Common sense from an uncommon economist

Ho Say Peng

Thomas E. Woods, Jr is a senior fellow at the Ludwig von Mises Institute. In 2009, he published the book “Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse”. It was on the New York Times Best Seller list for 10 weeks. This is my commentary on the book.

An Austrian's perspective

If you seek a factual and accurate explanation for the recent financial crisis, you will not find it from mainstream – i.e. Keynesian – economists. They have never been able to correctly account for past crises and their rhetoric has not changed. They blame the free market economy for every crisis and their solution is to demand more government regulation. They fail to notice that a free – i.e., an uncontrolled, unregulated, laissez-faire – market economy has never existed in human history and are ignorant of the distortive and destructive impact government intervention has on the economy.

President Barack Obama said in one of his weekly radio and Internet address that “every day we don’t act, the same system that led to bailouts remains in place, with the exact same loopholes and the exact same liabilities. And if we don’t change what led to the crisis, we’ll doom ourselves to repeat it.”

Obama has rightly stated that there is a problem, but he has wrongly identified the problem and has inadvertently proposed and enacted the wrong solution – the same wrong Keynesian solution of more government expenditure, rock-bottom interest rates, and more regulation.

“This is why,” writes U.S. Congressman and Austrian libertarian Ron Paul, in the foreword, “Meltdown is so important. This book actually get things right. It correctly identifies our problems, their causes, and what we should do about them.”

Woods begins by describing the U.S. government’s response to the increasingly dire economic situation in the fall of 2008: “The stock market plummeted, companies folded, and economic fear and uncertainty began to spread…President George W. Bush addressed the nation on September 24, 2008, with the proposed [$700 billion] bailout plan for the financial sector…[and] he devoted some time to [address] what were purportedly the downturn’s “root causes”…[on October 3, 2008,] the [$700 billion “rescue plan”] was promptly passed and signed into law.”

Woods continues by saying that the new Obama Administration is going to be no different. Obama’s promise of “change” is a farce. There is going to be no “change” insofar as the economy is concerned.

Obama supported Bush’s bailout package, appointed Timothy Geithner – who played a supporting role to Henry Paulson in the Bush administration – to Secretary of the Treasury, appointed Ben Bernanke – who chaired President Bush’s Council of Economic Advisors – to Chairman of the Federal Reserve, and appointed Lawrence Summers – Secretary of the Treasury to Democratic President Bill Clinton’s administration – to be director of the White House’s National Economic Council.

This is not “change we can believe in” – it is merely “more of the same – more bailouts, more government intervention, more addressing symptoms rather than causes – along with huge deficits and massive increases in government spending”, which means more of the same mistakes and as a result, more of the same disasters.

The million dollar – nay, $700 billion dollars – question is still unanswered: What is (or, are) the cause(s) of the financial crisis?

Some blame “excessive risk-taking” and “greed” for the crisis – which is as useful as “blaming plane crashes on gravity”. Some blame the free market economy for the crisis – but a free market economy has never existed.

In his speech on September 24, 2008, President Bush attempted to give an answer but it was ambiguously explained. He identified Fannie Mae and Freddie Mac, which are mortgage companies “chartered by Congress”, as the causes of the problem. He spoke about the implicit government guarantee of Fannie Mae and Freddie Mac which “allowed them to borrow enormous sums of money, fuel the market for questionable investments, and put our financial system at risk.”

However, Bush has yet addressed the “root causes” of the crisis. In the first chapter, “The Elephant in the Living Room”, Woods succeeds where Bush has failed. He correctly identifies the Federal Reserve, the central bank of the U.S., as the “primary culprit” of the whole financial meltdown.

“The Fed,” writes Woods, “is the elephant in the living room that everyone pretends not to notice. Even many of those who blame government for the current mess leave the Fed out of the picture altogether. The free market, meanwhile, takes the blame for the destructive consequences of what [the Fed] does. This charade has gone on long enough. It’s time to consider the possibility that maybe the elephant, and not little Johnny, is the one breaking all the furniture.” How the Federal Reserve’s intervention into the economy creates artificial booms, which must eventually end in busts, is elaborated in Chapter 2 and 4.

