When we talk about the business cycle, we’re referring to the repeating booms and busts we see in the economy over time. There are many theories as to what causes these cycles. We embrace what is known as Austrian Business Cycle Theory.
In a nutshell, the boom bust cycle is driven primarily by government and monetary policy. In simplest terms, easy money (artificially low interest rates that encourage borrowing) blows up bubbles. Bubbles pop and set off a crisis. Rinse. Wash. Repeat.
In practice, when the economy slows or enters into a recession, central banks like the Federal Reserve drive interest rates down and launch quantitative easing (QE) programs to “stimulate” the economy.
Low interest rates encourage borrowing and spending. The flood of cheap money suddenly available allows consumers to consume more — thus the stimulus. It also incentivizes corporations and government entities to borrow and spend. Coupled with quantitative easing, the central bank can pump billions of dollars of new money into the economy through this loose monetary policy.
In effect, QE is a fancy term for printing lots of money. The Fed doesn’t literally have a printing press in the basement of the Eccles Building running off dollar bills, but it generates the same practical effect. The Federal Reserve digitally creates money out of thin air and uses the new dollars to buy securities and government bonds, thereby putting “cash” directly into circulation. QE not only boosts the amount of money in the economy; it also has a secondary function. As the Federal Reserve buys US Treasury bonds, it monetizes government debt. The central bank can also buy financial instruments like mortgage-backed securities as it did during QE1 in 2008. This effectively serves as a bank bailout. Big banks get to remove these worthless assets from their balance sheets and shift them to the Fed’s. Theoretically, this makes the banks more solvent and encourages them to lend more money to ease the credit crunch that occurs when banks become financially shaky.
Surging economic growth, shrinking unemployment, and rising stock markets driven by money-creation give the illusion of a healthy economy. But the monetary policy hides the economic rot at the foundation.
In order to sustain an true economic expansion, you need capital goods — factories, machines, natural resources. Capital goods are produced through savings and investment. When central banks juice consumption without the requisite underlying capital structure, it will eventually become impossible to maintain. You can print all the dollars you want, but you can’t print stuff. At some point, the credit-driven expansion will outstrip the available stock of capital. At that point, the house of cards begins to collapse.
Imagine you plan to build a giant brick wall. With interest rates low and credit readily available, you borrow all the money you need to complete the job. But two-thirds of the way through, a brick shortage develops. You may have plenty of money, but you’ve got no bricks. You can’t finish your project.
This scenario provides a simplified picture of what happens in the economy during a Fed-fueled economic expansion. Flush with cash, investors begin all kinds of projects they will never be able to complete. Eventually, the malinvestments become apparent and the boom teeters and then collapses into a bust.
Of course, the Fed helps this process along as well.
Once the apparent recovery takes hold, in order to keep inflation under control, the Fed must tighten its monetary policy. It ends QE programs and begins to nudge interest rates back up. When the recovery appears to be in full swing, the central bank may even shift to quantitative tightening — shrinking its balance sheet. During the boom, governments, consumers and companies pile up enormous amounts of debt. Rising interest rates increase the cost of servicing that debt. They also discourage new borrowing. Easy money dries up. This speeds up the onset of the next recession and the cycle repeats itself.
What is Quantitative Easing?
With the US economy in consistent decline, many investors are awaiting the announcement of “QE3,” or the third round of quantitative easing by the Federal Reserve. This term is now thrown around like it’s commonplace, but it really only came into widespread use after the financial crisis struck in 2008. Here’s a simple guide to what it means, and what the difference is between QE1, QE2, and all future QEs.
Typically, the Federal Reserve dictates monetary policy by manipulating the target of the federal funds rate. This is the interest rate banks receive to loan other banks money to meet their minimum reserve requirements, as dictated by the Fed. The federal funds rate influences the prime rate, which affects the cost of borrowing from mortgages to credit cards.
As the 2008 recession unfolded, the Fed lowered the federal funds rate to near zero in hopes that cheap borrowing costs would help stimulate the economy – but it didn’t work. Since the Fed can’t realistically set rates any lower than zero, many thought they were out of firepower. Instead, they introduced quantitative easing.
