For an American, the two most momentous national events of this decade have to be the terrorist attack on 9/11 and the financial meltdown in September 2008. The consequences of these two events will be with us for a generation or more, and are deeply engraved in our memories. When Lehman Brothers went bankrupt exactly one year ago today, the stock market tanked on the following Monday, September 15, 2008. Since the financial meltdown, I’ve been reading numerous books and articles, in an effort to understand how it all happened. I’ve read David Smick’s The World is Curved, read articles and seen talks by Barry Ritholtz, author of Bail Out Nation, and resumed studies of economics and monetary policy, particularly by Austrian economists. But nothing has had more explanatory power for me personally than Thomas Woods’ Meltdown: A Free Market Look at Why the Stock Market Collapsed, the Economy Tanked, and the Government Bailouts Will Make Things Worse (Washington, DC: Regnery Publishing, 2009). The left has blamed the financial collapse on Bush, and the de-regulation of Wall Street promoted by the Republicans. (While there’s some truth to this, it’s also true that Clinton was President during some of this deregulation, and if you follow the reasoning in this article, you’ll see why I don’t think it explains the collapse.) Nixon’s phrase, “We’re all Keynsians Now,” headlines a January 18, 2008 Wall Street Journal article, when Bernanke trotted out the plans for the first fiscal stimulus package, well before the collapse in September 2008. Bush, Paulson, and Bernanke, in true Keynsian fashion, tried to stimulate (spend) America out of the financial crisis, as the Depression economic policies of the British economist John Maynard Keynes suddenly came back into vogue. (Coincidentally, contrary to the myth that he did nothing, Hoover also tried to stimulate America out of the Great Depression, and was roundly criticized for doing so during the 1932 Presidential campaign, according to Woods, p. 99). Of course FDR, once elected, massively outdid Hoover’s stimulus expenditures with his New Deal programs.
Obama basically won the 2008 Presidential race because the Democrats were able to cast blame for the economic collapse on the Republicans (that and McCain’s rather inept campaign). The only problem with Bush’s approach according to Obama and company was that he did not stimulate (spend enough money) the economy enough, and leftist Keynsian economists like Paul Krugman want Obama to spend even more, as he nationalizes banks, auto companies, healthcare (in the works), and God knows what else. A Newsweek article by John Meachem and Evan Thomas exuberantly proclaimed on February 7, 2009, “We’re All Socialists Now.” Well, not quite. Enter Thomas Woods, Jr.
So the conventional, Keynsian wisdom seems to be that when the economy collapses, the only way out is to spend more money and accumulate more debt. It’s an interesting concept. Try this thought experiment: next time you get into financial straits and face bankruptcy, just spend more money and accumulate more debt. Doesn’t work? Woods doesn’t think so either. It’s amazing how long a myth can last despite evidence to the contrary. For example, many Americans still believe that Roosevelt’s New Deal saved America from the Great Depression, when the evidence seems to indicate that Roosevelt’s policies may have caused the Great Depression: In other words, Roosevelt may have turned a rather short-term though severe recession into a major depression. Two UCLA economists, Harold L. Cole and Lee E. Ohanian completed a study in 2004 that showed that because “Roosevelt believed that excessive competition was responsible for the Depression by reducing prices and wages,” he implemented a policy that kept prices and wages artificially high, the consequences of which prolonged high unemployment rates (up to 25% and in double digits for over a decade) (see “Study: FDR Policies Prolonged Depression,” Newsmax.com, Tuesday, October 7, 2008. According to Cole:
The fact that the Depression dragged on for years convinced generations of economists and policy-makers that capitalism could not be trusted to recover from depressions and that significant government intervention was required to achieve good outcomes. . . . . Ironically, our work shows that the recovery would have been very rapid had the government not intervened.
The Cole and Ohanian article was called “New Deal Policies and the Persistence of the Great Depression” and appeared in the Journal of Political Economy 112 (August 2004: 813).
So did capitalism cause the recent financial collapse? George Reisman has written: “The news media are in the process of creating a great new historical myth. This is the myth that our present financial crisis is the result of economic freedom and laissez-faire capitalism” (“The Myth that Laissez Faire Is Responsible for Our Financial Crisis,” October 21, 2008). As Reisman points out in his article, when you consider that government spending at the time was forty per cent of GDP, or when you consider that we have “fifteen federal cabinet departments, nine of which exist for the very purpose of respectively interfering with housing, transportation, healthcare, education, energy, mining, agriculture, labor, and commerce,” or that we have an alphabet soup of “one hundred federal agencies and commissions” to monitor every aspect of our individual and economic lives, the charge that the financial collapse was a result of laissez-faire capitalism is ridiculous, absurd, and bordering on the delusional. But then nobody said that the perpetrators of the conventional wisdom were smart, did they?
So what did cause the financial collapse? Woods cites several culprits that contributed to the subprime mortgage crisis, such as Fannie Mae and Freddie Mac (despite Barney Frank’s claims in 2003 that Fannie and Freddie were sound, Woods, p. 16); the Community Reinvestment Act, “a Jimmy Carter-era law that was given new life by the Clinton Administration” (p. 17), encouraging affirmative action in lending; the government’s artificial stimulus to speculation, such as relaxed standards for lending and adjustable rate mortgages (ARMs); and the “pro-ownership” tax codes. And then there was the “too big to fail” mentality. When you have Federal Deposit Insurance (FDIC) insuring accounts up to $100,000 (temporarily, up to $250,000) at one end, and the government ready to bail out large banks with the “too big to fail” mentality at the other, where’s the moral hazard? With such a combination, Woods writes, “banks will take on considerably more risk than they would if they were subject to genuine market pressures” (p. 46).
But while contributive, none of the above factors caused the financial meltdown, according to Woods. The real culprit was the Federal Reserve and its inflationary monetary policies, most recently the easy money policies following the dot.com bubble and meltdown of 2000, and the 9/11 attack in 2001. To understand why the economy crashed in 2008 it is necessary to understand the boom and bust business cycles that created the conditions for a collapse. The Fed created the boom by increasing the money supply (inflation); that excess liquidity had to go somewhere so a bubble was created, this time within the housing sector. (Inflation can be defined as “an increase in the quantity of money and/or credit, relative to goods available for purchase” (see my “Inflation, the National Debt, and Monetary Reform” for a more detailed explanation.) During the boom phase, Woods contends, “the artificial lowering of interest rates causes the misdirection of capital and the initiation of unsustainable investments” (p. 72). The damage is done during the boom phase with the misallocation of resources, which is followed by the inevitable bust or collapse. However, instead of letting the market correct itself with a mild recession, Keynsian economists advise the government to stimulate consumption by spending more money, which only postpones the pain into the future (deficit spending). Woods quotes the Austrian economist and Nobel Prize winner, Friedrich Hayek: “To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means [inflation] that brought it about” (p. 71). The inevitable pain that our national leaders are postponing into the future can even be measured: by our $11 trillion dollar National Debt. Wood argues that “nobody likes unemployment and bankruptcy . . . but they would not have been necessary had the artificial boom not been stimulated in the first place” (Ibid.). Thus great harm is done to the people and to future generations by doing the same thing that got us into this predicament in the first place, inflating the money supply. This argument so far doesn’t even address the fact that the Obama administration has used their stimulus packages not to rejuvenate the economy but rather to pay off their cronies in what can only be called a political spoils system.
A fallacy at the core of the argument for stimulating the economy in a recession is the belief that flooding the economy with more money for consumers to spend will increase the supply of real resources, or goods and services (Woods, p. 128). This is a fallacy: increasing the money supply will only lead to higher prices; in other words, inflation (an increased quantity of money) results in higher prices (reflected in the Consumer Price Index, or CPI). The public often mistakenly thinks that higher prices are inflation, instead of an effect of inflation. This mistaken belief is often abetted by the media in their disingenuous search for scapegoats to blame, such as oil companies, greedy businessmen, or speculators (Ibid., p. 125).