Woods starts chapter 2, “How Government Created the Housing Bubble”, by telling the story of the housing market from 1998 – when home prices rose exponentially – to 2006 – when the housing bubble began to unravel. As more people default on their mortgage loans and the rate of foreclosure increased, mortgage-backed securities issued mostly by Fannie Mae and Freddie Mac began to lose value and their investors – which include many large financial institutions such as Lehman Brothers and Goldman Sachs – began to suffer heavy losses.

Next, Woods asks the question: “What institutional factors gave rise to all the foolish lending and borrowing in the first place? Why did the banks have so much money available to lend in the mortgage market – so many indeed that they could throw it even at applicants who lacked jobs, income, down payment money, and good credit?”

His answer – government. “These phenomena, as well as the housing bubble and the economic crisis more generally,” he writes, “are consistently traceable to government intervention in the economy.” Woods points out six specific culprits of government.

The first is Fannie Mae and Freddie Mae.

“At the center of the collapse,” says Woods, “were…Fannie Mae and Freddie Mac.” He proceeds to explain how these “government-sponsored enterprises” had conducted their mortgage business and how as their business came under increasingly political pressure, they took on “significantly more risk” by “[increasing] the number of minority and low-income home owners who [tended] to have worse credit ratings than non-Hispanic whites.”

Those who raised red flags about the two companies were balked at. One of them was Ron Paul, who on September 10, 2003, testified before the House Financial Services Committee warning that because of the “special privileges granted to Fannie and Freddie”, they had “distorted the housing market” by “attracting capital they could not attract under pure market conditions…[creating] a short-term boom in housing. Like all artificially created bubbles, the boom in housing prices cannot last forever.”

Ron Paul was proven right: In the late summer of 2005 and by the summer of 2006, in many parts of the U.S., several markets were facing the issues of ballooning inventories, falling prices and sharply reduced sales volumes. In March 2007, the whole mortgage industry collapsed. By August 2008, shares of both Fannie Mae and Freddie Mac had tumbled more than 90% from their one-year prior levels.

The second culprit is the “Community Reinvestment Act and affirmative action in lending”.

Signed into law in 1977 by President Jimmy Carter and given new impetus by the Clinton Administration, the CRA “opened banks up to crushing discrimination suits if they did not lend to minorities in number high enough to satisfy the authorities.” And, Woods writes, “It wasn’t just the CRA that was pushing lower lending standards. It was the entire political establishment.”

And together with “unscrupulous lenders [who] dishonestly forced subprime mortgages with unfavorable or complicated terms on helpless and uneducated borrowers” and “left-wing groups like ACORN [who] blocked drive-up lanes and made business impossible for banks until they surrendered to demand that they make billions in loans they wouldn’t other have made”, massive amount of excess capital flowed into the U.S housing market feeding the housing bubble.

The third and fourth culprits are “the government’s artificial stimulus to speculation” and “the “pro-ownership” tax code”.

Woods warns about placing too much emphasis on subprime loans. He says that “foreclosures primarily came about not because of subprime mortgages, but because of adjustable-rate mortgages – the one Alan Greenspan had once urged people to use – whether prime or subprime” and points out that “there was a larger percentage increase in adjustable-rate prime mortgages than there was in subprime mortgages, where all the trouble was said to be.”

The answer to Woods’s rhetorical question “How did prime adjustable-rate borrowers get more bamboozled than subprime borrowers?” is that people, “attracted to the adjustable-rate mortgages” bought houses with the intention of speculating. The adjustable-rate mortgage allows them to “unload their houses well before the teaser rate [“a low interest rate that makes these mortgages initially attractive”] expires”.