Effectively, QE is a fancy term for printing lots of money. The Fed uses this money to buy securities or government bonds, thereby putting the new cash directly into circulation.
In QE1, which Fed Chairman Ben Bernanke called “credit easing,” the Fed bought over a trillion dollars in toxic mortgage-backed securities. This allowed big banks to remove these worthless assets from their balance sheets, which the Fed hoped would the encourage the banks to lend out money again and ease the credit crunch. QE1 lasted until March 2010.
As the economy continued to stumble, the Fed began a second round of QE in November 2010 by buying loads of Treasury bonds. The goal was to push down long-term interest rates, thereby encouraging home-buying and other long-term capital investments. This also puts money into banks and credit institutions, as by law, the Fed cannot buy bonds directly from the Treasury. This program was ended in June of 2011.
As our readers well know, the economy is still listless and unemployment remains high. It’s unclear what QE3 will look like, though few doubt there will be one. Peter Schiff often says that there will be more QEs than Rocky movies. What is certain is the price of gold and silver has jumped with each additional action by the Fed.
What Are Negative Interest Rates?
In simplest terms, a negative interest rate means a borrower is credited interest instead of paying interest to the lender. In effect, the lender pays the borrower to take his money.
You won’t typically see negative nominal interest rates in an ordinary market transaction. After all, why would anyone lend $1,000 to receive $900 in return at some point in the future? But central banks do sometimes use negative rates as an extreme monetary policy tool during deep recessions.
Practically speaking, under a negative rate policy, financial institutions must pay to deposit excess reserves at the central bank. Normally, the central banks pay interest on funds deposited there. In effect, negative rates penalize banks for holding cash and incentivize them to lend cash out. Negative rates are designed to stimulate more lending, borrowing spending and investment to help prop up the economy. Negative rates effectively penalizes banks, if they do not engage in sufficient lending.
More broadly, when negative interest rate policy is in play, depositors are incentivized to spend money rather than save it at the bank and incur a guaranteed loss. In practice, commercial banks have been reluctant to pass negative rates on to their customers. Nevertheless, the negative rate central bank policy artificially depresses interest rates throughout the economy.
The Federal Reserve has never dabbled in negative interest rate policy, but a number of other central banks have including the European Central Bank, Switzerland and the Bank of Japan.
Negative interest rates have a perverse effect on the economy. As Mises Institute president Jeff Deist wrote, “Negative interest rates turn everything we know about economics upside down.”
Will Digital Currencies Displace Gold or Precious Metals?
Unlikely, and certainly not before a US dollar collapse.
As the US dollar and many other foreign fiat currencies inflate and lose value, you may rightly worry about preserving your hard-earned wealth from the ravages of inflation. While precious metals like gold and silver have long been stalwarts in preserving wealth, emerging digital currencies have been knighted by a few as hard money’s savior.
Most online currencies are backed by something. That means they are really just a trading platform for some other commodity, often precious metals. The success of these types of efforts is also positive for investors in physical metals because increased usage drives up the global price level.
Other online currencies are really just advanced barter systems. They may issue participants “credits” for performing tasks or selling goods to other members. These schemes are potentially very dangerous because if they collapse (or are shut down), the members are left with nothing. They are also of limited use, as only so much credit can be issued before the system becomes unstable – and the credits can only be spent with other members.
There is one online currency that actually meets the definition of money. By using cryptography to make bits of computer code scarce, Bitcoin has achieved what no other online system has before. As long as you have those bits of code on your computer or stored online, they can be traded anywhere you have a network connection. This has many heralding it as the “future of hard money.”
However, Bitcoin was only released in 2009. Gold was released in supernovae billions of years ago. Gold has functioned as a store of wealth for millennia, and it is recognized across cultures for this purpose. Bitcoin is promising, but new, volatile, and vulnerable to being replaced by another competing digital money project.
Precious metals do not require a computer or energy to use, they maintain your financial privacy, and they are accepted and desired worldwide. While digital currencies may grow in popularity, none are positioned to challenge precious metals as the ultimate reserve asset.