Monday, November 15, 2010

Economics: Bubbles pt 1 - Housing Bubble

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We know that inflation is merely the creation of new money, which results in higher prices (duh, because now the money outnumbers the goods/services and is therefore worth less than before). We know that deflation is the decrease in the money supply, which leads to a stronger dollar/currency, and lower prices. We know that money is merely a representation of a product or service, a placeholder for a future trade. Let us tackle the "boom and bust" cycle, or financial "bubbles" as they are often called.

A bubble is when something like a house is trading for more than it's actual value. This bubble bursts when no one is willing to trade at the higher value, therefore causing the value to decrease to a number that suits would-be buyers. It's a bit like "hot potato" in this fashion, as whoever is holding it when the bubble bursts is the loser.

The real question is "Where does the bubble come from?", and I intend to make this plain.

(Entire books are written on such things, so I will try to get the juiciest and most relevant bits. However, is a fantastic site with loads of audio, video and articles discussing a wide range of economic and philosophic matter.)

Let us focus on the most recent bubble, the housing market that burst a couple years ago that sent ripples throughout the globe. The opinions on who to blame spans far and wide, some blame speculators for driving up prices, some blame the home-owners for wanting nice housing they couldn't afford, some blame banks for making the loans so easy to get through Subprime mortgages (prime=deserves the credit, SUBprime=does not meet ordinary standards for a loan), some blame Wall Street for selling off these debts through Credit Default Swaps (basically an insurance policy to hedge their bets and free up capital).

While there's a certain amount of culpability for all of those mentioned, the actual secret demon is none other than the Federal Reserve (the Central Bank for the United States). At first glance you may think this to be absurd, I mean they only make money right? They don't tell us how to spend it, right? Eh, not so fast.

Yes, the Fed creates money (through many mechanisms, but for simplicity's sake and not to jump into Fractional Reserve banking practices yet we'll just say "create money" for now), but what happens when they put this money into circulation? Can they indeed influence how it is spent? Yes, they can, obviously first they get to decide where the money goes.

Imagine you're in a house with low water pressure, like say a slow trickle at every faucet. What if you found out one faucet was suddenly flowing? Well, you'd form a line at that faucet, get while the getting is good. Same difference! The Fed decided it would create money at low interest rates and let Fannie Mae and Freddie Mac lend it out. Fannie & Freddie are GSEs, Government-Sponsored Enterprises, who basically compete on the open market, but kind of like the US Post Office they get to offer the market certain things that are beyond competition.

So, the Fed in coordination with the government (through policy and Fannie & Freddie) turned on the spigot for capital to be poured into real estate. The money is pumping, that of course attracts speculators, who attract homeowners, who go to banks that already know that the money is there to lend out, thanks to the Fed! The banks want to keep the capital flowing so they sell off these risky mortgages to someone else. Before you know it there's so much money flowing, that due to this inflation (of the currency) the value of the product (real estate) has risen to accommodate all the new capital flooding in, whereas without the inflation these would never have been reasonable prices that would've attracted any sane person. What happens when the faucet gets closed? Crash.

Now perhaps I grammatically messed something up in there, but that IS the gist. You can blame irresponsible buyers who walked away from their upside-down mortgages (owing more than their real estate is worth), you can scream at greedy banks or write the President (Bush, thanks again buddy) about ill-advised housing policy, but NONE of those things matter as much as the Fed, because without the ability to create all of that money (from NOWHERE) none of those people are able to make their dumb decisions.

I hate dead horses, so allow me to keep beating on them: this is only one example, one area of where the Fed has hurt the economy. This isn't to say that many people didn't come out ahead, I'm sure a lot of speculators are quite happy, a lot of traders on Wall Street probably did okay as well. The real, true, heartless irony is that the people this was supposed to help, the poorer families, are actually the people who are worse off. They're the ones who can no longer afford their house, they're the ones whose money is worth less thanks to all of the inflating done by the Federal Reserve. So, if you want a face to blame for bubbles, I'll give you two: Alan Greenspan and Ben Bernanke.

Next week I'll go into a little more detail about the philosophy of why pure credit expansion is the cause of all boom/busts.
A View of Economics
Week 1: The Coming Disaster
Week 2: What is currency?
Week 3: Inflation
Week 4: Hyperinflation
Week 5: Deflation
Week 6: Money Represents Production
Week 7: Bubbles pt 1 - Housing Bubble
Week 8: Bubbles pt 2 - Pure Credit Expansion
Week 9: Bubbles pt 3 - The Bust is a Good Thing
Week 10: Productive vs Destructive


Regina Quentin said...