Woods also blames government’s involvement with rating agencies. According to economist Art Carden, “SEC regulations hung over the rating agencies like the sword of Damocles, and the raters didn’t want to attract undue regulatory attention by opposing a politically popular initiative” which was making risky subprime loans to those who could not afford to pay. Woods adds that, in fact, “the handful of approved rating agencies…are actually an SEC-created cartel protected from competition by regulatory barriers.”

Another to blame was the “pro-ownership” tax code such as the US$5000 tax break first-time home-buyers receive. Although tax breaks are always good, Woods cautions that “a “tax break” is an oasis of freedom to be broadened, not a loophole to be closed” and “instead, they should be extended to as many other kinds of purchases as possible, in order not to provide artificial stimulus to any one sector of the economy”.

The fifth culprit is the Federal Reserve and its policy of “artificially cheap credit”.

Woods has an entire chapter later dedicated to busting the crap out of the Federal Reserve. So, he is careful not to elaborate too much. He quickly explains without going into detail how “when the Federal Reserve pushes down interest rates…it encourages a boom…Fed’s artificial stimulus is not in line with real consumer demand…it encourages more and different kinds of projects to be undertaken than the economy can sustain…[and eventually] the bust comes.”

The six and final culprit is the “too big to fail” mentality.

This mentality drives the thinking of today’s U.S. politicians and it promotes moral hazard. Woods suggests “letting a few major firms actually go bankrupt” and allowing the market to run its course and correct the vast amount of damage government intervention has inflicted on the American and world economy.

In chapter 3, “The Great Wall Street Bailout”, Woods details the transpiration of events from March 2007 when Henry Paulson said “[the global economy]’s as strong as I’ve seen it in my business career” – to May 2007 when Ben Bernanke said “We do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system” – to September 2007 when Paulson announced Fannie Mae and Freddie Mac would be nationalized by the U.S. government – to the passing of the “the mother of all bailout”, the US$700 billion “Emergency Economic Stabilization Act of 2008” into law.

Woods also criticizes the ban on short-selling. Such bans, he writes, “have perverse effects, exactly contrary to the purpose for which they are proposed. If investors are to place their money somewhere, they need to know which positions are sound and which unsound. If speculators massively short certain companies, the remaining companies are implicitly given a clean bill of health. Investors can thereby make a safer, more informed decision…”

He explains that the reason why “regulators tend to be highly critical of short-selling” is because “short-sellers often show up the failures of regulators…often call attention to questionable firms before regulators themselves do…” Woods cites Enron as an example: “It was a short
-seller, namely James Chanos, who peered into Enron’s finances…saw a rotting corpse…shorted the stock and blew the whistle.”

In addition, he explains why regulation, not deregulation, is the problem and exposes the overblown claims of a “credit crunch”. Woods closes this chapter by warning us that “when the bill comes due”, there is going to be a price – a high price – to pay and invokes Friedrich von Hayek, who “won the Nobel Prize in economics for showing how central banks set the boom-bust cycle in motion”, as the voice we need to listen to in order to escape the current mess and avoid another one.

Chapter 4, “How Government Causes the Boom-Bust Cycle”, is a tour de force. Woods uses the Austrian Business Cycle Theory to explain how the Federal Reserve is the ultimate initiator of the boom and bust cycle, thereby “exonerating the free market of blame.”

In a free market economy, price is determined by supply and demand. Interest rate, which is the price of borrowing money, is determined by the supply of savers’ monies and the demand of borrowers such as individual consumers, businesses, etc.

When interest rate is low, due to higher net savings than borrowing, it means that, in general, there is “a relatively lower desire to consumer in the present” – which provides businesses an opportunity to engage in long-term investments with “an eye to future production” such as “increasing their productive capacity in the future – e.g., expanding existing facilities, building a new physical plant or acquiring new capital equipment.”

Vice versa: “If people posses an intense desire to consume right now, they will save less – making it less affordable for businesses to carry out long-term projects (because interest rates will be higher).”

