Monday, September 29, 2008

Tom Jenney on the bailout and economy

Part I: Policy Analysis

Part II: Policy Recommendations

Part III: Personal Recommendations (Main item: Don’t panic)

Part I: Policy Analysis

As Congress and the Administration flounder about, looking to slap together some kind of trillion-dollar bailout plan, there appears to be only one individual in the entire Congress who really understands the root cause of the crisis. In any case, he was the only individual in Congress who has been on public record for years predicting the current crisis. He also predicted the dot-com implosion years before it occurred. His comments are pasted below my signature.

The reason that lone Congressman understood and predicted the dot com and mortgage lending crises is that he has a strong grounding in the Austrian school of economics, and specifically, the Austrian theory of money and credit, and the effects of government interventions in those markets. (It is called the Austrian school because most of its founders, including F.A. Hayek and Ludwig von Mises, were from Austria.)

The short story is that this is a government-created crisis, from start to finish. Although spinners from the major parties are doing their best to pin the blame for the crisis on the other party, this is mostly a nonpartisan problem.

The root cause of this crisis—as with nearly every macroeconomic crisis—is governmental manipulation of the supply of money and credit. Since 1913, governmental monetary mischief has mainly been conducted by our central bank, the Federal Reserve System. Before 1913, the government manipulated the supply of money and credit through other means (google “Sherman Silver Purchase Act of 1890” for details).

Here is how it works, in ten easy steps:

Step 1) Credit Expansion. By creating artificial credit expansions (google “fractional reserve banking” for more details), the Federal Reserve System (“Fed”) expands the money supply available for loans used for consumption and investment, which lowers interest rates below the natural free-market rate.

Step 2) Malinvestment. With money easier to borrow, firms and entrepreneurs make more investments—and more erroneous investments—in the production of future goods and services than they would if faced with a natural, free-market interest rate. This is what the Austrian economists call “malinvestment.” (Some of the most highly-visible examples include: excessive and erroneous investments in radio and automobile companies in the 1920s, excessive and erroneous investments in dot-com startups in the 1990s, and excessive and erroneous investments in real estate from 2002 to 2006.)

Step 3) Disconnect between Production and Consumption. The main problem with artificial credit expansion is that the consuming public has not actually saved enough money to be able to afford all of the goods and services that result from the investments. (If the public had actually saved enough money, there would have been enough available money in the banking system to make the free-market interest rate low enough to make those investments viable, without the Fed’s “help.”)

Step 4) Minor Recession. At some point, the producers of goods and services notice that consumers are not interested in buying their products. They begin to cut back on production, shutting down operations, cancelling projects, and laying off workers. Facing a lack of adequate returns on their investments, investors sell stock shares. Stock market indices begin to fall. A recession has begun. The Blame Game often begins here (see Step 9 below).

Step 5) Central Bank Options. Seeing that a recession has begun, the Fed has two choices:

A) Stop the Expansion. The Fed can stop increasing the supply of money and credit, allowing interest rates to rise, and allowing overextended banks and firms that made bad investments to suffer losses or go bankrupt. This “liquidation” process allows factor and asset prices to fall until they reach realistic levels that make them attractive to firms and investors seeking to continue or to expand production. (At this point, the business cycle is over, until the Fed once again engineers an expansion of credit beyond natural levels.)

B) Continue the Expansion. The Fed can continue to increase the supply of money and credit, keeping interest rates artificially low so that: i) overextended banks can continue to lend money, ii) malinvested firms can continue to produce goods and services at artificially high levels of output, and, iii) consumers can borrow money to keep buying artificially large amounts of goods and services.

Step 6) Re-Inflation. The Fed, under pressure from Congress, the President, and Wall Street, typically chooses option 5B, which is to have some “hair of the dog” in the hopes of curing the hangover. The problem is that the Fed has to accelerate the increase in the supply of money and credit to keep the game going. By pumping even more money into the economy, the Fed begins to generate accelerating inflation. Sometimes, the extra money flows heavily into a few “hot” sectors of the economy (often causing stock market and real estate bubbles). Eventually, as the Fed becomes more desperate to keep the party going, the extra money generates an economy-wide inflation, with rapidly rising prices in all sectors (see the 1970s for details). (To keep this explanation relatively simple, I am not going to get into the mitigating and exacerbating effects of foreign currency exchanges and trade imbalances.)

