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Bradley in DC
08-11-2007, 08:22 AM
The Housing Bubble and the Credit Crunch

By George Reisman g.reisman@capitalism.net

The turmoil in the credit markets now emanating from the collapse of the
housing bubble can be understood in the light of the theory of the business
cycle developed by Ludwig von Mises and F.A. Hayek. These authors showed
that credit expansion distorts the pattern of spending and capital
investment in the economic system. This in turn leads to the large scale
loss of capital and thereby sets the stage for a subsequent credit
contraction, which is precisely what is beginning to happen now. (For the
benefit of readers unfamiliar with the expression, credit expansion is the
creation of new and additional money by the banking system and its lending
out at artificially low interest rates and/or to borrowers of low credit
worthiness.)

The genesis of the present problem goes back to the bursting of the
stock-market bubble in the early years of this decade. In an effort to avoid
its deflationary consequences, the bursting of the stock market bubble was
followed by successive Federal Reserve cuts in interest rates, all the way
down to little more than 1 percent by the end of 2003.

These cuts in interest rates were accomplished by means of repeated
injections of new and additional bank reserves. The essential interest rate
in question was the so-called Federal Funds rate. This is the interest rate
that the banks that are members of the Federal Reserve System charge or pay
in the lending and borrowing of the monetary reserves that they are obliged
to hold against their outstanding checking deposits.

The continuing inflow of new and additional reserves allowed the banking
system to create new and additional checking deposits for the benefit of
borrowers. The new and additional deposits were created to a multiple of ten
or more times the new and additional reserves and made possible the granting
of new and additional loans on a correspondingly large scale. The sharp
decline in interest rates that took place encouraged the making of mortgage
loans in particular. The reason for this was the steep decline in monthly
mortgage payments that results from a substantial decline in interest rates.
The new and additional checking deposits were money that was created out of
thin air and which was lent against mortgages to borrowers of poorer and
poorer credit.

So long as the new and additional money kept pouring into the housing market
at an accelerating rate, home prices rose and most people seemed to prosper.

But starting in 2004, and continuing all through 2005 and the first half of
2006, in fear of the inflationary consequences of its policy, the Federal
Reserve began gradually to raise interest rates. It did so in order to be
able to reduce its creation of new and additional reserves for the banking
system.

Once this policy succeeded to the point that the expansion of deposit credit
entering the housing market finally stopped accelerating, the basis for a
continuing rise in home prices was removed. For it meant a leveling off in
the demand for housing. To the extent that the credit expansion actually
fell, the demand for houses had to drop. This was because a major component
of the demand for houses had come to be precisely the funds provided by
credit expansion. A decline in that component constituted an equivalent
decline in the overall demand for houses. The decline in the demand for
houses, of course, was in turn followed by a decline in the price of houses
Housing prices also had to fall simply because of the unloading of homes
purchased in anticipation of continually rising prices, once it became clear
that that anticipation was mistaken.

This drop in the demand for and price of houses has now revealed a mass of
mortgage debt that is unpayable. It has also revealed a corresponding mass
of malinvested, wasted, capital: the capital used to make the unpayable
mortgage loans.

The loss of this vast amount of capital serves to undermine the rest of the
economic system.

The banks and other lenders who have made these loans are now unable to
continue their lending operations on the previous scale, and in some cases,
on any scale whatever. To the extent that they are not repaid by their
borrowers, they lack funds with which to make or renew loans themselves. To
continue in operation, not only can they no longer lend to the same extent
as before, but in many cases they themselves need to borrow, in order to
meet financial commitments made previously and now coming due.

Thus, what is present is both a reduction in the supply of loanable funds
and an increase in the demand for loanable funds, a situation that is aptly
described by the expression "credit crunch."

The phenomenon of the credit crunch is reinforced by the fact that credit
expansion, just like any other increase in the quantity of money, serves to
raise wage rates and the prices of raw materials. It thereby reduces the
buying power of any given amount of capital funds. This too leads to the
outcome of a credit crunch as soon as the spigot of new and additional
credit expansion is turned off. This is because firms now need more funds
than anticipated to complete their projects and thus must borrow more and/or
lend less in order to secure those funds. (This, incidentally, is the
present situation in the construction of power plants and other
infrastructure, where costs have risen dramatically in the last few years,
with the result that correspondingly larger sums of capital are now required
to carry out the same projects.) In addition, the decline in the stock and
bond markets that results after the prop of credit expansion is withdrawn
signifies a reduction in the assets available to fund business activities
and thus serves to intensify the credit crunch.

The situation today is essentially similar to all previous episodes of the
boom-bust business cycle launched by credit expansion. The only difference
is that in this case, the credit expansion fed an expanded demand for
housing and, at the same time, most of the additional capital funds created
by the credit expansion were invested in housing. Now that the demand for
housing has fallen, as the result of the slowdown of the credit expansion,
much of the additional capital funds invested in housing has turned out to
be malinvestments. In most previous instances, credit expansion fed an
additional demand for capital goods, notably plant and equipment, and most
of the additional capital funds created by credit expansion were invested in
the production of capital goods. When the credit expansion slowed, the
demand for capital goods fell and much of the additional capital funds
invested in their production turned out to be malinvestments.

