Frog Legs

The thesis being considered here is that the current credit cycle started in about 1983. The question I am attempting to answer is what exactly changed from pre-1983 to post-1983 that moved us from a relatively more stable and natural economic growth model to a more volatile boom/bust cycle as we currently have.

First I will begin with a discussion of monetary policy currently practiced by the Federal Reserve.

The Federal Reserve, in an attempt to increase GDP or economic growth for political reasons, forces the cost of money below a natural or free-market rate. They implement this by first setting a federal funds target rate (the rate at which banks borrow from each other) below the free-market level. To achieve the lower target rate, they use open market operations to buy securities either from banks or from the Treasury (i.e. providing liquidity). This has the effect of increasing the supply of money in the market, thereby decreasing the cost of money.

Additionally, the Fed also uses a lower discount window rate to lend money directly to banks at below-market rates, which has the same effect of shifting the supply curve of money and lowering the “price” (interest).

The lower interest rate, or cost of money, predictably results in an increased amount of borrowing (by moving along the demand curve) than would otherwise exist in the free-market. Additionally, because interest rates are at below-market rates, there is movement along the consumption/saving production possibilities curve among savers toward increased consumption. That is, individuals shift their preference toward consumption away from savings.

The reason for this is that with lower interest rates being paid for savings the benefit for deferring consumption to a later time (interest received) is lowered. Therefore some savers become consumers choosing to receive the consumption benefit of their dollars now instead of later. Further, because of the relatively low cost of money, many consumers increase consumption by way of credit (this is an important point) to a degree more than would have occurred with free-market levels of interest.

As Ludwig von Mises pointed out, “Credit transactions are in fact nothing but the exchange of present goods against future goods.” This fact manifests itself in the modern economy by way of business or credit cycles. Because the Fed is artificially increasing the amount of current consumption, in order to maintain the relationship of credit with present and future consumption there must be a below-market rate of consumption at some future time.

As the downside of this cycle draws closer, the Fed is often able to “put off” the trade off period by lowering interest rates and again artificially increasing present consumption for the sake of future consumption. However as the present rate of interest approaches zero, the ability of the Fed to defer below-market rates of consumption (i.e. economic contraction) to compensate for the overconsumption of the past, diminishes. Ultimately, the end result of this credit expansion is a corresponding economic contraction. The extent of this contraction should be approximately proportionate to the undue credit expansion of the same cycle.

It is documented that in about the early 80’s the Federal Reserve changed the general approach for control of the monetary system from a focus of M1 to a broader focus of influencing money and credit. I believe this is the source of the change that began in about 1983, namely the beginning of manipulation of market interest rates and credit as described above.

Previously, the Fed’s monetary policy was restricted to ensuring banks had enough M1 (cash) to maintain reserve requirements. With a specific monetary goal, that of maintaining reserve requirements, money and credit did not grow in the great leaps as it does now. More importantly the Fed was generally not involved in manipulating interest rates causing the extreme and unsustainable credit-based expansion seen today. When banks were short on M1 (physical cash) to cover reserve requirements, the Fed could inject money to shore up those reserves. However as soon as the reserve requirements were met, the Fed’s role was fulfilled and monetary manipulation generally halted as long as reserve requirements were maintained.

In contrast, in modern times starting in approximately 1983 the Fed began manipulating a broader definition of money and credit to fulfill other more political objectives, principally that of “economic growth.” In order to achieve this growth policy, the Fed began a cycle of expanding money and credit by steadily lowering interest rates to below-market levels.

One can see the credit expansion in the chart on this page, which can also be seen here. Probably the most interesting thing in this chart is the extent to which non-public debt growth began to separate from government debt where previously it closely tracked government debt. This is indicative of the growth of availability of credit in the market.

This new political objective of economic growth and the manipulation of credit and creation of the credit cycle to achieve said objective began in approximately the early 80’s and has continued to date.