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Correcting Thomas Sowell on Boom-Bust

Mises Daily: Wednesday, July 29, 2009 by

Thomas Sowell
Thomas Sowell
Rose and Milton Friedman Senior Fellow
The Hoover Institution
Stanford University

Thomas Sowell, an unabashed marketeer, has long been an oft-cited advocate of the economics of liberty — one whose body of work is accorded considerable respect, including by this author. In a recent interview for National Review, Sowell makes many clear and cogent points explaining the extent of the market interventions which created the dreaded housing boom.

In a particularly valuable part of the interview, Sowell exposes reasons for the existence of concentrated housing speculation in certain areas, such as the San Francisco bay area and the greater Phoenix metro area. These areas were subject to extensive zoning laws. Meanwhile, in areas such as Houston, which are devoid of such laws, prices tended to move slowly according to supply and demand. When one ponders it for a moment, one can see that the steady equilibration of prices in cities like Houston is firm proof of the resiliency of less-constrained markets.

However, despite all his worthwhile contributions, and despite being a self-proclaimed supply-side economist, Dr. Sowell fails to convincingly explain the cluster of errors which led to the housing boom. In the interview, Sowell correctly points out that government restrictions effectively oligopolize the market for bond and security ratings, and that the three ratings firms which are allowed to sell commercial ratings are also heavily regulated and influenced by the national government. While it is certain that government cartelization of the ratings market contributed to the cluster of errors in investment banking, and while it is further true that, as Sowell argues, calculation was made more difficult by the dearth of data regarding these "exotic" types of adjustable mortgages, Sowell completely neglects to account for the pernicious role of the Federal Reserve system and its interest rate manipulation in promoting widespread miscalculation.

By now, it is a well-known reality, even one revealed by the intellectually shallow analysts of the mainstream business media, that the Federal Reserve was actively engaged in inflationary policies throughout the 2000s. Yet all too often the connection between this inflation and the widespread miscalculation in investment banking is left unexplored in mainstream discussions. This concentration of business failures is no surprise, however, to students of Murray Rothbard's writings. Rothbard, in his beautiful work What Has Government Done to Our Money? expounds the role of monetary inflation in the process of economic calculation.

Rothbard taught that inflationary credit expansion, because of its propensity to artificially lower the interest rate, creates illusory profits in industries which are capital-intensive and long-term, that is to say industries which are far removed across time from the final point of sale for consumption. The interest rate, as Rothbard and Mises taught, is, in a free market, nothing more than a price for funds which represents a dynamic equilibrium between the desire of individuals to save and the desire of other individuals, entrepreneurs, and corporations to borrow and invest.

The housing market — in which entrepreneurs must scout out new locations, apply for permits, secure funding, acquire supplies and labor, engage in a lengthy physical construction process, and then scout out buyers — is a perfect example of a long-term market which is particularly sensitive to changes in the rate of interest.

In Meltdown, Tom Woods masterfully translates the Fed's recent interest rate manipulation into tangible layman's terms: a housing contractor is led by low interest rates to believe that consumers have abstained from purchasing more physical current goods and have instead saved their income to enable them greater consumption of future goods, thus allowing entrepreneurs to put those physical resources into long-term productive — and, the entrepreneur hopes, profitable — pursuits in the meantime. This, according to Woods, leaves the housing contractor to believe that there will be more physical bricks available for completion of homes in the future than will actually be available, and that consumers will have more funds available for the purchase of those homes in the future than they actually will.

Returning to our critique of Sowell's analysis, there is no basis for expecting the entrepreneur — or even the investment banker with an Ivy League education — to be able to discern between endeavors which will truly be profitable and those which have been made falsely profitable in the short run by distorted interest rates. In a market which is subject to false interest rates, it is impossible from a practical point of view for the entrepreneur to tell which products are rising in price as a result of fundamental consumer demands, and which are made falsely profitable by the infusion of government funds, as we now know housing was.

The discovery of which classes of goods — i.e., present or future goods — and even further which types of goods within a class (say, tennis shoes or mp3 players within present goods) are free of inflationary demand surges would require entrepreneurs to analyze the ultimate sources of funding of every group of consumers for every class and type of good able to be produced. Even entrepreneurs well-versed in Austrian theory, and therefore aware that monetary inflation feeds unsustainable booms in general future goods, would find it impossible to discern which goods within a time class of goods are made profitable by true demand rather than simple inflationary expansionism.

