Archive for the ‘Austrian Economics’ Category

I think this is a useful observation by Mark Thornton over at the Mises blog:

On top of all that, people suffer psychological consequences as well. The people most involved in the bubble are confident, jubilant, and self-assured by their apparently successful decision making. When the bubble bursts they lose confidence, go into despair and lose confidence in their decision making. In fact, they lose confidence in the “system,” which means they lose confidence in capitalism and become susceptible to new political “reforms” that offer structure and security in exchange for some of their autonomy and freedoms.

In this manner, great nations of people have given away their liberties in exchange for security. The Russians submitted to Communism and the Germans submitted to National Socialism because of economic chaos. In 20th century America, economic crises–and fear more generally–provided the justification for the adoption of “reforms” such as a central bank (i.e. the Federal Reserve), the New Deal, the Cold War, and even fiat money during the economic crisis of the early 1970s. Fear of terrorism after 9/11 resulted in a massive transfer of power to government at the expense of individual liberty. Submission of liberty and individual autonomy in exchange for security and the “greater good” is now often referred to as choosing the dark side.

The reason economic crises create fear and submission of liberty is that people do not generally know what caused the bust or economic crisis and generally do not even know that there was even a bubble in the first place. In fact, as the bubble is bursting many people will deny that there is a problem and believe that the whole situation will quickly return to what they consider normal. The average citizen thinks very little about what makes the economy work, but simply accepts the system for what it is, and tries to make the most of it.

People want practical goods from government and from the economy: predictable laws, a job, safety, order, and prosperity. The government’s failure to provide those things (or the conditions for them) as a consequence of its own mistakes–subsidizing housing and lending with loose money for over a decade–does not lead most people to demand that government steps back. Instead, its apparent power is intoxicating. Our intimate familiarity with this power and an ignorance of the ways it leads economies astray leads for calls for new, radical expansions of government.

Politicians (including the politicians at the Fed and the Treasury) willingly oblige, and the voices of restraint are labeled as special interests, reactionaries, or worse. People are becoming desperate, particularly as we have become less self-reliant and more dependent on cheap credit than in the past. Combined with ignorance of the business cycle and a misplaced trust in government, we’ve seen the Federal Reserve and treasury step into uncharted waters like unsecured short-term commercial credit, ownership stakes in banks, and huge bailouts of the least necessary players in the investment world, i.e., Bear Stearns.

Isn’t it comforting to know that in this fertile soil we will soon make a choice between a pompous socialist with a cult of personality on one side of the ballot and a guy with little respect for the private sector who yearns to unify the people through soul-purifying historical change on the other?

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In March of this year, wrote that the credit crisis is not an issue of liquidity but of malinvestment enabled by central banking’s penchant for inflation.  This was also the chief cause of the Great Depression, and many economists’ misreading of the Depression as a liquidity problem has led the supposed free-market oriented Monetarists into the weeds ever since.

There is a good article over at the Von Mises website about why the bailout will delay recovery by continuing to prop up these bad investments, whether they are derivatives secured by worthless housing or anything else that is tanking. To proponents of the bailouts, Frank Shostak writes:

They argue that were it not for the Fed’s injecting $105 billion and the subsequent announcement of the rescue package, the stock market would have had a massive fall. They also believe that the massive monetary injection prevented a run on money-market mutual funds and prevented a major disaster.

They further believe that if people had taken the money out of their money-market mutual funds, banks wouldn’t be able to secure money to fund credit cards and various consumer and business loans. This in turn would have paralyzed the economy.

So let us think about this. Say that people take their money from the money-market mutual funds. What happens then? They will have placed it somewhere else, mostly likely with commercial banks. Hence money wouldn’t disappear and banks could continue to fund activities as before.

If large money-market funds were to go under, some of their assets would be sold and the shareholders would suffer losses; this however, cannot provide justification for the Fed to pump money and to introduce a rescue package. Monetary expansion and a rescue package do not undo the bad investment decisions of the money-market-mutual-fund managers. Why should people who didn’t risk investments in the fund pick up the tab?

A fall in asset prices, including stocks, and a run on financial institutions are just symptoms and not the cause of anything. The key factor behind the current difficulty in the credit markets is the lagged effect coming from the Fed’s tighter stance between June 2004 and August 2007, when the federal-funds-rate target was raised from 1% to 5.25%.

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Market-oriented Republicans see the housing crisis and say, “The market is working, and will, if only we let it.”  Democrats see the temporary pain of the slowdown and say that we need a stimulus.  Missing from both accounts is any talk of monteary policy; today, monetary policy is out of the hands of the domestic market and in the hands of the Federal Reserve.  It is a government agency with a twist:  with worldwide currency markets, the Fed must act like other market players at least in regard to international markets or our currency will be rejected or devalued (as it has been in recent months).  More important, like players in any other competitive market, the Fed can make mistakes, particularly as it balances its contradictory mandates of stopping inflation and keeping full employment. 

