By James Henry

Where do bubbles come from anyway?

With storm clouds looming over the economy, evidence of over-heated, over-inflated markets is accumulating. Many analysts believe we are on the edge of a bubble that’s about to deflate. Having lived through these booms and busts before should make us step back and ask—where do these bubbles come from? Clearly not all entrepreneurs are successful all the time but why is it that periodically, all of a sudden, they all go bankrupt?

Who or what is behind this economic mystery variously labeled the economic cycle, the business cycle, the trade cycle, booms and busts, bonanzas followed by bankruptcies?

The answer to this question lies at the heart of how our banking and monetary system works. In the past, people used all variety of things as money, but typically settled on gold and silver as they had the most moneyish qualities—these qualities being acceptability, portability, divisibility, fungibility and store of value. Over time, people started storing their money with goldsmiths, for safekeeping, who gave them paper receipts in return, IOUs to pick up their money at a later time (bailment contract). Eventually the goldsmiths became bankers and began issuing more IOU’s than actual money deposited. This practice, legalized by the monarchs of Europe (in return for lots of loans of course) can be termed the fractional reserve banking system. It’s called this because when you deposit money in a bank, it only keeps a fraction on hand and loans the rest out; the interest on the loans is their profit. Over time, banks became the masters of the economy and society, replacing the church, monarchies, and aristocracy. That’s wonderful and all—but what about the bubbles, you may ask?!?! The answer is as follows.

When banks loan out someone’s checking account deposit to another client to buy a house, or car, etc., both parties think they have use of that same money. As more money is dished out into the economy as a result of bank credit expansion, wherever that new money is spent, prices and materials prices rise and we have a boom on our hands. As prices begin to rise, entrepreneurs calculate that they can make some serious profits in booming industries. But at some point prices outstrip what the market can bear and eventually we have a bust on our hands. The house of cards falls and depression sets in. Governments, egged on by banks, rush to plug the holes with more (you guessed it) borrowed money for, guess who, the banks—and nothing improves.

Business cycles wreak havoc on the price system, make it hard for entrepreneurs to forecast their probability of success, and inhibit regular people’s ability to save for the future. To truly put an end to these cycles of crisis, distorted prices (which only rise of course) and economic chaos, we must fundamentally reform the banking system. Money must return to a means of exchange, not a parasitic means to an end.

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