While the Fed, the government, and their lackeys in the press profess to fear deflation much more than inflation, there is a ready explanation for this also. Hayek has written that while “moderate inflation is generally pleasant while it proceeds, . . . deflation is immediately and acutely painful” (The Constitution of Liberty, p. 330). Governments love inflation because it allows them to spend money recklessly in the present, while the painful consequences can be postponed into the future until the inevitable day of reckoning when the economy collapses. As Hayek observed, “there is more than a mere superficial similarity between inflation and drug-taking” (Ibid.). In addition to causing a boom-bust business cycle, inflation also has several other deleterious effects: it makes it nearly impossible for people of moderate means to save enough for retirement; it encourages people to go into debt instead of save because of the time-value of money; it’s destructive of the middle class, widening the gap between rich and poor; it encourages short-term thinking; and it increases the dependence of the individual upon the government (Ibid., pp. 338 – 39). Regarding inflation’s effect on savings: Before the creation of the Fed in 1913, with its inflationary monetary policies, individuals with moderate income could save enough money for old age in low risk savings or CD accounts. Gold-backed money actually appreciated in value. With the excessive inflation of the past century however, this was no longer possible. Thus savings, to keep up with inflation, had to be invested in higher risk equities, which also accounts for the two decades long bull market in the stock market.
But if governments advocate inflationary policies, why would they do so if the result is an inevitable economic collapse? First of all, as Keynes so aptly put it:
There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose. (The Economic Consequences of the Peace, London, 1919, p. 220)
In other words, most people are fairly ignorant of economics and monetary theory (and most politicians too), so they are easily dissuaded from casting blame at the correct target. But also, as Hayek has argued, Keynes wrote his General Theory of Employment, Interest, and Money in 1935 in the midst of the Great Depression. One of his assumptions at the time was that you couldn’t lower wages because of labor unions, yet full employment was his primary goal. If wages are too high, full employment is not possible. So the only way to reduce actual wages, and guarantee full employment, was to inflate the money supply and devalue the currency. This really created the contemporary boom- bust business cycle; the inflationary spiral was the result of Keynesian economic theory (see Hayek, A Tiger By the Tail: The Keynsian Legacy of Inflation, 1979, San Francisco: Cato Institute, pp. 59 – 62, 101 – 02).
Another fallacy that contributed to the Keynsian theory that the way out of a recession is to stimulate the economy is the belief that “consumer spending drives the economy.” But this is true, Woods argued, only in the sense that consumer spending determines what businesses should produce and in what quantity: “their wishes are what motivates the production decisions of producers.” But wealth is not “generated by the mere fact of our spending” (p. 142). No country ever became rich “simply by using things up”: “Before things can be used up, they must be produced” (p. 143). This gets to the root of America’s huge trade deficit: We have become a nation of consumers; we consume more than we produce. This can last only so long. Nations become rich by producing goods and services, like China today and the U.S. in the past, not by consuming things.
One final point on why government stimulus packages don’t work: They don’t work for the same reason that socialist command economies like the Soviet Union didn’t work; they have no feedback mechanism (prices) to determine how to allocate resources. As Woods argued,
Government . . . has no non-arbitrary way of knowing how much of something to produce, where to produce it, using what materials and which production methods. Private firms use a profit-and-loss test to gauge how well they are meeting consumer needs. If they make profits, the market has ratified their production decisions. (p. 78)
Government is just as likely to build a bridge to nowhere or a one million dollar plus emergency operations center for homeland security in a rural town of 2,000 with seven law enforcement officers.
To conclude: The point of this article is not to argue that some targeted regulation of the financial industry is not needed. Certainly, the lax lending standards (or lack thereof), such as the creation of NINA (No Assets, No Income) loans, were contributive factors in the meltdown. But the bottom line, according to Woods, is that the housing bubble never would have occurred without the inflationary monetary policies of the Fed that flooded the system with excess liquidity, looking for a place to invest trillions of dollars when interest rates were practically zero. But nobody dares cast blame on the real culprit, the Fed, which is both the elephant in the middle of the room and the Emperor with no clothes. The question is: Is the Fed the guarantor of our economic stability, or is it actually the cause of our economic instability and collapse?
