Credit bubbles and GDP targeting

In 2010 Scott Sumner first proposed that the Fed use GDP targeting rather than targeting inflation, which is prone to measurement error. Since then support for this approach has grown, with Lars Christensen, an economist with the Danish central bank, coining the term Market Monetarism.

Sumner holds that inflation is “measured inaccurately and does not discriminate between demand versus supply shocks” and that “Inflation often changes with a lag… but nominal GDP growth falls very quickly, so it’ll give you a more timely signal….” [Bloomberg]

The ratio of US credit to GDP highlights credit bubbles in the economy. The ratio rises when credit is growing faster than GDP and falls when credit bubbles burst. The graph below compares credit growth/GDP to actual GDP growth (on the right-hand scale). The red line illustrates a proposed GDP target at 5.0% growth.

US Credit Growth & GDP Targeting

What this shows is that the Fed would have adopted tighter monetary policies through most of the 1990s in order to keep GDP growth at the 5% target. That would have avoided the credit spike ahead of the Dotcom crash. More importantly, tighter monetary policy from 2003 to 2006 would have cut the last credit bubble off at the knees — avoiding the debacle we now face, with a massive spike in credit and declining GDP growth.

While poor monetary policy may have caused the problem, correcting those policies is unlikely to rectify it. The genie has escaped from the bottle. The only viable solution now seems to be fiscal policy, with massive infrastructure investment to restore GDP growth. That may seem counter-intuitive as it means fighting fire with fire, increasing public debt in order to remedy ballooning private debt.

Rising public debt is only sustainable if invested in productive infrastructure that yields market-related returns. Not in sports stadiums and public libraries. Difficult as this may be to achieve — with politicians poor history of selecting projects based on their ability to garner votes rather than economic criteria — it is our best bet. What is required is bi-partisan selection of projects and of private partners to construct and maintain the infrastructure. And private partners with enough skin in the game to enforce market discipline. I have discussed this at length in earlier posts.

The Socialist Myth of Economic Bubbles | Iakovos Alhadeff

Essay on the underlying causes of asset bubbles, reproduced with kind permission from Iakovos Alhadeff.


In my essay “The Causes of the Economic Crisis for non Economists”, I explained why the American crisis was caused by government intervention and not by the free market. Since the housing bubble was one of the main elements of this crisis, I discussed on the issue of the American housing bubble too. In this essay I want to examine asset bubbles on their own, and not as part of the American crisis or any other crisis. I will use various examples, but the emphasis will be on asset bubbles themselves and not on a particular crisis. More specifically the emphasis will be on the forces that lead to their formation and collapse. I will focus on housing bubbles, since they are very common, and also a kind of bubble we have all gathered a lot of experience about.

I want to begin with a bubble in a simple barter economy, which will actually say almost everything that can be said about bubbles, because I believe asset bubbles are a much simpler phenomenon than they seem to be. The aim of this essay is to explain why bubbles are always the result of government policies and not of the free market. I believe it is better to read my essay “The Socialist Myth of the Greedy Banker” before reading this one. Because most people think that it is private banks that create money and crises, and in the aforementioned essay I explain why this is not so, which is the first step to understand bubbles. But the two essays are independent documents.

A Bubble in a Simple Barter Economy

Assume an economy with two individuals and many goods. The good used as money in the economy is oranges. And I happen to produce oranges. Everyday I produce 10 oranges and I consume 5 of them. I put the 5 oranges that I save in a box called “bank”. This box keeps track of the number of oranges I place in it everyday, and issues a receipt. This box is a mechanism that finds someone to lend my oranges and who is willing to pay a higher interest rate than the one the “bank” has to pay me. I do not know how my savings/oranges will be used. I simply have a deposit account which keeps track of the oranges I put in the box/bank.

Let’s assume that this mechanism/box/bank agrees with the other individual in the economy to lend him my oranges. The other person somehow decides that the most profitable way to use my oranges is to convert them to houses i.e. eat them in order to sustain himself and build houses. I assume for simplicity that he is using whatever materials he finds around to build the houses i.e. he does not have to buy and sell construction materials.

At some point the houses are ready. So I have deposited let’s say 1.000 oranges in the box/bank, the builder has eaten the oranges, and has built the houses. But now he has to repay his loan i.e. the 1.000 oranges. But in order to do so he needs to sell some of the houses. If I am willing to buy a part of the houses for 1.000 oranges, I will transfer him the credits in my deposit account, and everything will be fine. There is an intermediary of course i.e. the box/bank, but it is the two of us who are the important players. If I agree to buy at the price he is selling, and which is the price that covers for my oranges, everything is fine. Therefore if I want a house and I am willing to pay approximately 1.000 oranges for it, I will write a check transferring him the credits I have in my deposit account, he will put these newly earned credits in the box/bank to clear his debt, he will also make a profit, and everything will be fine. Case closed.

If however I find the price he is asking i.e. something around 1.000 oranges very expensive, I will not buy the house. But this is a big problem, because the only way this man can find money to pay his debt is by selling houses to people with the purchasing power to buy houses i.e. people with the bank accounts i.e. people with the savings i.e. people whose savings (past surpluses) he used to build the houses i.e. only me in this case. If I do not want to buy the house at this price, it means I prefer something else i.e. a car. But my savings were used to produce a house and therefore there is no car. I therefore go to the bank to take my oranges back.

But my oranges are not there since the house builder ate them in order to produce the house. I am very upset and I ask for my oranges. The bank says that it does not have the oranges, but it can confiscate the houses of the person to whom my money was lent. But I have already seen this house as a consumer, and I did not want this house for 1.000 oranges. I would buy it maybe for 500 oranges. Therefore the bank confiscates it and gives it to me. But I am not happy. I want my other 500 oranges. The bank does not have these oranges, and it goes bankrupt. If there was a government it would either let me lose my savings/deposits of 500 “oranges”, or as it usually happens, it would ask the tax payer to pay for my deposits/ “oranges”.

So what really happened in this little story? What happened is that somehow my savings were used for something that I did not value as much as my 1.000 oranges, and which I would therefore not exchange for my savings/ “oranges”. This asset (the house in my example) is a bubble, since it cannot be sold for an amount which will cover its costs (1.000 oranges) i.e. the savings that were used for it. If you think about millions or even billions of savers you are talking about a huge bubble. That’s exactly the housing bubble today. Some people’s savings were used for housing or for other purposes, but these other purposes and housing were not what these savers wanted. They would not be willing to exchange their savings with what has been produced with their savings. Therefore, a bubble is a situation where savings have been used in the wrong way but in a massive scale. You might hear many definitions for bubbles, which might sound smarter, prettier, more sophisticated etc, but I believe this one is more accurate even though it sounds somewhat simplistic. And you should not think that only houses are involved in bubbles. As I already said, there are many other ways that savings can be used in the wrong way i.e. to produce something that savers do not value as much as their savings.


Therefore the magic word in order to understand bubbles is savings. And the magic question that needs to be answered in order to understand bubbles is why savings were inappropriately invested in the bubble market? If we were to ask people what a housing bubble is, most of them would probably give the simplistic answer “too many houses were built and their prices collapsed”. Even though this statement has an element of truth, it is very simplistic and it does not help one understand what asset bubbles are. What is of great importance to realize, is that if the prices of houses were to decrease significantly, there would be a price level at which they would all be sold. If we all sell our property for 1 euro for example, everybody will rush to buy. Therefore if we want to be more accurate, the problem is not that too many houses exist. The problem is that market prices are so low that they cannot cover for their costs i.e. the loans provided by the banks i.e. the “oranges” that were deposited at the banks.

