What causes the boom and bust cycle?

[Capitalism Forever]

Characteristic of a recession: A recession is characterized by a sudden decline in economic activity across a wide range of industries. Any industry may see a sudden fall off in the demand for its products for a variety of unanticipated reasons. Similarly, a business (or even an industry) may forecast higher demand than actually transpires. That industry may then face a period of lowered prices of goods, cost-cutting, layoffs, falling stock prices, and so on. However, in a recession, this type of problem ranges across the economy. All sorts of industries find less demand for their products than they anticipated and end up cutting back.

Most economists agree with these characteristics, but offer varying explanations of the causes.

Of course, the characteristics themselves are wrong, as they are a clear example of the primacy-of-consumption premise. The idea that businesses across the economy could all possibly face lower demand for their goods (and thus lower prices) rests on the ignorance of the fact that demand is only made possible by supply. If a manufacturer of cars faces a lower demand for its goods, that means there are fewer people offering other products (say, package holidays) in exchange for cars--that is, the lower demand for cars means a lower supply of package holidays (and other products). So we have one product (cars) facing a lowered demand relative to supply, but another product (holidays) facing the opposite situation. There is not, and cannot be, a general low demand across the economy; as David has stated, there can be no general overproduction (or oversupply or underconsumption or underdemand or whatever name one may attach to it).

What, then, is a correct definition of a recession? I have written about it here:

I would define a recession as an economic disturbance--a period of time when producers experience difficulties in creating wealth. Whether this involves an actual decline or merely a slow growth in aggregate measures such as the GDP is irrelevant; these aggregates are far too inexact measures of prosperity to be trusted to the level of percentage points of growth (see Mr. Salsman's response on Measures of Economic Growth). The important characteristic is that the producers face obstacles that they wouldn't have faced if it hadn't been for the factors causing the recession.

[softwareNerd]

The primacy of consumption is not implied. What is implied is a difference in the expectations of producers (of consumption goods and business-supply goods) and the actual expressed requirements of their customers (both consumers and businesses).

[Capitalism Forever]

The primacy of consumption is not implied.

Not implied, but nonetheless often present among their premises, it appears.

What is implied is a difference in the expectations of producers (of consumption goods and business-supply goods) and the actual expressed requirements of their customers (both consumers and businesses).

Sounds like a rather complicated theory--I guess I will need a whole weekend after all to really understand it. I might write more on it when I've got all the details, but meanwhile, my response to the article linked by David stands.

[softwareNerd]

I should clarify that I was trying to explain the Austrian theory, not to support it. Personally, I do not know enough to say if it is true. In my mind, it stands as a "plausible hypothesis". I have a general idea of the type of validation that would be required, but have not studied the Austrians enough to know if that validation has been provided.

It appears that what I posted is being read as a variant of Keynesianism. For instance, my explanation of the "characteristics" above was not meant to imply any cause. Rather, I meant it as an uncontroversial description of the proximate observable facts: wide-spread business failure and unemployment; i.e., businesses economy-wide finding themselves with less sales than expected, needing to cut costs, lay off employees, go out of business. etc.

The Austrians do not subscribe to the ideas of overproduction or under-consumption, as the Keynesians use them: i.e. as naturally occurring phenomena in a free enterprise economy.

The Austrian theory holds government-initiated credit expansion as primarily responsible for booms. At this broad level, the Austrians agree with monetarists like Milton Friedman. However, at the next level of detail, the main culprit -- according to the Austrians -- comes through credit expansion to businesses (as opposed to to consumers). The easier availability of credit allows businesses to make investments that they otherwise would not.

As the credit expansion is underway, and begins to have an effect on prices, nominal interest rates will start to have an inflation-adjustment component. However, since there is a lag between the expansion and price-rises, this inflation-adjustment component may not account for the the coming inflation. At some point, the realization sets in and the "boom" reverses into a bust. [The conceptual analysis using time-preference and "pure interest rate" can just as well be described as lower inflation premiums built into interest rates.]

