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Strategies & Market Trends : The Epic American Credit and Bond Bubble Laboratory
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To: Crimson Ghost who wrote (29916)4/3/2005 5:24:38 AM
From: Elroy Jetson  Read Replies (3) of 110194
 
While it might seem logical to presume that rising interest rates lead to declining loan demand, this places the cart before the horse. Rising interest rates are a result of declining loan demand, such as when a bubble can no longer be supported by a sufficient number of buyers. Conversely, falling interest rates indicate a rise in new credit being issued - as happens when a financial bubble picks up strength.

This may seem contrary to what everyone knows about supply and demand. Because it is. When credit demand rises, the limited amount of savings is rationed through higher prices - that's a typical market economy.

But we live in a monetarist economy based on fractional reserve banking and a Federal Reserve which can create an unlimited amount of money out of thin air. As each new billion of credit is issued, the amount of issued "money" outstanding is increased by nearly the same amount. Thus as credit demand increases, such as in a real estate bubble, the supply of "money" increases - sending interest rates lower. This is a problem in monetarist economies - financial bubbles become self-sustaining by lowering interest rates as they create more of their own monetary rocket fuel.

When the demand for new loans falls off, such as when a bubble runs out of buyers, the interest rate begins to rise as there is a decrease in the expansion of the "money supply". Bubbles collapse when you run out of sufficient buyers. In a monetarist economy this results in higher interest rates. If the central bank wanted interest rates lower, they would need to find an alternate way to put significant new large amounts of credit into the system.

These perverse situations most often occur in deflationary periods. When the central bank attempts to stabilize prices through significant increases in credit, the unintentional result is a series of financial bubbles as money rushes to the hottest part of the economy.
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