For instance I owe the bank 300.000 euros, and I have stopped paying my loan, and the bank cannot sell the house to someone else for let’s say more than 150.000 euros. This is exactly the same situation with the situation in my simple barter economy. At a price of 150.000 euros the bank will make a loss of 150.000 euros. If this was a single case it would not matter at all. The problem is that when bubbles arise this is a very common phenomenon. Therefore the banks make huge losses, and if the banks make huge losses the first thing that happens is that shareholders lose their equity and the bank shares go to the state, the second thing that happens is that banks’ creditors lose their money, and finally either depositors will have to lose their savings/deposits/ “oranges”, or the tax payer will have to pay for their deposits/savings/ “oranges” not to be lost. Depositors whose savings the banks cannot pay back are the equivalent of the orange producer in my example. What is of great importance is the issue of miscalculation of profits and misallocation of savings/ “oranges”. And the very important question that needs to be answered is “why so many people were the victims of this miscalculation of profits i.e. why they expected they would make profits from the houses at very high selling prices, and why savings were massively directed to the development of the wrong products?

This is therefore the question that must puzzle us i.e. why there was this misallocation of resources, why so much of peoples’ savings were inappropriately invested in the bubble asset and not in something else more valued by savers. Man has unlimited wants, and therefore it can’t be that there was some idle capital and somebody said “hey guys lets build some housing with this extra capital”. Some countries with housing bubbles cannot even satisfy their primary needs i.e. meat, grains etc, and once the bubbles burst they face severe political turmoil or even the danger of hunger, or even of civil war, if not supported by other countries i.e. Greece. And yet they excessively invested in houses that now nobody wants at prices that would cover their costs i.e. the mortgages. Therefore resources and savings that were used in housing in such countries should have been used in something else or even somewhere else i.e. in other countries. It is therefore very important to realize that the savings that are used in bubbles are not abundant savings,but rather misallocated savings. Once we realize that, we need to proceed and examine what leads home owners and house constructors all together to be so wrong at the same time.

Because many people think that the problem is that homeowners can’t pay their mortgages. That is indeed a problem, but it is not the main problem, because the houses these people are living in were not built with their own money (savings). They were built with depositors’ money/ “oranges”. The problem is that the people who are living in the houses cannot pay their mortgages, and people with whose savings/deposits/ “oranges” these houses were built, do not want to exchange their deposits/savings with these houses. If the real owners of these houses i.e. the people whose savings were used in order for these houses to be built i.e. the people with the deposit accounts, wanted the houses for prices that would cover their costs (mortgages), everything would be fine. The houses would be confiscated from the people who do not pay their mortgages and given to the people who really own them i.e. depositors. But as I already said depositors do not want to buy these houses at current prices i.e. they do not want to exchange their deposits/ “oranges” with these houses. They value more other products i.e. cars, oranges, televisions, computers, holidays etc.

As I will explain, behind every bubble there are one or more governments that mess with the way savings are allocated. By doing so, governments do not allow the market to allocate scarce resources according to economic fundamentals, and there is a misallocation of resources, and at some point the misallocation is so great that readjustment is unavoidable. There are endless policies by which governments affect the way savings are allocated. Different policies are used for different purposes by different governments in different countries. I cannot describe all of them. I will provide some examples, and I hope it will be quite easy to imagine many other paths by which governments try to affect the way savings are allocated focusing on their policy objectives and ignoring economic fundamentals.

Taxation, Debt and Inflation as Means of Financing Government Deficits

Before I proceed, I want to mention that there are three ways by which governments can finance their spending, namely taxation, borrowing, and money creation (inflation). The first and second ones are quite straight forward. A government can tax its citizens or it can borrow domestically or internationally. The third one is somewhat less obvious but it is a very simple idea. A government can create new paper money through its central bank, either in electronic or paper form, and use it “buy” domestic or foreign citizens’ wealth. This is obviously a form of taxation, since the country’s wealth did not increase because new money was created. With newly created money, there is more money running after the same amount of wealth (goods), thus causing inflation.

In my essays “Central Banks for non Economists Part I: Inflation and Taxation”, and “The Socialist Myth of the Greedy Banker”, I describe in great detail how governments use their monetary policy to tax their citizens. However I will say a few words here too in order for this document to be autonomous. From these three ways of financing government spending, the most dangerous one is the creation of money, and the safest one is taxation. Taxation is observed both by the beneficiary and the payee, and therefore it does not create any illusions since both the payee and the beneficiary are fully aware that they are receiving and paying money. However this is not the case with money printing. In this case the payee incurs an obligation which is not obvious. Money creation is an indirect tax in the form of inflation. For instance let’s assume that there are 10 oranges in the economy and 10 euros, and each orange costs 1 euro.

If the government prints another 10 euros, there will be 20 euros running after the same oranges, and their price should increase to 2 euros each (this is an oversimplification of course). The government can now buy 5 of the oranges with the 10 newly printed euros (10/2 = 5 oranges), which means its citizens paid a real tax of 5 oranges. However they were not aware that they were paying a tax. They thought that their money lost its purchasing power because of inflation, and they think inflation is an exogenous phenomenon. It is exactly this difficulty on the part of the tax payer to understand the relation between money creation and taxation that makes financing government spending through money creation (inflation) so popular with politicians. I can now continue in demonstrating various ways that government policies can create bubbles. As I already mentioned, my examples will not be exhaustive, and they are meant to present only some of the possible ways that government intervention creates asset bubbles.

A Primitive Example of Government Induced Bubbles

I now want to use a second example of government intervention and bubble creation. Imagine a closed economy with no foreign trade and no paper (fiat) money. Let’s assume there are only two kinds of professions, the orange producers and the house builders. Oranges do not perish. People eat oranges to survive and build houses to protect themselves from the cold and rain, and when they can afford it they improve these houses to make them more comfortable. Therefore oranges cover a more basic need, and housing a more luxurious one.

For simplification imagine that house building is a pure service. House builders do not buy or sell materials. They only use their skills to build houses with whatever materials they find around. In the real world each person has his own personal preferences towards consumption (eating oranges), savings (saving oranges) and housing (giving oranges to house builders) etc, but in order to build an example, I will assume that all people have identical preferences, and want to consume 50% of their income (eat 50% of the oranges they have), save 30% of them (save 30% of the oranges they have), and invest 20% in housing (giving oranges to someone to build them a house, or eating oranges themselves while building a house themselves).

Thus the economy’s appetite for consumption, savings and housing is 50-30-20, it is constant, and identical for everyone. To invest in housing for the orange producers means to give oranges to a house builder, in order for the latter to build a house for them. To invest in housing for the house builders means to eat oranges previously earned for building houses for themselves. And let’s also assume for simplicity that productivity is constant, which means that to build more houses you must produce less oranges, and to produce more oranges you must produce less houses. In other words I assume for simplicity that there are no positive productivity shocks.

Please note that savings are not equally spread in the population. I assumed for simplicity that all people have equal tastes regarding consumption, savings, and housing (50-30-20), but that does not mean that they are all equally good in production. I did not assume wealth is evenly distributed in the economy. There are rich and poor. The oranges that were saved are not evenly spread. Some people produced more than others, and therefore the 30% of their savings amounts to a larger number of oranges in absolute terms.

Let’s assume that we are at time 0, and the government sets up a central bank, where people deposit their oranges (savings). In the first year the economy produced 100.000 oranges. Therefore at the end of the year the citizens have consumed 50.000 of them, have deposited at the central bank 30.000 oranges, and have invested in housing 20.000 oranges. Let’s assume that next year they produce another 100.000 oranges. However the government needs some oranges to finance some expenditure. Let’s assume it wants to help some of the poorest citizens. Or it wants to construct a road. But because it does not want to tax its citizens, it takes their savings of 30.000 oranges and distributes it to the poor or use it for the road. And it replaces the oranges in the vault with pieces of paper that say how many oranges each citizen had, in order to pay them back at later more affluent times. Therefore there are now 130.000 oranges circulating in the economy during this second year. The 100.000 oranges produced, plus the 30.000 that were saved last year and which were thrown back in the economy by the government.