The point you raise about businessmen not allowing themselves to be fooled repeatedly is valid. However, expectations flow from intellectual thinking about economics. Some Austrians claim that Keynesian-ism played a role in making people think the old remedies could work if only they were managed by newly-enlightened economists. Nevertheless, one might well make the case that nobody will fall for a "Great Depression" type scenario again.

I'm not sure why the Austrians do not think credit expansion to consumers has a significant role to play. Historically, it was unimportant in the "Great Depression"; however, I do not understand why it would be so today.

Anyhow, that's my re-statement, and I hope it makes it somewhat clearer.

[John McVey]

As the credit expansion is underway, and begins to have an effect on prices, nominal interest rates will start to have an inflation-adjustment component. However, since there is a lag between the expansion and price-rises, this inflation-adjustment component may not account for the the coming inflation. At some point, the realization sets in and the "boom" reverses into a bust. [The conceptual analysis using time-preference and "pure interest rate" can just as well be described as lower inflation premiums built into interest rates.]

You're focussing too much on rates and other prices. They have an affect in their own right, but the real core is actual spending patterns and volumes. The manipulation of credit does not just manipulate the relative prices of consumption and production goods, it perverts the composition of total spending to more spending on capital expenditure than people's time preferences would lead them to spend, which includes payrolls. Result: boom. But all funds eventually circulate. The increase in money spent on and in business finds its way into people's pockets in wages, rent, and profits, which people then spend according to their actual time preferences and balance between consumption and production. This balance is different to that set as an appearance created by the credit expansion - and this fact is the crux of the argument.

There is not so much as a mere ideational 'realisation,' but that the total spending in the economy is physically wrenched away from the balance of production and consumption initially set by the credit expansion, thereby reducing investment away from what the expansion initiated, as people's actual time preferences are manifested out of their personal expenditures. Cutting a long story short, this reduced investment spending physically manifests itself in there not being the business inputs in the future that businesses need to continue to produce because spending is more in favour of present consumption rather than production. As a result, the extra capital goods are revealed to be a waste because their required complements are not made available, and the jobs initially created to use them therefore evaporate, and people are forced to take jobs that pay less (if labour law even allows this). Result: bust, which may or may not be accompanied by significant long term unemployment depending on the state and law of labour markets. I can give a far more detailed listing of what happens, if anyone is interested.

The point you raise about businessmen not allowing themselves to be fooled repeatedly is valid. However, expectations flow from intellectual thinking about economics. Some Austrians claim that Keynesian-ism played a role in making people think the old remedies could work if only they were managed by newly-enlightened economists. Nevertheless, one might well make the case that nobody will fall for a "Great Depression" type scenario again.

There is too much emphasis on the 'fooling' element, too. But not even perfect information would stop the boom and bust, again because of the actual pattern of spending. That is never going to be increased uniformly enough to have no effect, no matter how well people realise what is going on. The initial expansion creates a real shift in ownership of capital from one set of people to another with different sets of consumer preferences and time-preferences. No ifs, no buts.

JJM

[softwareNerd]

Thanks for the explanation, John. Do you agree with the Austrian theory, then? If so, I'd like to understand what proof the Austrian's offer for this. For instance, studying booms from history, does one actually find these changing ratios of productive and consumption expenditures?

[John McVey]

Do you agree with the Austrian theory, then?

While writing the list in case someone asks me to make good on my offer, looking back at what I think I've come across a bit of a problem. I can no longer remember what part of that is Austrian, and what part is me with my own thinking. I do know that I agree with the gist of the Austrian argument, particularly the composition of spending and the reassertion of proper time preferences through funds being cycled back and a new composition forming as I described to you. I know that I got that from Rothbard somewhere. Whether or not this means I agree with the whole of the Austrian argument, as it actually is and shorn of what I have added for my own edification, is another matter.