In short, “interest rate coordinates production across time. It ensures a compatible mix of market forces: if people want to consume now, businesses respond accordingly; if people want to consume in the future, businesses allocate resources to satisfy that desire as well.”

The interest rate can perform this coordinating function only in a free market economy “where it is allowed to move up and down freely in response to changes in supply and demand.”

So, when there exists a central bank and it manipulates the interest rate through a variety of ways, the “coordination of production across time is disrupted.” The central bank creates a mismatch of market forces. This mismatch occurred when Alan Greenspan lowered real long-term interest rate to 3-3.5% following September 11 in 2001, which, together with factors discussed in chapter 2, launched the U.S. housing market into an artificial boom – which, according to Austrian Business Cycle Theory, had to culminate in a bust – and it did.

But without doubt, more mistakes will be and are currently being made following the bust. The recession, or depression, which results, is a “necessary if unfortunate correction process by which the mal-investments of the boom period, having at last been brought to light, are finally liquidated, redeployed elsewhere in the economy where they can contribute to producing something consumers actually want.”

In its usual delusion and megalomania, the U.S. government does everything it should not be doing: namely, implementing Keynesian policies and more regulation.

The recession is not the problem, but a correction of it. The problem is the Federal Reserve and its mistake is distorting the market interest rate by lowering it to levels which does not reflect economic reality. But, instead of recognizing the mistake, the U.S government (and most governments from the rest of the world) exacerbates the situation by dropping the interest rate even further. On April 28, 2010, I received a “Breaking News Alert” from the New York Times informing me that the “Fed [kept] short-term interest rates near zero.”

Woods quotes Hayek who wrote this during the Great Depression: “Instead of furthering the inevitable liquidation of the maladjustments brought about by the boom…all conceivable means have been used to prevent that readjustment from taking place…one of these means…has been this deliberate policy of credit expansion. To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about…”

Woods further criticizes Keynesian “pump-priming”, i.e., government spending: “Take from the economy as a whole [through taxation] and pour resources into particular sectors – that should make us rich! Economic historian Robert Higgs compared plans like these to someone taking water from the deep end of a pool, pouring it into the shallow end, and expecting the water level to rise.” Printing money out of thin air to fund government spending is an equally counterproductive strategy.

He then points to the dot-com boom and 1980s and 90s Japan as examples of the Austrian Business Cycle Theory in action – particularly Japan, who did everything the Austrians warned against – which is everything the Americans are doing today – the Japanese government cut interest rate to zero, launched over $100 trillion of stimulus packages – and as a result, suffered a “Lost Decade” of economic growth.

Woods writes that “had [the Japanese] government not distorted the market so severely and seized all these resources for its own uneconomic use, the private sector would have been in much healthier position to build toward recovery.”

In Chapter 5, “Great Myths about the Great Depression”, Woods repudiates the myths of the 1920s and 30s depression. This is important because these myths “long since discarded by reputable historians, are making a predictable comeback at the hands of ambitious politicians who seek to malign the free market and grab additional powers for themselves.”

But before Woods does so, he explains why booms and busts occurred before the Federal Reserve came into existence in 1913 when the Federal Reserve Act was enacted by President Woodrow Wilson. Again, he traces it to government: “The Panic of 1819 resulted from the excessive issue of paper money by banks at all levels. This issuing of money did not correspond to gold in their vaults… Chartered by the U.S. government in 1816, the Second Bank of the United States…had joined in this over-issue of paper money…” and “as in later crises, banks were allowed to suspend specie payment (a fancy way of saying that the low permitted them to refuse to hand over their depositors’ money when their customers came looking for it) while permitting them to carry on their operations. The knowledge that government could be counted on to bail out the banks in this way created a…problem of moral hazard…” and “During the 1830s, the Second Bank [chartered by the U.S. government]…orchestrated an inflationary boom that led to an inevitable bust…”, etc, etc.