But the citizens’ tastes have not changed. Therefore they consume 50% i.e. 65.000 of the 130.000 oranges, save 30% of them i.e. 39.000 (130K * 30%) of them, and invest in housing 20% of them i.e. 26.000 (130K*20%) of them. Notice that total savings are 39.000 (0 left from last year plus the 39.000 oranges of this year), but citizens think they have saved 69.000 oranges, because they have not realized that the government has used their savings. Moreover notice that this year citizens invested in housing 26.000 oranges, while their true wish would have been to invest 20.000 oranges (i.e. 20% of the real production). But they were fooled by the 30.000 oranges that were thrown at them by the government, and which they perceived as new wealth, while in reality it was their last year’s savings. That means that the economic agents’ behavior was altered not by real factors but because of the government’s policies, and this led to higher consumption, higher investment in housing, and lower savings, all these contrary to the citizens’ wishes and without their knowledge.

In reality, the artificial increase in housing activity could have only been generated by a movement of workers from orange production to housing construction. Remember I assumed for simplicity constant productivity. If the government continues to throw savings in the economy, the increased investment in housing and the increased consumption will continue, which means that more and more workers will move from orange production to housing construction. As this process continues, orange production will keep falling, savings will keep falling, and housing construction and spending (orange eating) will keep rising. But as this process continues the government will find it increasingly hard to provide the same quality of social services, since orange production which satisfies the more basic needs is falling.

This situation is not sustainable. To build houses you need orange production to sustain the workers in the housing industry. At some point everybody will realize that there is not enough orange production to fund the house construction industry i.e. the economy does not produce enough oranges to feed so many workers in the housing industry, which means that some house builders will have to move from house construction to orange production. Citizens will realize that the prospects of the economy are not good, and will be panicked. They might rush to take their savings from the central bank. But to their surprise there will be no savings or there will be only a part of it. Everybody will try to sell their houses in order to get more oranges.

But because they are all trying to sell their houses and buy oranges, the prices of houses collapse. Actually the price of houses relative to the price of oranges must fall, since it became apparent that the economy has too many houses and too few oranges. But the panic makes things even worse. And citizens find it very difficult to find someone to pay them a descent amount of oranges for their houses. The reason that this happened is that an imbalance was created in the economy. Due to government intervention, the economy produced more housing and less oranges than the citizens wanted and could afford. This can now be only corrected by a painful depression. A reverse process must begin for the economy to go back to equilibrium, where workers must move from the housing business to orange production.

Unfortunately this cannot be done immediately because orange production requires a different set of skills than housing construction. Moreover people find it very painful to change professions and industries since they must start from scratch i.e. in a field they have not at all expertise, which means a decrease in their standards of living. Most of the citizens however, believe it was the free market that led to the misallocation of resources. They do not realize that it was the government’s mistake. And they are not helped by the media to realize it, since in every country the political system is always very well represented in the media. There will be growing political tension.

House builders will be losing their jobs and will be asking for more government protection, and house builders and orange producers will be asking the government to give them back the oranges they deposited. There can be riots or even a civil war between orange producers and house builders. Politicians will not accept responsibility and will try to persuade the public that the damage was caused by someone else i.e. capitalism, private banks, the Jews etc.

Introducing Paper Money

The above example might not seem very realistic, but unfortunately it is not far from reality. Actually in reality it is much easier for governments to steal peoples’ savings/ “oranges”, because the good which is used as money (and as a store of value) is not a real good (i.e. oranges, gold etc), but paper money instead. Paper money is not a real good and it derives its value by a government law which establishes it as the legal means of payment. Therefore in monetary economies people do not save in real goods but in paper made by governments. In the example with the oranges, there was always the possibility that citizens’ would lose their confidence and ask to see their oranges, but there would be no oranges since the government cannot create oranges. This is a constraint for governments since it imposes a limit on the money creation process. However with paper money, the government can create as much paper money as it wants and can therefore confiscates its citizens’ savings without them noticing.

And even if they notice it, the government can always produce more paper to pay them back. Therefore even though my previous example seemed a bit simplistic, in reality it is even easier for governments to steal their citizens’ savings. But citizens are not aware that this is happening, they feel wealthier when the government is throwing paper money at them, and they do not change their consumption/savings patterns to account for the reduction in their real savings, which is a reduction in their real wealth, and they might even feel wealthier due to the expansionary government policies and increase spending, housing purchases etc.

Interest Rates, Real Savings and Paper Savings

In previous sections I explained how governments can distort the market mechanism by irresponsible fiscal and monetary policies. But I omitted the main distortion caused by such policies, namely the effect such policies have on interest rates. The interest rate is the price investors have to pay if they want to borrow savings. If for instance the interest rate is 100%, it means that to borrow 1 orange of savings today, an investor has to pay 2 oranges in a year’s time i.e. a whole extra orange is the price for borrowing one orange of savings today (that is with an interest rate of 100%). The level of interest rates i.e. whether you pay 2%, 10% or 20% when you borrow savings, depends on the quantity of savings in the economy. The higher the quantity of savings the lower their price (interest rate), and the lower the quantity of savings the higher their price (interest rate).

Imagine an economy with 1.000 people who produce 1 orange each (1.000 oranges in total). And assume that everyday they need 1 orange each to survive. With less than that they die. For the economy to grow, there must be some people who do not work in orange production, but they spent their time constructing machines that will enhance orange production i.e. tractors, or building houses to improve the standards of living etc. People that will undertake such projects need to borrow savings i.e. oranges, to sustain themselves during the investment period, and pay for the savings they borrow when their investments bear fruits, which by the way is not certain (investments can go sour too).

But it is impossible to borrow in such an economy since each individual produces 1 orange and needs 1 orange to survive. Therefore if I wanted to borrow some oranges everyday in order to invest in something, it would be impossible. What would the interest rate in this economy be i.e. what would the price (interest rate) an investor would have to pay in order to borrow oranges? It would tend to infinity, because if a person wanted to save his orange and lend it to an investor, that person would die from famine, since I assumed each person needed at least 1 orange per day to survive. If the 1.000 people of the example did not only produce 1.000 oranges every day, but a bit more, interest rates would not tend to infinity, but they would be extremely high, because in a poor agricultural economy savings are very valuable, and people are very reluctant in using their savings to fund more sophisticated or luxurious projects. They worry about satisfying their most basic needs.

Very high interest rates are a signal to investors that there are not enough savings in the economy i.e. oranges are very scarce and valuable to citizens. They are therefore very reluctant to invest in luxuries i.e. better houses. They feel the pressure to invest in something that will deliver oranges quite fast i.e. in the next period. Because even when you invest in something that ultimately delivers oranges and not something more luxurious (houses), you have to decide on the time horizon of the investment. If oranges are scarce and interest rates for borrowing them are very high, an investor would go for the development of a simple tool i.e. shovels which would increase orange production soon. If on the other hand there is an abundance of oranges (savings) and the price (interest rate) of borrowing savings is very low, investors would go for a more ambitious and of longer term projects i.e. to develop tractors.

We therefore see that the interest rate is the price of borrowing savings (oranges), and the price of borrowing savings is one of the most important factors that businessmen take into account in order to decide whether a project is profitable or not. The lower the interest rates the more projects are profitable. A project that is profitable with an interest rate of 2% might be unprofitable with an interest rate of 10%. What I am trying to say is that interest rates play a major role in what will be produced with an economy’s savings i.e. oranges or houses, but they also play a major role on the time horizon of investments i.e. whether shovels or tractors will be produced. Prices are extremely important in free market economies, but if one had to decide which price is of the greatest importance, it would probably have to be the price of borrowing savings i.e. the interest rate. If the price of bread is for some reason distorted by government policies i.e. because of subsidies or tariffs it is of minor importance compared to distortions in the level of interest rates which have a much wider effect on the economy, since they play a major role in the process of savings allocation.

Interest rate is the free market mechanism that ensures savings will be directed towards the uses most preferred by the owners of these savings i.e. the people who had surpluses in previous years i.e. people with deposit accounts. To distort the interest rate mechanism, is to distort the ability of the economy to transform savings into something that depositors would exchange for their savings. It is mainly this distortion in interest rates caused by irresponsible fiscal and monetary policies that causes the creation of economic bubbles.

