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What Would Mises Say?

Mises Daily: Wednesday, March 25, 2009 by

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Ludwig von Mises

Far from being prosperous, our America is now being buffeted by the worst financial tsunami in generations. All of us want to know what happened. What really caused this unbelievable turbulence?

To answer this, why not turn to the teachings of my late professor, Ludwig von Mises, the greatest economic analyst of the past century?

In the early 1920s, Mises predicted that the newly organized Soviet Union had set up an unviable economic system that would not be able to survive. Mises based his death verdict (made in his book, Socialism, shortly after the Russian Revolution) on the principle that a society cannot rely on political committees to set market prices as the commissars were trying to do; only the freely demonstrated choices of the market can produce functioning prices. All artificial prices are unworkable; they cannot tell the central planners which goods are expensive and which are cheap, so it would be impossible for them to organize production in an efficient way.

Without real prices, there could be no economization. Mises was derided for this analysis, even to the end of his life. But Mises was right, and history has approved his verdict, although he passed away without receiving due accolades. Even posthumously — when the Russian monster collapsed in 1989 — recognition of his genius was scant.

For this reason I consider myself justified in naming him as the greatest analyst ever.

A Flood of New Money

Although Mises is no longer with us to comment on our present debacle, we know which economic principles (truths) he relied on, and it is certainly apropos to raise the question, what would Mises say about the present crisis?

The scene is muddied by so many diverse factors — the low and then high rates of interest, the proliferation of mortgages that could never be paid off, the delirious purchase of those leveraged investments by the banking system, the overzealous federal promotion of home ownership and bailouts — but his reply would be clear as day.

The true cause of the economic instability is what he labeled inflationism.

By this he meant the unlimited creation of new money on the part of governments — fiat money without any backing whatsoever. The modern conviction is that our economic system is inherently unstable and that banking authorities must continually create more and more money out of nothing in order to maintain a prosperous economy. And this is certainly what our present monetary chiefs have been doing — to the extent of magically producing 9 trillion newly hatched dollars since the crisis began, with no end in sight!

They have made the world awash with liquidity. This is a violation of the basic principle that Mises held to be indispensable for a sound monetary system: you must never increase the existing amount of money.

The prevailing quantity of money is uniquely adjusted to the actual availability of goods and services. Augmenting or reducing the number of dollars in circulation only creates distortions in the economy. It causes prices and costs to rise, destroys the meaning of the accounting ledgers, creates all sorts of bubbles in the prices of stocks and of housing, and (even now) of government bonds. It turns new "investments" into nothing but the destruction of capital.

Inflationism, Mises held, has always been the worst of all social evils. This fact has gone unnoticed by historians, who dedicate their studies to rulers and wars and discoveries, but have never realized the impoverishing effects of debasing money (in the metallic period) or, similarly, of multiplying the monetary units (in our international financial system), causing each unit to lose its prior value.

It is the avalanche of new dollars (in some years growing by as much as ten percent, and now, with the new recovery packages, at an exponential rate yet to be determined) that has produced and sustains without remedy the mess that we are in. Were it not for this flood of new money, the prices of housing could never have risen to unsustainable heights, the securitized mortgages would not have multiplied, and our financial institutions would not have been gluttonously attracted to them. It was the unlimited creation of new cash that was the cause of all these disasters, and it provided both governments and institutions the temptation to distort and disrupt reality.

But what is astounding is that the remedy proposed by our ignorant politicians is the flush of unbounded new liquidity that they are creating for renewing reserves, multiplying bailouts, sustaining the overpriced mortgages, and on and on. This excess has been pushed by two presidents and almost unanimously promoted by a Democratic congress. Liquidity was the cause of the crisis, and now excess liquidity is presented as its solution! For this reason the crisis cannot possibly end in the short run. The remedy proposed is worsening things all over, and assures us that we will never get back to a sound and prosperous economy as long as we defy monetary sobriety.

The very life of our dollar is at stake. That would be Mises's message today. The quantity of money must never be increased.

The Interest Rate: Breaking the Levees

Another fundamental cause of all this mischief, Mises would instruct us, is the reckless rollercoaster tampering with the rate of interest — made low in the 1990s, raised five times in 2000, lowered down nearly to zero with 12 reductions in 2001, and held there until the fear of inflation raised it in 2004. Our monetary gatekeepers consider the interest rate a tool (or better, a toy) at their disposal, to be raised whenever there is fear of impending price rises (what they commonly mislabel as inflation) and to be lowered when there is danger of recession.

It is not that the Fed really raises or lowers interest rates or tampers with the scale of risk that the different levels of interest rate reflect. It has no power or means to do that. What the Fed does is to set a "target" rate for the securest type of loans (those from one bank to another), and then adjust the creation of new money to secure this goal. When the Fed wants to expand or restrain economic activity, more or less new money is created, respectively. But there is always new money in the works.

Interest is commonly considered something like a monetary faucet to be opened wide to pump the economy and to be shut off when prices get out of hand. But interest is not a monetary toy, as Mises has told us. It is not a price that can be adjusted at will. Rather, interest is meant to be a measure of the real savings accumulated at any one moment in the economy. Interest is high when the economy embarks on a spending spree and savings are reduced (as has been the case in recent years). Interest is low when consumption is reduced and savings are being generated to fuel new investment. The interest rate is like a semaphore, telling the investor whether to promote more current consumer goods as people are spending more and the interest rate is high, or, when the interest rate is low, to transfer resources to new investments that will develop more and better products for future, not present, consumption.

Thus the interest rate is not monetary but temporal: a ratio representing the tradeoff between current and future consumption.

