Sunday, July 20, 2008

The Cause of Recessions

It is not capitalism that causes all the turbulence that we see in financial markets. It is government intervention to prevent the proper functioning of markets that causes most of the problems. Foremost among these interventions is the setting of monetary policy by the Federal Reserve. The Fed causes the credit expansions which lead ineveitably to the corrections. Now comes some scientific proof of that:

Hayek was right. The cause of business cycles and market turbulence is – governments.

In the latest New Scientist, a bunch of 'econophysicists', using sophisticated computer analysis, suggest that crashes might well have something to do with the euphoric levels of credit that precede them. In other words, the cause of your hangover is the binge you went on the night before.

The geeks used some pretty impressive technology – not just looking at portfolios, but programming virtual hedge funds and brokers to see how they react to market conditions. In stable times, they conclude, these agents all work pretty well, spotting under-priced stock and borrowing to invest in it. But when credit is cheap and they borrow and buy more is when they can get into difficulties. Some single chance event can send waves through the entire market: because when everyone's borrowing, one person's failure becomes everyone else's problem.

So that's it. Politicians and monetary authorities love it when we're all borrowing to spend wildly. It's boom-time, everything succeeds, employment rises, production soars, house prices rocket, we all feel rich. And then pop! – the first person who can't pay the bills leaves a second short of cash, which knocks on to a third, a fourth, a fifth... Pretty soon the economy's in a tailspin. All those people the banks and building societies lent to suddenly can't pay it back.

You could mitigate this by regulating the gearing of financial institutions. Much better to do it through a sensible monetary policy that doesn't make credit too easy and keeps a close and concerned watch on the monetary aggregates. The quasi-independence of the Bank of England has probably helped: but it evidently needs tougher targets if boom and bust is truly to be eliminated for the future.

This is from the Adam Smith Institute and references the Bank of England but the same applies to the US where the Fed is probably more interventionist than the BOE.

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