"We won’t know the full results of what we have done until the very institutions we have created, the regulations we have suggested and provided for are actually tested." ~ Sen. Chris Dodd

In remarks delivered 13 July 2010, His Beatitude spoke, with reference to the recently signed financial reform bill of the end of an "era of irresponsibility". One must simply smile in order to avoid pulling out one's hair over a financial reform bill which not only leaves in place the entity, such as The Federal Reserve most responsible for this era (an era which, to some of us, goes all the way back to 1913, but actually gives to this entity, even more power over the economy:



Nice.

We are told that, although the government does exert a great deal of control over the economy, the fact that the financial meltdown occurred at all means that it still is not enough control. The "free market", we've been told, failed us. (It's funny how every failure of the "free" market is testimony to the fact that it doesn't really work, but any successes are not evidence of the contrary. But I digress.) More is needed, and so we have the financial reform bill. As we've heard, over and over, the free market clearly doesn't work the way its supporters say it works. There is never permitted the slightest suggestion that, despite the supposedly little control the government has over the economy, it has still been sufficient control to be the greater cause of our present difficulties than the "free" market.

The irresponsibility for the meltdown, we've been told, lay in the over-reliance upon credit, motivated, naturally, by greed. But who, precisely, extended and expanded this credit? Not the greedy people who borrowed the money. They don't have that kind of power. Not the lending institutions. They don't have that power, either. If we really are talking about money which should not have been loaned, then why were the interest rates as low as they were? The fact of the matter is that the Fed controls the money supply, expanding it or shrinking it as they see fit. This has an effect on the so-called free market, making it rather un-free. It is, in fact, one could say, driven. There is a reason why people took out loans they should not have done. There is a reason why banks lent money they should not have done. And greed is an acceptable explanation only if gravity is an acceptable explanation for every plan crash.

"Why did the passenger jet crash"?

"Gravity." Think of the billions that could be saved if the NTSB would stop investigating plane crashes.

The money was lent because Alan Greenspan made it availabe and it was virtually (but only virtually) free. Recall the present complaints that banks have been given a great deal of money which they are not lending. Had the banks not lent the money which started the boom, we'd have had the same complaints in 2003 and 2004. One of the reasons the banks are not lending is that there is no way for them to know which loans to grant.

For what follows, think of money not as a medium of exchange, but as a commodity which, like any commodity, can be bought and sold. When you work a job you purchase money with your labor; your boss purchases your labor with money. Think also of interest as the cost of money between borrower (buyer) and lender (seller). Money is a commodity; interest is the price of this commodity.

Now think about the function of price. For most of us, price affects a great many of the decisions we make. There is a reason I bought a 2000 Saturn in 2000 rather than a 2000 Lambourghini: price. I could easily afford the former, but not the latter. But let's say the price of a 2000 Lambourghini, as well as the cost of owning one, suddenly dropped to a point equal to that of the 2000 Saturn, making it possible for me to own a Lambourghini for as much as it would cost me to own a Saturn. I assure you, that would have been sufficient reason for me to have purchased the Lamboughini. So it is with interest rates. A higher interest rate has a different effect on calculation than a lower one. If the interest rate is too high I might be reluctant to seek a loan for a business venture, or even a house. Both are risky activities; and part of the risk is the ability to pay the loan. The higher the interest rate, the greater the risk, especially since, in the beginning, the bulk of each loan payment is on the interest of the loan, not the principle. But if the interest rate drops to almost zero (that is, almost free), then things change. A business venture at 20% interest is clearly much riskier than at 2%. At 2% it's almost like passing up a Lambourghini for $1,500.00 to purchase a Saturn for $15,000.00. Pass up a virtually free Lambourghini? Are you mad?

In the same way that price affects my decision about a car purchase, the interest rate affects a businessman's calculation concerning the chances of turning a profit from any projects he may be considering. Just like the prices of the material factors of production, wage rates, and the anticipated future prices of the products, the interest rate (the price of money) is an item that must enter into the planning businessman’s calculations. The result of this calculation gives the businessman an idea of whether or not a certain project will pay off. A drop in interest rate makes the businessman’s calculations misleading. These false calculations will tend to make some projects appear profitable and realizable which a correct calculation, based on an interest rate not arbitrarily manipulated by credit expansion, would have shown as unrealizable. Being misled by the interest rate the businessman undertakes a project he would not otherwise have done. Business activities are stimulated, and a (credit-generated) boom begins. About the only thing the current president has correct about the recently ended boom (the meltdown) is that it was false. Indeed it was, as would any boom be which was egged on by a false interest rate. But that is about the only thing, because what neither he nor any other administration, would admit is that this false boom was egged on by a false interest rate, an interest rate set arbitrarily by The Federal Reserve, an interest set as low as it was precisely to start a boom in the first damn place! Now, they blame the businessmen for their miscalculations, and, on top of that, blame these miscalculations not on the Federal Reserve's interest rate, but on businessmen's greed.

The interest rate in a truly free market (as opposed to a centrally manipulated market that is called free) would be set by individual lending institutions, about as follows. To get straight to the relevant point, banks need to lend money, especially if they are to pay you interest on your savings accounts. The more you save, the lower they would set their lending interest rate. The less you save, the higher would be the lending interest rate. Why? When you save alot you send a signal to the bank that you are putting off consumption until the future, the more you save, the futher into the future you are putting your consumption. Moreover, the more you save, the more reserves the bank has on hand for lending. Recall that money is a commodity. When a bank has a lot in reserve it is like a car dealer with too much inventory, so it will usually lower its lending interest rate (the commodity price) in order to lend from these reserves (sell the money), taking some of the interest from these loans for itsef, as its profit, and passing some more of it to you in the form on interest on your savings account, certificates of deposit, or money market account. As banks lower their lending interest rates, this sends a signal to businessmen that a large portion of the population is putting off consumption into the future. In the future, they will consume. Businessmen, anticipating what these savers will want to consume in the future, and anticipating much more consumption in the future than if savings were lower, will take out loans either for research into and development of new, as yet non-existent products, or improvements in current products, or simply increased production (without improvement) of current products. When savings are low, banks, having less in reserve, will raise their lending interest rate. This signals to businessmen that consumers are preferring present consumption to future consumption. Consequently, they will discipline themselves and concentrate their efforts on producing such products as are presently being consumed because higher interest rates mean less tolerance for risk.

