Wednesday, October 8, 2008

The Boom was the Financial Crisis

The actual financial crisis occurred during the so-called boom years. Artificially low interest rates set by the Federal Reserve stimulated borrowing from the central bank itself. This expansion of credit in turn creates an expansion of the money supply. More money created means more money for banks to lend, more money for banks to lend, means more money for individuals to borrow. More individuals with access to cheap money, means that home prices will go up, because sellers want to get the most profit. Although individuals and banks may have appeared prosperous, both were in the midst of a financial crisis.

The caveat is, that since borrowing was stimulated by artificially low interest rates, borrowed investment was malinvested. Capital resources were misallocated into areas which would not normally garner investment if the money supply was stable. Houses are expensive things to be, and got even more expensive with easy money available. Money was used to purchase overpriced houses. In a market driven economy house prices and interest rates would by the market itself, rather than a central bank inducing artificially low interest rates, hence distorting home prices. House price and interest rates would fluctuate regionally, and locally, according to what the market can handle.

Now, how do we end the financial crisis? End the Federal Reserves monopoly control over money and interest rates. Otherwise we are doomed to repeat it again, assuming we can get out of the current mess.

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