Republicans should take notice that markets have always been vulnerable to force and fraud and do not work well when those threats are undetected and unpunished.  This is why we have laws.  This is why in the “internal market” of a corporation people are fired or rewarded for making money for the company.  Mortgage markets are vulnerable to fraud where obligations travel up a chain from buyer, to broker, to bank, and finally to some mortgage backed security holder.  The broker gets paid up front even though the real risk holder bears the cost of default down the line.  This is cause for external regulatory reform and also internal business structure reform.  For example, wouldn’t banks and brokers be more careful if they had to return some of their commission (or otherwise be penalized) if whatever they sold had to be refunded if it defaulted within, say, five years?  Alternately, they could be paid partially by a stake in the mortgage backed securities holding their notes.  Bundles of mortgages could be valued based on a particular bank, broker, zip code, or some other combination of common, information-bearing factors.  Brokers, banks, and anyone who gathers information from lendees ideally should have “skin in the game.”  

These mortgage backed security holders should not be bailed out, of course, as this conflict of interest between lender and note holder should have been apparent to anyone purchasing these instruments.  Spreading risk may still be valuable, however, and would be more so in a proper environment of incnetives, including targeted regulation.  (We should also consider how much of this craziness was a function of the rates themselves, which drove a “flip this house” culture and shook up banks’ otherwise conservative culture.  Higher rates might do much of the work of bringing banks down to earth as any specific regulation or structural reform.)

The problem today is not a lack of stimulus or demand in the economy.  Rather, we are in a classic “supply shock” correction featuring simultaneous inflation and a reduction in output.  It’s sad that the NY Times editorial on the recent slowdown is largely silent about the causes and, in particular, ignores the fact that we are reaping the rewards of an early “stimulus” policy in the form of extraordinarily cheap money from 2001-2004.  They write, in Pavlovian fashion:

The best place to start is by rethinking economic stimulus. When Congress passed the existing stimulus package, gasoline was around $3 a gallon. By the time the rebate checks start going out in May, gasoline is likely to be well on its way to $4 a gallon. At that price, much of the $100 billion or so in rebates will go to fill Americans’ tanks, a bigger boost to nations that sell oil to the United States than to the United States itself.

The next round of stimulus, which Congress should be considering now, must accomplish what the first round neglected. It must focus on bolstered unemployment compensation and bolstered food stamps, ensuring that taxpayer dollars are spent on the neediest and on programs that are proven to spur the most economic activity for every dollar provided. The nation cannot afford more misguided giveaways.

The Carter administration faced the same problem in the late 1970s.  Bound by Keynesian analysis, they simply couldn’t make sense of the simultaneous reduction in demand and inflation that signalled the supply shocks rolling in from OPEC and elsewhere.  Stimulus packages may win a vote or two, but this kind of response is simply the fiscal equivalent of the loose money policy that Treasury Secretary Paulson and Fed Chairman Bernake continue to embrace in response to the current financial crisis.  Neither the NY Times, nor Bernake and Paulson, care to acknowledge that the earlier Fed-driven inflation and the fiscal stimulus of Bush’s deficit spending are largely the reason we are where we are now. 

As the old saying goes, when you’re in a hole, the first thing you’ve got to do is stop digging.

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Treasury Secretary Henry Paulson’s proposal to consoldiate various financial regulatory agencies is uninspired and likely will prove useless.  This proposal rests on the unquestioned assumption that bad economic results should never occur, and, if they do on a large enough scale, should be bailed out by the government.  If they should be bailed out, then the federal government rightly acquires some interest in preventing them. But consolidation alone won’t do the trick, even if these flawed assumptions about the goals of economic regulation are accepted. 

Without new rules and expanded authority–which Paulson  has renounced–it’s unlikely any consolidation of the SEC, CFTC, OCC, and other regulatory agencies can yield better results than today.  This is the same logic behind joining various agencies under the Department of Homeland Security, which has accomplished little more than these agencies could in the past working seperately because of old fashioned rules on profiling and the lack of increased border infrastructure.  The case for consolidation is even less compelling in the case of finanical regulators, as poor inter-agency communication was widely reputed to be one factor in the 9/11 attacks.  By contrast, no one thinks that the current mortgage crisis is the result of some regulatory gaps or bad communication between the agencies.  Rather, investment banks, hedge funds, and other unregulated organizations now control huge amounts of the lending going on today and largely do their work off of the regulators’ radar. 

