Legends of the Fall: The Real and Imagined Sources of Our Bubble Economy




The Foundation for Economic Education is pleased to announce that Richard W. Fulmer of Humble, Texas, is the winner of the second annual Eugene S. Thorpe writing competition. Mr. Fulmer holds a bachelor’s degree in mechanical engineering from New Mexico State University and for over 20 years has worked as a systems analyst in the energy industry. With Robert L. Bradley, Jr., he is the author of Energy: The Master Resource. His article, “Legends of the Fall: The Real and Imagined Sources of our Bubble Economy,” is published below.

We have for the better part of a century now lived in a world of fiat money, and fiat monetary systems are sophisticated versions of central planning. The belief system that supports them carries an inherent hubris that the planner’s vision of the future is sufficiently precise to chart the path of the chaotic interaction of variables that made up an economy. It is a recurring myth, with consistent historical outcomes. Mr. Fulmer’s paper goes directly to first causes and discusses the real estate bubble as a predictable consequence of our central- banking system.

One hundred eighty-two authors responded to FEE’s call for papers in competition for the 2009 Eugene S. Thorpe Award, and many wrote eloquently of multiple secondary causes. The unintended consequences of the Community Reinvestment Act? Fannie, Freddie, Ginnie, and assorted ill-conceived cousins? Zigging instead of zagging by our central bankers? Political opportunism and legalized graft? All surely true. Greed and other venal motives? Of course. But it misses the point to blame either human motivation or human error. The problem is systemic and foundational. It’s not what people do with or to the system—it’s the system itself.

The selection committee thanks all the contestants for their contributions. The rules allow for only one winner, but special recognition and honorable mentions are in order for several of the runner-up contributors. Erin Mundahl of Independence, Minnesota, wrote of government policies that disrupted the natural brakes on risk taking: “Free-market policies naturally limit risk exposure. Regulations which encouraged or even mandated an expansion of risk counteracted this natural limitation.” The risks were ultimately socialized to the taxpayers. The returns accrued to the congressional and bureaucratic elites that benefited both financially and politically. Government operates outside the confines of the natural constraints imposed by profit and loss, and grants political rewards based on the social choices valued by bureaucratic actors.

Charles N. Steele of Hillsdale, Michigan, observed that government not only did what it shouldn’t; government also failed to do what it should. A free market cannot function without the supportive infrastructure of the rule of law, and one of the legitimate functions of government is to prosecute criminal activity. Mr. Steele observes that “Deception, false representation of products, and failure to live up to contractual terms are not legitimate methods of competition in the free market. They are criminal activity, and the free market requires that such activities be policed.” Just so.

From Nero to FDR, emperors and their kin have listened to the sirens of monetary manipulation. The voices are enchanting and sing of wealth without work. But the ships of many states have foundered on the rocky shores to which such fantasies inevitably draw them. Real wealth creation cannot be manipulated; it results from increased efficiencies of resource allocation and production. A drunken Saturday night party may be fun while it lasts, but the Sunday morning hangover that follows is a predictable consequence of the shortsighted behavior that created it. Unless and until our system of monetary creation and control is redesigned to benefit from the power of market pricing mechanisms, we can expect the recurring cycle of boom and bust to continue.

Congratulations to Richard W. Fulmer on his winning article.

Karl Borden
Professor of financial economics, University of Nebraska-Kearney
Chairman, Eugene S. Thorpe Writing Competition Committee

* * *

Businesses, competing for consumer dollars in a free market, must deal with the world as it is in order to survive. Politicians, competing for constituent votes, spin facts to recreate the world as they want it to be in order to gain support for their policies, hide mistakes, and shift blame. In this world of spun reality, the failure of government intervention provides the rationale for still more intervention. So spins the endless cycle in which legislatures create unintended consequences, condemn “market failure,” and demand further legislation. Government grows in crisis, even if it created the crisis.

Our current financial problems provide an illustration of this all-too-familiar pattern. In response to the housing bust, politicians hid behind long-discredited myths, moving swiftly to lay blame variously on Wall Street greed, oil speculation, investors’ animal spirits, deregulation, unrestrained capitalism, predatory lending practices, and, of course, the business cycle. Yet even a brief look at the facts reveals government intervention throughout.


