Pumped Up

Investor’s Business Daily
September 17, 1998

Trouble In The U.S.?

What goes up must come down. Asian economies have proved that old saying true. Some economists say the U.S. may soon show the same principle at work, too—for many of the same reasons. Are they right?

“The great Asian boom of 1988-97 was doomed from the outset,” wrote Jim Walker, head of the Credit Lyonnais Securities economic forecasting team for Asia.

Walker argues that the very forces that created the boom set the stages for the following bust. And those forces were themselves set in motion by government manipulation of the money supply.

The governments in those nations pushed policies that artificially expanded credit, driving interest rates below their “natural” rate, he says. These low interest rates made many investments seem more profitable than they actually were.

This caused businesses in those countries to expand, adding new plants, buying new equipment and adding new workers.

The result wasn’t as some observers have said, overinvestment; it was malinvestment.

That became apparent in ‘97.

People in those nations weren’t saving any more than they had been. So as new money made its way through their economies, interest rates started to rise back to their “natural” levels—bringing savings supply and demand into balance.

As this happened, many of those investments made during the boom began to mature, writes Walker.

And many firms found that the demand they expected for their goods and services just wasn’t there. Others found they couldn’t borrow more money to finish projects.

What happened to Asia isn’t unusual.

The late Austrian-school economist Murray Rothbard told a similar story about the Great Depression.

In the ‘20s, the Federal Reserve pursued a policy of stable prices, wrote Rothbard. But the ‘20s were a time of rising productivity, which would have forced prices down.

The only way for the Fed to keep prices stable was to inflate the money supply, which it did. Rothbard found the money supply grew by 60% between ‘21 and ‘29.

The flood of money drove interest rates down, caused businesses to expand even more and drove up stock prices.

This party would have fallen apart anyway, but its end was hastened when the Fed started raising interest rates in ‘28.

Firms found that their investments weren’t profitable, borrowers couldn’t repay loans, and banks started going belly up. And when banks started going bust, the money supply began to shrink.

Some economists have argued that the shrinking money supply caused the Great Depression. Rothbard argues it was actually the Depression that caused the money supply to shrink.

So what does that have to do with the U.S.?

Plenty, say some economists.

Over the last several years, the U.S. has pursued a policy of easy money.

The U.S. monetary base, currency plus bank reserves, has grown by 74% since ‘90. M2, the base plus checking accounts, has grown 30% since ‘90.

There are plenty of signs of a credit boom. Total household debt, for instance, has climbed form 68% to 95% of personal income over the last decade.

Some economists worry that the U.S. expansion over the last seven years has been fueled in part by easy credit. If so, the U.S. could be in trouble.

Time to worry? Not necessarily.

Although the monetary vas has grown by three-fourths since ‘90, the U.S. economy has grown by nearly 50% before adjusting for inflation during the same period.

So most of the money went to fuel U.S. growth. What happened to the rest? It can be found overseas. The Fed now estimates that nearly two-thirds of all U.S. currency is held by foreigners in other countries. It’s like an interest-free loan to the U.S.

Some worry those dollars, if they were sent back in one massive wave, could set off inflation. But that’s not likely. And if it did happen, all the Fed would have to do is sop up the extra money by raising interest rates.

But raising rates now, while much of the world economy is in crisis, would do more than hurt struggling nations in Asia and Latin America. It would cause a severe downturn in the U.S..