According to government statistics, the economy has seen 96 months in a row of positive economic growth. Since the depths of the great recession, more than 12 million jobs have been created and the stock market has been booming for 8 years.
But is this a bout of real, sustainable growth, or yet another bubble fueled by Federal Reserve money creation destined to pop in destructive fashion?
The answer has significant implications for North Carolina budget and tax policies.
The “Austrian” theory of the business cycle can help us answer this question. The theory gets its moniker because it was developed and refined by economists like Ludwig von Mises, Murray Rothbard and Friedrich Hayek – who was awarded the Noble Prize in economics for his work on the theory. All three were leading figures in the so-called “Austrian” school of economics that emerged in Austria in the late 1800s and since then has been adopted by economists across the world.
So, what does this theory tell us about what a bubble economy – or an unsustainable boom – looks like?
There are several characteristics that would help identify a bubble, this article will focus on arguably the three most important.
First is the artificial creation of money by the banking system, which typically gets introduced into the economy via credit by lending institutions. In the U.S., this happens when the Federal Reserve acts to lower interest rates by purchasing government bonds with money they create out of thin air. In the old days, the Fed used to crank up the printing press to create new money to make the purchases. In modern times it simply electronically credits the bond sellers.
In the words of Texas Tech University economist Robert Murphy: “When the Fed buys (say) $1 million in bonds from Bank XYZ, Bank XYZ surrenders ownership of the bonds but sees that its deposits of reserves at the Fed go up by $1 million. But the Fed didn’t transfer this money from some other account. No, it simply increased the electronic entry representing Bank XYZ’s total reserve on deposit. There is no offsetting debit anywhere in the banking system. Bank XYZ now has $1 million more in reserves, while no other bank has less. Bank XYZ is now free to go out and loan more reserves to other banks, or to make loans to its own customers.”
A look at the charts below shows that the Fed has aggressively pursued this path over the last several years, dropping interest rates significantly and keeping them there[i], while more than quadrupling the monetary base, from $874 billion in late 2008 to nearly $3.9 trillion today.[ii]
Federal Funds Interest Rate
This leads us to the second characteristic, which identifies where this newly-created money ends up. The new money isn’t dropped out of a helicopter evenly across the economy, but rather injected at specific points. Much of it will naturally find its way to those sectors that are most sensitive to interest rate changes. The process of injecting the newly created money is often referred to as “credit expansion.” Housing, cars, and the stock market, along with business investment in durable capital goods are all prime examples of industries that may receive an out-sized portion of the credit creation during a boom. Such expenditures are typically long-term investments more likely to be financed by longer-term loans charging interest.
As Mises pointed out in his economic treatise Human Action: “In any case, they create an abundance of disposable money (via credit expansion) for which its owners try to find the most profitable investment. Very promptly these funds find outlets in the stock exchange or fixed investment. The notion that it is possible to pursue a credit expansion without making stock prices rise and fixed investment expand is absurd.”
For the current economic upswing, we can see that much of that newly created money has been focused on propping up the housing and auto industries, along with the stock market. As we see in the charts below, median home prices and housing starts have exploded once again off their 2009 lows.
For instance, last month’s 856,000 single-unit private housing starts were nearly two and a half times that of the recession’s low point of 353,000 in March of 2009.[iii]
Prices have also ballooned during this time, with the median home price climbing 52 percent from its low of $208,300 in the first quarter of 2009, to $317,200 in the first quarter of 2017.[iv]
Privately-Owned, Single Unit Housing Starts
Median Sale Price of Houses in U.S.
Moreover, car sales have enjoyed seven years of positive growth coming off lows in 2009, experiencing a whopping 70% spike.
Compare these outsized growth rates to the overall average cumulative price inflation of roughly 14 percent from 2009 to present. Thus far, the evidence seems to be favoring the economic bubble narrative.
