causing malinvestment and artificial wealth and opportunity. This provides short-term relief and optimism to the economy at the expense of the creation of a larger, irrational, unsustainable bubble that is fueled by the easy credit. Activating the printing presses and creating cheap credit appear to be some of the easiest illusions for government and central planners to work under in order to expand their power and presence within the economy.

Ever since we lost the last connection to gold in 1971, the U.S. has been on a path of self destruction by ignoring sound monetary policies that a lasting economy is built upon. We have followed the flawed Keynesian economics’ belief that you can devalue the currency and pile up debt with little consideration of the longer-term consequences.

The Fed injects money into the economy at low rates that would not be acceptable with a free market monetary system. This manipulation devalues the dollar, pressures the middle class (due to decreased purchasing power of the currency), and promotes irresponsible and unsustainable behavior such as excessive speculation, overvaluing assets, and discouraging wise saving practices. This is the reality that we will have to face sooner rather than later. No amount of government control and central intervention can sustain failed ideas and principles.

It is not the principles of the savings, production, and individual responsibility that create massive bubbles; rather, it is the Keynesian ideals of currency inflation, debt and borrowing, and interventionism that create messes like the one we face today.

Bubbles do not come out of nowhere, but they are pushed along by money and credit created out of thin air by an elite few. An economy built on corporatism, central planning, and government control is forever destined to suffer the perils of an unstable, manipulated, inflated foundation. The only lasting cures for these economic ills are the principles of hard work, savings and investment, with the freedom and responsibility of private property.

The issue of credit is so intertwined with our current economic system, it is critical that it be researched, discussed, and brought to the light of the public.

What is credit? Webster defines it as the “reliance on the truth or reality of something”. Simple enough. The Federal Reserve controls the supply and creation of money and credit in the United States. Credit creation is defined as the “collective abilities of lenders to make money available to borrowers”. The Federal Reserve, through its monopoly power over interest rates, is able to control the flow of credit. When interest rates are lowered, banks can borrow funds from the Fed at cheaper levels in order to lend it more easily to their customers.

The manipulation of interest rates is an important topic to understand today’s economic climate. For better or worse, the concentrated group of bankers that is the Federal Reserve dictates all monetary and credit policies. Over the past decade the Fed has kept interest rates at particularly artificial low levels in order to boost and stimulate the economy. But, lowering interest rates doesn’t just “stimulate” the economy. It cheapens money for banks to borrow. When the Fed lowers rates to levels that the market wouldn’t normally allow, it builds up a manipulated situation of wealth and credit, which then creates an artificial, short-sighted opportunity for people. While this may create a fantastic situation for the economy in the short-term, the bubble always bursts.

The subprime mortgage escalation that we saw over the past decade would not have been possible were it not for the Fed’s control over interest rates and therefore control of credit. Ordinarily, banks would not have had the capital to continue lending ridiculous loans to people who certainly could not afford them. However, when interest rates are kept low, the artificial creation of credit allowed banks to continue the unsustainable process much longer than the regulatory forces of the market would naturally allow. So, while the printing of money out of thin air is what causes the monetary inflation problems; it is the Fed’s control and manipulation of credit that allows banks to go down the road of unsustainable, irresponsible business decisions without immediately feeling the effects as they would in a free market.

The federal government’s role in this cannot be downsized, either. Primarily through Fannie Mae and Freddie Mac, the government supported the subprime loans and loans in general to people who normally couldn’t afford a loan. While this may be a worthy cause, intervening in the markets will not come without its consequences, usually over the long-term. Whether it comes from the government or a central bank, it is not possible to make the market more “fair” or level out the playing field, so to speak, with interventionist policies. Through cheap credit and government backed loans we have gotten to where we are today.

Just as money can’t be printed out of thin air without having substantial negative effects on the currency, neither can credit be artificially created without it coming back to bite the very hand that fed it. Today, the same path is being followed. The Fed has announced a new program “aimed at boosting the availability of credit to consumers and small businesses.” It seems that the Fed is either unable or unwilling to learn from its past mistakes that brought us here in the first place.

The Fed’s new program will “spur consumer lending” by loaning up to $200 billion, hopefully enough to dupe people into thinking they can once again afford things they thought they couldn’t before. Common sense will tell us that creating more cheap credit will not solve a problem created by cheap credit in the first place.

The problem with the  government and Federal Reserve is shortsightedness. The short-term spending and performance of the economy is all they seem to pay any attention to. Therefore, the fed and the Fed (that is my cheap attempt at a pun) do what is in their power to get the economy stimulated for the next quarter, or focus on the next week’s unemployment numbers, rather than stepping back and look at what makes a sustainable economy.

Short-term spending is not what creates a prosperous and sustainable economy. We should be able to know this by now after everything we’ve gone through, but the constant federal and central interventions discourage people from looking at the larger scheme of events. We’re lead to believe that it’s okay for us to go deeply into debt and buy loans that we can’t afford, because the government is “backing” those loans. After the government and Fed’s relentless pursuit to prevent businesses and homeowners from failing, I have a hard time believing that people are going to come away from this crisis understanding the principles and benefits of individual responsibility and hard work.

Saving and investing are what sound economies are based upon, not spending. Rather than constantly spending money in the short-term on items that really are unnecessary and even irrelevant to our personal lives, as the government and Fed encourage, it is through wise saving and investing at one’s own discretion that funds are built up for children to go to school, for houses to be built, and have a sustainable lifestyle that will benefit the economy for years rather than quarters.

While saving and investing may not create an immediately noticeable effect, they will do far more in creating a sustainable, truly prosperous economy over the long run. Focusing on the short-term results and disregarding the long-term aspects of decisions played a major role in the messes that both individuals and governments around the world find themselves in today.

Credit cannot be created nor cheapened by a central bank sustainably over the long-term, as hard as it may try. True and sustainable credit is built from a strong reputation built on the foundations of living within one’s means, saving, investing, and at the heart of it, having a long-term focus. The laws and abilities of the free market are what promote these key qualities for the prosperity of both people, and nations. Federal and central control, manipulation, and intervention promote the opposite: a spending economy, a short-term focus, and living beyond one’s means in order to achieve greater wealth in the short-term, as unsustainable as it may be.

Let us solve our current problems not from more of the same, but a return to the principles of personal savings, hard work, and individual responsibility.

This is part of the ongoing Recommended Video archive.