The Austrians I got what I think from are von Mises, Reisman, Rothbard, and an Australian Austrian called Gerard Jackson. Hayek's Pure Theory of Capital is unreadable. There are also a few classicals recommended by Jackson. Smith and the Mills have interesting things to say, for instance.

If so, I'd like to understand what proof the Austrian's offer for this.

The Austrians are, or claim to be, very rationalistic. There's even one guy, Hans Herman Hoppe, who has an economics methodology work out called "In Defense Of Extreme Rationalism." As you can imagine, people like Hoppe hate Objectivism with a passion. Not all Austrians do, such Jackson, who is admiring of Prodos Marinakis and (he vice-versa).

That being said, the better Austrians (now dead and replaced by the likes of Hoppe) are not as rationalistic as they claim, particularly von Mises. I get the impression that because of their formal committment to rationalism what they're doing is forming their theories inductively but then trying to formulate rationalist arguments to support those theories conclusions, whether they realise it or not. IMSM, Buechner said the same thing too.

I do know that I can demonstrate what *I* believe inductively and draw key principles from human nature, the physical nature of production, the actual natures of money and capital spending of various types, and so on. Again however, I can no longer remember what part of that is Austrianism and what part of that is me. The mere fact that I can demonstrate something inductively isn't proof that it is me as it could just be the work of the Austrians when they were better.

For instance, studying booms from history, does one actually find these changing ratios of productive and consumption expenditures?

I'm yet to check the numbers myself, but Gerard Jackson says yes, over and over, and that it is shown both in the economic history of the last few hundred years and what is going on in Australia right now. Check out his website - www.brookesnews.com (though annoyingly it is becoming a bit more like a christian version of the LR crowd's site as time passes). For instance, recent entries are here, here, and here.

JJM

[mrocktor]

The Austrians are, or claim to be, very rationalistic.

While this is true of many, and more of the current crop than of their predecessors (as you said), it is in stark contrast to the "founding father" of the school. I'm talking about Carl Menger. I'm in the middle of his "Principles of Economics" and recommend it highly.

Here is the opening sentence of the book:

All things are subject to the law of cause and effect.

[Capitalism Forever]

I can give a far more detailed listing of what happens, if anyone is interested.

I would appreciate it.

One thing I'm particularly curious about is whether the theory is aware of the distinction between short-term and long-term interest rates. After all, what the Fed manipulates are the rates of very short-term loans (overnight to 2 weeks), while the long-term investment projects that the theory talks about rely on loans of much longer maturities (measured in years or even decades). Long-term interest rates have been known to move quite independently of short-term ones.

[y_feldblum]

I'm not sure that I agree with, or even understand, softwareNerd's and John McVey's recent posts.

It seems to me that there would ordinarily be some level of credit, backed with real assets; but when government requires lenders to expand credit or businesses to expand borrowing, backed not with assets but with force, inevitably many borrowers default - the borrowers whom government forced to borrow and to whom government forced the lenders to lend -, the lenders call in their other loans, their other borrowers fail, the lenders themselves fail, etc.

I, not an economic scientist, wonder how reasonable this explanation is.

[JMeganSnow]

Issuing new money in exchange for assets serves to monetize those assets, i.e. allows claims to them to circulate as means of exchange.

Yes, but issuing new money in exchange for *nothing* does not serve to monetize assets: it serves to cause a glut on the capital market. The Fed caused The Great Depression in part because it flooded the economy with money that wasn't backed by anything.

Yes, the Fed holds immense amounts of gold, but the constantly rising price of gold attests to the fact that the Fed is not withholding this asset from the market: on the contrary it more or less permanently issues more credit than the value that exists in its reserves.

Greenspan was the major person keeping this process in check (relatively) recently, and it's why he kept the interest rates high and dumped us over into a recession: If he hadn't, the recession when it eventually came would have been much worse.

[John McVey]

I would appreciate it.

NP. I have a word document with it in it. Anyone who wants a copy should PM me their email address. However, as I said to SoftwareNerd I no longer remember what part is Austrian, what part is other economists, and what part is my thinking. All of it is what I believe, where-ever I got it from.

