The Bubble Finance Cycle: What Our Keynesian School Marm Doesn’t Get, Part 2
In Part 1 of The Bubble Finance Cycle we demonstrated that a main street based wage and price spiral always proceeded recessions during the era of Lite Touch monetary policy (1951 to 1985). That happened because the Fed was perennially “behind the curve” and was therefore forced to hit the monetary brakes hard in order to rein in an overheated economy.
So doing, it drained reserves from the banking system, causing an abrupt interruption of household and business credit formation. The resulting sharp drop in business CapEx, household durables and especially mortgage-based spending on new housing construction caused a brief recessionary setback in aggregate economic activity.
To be sure, that discontinuity and the related unemployment and loss of output was wholly unnecessary and by no means a natural outcome on the free market.
Under a regime of free market interest rates, in fact, the pricing mechanism for credit would have operated far more smoothly and continuously, meaning that credit-fueled booms would be nipped in the bud. Flexible, continuously adjusting money market rates and yield curves would choke off unsustainable borrowing and induce an uptake in private savings due to higher rewards for the deferral of current period spending.
Accordingly, the recessions of the Lite Touch monetary era were mainly a “payback” phenomenon that reflected the displacement of economic activity in time caused by monetary intervention. That is, the artificial “stop and go” economy lamented by proponents of sound money was a function of central bank intrusion in the pricing of money and the ebb and flow of credit.
During bank credit fueled inflationary booms, businesses tended to over-invest in fixed assets and inventory and to over-hire in anticipation that the good times would just keep rolling along. But when the central bank was forced to correct for its too heavy foot on the monetary accelerator (i.e. the provision of fiat credit reserves to the banking system) and slam on the credit expansion brakes, businesses dutifully went about reeling-in the prior excesses.
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