How an Economy Grows and Why It Crashes

by Peter D. Schiff

In his book Irrational Exuberance economist Robert Shiller determined that in the 100 years between 1900 and 2000, home prices in the United States increased by an average of 3.4 percent per year (which is just slightly higher than the average rate of inflation). There were good reasons for this. Prices were firmly tied to people’s ability to pay, which is a function of income and credit availability. But from 1997 to 2006 national home prices gained an astounding 19.4 percent per year on average. Over that time incomes barely budged. So why could people pay so much? The difference was credit, which government policy made much cheaper and easier to get. But credit could not expand forever, and eventually conditions tightened. When they did, there was nothing to hold prices up. So when the market crested, the easy money that for years had poured into the economy stopped flowing. Even if there had been no other economic reversals that followed the housing bust (which there were), the economy would have had to shrink without all the free cash. A recession was not only inevitable but absolutely necessary to rebalance the economy. But when the economy started to contract, lawmakers and economists treated the development not as the inevitable consequence of years of easy money and overspending, but as the problem itself. In other words, they mistook the cure for the disease.