With the system of fiat (paper) money, governments can not only confiscate the economy’s savings without the owners of the savings (depositors) noticing as I explained before, but they can also artificially decrease interest rates (the price of borrowing savings), in order to make borrowing cheaper, thus boosting economic activity as I will now explain. Politicians always like low interest rate because they boost economic activity, and increased economic activity makes politicians popular. Imagine an economy where the medium of payments and the store of value are golden coins. In this economy, if I save an orange, I exchange it for let’s say a golden coin, and I keep my savings in gold. Gold is a scarce and real good like all other goods. It takes a lot of effort to produce gold. Sometimes more gold will be produced sometimes less, and accordingly its price relative to the prices of all other goods will fluctuate, in the same way that the price of apples will fluctuate relative to the prices of all other goods according to supply and demand. If for example there is enough gold, and what the economy needs is oranges, the price of gold will start falling relative to the price of oranges, which means people will start moving from the production of gold to the production of oranges.

Therefore when savings are kept in the form of a real good i.e. gold etc, the government cannot affect the price (interest rate) one has to pay for borrowing these savings, since the government cannot influence (increase or decrease) the quantity of savings (gold). And if the government cannot affect the quantity of savings (gold, oranges etc), it cannot affect their price either (the interest rate one has to pay to borrow these savings). But with fiat money, savings are kept in paper (fiat money) or electronic form (deposits), and the government can create as much of it as it wants. Therefore through its central bank it can increase the supply of paper and electronic savings until the price of borrowing savings i.e. the interest rate of borrowing paper savings, increases or decreases to the level that satisfies the government’s objectives. And that’s exactly what governments do. They print paper savings to buy (confiscate) a part of the real savings, and they ask banks to expand electronic savings (credit), in order to decrease interest rates and boost economic activity too.

These actions have the following simple implications. Let’s say I have savings of 10 oranges. A part of it, let’s say 5 oranges, is confiscated by the government i.e. the government prints paper money and buys these 5 oranges directly and does whatever it wants with it. I am under the impression that I sold the 5 oranges while in reality they were confiscated. Investors can borrow what is left from my savings i.e. the other 5 oranges in order to invest them in something useful and profitable. However most of the time they pay a much lower price (interest rate) to borrow my real savings than the one dictated by economic fundamentals, because governments perform a credit expansion through their central banks (an increase in paper and electronic savings), in order to lower interest rates and boost economic activity.

Therefore an investor goes to the bank, he takes a loan in paper or electronic form, and comes and buys these oranges from me, and I in turn take this paper money and deposit it to the bank, and earn an interest rate on my paper savings. The interest rates that the investor pays and I earn, are much lower than the interest rates he would pay and I would earn if the government had not ordered a credit expansion i.e. an increase in paper and electronic savings.

Therefore not only I lose the 5 oranges that were confiscated by the government with the newly create money, something I did not realize and therefore I feel wealthier than I really am (and I therefore spend more and save less), not only my savings are lent at interest rates that are much lower than the ones dictated by market fundamentals, but also the entrepreneurs that borrow the other 5 oranges which were left, receive the wrong signals from the very low interest rates that they have to pay. They are fooled to believe that there is an abundance of savings in the economy. Many projects seem to be profitable only because of the low interest rates one has to pay to borrow paper savings. But this is an illusion because lower interest rates are the result of the increase in paper and electronic savings, and not the result of an increase in real savings (“oranges”). That’s the problem with credit expansions. Credit expansions do not create more real savings they only lower the interest rate one has to pay for borrowing real savings.

Moreover with government induced credit expansions, consumers can borrow at very cheap rates too, and they might thing that it is a good idea to borrow in order to buy a house, a car, a holiday, or to invest in the stock market etc. I might decide to borrow to buy a house with an interest rate of 5% but maybe I would have decided differently if the interest rate was 15%. The point is that increases in paper and electronic savings are fake expansions of savings, but they have very real effects on the behavior of economic agents, and this smells like a bubble. At the end of this process, savers end up in a situation like the one described in my first example, where the person who saved the 1.000 oranges only had the option to exchange his savings with a house he did not value as much as his savings. Unfortunately a part of his savings was confiscated by the government without him realizing, and the other part was lent at artificially low interest rates and as a result it was malinvested.

He is therefore very upset, and the government instead of explaining him what really happened, it tells him that it guarantees his paper savings. But what it does not tell him is that his real savings i.e. the “oranges” are gone. Some of them were confiscated by the government (the ones confiscated with money creation) and some were misallocated by the private sector due to the artificially low interest rates that followed the aggressive monetary policy and the credit expansion. He is therefore left with paper savings and inflation or hyperinflation. The government by assuming responsibility of the savings (guaranteeing the savings), is essentially asking the tax payer to pay for these savings, which is called a “bail out”. The other option is to let depositors to lose their money, which is called a “bail in”.

Is It Moral for a Government to Use the Economy’s Savings?

Before I continue with government distortions, I would like to clarify something. The aim of this essay is not to discuss how moral it is or it is not for a government to use its citizens’ savings. This is a very different issue, namely whether socialism is better than capitalism and whether equality is better than freedom. The aim of this essay is not to defend capitalism and freedom over socialism and equality. The aim of the essay is to demonstrate that it is government intervention that creates asset bubbles.

All the above distortions could have been avoided, if only the government had used taxation instead of monetary policy to finance its spending. Taxation does not create the illusion of wealth. People that pay for the social network through taxation are fully aware that they are paying, and they are not under the illusion that they are saving as the citizens of my examples were. Taxation does of course increase interest rates, because when a government is using a part of the economy’s savings, the quantity of savings that is left for the private sector is reduced, and therefore its price (interest rate) rises. But if the supplies of real savings fall interest rates must rise, so that investors receive the right signals and react accordingly, in order not to misallocate them (do not built houses instead of tractors).

Therefore the question is not whether the socialist principle of redistribution is correct or not. The issue is that socialist and interventionist governments should mainly use taxation as a form of financing their expenditures, in order to keep economic agents informed about the real wealth they possess. The problem is that the more socialist and the more interventionist a government is, the more it needs monetary policy as a means of taxation, since heavy taxes are never popular. On the contrary, the less socialist and the less interventionist a government is, the less it needs monetary policy, since some reasonable taxes are welcomed by everyone, and these reasonable taxes suffice to finance the activities of a market friendly government. And this is the reason that free market proponents are always in favor of passing laws that require balanced government budgets (no deficits). With balanced budgets (government expenditures equal government revenues i.e. taxes), and a government can only finance its policies through taxation, and therefore socialists and statists cannot fool voters by using monetary policy as a source of redistribution.

Trade Deficits

In the previous examples I discussed misallocation of savings due to irresponsible fiscal and monetary policies within the same country i.e. for countries with production surpluses. However this is the good scenario. At the end of this process, banks owe money (savings) to depositors (whose savings were used), and these savings are not available. The good thing is that people with savings/deposit accounts are domestic citizens. They do not want to exchange their savings with these houses, but at least they are local citizens. After all, the government can say to local depositors “gentlemen, unfortunately your savings are gone, and now whether you like it or not you will take the houses held as collateral by banks in exchange for your savings/deposits”. That’s basically the outcome whether the government chooses a bail out or a bail in solution i.e. whether depositors’ money is guaranteed by the government and the taxpayer, or whether depositors lose their money. But since depositors are also tax payers and tax payers are also depositors, these solutions are not as clear-cut as they seem to be. I personally think that bail ins are a bit more fair than bail outs, but this is open to discussion.

However things are more complicated when it is foreigners’ savings that have been used to finance the bubble. For instance the American and the Greek housing bubbles were financed with Chinese, German and other exporting countries savings. It is even worse when the misallocation of savings is not of domestic but of international nature. How can the Greeks say to Germans, Chinese etc that they will have to take the Greek stock of houses held as collateral by the Greek banks, in exchange for the loans they made to Greece, which were the savings of the German and the Chinese people? This situation does not only create political turmoil domestically, but it also creates international tensions and potential conflicts in the international arena.

