I’m very economically ignorant and so please bear with me.
What are these Federal Reserve interest rates which economists keep taking about?
How did the Fed’s low interest rates contribute to the housing market bubble & financial crisis?
I will use simple (imprecise) terms, but hopefully this will help you. The central bank creates money from nothing (I won’t get into the mechanism used to accomplish this). This money is placed into the banking system. As the amount of new money in the system increases, banks find they have “excess” money (they call it “excess reserves”, but we’ll call it “money” to keep it simple). With more money available in the banking system, banks are willing to lend to each other at a lower interest rate (the overnight loan rate, the “Fed Funds Rate”).
(Banks lend to each other on an overnight basis because in the normal clearing process, some banks may have extra funds to lend and others need funds, a perfectly normal activity.)
During most of the Greenspan era, the Fed decided to publically “target” a “Fed Funds Rate”. If they wanted the rate to decrease, they would simply keep printing money until the actual overnight rate declined to where they wanted it to be. To increase the rate, the central bank reverses the process, and takes money out of the banking system where it vanishes into the same black hole from which it came.
{EDIT} So, the “Fed Funds Rate” is the rate banks charge each other for overnight funds, but more signficantly, it is the rate targeted by the central bank in order to manipulate the money supply (at least it was prior to the Sept. 2008 collapse, the Fed’s using other methods now).
This is an extremely abbreviated explanation, and many important details are left out. But we are trying to keep things simple, we must start somewhere. The short story is that money created from nothing causes real goods to get consumed without prior production. (Ask yourself what happens if a neighborhood has a local counterfeiter who exchanges his “money” for real goods; the real goods get consumed, but there is no prior production, except for some paper and ink.) Simultaneously, low interest rates due to money creation cause long term projects to appear profitable. But in reality, because the actual supply of real goods is insufficient, these projects are not profitable as there are insufficient resources available to see these projects through to completion.
The process of simultaneously consuming goods and starting long term projects creates what is perceived to be a “boom” period. It seems real to all participants. Prices and labor rates rise, unemployment falls. In reality, as noted above, there are not enough real resources to see these projects (ie, home building) through to completion. The bust occurs, which is what we are experiencing now.
Here’s a good place to start: The Mystery of Banking The Bailout Reader Keynes Hayek Rap
" inflation is two-fold. Firstly, the Fed pushes new reserves into the system via the OMOs (i was told this was a purchase of sort type of bank holdings for the most part) in order to try to bring the FFR (federal funds rate) down. Secondly the ‘commercial banks pyramid loans on the basis of those reserves.’ So normally if the Fed increases the monetary base (not typically notes and coins but more commonly by increasing the total quantity of reserves in the system held on account with the Fed itself) by 100 billion you might expect an actual expansion of the overall money supply of maybe 1 trillion (in a very simple example)."
found here the actual procedure of creating money (alt thread)"
according to this post-reply i received the federal reserve conjurs up currency (a credit form - non paper or coin) and purchases often shakey bank assets. with the old bank assets in the hands of the federal reserve the ‘new money’ now with the banks cheapens the cost of money; ie, the interest rate.
i cannot say for sure how the assets aquired by the federal reserve (if true) are paid down…reducing the amount of overall ‘inflation’.
There is a great video rap that describes this process better than could ever do: http://econstories.tv/home.html
But I will give it a try anyway:
The FED injects new money into the banking system they create from nothing. Banks take this money and loan out 90% and keep 10%. So this means that there is 10 times as much money in the economy as was injected by the FED. Consumers see these low interest rates and borrow the money and buy higher order goods like cars and homes WHEN THEY WOULD NOT HAVE DONE SO WITHOUT THE LOW INTEREST RATES. So this is the start of the bubble as entrepreneurs move into these business areas hoping to sell to these consumers. In the beginning of the bubble everyone is happy, banks are lending like crazy, consumers are buying stuff with the borrowed money and entrepreneurs are making investments in the labor, land and equipment to satisfy the consumers.
What could possibly go wrong? Well this new money is now 10 times the original amount. This means that there is all this money chasing the same number of goods. Keep in mind that making money is a whole lot easier than making products and services desired by consumers. So prices begin to rise. They rise first in the bubble area but then spread to other parts of the economy. The end result is that these price rises start to accelerate. The FED at some point has to step in to stop the inflation before it really starts to accelerate like it did when I was a kid in the 1970s. So the FED slows (Does not stop or decrease but merely SLOWS the injections of money.) This is the little pebble rolled down the snow coverd hill in the cartoons. This little adjustment has banks raise their interest rates just a little bit. Then there are a little fewer consumers borrowing the money to buy the homes and other items. So we have a building of inventory by the entrepreneurs. Las Vegas come to mind?.
So this inventory means that buyers can now negotiate with sellers that starts the price decreases going. And this is where the bubble pops as entrepreneurs get stuck with inventory they have to mark down. They mark down the inventory and sell it at a loss. Then they start not only dumping inventory but laying off workers and selling equipment to stay in business. This is the bust.
Bogart’s answer was the best answer so far for the layman. There are many more articles, topics, and books detailing this very intricate theory know as the Austrian Business Cycle Theory or ABCT. Many people in the public eye besides Peter Schiff/ Ron Paul do not put forward this theory.