A History of Economic Booms and Busts

Release Date
September 6, 2011

Topic

The Fed & Monetary Policy
Description

When an economy falls into a recession, we typically observe a cluster of people making similar investment mistakes.  According to historian Stephen Davies, these investment errors occur because governments or central banks manipulate the supply of money. These manipulations place artificial downward pressure on interest rates, creating false signals that entice individuals to invest in what end up being unprofitable ventures. Booms and busts are not a new phenomenon of this century, but rather, have occurred throughout history both in America and around the globe.

A History of Economic Booms and Busts
Why is it that so many people all make the same investment mistake? The obvious explanation is that there’s a failure in the signaling mechanism of the market economy, which in this case particularly means the monetary system.
The United States and other countries have had a succession of financial crises over the last 300 years, similar to the one that we have just experienced. So in the United States, for example, there was a major crisis in 1929 to 1932, before then in 1920–21, before then in 1906, before then in 1892–93, before then in 1870–71.
The common feature of all of them is an unsustainable boom, in which some kinds of assets—tulips, railroad shares, stocks and bonds, or in the most recent case, real estate—become the subject of a speculative bubble, in which people buy the product in question, not because they expect to get income from it or to use it, but because they expect simply to be selling it onto another person at a higher price than the one they paid for it.
In the most recent case, what you had was an enormous real estate bubble in the United States and other parts of the world, which has now very painfully burst, with U.S. real estate prices down over 50 percent from their peak in 2007.
Why is it that so many people all make the same investment mistake? The obvious explanation is that there’s a failure in the signaling mechanism of the market economy, which in this case particularly, means the monetary system. The underlying common factor in all of the crises and panics I’ve mentioned is some disorder in the monetary system, brought about by action by governments, whether these are rulers or, more recently, central banks.
What these agents do is, essentially, to lower the price of money below its true market level. In other words, they keep the rates of interest below what it ought to be. What this means is that all kinds of investment opportunities appear to be profitable when in fact they are not. Eventually, however, it becomes apparent that the investments are not going to yield the kind of profits that the people making them expect. And at that point, suddenly everyone tries to get out; they try to liquidate their investment before it’s too late. And at that point, there’s a crash, and the assets collapse in value.