USA and China

A classic example of a housing bubble that involved international misallocation of savings i.e. misallocation of foreign savings, was the American one. The American bubble was funded through a flood of imports flowing from China to U.S.A. (from elsewhere too, but the main trading partner of U.S.A. was China). On one side there was a country hungry for imports i.e. U.S.A., and on the other side there was a country hungry for exports i.e. China. Huge production surpluses were flowing from China to cover huge production deficits in U.S.A., and huge numbers of securities (i.e. government and corporate bonds/debts) were flowing from U.S.A. to China to cover for the deficits in trade. For instance China was sending to U.S. a 50$ television and the U.S.A. was sending an American bond (debt) of 50$ to China (in a massive scale though).

It was therefore very easy for American people to obtain “oranges” from China. It was so easy that nobody had to worry about “oranges” anymore. Everybody worried about improving their standards of living i.e. buying nice houses, nice cars etc. Until one day the Chinese realized that it was not such a clever idea to send their “oranges” to the USA for the Americans to build nice houses and military aircrafts, since these nice houses and military aircrafts would not produce “oranges” to pay them back. Moreover the Americans realized that their “orange” production had decreased dramatically, and they had become very dependent and indebted to the Chinese.

Moreover the Chinese did not want to exchange their savings/oranges (which were lent to the U.S.A.) with the houses, the cars etc that were made with these savings/ “oranges” in the U.S.A. Maybe they would be willing to exchange a part of it with the military aircrafts that were made with these “oranges”, but of course the Americans would not agree. At some point, the Americans who were living in these houses, and were driving the nice cars stopped paying their mortgages and loans, and since the people (Chinese) whose savings had been used to produce these houses and cars did not want to take them in return for their savings, the prices of houses and cars etc collapsed, and the banks who were the intermediaries went bust.

One might say that the above situation is a free market flaw, but it is not. As I explain in my essay “Free Trade or Protectionism? The Case for Free Trade”, under a regime of free international trade it is impossible for significant trade imbalances to arise. However things are very different when international trade is conducted under heavy government intervention, which was the case in the American-Chinese trade relations. In the same way that it takes two to tango, it takes two to generate a great trade imbalance. Let’s assume that only the American government was willing to borrow excessively while the Chinese government was not willing to lend excessively. The U.S.A. would start importing excessively Chinese goods, but if the Chinese government was not interested to systematically fund American deficits, it would not intervene in foreign markets, and there would therefore be less demand for dollars and greater demand for yuans.

The higher demand for yuans would make the yuan more expensive vis a vis the dollar, making American goods more attractive for the Chinese, and Chinese goods less attractive for the Americans. In addition, the flood of the Chinese imports in the American markets would cause an increase in unemployment in the U.S.A. This would put downward pressure on American wages, making American goods cheaper and more attractive to foreigners. All the above would reverse the flow of imports. In a nutshell, when I trade with my neighbor, even if he is better in everything, if he does not want anything I produce, there will not be a trade deficit, because he will not desire any of my products, and if he does not desire any of my products he will not be willing to offer me any of his products either. But things are very different when you have an American government hungry for imports, and a Chinese government hungry for exports.

The Chinese government did want to fund American deficits, and the American government did want to run these deficits. The Chinese would therefore print new yuans, and use them to buy American bonds (from both the public and private sector), essentially giving American people yuans to buy Chinese goods, and thus creating artificially a high demand for the dollar. The Americans would use these yuans to import Chinese goods. Therefore even though Americans were asking huge quantities of yuans to import Chinese goods, the price of the yuan would not rise relative to the price of the dollar, because the Chinese government was offsetting the downward pressure on the price of the dollar by asking for dollars i.e. by buying dollars i.e. by buying American securities i.e. mainly American government bonds i.e. by lending to Americans in order for the latter to keep running deficits and keep buying Chinese goods. Thus the yuan would remain artificially cheaper and the Chinese competitiveness would not decrease, as would have happened under a free trade regime.

Moreover you have to keep in mind that China is under a Communist dictatorship, and therefore wages are set by the communist government and not by the market. Therefore wages would not rise as a result of the increasing demand for Chinese products as would have happened under a free market regime, since the Chinese government would not allow this to happen, and therefore the competitiveness of the Chinese economy was again kept artificially high.

But as I already said it takes two to tango. At the same time the Americans allowed an unprecedented credit expansion to take place at home. The huge credit expansion led to very low interest rates. Therefore economic activity did not decrease because Americans could borrow at very low interest rates and buy Chinese savings/“oranges”, and they could do whatever they wanted with these “oranges” i.e. eat them, build houses, invest in tractors etc. Unfortunately this is a recipe for bubbles. The bubble did not have to manifest itself in housing. It could have appeared somewhere else. But both Democratic and Republican governments were very active in channeling funds to the housing industry. If they had channeled them somewhere else, the bubble could have appeared somewhere else. Actually housing was not the only American bubble but that’s not the issue here. The above hunger of the U.S. to increase their standards of living and finance their wars, and the hunger of China to keep its economy rising by boosting competitiveness and exports, led to the American bubbles. However this crisis would have not happened if the U.S. and the Chinese governments had not undermined the free market forces.

But they did undermine the free market, and they ended up in a situation where Chinese savings were used to fund the American housing bubble and other American expenditures, and the Chinese are not happy about it, since the Americans are now paying them back by printing “soft” fresh dollars, doing what is called “debt monetazation”. monetizing your debt is good since you do not pay your debt, but it creates tensions with the creditor countries, and moreover it involves the risk of destroying your currency through excessive use of the printing press i.e. high inflations or even hyperinflations at the end of the process. Therefore the American bubbles involved the misallocation of mainly Chinese savings into American houses, cars, military aircrafts etc.

The Eurozone Crisis

With the introduction of the euro, the socialist Southern European countries had access to very cheap credit, since people thought that the euro would be a copy of the Deutsche Mark, and moreover that the northern countries would guarantee the debts of the southern countries. I have to say that the socialist South believes much more than the European North in using monetary policy aggressively for redistribution purposes. You have to remember that in monetary economies people do not save in real goods i.e. oranges, gold etc. If I have a surplus of an apple, I sell it for let’s say 1 drachma (the Greek currency), and I store my surplus/savings of 1 apple in drachmas.

Therefore the socialists can print more drachmas and confiscate part or all of my savings without me realizing at least for a while, what happened to my savings. The Southern European countries i.e. France, Spain, Italy, Greece, are socialist in the more traditional sense i.e. the do not only believe in redistribution, but also in heavy interventionism, and monetary policy is always the best tool for interventionism. On the other hand, the Northern countries had a lot more respect for their citizens’ savings, and would not fool them by taxing them indirectly through money creation. They were doing it too of course, but to a much lesser extent compared to the South. And you should not think that the Southerners are more sensitive when it comes to social issues. If you look at the following Eurostat link, you will see that spending for education (green color), health (light green color) etc are not lower in the Northern countries compared to the socialist south. The only difference is that the politicians of the Northern countries are more honest than the ones of the South.

Eurostats: General government expenditure by COFOG function, 2011 (1) (%25_of_GDP)

Therefore the Northerners were much more restrained in their monetary policies compared to the Southern countries, with Bundesbank being the best example of an independent central bank, which was beyond the political system’s control, and could not be used during elections etc. As a result people all around the world preferred to put their savings in the currencies of the Northern countries, since they knew that if they put them in the currencies of the Southern European countries, the socialists would confiscate them by money creation. As a result, the Northern currencies, and especially the Deutsche mark, were always embarrassing the currencies and the governments of the South, who very often would have to devalue their currencies and offer higher interest rates to depositors as a result of their aggressive monetary policies. After the fall of the Berlin Wall in 1989, the Germans had to surrender their currency to the socialist South (especially France), in order for the winners of WWII to allow the reunification of Germany.