One thing I'm particularly curious about is whether the theory is aware of the distinction between short-term and long-term interest rates.

Yes. They are big on monitoring the shape of the yield curve. Each Austrian has different precise criteria, but they generally hold that if the curve goes inverted for long enough then there is a recession looming. The how and why is explained in what I'll send.

JJM

[John McVey]

While this is true of many, and more of the current crop than of their predecessors (as you said), it is in stark contrast to the "founding father" of the school. I'm talking about Carl Menger. I'm in the middle of his "Principles of Economics" and recommend it highly.

I should have qualified what I said with 'later Austrians, starting with von Mises.' Menger (as you point out) and also Eugen von Bohm-Bawerk, aren't all that rationalist at all - where Menger is Aristotelean, hence his starting with the law of cause and effect.

As it happens, I am re-reading Menger's PoE at present

It seems to me that there would ordinarily be some level of credit, backed with real assets; but when government requires lenders to expand credit or businesses to expand borrowing, backed not with assets but with force, inevitably many borrowers default - the borrowers whom government forced to borrow and to whom government forced the lenders to lend -, the lenders call in their other loans, their other borrowers fail, the lenders themselves fail, etc.

Defaults start because the debts cannot be serviced, not because there was supposedly nothing backing them. You will also find that the Austrians make much out of what is called the structure of production: the balance between industries producing capital goods ("higher order") and industries producing consumer goods ("lower order").

Capital goods wear out and must be maintained and replaced over time. A capital base needs continual capital spending to maintain. After the expansion wears off and people's true time preferences get felt in their spending, the rising inflation effects generate an inflation premium. This raises capital costs and encourages capital withdrawal. As a consequence there isn't the required continued spending on capital goods to maintain their totality. The industries geared towards production of capital goods get hammered first by way of not getting the revenues they need to pay their rising costs - that's why the default start. Initially in the economy generally, this is masked by the consumer industries still getting their revenues from consumers spending their increased nominal incomes, so the boom continues. Job loses from the higher order industries starts biting into consumer sales, especially since capital goods industries tend to employ well paid high skilled people while consumer industries employ less well paid people. Over time therefore, this hammering works its way through industries closer and close to the consumer industries, and when it gets far enough the economy peaks and starts tanking. The rates of defaults rise as this hammering of rising costs and falling revenues moves further down the structure of production from higher order industries to lower order industries until at some point the bust also wears off just as the expansionary boom did.

The force is at the beginning and at a deeper level (macro rather than micro), as an instance of fraud where part of which is making businesses think that there will be more capital available in the future than there will actually be. The expected capital funding translates to expected capital spending which does not eventuate, as per the above. All this is triggered by the one-off force at the start in the economic foundations, not so much any on-going instances of force nor in buiness or financial houses directly. That force is in the expansion of the money supply that is injected into financial markets. That expansion may be direct, which for instance is new physical or electronic money, or be indirect, which for instance is a reduction in required minimum reserves. Either way it is indeed force, but it is not that borrowers borrow and lenders lend with guns actually pointed at them.

JJM

[fatdogs12]

It's not possible for "overproduction" to be a global problem in a free market. Dealing with uncertainty is one of the most fundamental problems faced by entepreneurs, and markets have developed numerous means of dealing with it. Commodity markets, futures contracts, options, derivatives, swaps and various other financial instruments all serve to both inform actors about future expectations and protect producers and investors against uncertainty. These financial instruments allow "dumb" individual commodity producers to not have to care about future demand - they can focus on present prices.

This system fails to function when the government manipulates the money supply and interest rates, which is how we get business cycles and the myth of "over" and "under" production.

How could an individual commodity producer not have to care about future demand?

If they don't try to forecast that demand they could be in a terrible situation in the future.

This has happened over and over again in nearly every industry. Are you saying that

if the government had no interference there wouldn't be overproduction of goods?

