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Answer to Second Q about Recessions

In an earlier post, Recessions in One Lesson, we explained what causes recessions in simple terms. Basically, it always starts with huge amounts of money being borrowed, more than can be repaid.

We said there are three questions one must always ask to understand a recession.
Last post, we gave typical answers to the first question, where did the money come from?

Today we will talk about the second question, to wit:
2. Where did the banks come from? By which I mean, why did the banks make these doomed loans in the first place? Don’t they want their money back?

Nowadays, meaning since the creation of the FDIC in 1934, this question loses some of its sting when it comes to US banks. They can take any wild risks they want, and if they lose money, the US govt just gives it right back to them.

But what about entities besides banks, or foreign banks [that got a hold of the new money somehow] where there is no FDIC? And even US banks can’t rely totally on the FDIC, because if they mess up hopelessly, the FDIC takes them over.

One answer is that they have to be duped in some way, such as the ratings agencies giving a AAA rating to the loan when it is sold off. Another is that they have some kind of govt assurance, not necessarily from the FDIC, that they can gamble all they want and the govt will pay them back if they lose.

One may ask, but surely in the 1600’s when the Dutch had their Tulipmania there were no govts promises, or crooked ratings agencies saying one tulip is such a great buy, well worth the income of a skilled craftsman from 13 years of hard work?

Very true. So we dig deeper. Let’s think about banks. Absent govt promises to cover their backs, banks are super worried about one thing: Will they get their money back? So they are very careful to lend money only to the most solid respectable borrowers, who show clear proof that they are very likely to be able to repay in full with all the interest.

That’s what they do in normal times. But what happens if they get oodles and oodles of money, literally hot off the presses? There just aren’t enough respectable citizens to go round. Those respectable citizens can only borrow so much money, and the banks feel stuck with the rest. So they decide to be brave and live dangerously. They lend the money to riskier types. Of course, they reward themselves for this courageous act by charging a higher rate of interest to the seedy type. The technical term for it is a risk premium.

When there is massive money printing, the banks get really worried. There aren’t even enough seedy types to go round. Not only that, the smarter bankers realize that the money in their safe is a hot potato, because lots of money sloshing around the country means that, by the law of supply and demand, that money will lose purchasing power. By doing nothing, they lose. Better to find someone, anyone, who will borrow the money, pay them the standard interest rate plus a risk premium plus what the banks expect inflation will be, and pray that he comes up with the money.

Sounds pretty foolish, but that’s what they do.

Of course, being only human, they are also subject to manias, meaning sudden idiotic ideas that infect almost everyone in such times. “Housing prices can only go up.” “Internet stocks can only make money.” “Tulips are so worth it, at least that’s what everyone else thinks.”

One last thing, not to get too technical. The great Ludwig von Mises and other brilliant Austrian economists went into great detail to prove that lower interest rates [which come with money printing] cause people to draw wrong conclusions about the feasibility of their various business schemes. I think it’s way beyond the scope of these humble posts to go into that.

As for our recent housing bubble, this little audio at the thirty minute mark [recorded years before the bubble burst] spells out the answer to our question 2 in great detail.

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