Investors know that these organizations are less regulated and more opaque than the regulated alternatives in the form of commercial banks and publicly traded companies.  The reason people still invest in these entities in spite of these demerits is a greater anticipated yield.  But everything comes at a price.  Investors of capital overseas, for instance, take the risk of other countries’ screwed up legal systems and greater degrees of corruption.  This is as it should be.  The whole point of regulation is to promote the proper pricing of risk and divert capital into safer investments at home to further American economic enterprise.  Bailing out investment banks and other holders of subprime mortgage instruments would instead reward high risk speculators, bailing them out of their risky choices, even as Paulson eschews more regulatory authority.

If the DHS is a good analogy to the proposed regulatory consoldiation, the best analogy for the Federal Reserve’s bailout of failing investment banks is the failed IMF strategy of bailing out the central banks of corrupt nations during the Asian currency crisis of the late 90s.  There, as in the US today, under-regulated high risk investments overseas attracted too much capital that underestimated the risks.  Investors seemingly forgot that the Third World is impoverished for a reason.  This led to a number of investment and monetary bubbles, which in turn burst.  Instead of allowing the devaluation to run its course, which it eventually did, the IMF at first bailed out Asian central banks and their investors leading to continued over-investment in “emerging markets.”  It would have been preferable if investors were forced to take their lumps as regimes as varied as China and Indonesia suffered the painful “correction” they deserved because of their instability and corruption. 

Our own Indonesia, the free-wheeling world of hedge funds and subprime securitized mortgages, needs to be shaken out so that in the future capital will not be invested to an irrationally high degree in high risk, underregulated investments.  Consolidating regulators and bailing out the failed investors is the worst of both worlds:   it increases public exposure without any concomitant increase in regulatory authority over the high risk institutions involved.

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Bush proposes a Keynsian-style stimulus package of tax cuts, refunds, coerced loan renegotiations, and other gimmicks to boost us out of the recent economic slump.  But why are we here?  Isn’t understanding that somewhat important to getting out of this jam?  We are here, it seems, for a variety of inflationary pressures on the economy mostly caused by the government:  artificially low interest rates from an undisciplined federal reserve strategy; a glut of bad loans and improvident consumer spending from refinances (also caused by loose money); a slump in the housing market (from earlier waves of overspending and overbidding); too many “house poor” Americans now paying on upside down or poorly capitalized loans; and a very weak dollar from the combination of a loose federal reserve policy and high government deficits and spending.  Finally, we should not forget, our trade policy with China that has caused a massive increase in demand for various raw materials (and a simultaneous drop in the prices of certain manufactured goods) has also been caused in a sense by a government policy, the no-restrictions trade regime we have with Communist China.

We are in the midst of what the Austrian Economists would call a crash or correction caused by an artificial and inflationary monetary policy.  The chickens are coming home to roost.  Assets need to be redistributed to more productive uses, even if that is to lie dormant in some cases, i.e., half-finished “downtown revitalization” projects and the like.  Homes must be foreclosed and resold.  But so long as the government continues to inflate, and try to spend its way out of the problem, the dollar will remain weak, the economy will remain unstable, and we will risk the kind of hyperinflation that has plagued other high-debt, loose money economies, i.e., Asia in the late 90s, Argentina in the 2002 time frame, Weimar Germany in the 30s.   Needless to say, holders of hard, high-value assets like gold, copper, oil, and the like will benefit tremendously.

Every recession since WWII and Breton Woods has been inflationary.  Under the classic macroeconomic model, that means instead of having a mere shortage of demand, we instead had a supply shock.  (Of course, very few have connected the dots on this fact-of-life other than the redoubtable Austrians.)  In a “shock,” the supply curve is moving left, as represented in the graph below.  This is bad, but it can self-correct much more quickly without artificial and misguided Keynsian interventions. Purposeful and artifical inflation won’t stop the inevitable redistributon of assets and investments necessitated by the shock, particularly as the overextension of supply and investment was a consequence of overspending and central-bank-created loose money in the first place. 

The rules of personal and public finance are not that different:  do not spend more than you make; save for a rainy day; be prudent and deliberate about non-investment spending; be especially prudent about debt; and you cannot get something for nothing.  Keynesianism has apparently displaced the Chicago School’s monetarist revolution at the Federla Reserve in the late 1970s.  While not perfect, this regime at least attempted to recreate what would result from a sound money system, such as the earlier gold standard. 

Today the eternal, inflationary temptation of Keynes has returned because his philosophy amounts to a kind of flattery of both politicians and consumers:  do as you will, spend as you like, encourage others to do the same, and everything will be OK.  For Keynes, such profligacy is a public duty and, as he said, “in the long run, we are all dead.” 

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