I can't see how that could possibly be. Having been an entrepreneur for many years now

I find that I have to constantly pay attention to what is in demand if I am going to make

money. If I produce too much of one good I may have to take a loss. In many markets

such as the current housing market the demand for a product can very quickly dry up

and developers can be left holding a substantial amount of product that they cannot sell.

[softwareNerd]

How could an individual commodity producer not have to care about future demand?

The context of the quote was commodity producers, not businessmen in general. So, an example would be a producer of oil or coal. Such producers can be hit by surprising market downturns and can benefit from surprising upturns. However, if they want to play low risk, they can, in any market where futures are available for 5 or more years out. For instance, oil futures can be sold today for the year 2015. That implies that a producer can cover the price-risk for the next 7 years, as can a large consumer of oil. The risks are borne by "pure" risk-takers in the financial markets. This is not possible in all commodities, but that was the context of the quote.

Of course businesses do have to project demand, and it's a vital part of what they do. Even if they can lay off some of the risk, does not mean they ought to. A major unexpected change (say in technology) might lead people to abandon one type of product for some other. However, while one industry suffers, a different one prospers. When all industries, across the economy are being hit, one has to look for the cause elsewhere.

In many markets such as the current housing market the demand for a product can very quickly dry up and developers can be left holding a substantial amount of product that they cannot sell.

This begs the question of why demand would very quickly dry up. After all, the demographics in the US have not seen a big change. It comes back to government control affecting the financial system.

Aside: While we're talking of credit expansion, governments in the western world are doing some major "liquidity infusion".

[Fireball]

Today the US government's central bank, the Federal Reserve Bank, pumped $38b of fiat currency into the economy. It probably will reduce interest rates .25% in the next few weeks. This has an effect of (1) debasing all existing currency in the US economy as evidenced by the price of gold rising $10 today, which results in inflation and (2) introducing new "easy" money into financial markets that will be used to finance even more risky/unsustainable business endeavors. All such actions further the boom we're in, and what goes up must come down...in 2009, 2010, 2011? No one knows exactly when.

In a laissez-faire capitalist economy, free-market banks would increase the money supply when it was needed. But the money would be backed by specie, meaning it would be objective money, thus keeping prices unchanged.

[Capitalism Forever]

issuing new money in exchange for *nothing* does not serve to monetize assets

The Fed never actually does that. All money issued by the Fed must be collateralized by either gold or securities--specifically, government bills, notes and bonds.

A government security IS something: it represents a claim to wealth that is going to be taken from taxpayers. While the government is not morally entitled to take any wealth from taxpayers, what it takes still IS wealth, and the holder of the bond will receive that wealth. So a government security IS an asset, just like gold is.

(Government securities might still exist under voluntary government financing, although they would probably be considered much riskier instruments than today's treasury bonds are!)

it serves to cause a glut on the capital market.

I'm curious what exactly you mean by that.

I define a "glut" as an amount of supply that exceeds what can be sold profitably. According to Say's Law, there can be no general glut; that is to say, there cannot be too much of wealth as such. There can be too many radios, or too many cars, or too many hair brushes, but there cannot be too much of whatever values you need for your life, i.e. wealth. And for the same reason, there can be no "general overinvestment," or a glut on the capital market: capital can always be used to create wealth, and there is always a use for wealth, so you cannot have too much capital.

The Fed caused The Great Depression in part because it flooded the economy with money that wasn't backed by anything.

The dollar was on a gold standard in the 1920s, so the money issued in that period was not only backed by something, but it was backed by gold.

A rise in the money supply causes neither a boom nor a great depression; what it might cause is a temporary disruption in productive output as the price signals propagate through the economy. A boom, if you define it as a rise in productive output, can only be caused by the producers.

[Capitalism Forever]

Today the US government's central bank, the Federal Reserve Bank, pumped $38b of fiat currency into the economy. It probably will reduce interest rates .25% in the next few weeks. This has an effect of (1) debasing all existing currency in the US economy as evidenced by the price of gold rising $10 today, which results in inflation and (2) introducing new "easy" money into financial markets that will be used to finance even more risky/unsustainable business endeavors.