To wit, the entrepreneur, in an attempt to discover areas of production which have been made profitable by truly increased demand, rather than by government credit expansion, would have to research the sustainability of the streams of income of all prospective purchasers of the goods he is considering, the sustainability of the streams feeding those streams through exchange, and so forth until he discovers the ultimate sources of funding and demand for all possible consumers and therefore is able to discover which industries have been most influenced by false credit expansion.

It is beyond ridiculous to conceive of such data collection and economic calculation as being practicable in an interconnected and ever-changing economy. It is also impossible for the entrepreneur — even if by 'entrepreneur' we mean a team of wealthy and brilliant investment bankers — to be able to collect and process such copious amounts of data while simultaneously learning about the physical steps and intricacies of several actual productive processes and successfully forecasting for a future which has been falsely painted as one rich in saved resources. Therefore, all these entrepreneurs have at their disposal are statistical analysis of past market price trends and educated guesses about the future directions of those trends, all based on distorted prices and a deeply perverted market for investment and savings.

Indeed, during the beginning months or even years of an inflationary boom period, these capital-intensive and long-term processes are profitable. This is corroborated by commonly known statistical analyses of the mid-2000s, when housing prices soared and profits in construction, investment banking, and input production soared. And as Mises taught in many of his writings, past profits are an indication of successful forecasting and therefore will lead to further investment in such industries as were recently profitable, while funds are sucked away from pursuits which have recently been unprofitable. It is no surprise, then, that investment banks and other financial institutions invested more and more heavily in those capital-intensive industries which appeared profitable due to price signals but which were ultimately doomed to fail. This widespread movement in the financial markets toward bubble-based investment was not simple "market mania," as Dr. Sowell grudgingly concedes at one point during the interview, but seemingly rational behaviors by highly educated individuals acting in a marketplace whose profit and loss mechanisms were subverted by government interventions.

Not only does Dr. Sowell's explanation insufficiently explain the housing boom and bust, it also neglects the larger boom and bust in other high-order goods. It is important for the critical economist to observe and remember that the boom and bust did not take place exclusively in housing and mortgage-heavy investing. Rather, prices and profits in all manner of time-intensive and capital-heavy production followed the same pattern as did housing and investment banking. Dr. Sowell's explanation that loosened mortgage credit through Freddie Mac and Fannie Mae, combined with municipal zoning laws, caused the global boom and bust is far from convincing. His explanation offers no basis for the general boom and subsequent bust within all long-term production processes, from palladium mining to commercial plant expansion, which has been shown to have taken place alongside the housing boom.

Not coincidentally, Tom Woods's account of the recession in Meltdown accounts not only for the wild rise in housing prices in certain markets, but for the unsustainable rise in long-term production in general. Woods's account, therefore, addresses the causal forces behind the rise of commodities futures speculation, the upward surge in oil prices which preceded the bust, and the heavy losses recently sustained by capital goods and input producers whose products are only tangentially related to housing prices, such as US Steel.

The only theory which can accurately and completely explain each phenomenon taking place in the nationwide market is the Misesian-Hayekian theory of the business cycle. Dr. Sowell's book The Housing Boom and Bust, while insufficient as an explanation of the marketwide (and indeed, worldwide) inflationary cycle and subsequent depression, is a good exposé of the political forces which channeled the glut of liquidity into the housing market. Taken together with a strong understanding of Austrian business cycle theory, this book will prepare its readers to debate the economic and political forces behind the general boom and bust of the American economy.

For those looking for a thorough, accurate, and logically consistent analysis of broad market forces and the role of the Federal Reserve in promoting a general and unsustainable boom in long-term production, Tom Woods's Meltdown remains the best choice on the market. In what we can only hope will become the seminal and most-cited record of the current recession, Woods shows that the Misesian-Hayekian theory of the business cycle is the only one that can completely explain the current recession, and also withstand rigorous criticism.

Even Dr. Thomas Sowell himself would benefit intellectually from Woods's accessible study of the current recession and Austrian economic theory.