Economics on a Bike

Jim and Harry went on their bikes for a friendly 10 mile bike race. After they were well past the half way point Harry had a comfortable lead and could see Jim several hundred yards behind him. The two men were cruising along at a fast pace.

Suddenly Harry’s bike chain became dislodged. As he began to slow, he thought of his options. If he stopped to reload the chain onto the gears, Jim would surely catch up and pass him before he could get back up to speed. The prospect of wasting time off the bike and then having to pedal doubly fast to catch Jim again was an unpleasant one.

This was a new course for the men so they were unfamiliar with the terrain. As Harry rounded a turn in the road, he noticed that the road was now in what looked to be a long continuous down slope. Harry’s eyes perked up as he realized he was again gaining speed. Harry made the decision that he should stay on the bike in light of this new development. Harry coasted down the hill and lowered his profile so as not to let the wind slow him down. His lead over Jim was maintained

While Harry was at first apprehensive about not stopping to fix the bike chain, he was happy that as fate would have it, he was able to coast down the hill without having to stop. Harry figured he could always fix it later if the hill let up and he would be no worse off. Harry lowered his profile still more and heard the wind whip past his helmet.

Several minutes passed before Harry turned his head. To his surprise Jim was now only about 20 yards behind him. Of course, Harry muttered to himself as he realized that due to his pedaling Jim had entered the down turn at a higher speed before beginning the descent. Jim was gaining fast and it was clear he would soon overtake Harry. Harry’s mind raced as he wondered what to do next. He saw the finish line approaching and realized his fate was sealed.

This story is paralleling the burden of Harry's bike chain being dislodged with that of large amount of debts. The down slope reduces the burden of Harry's problem. Similarly lower interest rates reduce the burden of the debt load. In both cases the problems are not solved, only postponed. They look as if things have improved but in actuality nothing has been done correct the problems. It only masks it and eventually makes his problems worse.

Debt is a burden, whether owed by a person, company or country. It costs money to pay the interest on debt. When people make a rational decision to retrench and reduce their debt burden they emerge in a stronger financial position. Harry was burdened by his bike chain becoming dislodged. His life would have been much easier had he gotten off his bike to fix it and reentered the race in a strong situation with a fully functioning bike.

When the Fed lowers interest rates below their naturally occurring free market rate, they are encouraging people to continue along as if their debt burdens were not a problem. True enough the interest burdens are temporarily lessened but just as in the story above, the fix is illusory and temporary.

When interest rates are lowered artificially below their natural rate it sends a false signal to the market participants. This not only prevents a true lasting recovery from taking place, it also sows the seeds for the next boom mania period where projects will be started that are doomed to fail.

We have seen this occur twice already just in the past ten years. The Nasdaq dot com bubble burst, a historic period of malinvestent. Instead of allowing the market to respond efficiently to eliminate the bad businesses and debts, thus letting the successful companies thrive, the Fed lowered rates to 1%. The much needed recession upon which a lasting prosperity could occur was cut short. In its place, a new even larger boom period of malinvestment began. The housing bubble wreaked havoc on millions of people and cost trillions of dollars of losses. The mortgage and related securities melted down in fall 2008 with the infamous banking crisis as bad bets could no longer be ignored by the firms foolish enough to have engaged in them.

Instead of at last letting the recession finally come and clean the slate for all the poor decisions, the Treasury nationalized enormous companies and the Federal Reserves bailed out firms that should have failed by making them whole on their bad bets. Then on top of that the Fed lowered rates to close to 0%, which is where we still stand today. There will be no lasting period of prosperity with the Fed in charge. The best we can hope for is yet another bubble to distract everyone from their precarious debt situation.