This Misesian idea is entirely alien to the would-be managers of the American economy. The Fed was holding rates as near to zero as it could while America was on a spending spree — with negative savings to boot — when it should have let the market raise them to new heights. This gave our entrepreneurs a false green light to pursue investments in multiple new projects like home building, generous mortgage lending, securitized packages, and whatnot.

The true rate of interest is the levee that holds back unsound investments. The levee was broken and the hurricane of inflated money washed out the economy.

The wild consumption and even wilder investment (well leveraged with debt) surpassed the ability of our limited resources to satisfy this hyperdemand, and thus made inevitable the rise in prices. This rise then burdened all the new investments with higher operating costs that became so unmanageable that firms began to fail, the hallmark of a recession. There was no more economizing. We were trying to do everything at once, spending beyond our means, without the accumulated savings required to safely finance all this activity.

"Liquidity was the cause of the crisis, and now excess liquidity is presented as its solution!"

Now, with the recession in full swing, we should be tightening our belts and reducing our expenditures. But what are our leaders doing? Reducing interest rates again as close to zero as they can, and washing us with money in order to "stimulate" everything in sight.

The sky is, once again, the projected limit. We must resurrect the economy — with yet more reckless buying and investing.

The worst thing that the Fed does is to distort the vital semaphore of the economy, making it red when it should show green and vice versa. The near-zero rate will be fatal to any possible chance of an early recovery. It should be high until the rate of savings justifies a lower rate.

We can thank the good Lord that the country, on its own — and not due to the master plans of Washington — has begun to buy less and save more. This new source of savings will tend to offset the annulment of the interest rate. But it won't be enough to hold back the continuous reflooding of the economy with unbacked fiat dollars. No relief is in sight, as Mises would tell us.

Can't Someone Do Something!

The authorities, however, insist that it is their solemn duty to ward off all this downturn negativity. They must reduce the threat of unemployment and ward off the effects of home foreclosures. Through bailouts, they must rescue once-prestigious beacons of capitalist enterprise and repurchase all the overbloated securities. All of this, of course, demands the creation of trillions and more — infinite new money and infinite new debt.

We have an activist government: nothing passive can be tolerated. Don't stand there, they are all saying. Do something! We are told on all sides that the government and the central bank must act immediately and forcibly. And it could be that the trillions in proposed remedies might not be sufficient to force an upturn in the economy. We must do something drastic. The response must be unprecedentedly virile. Both our presidents have been buttressed by the nearly unanimous verdict of the Democratic portion of the Congress, by all of the Nobel-winning supereconomists, and by a united press. In unison, they all are insisting that we can't be timid; we must act boldly. All our reserves must be committed at once. No experiment must be left untried.

What would our mentor, Mises, the lone voice predicting the fall of the Soviet economy, tell us now? He warned us not to augment the supply of money and not to tamper with the rate of interest. Here again, we find him, almost alone in the world, although many new and saner voices are day-by-day echoing Mises.

His resounding reply: do nothing. Tell the government to stay out of the picture and let the chips fall where they may. Let the folks in the market take care of restoring the economy. That means no more fiat money, much higher interest rates, no more bailouts, rescues, bolstering of prices, purchasing or creating make-work. Do nothing. Period.

When economic affairs are left to the judgment of the ordinary participants in the economy, things tend rapidly to straighten themselves out.

We saw this in a striking manner when the American people, confronted with an unprecedented rise in the price of gasoline, merely decided, spontaneously, to park their cars; the price of fuel quickly fell to seemingly bargain prices. When Lehman Brothers failed last September, the government abstained from interfering, and foreign companies rapidly bought up what was good in Lehman's assets. There are millions of good thinkers in the market, and there will always be someone there to save the day.

Does it make sense to bail out companies that have wantonly invested in overpriced and overextended mortgages? Their leaders have wasted the scarce capital entrusted to them. Leveraging their mortgage purchases with substantial increments of colossal corporate debt; they have betrayed not only their stockholders but also the entire economy, the rest of us, who had entrusted them with the creation of enriching and safe investment projects. These traitors must not be artificially propped up, forgiven, and even rewarded. Bankruptcy is the only sensible route to oust them. It will force down the prices of their remaining good assets, and new entrepreneurs will promptly appear to buy them up at bargain prices and get the companies going again at modest cost.

Of course, there will always be unavoidable suffering involved, especially on the part of the employees who must temporarily be displaced, but the pains will be minimized by the rapid resolution of the problem through the forces of the market.

Then why should anyone be buying up all the overbloated assets at their bubble values? That is ridiculous. It only serves to perpetuate the phoniness of a phony economy. All prices must be allowed to sink, as rapidly as economic gravity can suck them down, to the value that the market would normally assign them. We can't have a livable economy with houses that cost hundreds of thousands of dollars. Who would be able to afford them? Only reasonable prices can survive in the market.

Moreover, it is inherently unjust to create liquidity to rescue those who have behaved with total disdain for prudence, those who issued or contracted mortgages without healthy foresight, those who overextended their credit to buy all sorts of surplus stuff. They are the very ones who have contributed to the general malaise. If some credit agencies are failing, let them go bankrupt. Other entrepreneurs would get together the new capital needed to replace them. This would promote greater prudence in the future.

The opponents of the market deride this solution, saying that it smacks of laissez-faire. But was it not the exaggerated intromission of both the central bank and the Congress in promoting liquidity, massive home ownership, unrestrained interest rates, etc., that got us here in the first place? Prosperity will never come from experiments that violate common sense, experience, and the norms of sound economic theory, especially when such experiments are wilder than ever before. On the contrary, if we follow the Misesian wisdom and the government not be allowed to upset the applecart, the market will shortly make the crisis fade away. Otherwise, who knows how long it will take for prosperity to return?