Step 7) Stagflation. At some point, even massive credit inflation and printing of money cannot keep the game going. Prices go up, but the economy stalls (“stagflation”). Unemployment is somewhat high, and wages do not keep up with rising prices.

Step 8) Contraction. To avoid hyperinflation, the Fed has to allow for a monetary contraction. It’s the same scenario as 5A, but much involves more unemployment, because factor and asset prices need to fall a lot farther to reach realistic levels. Lots of banks, savings and loans, and investment houses start going bankrupt. Fed chairman Paul Volcker led the country through a tough contraction from 1981-1983. It’s not a pretty picture, but the alternative is to become a hyper-inflation/devaluation basket case, like many of the Latin American economies were in the 1970s and 1980s. During contractions in recent decades, the government has resorted to using taxpayer money to bail out depositors, lenders, and/or borrowers. When overly inflated sectors begin to contract, that’s when the Blame Game really gets going.

Step 9) The Blame Game. When things get tough, accusations begin to fly. Some are grounded in reality, many are not. Some accusations are made in earnest, many are simply forwarded for short-term partisan advantage:

A) Blame the “Free Market.” Regulatory enthusiasts from both parties blame the “free market” and a lack of adequate regulation for the failures. They usually ignore the fact that the markets were not able to regulate themselves because government had created “moral hazard” situations. If the government has promised to bail out lending institutions (explicitly, through the Federal Deposit Insurance Corporation, or implicitly, through credit reflation and public-private bailouts), we should not be surprised to see lending institutions taking crazy risks.

Of course, the regulatory enthusiasts never seem to lose faith in regulation. Instead, they whine about Regulation Q (during the S&L meltdown), the loosening of the Glass-Steagall firewall, and the lax oversight of the SEC with regard to mortgage-backed securities. The reality is that in an artificial credit expansion, there is no way for government to prevent even a small fraction of the bad investments. (You would need to put a government regulator in every other S&L, I-bank, and mortgage re-fi operation in the country—and that assumes that regulators would know more than the lenders about how far credit can safely be extended.)

B) Blame high interest rates. Some Wall Street boosters continue to blame the Fed for failing to keep interest rates low enough. Just a little more hair of the dog, and we can get through this hangover…

C) Blame government regulations. Conservatives blame heavy-handed government regulations. Those accusations do not get to the root cause of the crisis, but they at least contain grains of truth. For example, it is clear that the Community Reinvestment Act and the lending policies of the quasi-governmental Fannie and Freddie did result in the extension of credit to many individuals who had no realistic ability to pay back loans. But with too much credit in the whole system, someone was going to get bad loans—it was just a question of who and how much.

Another conservative accusation that contains a substantial amount of truth is the claim that government regulators and bailout managers have disrupted the orderly liquidation of bad investments. In the current crisis, the “marked-to-market” accounting rules are forcing some companies to sell their assets at the bottom of a stalled market. In the wake of the S&L debacle, the government-created Resolution Trust Corporation in many cases forced S&Ls to sell off their assets at the worst possible moment, even though the asset prices would eventually have rebounded to higher levels, making losses not so severe.

D) Blame Wall Street. Middle Americans naturally pin much of the blame for the business cycle on “greedy” Wall Street stockjobbers and speculators. In doing so, they are supported by macroeconomists of the Keynesian school, who see the investment world as ruled by the “animal spirits” of greed and fear. The problem with that notion is that simple greed cannot cause markets to soar very high in the absence of an artificial credit expansion—there simply isn’t enough cash around to place a lot of bad bets. And fear can’t do much to create a severe contraction if consumers have saved enough to buy an adequate portion of the goods and services produced by investors and firm.

E) Blame foreigners. Middle Americans frequently blame foreigners and interest groups connected to foreigners. They blame the trade deficit, foreign competition, and immigration for America’s job losses during the contraction. And yet, nearly everything that is wrong with the American economy is self-caused: most of our systemic problems are the result of tax-and-spend-and-inflate government policies.

