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Bubbles
By John | October 20, 2008
The United States has been experiencing asset bubbles at an accelerating rate in recent years. The stock market bubble of the 90s was soon followed by the housing bubble. As that bubble was deflating, commodities were accelerating in price. Will these bubbles continue? What causes them?
The U.S. Federal Reserve has a stated policy objective of maintaining stable inflation at a rate of 2% or below annually. Recently, the target level has been exceeded, as the consumer price index has been registering in the 4% range. That doesn’t seem to alarm the Feds, however, as they see economic weakness as our primary problem, and inflation should decline along with economic activity.
Does this mean we do not need to be concerned about inflation? Hardly.
The Consumer Price Index measures the price of goods and services typically purchased by consumers. If these prices are rising at an annual rate of no more than 2%, the Federal Reserve believes they are doing their job. Are they?
Through productivity improvements (which lower the real costs of producing goods and services) and through increases in international trade (which allows goods and services to be produced in that part of the world where they can be produced most efficiently and at the lowest cost), the REAL price of consumer goods and services is steadily declining.
If one were to graph the real price of consumer goods and services, with the vertical axis representing price expressed in constant dollars and the horizontal axis representing time, we would see a price line declining downward as we move from left to right on the graph.
How would that same graph look if we were to show prices, not in real terms, but in terms of current dollars? As stated above, the Federal Reserve would be satisfied if prices were increasing at a 2% annual rate. So, if we were to graph consumer prices, measured in CURRENT DOLLARS (as opposed to constant dollars), the line would be INCLINING as we move from left to right.
Now, if we were to graph both real consumer prices (as measured by constant dollars) and consumer prices as measured by current dollars on the same graph, we would see that they move rapidly apart, with prices measured in current dollars going steadily up in price, while the prices measured in real terms are steadily going down in price. The difference between these two lines represents a measurement of real inflation, or the real decline in the purchasing power of the dollar over time.
In real terms, we don’t have 2% annual inflation. We have 2% plus the decline in the real cost of consumer goods and services. If real costs are declining at a 3% annual rate, that means the purchasing power of the dollar is declining at least at a 5% annual rate.
Why do I say “at least?” Because the above only takes into consideration consumer prices. I maintain real inflation has been occurring at a rate well in excess of 5% annually in recent years. That is because most of those extra dollars the government keeps creating don’t go into consumer items. They go into investment assets. Why? Because government policy encourages it.
Let’s say the real decline in the value of the dollar is 8% per year. As the Federal Reserve, in conjunction with the U.S. Treasury, attempts to re-inflate the money supply and credit, interest rates are kept well below 8%. If I can borrow money at 6% per year, I will be making 2% on someone else’s money, even if I only invest in things that maintain constant, real value. In essence, I will borrow money and later pay back money that possesses less purchasing power than the money I borrowed. And, if I can borrow that money and place it in an asset that is rapidly escalating in price, I can make a financial killing!
That is what stock market speculators did in the 1990s. That is what real estate speculators did in the early 2000s. That is what commodity speculators did in recent months. That is what many speculators are waiting to do next, as soon as the taxpayers finish bailing out the last round of losers, so credit can again be made available and we can proceed to “re-inflate”.
These incentives were created by irresponsible monetary management and are destructive to our economy. Is it any wonder we have a negative savings rate as a nation, when only suckers save depreciating dollars, and those wanting to get ahead financially are provided with such strong incentives to borrow and speculate?
At some point, the government will no longer be able to inflate. At some point, the whole system will collapse. This will be blamed on capitalism. This will be blamed on greedy speculators. Yet, as long as the government provides the incentives, the activities of the speculators are fully predictable.
How can the cycle be stopped, before the system collapses? By simply requiring that the Federal Reserve do what all central banks are supposed to do: Maintain a STABLE currency; not a currency that inflates at a stable rate.
In a capitalist economy, capital is allocated through millions of individual decisions, influenced by the supply and demand for goods and services, and the economy functions smoothly. However, when government intervenes in the marketplace to override those individual decisions by providing incentives that would not otherwise exist, distortions in capital allocation occur which can have a very destructive effect on the economy if left unchecked over time.
Capitalism is under siege. By those who “know better.”
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