In a free market, when there is less demand to spend money now — meaning consumers have less urgency to finance purchases and are more willing to save money and defer consumption spending into the future — interest rates will fall because lending institutions have a large supply of savings with which they can use as loanable funds, matched with lower demand. Banks will lower interest rates to encourage business investment, and entice otherwise reluctant spenders to borrow to finance purchases of durable consumer goods like cars and homes.
In short, lower interest rates are a result of increased real savings.
As savings are lent out in the form of mortgages and car loans, without artificial credit expansion by the Fed, the pool of available savings to lend out would begin to dry up and force interest rates higher. Demand for houses and cars would fall in response to the higher interest rates. Freely fluctuating interest rates would temper the chance for bubbles to inflate.
As author Thomas E. Woods wrote in his NYT bestselling book, Meltdown, “The interest rate acts as the market’s restraint on how many such projects are begun, in order to prevent the initiation of more projects than the pool of savings can support in the long run.”
But when the Fed creates money to lower interest rates, there is no increase in real savings. The low interest rates that result send false signals throughout the economy.
Credit expansion leads to particular branches of industry to be over-expanded relative to the rest of the economic system, and relative to what they normally would have been absent the credit creation.
When the Fed decides to stop inflating the money supply, however, interest rates rise and reveal that the Fed has distorted the connection between real savings and the interest rate. We see that too many projects were begun in the interest rate sensitive industries.
“Not enough people want or can afford half-million-dollar homes. The prices these homes can fetch are far lower than initially anticipated,” wrote Woods. Real estate developers had been misled by artificially low interest rates to believe otherwise.
Returning now to characteristics that help us identify an economic bubble, this brings us to speculation and the stock market. The cycle is a familiar one. As the onset of the boom boosts company profits, investing in stocks becomes more attractive. As stock prices rise, corporations borrow money seeking the higher returns, engaging in stock buybacks and mergers and acquisitions through the purchase of shares of stock from other companies (with near-zero interest rates of course making it quite attractive to borrow funds for such investments).
Moreover, due to low interest rates safer investments like bonds, savings accounts or CD’s pay next to nothing. As a result, investors (including everyday people looking to grow savings and retirement funds) will seek higher returns in riskier ventures – like the stock market.
As mentioned earlier, over the past eight years, uncontrolled money creation by the Federal Reserve has ballooned stock values. After bottoming out in early 2009, the Dow Jones average, for instance, has more than tripled thanks in large part to the Fed’s credit creation.[v]
DOW JONES INDUSTRIAL AVERAGE
A full explanation of the characteristics and causes of business cycles is a task far more complex and nuanced than the purposes of this overview. You can learn more about the Austrian School of Economics and its important business cycle theory with this educational app.
What we can say about the business cycle however, is that at this point the evidence strongly suggests that our nation’s current economic growth is not the result of sound fundamentals or sustainable patterns of productive investment. Rather, it fits rather nicely the characteristics of what a bubble economy looks like.
Because we know the cycle’s progression, It’s not a matter of if the economy will come crashing down again, but when. Unfortunately, there is nothing that state legislators can do to stop the Federal Reserve’s artificial distortion of the money supply, and the cyclical booms and busts it causes.
However, there are things North Carolina can do to better prepare itself for what may be around the corner. These include: aggressively building up reserve funds, keeping taxes low (or lowering them further), and limiting or decreasing recurring budget expenditure commitments.
[i] Federal Funds rate historical chart accessed online at: http://www.macrotrends.net/2015/fed-funds-rate-historical-chart’>Source</a>
[ii] St. Louis Federal Reserve, accessed online at: https://fred.stlouisfed.org/series/BASE#0
[iii] U.S. Bureau of the Census, Privately Owned Housing Starts: 1-Unit Structures [HOUST1F], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/HOUST1F, August 21, 2017
[iv] U.S. Bureau of the Census, Median Sales Price of Houses Sold for the United States [MSPUS], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/MSPUS, August 22, 2017.
[v] Dow Jones 100-Year Historical Chart, Macrotrends.com. Available online at: http://www.macrotrends.net/1319/dow-jones-100-year-historical-chart’>Dow Jones – 100 Year Historical Chart</a>