As John McVey has just explained, even the Austrians acknowledge that an inverted yield curve bodes ill for the economy:

They [the Austrians] are big on monitoring the shape of the yield curve. Each Austrian has different precise criteria, but they generally hold that if the curve goes inverted for long enough then there is a recession looming.

If I remember correctly, the U.S. yield curve has been inverted for at least a year now, so a rate cut has been long overdue.

Also, as I wrote, it is important to distinguish increases in the money supply from making credit more available. According to softwareNerd's link, the "extra liquidity" comes through the "repurchase market" (emphasis mine):

The Federal Reserve became the latest central bank to make extra liquidity available to the financial institutions in the repurchase market.

In a statement on Friday morning, the Federal Reserve said it was “providing liquidity to facilitate the orderly functioning of financial markets” and offered to provide reserves “as necessary” to promote a federal funds rate close to its target rate of 5.25 per cent.

Repurchase agreements are a way of lending funds to banks, and it seems like the Fed is simply trying to reduce the Federal funds rate to its target--i.e. what the target interest rate has been all along, i.e. the actual rates on the market have apparently exceeded the Fed's target and the Fed is just doing what it always does: lend more whenever the actual rate is above target and needs to be brought down.

All such actions further the boom we're in, and what goes up must come down...in 2009, 2010, 2011? No one knows exactly when.

I would be interested in your definition of a boom and whether you think (as your above sentence seems to imply) that all booms are necessarily "unsustainable." Is all prosperity an illusion? Whenever you think you're well off, you're just seeing a mirage?

Edited August 10, 2007 by Capitalism Forever

[DarkWaters]

For the sake of discussing some more real-world examples, do any of you have an opinion on what is causing the alleged sub-prime mortgage bust in the U.S. housing market?

[softwareNerd]

The proximate problem is that there's a higher % of sub-prime loans than in previous years. Apart from being riskier in terms of requiring lower down payments, a large % of these loans have been structured as "variable-rate", and the borrowers are being hit by "re-sets" where they are just coming out of their first few years of fixed-interest rate, and their rate is now re-setting to a higher level. Even more such loans re-set in 2008.

For reasons, one can point to all sorts of places. Some candidates for blame:

• Lenders loosened standards (I believe this is true; not sure if it is primary)
  
• Borrowers were tempted beyond a reasonable calculation of what they should borrow (I believe this is true; not sure if this is primary)
  
• The Fed causes these rates to go up and down, and makes it tough for folks to figure out what they can afford to borrow/lend (I believe this is true; not sure if it is primary)
  

I should add that this is more like a downturn in a particular industry -- residential real estate -- rather than something that has hit other industries.

Edited August 11, 2007 by softwareNerd

[Fireball]

I would be interested in your definition of a boom and whether you think (as your above sentence seems to imply) that all booms are necessarily "unsustainable." Is all prosperity an illusion?

Boom/bust cycles, illusory prosperity and inflation are attributes of a collectivist economy. These do not exist in a laissez-faire capitalist economy. The reason these exist is to create chaos so producers do not see parasites draining the productive class.

[Solid_Choke]

As I stated in my post, a overproduction in one sector can have huge negative implications for many others. Esp if that is a big sector.

There is no such thing as overproduction. If too many shoes were made to sell at $80 a pair the price will be reduced until they will sell, say $50 a pair. Sometimes this results in a loss which is good because it punishes entrepreneurs for making mistakes. The price system is a built in feature of the free market that makes overproduction very costly to businesses but also rewards businesses that produce the exact right amount. If you really want to find cases of overproduction and underconsumption you will have to look in command economics such as the USSR. Many times they didn't have enough undershirts for everyone who wanted one(forcing some to buy them on the black market) and also made too many pieces of farm equipment that they could never get rid of and just left to rust. Meanwhile entire factories and hundreds of workers would continue building this equipment even though it would cost less to just have them sit around and watch TV all day because at least it would use less valuable resources.

Edited August 13, 2007 by Solid_Choke

[John McVey]

There is no such thing as overproduction.

You're missing the point. There is no such thing as general overproduction, but there is often overproduction in particular sectors, just as FD said. You're even noticing this yourself and then just mislabeling things.

Leaving aside a host of complications, for any given product there is a peak net revenue point of price times quantity less total costs. Produce more or less than that quantity and one gets less profit than this optimum. Underproduction is not producing enough to reach that optimum - that's where a business can lower its price and make up for it on volume. Overproduction is producing too much and having gone past that optimum - and that's where businesses have to cut back on volume and increase the price.

Both under and overproduction are real and do take place - constantly. The overproductionists say that overproduction can happen universally and cause problems for the economy in aggregate. Say's Law, and Mill's Doctrine of Proportionality, point out that this cannot happen: the grand total of all overproduction is matched by the grand total of all underproduction, netting things out. Certainly, aggregate profits are not as high as they could be, arising from that some resources are not being put to the best use that their owners could get from them, but the mere fact that aggregate profits are down doesn't mean there have to be aggregate job losses. To fix the profits problem the overproducers do have to cut back, including some jobs - but the underproducers have to ramp up and hire more people. Again things match out.

The error made by the overproductionists is not in the assertion that overproduction takes place at all but in their commission of an instance of the Fallacy of Composition. Overproduction is involved in the B&B cycle, but it is matched by underconsumption elsewhere. The credit expansion is the cause of that imbalance by messing about with the allocation of people's spending preferences. The expansion causes overproduction of various types of capital goods, and underproduction of various types of consumer and near-consumer goods. When the expansion effect wears off then businesses realise their mistakes and fix things up, as above. There is also some swinging back and forth in various industries to boot as the proper state of affairs is reestablished. Unless there is hampering of labour markets' operations, increased unemployment is limited in scope and is short-run only as this swinging works itself out.

JJM

[John McVey]

[*]Lenders loosened standards (I believe this is true; not sure if it is primary)

It is more accurate to say that lenders were forced to loosen standards. This is mostly the result of years of laws trying to ban redlining and other 'discriminatory' lending practices.

Another cause is capital adequacy standards under the Basel Accords. Amongst other idiocies, these rules weight loans to pay for housing or borrowing backed by housing as more secure than loans to industry. Naturally therefore, a bank with X to lend will prefer to lend to a consumer than a producer unless the producer is willing to pay a higher interest rate as compensation, even though the consumer can only pay back if the producer can produce. Things get really stupid from the fact that these weightings do not change despite changes in relative degrees of exposures by lenders, so lenders will max out their loans to consumers to the hilt and producers are still forced to pay higher rates than consumers. The result is heavy exposure to a consumer industry while starving the very thing that props up the value of those loan assets. Fun stuff!

Basel I, the main culprit of the above, was issued in 1998 and is in force now. Basel II was issued for review in 2004, with full publication in June 2006. Financial regulators around the world are still in the process of changing their own regulations to be in compliance with Basel II. Some countries' regulators, including UK and Germany, are already in significant compliance. That compliance includes new requirements for expanded disclosures and recognitions by financial institutions. After you read below, make of this what you will.

[*]Borrowers were tempted beyond a reasonable calculation of what they should borrow (I believe this is true; not sure if this is primary)

Very true. Gotta love the welfare state and its inculcation of attitudes such as no longer needing to save for a rainy day and demands of bail-me-out-NOW!

Then there is the so-called 'wealth effect,' which is a new driver. The optimistic economists said it was real, arising from the idiotic notion that one's own home is an investment, but it is a fallacy. As per good old fashioned squeezing out of real savings with inflated credit, the pushing down of interest rates via credit expansion encourages borrowing to spend to consume as well as a there being a reduction in the amount people save and put in banks for on-lending. The 'wealth effect' is a new twist, that the extra borrowing was based upon the value of people's homes rising and hence giving more nominal collateral for that borrowing. I think that prior to the recent decade it generally wasn't possible to redraw equity from one's home through the mortgage. The way out was found by a new application of an instrument called the Colleralised Debt Obligation (CDO), itself only invented in the 80's. More on this below.

On top of that again were the 'flippers.' These were people riding the credit expansion wave. They were getting quick loans, buying property even sometimes sight unseen, and selling it again only a short time later. A lot of blame is put on these people for driving up housing prices, but in essence these guys were just the messengers. Like all speculators they have largely been scapegoated, but do share blame to the extent they were reckless and borrowed on little calculation if any. Television programs glorifying them have also been singled out for criticism for goading people into flipping and quick renos etc.

[*]The Fed causes these rates to go up and down,

The Fed affects ('targets') overnight rates by pumping in cash to the commercial banks (the actual mechanism is a Rube Goldberg contraption), but does not directly control any other rates. For a little while now, pretty much since Bernanke took over the helm, the Fed has not been pumping in as much cash as it had been under Greenspan.

Another source is not the Fed but the Japanese' central bank. Interest rates in Japan were 0 for a while, and are still very close to it today. The 'carry trade' is the practice of people borrowing large sums at rock bottom interest rates from the BoJ and investing them elsewhere in the world at higher rates. I believe the US was the #1 destination for these borrowed funds, which itself propped up both consumption directly by keeping the US dollar higher than it should be (hence able to buy more goodies from overseas, such as from Japan as the BoJ intended) and by funding all that borrowing to consume.

Through the use of CDOs, the retail banks were able to offload many mortgages they had originated onto investment banks and hedge funds, who funded their new vehicles with CDO's issued to investors. All of these were flush with funds made available by the Fed and the BoJ, which for a long time had floated the property market by allowing the retail banks to continue originating more housing loans. The BoJ raised its interest rates above zero a few years back and gave everyone the jitters because the carry trade got threatened. Then the Fed cut back its own pouring in of cash once Bernanke took over. The money stopped pouring into housing via the backwash of funds from the investors to retail banks to borrowers, and as an inevitable result the property bubble began popping. That caused hits on the values of assets held by the CDO-funded investment vehicles, and in turn upon the value of the CDOs themselves as the vehicles' solvencies become questioned. Chuck in political considerations from the sheer size of the problem and you then get governments throwing in scads of freshly printed funds as emergency measures.

[*]and makes it tough for folks to figure out what they can afford to borrow/lend (I believe this is true; not sure if it is primary)

I think many borrowers often stopped giving a damn all together. Certainly lenders like the BoJ acted like it didn't care for a while, and the Japanese government is still under a cloud for having propped up many influential businesses' bad loans for political reasons rather than economic ones.

The cause is also more than just the actions of the central banks as it also includes the welfare state effects as described above. That was especially so for consuming borrowers, who just jumped at the chance to borrow against their homes and spend the money in the hugely increased array of consumer goods coming from China and the rest of Asia. Then there were the flippers who were in and out of borrowings in the space of months or less, who didn't much give a damn about interest rates because they expected the capital gains to be way more than their interest bills whatever they may be.

JJM

[softwareNerd]

It is more accurate to say that lenders were forced to loosen standards. This is mostly the result of years of laws trying to ban redlining and other 'discriminatory' lending practices.

It's true that lenders had been forced to make loans like that. Some of them have managers who are tasked specifically with making loans to "under-served segments", in the hope that they will not be accused of being discriminatory. Then, when they actually do, the government turns around and fines them for "predatory lending" to people who cannot repay. Damned if they don't; damned if they do.

On the other hand, this is not all there is to it. Just as some borrowers evade the long term and want easy loans that they probably can't repay, similarly some businesses evade the long term and make (or buy) such loans without pricing appropriately for the risk. Such businesses can ride the boom for 5-6 years, and then go bust.

Unrelated to this point, but on the topic on this thread, economist George Reisman recently blogged about the U.S. housing credit crunch.