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Down on the beach I was looking for one of those “stimulus packages” they’ve been talking about. Thought I might find one washed up on the sand — you never can tell. But there were only plastic bags. So I sat down on a rock with another beachcomber to pass the time of day. I said how much I wanted to help the government stimulate the economy, and a million dollars of flotsam would be just the thing.

“Nah, only make things worse”. My mate reckoned it would mostly stimulate inflation, and weaken the currency too. He’d been reading a book that was full of bad economic news. “If I found a million dollars I’d put it under my bed.”

Now I think this is crazy. Like other beachcombers I read the newspapers and know that capitalism is on the rocks and the solution is obvious: spend money, as much as you can on anything at all — the other day Paul Krugman said Obama should just come up with a figure and then add 50 percent and spend, spend, spend. Free money will free up the free market. Stands to reason.

“Nah, it’s been tried. Won’t work. Read this.” My beachcombing pal took his book and pointed to something written by FDR’s Treasury Secretary, Henry Morgenthau, over 70 years ago:

We have tried spending money. We are spending more than we have ever spent before and it doesn’t work… We have never made good on our promises… After eight years of this Administration we have just as much unemployment as when we started… and an enormous debt to boot!

That had to be wrong. Wasn’t Morgenthau the guy who said German industry should be levelled and the country turned into cow pastures? In 1944? Anyway that was a long time ago and economists are heaps smarter now. Right? How about Japan in the 1990s I asked.

“Japan? Gotta be joking!”

Shifting to a more comfortable rock, suitable for a more expansive exegesis, my learned friend said that between 1989 and 1992 the Nikkei dropped from 40,000 to 15,000, that real estate prices dropped 80 percent from 1991 to 1998, that the Bank of Japan and the Japanese government did all they could to prop up prices and bad debt.

Interest rates were pushed to zero, trillions of yen were spent on public works, zombie companies had billions thrown at them to prevent them going bust, and the government launched no fewer than ten stimulus packages totalling over 100 trillion yen. None of it worked. Japan’s depression lasted nearly two decades.

“But what about the Fed!” I cried, for surely the Federal Reserve is an economic rock, placed there to protect all beachcombers against adversity and guide us toward the promised land.

“The what? Gimme a break!” As he saw it the Fed was the greatest culprit of all by messing with interest rates. First of all the Federal Reserve Bank has nothing to do with capitalism and is not a free-market institution at all. It exists to politically interfere with the natural price of money. Left to itself the interest rate has a useful role: it coordinates production across time. But it can only do this if it’s allowed to freely move up and down. According to my beachcombing friend the Fed’s intervention constantly mismatches market forces.

As for the Fed being chartered to protect the interests of ordinary beachcombers, he laughed in my face. The Federal Reserve Act, he said, was actually drafted by a cabal of bankers at a private meeting on Jekyll Island, Georgia, in 1910, to entrench the special privileges of the banking industry at the expense of everyone else. When it became law in 1913, he said, it was “special interest legislation masquerading as a public-spirited measure”. Much better to let banks fail than have a privileged banker’s bank like the Fed using tax revenue to protect bankers from their own follies. Why should the guy in the corner store be the only one forced to fail?

And there’s no such thing as easy credit. What’s easy credit during politically engineered booms is hard cheese when cometh the bust. And for some it’s worse than that. Leveraging’s really cantileveraging, like an unbalanced crane on the edge of El Capitan swinging further and further out into space… til down it crashes to the valley floor.

I’d had enough. It was time to leave. No more bad news for me. But on pages 74-75 of his little book I did find this. It’s called “The Austrian Theory” and may perhaps be of interest.

  1. Interest rates come down in two ways. Either the public saves more and they come down spontaneously, or the central bank artificially forces them down.
  2. Businessmen respond to lower rates by starting new projects. The projects they start tend to be interest-rate sensitive — big projects like mining, construction, etc.
  3. If the interest rate is lower because of natural causes — increased saving for example — then the market works smoothly. Those savings provide the wherewithal for new investment projects that can be seen all the way to completion.
  4. If the interest rate is lower because of the political manipulations of a central bank — then these projects cannot all be completed. This is because the necessary resources to do so have not been saved by the public. Investors have been misled into forms of production they cannot sustain.
  5. Imagine a builder who thinks he has 20 percent more bricks than he really has. And 20 percent more bricks than he can pay for. That inaccurate brick count will have dire consequences: the house will be bigger than it should be, and the longer he goes on building without realizing the real situation the worse the final reckoning will be.
  6. The economy is like the home builder. Forcing interest rates lower than the free market would have set them makes us act as if there are more saved resources than really exist. Some of our new investment is malinvestment — investment that makes no sense in the light of reality.
  7. That’s what has happened. Politically imposed low rates misdirected huge resources into home construction. It was unsustainable. There were only so many $900,000 homes that the public, which had been saving very little, was able to buy.
  8. The sooner this chronic monetary manipulation comes to an end the sooner the malinvestment can be shaken out, and misallocated resources directed into sustainable lines. And the longer we try propping things up and bailing things out the worse the bust will be. For everyone.

[The title of the book my beachcombing friend Rafe passed along is Meltdown: a free-market look at why the stock market collapsed, the economy tanked, and government bailouts will make things worse, Regnery, 2009. Its publishers have done us all a service, and I hope its author, Thomas E. Woods Jr, will forgive me for pilfering his text.]

Three quotations from Meltdown

Fannie Mae and Freddie Mac

The special privileges granted to Fannie and Freddie have distorted the housing market by allowing them to attract capital they could not attract under pure market conditions. As a result, capital is diverted from its most productive use into housing. This reduces the efficacy of the entire market and thus reduces the standard of living of all Americans.

Despite the long-term damage to the economy inflicted by the government’s interference in the housing market, the government’s policy of diverting capital to other uses creates a short-term boom in housing. Like all artificially created bubbles, the boom in housing prices cannot last forever.

When housing prices fall, homeowners will experience difficulty as their equity is wiped out. Furthermore, the holders of the mortgage debt will also have a loss. These losses will be greater than they would have otherwise been had government policy not actively encouraged overinvestment in housing. (16)

Congressman Ron Paul of Texas, testifying before the House Financial Services Committee, September 10, 2003.

“We need more regulation!”

Financial “deregulation” has often been blamed for the economic meltdown, with then Senator Barack Obama late in the 2008 campaign ceaselessly condemning the Bush administration’s alleged drive to “strip away regulation”.

But lenders in the housing market were doing exactly what the federal government and its central bank wanted them to do. Saying that more government oversight was needed misses the point. More and riskier loans are what the government wanted.

Fashionable opinion everywhere, especially throughout the government sector, cheered as traditional lending practices were abandoned and riskier ones adopted — why, the American dream is being extended to more and more people! (29)

Symptoms, causes, and the war on reality

The fall of stock prices is not the cause of problems in the economy. Stock prices are merely a reflection of the economy’s condition. Artificially inflating them treats the symptom rather than the cause… The fact is financial bubbles need to burst, so that the inflated prices of the assets involved can fall to their market price…

Nor are falling house prices the problem. They are the market’s way of correcting the distortions produced by unleashing the Fed’s credit spigot.

Yet here we have the federal government, which claims to want to make housing more affordable… endorsing a policy of maintaining bubble prices in the real estate market. Whatever happened to the goal of affordable housing? Can a stream of rational thought be found amid all this convoluted nonsense? (57)

Posted in For the Record.