In all instances of credit expansion what is present is the introduction
into the economic system of a mass of capital funds that so long as it is
present has the appearance of real wealth and capital and provides the basis
for sharply increased buying and selling and a corresponding rise in asset
prices. Unfortunately, once the credit expansion that creates these capital
funds slows, the basis of the profitability of the funds previously created
by the credit expansion is withdrawn. This is because those funds are
invested in lines dependent for their profitability on a demand that only
the continuation of the credit expansion can provide.

In the aftermath of credit expansion, today no less than in the past, the
economic system is primed for a veritable implosion of credit, money, and
spending. The mass of capital funds put into the economic system by credit
expansion quickly begins evaporating (the hedge funds of Bear Stearns are an
excellent recent example), with the potential to wipe out further vast
amounts of capital funds.

As the consequence of a credit crunch, there are firms with liabilities
coming due that are simply unable to meet them. They cannot renew the loans
they have taken out nor replace them. These firms become insolvent and go
bankrupt. Attempts to avoid the plight of such firms can easily precipitate
a process of financial contraction and deflation.

This is because the specter of being unable to repay debt brings about a
rise in the demand for money for holding. Firms need to raise cash in order
to have the funds available to repay debts coming due. They can no longer
count on easily and profitably obtaining these funds through borrowing, as
they could under credit expansion, or, indeed, obtaining them at all through
borrowing. Nor can they readily and profitably obtain funds by liquidating
the securities or other assets that they hold. Thus, in addition to whatever
funds they may still be able to raise in such ways, they must attempt to
accumulate funds by reducing their expenditures out of their receipts. This
reduction in expenditures, however, serves to reduce sales revenues and
profits in the economic system and thus further reduces the ability to repay
debt.

To the extent that anywhere along the line, the process of bankruptcies
results in bank failures, the quantity of money in the economic system is
actually reduced, for the checking deposits of failed banks lose the
character of money and assume that of junk bonds, which no one will accept
in payment for goods or services.

Declines in the quantity of money, and in the spending that depends on the
part of the money supply that has been lost, results in more bankruptcies
and bank failures, and still more declines in the quantity of money, as well
as in further increases in the demand for money for holding. Such was the
record of The Great Depression of 1929-1933.

Given the unlimited powers of money creation that the Federal Reserve has
today, it is doubtful that any significant actual deflation of the money
supply will take place. The same is true of financial contraction caused by
an increase in the demand for money for holding. In confirmation of this,
The
<http://www.nytimes. com/2007/ 08/11/business/ apee-fed. html?_r=1& oref=slogin>
New York Times reports, in an online article dated August 11, 2007, that
"The Federal Reserve, trying to calm turmoil on Wall Street, announced today
that it will pump as much money as needed into the financial system to help
overcome the ill effects of a spreading credit crunch.. The Fed pushed $38
billion in temporary reserves into the system this morning, on top of a
similar move [$24 billion] the day before." In addition, the print edition
of The Times, dated a day earlier, reported in its lead front-page story
that "the European Central Bank in Frankfurt lent more than $130 billion
overnight at a rate of 4 percent to tamp down a surge in the rates banks
charge each other for very short-term loans."

Thus the likely outcome will be a future surge in spending and in prices of
all kinds based on an expansion of the money supply of sufficient magnitude
to overcome even the very powerful impetus to contraction and deflation that
has come about as the result of the bursting of the housing bubble.

Another outcome will almost certainly be the enactment of still more laws
and regulations concerning financial activity. Oblivious to the essential
role of credit expansion and of the government's role in the existence of
credit expansion, the politicians and the media are already attempting to
blame the present debacle on whatever aspects of economic and financial
activity still remain free of the government's control.

It probably is the case that at this point the only thing that can prevent
the emergence of a full-blown major depression is the creation of yet still
more money. But that new and additional money does not necessarily have to
be in the form of paper and checkbook money. An alternative would be to
declare gold and silver coin and bullion legal tender for the payment of
debts denominated in paper dollars. There is no limit to the amount of
debt-paying power in terms of paper dollars that gold and silver can have.
It depends only on the number of dollars per ounce.

To be sure, this is an extremely radical suggestion, but something along
these lines will someday be necessary if the world is ever to get off the
paper-money merry-go-round of the unending ups and downs of boom and bust,
accompanied since 1933 by the continuing loss of the buying power of money.

Copyright C 2007, by George Reisman. George Reisman is the author of
Capitalism: <http://www.capitali sm.net/> A Treatise on Economics (Ottawa,
Illinois: Jameson Books, 1996) and is Pepperdine University Professor
Emeritus of Economics. His web site is www.capitalism. net
<http://www.capitali sm.net/> .

Bradley in DC
08-11-2007, 08:40 AM
For more background, please see:

Mises, the Theory of Money and Credit
http://www.econlib.org/library/mises/msTContents.html

and Hayek, Prices and Production
http://www.amazon.com/Prices-Production-Fredrich-Hayek/dp/0678065152

Updated here:
http://www.econlib.org/library/NPDBooks/ODriscoll/odrCP.html

More here:
http://www.auburn.edu/~garriro/amagi.htm

and a more basic book
http://www.mises.org/store/An-Introduction-to-Austrian-Economics-P72C22.aspx

Darren McFillintheBlank
08-11-2007, 09:10 AM
..

MozoVote
09-03-2007, 10:30 AM
The rot in mortgage lending is putting some big names like Countrywide in an unpleasant light:

http://digg.com/business_finance/Countrywide_s_message_of_confidence_turned_to_cris is_LA_Times