The political background of the euro is beyond the scope of this essay, but those interested on the politics of the euro should read “The Tragedy of the Euro” by Philip Bagus, which is a great account of the Eurozone adventure. You can read this book at for free, or you can buy the kindle edition at Amazon. However the main economic issue, which is the one that led to the Southern housing bubbles, is that the socialist politicians of the South were suddenly found with Northern European credit cards in their hands, since investors saw the Greek, the Italian, the Portuguese debt as guaranteed by the Germans and the other Northerners. And the socialists of the South decided to do what socialists very often do. They used these northern “credit cards” to go shopping. According to the agreement for the common currency, Eurozone members were supposed to avoid budget deficits or keep them at very low levels. Unfortunately there was no mechanism to enforce fiscal discipline to the socialist South. This was a road which guaranteed the creation of bubbles.

Therefore because of the euro the southern countries had access to rivers of borrowed funds. There was a situation with irresponsible governments that could borrow savings/ “oranges” at very low prices (interest rates) using the credibility of the European North. And that’s exactly what they did. Now there is a lot of tension because the Northerners are very upset for having to pay irresponsible southern policies. They ask the southerners to liberalize their economies and make them more competitive in order to be able to produce more. However the southern countries don’t want to change their socialist and interventionist economic models. They want the northerners to pay even more than they are already paying, which generates even more tension.

In a nutshell, the bubbles of the European South were funded by the savings of people who thought that the Greek euros were identical to German euros etc. Therefore the bubbles were not created by the free market, but by establishing a common currency without first establishing a mechanism that would impose fiscal discipline on irresponsible southern politicians.

The motives of the American and the southern European governments that led to the bubbles were quite different, but the outcomes were quite similar. A flood of imports/ “oranges”, a lot of cheap credit, and too many houses, cars, holidays etc. The U.S.A. is not a socialist country though. Even though the U.S.A. has moved a lot from the ideal of freedom towards the ideal of equality, it is still a much more free country than the European countries which take equality much more seriously than freedom. I believe that if they didn’t have to fight the wars they would have not used their monetary policies in such an irresponsible way. The story is quite different for the socialist Southern European countries where redistribution counts a lot more than freedom as a policy objective. The Southerners would use their monetary policies aggressively even if they did not have to finance a defense system, because monetary policy is the most efficient way for redistribution. But at the end of the day, if you ignore the different motives, the mechanics of the bubbles were quite similar.

The American Great Depression of 1929

What China was doing in the 21st century i.e. exporting and lending to everybody, the U.S.A. was doing in the 1920’s. The U.S.A. was one of the few industrial countries (together with Sweden) that did not have battles on its territories (with a few exceptions i.e. Pearl Harbor).

The U.S.A. not only had to help the allies during the wars, but they also had to help them after the war in order for the latter to rebuild their countries. Actually they were not only helping the allies, but even the axis powers i.e. Germany. Helping the destroyed European continent involved huge costs. It is not a coincidence that the U.S.A. did not establish a central bank until 1914 (actually December 1913). On December 1913, the Federal Reserve Bank (the American central bank) came into being. It can be no coincidence that the American central bank, the Fed, was established at the outbreak of the First World War (1914-1918). It is a very common practice for all countries to use their central banks during wars in order to finance their military expenditures. The U.S.A. was not an exception to this rule.

From 1914 until the crash of 1929, there was a dramatic increase in the money supply in the U.S.A. American governments not only wanted to help their allies, but they also wanted to protect American producers from foreign competition i.e. farmers etc. They therefore imposed tariffs as a means of protecting American producers with political influence. This made it even harder for the rest of the world to buy badly needed American products, since it was even harder for them to sell to the U.S.A. their own goods, obtain dollars, and use them to buy the huge American production surpluses. American governments should have abolished tariffs in order for foreigners to be able to sell to the U.S.A. and obtain dollars to buy American goods. But instead of doing that, they started to encourage foreign lending, in order to help their allies, and protect their producers at the same time. They were therefore printing dollars, handing them to foreigners, who in turn used them to buy American goods. This was taking place both through the public and the private sectors. American governments were even encouraging the private sector to lend abroad.

The ability of the foreigners to repay these loans was not taken into account though. The lending was mainly based on politics. These foreign bonds were toxic bonds, and they were the equivalent of the toxic sub-prime mortgages of 2008. Foreign bonds held by Americans were the bubble of the time. They were a bubble in the sense that they represented savings of the American people who were lent or given in the form of help or lending abroad, which were never going to be paid back. They were a bubble in the same way that the American bonds held by the Chinese government today are a bubble since the Americans cannot pay them back with real goods but only with freshly printed dollars. Therefore the savings of the American people were misallocated in the 1920’s i.e. they were handed to foreigners who did not have the ability to pay back. At the same time the very low interest rates that resulted from the expansionary monetary policy in the U.S.A. distorted production and even led to a housing boom.

I am not judging whether American governments were right or wrong to help foreigners. I am judging the way they did so i.e. by indirect taxation i.e. by money creation. After the 1929 crash, foreign bonds held by Americans were selling at about 10% of their face value i.e. they lost approximately 90% of their value, which was also what happened to the bonds for the sub-prime mortgages of 2008. What happened to American people during 20’s is what recently happened to the Chinese people.

Once the foreign bond bubble burst, the foreign demand collapsed and so did the demand for American exports. The American economy had to readjust to absorb this great decline of foreign demand. The American automobile production capacity was 2 million vehicles annually in 1920 and increased to 6 millions in 1929. Automobile sales were 5.3 million vehicles in 1929 and decreased to 1.4 million in 1932.

It is therefore ridiculous to blame the free market for the 1929 crash. It was a period of world wars. Even in the freest economies of the world i.e. U.S.A. , governments were deciding what and how to be produced. And you have socialists advocating that the 1929 crash was caused by the free market. What can you do? Socialists…..

The Dutch Tulip mania of the 1634

Before the appearance of central banks it was very difficult to tax people by money creation. There were ways of course to do so, none of which had the efficacy of a central bank and paper money. For instance very often a king would ask his people to hand in their golden coins, and would debase these coins. For example he would make 3 out of each golden coin, and would give only 1 of them to the person who had handed in the original one. This was in effect a means of taxation, and such actions were a primitive form of central banking.

In early 17th century (1600-1699), Holland was one of the most dominant forces in European commerce. Even New York was originally under the control of the Dutch and was originally called New Amsterdam before the English took control of it and renamed it. At the time each country had its own coins, but it was difficult to be sure of the quality of these coins, and this was a restraint to trade. The Dutch government allowed free coinage. Free coinage meant that anyone could hand in his gold, and they would be minted to golden Dutch guilders by simply paying a commission. Moreover the Bank of Amsterdam was established in 1608, which offered deposits covered 100% by gold. In other words I could hand in my gold, and would receive a deposit for that gold. These deposits were highly regarded, since they were a uniform means of payment and did not carry the risk of golden coins which could be fake etc, and moreover they were covered 100% by gold.

This was a period that the Spanish and the Portuguese were stealing the gold of the Indians in Latin America. They were literally stealing it (their jewelry), but they were also using them as slaves to extract gold from the gold rich Latin America. The Free coinage regime in Holland, the provision of a sound monetary system, and the commercial significance of Holland, made a lot of this gold to find its way to Amsterdam. Having the Latin Americans working as slaves in order to extract gold and stealing this gold, was in essence like having a central bank. Of course gold can never be like fiat money, because even with slaves there is a limit to its production, while there is no limit in the production of fiat money.

There was therefore a tremendous increase in the Dutch money supply which led to the tulip mania. People were buying tulip bulbs at very high prices. The stranger the tulip color, the higher their prices. This frenzy lasted for three years, from 1634 to 1637. This was one of the first bubbles in history. In this case the savings of the Indians were misallocated, and were used in the Netherlands for tulip bulbs and other purposes. But it was a minor bubble compared to the ones created by central banks.


