The End of Growth: Adapting to Our New Economic Reality (9 page)

Business Cycles, Interest Rates, and Central Banks

We have just reviewed a minimalist history of human economies and the economic theories that have been invented to explain and manage them. But there is a lot of detail to be filled in if we are to understand what’s happening in the world economy
today
. And much of that detail has to do with the spectacular growth of debt — in obvious and subtle forms — that has occurred during the past few decades. The modern debt phenomenon in turn must be seen in light of recurring
business cycles
that characterize economic activity in modern industrial societies, and the central banks that have been set up to manage them.

We’ve already noted that nations learned to support the fossil fuel-stoked growth of their real economies by increasing their money supply via fractional reserve banking. As money was gradually de-linked from physical substance (i.e., precious metals), the creation of money became tied to the making of loans by commercial banks. This meant that the supply of money was entirely elastic — as much could be created as was needed, and the amount in circulation could contract as well as expand. Growth of money was tied to growth of debt.

The system is dynamic and unstable, and this instability manifests in the business cycle, which in a simplified model looks something like this.
¹²
In the expansionary phase of the cycle, businesses see the future as rosy, and therefore take out loans to build more productive capacity and hire new workers. Because many businesses are doing this at the same time, the pool of available workers shrinks; so, to attract and keep the best workers, businesses have to raise wages. With wages increasing, worker-consumers have more money in their pockets, which they then spend on products made by businesses. This increases demand, and businesses see the future as even rosier and take out more loans to build even more productive capacity and hire even more workers...and so the cycle continues. Amid all this euphoria, workers go into debt based on the expectation that their wages will continue to grow, making it easy to repay loans. Businesses go into debt to expand their productive capacity. Real estate prices go up because of rising demand (former renters decide they can now afford to buy), which means that houses are worth more as collateral for homeowner loans. All of this borrowing and spending increases both the money supply and the “velocity” of money — the rate at which it is spent and re-spent.

At some point, however, the overall mood of the country changes. Businesses have invested in as much productive capacity as they are likely to need for a while. They feel they have taken on as much debt as they can handle and don’t need to hire more employees. Upward pressure on wages ceases, which helps dampen the general sense of optimism about the economy. Workers likewise become shy about taking on more debt, and instead concentrate on paying off existing debts. Or, in the worst case, if they have lost their jobs, they may fail to make debt payments or even declare bankruptcy. With fewer loans being written, less new money is being created; meanwhile, as earlier loans are paid off or defaulted upon, money effectively disappears from the system. The nation’s money supply contracts in a self-reinforcing spiral.

But if people increase their savings during this downward segment of the cycle, they eventually will feel more secure and therefore more willing to begin spending again. Also, businesses will eventually have liquidated much of their surplus productive capacity and reduced their debt burden. This sets the stage for the next expansion phase.

Business cycles can be gentle or rough, and their timing is somewhat random and largely unpredictable.
¹³
They are also controversial: Austrian School and Chicago School economists believe they are self-correcting as long as the government and central banks (which we’ll discuss below) don’t interfere; Keynesians believe they are only partially self-correcting and must be managed.

In the worst case, the upside of the cycle can constitute a bubble, and the downside a recession or even a depression. A
recession
is a widespread decline in GDP, employment, and trade lasting from six months to a year; a
depression
is a sustained, multi-year contraction in economic activity. In the narrow sense of the term, a
bubble
consists of trade in high volumes at prices that are considerably at odds with intrinsic values, but the word can also be used more broadly to refer to any instance of rapid expansion of currency or credit that’s not sustainable over the long run. Bubbles always end with a crash: a rapid, sharp decline in asset values.

Interest rates can play an important role in the business cycle. When rates are low, both businesses and individuals are more likely to want to take on more debt; when rates are high, new debt is more expensive to service. When money is flooding the system, the price of money (in terms of interest rates) naturally tends to fall, and when money is tight its price tends to rise — effects that magnify the existing trend.
¹⁴

During the 19th century, as banks acted with little supervision in creating money to fuel business growth cycles and bubbles, a series of financial crises ensued. In response, bankers in many countries organized to pressure governments to authorize central banks to manage the national money supply. In the US, the Federal Reserve (“the Fed”) was authorized by Congress in 1913 to act as the nation’s central bank.

