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Failure and Prosperity

Mises Daily: Tuesday, March 02, 2010 by

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[Speech given at "The Birth and Death of the Fed," February 26, 2010, at Jekyll Island, Georgia. The audio is available in Mises Media.]

Doug French at Jekyll Island

If you watch any of the financial channels for any length of time, you'll eventually hear someone going on about how grateful we should be for government intervention: "thank goodness the government stepped in or the world financial system would have collapsed." I'm afraid this kind of talk is going to go on longer than the war on terror.

If the bailouts are questioned at all, the TV talking-head will reply, "yes but everyone was worried in the fall of 2008 that they would go to the ATM and wonder whether any money would come out."

"Look how rocky the markets were after Lehman Brothers filed bankruptcy," they say. "Imagine if other big firms were left to fail!"

"If there had been no bailout and no stimulus, it would have been a depression for sure. Hey, it's been bad, but if not for the wise men at Treasury and the Fed, we'd all be standing in soup lines or selling apples on street corners. Prices would plummet, we'd all be doomed."

White House economic director Lawrence Summers said a year ago, "Deflation is a real risk facing the economy," urging passage of a stimulus bill and taxpayer funds to bail out banks. Summers said that stimulus and bailouts were required for "our economic security."

Do financial failures and falling prices mean the depression and stagnant economy that Summers and others fear?

Many historians describe the period after the crash of 1873 to 1896 as a deflationary dark age. M. John Lubetkin in his book Jay Cooke's Gamble: The Northern Pacific Railroad, The Sioux, and the Panic of 1873 writes that the damage from the Panic of 1873 lasted for five years "and its economic damage was second only to the past century's Great Depression."

However as Jim Grant of Grant's Interest Rate Observer writes, "you can look far and wide without finding a decade so ebullient, prosperous and — in so many ways —so modern as that of the 1880s."

The US economy in the 1880s moved from agriculture to manufacturing; and even then global trade was controversial. But while prices fell, the US economy prospered. Industry expanded; the railroads expanded; physical output, net national product, and real per capita income all roared ahead. For the decade from 1869 to 1879, the real national product grew 6.8% per year and real-product-per-capita growth was described by Murray Rothbard, in his History of Money and Banking in the United States: The Colonial Era to World War II as "phenomenal" at 4.5% per year.

So the period that Wikipedia describes as "a severe nationwide economic depression that lasted until 1879," was really a period of prosperity. This "great depression" was a myth, as Rothbard explains "a myth brought about by misinterpretation of the fact that prices in general fell sharply during the entire period," Sure, prices fell, by 3.8% per annum according to Milton Friedman and Anna Schwartz, but what's so bad about that?

While many economists and historians believe that falling prices equal bad times, that's just not true. Falling prices in the United States mean dollars are worth more. If the price of goods and services are falling, more and more people in all income brackets can enjoy the fruits that the efficiencies of free-market capitalism can provide.

It is, in fact, the definition of prosperity when everyone's standard of living improves as goods become more affordable.

Rothbard explains that what these economists have overlooked is

the fact that in the natural course of events, when government and the banking system do not increase the money supply very rapidly, free-market capitalism will result in an increase in production and economic growth so great as to swamp the increase of money supply. Prices will fall, and the consequences will be not depression or stagnation, but prosperity (since costs are falling, too), economic growth, and the spread of the increased living standard to all the consumers.

All the panic of 1873 did was topple bloated banks and railroads into bankruptcy. Philadelphia banking firm Jay Cooke & Company was a powerful government-bond dealer. Its owner, Jay Cooke, was one of the creators of the national banking system. He also controlled the Northern Pacific Railroad, which had benefited from 47 million acres' worth of land grants from the federal government in the 1860s.

Cooke had sold Northern Pacific bonds by hiring pamphleteers to spin tales alleging that the climate in the northwest was similar to that of the Mediterranean. And he had a number of politicians and government officials on his payroll.

The mighty House of Cook fell apart in 1873, with the banking firm filing for bankruptcy on September 18th of that year. But the panic of 1873 was a worldwide affair (just like the panic of 2008), starting with a stock-market crash in Vienna, then in Berlin and throughout Europe; and then, three months later, the New York Warehouse & Security Company failed, followed by Jay Cooke's firm.

Jay Cooke was a powerful financier and millionaire many times over. He lived in a 53-room mansion on 200 acres just north of Philadelphia, where he entertained presidents and the captains of industry.

"Jay Cooke & Co., if not the nation's largest banking house, was clearly its most powerful," writes Lubetkin.

Decades later, people who knew both men would compare J. Pierpont Morgan with Cooke, the man regarded as one of the Union's saviors, the "financier of the Civil War," who had conceived and managed the sale of over $1.6 billion in federal bonds to hundreds of thousands of investors, all without a whiff of scandal.