What I said for the socialist European South is also true for Greece. However all the wrong doings of the South are exacerbated in Greece. In this section however I do not want to elaborate on the Greek socialist economic model, with the large and corrupted public sector, but rather to say a few things about the Greek banking crisis.

Greek banks were not very exposed to toxic products of the sub-prime mortgage crisis, but they were very exposed to Greek government debt. With the Greek bankruptcy and the PSI (the haircut in Greek government bonds), Greek banks lost approximately 35 billion euros. To give you an idea of how significant this figure is for the Greek banking sector, I must say that the fortune of one of the richest Greek banker, Spyros Latsis, is according to forbes’ list 2 billion euros. We all now that if he tried to sell everything he would obtain much less but anyway let’s pretend it is indeed 2 billion euros.

Spyros Latsis was the biggest shareholder of EFG Eurobank, one of the major Greek banks. And the Greek bankruptcy imposed a cost of 35 billion euros to the Greek banking sector. It therefore wiped out all of the big bankers share capital and much more. However this is not explained to the Greek people. The reason is that the Greek banking system was heavily controlled by the corrupted Greek political system, and that’s the reason that all political parties are heavily indebted to Greek banks, and these loans will never be paid back, and the Greek people will have to pay instead. After the haircut of the Greek government bonds, Greek banks had to be recapitalized. For bank recapitalization see my essay “Introduction to Bank Recapitalization”. But the Greek oligarchs did not have or did not want to put additional capital in the Greek banks.

Therefore the Greek government borrowed from the relevant European mechanism and injected more capital in the Greek banks, and the ownership of the Greek banks passed to the Greek state, and at some point it will go back to the private sector. The problem is that the Greek political system is very upset, because the Greek banking system was one of its major sources of funding. Not only in the form of lending to Greek parties, but also in the form of lending to private companies owned by friends of Greek politicians. Therefore Greek politicians do not want to lose control of the banking system. They want to control it either directly by public ownership, or they want the Greek banks to be run by businessmen who are within their control.

For this reason they do not explain to the Greek people what has happened. They blame the Germans, and they say to the Greek people who it is very unfair for the people who borrowed to buy the houses to lose the houses they are living in, and which are held by the banks as collateral. Depositors and taxpayers on the other hand, do not realize that these houses are their ownership and therefore they have no problem with that. Therefore the Greek political system (especially the left) has transformed mortgage owners (borrowers) to hostages, and they have persuaded them that it is the greedy bankers and the mean Germans that want to confiscate their houses. Therefore they have a large part of the electorate that wants the Greek banks to be permanently publicly owned, because they believe the state will let them keep the houses for free.

A main technique used by the Greek political system in order to attack mortgage lenders, is to ask them to count the total amount of payments they made to the banks. For instance if the monthly payment is 600 euros, and if they have been paying for 10 years the amount is 72.000 euros. And they tell them the capital paid is much smaller i.e. 30.000 euros, and therefore the banks are stealing them by charging too much interest. And they do not explain to them that in the first phases of a loan, the debtor has to pay a small part of the capital and a large part of the interest in order for the monthly payment to be small (because the full amount of capital is owed). As time goes by, capital owed is reduced and interest payments start falling, and at the end of the loan most of the payment covers capital and a small part covers interest.

But throughout the whole period the interest rate is 3%-4% something like that, which is extremely low. If I go now (2014) to borrow money from the Greek banks, they will not give me credit. And if I try to borrow from outside the banking system, I might have to pay 15% or even 20% to borrow, and that’s IF I find someone to lend me money. And at the same time the interest rates for people who borrowed to buy houses are kept at artificially low levels i.e. still in the region of 3 to 4 per cent. The low interest rates are not real, and it is the European Central Bank that keeps interest rates artificially low. And at the same time you have the Greek politicians saying to the Greek borrowers (mortgage owners) that the banks are stealing them, only to have them ready to ask for banks to become permanently owned by the state, so that politicians do not lose their control.

They do not say all the things I have said in this essay i.e. that the Greek political system has stolen the savings of the Greek people either in the form of deposits or in the form of insurance and security payments. And that in reality the houses held as collateral by bankrupt banks is these people’s property and not the property of borrowers. It is with their savings/ “oranges” that these houses were built, and not with the savings of the borrowers. But all Greek politicians care about is not to lose control of the goose with the golden eggs, and they therefore need borrowers as hostages. Therefore people have no idea about how their savings have been misallocated, and how the houses held by banks are these misallocated savings, and so they are not angry. Borrowers at the same time think that the houses they are living in, and for which they have stopped paying are their property and that the greedy bankers want to steal them from them. Therefore foreign banks will not dare to buy Greek banks, since they know that the Greek political system can turn borrowers against them. Only with the blessings of the Greek political system a foreign bank will dare to invest in Greek banks.

Free-Market versus Government Induced Bubbles

As Murray Rothbard says in his famous book “America’s Great Depression”, main economic crisis of the bubble type that we experience today, appeared approximately in the 18th century (1700-1799). Before the 18th century, there were major crisis, but their causes were obvious. There was for instance a drought which would destroy agricultural production and would cause famine. Or there would be a war which would destroy the production process. Or there was a king who would confiscate most of his citizens’ wealth for some purposes. The causes of major economic crisis were always very visible and very easily explained. It was from the 18th century (1700-1799) onwards, that major crisis would arise, and which could not be easily explained. In other words after the 18th century, the causes of major economic crises stopped being obvious.

So in what respect was the world different in the 18th century? There were two major changes. One of them was the industrial revolution (approximately 1760), and the other was the appearance of central banks, with the Bank of Sweden being the oldest central bank, and the Bank of England being the second oldest one (Bank of Sweden 1656 and Bank of England 1694). According to socialists, crises are the result of the industrial revolution and the free market, and according to the free-market economists (mainly economists of the Austrian School) the crises are caused by central banks. Since socialists blame it on the market they ask for more government regulation, and since free-market economists blame it on governments they ask for less government intervention.

Socialists and interventionists use various theories to explain crises and bubbles. Very famous explanations are the “over production” crisis theory, the “under consumption” theory, and the “speculative” or “behavioral” explanations of crises.

Under Consumption Theory

The under consumption theory is a Marxist explanation of crises. Marxism has long been discredited as a valid economic theory. In my essay “Why Marx Was Wrong”, I explain why the Marxist theory is discredited as a valid economic theory. But let’s assume that the Marxist theory was a valid one, and let’s examine housing bubbles using the under consumption theory. According to this theory, capitalists (producers) exploit poor people (workers), and therefore the latter do not have the purchasing power to absorb what they produce i.e. houses (or some other goods in bubble markets).

However Marxists fail to answer the most important question. Why prices do not fall enough for surpluses in the bubble markets to be sold? There are two possible explanations why sellers do not lower their prices. The first one is that sellers wait to obtain better prices in the future, and the second is that the current market prices do not cover costs. Which one of the two we observe today? If sellers could afford to wait, they would not be under extreme pressure, and they would not face the threat of bankruptcy. Is that what we see with banks for example? No, it is not. What we see is the second case i.e. the market prices of the houses held by banks as collateral, cannot cover the loans that were provided for these houses, and the banks go bankrupt.

But then the problem is not that the market cannot absorb these houses. If prices fall enough the market can absorb them. The problem is that market prices do not cover costs and cause bankruptcies. Therefore the problem is that for some “unexplained” reason, all market participants believed that these houses could be sold at higher prices. But then it is not a problem of under consumption, but a problem of misallocation of savings and miscalculation of profits. Put it in another way at current prices i.e. prices that cover bank loans, depositors/savers do not want to buy the houses. But the purchasing power is there i.e. the deposits. These deposits could be used to buy these houses. Therefore we have to assume that the market has used depositors’ savings in the wrong way and it did so in a massive scale.

