Tuesday, November 24, 2009

The Boom-Bust Cycle Examined (And Why Another Bust Is Coming)

Frank Shostak has a great piece on the boom-bust cycle and why it is Fed money expansion that causes the boom-bust cycle. It is one of the best explanations of Austrian Business Cycle Theory, combined with economic data from recent boom-busts in the economy, that I have seen. Here are key excerpts from his piece:
Irrespective of their psychological disposition, if the pool of money is not expanding, people's ability to generate bubbles in various markets is not tenable.

Recall that [Former Fed Governor and Bernanke confidant Frederic] Mishkin holds that bubbles in the first category — the dangerous bubbles — are set in motion by exuberant expectations about economic prospects or structural changes in financial markets, which trigger a credit boom.

But even if these factors are capable of triggering increases in credit, why must all this produce an expansion in the money supply? The increase in the money supply is the key for the emergence of asset bubbles.

For instance, when Joe lends his $100 to Bob via his bank, this means that Joe via the intermediary lends his money to Bob. On the maturity date, Bob transfers the money to the bank, and the bank in turn (after charging a fee) transfers the $100 plus interest to Joe.
Observe that here we don't have any increase in the money supply — the existing $100 was transferred from Joe to Bob. Also note that the $100 loan by Joe to Bob is fully backed up by $100.

Things are however quite different when Joe keeps the $100 in the bank warehouse or demand deposit. Now, by keeping the money in a demand deposit, Joe is ready to employ the $100 in an exchange at any time he deems it is necessary.

If the bank lends Bob $50 by taking it from Joe's deposit, the bank has now created $50 of unbacked credit, i.e., credit "out of thin air." There is now $150 in demand deposits backed by $100. By lending $50 to Bob, the bank creates $50 of demand deposit.

In this sense, the lending here is without a lender as such. The intermediary, i.e., the bank, has created a mirage transaction without any proper lender. On the maturity date, once the money is repaid to the bank, this type of money disappears. The amount of money will revert back to $100.

Hence an increase in the credit created out of thin air, all other things being equal, gives rise to the expansion in money supply. A fall in the credit created out of thin air, all other things being equal, results in the contraction of the money supply.

What then matters for asset price bubbles is the expansion in credit out of thin air. It is this type of credit that boosts the money-supply rate of growth and hence fuels asset-price bubbles.
Again, an increase in normal credit (i.e., credit that has an original lender) doesn't alter the money supply and hence has nothing to do with asset-price bubbles. (When Bob lends $100 to Joe, what we have here is an increase in lending and a transfer of an existing $100 from lender to borrower — and no change in the money supply)...

The modern banking system can be seen as one huge monopoly bank, which is guided and coordinated by the central bank. Banks in this framework can be regarded as the branches of the central bank...

Through ongoing monetary management, i.e., monetary pumping, the central bank makes sure that all the banks engage jointly in the expansion of credit out of thin air...

Once it is realized that the key source for asset bubbles is the monetary pumping of the Fed (i.e., central bank) it becomes clear that there is no need to categorize various bubbles.

What matters is the fact that the Fed's loose monetary policy gives rise to various nonproductive (bubble) activities that undermine the process of real-wealth formation, thereby impoverishing the economy.

The reversal of the Fed's pace of money pumping sets in motion the bursting of bubble activities...

Both the plunge in technology stocks from February 2000 to September 2002 and the October 1987 stock market crash were set in motion by the boom–bust policies of the Fed.

By the end of September 2002, the NASDAQ composite stock-price index closed at 1,172.06 — a fall of 75% from the high of 4,696.69 reached at the end of February 2000.

What set this collapse in motion was a sharp fall in the growth momentum of the Fed's monetary pumping. Year-on-year, the rate of growth of the Fed's balance sheet fell from 16.9% in December 1999 (Y2K pumping) to −3% by December 2000.

In response to this, the yearly rate of growth of our monetary measure AMS[2] fell from 6.7% in January 2000 to −1% by December 2000.

Also note that the yearly rate of growth of commercial-bank lending fell from 13.1% in September 2000 to 1.5% by December 2001. (Given the sharp decline in the growth momentum of commercial-bank lending, it is quite likely that the growth momentum of commercial-bank lending out of thin air had also fallen).

The yearly rate of growth of our measure of monetary liquidity fell from −1.1% in January 2000 to −5.3% by December 2000.

As a result of the plunge in the pace of monetary pumping, the yearly rate of growth of industrial production fell from 5.5% in June 2000 to −5.7% by November 2001.

Also, in the October 1987 stock-market crash, the Fed's monetary policy played a key role. By the end of October 1987 the S&P500 closed at 251.79 — a fall of 23.7% from the end of August 1987.

What set in motion this plunge was the sharp fall in the yearly rate of growth of Fed's balance sheet from 17% in April 1987 to 7.5% by September of that year.

In response to this, the yearly rate of growth of our monetary measure AMS fell from 17.2% in January 1987 to 10.5% by September. (Our measure of liquidity plunged from 15.1% in January to −0.3% in September).

As a result of the decline in the Fed's monetary pumping, the yearly rate of growth of industrial production fell from 7.7% in November 1987 to −0.3% by October 1989.

At present we are observing a repetition of the past boom–bust policies of the Fed. Thus the yearly rate of growth of the Fed's balance sheet jumped from 1.5% in February 2008 to almost 153% by December of last year.

Afterwards, the yearly rate of growth has been in steep decline, closing at 0.3% by mid-November this year. It seems that notwithstanding pronouncements by various Fed officials that the US central bank will keep its easy stance intact, the Fed in fact has already drastically reduced the pace of monetary pumping.

As a result of the wild fluctuations in the pace of money pumping by the Fed, the yearly rate of growth of AMS jumped from 0.8% in January last year to 33.1% by November of 2008. In early November 2009 the yearly rate of growth of AMS stood at −9.1% against −6.2% in October. In short, the Fed has already set in motion another economic bust.
Read the entire article here.

(Thanks to Centermass)


  1. Question: The article states "The amount of money will revert back to $100." Won't that be $100 plus the interest charged on the loan, increasing the money supply by the amount of the interest?

  2. The interest paid is coming from money already in the system, so it doesn't impact money supply.

  3. Doh! I can't tell you how much I enjoy your site - I have forgotten so much from my econ classes many years ago.


  4. Bob, do you follow AMS or do you have an opinion on it?

  5. @Steve

    I look at it. My only qualm is that it doesn't include money market funds, and I think a lot of people think of their money markets as cash.

    There's not enough of a difference for me to raise a big stink, and money markets are complicated because for some it is savings, so I put just a little more weight in M2.

  6. Rhetorically compelling, but than it was compelling 6 months ago and 6 years ago... Forecasting another "Bust" is a little like forecasting rain. If you live on the planet earth you can be reasonably certain it will rain, you're just not sure WHEN!

    And what about the elephant in the room? Shostak doesn't mention it because I'm sure he views the elephant as not part of "economics," although it does relate to cost and human nature.

    The elephant I am referring to is the fact that the cost of implementing a policy implied by Shostak's economic theory (free market capitalism) far exceeds the benefits that any one or even a moderately large number of legislators or citizens could receive.

    How do I know this? Because a policy of free market capitalism has been systematically blocked by anyone with the force to do so since man began trading. Forgive me the rant, but Shostak needs to address this cost if free market capitalism is ever to be implemented, ridding us of this boom-bust cycle.