The Monetary Cycle

Supply and demand regulate prices in a free-market economy. Increased borrowing (demand for loanable funds) or decreased saving (supply) leads to rising interest rates (prices). Conversely, lower interest rates stem from less borrowing, more savings, or both. More saving means that consumers favor future consumption over current spending. Banks, with rising deposits on hand, drop their interest rates to compete for borrowers. Capital investments deemed infeasible when interest rates were higher now appear attractive. Companies borrow to expand productive capacity, anticipating future rising demand made possible by rising present consumer saving.

Suppose, however, that the government intervenes to artificially lower the price of money. Reduced interest rates make saving less attractive and consumption more so. At the same time businesses, taking advantage of lower rates, borrow to fund expansion. Prices rise as consumers and producers compete for scarce resources—a sack of seed corn cannot be both eaten and planted. Sales increase and markets boom. Eventually, however, the central bank must raise interest rates to prevent inflation, and the boom goes bust. Businesses find that they have overinvested or invested in the wrong things.

Such malinvestment is an unsustainable allocation of scarce resources to create goods and services for which there is insufficient demand. A correction occurs when resources are reallocated to produce what people actually want. Corrections can be very painful as industries that overexpanded during the boom now downsize, shedding employees and suppliers. Avoiding the adjustments, however, simply postpones the pain. Resources often continue to be poorly invested, compounding the damage and making the inevitable correction that much more agonizing when it comes.

Boom and bust cycles nearly always result from monetary expansions that disrupt the price signals regulating an economy. Such expansions preceded Holland’s Tulip Mania in 1636–1637, the nineteenth-century banking panics in the United States, the Great Depression, the dot-com bubble, and the current housing debacle.

Ironically, these monetary cycles are called “business cycles,” as if they were an inherent part of the free market. Proponents of some business-cycle theories believe that, left unregulated, businesses will overproduce, creating a glut of unwanted goods. Factories must then reduce production or even shut down until the glut is eliminated.

Yet what mechanism would drive businesses in different industries across an entire nation to produce unwanted goods? How could, to cite the most recent example, home builders in California, Nevada, Arizona, Florida, and markets in between have simultaneously misread local demand to such an extent? A nationwide spike in greed? Irrational exuberance? Bankers’ bonuses? A simpler, more rational explanation is that they were misled by government policies that artificially inflated housing prices, giving the appearance of greater demand than was actually there. Overproduction is a symptom, not a primary cause.


The Housing Bubble

Early in the new millennium, the Federal Reserve slashed interest rates in response to the dot-com collapse and the 9/11 attacks. Other nations’ central banks soon followed suit. Now awash in liquidity, investors from around the world needed investments that would yield returns higher than the rate of inflation. Coincidentally, American local and federal policies—including land-use restrictions, preferential tax treatment, buyer subsidies, and regulations favoring low-income buyers—had made investing in residential housing more attractive than other options. Housing prices rose as homeowners upgraded and renters became owners.

Home loans were sold in the secondary mortgage market, which is dominated by the government-sponsored enterprises: the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae). Mortgages were then bundled into “packages” in order to diversify risk. Individuals and institutions worldwide purchased these packages as investments. “Derivatives” such as credit-default swaps (essentially insurance against bond or, in this case, loan failure) and other such securities created a “multiplier effect,” as these investment vehicles were based on other vehicles that were, in turn, based on mortgages.

The complex system that resulted was inherently unstable and was made more so by regulations that coerced lending institutions into making home loans to borrowers who could not afford to repay them. In addition, Congress encouraged Freddie Mac and Fannie Mae to buy trillions of dollars worth of these “subprime” loans, enabling lending institutions to engage in even more such dangerous lending with little (or reduced) incentive to vet borrowers.

Credit-rating agencies, members of a cartel created by the Securities and Exchange Commission, gave unrealistically high ratings to packaged debt containing subprime loans. Basel II, an international banking accord, similarly understated the associated risks and encouraged banks to hold mortgage-backed securities by requiring them to keep smaller cash reserves to back such instruments than it required for traditional loans. Implicit government support for Freddie Mac and Fannie Mae and the “Greenspan put” (an unstated Federal Reserve policy of injecting liquidity into the economy in response to any serious difficulty) encouraged investors to take risks in the belief that the government would cover any losses.

