Who's to Blame?

Who is responsible for this mess?

When we discover the cause for the irrational consumer behavior, we'll have the answer.

There are dozens of theories which try to explain the rapid shift in consumer demand, but I felt that only one theory has been successful.

It all starts with the Federal Reserve's manipulation of the interest rates.

In a free market, the interest rates are set by the amount of savings deposited in the bank. The law of marginal utility requires a lower price when the supply is higher. When people deposit money into a bank, it is loaned out to other people. The more money that people save, the more loanable funds available. This means the interest rates drop, and loans become more appealing.

So investments that were not profitable before become much more appealing at lower interest rates.

From the business standpoint, there is yet another dimension. When interest rates are low, it means lots of people are saving their money. This is a signal that people don't want to consume today, but consume in the future instead. Conversely, when interest rates are high, it shows that people are not saving, but consuming in the present.

So the interest rates are a signal for businesses. Investors choose how to allocate funds based on these interest rates. As I have said, if the interest rates are low, it looks like people are saving rather than consuming. So to investors, this is the best time to invest in future projects.

This is the problem.

Countless investments were made because loans were cheap.

Think of a steel plant who buys one more expensive piece of machinery. The piece of machinery wasn't affordable, and it wasn't required, but it was bought anyway due to the ease of getting a loan. Imagine this on the national level. Risky investments were made by the thousands because it's cheap, not because it's needed or even profitable.

Then comes the problems of time preference.

What happens when investments are made based on fake interest rates? When the rates are low because of the Federal Reserve and not the amount of savings, everything gets distorted. Businesses invest based on how much people are saving or consuming. Since the interest rates are low, it looked like people were saving at that time, and going to spend in the future.

Businesses changed plans accordingly. Since people were going to increase spending in the future, investments were made for future production. New factories were built, technologies were researched, and the economy was greatly invested in for future consumption.

The problem is that people never did increase savings. The interest rates were low because of the Federal Reserve, not because of high savings. So when all of these new projects were started, they couldn't be sustained. The savings didn't exist which were supposed to fund these projects.

These projects have to be discontinued. Factories need to shut down, people have to be laid off, and the economy must slow down.

This is when the slowdown occurs. Businesses realize they have invested too much for the amount of savings that exists, and they have also realized that they have made foolish investments because it was easy to get loans.

This is just the beginning of the problem.

Next week I'll expand on it by talking about inflation, reserve requirements, and the purchasing of bonds through open market operations.