Intervention in the market mechanism root cause of credit crisis

Severe economic and financial crisis do not happen out of nothing. Knowing the fundamental reasons for a crisis give insight in how effective the measures are to fight the crisis. We believe misinterpretation of Friedman's and Keynes' theories are the root cause of the Great Recession.

At the macro economic level, there are all kinds of price mechanisms for gaining balance. These ensure that there is not too much borrowing, not too little saving, not too much investment and so forth. One might then wonder where the current credit crisis comes from. It caused a terrific shock, which means that something  - in the area of credit extension in particular – must have become entirely unbalanced. Normally, the price formation system ensures so many checks and balances that there are no great imbalances. Major imbalance is therefore virtually always caused by intervention in the   market mechanism. This is exactly what happened over the past few decades.

In the decades preceding the credit crisis, a number of developments quickly led to a rapid increase in the supply of goods and services worldwide. An increasing labour surplus was created. This, in turn, suppressed (real) wage rises, so consumers actually had less to spend. It is therefore understandable that inflation came under increasing downward pressure. This, however, resulted in the first human interventions in the price mechanism. According to monetary theories, the money supply should not be allowed to grow more quickly than the real growth of the economy plus a little extra growth to keep inflation between 0% and 2%. This is seen as optimal inflation for ensuring the highest growth possible. The only problem for Greenspan was that liberalisation of the money market meant it was no longer possible to measure the money supply properly. The Greenspan doctrine was therefore developed. This entailed continually lowering interest rates (and therefore increasing the money supply at the same time) until the first signs of inflation appeared. In a period of rapidly growing supply of goods and services and a highly limited increase in demand – due to the slow growth in incomes – there was far more downward than upward pressure on prices, however. Greenspan was therefore able to flood the system monetarily without causing inflation. In other words, the money supply increased far more rapidly than necessary for the real economy (this would have been impossible under the previous gold standard system). The money surplus had to go somewhere, however. This exerted increasing downward pressure on real interest rates – the difference between nominal rates and inflation. Stock and property prices rose sharply in response. Consumers were then able to borrow far more against these assets, particularly with low interest rates.

Then something happened that would also have happened without human intervention. Western multinationals increasingly relocated their production from Eastern Europe to Asia. There, as all kinds of products could be produced far more cheaply, many prices could be reduced instead of raised, which everyone had got used to in the 1960s and 1970s. This caused the strange effect of consumers borrowing increasingly against rising stock and housing prices and therefore considerably increasing their consumption without causing any bottlenecks in production and therefore rising inflation. If that had happened, then the Fed would have increased interest rates, asset prices would have fallen and consumers would have stopped borrowing more. The amazing thing that happened now was that consumers started borrowing and consuming more, but inflation actually continued falling.

This is where the second human intervention in the price mechanism is involved. By importing far more from the emerging industrial countries, the US created an increasing deficit on its trade balance. This should have quickly led to a weaker dollar, pushing up import prices. Consumers would then automatically have stopped buying imported items and/or the Fed would have raised interest rates to tackle inflation resulting from rising import prices. None of this happened, however, as most Asian countries kept their currencies pegged to the dollar. As soon as the dollar showed the tendency to drop in relation to their own currency, their central banks bought dollars and sold the domestic currency. The great advantage here was that the central bank then invested the majority of the dollars it bought in US bonds, keeping interest rates low in the United States. Housing and stock prices therefore continued to rise in the US, so consumers were easily able to borrow against these assets, etc.