Speculators exploited zero-down loans and “adjustable-rate mortgages,” intended for disadvantaged home buyers, and began “flipping” homes (buying houses only to quickly resell them at a profit). In some cases, houses were built strictly as investments—built to be sold and sold again, not to be occupied. Such overbuilding could not be sustained and, when the Federal Reserve raised short-term interest rates—contracting the money supply—the bubble burst. The value of investments based on bundled home mortgages quickly plummeted.

Mark-to-market accounting rules enforced by the Securities and Exchange Commission (SEC) compounded the problem. SEC rules required financial instruments to be valued at current market prices, amplifying the effects of both boom and bust. Mortgage-based securities, overvalued when housing prices soared, became undervalued as the panic grew and financial institutions saw their assets become virtually worthless almost overnight.

The key intervention and primary cause of the entire cycle of events, however, was the Fed’s initial monetary expansion. Government policies all but dictated that the resulting boom would be concentrated in residential housing and that the eventual bust would be far worse than it would otherwise have been. Even without these policies, though, a boom would still have occurred. Perhaps it would have been concentrated in another sector of the economy; or perhaps there would have been a general rise in capital investment. Either way, once the Federal Reserve triggered the expansion, a boom was inevitable. And, because the boom was artificial (that is, the credit expansion was not based on real savings), a bust had to follow.

Government control of a nation’s money supply guarantees boom and bust cycles. To illustrate this, imagine a car with some very special features. Its windshield is frosted so that the driver cannot see where he is going, and its side windows are just clear enough to allow him only a vague idea of where he is. The rear window alone affords an unobstructed view. Finally, the steering linkage is on a 30-second delay. The car will not change course until half a minute after the driver turns the steering wheel.

Now imagine trying to drive such a car. You steer a straight course as long as you see the highway stretched out behind you in the rear view mirror. When the road curves, you realize it only after the fact. You turn the wheel to get back on the highway, but nothing happens. So you turn the wheel some more. Again, nothing happens, so you turn the wheel still farther. Suddenly, the steering kicks in, and the car veers wildly. Desperately, you swing the wheel in the other direction, but the car continues turning the other way. What follows is a series of violent overcorrections ending in a crash.

Trying to regulate a nation’s money supply works about the same way. Central bankers cannot see into the future. They see only dimly where they are, and it is only in hindsight that their vision is clear. The impact of adjustments they make to the money supply may not be fully felt for a year or more. Such a system, like our car, is inherently unstable.

In response to the bust the Federal Reserve has moved quickly to re-inflate the economy, just as it had done after the dot-com collapse. The result is being termed a “recovery,” but more likely it is another overcorrection, the beginning of yet another boom and bust cycle, and a further misallocation of scarce resources. We cannot spend our way into prosperity. Production, not consumption, creates wealth.


The Road Back

We face two basic issues: How do we recover from the current recession, and how do we stop monetary boom and bust cycles? The answer to both is to increase economic freedom.

Our immediate problem stems from an imbalance between money and goods and from resource misallocation resulting from government interference with the market. The money-goods balance can be restored by shutting off the federal money spigot. This requires reining in government spending (which competes with the private sector for scarce resources), cutting taxes, and freeing markets. Correcting the misallocation of resources requires eliminating the policies that favor residential housing over other consumer needs.

The longer-term problem of taming boom and bust cycles can be addressed only by eliminating the Federal Reserve’s money monopoly. Repealing legal tender laws (which grant a monopoly on the creation of media of exchange to the Federal Reserve) would free Americans to choose forms of money that both meet their needs and maintain their value.

Before any of this can happen, though, the myth of the “business cycle” must be dispelled. Legends are luxuries we cannot afford. Reality is not optional.


April 2010



Richard Fulmer is a freelance writer from Humble, Texas, and the winner of the third annual Beth A. Hoffman Memorial Prize for Economic Writing for his article "Cavemen and Middlemen," from the April 2012 Freeman

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