Step 10) Congress and the Administration Experiment. Because they do not understand the monetary origins of the crisis, or because they are hoping for a “free lunch” that will avoid the pain of a corrective contraction, Congress and the Administration begin casting about for policy options, trying to buoy the markets and convince the public that they have the situation under control. Most of their policy “cures” make the disease worse:

A) Price supports. During a contraction, when prices and wages need to fall for a proper liquidation, politicians often become desperate to prop up prices and wages. That was the heart of the Hoover-FDR reactions to the contraction that began in 1930. Most of the policies they enacted—the campaigns to keep wages high, the raising of tariff barriers, the cartelization of industries, quotas and price supports in agriculture, the confiscation of private gold stocks—were designed to prop up factor prices. Those policies were highly counterproductive, resulting in massive unemployment and destruction of social wealth. Further, the government’s hyperactivity (FDR’s “bold, persistent experimentation”) served to spook investors, consumers, and business leaders, who had no idea what the government would do next. As a result, Hoover and FDR turned a typical American depression (which tended to last from one to three years) into a double-dip depression that lasted at least ten years (it may not have actually ended until 1946).

B) Compulsive regulation. At the very point when many businesses are struggling to keep going, Congress enacts redundant or pointless new regulatory regimes (such as the Glass-Steagall Act in 1933, or the Sarbanes-Oxley Act of 2002). At best, those regimes cause firms and investors to waste time and money in compliance. At worst, those regimes weaken financial institutions, making them more vulnerable to shocks. (Glass-Steagall broke up universal banks into deposit banks and investment banks, even though the universal banks, which were better-diversified, did not fail nearly as often as depositor banks during the 1920s.)

C) Moral hazards. Congress often reacts to crises by establishing institutions that explicitly or implicitly promise government bailouts for persons and firms that make unwise investments. The Federal Deposit Insurance Corporation (which guaranteed bad bets by S&Ls) and Fannie Mae (which is at the center of the current mess) were created during the New Deal. With the current wave of bailouts, Congress and the Administration are telling future gamblers that the federal government stands ready to cover their bets.

D) Spending huge amounts of taxpayer money. Of course, covering all those bets requires a source of money. That money comes out of the paychecks and bank accounts of taxpayers. The same is true of Keynesian fiscal “stimulus” packages. As economic historian Robert Higgs has noted, government fiscal stimulus is like taking water out of the deep end of the pool, dumping it in the shallow end, and expecting the level of water to rise.

E) Tax increases. America’s heavy personal and corporate income taxes already punish work and discourage saving. The low savings rate means a smaller supply of loanable funds, which in turn means less investment and slower economic growth. That is one of the reasons that the Fed feels compelled to push interest rates to artificially low levels: to create the illusion of having the supply of loanable funds that would be available if people actually saved more. Any increases in taxation will make the problem worse.

F) Debt and Inflation (= Taxation). When the government spends more money than it collects from taxpayers, it begins to run deficits and accumulate debt. The federal government is already in massive debt, so it must borrow even more money in order to bail out Wall Street and Main Street. And bear in mind that the American government’s unfunded liabilities (the benefits we have promised to people, for which we have no foreseeable revenue stream) for the next 75 years are already at least $60 trillion (more than four times the nation’s yearly income, or $200,000 for every man, woman and child in the country). At some point, Congress and the Fed are going to have to crank up the printing press in earnest, so that they will have more pieces of green paper with which to pay everyone what has been promised. Because the green paper in people’s pockets will be rapidly losing its value, the result will be the same as if the government had levied a massive, growth-strangling tax.

Part II. Policy Recommendations

For what it’s worth, I recommend that Congress and the Administration do none of the above (see Step 10, A-F). As for positive steps, I recommend the following:

1) To address the short-term financial market crisis, Congress and the President should suspend taxes on private capital in order to allow private investment groups to rescue failed entities and/or buy their assets. (That’s a realistic option.)