And Marxists have no explanation of why market participants were wrong in such a massive scale. Shouldn’t we assume that there was an exogenous factor that fooled both producers and consumers? Why didn’t capitalists realize that poor people could not purchase these houses in order to produce something else? Remember that all countries with trade deficits that experience housing bubbles cannot cover their primary needs after the bubbles burst i.e. meat, grain, oil etc. Why then so much was invested in housing and not in meat production for example? Why didn’t capitalists realize that poor people could not purchase these houses in order to produce meat instead?

All Marxists will tell you that the Greek workers were exploited by Greek capitalists and that’s the reason of the crisis, but no Marxist will explain to you, why if Greece had not received the European support there would be many poor Greeks in expensive houses without meat to eat. How could that be?

I believe that a lot of confusion is due to the fact that many people do not realize that the housing bubble is a problem for depositors/savers and not for mortgage owners. The problem is that depositors do not want these houses. These houses were built with the depositors’ savings and not with the savings of the people who do not pay their mortgages. But nobody says that, because they do not want depositors to realize what happened, because if they do realize what happened, they will also realize what their governments did to their savings.

Moreover you have to remember that when a bubble bursts, it is the relative and not the nominal price of the good in the bubble market that must be adjusted. It is the relative price adjustment that is important and not the nominal one. For example during the bubble the price of a house was 1.000.000 oranges when its cost was measured in oranges, and now it has to drop to 500.000 oranges, its cost was 10.000 cars and now its price has to drop to 6.000 cars etc. In other words not all real prices go down. Some prices go up. What is a dramatic decrease in the relative price of the asset in the bubble market i.e. houses, is a dramatic increase in the relative price of all other goods when measured in houses. The relative price of houses drops from 1.000.000 oranges to 500.000 oranges but the relative price of oranges increases from 1/1.000.000 of a house to 1/500.000 of a house. A dramatic decrease in the relative price of houses is matched by a dramatic increase in the relative price of oranges. This is a clear indication that for some reasons the market produced more houses than oranges, and the mistake was not corrected for a long time. It is a clear misallocation of savings.

In a free market relative price changes occur all the time of course, and it is a very healthy phenomenon. However what happens in bubbles is quite unique. The relative price of the asset in the bubble market not only falls dramatically, but it also falls for almost all other goods in relative terms. Changes in relative prices which are due to changing market conditions are much smoother and they move in opposite direction i.e. the price of oranges measured in apples falls, but the price of oranges measured in pears rises. When a good’s relative price falls dramatically and for almost all goods, it means that its price was for some reason irrationally high i.e. there was a bubble. This can be only explained when there is an exogenous and obvious shock. For instance the OPEC countries reduce the quantity of oil supplied and the relative price of oil rises for all goods. But in cases of asset bubbles there is no exogenous shock. At least there is not an obvious exogenous shock. In reality there is an exogenous shock, and that shock is the dramatic increase in the money supply.

Therefore the problem is not as Marxists say that consumers do not have the purchasing power to absorb the goods. There are many depositors who could use their money to buy these goods. The problem is that these depositors and the economy in general need something else. The wrong goods have been produced, and the whole production structure was disrupted i.e. the market produced houses when it should have produced oranges. And now not only borrowers are found with houses they cannot pay, not only lenders (depositors) do not want to exchange their deposits/savings with these houses, but there is also an economy that does not have the production structure to produce the right goods i.e. the economy is set up to produce houses when it should have been set up to produce oranges. And the adjustment is a very painful recession.

We all experienced the Great Depression of 2008. We can judge for ourselves now, we do not need Marx, Adam Smith and John Maynard Keynes to understand. It is very easy to understand that what happened is not that workers were overexploited. The problem is that somehow the economy was overproducing luxury goods i.e. houses, cars, holidays etc, and under producing more basic goods i.e. meat, oranges etc. And Marxists have no explanation for that.

Another thing that Marxists cannot explain is that it is the industries producing producer goods that suffer first, and not the industries producing consumer goods i.e. companies producing goods for other companies suffer first, and not companies producing goods for consumers. If the Marxist theory was correct, the companies producing goods for consumers should have been hit first during recessions. But that’s not what we observe in practice. This might not seem to be a very important argument, but some economists consider it as the greatest flaw of the Marxist theory.

Over Production Crises

This theory is closely related to the under consumption one. Proponents of this theory, argue that sometimes the capitalist machine outperforms itself and it produces so much, that consumers’ incomes do not keep pace with increases in production, and they cannot absorb the outcome of the capitalist machine. They mean that they do not have the necessary means to absorb production increases. It is indeed a very naïve theory because producers could simply lower prices enough for the “bubble” products to be sold. And then again we enter a path of reasoning similar to the under consumption one, i.e. that there are two possible explanations why sellers do not lower their prices. One is that they wait to obtain better prices and two that market prices cannot cover costs. The reasoning is exactly the same with the under consumption theory, and the conclusion is that there is no over production in general, but over production in some sectors and under production in some other sectors i.e. misallocation of savings and miscalculation of profits and so on.

Psychological-Speculative Crises

Others say that bubbles are due to psychological factors. People see rising house prices, and they believe that they will keep rising for ever, and they start investing in houses, and they keep buying houses, and that kind of nonsense. These people confuse the symptom with the cause. Optimism is the symptom of the excellent economic climate that follows the overproduction of paper money. The cause of this optimism is what people perceive as an abundance of “oranges”, an abundance of savings. “Oranges” are not important anymore, people stop worrying about the basics, the question is how to improve the standards of living i.e. houses, cars, holidays, education etc, how to increase profits etc. Everybody takes “oranges” for granted. Nobody believes that one day will come that oranges will be scarce again.

In the same way, the panic that follows the boom is not due to psychological factors. It is due to objective facts i.e. that everybody realizes that “oranges” should not be taken for granted, and there is even a possibility of living in a great house without any “oranges” to eat. It is very natural for people to panic. They panic because they realize there is a shortage in “oranges”, a shortage in savings, and in the same way they were optimistic because they thought there was an abundance of savings they are now pessimistic because they realize there is a shortage of savings. Both their optimism and pessimism were based on what was going on around them. The increase in the production of paper and electronic savings generated by the government was very real. How could people know that what they perceived as and abundance of savings was not real and that a recession would follow?

It is therefore the increase in paper savings that causes the optimism and the bull market and not psychology or a thirst for speculation. As I already explained, the increase of paper savings does not increase the real savings i.e. “oranges” of the economy. It either allows domestic citizens to borrow very cheaply domestic real savings i.e. at interest rates that are much lower than the ones dictated by economic fundamentals (in the case of countries with production surpluses), or they allow domestic citizens to borrow very cheaply foreign real savings. When the bubble is created with cheap foreign savings, the foreign governments did something wrong too i.e. China in the 21 century and U.S.A. in the 1920’s.

The Socialist Myth of the Greedy Banker

An explanation of the crisis very often put forward by socialists is the one of the greedy banker. In my essay “The Socialist Myth of the Greedy Banker”, I explain why private banks have nothing to do with the crisis. Private banks buy and sell paper savings. The more paper savings they buy (deposits) and sell (loans), the more profit they make. However private banks have nothing to do with the quantity of paper savings in the economy. The amount of paper and electronic savings in the economy is controlled by the government and its central bank.

It is of course true that private banks will never say no to more credit, since with more credit they will make more loans and more profit. But they cannot create money as I explain in the aforementioned essay. People are confused by the fractional reserve system, under which private banks can lend more than they take in deposits. But this is a tool used by governments to boost credit and economic activity. It is very easy for governments to ask for less credit expansion. Anyway, since I explain it in detail in the relevant essay I will not elaborate further.


Murray Rothbard “The Great American Depression”

Murray Rothbard “What Has Government Done to our Money”

Murray Rothbard “The Case Against the Fed”

David Stockman “How the Artificial Boom of 1914 Caused the Great Depression”

Douglas French “Early Speculative Bubbles and Increases in the Money Supply”

Philip Bagus “The Tragedy of the Euro”

Irwin Schiff & Vic Lockman “How an Economy Grows and Why it Doesn’t”