One of my thoughts on the financial crisis is that the cause of disagreement among experts on how to prevent a disaster from the mortgage correction is rooted chiefly in theories of the causes of the Great Depression and the cause of the business cycle in general.
Fed Chairman, Ben Bernanke, and certain monetarists view the depression as rooted in a liquidity crisis. If that crisis could have been avoided, then a cascading series of confidence failures could also have been avoided. The theory is that the central bankers of the 1930s pursued an austerity policy at the wrong time, leading to runs on banks, hoarding of hard assets like gold, leading in turn to the inability of functional businesses to get capital in what should have been a prime, deflationary environment with which to attract labor and purchase capital assets.
The Austrians and I view the depression and the business cycle in general as a phenomenon of inflationary monetary policy and the distorted economic cycles caused by central banking and fiat currency. Central bank artificial inflation allows artificially long and non-correcting cycles of inflation. In the older regime of private banks, hard currency, and the “bank run,” any one bank’s over-extension would represent an arbitrage opportunity for other banks, so the cycle was often self-correcting, just as in private markets of other kinds, such as international currency exchanges. It was unlikely and unusual for too many players to make the same kind of error at the same time, but such “errors” are built into the system of central banking monetary policy because, at least in the short run, betting on speculative bubbles makes sense in today’s environment.
Further, central banks make these errors repeatedly not only because they are big, but because they are subject to various political pressures, such as the current pressure to avoid a recession at all costs. This relatively unregulated (in the short term) central bank inflationary policy leads to incorrect signals and speculative bubbles. When the market’s investors realize that they have diverted real savings into bad investments, the price of these investments drop, assets must be liquidated, and businesses fail.
Efforts to “prime the pump” and get the economy moving again lead to additional inflation and frantic activity, until rising interest rates are imposed out of the absolute necessity to cover rising prices from inflation and to attract foreign investors who have stronger currencies to invest in bank debt.
The Austrians note that the “supply shock” crises of the 19th Century–before the era of central banking or fiat currency–were over very quickly in contrast to the frequent, repeated, inflationary, and drawn out recessions of the 20th.
The third view, the Keynesian view, is that demand-side fluctuations call for government austerity (in times of inflation) and increased spending (during a slow down). These maneuvers are supposed to counterbalance inflation or increase demand respectively. These proposals rely a great deal on the multiplier effects of spending, but the Keynesian theory does not take adequate account of the “crowding out effect” of government debt spending and the historical unlikelihood of the government practicing austerity during boom times. The money comes from somewhere, and it would otherwise go to private bonds, private equities, and other productive uses.
Neither Bernanke, nor his Austrian critics, really endorses this view. But Bush does implicitly in his stupid stimulus package. It should be obvious why the Keynesian big government theory has been popular with government officials since its origination in the 1930s. It lets them spend money they don’t have, as if this were some courageous and far-sighted measure, rather than a demagogue’s natural instinct. Needless to say, the 1937 downturn should put to bed the Keynesians’ hoary view that the CCC and other public works projects of the New Deal pulled us out of the Great Depression. In fact, they made it worse.
But here we are again. We have the benefit of what should be the clear inflationary lessons from the 1920s, but Greenspan inflated the money supply like crazy after 2000, and Bernanke is undertaking another doomed effort to inflate our way out of an inflationary-speculative bubble.
A downturn of any kind is like pulling off a band-aid. The quicker we liquidate the bad investments, homes, nonperforming commercial paper, and upside-down businesses, the better off we’ll all be, and the quicker we’ll move onto the next cycle of growth. As Secretary of Treasury Andrew Mellon infamously said, “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.” Indeed.
It’s not like anyone is going to debtor’s prison. Moreover, the more people “hurt” by seeking bankruptcy protection, the less stigma there will be to folks who are otherwise good risks. Protecting speculators, improvident banks, overly leveraged hedge funds, and over-extended mortgage holders from the consequences of their actions will only drag out the pain and delay a recovery.