Late-2000s recession: Credit creation as a cause

The Austrian School of Economics proposes that the crisis is an excellent example of the Austrian Business Cycle Theory, in which credit created through the policies of central banking gives rise to an artificial boom, which is inevitably followed by a bust. This perspective argues that the monetary policy of central banks creates excessive quantities of cheap credit by setting interest rates below where they would be set by a free market. This easy availability of credit inspires a bundle of malinvestments, particularly on long term projects such as housing and capital assets, and also spurs a consumption boom as incentives to save are diminished. Thus an unsustainable boom arises, characterized by malinvestments and overconsumption.

But the created credit is not backed by any real savings nor is in response to any change in the real economy, hence, there are physically not enough resources to finance either the malinvestments or the consumption rate indefinitely. The bust occurs when investors collectively realize their mistake. This happens usually some time after interest rates rise again. The liquidation of the malinvestments and the consequent reduction in consumption throw the economy into a recession, whose severity mirrors the scale of the boom's excesses.

The Austrian School argues that the conditions previous to the crisis of the late 2000s correspond exactly to the scenario described above. The central bank of the United States, led by Federal Reserve Chairman Alan Greenspan, kept interest rates very low for a long period of time to blunt the recession of the early 2000s. The resulting malinvestment and overconsumption of investors and consumers prompted the development of a housing bubble that ultimately burst, precipitating the financial crisis. This crisis, together with sudden and necessary deleveraging and cutbacks by consumers, businesses and banks, led to the recession. Austrian Economists argue further that while they probably affected the nature and severity of the crisis, factors such as a lack regulation, the Community Reinvestment Act, and entities such as Fannie Mae and Freddie Mac are insufficient by themselves to explain it.

Austrian economists[who?] argue that the history of the yield curve from 2000 through 2007 illustrates the role that credit creation by the Federal Reserve may have played in the on-set of the financial crisis in 2007 and 2008. The yield curve (also known as the term structure of interest rates) is the shape formed by a graph showing US Treasury Bill or Bond interest rates on the vertical axis and time to maturity on the horizontal axis. When short-term interest rates are lower than long-term interest rates the yield curve is said to be “positively sloped”. When short-term interest rates are higher than long-term interest rates the yield curve is said to be “inverted”. When long term and short term interest rates are equal the yield curve is said to be “flat”. The yield curve is believed by some to be a strong predictor of recession (when inverted) and inflation (when positively sloped). However, the yield curve is believed to act on the real economy with a lag of 1 to 3 years.

A positively sloped yield curve allows Primary Dealers (such as large investment banks) in the Federal Reserve system to fund themselves with cheap short term money while lending out at higher long-term rates. This strategy is profitable so long as the yield curve remains positively sloped. However, it creates a liquidity risk if the yield curve were to become inverted and banks would have to refund themselves at expensive short term rates while losing money on longer term loans.

The narrowing of the yield curve from 2004 and the inversion of the yield curve during 2007 resulted (with the expected 1 to 3 year delay) in a bursting of the housing bubble and a wild gyration of commodities prices as moneys flowed out of assets like housing or stocks and sought safe haven in commodities. The price of oil rose to over $140 dollars per barrel in 2008 before plunging as the financial crisis began to take hold in late 2008.

Other observers have doubted the role that the yield curve plays in controlling the business cycle. In a May 24, 2006 story CNN Money reported: “…in recent comments, Fed Chairman Ben Bernanke repeated the view expressed by his predecessor Alan Greenspan that an inverted yield curve is no longer a good indicator of a recession ahead."