Now – the Great Depression. First, Woods lays out “the groundwork for the Great Depression”. He describes the economic situation before the Depression and explains how the Fed’s inflationary policy, i.e., “a substantial inflation of money supply”, in “the form of additional loans to business” led to the artificial boom of the capital-goods industries and the stock market. “Finally and inevitably, the correction came. The stock market crash of October 1929…sharp declines in output and employment…”

It is a myth that “President Herbert Hoover, who is described as a strict proponent of laissez-faire, sat back and did nothing as the Great Depression devastated the country” and “only when Franklin Roosevelt took office…was serious action taken to arrest the economy’s decline.”

President Hoover “launched public works projects, raised taxes, extended emergency loans to failing firms, hobbled international trade [one of his policies was the infamous Smoot-Hawley Tariff], and lent money to the states for relief programs. He sought to prop up wages at a time when consumer prices were falling…” which led to Roosevelt accusing Hoover of presiding over “the greatest spending administration in peacetime in all of history” and derided him for believing “that we ought to center control of everything in Washington as rapidly as possible.”

But, President Roosevelt was not the better man. He made “much bolder moves than his predecessor.” He launched a leviathan economic program called the New Deal, which prevented the economy from correcting itself and prolonged the Great Depression.

The last myth to debunk is the notion that – in the words of Keynesian economist Paul Krugman – “what saved the economy, and the New Deal, was the enormous public works project known as World War II, which finally provided a fiscal stimulus adequate to the economy’s needs.”

“If spending on munitions really makes a country wealthy,” writes Woods, “the United States and Japan should do the following…” and he cites Jon Basil Utley’s thought experiment:

“Each should seek to build the most spectacular naval fleet in history, an enormous armada of gigantic, powerful, technologically advanced ships. The two fleets should then meet in the Pacific. Naturally, since they would want to avoid the loss of life that accompanies war, all naval personnel would be evacuated from the ships. At that point the U.S. and Japan would ink each other’s fleets. Then they could celebrate how much richer they had made themselves by devoting labour, steel, and countless other inputs to the production of things that would wind up at the bottom of the ocean.”

The “war brings prosperity” argument “is based on the same central fallacy as the “consumer spending drives the economy” silliness”, which will be refuted in Chapter 7.

“The purpose of this chapter,” says Woods in Chapter 6, “Money”, “is to introduce some important concepts and to overturn some of the myths that stand in the way of evaluating the idea of getting government out of the money business.”

He begins by asking “where does money come from?” and proceeds to explain the old system of barter trade, and when “people who are dissatisfied with…barter perceive that they can acquire a more widely desired good than the one they currently possess, they are more likely to find someone willing to exchange with them”, and money was borne.

“Money has to originate on the market in this way,” Woods writes, “since only then would people know what its value was…”

All economies, after the slow dissolution of the barter system, have always adopted commodity money as the medium of exchange, and they “have most often chosen gold and silver” after millennial of experimentation with other solutions such as whales’ teeth, giant stone disks, string of beads – Homer recalls the use of cauldrons and iron tripods as money in the ancient world.

Fiat currency could not have come about without commodity money first appearing. This is because, if something was to be used as a medium of exchange, it has to be something of universal value such as gold or silver, and “in the processing of becoming a money, it would acquire an array of prices of other goods in terms of itself.”

Paper is of no value if it is not backed with some commodity. Yet this is what we have today. And how did this happen? Woods explains: “The usual pattern runs as follows: (1) society adopts a commodity money; (2) paper notes issued by banks (or by governments) that can be redeemed in a given weight of the commodity money begin to circulate as a convenient substitute for carrying precious metal coins; and (3) government confiscates the commodity to which the paper notes entitle their holders, and thereby leaves the people with an inconvertible fiat paper money.”

