By The Foundation for Economic Education. Originally published at ValueWalk.
What we now know was one of the worst post-World War II economic and financial crises began about ten years ago in 2007. Various retrospective commentaries have focused on the severity of the economic downturn, its impact on different markets and segments of the population, and the lessons from it. An especially important lesson to be learned is that this was a crisis caused by government policy, and not something inherent in a free market economy.
The recession has its origin in years of monetary mismanagement and misguided interventionist policies emanating from the Federal Reserve System and Washington, D.C.
Monetary Expansion
Between 2003 and 2008, the Federal Reserve flooded the financial markets with a huge amount of money. The Federal Reserve’s M-2 measurement of the money supply (cash, checking accounts and various small denomination savings and investment accounts) increased by nearly 40 percent during those five years. The Federal Reserve’s MZM money measurement (M-2 plus a variety money market accounts minus some time deposits) expanded by almost 50 percent over that half-decade.
The St. Louis Federal Reserve Bank tracks the impact of monetary expansion on nominal and real interest rates. For most of those years, key market rates of interest, when adjusted for inflation, were either zero or even negative.
Between late 2002 to the end of 2005, the Federal Funds Rate (the rate at which banks lend funds to each for short periods of time) and the one-year Treasury security yield were between zero and minus two percent, when adjusted for price inflation (as measured by the Consumer Price Index).
They rose into positive territory in 2006 and 2007, but then they tumbled back into the negative range in early 2008. And ever since then, except for a brief period in 2009, they have remained in the real interest rate negative range, sometimes a negative two to even four percent.
Interest Rate Manipulation
What does that actually mean? Suppose that I agree to lend you $100 for a year, with your promise to pay me back the principle of $100 plus $2, representing a two percent interest on the money, at the end of the twelve months. But suppose that at the end of that year you hand me not the $100 that I lent you, but only $98? Not only have I not gotten back my original $100 with the promised $2 of interest payment, I’m short $2 of what you originally borrowed.
Now, once more, suppose I lend you $100 with your promise to pay me $102 a year from now. And suppose that, in fact, at the end of the twelve months you do pay me back $102. But also suppose that during that year prices have increased by two percent. A basket of goods that I might have been able to purchase with that $100 before I lent you the money now costs $102 to buy. In real buying terms, the $102 I received from you is only enough to buy the same basket of goods that $100 bought a year earlier. In real buying terms, as the lender, I’ve received no positive interest income from my lending to you.
Banks not only lowered the cost of borrowing, they also lowered their standards for creditworthiness.
But suppose that prices have risen, by more than two percent, so that basket of goods increases in cost to, say, $104 dollars. Then the $102 you return to me is not even enough to buy the same basket of goods from a year earlier. That represents a “negative” rate of interest on my lending.
Of course, from the borrowers point-of-view the lenders’ loss is his gain. He returns principle and interest that has depreciated in market buying power over the period of the loan, thus obtaining investable funds at a lower cost than if prices, in general, had remained relatively stable or if the nominal interest of interest had been higher relative to the rate of price inflation during that time.
The Housing Bubble and Crash
Due to Federal Reserve monetary policy during 2003-2008, the banking system was awash in money to lend to all types of borrowers. To attract people to take out loans, banks not only lowered nominal interest rates (and therefore the cost of borrowing), they also lowered their standards for creditworthiness.
To get the money out the door, financial institutions found “creative” ways to bundle mortgage loans into tradable packages that they could then pass onto other investors. It seemed to minimize the risk from issuing all those subprime home loans that were really the housing market’s version of high-risk junk bonds. The fears were soothed by the fact that housing prices kept climbing as home buyers pushed them higher and higher with all of that newly created Federal Reserve money.
With interest rates so low, there was little incentive to save for tomorrow and big incentives to borrow today.
At the same time, government-created home-insurance agencies like Fannie Mae and Freddie Mac were guaranteeing a growing number of high-risk mortgages, with the assurance that the “full faith and credit” of Uncle Sam stood behind them. By the time the Federal government took over complete control of Fannie and Freddie in 2008-2009, they were holding the guarantees for half of the $10 trillion American housing market. (See my article, “A Collapse Made in Washington,” p. 4).
Low-interest rates and reduced credit standards were also feeding a huge consumer-spending boom that resulted in a 25 percent increase in consumer debt between 2003 and 2008, from $2 trillion to over $2.5 trillion. With interest rates so low, there was little incentive to save for tomorrow and big incentives to borrow and consume today. But, according to the U.S. Census Bureau, during this five-year period average real income only increased by 2 percent at the most. People’s’ debt burdens, therefore, rose dramatically.
The Federal Reserve’s easy money and U.S. government’s guaranteed mortgage house of cards all started to come tumbling down in 2008, and then with a huge market crash in 2008-2009. The monetary-induced low interest rates and creative credit methods resulted in a significant misuse and misallocation of resources: Too many houses that too many people could not afford; too many investment projects that were unsustainable in the post-bubble environment; and too much consumer debt for what people could realistically afford out of their recession-adjusted wealth and income.
Post-Crash Monetary Expansion and Interest Rate Manipulations
The same Federal Reserve System that produced the monetary excesses that generated the bubble and its eventual burst then got busy flooding the financial markets with even more newly created money.
Between 2009 and 2016, America’s central bank increased the Monetary Base (cash and reserves in the banking system) by more than $3 trillion by purchasing U.S. government securities and buying a huge amount of “toxic” mortgage-backed securities, adding to its own portfolio of “assets” by the equivalent amount. During this time, the Federal Reserve’s M-2 and MZM measurements of the money supply each increased by almost 85 percent from what they were in 2008, a near doubling of the money supply being utilized by people in the marketplace.
Even a small differential adds up to a lot of money.
But with such a huge $3 trillion increase in
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