Credit Expansion and Contraction

While malinvestments always lead to lower prices in the end, they start off with prices going up. This happens as a direct result of credit expansion. Banks take the signal of low interest rates from the central bank and convert it into credit that it hands out to customers. Investors get credit notes in the form of dollars, euros, pounds etc. They subsequently go out and spend it on raw materials and property. Capital goods are produced with an increased supply of finished products as result.

However, credit is not money. It is merely the trust of an institution in a future payment. The investors command credit because the lenders trust them to pay back on their loans. It follows that credit cannot be infinitely extended. At some point, the limit to what we can trust people to deliver is reached, and no more credit can be extended without loss.

What happens when interest on loans are kept artificially low is that banks can afford to trust people more than they should. They expand credit beyond the reasonable, and since interest rates are determined centrally for all customers, the expansion goes to everyone in the economy. Everyone leverages up on debt at the same time.

When interest rates starts to rise, everyone get in trouble at the same time as well. Positions have to be unwound in order to cover debt. Suddenly, there is a rush to sell, and prices fall. This is the moment when malinvestments become clear to see. There are too may houses, they are too big, they are in the wrong area. There are too many products of various kinds. The demand was not based on real wealth but credit. The customers are no longer there.

Prices may well continue to go up in nominal terms. Relative to dollars and euros, prices may rise. However, relative to gold, prices go down. As things stand right now, it appears that we have reached the peak of the current expansion and that a drop in prices relative to gold is inevitable.

By US-gov - From an SSA poster: http://www.ssa.gov/history/wallst.html, Public Domain, Link