Okay, so I read this, and I learned. And now I want to know about pure credit expansion. This is interesting, shall I say eye-opening, when it is explained in succinct sentences that I can grasp. Thanks.

Now for the ignorant questions: who decides when the Federal Reserve pumps out money and is there the same check & balance there is in other forms of gov (we will not debate the effectiveness of this however)?

How do we know when this is happening?

Wes Hemings said...

Those are actually excellent and *reasonable* questions (I add emphasis because there are some who deem such questions unreasonable).

1. Who decides when the Federal Reserve pumps out money?
In this current system the Fed gets to call that shot, namely the Fed's President, though he does have a board of advisers and sometimes they vote on these things, but the buck stops at the Fed's President (currently Ben Bernanke).

Now you can also look at the US Treasurer (Timothy Geithner) because when our House of Reps decide to raise the debt ceiling or approve deficits it's the Treasurer who "raises" the money by approving the sale of US Bonds. So you can already see a whole host of people responsible, 1. The Fed, 2. Congress/Senate/President (for spending more than they have) 3. US Secretary of Treasury (who either sells the bonds to foreign nations or directly to the Fed). That isn't to say that the only way the Fed puts money into the market is through Gov spending, as noted by the recent revelations on who the Fed bailed out during the crisis.

2. Is there the same check & balance as in other forms of government?

None whatsoever. When Congress created the Fed and handed them the keys to our money (can you drive money? I dunno, but stop interrupting.) they gave them absolute secrecy, no real audits ever happen, we never know where money has truly ever gone. The Fed makes some things public, but only the things they want to be public. They aren't required to disclose anything, and often when asked by intelligent Congressmen (okay fine, Ron Paul) they're either evasive or just flat out refuse to disclose. They verbally justify this secrecy by citing that their independence is vital to their effectiveness, which may be true but I guess that depends on our definitions of "effective".

3. How do we know when this is happening?

Well the Fed has flown under the radar for nearly a century, so when they're spending it's not making any newspapers, well NOW it is, but it normally wasn't. We know when the gov runs a deficit that new money is being created (which ultimately lands at the feet of the Fed, who is the "lender of last resort"). We know when the Fed adjusts the lending rate that it's creating new money, but this is only the stuff it *wants* the market to know about, it has an insane amount of power and can actually lend trillions out without permission (and does/did) or disclosure, no one knows the real amount and location of our money, and unless Congress makes new laws forcing transparency we never will. Therein lies a whole other host of issues, who wants to kill their magic money-making machine?

Regina Quentin said...

Thank you. Your answer was thorough and I feel like doing some research now. What book (written in plain language please) do you recommend if any? I've gotten two good book recommendations lately; I'm in a reading mood now that I'm done with The Manual of Detection and The Warmth of Other Suns (well, just paused on this one cause it is 55,000 pages long).

Anyhow, just a book I can read that explains things as they are, or as they should be, or whatever ... or maybe one that talks about what we should strive to do with our finances ... do you know of anything like that?

Wes Hemings said...

I can recommend a few and what they're good at explaining.

1. The Revolution: A Manifesto - by Ron Paul
This is discussion on a whole host of issues such as economics, foreign policy, the function of government, the constitution, American Politics, civil liberties and personal freedom. It's broad but still quite challenging and specific. If someone wanted an overview of where my 'headspace' is these days this would be where I point them.

2. End the Fed - by Ron Paul
I know, 2 RP books, but this one (as the title suggests) is all about the Federal Reserve and covers some solid economic principles without bogging down in meaningless details, but it does cover the many ways that the Fed hampers our society through their monetary monopoly.

3. Economics in One Lesson - Henry Hazlitt
Haven't even finished this book and can say that it's full of great economic principles. A very good starting point for someone curious about sound economic philosophy that benefits everyone in society rather than the few. It's around 200 pages and contains no graphs, charts or formulas, strictly principle.

4. What Has Government Done to Our Money - by Murray N. Rothbard
This is only like 60 pages, but it's so carefully written that I got lost in some sentences trying to grasp what's being said (chock that up to my poor computational ability). This was a amazingly executed book, laid out quite flawless reasoning on economic and monetary principle. Lots of great analogies and builds from the basics to the more complex reasons of how Government has a tendency to destroy wealth, not that it's anti-gov't.

If I had to only recommend one I may I'd say the first since it covers a gamut of topics.

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