That is how banking would work in a free market. By increasing or decreasing their savings, by preferring present consumption to future consumption, or vice-versa, consumers -- not the government, not the Federal Reserve, not any bank -- would control the interest rates. But that is not the way it works. The Federal Reserve controls interest rates, and by virtue of this control it can launch an economic boom, for which, of course, greedy businessmen will be blamed.

After the dot-com bubble burst, and in the wake of the 11 September 2001 attacks, Alan Greenspan decided to increase the money supply by targeting the federal funds rate, the rate at which banks lend to each other to cover their reserve requirements, lowering it to 1%. (Can you say, "Fifteen hundred dollar Lambourghini"?) And he held it there 2003 to 2004, the heart of the housing bubble.

As I mentioned above, this injection of liquidity sent a signal, as any change in any interest rates will do. For reasons I shant go into here, the dot-com bust resulted in a loss of confidence in the stock market. Where to invest this new liquidity? Confidence immediately turned to real estate. Among other things, the artificially low interest rate drove people into the building industry who, in a "normal" market would have been laughed out of a bank. In the market with which I am most personally familiar some of those who entered the general contractor profession included disk jockeys, cabinet makers, carpet and brick layers, electricians and one record producer (or drug dealer, still not sure.) Why could these people get loans to build homes, including "spec" homes? Because the loans were that cheap and, thanks to belief in a bit of nonsense which became known as The Greenspan Put, banks, among many, many others, falsely believed risk had been banished from existence. But also because, in most cases the banks would never have to wait for these loans to be paid.

What typically happens is that banks eventually sell the loans they make. To the uninitiated this sounds mysterious. But think of it. If money is a commodity, then so is a loan. In practical terms, the loan is the paper it's written on, that is, the loan contract. So the loan contract itself, like the money it represents, is also a commodity, bought and sold like any other commodity. So let's say, keeping it simple, you take out a $1,000,000.00 million dollar loan which, when amortized, will mean that when you've paid it off, you will have paid $1,750,000.00. Let us stipulate also that this is a twenty year loan, meaning the bank must wait twenty years to get its $1,750,000.00. On the other hand, it could sell the loan for, say, $1,250,000.00. It just made $500,000.00 and it doesn't have to wait twenty years for you to pay anything. So if a bank loans money to a disk jockey who wants to play general contractor it risks virtually nothing if it can sell that loan. As we know, many of these loans were bundled together and sold as mortgage-backed securities.

Of course, it would be one thing (forgivable, even) for banks simply to have loaned money to disk jockeys to build spec homes. It is quite another for them to have loaned to people who, as we've heard, had no chance of paying them. As we've heard, banks were not even requiring proof of income. This, we've been told, was because banks were unscrupulous, greedy. (Ostensibly, the people who falsely reported, or perhaps inflated, their incomes were innocent by-standers, unwitting victims of bankers' greed. Who were sitting around, minding their own business, when these unscrupulous bankers knocked on their doors with offers that couldn't be refused. The poor dears.) Clearly, if all banks have to do is loan money and then turn round and sell the loans, it almost doesn't matter to the bank whether the mortgagee can pay. Almost. In a truly free market it would matter a great deal: the one who buys the loan could sue the bank for failing to perform due diligence. In selling the loan the bank would have been understood as warranting to the buyer that it had ascertained the mortgagee's ability to pay the mortgage. And the bank should have done, for if it could not find a buyer for the loan, then it would have been stuck with that loan itself. But in a market in which losses are socialized, this is not a problem.

For my purposes here, it doesn't matter why banks loaned money to people who couldn't pay them. Some blame the Community Reinvestment Act. It probably played a role. But, like I said, it doesn't matter. The boom was fueled by manipulation of interest rates by the Federal Reserve. If the boom had not occured in housing it would have occured elsewhere. Remember that the lowering of the federal funds rate gave banks virtually free money to lend. Banks make money by lending money the same way car dealers make money selling cars. That money -- that liquidity -- was going somewhere. Loans were going to be made to someone. A boom somewhere was inevitable thanks not to greedy speculators, drunk with "irrational exuberance", who can't do squat without liquidity, but to the Federal Reserve, which provides the liquidity.

And now, two weeks after Chris Dodd told us we won't know what the financial reform bill will do until after it's tested, the POTUS tells us the bill, which leaves the Federal Reserve in place and even gives it more control over the economy, will save us from the boom-bust cycle. If only the mafia could make their operations work as beautifully.

Finally, a brief explanation of the bust. The sad fact is the Federal Reserve may be able to create money out of thin air, but it cannot create factors of production. There may suddenly be more money available for business projects, but there is not equally as suddenly the material for these projects. At some point, producers are unable to keep up with the Federal-Reserve-driven demand for production goods. The market slows down as businesses wait for the needed material. Unfortunately, banks don't wait for loan payments, not for long anyway. Finally, projects increasingly cannot be completed. But these projects need to be completed in order for loans to be paid. The boom is over.