Smoke and Mirrors

So, it's finally happening - the bubble has burst and the economy is in a melt down. This comes as no surprise to many of us. Paul Krugman anticipated it in August of 2005.

Well, last week Mr Greenspan warned us about the very condition his smoke and mirrors economics had created and Paul Krugman explains.
Greenspan and the Bubble

What he did say, after emphasizing the recent economic importance of rising house prices, was that "this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent." And he warned that "history has not dealt kindly with the aftermath of protracted periods of low-risk premiums." I believe that translates as "Beware the bursting bubble."

Like everything else, the economic policy of the Bush administration has been driven by politics. The so called "recovery" has not created new wealth, only debt and Alan Greenspan has been a good Republican soldier first and an economist last. A recovery based only on debt is not a recovery and can't be sustained. As Krugman points out Greenspan is now warning us about the very things he was encouraging less than a year ago.

But as recently as last October Mr. Greenspan dismissed talk of a housing bubble: "While local economies may experience significant speculative price imbalances, a national severe price distortion seems most unlikely."

Wait, it gets worse. These days Mr. Greenspan expresses concern about the financial risks created by "the prevalence of interest-only loans and the introduction of more-exotic forms of adjustable-rate mortgages." But last year he encouraged families to take on those very risks, touting the advantages of adjustable-rate mortgages and declaring that "American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage."

If Mr. Greenspan had said two years ago what he's saying now, people might have borrowed less and bought more wisely. But he didn't, and now it's too late. There are signs that the housing market either has peaked already or soon will. And it will be up to Mr. Greenspan's successor to manage the bubble's aftermath.

In June of 2005 Eric Englund discussed the The Austrian Theory of the Trade Cycle.

The Austrian theory of the business cycle emerges straightforwardly from a simple comparison of savings-induced growth, which is sustainable, with a credit-induced boom, which is not. An increase in saving by individuals and a credit expansion orchestrated by the central bank set into motion market processes whose initial allocational effects on the economy's capital structure are similar. But the ultimate consequences of the two processes stand in stark contrast: Saving gets us genuine growth; credit expansion gets us boom and bust.

Since busts are not politically acceptable credit was eased to create a new boom:

Alan Greenspan, of course, would not tolerate a recession. Accordingly, the Federal Reserve went on a money and credit creation binge and eventually brought short-term interest rates down to 1% (in 2003). The Federal Reserve, in total, cut interest rates 13 times between 2001 and 2003. With interest rates so seductively low, Americans went on a borrowing and spending spree which pulled Uncle Sam out of the recession – at least for now.

As Murray Rothbard explains, in The Austrian Theory of the Trade Cycle, America’s debt-driven "prosperity" is a mirage built upon the opiate of easy credit. Alan Greenspan’s multiple interest rate cuts, as Dr. Rothbard conveys, is nothing new in the field of central banking:

… the point is that the credit expansion is not one-shot; it proceeds on and on, never giving consumers the chance to reestablish their preferred proportions of consumption and saving, never allowing the rise in costs in the capital goods industries to catch up to the inflationary rise in prices. Like the repeated doping of a horse, the boom is kept on its way and ahead of its inevitable comeuppance, by repeated doses of the stimulant of bank credit.

Well nearly three years later many more are catching on.
How Real Was the Prosperity?
We're just beginning to figure out how much of the nation's recent growth was the result of a credit-induced frenzy. Here are some guideposts

The housing markets, of course, overshot as too many buyers took out subprime mortgages they couldn't afford. The outcome will be a decline in home values, with prices in some areas already down.

But the economic writedown is likely to go far beyond housing. Household spending, consumer debt, financial sector profits: All may need a retrenchment, sudden or gradual, to get back to sustainable levels. That's bad news for investors and the global economy, which still depends heavily on U.S. consumption for growth.

There may even be a reassessment of whether recent productivity gains were fueled by excess credit. If growth in productivity slows, the economy will stagnate, real wages will weaken, corporate earnings targets will be harder to meet, and inflationary risks will increase.

Hale "Bonddad" Stewart has more:
The Illusion of the Bush Economy's Growth is Revealed
The current mess was predicted but was politically inevitable.