According to the many of the world’s leading economists, the free market has resulted in a catastrophy. There is not enough credit to go around, and the main culprits are the people who will not consume. So now comes the time to find solutions. What are we to do in this mess when no one seems to have the answer? Well the financial crisis is not what it seems, and I will show you why.
First, I will address the fallacy that the free market is part of the reason for failure. The first industry to fail was the banking industry. The banking industry is the most heavily regulated in the U.S. The Federal Reserve manipulates the interest rates, controls their reserves, regulates who get the loans, buy and sell them bonds, and insure them with funds they do not have. This is not a free industry.
The FED bought bonds from commercial banks, increasing their reserves. When they do this, the interest rates decrease. When the interest rates are extremely low, people borrow more than they normally would. This results in unwise investments which were made because of the low interest rates. If this were to happen at 1 or 2 banks, it wouldn’t be a problem. However, this interest rates effect every bank in the country. This is the cause of fake booms and very real busts. If it was not centralized, booms and busts would not be possible.
Now to the credit shortage. Excessive borrowing is how we get into this mess in the first place. People borrow much more than they have, so the marginal propensity to spend is above 1. An economy cannot sustain itself when the participants are spending 1.2 of every 1 dollar they earn.
Besides, if there is not enough money to go around, the easiest solution of course would be to legalize counterfeiting.
Next is the lack of consumption. The equation for GDP is GDP=C+I+G+NX. The problem is that C (consumption) is too low, so our GDP is going to shift to the left, showing a decrease is total GDP. Of course that sounds awful, but is it really?
Before I show the cons of consumption, I will show the difference between hoarding money and saving money. When people spend less, the assumption is that they are keeping their moey hidden under their bed. However, the truth is that hoarding does not happen. Instead, people put their money in the bank or in the stock market. When the money is put in the bank for saving, it becomes available for the banks to loan out. The alternative of that, is to invest it in mutual funds, bonds, or the stock market. This causes an increase in I (investment). This increase in I is more important than the decrease in C because I is investment in production, where C is spending alone. Also, most spending is on imports, which causes another decrease in NX (net exports), causing the GDP to shift to the left.
Our current GDP is way beyond the potential GDP. How can we be beyond the potential? Borrowing. As I mentioned before, people are borrowing much more than normal due to the low interest rates. So people borrow this money, and plug it into the equation GDP=C+I+G+NX in the form of C and I. So the GDP is boosted, but not because of increased production wealth, but borrowed funds. So the level of GDP we have had is fake. It is beyond the potential because of the borrowing. This is called an inflationary gap.
In time, the bad investments and massive defaulting on loans results in an economic crash, which we have just had. We fall back to the potential GDP, or slightly below. This is called a recessionary gap. It is healthy for the economy, as long as the market is allowed to make the corrections needed.
However, inaction is political suicide, so the market will not be able to correct itself. The government will attempt to boost GDP by increasing G (government spending). However, this will fail because C= consumption+[MPC(Y-T)]. T (taxes) is increased in order to increase G. By increasing G, it will decrease C which means the GDP will not increase at all.
This is the real financial crisis which you will not hear in the media. It will not get better anytime soon because the only solution is to free the market. When people are in a state of panic, which they are right now, people want the government to help. Too bad no one realizes that they will only make it worse.