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Archive for the ‘Von Mises’ 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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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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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.

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