2) Congress and the President should immediately reduce the annual rate of growth of all federal spending, including entitlement spending, to no more than three percent annually in nominal terms. (Chances of that are slim. We got down to about four percent under Clinton and the Republican Class of ’94, and that was during a period of abnormally low rates of inflation…)

3) As budget surpluses materialize, Congress should begin paying down the debt. (Very slim.)

4) Once the debt is on a steady path toward elimination, Congress should reduce and simplify federal taxes. (Again, very slim chances of that happening.)

5) Congress should move America toward a sound, inflation-proof monetary system—ideally, a system in which federal notes are redeemable in gold. (Fat chance. There is only one guy in the entire Congress who is talking about sound money. As the country’s biggest debtor, the federal government and tax-taker interest groups have a vested interest in maintaining a regime of permanent inflation.)

6) Congress should get the country off the recurring rollercoaster of credit inflation cycles by moving America toward a system of free banking, in which the free market determines the supply of money and credit, and in which the government is prohibited from bailing out banks that become overextended. (Again, fat chance. Of course, those who are wealthy enough and mobile enough to get their assets offshore already have access to a version of free banking, in that they can choose among dozens of competing national currencies when it comes to denominating their assets and conducting business. But most of us are stuck riding out the dollar…)

Part III. Personal Recommendations

First and foremost, don’t panic. We’re not going to have anything like the Great Depression. The main reason is that very few of our modern politicians seem to be seeking the kind of wholesale cartelization programs that FDR and the New Dealers unleashed on this country during the 1930s. (And in any case, even New Deal-style economic chaos would occur at a much higher level of economic development, so people now would suffer less than people did in the 1930s.)

Even deflation (which is unlikely) is no cause for panic, especially if the government does not hurt productivity through massive tax increases and/or regulatory excesses. One of the greatest periods of growth in American history occurred during the deflation from 1869 to 1896 (it did help that people’s expectations were set for hard money). Hong Kong has had deflation since 1997, but has grown at an average of four percent annually during that time. Even the comparatively sclerotic Japanese economy muddled along okay through a decade-long deflation (which can actually be good for persons on fixed incomes).

That said, we may be in for tough times in the next few years. I seriously doubt that the Fed will suddenly change course and allow for a clean contraction and liquidation (which is what it should do). If the Fed proceeds with an aggressive credit/monetary expansion, it will probably result in a small boost, followed by stagflation, followed by a tougher contraction, in the style of 1971-1983. But every cycle is a little different, and I don’t have a crystal ball.

Speaking of which, I would like to be able to make some financial recommendations, but I am like everybody else: I don’t really know what is going to happen in the short run. I believe that we are in for significant inflation in the years ahead, so that would argue for gold, but you never know for sure.

For the medium to long run, we all need to increase our savings, especially in assets with values that can keep up with inflation. For those who are not in the habit of saving, it will be hard to change course, especially if you get laid off from work. And, as I said above, federal tax policies constantly undermine our efforts to save.

Other than saving, we should keep doing the basics: work hard, take care of our families, look out for our neighbors. I strongly suggest joining a church or another form of mutual-aid society, and helping people out (it’s the right thing to do, and you never know when you’ll need them to return the favor).


September 25, 2008

Dear Friends:

The financial meltdown the economists of the Austrian School predicted has arrived.

We are in this crisis because of an excess of artificially created credit at the hands of the Federal Reserve System. The solution being proposed? More artificial credit by the Federal Reserve. No liquidation of bad debt and malinvestment is to be allowed. By doing more of the same, we will only continue and intensify the distortions in our economy - all the capital misallocation, all the malinvestment - and prevent the market's attempt to re-establish rational pricing of houses and other assets.

Last night the president addressed the nation about the financial crisis. There is no point in going through his remarks line by line, since I'd only be repeating what I've been saying over and over - not just for the past several days, but for years and even decades.

Still, at least a few observations are necessary.

The president assures us that his administration "is working with Congress to address the root cause behind much of the instability in our markets." Care to take a guess at whether the Federal Reserve and its money creation spree were even mentioned?