“The substitution of fiat paper money for an existing commodity money always and everywhere comes about by some government violation of private property rights. It always involves the threat of violence and never occurs voluntarily,” Woods continues, “After 1993, when the federal government ordered Americans to hand over all their monetary gold to the authorities, the paper money that had once been a claim to a weight of gold continued to circulate out of habit, and because an array of price had already come into existence in terms of that money.”

The central bank controls a nation’s money supply; it controls the value of your money. When the central bank decides to lower interest rate, it inflates the money supply; and the value of your money falls. When you used to spend $8.50 on a movie ticket, now it will cost you more: $10. Keynesians like to define this rise in price as “inflation”. In fact, inflation is the undue expansion of money supply; and the rise in price is its inexorable consequence.

(But not all price rises are due to manipulation of money supply. Ludwig von Mises termed these noninflationary price rises as “goods-induced” price changes.)

Woods explains why “inflation [undue expansion of money supply] can occur without rising prices…for example, an increased abundance of goods had been pushing prices lower, a greater money supply, by putting upward pressure on prices, could cancel out that downward trend and keep overall price level stable… In that case, the inflation deprives us of the increases in our standard of living that falling prices would have brought about.” He also exposes the fallacy of “cost-push inflation”.

Woods distinguishes two kinds of economic growth – one driven by cheap money supplied by the central bank – which is artificial – and one driven by savings and production – which is sustainable. He closes this chapter by refuting those who condemn commodity money. “A note on deflation” is attached at the end of the chapter. Woods dismisses the standard negative claims of deflation with rigorous clarity.

What a read! “What now?” Wood asks at the start of the final chapter, “What Now?”

Before that, Woods want us to get one last thing right: consumer spending does not drive the economy: “Consumption is the act of using things up. How did any country ever become rich simply by using things up? Before things can be used up, they need to be produced. Production, in fact, is what makes consumption possible in the first place, because it gives us the means with which we can acquire the goods we want. To consume more, we first have to produce something ourselves.”

Woods invokes John Stuart Mill to back his argument: “What a country wants to make it richer is never consumption, but production. Where there is the latter, we may be sure that there is no want [lack] of the former. To produce, implies that the producer desires to consume; why else should he give himself useless labor? He may not wish to consume what he himself produces, but his motive for producing and selling is the desire to buy. Therefore, if the producers generally produce and sell more and more, they certainly also buy more and more.”

Finally, what should America – and the rest of the world, if it applies – do?

“Let [firms who need to go bankrupt] go bankrupt” – “Abolish Fannie and Freddie” – “Stop the bailouts and cut government spending” – “End government manipulation of money” – “Put the Fed on the table” – “Close those special lending windows” – “End the monopoly money” – and establish the gold/silver standard!

From 2005 to 2007, Peter Schiff, an Austrian proponent, used the Austrian Business Cycle Theory, and accurately predicted and repeatedly warned the public through a series of television appearances that the American economy is “like the Titanic” and “what’s going to happen in 2007” is that “real estate prices are going to come crashing back down to Earth”… “I see a real financial crisis coming for the United States.”

Like Ron Paul, Peter Schiff was proven right. On April 27, 2010, Peter Schiff appeared on CNBC and he warned that if the U.S. continues on its destructive path of low interest rate and high deficit spending, the dollar will lose all its value and collapse.

Such an event will have an even worse worldwide catastrophe than the recent crisis. To prevent this from happening, Woods suggests we “abandon our superstitions about the expertise of Fed officials and their ability to manage our monetary system” and “listen to people who have a coherent theory to explain why these crises occur, saw this crisis coming, and have something to suggest other than juvenile fantasies about spending and inflating our way to prosperity.”

The choice is clear: choose pure economic freedom and prosper beyond your wildest imagination, or some mongrel mix of freedom and control and wait till the government poison kills you. In any compromise between food and poison, it is only death that can win.

Meltdown is available for purchase at Kinokuniya for S$48.44 — a reasonable price to pay for the truth.