Cooke bribed two vice presidents, bought members of Congress, and while he was feared by all politicians, he was venerated by the public for his philanthropy and, according to John T. Flynn, was considered by all the country's leading banker.

Imagine, here was the bank that had unprecedented monopoly power to underwrite all government bonds. Its owner was close friends with the secretary of the Treasury, controlled the railroad that had been allowed to grab more acreage than any other, and had "managed to have himself granted several national bank charters."

And while historians believe the Grant administration was culpable for not responding to the crisis soon enough and not bailing out the big banks, this big, powerful, (dare we say) systemically important bank was allowed to fail in 1873 — and what happened? Prosperity!

And that prosperity continued for another two decades. From 1879 to 1896 the phenomenal growth of American industry and production continued. "Real net national product rose at the rate of 3.7% per year from 1879 to 1897, while per-capita net national product increased by 1.5 percent per year," Rothbard points out.

Prices were falling during this period by over 1% per year, and, although the money supply increased slightly, it wasn't fast enough to outpace the gains in productivity and the supply of products. Prices fell less than the earlier 1873 to 1879 period because the money supply grew more despite the return to the gold standard in 1879.

Of course there was agitation to inflate the currency in response to the panic of 1873, and 60 inflation bills were introduced in Congress. Congress actually debated inflationary policy and passed the Inflation Bill of 1874, which called for the release of $18 million in greenbacks.

But, President Ulysses S. Grant unexpectedly vetoed the bill, against the wishes of the Republican Party, believing that the inflation would destroy the credit of the nation. The next year Grant signed the Resumption of Specie Act which provided that paper money in circulation be exchanged for gold and silver effective January 1, 1879.

There was a financial crisis in 1884, "triggered by an overflow of gold abroad, as foreigners began to lose confidence in the willingness of the United States to remain on the gold standard." As Jim Grant describes, the crisis was "the real McCoy — 'the wildest kind of panic raged, and securities were thrown overboard regardless of price.'"

But remember there was no Federal Reserve, no lender of last resort, no central bank to flood the market with liquidity and cheap credit. So, left to the market, the overnight money rate rose to 4% — per day! (That's a higher rate than your local payday-loan store offers these days) But the crisis only lasted three weeks, writes Elmus Wicker in Banking Panics of the Gilded Age.

From 1879 to 1889, prices kept falling, but wages actually rose by 23%. So, since there was no inflation, real wages soared. "No decade before or since produced such a sustainable rise in real wages," wrote Rothbard.

Rothbard goes on to point out that three conditions must be present to produce such a rise in real wages: an absence of inflation, an increase in savings, and capital formation.

Bond yields fell during this time, from 6.45% on railroad bonds in 1878 to 4.43% in 1889. And considering that consumer prices had fallen 7% during that period, savers and lenders were richly rewarded. Productivity was a robust 3.8% per year, according to R.W. Goldsmith, and gross domestic product (GDP) almost doubled in the 1880s from the decade before, a larger jump, decade on decade, than anytime since.

Labor productivity increased 26.5% and reflects the increase in capital investment. There was an explosion of business startups in the 1880s as well as a 500% increase in the purchase of structures and equipment. Farm productivity and production increased, and capital formation roughly doubled, all while commodity prices were falling. Farm wages also increased.

So, the most powerful bank in the country failed and what followed was a couple decades of prosperity with no too-big-to-fail policy and no worry about systemic risk. Jay Cooke & Company blew up, and not only did life go on but the economy flourished.

But what happens now? Back in the fall of 2008, AIG, an insurance company, was viewed as too systemically important to be allowed to fail. Suze Orman told Larry King, "Thank God, they bailed out AIG."

Felix Salmon wrote in Portfolio magazine,

Whether or not AIG deserved the money was pretty much beside the point: the key thing was that if it didn't get the money, the entire global financial system would be put at risk of collapse. In which light, the cost of the AIG bailout looks positively modest, compared to its benefit.

Nobel laurete Paul Krugman claims the rescue has "pulled us a few inches back from the edge of the abyss."

And why was AIG rescued? Pennsylvania Representative Paul Kanjorski told reporters, "One of the reasons we had to rescue AIG was the fact that it was going to bring down Europe." Yet 18 months later much of Europe continues to be in trouble.

Now it turns out that Goldman Sachs was one of 16 banks paid off when AIG was bailed out. Two hundred billion dollars in taxpayers' money was pumped into AIG's holding company, in a huge "backdoor bailout" to international investment banks led by Goldman Sachs.

"Well, I got to tell you, I sure believed [Goldman Sachs] was in jeopardy," then-Treasury Secretary Hank Paulson told CNBC's Steve Liesman.