We are told that "low interest rates" led to excessive borrowing, but we are not told how these low interest rates came about. They were a deliberate policy of the Federal Reserve. As always, artificially low interest rates distort the market. Entrepreneurs engage in malinvestments - investments that do not make sense in light of current resource availability, that occur in more temporally remote stages of the capital structure than the pattern of consumer demand can support, and that would not have been made at all if the interest rate had been permitted to tell the truth instead of being toyed with by the Fed.

Not a word about any of that, of course, because Americans might then discover how the great wise men in Washington caused this great debacle. Better to keep scapegoating the mortgage industry or "wildcat capitalism" (as if we actually have a pure free market!).

Speaking about Fannie Mae and Freddie Mac, the president said: "Because these companies were chartered by Congress, many believed they were guaranteed by the federal government. This allowed them to borrow enormous sums of money, fuel the market for questionable investments, and put our financial system at risk."

Doesn't that prove the foolishness of chartering Fannie and Freddie in the first place? Doesn't that suggest that maybe, just maybe, government may have contributed to this mess? And of course, by bailing out Fannie and Freddie, hasn't the federal government shown that the "many" who "believed they were guaranteed by the federal government" were in fact correct?

Then come the scare tactics. If we don't give dictatorial powers to the Treasury Secretary "the stock market would drop even more, which would reduce the value of your retirement account. The value of your home could plummet." Left unsaid, naturally, is that with the bailout and all the money and credit that must be produced out of thin air to fund it, the value of your retirement account will drop anyway, because the value of the dollar will suffer a precipitous decline. As for home prices, they are obviously much too high, and supply and demand cannot equilibrate if government insists on propping them up.

It's the same destructive strategy that government tried during the Great Depression: prop up prices at all costs. The Depression went on for over a decade. On the other hand, when liquidation was allowed to occur in the equally devastating downturn of 1921, the economy recovered within less than a year.

The president also tells us that Senators McCain and Obama will join him at the White House today in order to figure out how to get the bipartisan bailout passed. The two senators would do their country much more good if they stayed on the campaign trail debating who the bigger celebrity is, or whatever it is that occupies their attention these days.

F.A. Hayek won the Nobel Prize for showing how central banks' manipulation of interest rates creates the boom-bust cycle with which we are sadly familiar. In 1932, in the depths of the Great Depression, he described the foolish policies being pursued in his day - and which are being proposed, just as destructively, in our own:

Instead of furthering the inevitable liquidation of the maladjustments brought about by the boom during the last three years, all conceivable means have been used to prevent that readjustment from taking place; and one of these means, which has been repeatedly tried though without success, from the earliest to the most recent stages of depression, 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; because we are suffering from a misdirection of production, we want to create further misdirection - a procedure that can only lead to a much more severe crisis as soon as the credit expansion comes to an end... It is probably to this experiment, together with the attempts to prevent liquidation once the crisis had come, that we owe the exceptional severity and duration of the depression.

The only thing we learn from history, I am afraid, is that we do not learn from history.

The very people who have spent the past several years assuring us that the economy is fundamentally sound, and who themselves foolishly cheered the extension of all these novel kinds of mortgages, are the ones who now claim to be the experts who will restore prosperity! Just how spectacularly wrong, how utterly without a clue, does someone have to be before his expert status is called into question?

Oh, and did you notice that the bailout is now being called a "rescue plan"? I guess "bailout" wasn't sitting too well with the American people.

The very people who with somber faces tell us of their deep concern for the spread of democracy around the world are the ones most insistent on forcing a bill through Congress that the American people overwhelmingly oppose. The very fact that some of you seem to think you're supposed to have a voice in all this actually seems to annoy them.

I continue to urge you to contact your representatives and give them a piece of your mind. I myself am doing everything I can to promote the correct point of view on the crisis. Be sure also to educate yourselves on these subjects - the Campaign for Liberty blog is an excellent place to start. Read the posts, ask questions in the comment section, and learn.

H.G. Wells once said that civilization was in a race between education and catastrophe. Let us learn the truth and spread it as far and wide as our circumstances allow. For the truth is the greatest weapon we have.

In liberty,

Ron Paul

No comments: