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Meltdown Reveals Causes of Housing Bust

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There it was, in The Arizona Republic. It had to be true: Real-estate cycles still mysterious. The article started with the timeworn cliché, “This real-estate downturn has entered uncharted territory.” Obviously, the writer had not read Meltdown by Thomas E. Woods Jr.

The third paragraph provided still more evidence that the writer had not read Wood’s bestseller. “Much less is known about housing boom and bust cycles than, say, historic performance patterns for the stock or bond markets.”

To support his position, the writer cited an unnamed report released in June by the Federal Housing Finance Agency. The report asserted that “Most of the larger historical downturns were caused by sharp increases in unemployment rates and shocks to personal income.” But, as the writer admitted, these factors were not in play when housing “started into its tailspin for other reasons.”

Although the author went on with statistics about the housing bust and offered opinions about recovery, he did not discuss the “other reasons” for the bust. He could have, though, had he read only chapter four of Meltdown: How government causes the boom-bust business cycle.

Citing the work of F.A. Hayek, the 1974 Nobel Prize winner in economics for his theory of the business cycle and the work of the esteemed free-market economist Ludwig von Mises, Woods lays the blame for our housing bust at the feet of the Federal Reserve, the central bank for the United States. Although posturing as the “protector of the economy and the source of relief from business cycles,” the Fed is the cause of the business cycle as it distorts the business community’s perception as to the availability and the cost of money.

“As with all goods,” Woods notes, “the supply of loanable funds sometimes goes up and down, and on the other hand demand for loanable funds goes up and down. The supply and demand determine the price (of money).” When people are saving more, the supply of money is up and interest rates are down.

“From a business’s perspective, low interest rates provide an opportunity to engage in long-term projects that would not pay off under higher interest rates.”

. . . But then the Fed steps in

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Using several mechanisms at its disposal (Woods explains the Fed’s workings in chapter six.), the Fed artificially manipulates interest rates, distorting the business community’s perception of the real cost of money and the real availability of money. And, because the economy “can support only so many investment projects at once,” many business ventures turn into busts when not enough funds are available.

This scenario plays out most often when the Fed drives down interest rates, as it did under Alan Greenspan in 2001 with eleven consecutive rate cuts. From June 2003 to June 2004, the discount rate (the rate at which banks lend to each other and an important benchmark for interest rates) stood at a 1%.

Although the Fed’s efforts did not reignite a faltering stock market, as the Fed had hoped, they did kick off a housing boom, which, of course, brought us the housing bust when it became evident that not enough funds were available to continue lending. And the rest, as they say, is history.

Boom-bust cycles are neither mysterious nor unexplainable. Grasping boom-bust cycles takes only a rudimentary understanding of Austrian economic theory, and Meltdown goes a long way in providing that understanding. It is must read for persons seeking an understanding to what is happening in our economy and what we can expect if the government continues to interfere in the marketplace.

July 1, 2009