Addicted to Easy Credit - Business Cyles and Fiat Money

Economists, bankers, and businesses have a horrible track record of predicting credit bubbles. Every time an economy cycles from boom to bust, malinvestments are revealed. Given the wealth of data freely available on money flows and business operations it is inconceivable that lenders, investors, and economists can be so wrong so often.

In the physical sciences, when the hypothesis does not explain the data, the hypothesis is refined. Economists, bankers, and businesses that, ironically enough, derive their profits from accurately predicting risk, refuse to publicly examine the underlying causes and risks of the boom-bust cycle. Like a plastic-wielding shopper, they are all addicted to the lure of easy credit and don't want to cut off its source.

For businesses, the availability of credit means that they can leverage existing assets to make larger investments. They carefully weigh the investment risk against the cost of borrowing: the interest rate on the loan. For any given investment opportunity, then, an individual business is more likely to make the investment if the interest rate on borrowed funds is lowered.

Put another way, a lower interest rate is an indication that lenders are willing to loan funds for higher-risk investments. Lenders will only accept a lower rate for higher risk if they have more funds to lend than they have lower-risk opportunities to lend.

In a real sense, prevailing interest rates are an indicator of the risk-tolerance of the lenders.

Doubtless, in the normal course of business, some investments (a number proportional to their risk) will be revealed as malinvestments, but lenders are betting that the good investments will more than compensate for those losses. This hedging occurs automatically on the financial markets; safer investments and borrowers willing to pay higher interest get their orders filled before higher-risk and lower-rate loans are made.

If, however, the interest rate is not set purely by the financial market, then the risk premium information contained within the interest rate is diminished or lost. When newly-created fiat money hits the financial market, it competes with saved money for investments; the end result is that lower interest rate and higher-risk loans are made than would otherwise be.

This upsets the automatic hedging apple cart. As the higher-risk loans are more likely to be revealed as malinvestments, too many capital goods are produced and businesses, banks, and savers suffer losses due to higher than normal defaults. Capital goods markets become depressed, factories close, and workers lose jobs just at the time the newly-created money hits the consumer goods market, inflating prices on staple goods, housing, and energy.

The bust part of the business cycle will continue until the capital goods markets naturally clear the excess supply. Economists, never admitting that monetary policies caused the credit bubble, devise soft landing solutions entailing increased government spending, bank bailouts, and lowering interest rates to spur more (mal)investment in capital goods. Businesses, looking to invest, and banks, looking to make more loans, dont object to the economists solution.

As the soft landing solution spurs more of what is causing the bust, the bust period is elongated and in some cases deepened. But, businesses, bankers, and economists, addicted to easy credit, prefer this to the alternate.

What is the alternate? In a financial market with sound money, the interest rate cannot be artificially manipulated. The funds available and prevailing interest rates on the market reflect the true level of delayed consumption and risk-tolerance of the lenders. Fewer investments in capital goods are made, but the ones that are made are less likely to be malinvestments as the optimism of the businessmen is restricted by the financial market.

When consumers switch from saving to consumption, the change is evident on the financial market. High-risk loans are not made, and interest rates rise. This is a clear indicator to businesses that they dont need extra production capacity or, rather, only the businesses that can truly justify building extra production capacity receive the loans.

When consumers switch back to saving, financial markets become flush, interest rates fall, and more loans are made for capital goods. With each cycle, productive capacity increases, real profits and wages rise, and money velocity increases allowing lenders to make more loans on more balanced portfolios. The business cycle doesnt disappear, but it changes from boom and bust to steady overall progress with different business sectors reaching peaks and valleys at different times rather than all together.

As long as businesses, banks, and economists remain addicted to easy credit, they will sacrifice long-term gains for short-term profits, and the business cycle will go through bigger and more frequent booms and busts. And, they will continue to lobby governments around the world to keep sound money systems in an outlaw status.

Investor, economist, and author, Brock Lorber writes about money, banking, and financial markets. Learn more about sound money, banking, and financial markets at:

http://www.squidoo.com/sound_money/
http://www.squidoo.com/money-banking-financial/
http://bloodymarybreakfast.blogspot.com

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