The essential role of central banks, such as the Fed, is to conduct the nation’s monetary policy, supervise and regulate banks, maintain the stability of the financial system, and provide financial services to both banks and the government. In doing this, central banks also often aim to moderate business cycles by controlling interest rates. The idea is simple enough: lowering interest rates makes borrowing easier, leading to an increasing money supply and the moderation of recessionary trends; high interest rates discourage borrowing and deflate dangerous bubbles.

The Federal Reserve charters member banks, which must obey rules if they are to maintain the privilege of creating money through generating loans. It effectively controls interest rates for the banking system as a whole by influencing the rate that banks charge each other for overnight loans of federal funds, and the rate for overnight loans that member banks borrow directly from the Fed. In addition, the Fed can purchase government debt obligations, creating the money out of thin air (by
fiat
) with which to do so, thus directly expanding the nation’s money supply and thereby influencing the interest rates on bonds.

The Fed has often been a magnet for controversy. While it operates without fanfare and issues statements filled with terms opaque even to many trained economists, its secrecy and power have led many critics to call for reforms or for its replacement with other kinds of banking regulatory institutions. Critics point out that the Fed is not really democratic (the Fed chairman is appointed by the US President, but other board members are chosen by private banks, which also own shares in the institution, making it an odd government-corporate hybrid).

Other central banks serve similar functions within their domestic economies, but with some differences: The Bank of England, for example, was nationalized in 1946 and is now wholly owned by the government; the Bank of Russia was set up in 1990 and by law must channel half of its profits into the national budget (the Fed does this with all its profits, after deducting operating expenses). Nevertheless, many see the Fed and central banks elsewhere (the European Central Bank, the Bank of Canada, the People’s Bank of China, the Reserve Bank of India) as clubs of bankers that run national economies largely for their own benefit. Suspicions are most often voiced with regard to the Fed itself, which is arguably the most secretive and certainly the most powerful of the central banks. Consider the Fed’s theoretical ability to engineer either a euphoric financial bubble or a Wall Street crash immediately before an election, and its ability therefore to substantially impact that election. It is not hard to see why president James Garfield would write, “Whoever controls the volume of money in any country is absolute master of industry and commerce,” or why Thomas Jefferson would opine, “Banking establishments are more dangerous than standing armies.”

Still, the US government itself — apart from the Fed — maintains an enormous role in managing the economy. National governments set and collect taxes, which encourage or discourage various kinds of economic activity (taxes on cigarettes encourage smokers to quit; tax breaks for oil companies discourage alternative energy producers). General tax cuts can spur more activity throughout the economy, while generally higher taxes may dampen borrowing and spending. Governments also regulate the financial system by setting their own rules for banks, insurance companies, and investment institutions.

Meanwhile, as Keynes advised, governments also borrow and spend to create infrastructure and jobs, becoming the borrowers and spenders of last resort during recessions. A non-trivial example: In the US since World War II, military spending has supported a substantial segment of the national economy — the weapons industries and various private military contractors — while directly providing hundreds of thousands of jobs, at any given moment, for soldiers and support personnel. Critics describe the system as a military-industrial “welfare state for corporations.”15

The upsides and downsides of the business cycle are reflected in higher or lower levels of inflation. Inflation is often defined in terms of higher wages and prices, but (as Austrian School economists have persuasively argued) wage and price inflation is actually just the symptom of an increase in the money supply relative to the amounts of goods and services being traded, which in turn is typically the result of exuberant borrowing and spending. Inflation causes each unit of currency to lose value. The downside of the business cycle, in the worst instance, can produce the opposite of inflation, or
deflation
. Deflation manifests as declining wages and prices, due to a declining money supply relative to goods and services traded (which causes each unit of currency to increase in purchasing power), itself due to a contraction of borrowing and spending or to widespread defaults.

Business cycles, and regulated monetary and banking systems, constitute the framework within which companies, investors, workers, and consumers act. But over the past few decades something remarkable has happened within that framework. In the US, the financial services industry has ballooned to unprecedented proportions, and has plunged society as a whole into a crisis of still-unknown proportions. How and why did this happen? As we are about to see, these recent developments have deep roots.

Mad Money

Investing is a practice nearly as old as money itself, and from the earliest times motives for investment were two-fold: to share in profits from productive enterprise, and to speculate on anticipated growth in the value of assets. The former kind of investment is generally regarded as helpful to society, while the latter is seen, by some at least, as a form of gambling that eventually results in wasteful destruction of wealth. It is important to remember that the difference between the two is not always clear-cut, as investment always carries risk as well as an expectation of reward.16