What happens when a central bank artificially lowers the interest rate? It sends mixed signals to market participants. On the one hand, entrepreneurs invest more and increase the depth of the production process. On the other hand, consumers spend more as saving is unattractive. When the excess products created through the cheap money induced investments reach the market, consumers are unable to buy them.
That is the basis of the boom and bust cycles. It is important to note that those cycles did not exist until central banks started actively intervening in markets. In other words, interest rate manipulation create bubbles, and, hence, busts.
According to the Austrian Business Cycle Theory, a recession arrives when the economy readjusts as consumers come to reestablish their desired allocation of saving at prevailing interest rates. That is when consumers decide to save more and consume less. In such a market correction, everything goes down. It is a reversal of the inflationary pick up during the boom. The longer malinvestments continue, the more aggressive the correction becomes.
This microdocumentary video does an excellent job explaining four major boom and busts which occured in the last 100 years. It shows how monetary policy created a boom which resulted in the inevitable bust.
Did you know the following about the Great Depression of the 30’s?
Between 1921 and 1929, money supply surged 63%. This spike in inflation was not in circulated currency, but rather in bank deposits and other monetary instruments that caused the expansion of the credit base of commercial banks. More so, the US Fed gave banks the green light to finance stock investors. The stock market boomed and speculation was on the rise, to the extent that it did not reflect the realities of a depression until months after money supply growth figures slowed down. The monetary inflation was completed by the end of 1928. The correction followed soon thereafter.
Did you know the following about The Recession of 1990?
Between 1981 and 1986, the FED increased the money supply by an average of 9.6% per year, while real GNP rose by only 2.6%. After 1986, the FED toned down its strategy as money supply increased by 4.1% per year. Meanwhile, GNP remained stable around 2%. Although money supply expansion and the boom of the higher order industries, particularly iron and steel, ended in 1986, the recession was not really felt until 4 years later.
Where are we in the current cycle?
It is very likely that the recessions discussed in the microdocumentary video could fall into the category of short-term cycles. The booming phase of the long-term economic cycle which started in 1971 (when Nixon closed the Gold Window) could be reaching its peak, meaning we could be approaching a devastating bust. Pinpointing the tipping point is impossible. The current cycle can easily continue for some years. For more insights on our position in the long term cycle, readers are adviced to go to the 12-minute mark in the video.
In a bust scenario, capital flees down Exter’s pyramid to their safe haven, being gold. When busts occurs, phyiscal gold is considered a precious counter-balance to other asset classes. Holding a scarce asset with absolutely no counterparty risk affords investors a “hedge” against a crisis! It offers a much-needed safety net when the banking system and all that it is based on, fails.