I — and I believed that if any major financial institution, Goldman Sachs or any other major financial institution, had gone down right then, with everything else going on in the market, it would have been all she wrote for the American economy.

Current Treasury Secretary Tim Geithner has testified, under oath, that he knew nothing about the bailout of the banks' worthless derivatives contracts through AIG, although he was then president of the New York Fed, which carried out that bailout.

But the government's special inspector-general for the TARP bail-out program, Neil Barofsky, has testified that Geithner personally made the immediate early-November 2008 decision to pay the banks full face "value" for toxic derivatives and collateralized debt securities to the tune of $62 billion.

During a hearing in Capital Hill, Representative Stephen Lynch shouted at Geithner for several minutes, "The commitment to Goldman Sachs trumped your responsibility to the American people."

But Geithner probably feels that he was being responsible to the American people; after all, Goldman Chairman Lloyd Blankfein says,

I'm charged with managing and preserving the franchise for the good of shareholders, and while I don't want to sound highfalutin, it is also for the good of America. I think a strong Goldman Sachs is good for the country.

"Cooke & Co. was the Bear Stearns of its time, a pillar of national finance," writes Peter Grier in the Christian Science Monitor. "If it could fail, anyone could, and the US stock market collapsed that awful autumn."

But the House of Cooke would never be allowed to fail today. Today's Jay Cooke is AIG or Goldman Sachs, not Bear Sterns or Lehman Brothers. The politically connected Cooke today would be thrown a life preserver that would save not only his bank but his ill-conceived Northern Pacific. More efficient firms would not be moving in to take over what is left of his firms, nor buying what can be put to productive use.

Auburn University economics instructor Henry Thompson wrote on Mises.org,

The underlying goal of the financial bailout is not to keep the economy "healthy" but to keep a few Wall Street firms, mortgage banks, and insurance firms in business.

Never mind that most mortgage and insurance firms in the country are profitable; the government wants to support the inefficient, large, high-profile firms. If these firms were allowed to go bankrupt, the economy would recover quickly.

Bankruptcies do little economic harm. The economy would return to prosperity quickly if the government would just let the markets operate and let inefficient firms go broke.

But General Motors, Chrysler, Fannie Mae, Freddie Mac, Citigroup, and of course AIG and Goldman Sachs are still with us, propped up directly with taxpayer dollars, and zero interest rates. Just last week Fed Chairman and 2009 Man of the Year Ben Bernanke reiterated that central-bank officials expect the Fed's key short-term interest rate to remain at a record low near zero for an "extended period" — generally understood to be for at least several months.

And while Bernanke believes "most indicators suggest that inflation likely will be subdued for some time," John Williams at Shadowstats.com, who measures price inflation the way they did in the old days, says price inflation is running nearly 10% per annum.

If only we could return to the 1880s deflation, because price deflation, instead of being evil, as Jörg Guido Hülsmann points out in Deflation & Liberty, "fulfills the very important social function of cleansing the economy and the body politic from all sorts of parasites that have thrived on the previous inflation."

Explains Hülsmann, "There is absolutely no reason to be concerned about the economic effects of deflation — unless one equates the welfare of the nation with the welfare of its false elites."

But to say governments and their friends are concerned about deflation is an understatement. Professor Peter Spencer from York University says central banks have learned many hard lessons since the Bank of England was founded in 1694. With no gold standard to get in the way, central banks are "cutting rates very fast, and if necessary they too will turn to the helicopters," Spencer says, referring to Milton Friedman's (or Ben Bernanke's) idea that governments are capable of dropping bundles of banknotes from helicopters to stop deflation.

This printing of money "will keep the [deflation] wolf from the door," according to Professor Spencer.

But creating more money doesn't create more goods and services.

There is no wolf at society's door. "From the standpoint of the commonly shared interests of all members of society, the quantity of money is irrelevant," Hülsmann makes clear. And if the overindebted and the overlent go bankrupt, that's fine. The fact is, these liquidations have no effect on the real wealth of a nation, and as Hülsmann stresses, "they do not prevent the successful continuation of production."

Deflation is a "great liberating force," Hülsmann explains, "because it destroys the economic basis of the social engineers, spin doctors, and brain washers."

"We sometimes find ourselves wondering how different the world might be if Bernanke had studied the Gilded Age rather than the Great Depression," writes Jim Grant.

It's safe to say the teetotaling George W. Bush was no match to the inebriated Ulysses S. Grant. And instead of there being no Fed for the Wall Street elites to fall back on, now Ben Bernanke continues the policy — created at this very place in 1913 — of directing the world toward an inflationary poverty and despair that only benefits the politically connected select few.

It is Rothbard and Hülsmann that know the way to prosperity: we must bring back failure and deflation.