This mal-investment thing is easy to grasp. Just walk around downtown Bellevue and admire all of the new but substantially empty condo towers. That's mal-investment caused by cheap money (i.e., low interest rates). Keeping interest rates low doesn't really solve anything. It doesn't cause more people to move into town. It doesn't make all of the other housing opportunities disappear. It just makes it easier for those companies to hang onto their empty buildings a little longer before they go bust. Then someone will swoop in and buy the stuff cheap and figure out something useful to do with it.
We received a copy of your correspondence and because we think the LSE has confused the issue, we wish to try to sort it out for you. First of all, you must realize that the LSE has a socialist and collectivist bent and is well known for its specialization in a form of economics called econometrics. Econometrics and socialism go hand-in-hand. Collectivism mandates government control. And if government is going to control something, it will need forecasts and modeling on which to base budgets. Econometrics provides what is necessary. The math is impressive and the individuals involved have a good deal of skill when it comes to numbers.
But a facility with mathematics does not necessarily create a logical or realistic model. In fact, modeling does not work. Free-market economists have pointed out that through human action individuals change their behavior based on their conditions. A model may show a lack of food and upcoming mass starvation, but people faced with starvation will try to plant gardens and raise animals to ward off hunger. Thus, no matter how good the models are, they will never correspond to reality as they are based on trends that will always readjust, throwing the model out of whack.
So, what really did happen? It is the same thing that happens every time. Western central banks inflated, causing a build up of mal-investments that eventually caused a very bad bust. There is not much to do about it at this point except let the ruin run its course. But instead governments in the West are propping up the financial industry and refusing to let large companies fail."
Your basic Libertarian - namely Peter Schiff - will say, "We have to take the medicine of bankruptcy to fix the problem of cheap money" or some such. It sounds so horrible. But if you look at those empty buildings you think, "Some idiot made a bad bet and now we have a giant empty building in our town. Too bad his company will go bust." You don't think about society and social engineering and medicine. You think, "Bummer. I'm glad that's not me." Unless, of course, it is you, but then your company (probably not you) would go bankrupt and you would have to find something new to do.
But the government makes it hard for you to start over as well when they keep interest rates low. Instead of some entrepreneur figuring out what to do with the empty building it just sits there. There's no new construction going on ... there isn't even any demolition work! It's just a malaise and it's very sad. The cheap money keeps bankers from going bankrupt from the losses on these loans but it doesn't do anything else for the community except help it stagnate.
(Bellevue's not that bad off ... but by all accounts Detroit is.)
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