This Craziness Will End
[This talk was delivered at the Berry College Omicron Delta Epsilon installation dinner in Rome, Georgia, on April 2, 2009.]
Studying economics over the last year or so is like an astronomer studying meteors during a dangerous meteor shower. You see dangers out there with some hits and many near misses, you understand them and see their seriousness, all the while the masses are either oblivious or panicky, and the events are so large that, while you understand them, you can do nothing to stop them. They can be exciting professionally, but at the same time you note that, in the extreme, the world could end. Those are the times when you wonder, why did I major in economics?
It reminds me of the joke that one of the reasons to major in economics is that, when you are unemployed, at least you'll know why.
You economics majors should have a leg up in understanding this current episode on anyone with less formal training in economics. This is especially true due to your training here at Berry. This should give you some sense of superiority, because the problems affecting the global economy today have their genesis in a poor understanding of economics translated into policies. We who study economics should recognize the evidence of this poor understanding every time we read the news. But we can also feel helpless, because we are outnumbered by both those who are ignorant of economics and by a few bad apples who make bad consequences more likely. Some of them even teach at Princeton and win Nobel prizes.
Well, no one ever said it was easy being an astronomer. The same is true for being a free-market economist.
You see, the true free-market economists were concerned with the state of the economy not simply in March of 2008 when the government bailed out Bear Stearns. They were raising warning flags in the months immediately following 9/11 and the unprecedented influx of credit that that event was seen to justify, as well as during the years of unsustainable, bubble-plagued growth that followed. This influx of credit was justified on the basis of a fundamental misunderstanding of credit.
How many times do you hear that low interest rates are necessary for economic growth? This is true, but the cause of the low interest rates determines the kind of growth you have. If such interest rates bring long-term sustainable growth, they result from good credit. If they bring short-term growth (which often maximizes output around election years), they result from bad.
Bad credit is credit produced out of thin air. In this case, when there is not enough money available to fuel a desired level of economic activity, it is simply printed up and injected into the banking system. It is no different, really, from when medieval kings would clip their coins or otherwise debase their currencies so they could finance wars and other spending necessary to their remaining in power. This was a practice that was roundly condemned as fraud and as a form of stealing by Scholastic scholars, who were the precursors to today's Austrian School economists.
For instance, the great Juan de Mariana invoked the papal bull Coena Domini — which excommunicated any ruler who imposed new taxes — to justify excommunicating rulers who debased the currency. Taxes and inflation, you see, were seen as equal forms of theft and as an evil that could endanger one's soul. (The king didn't like Mariana's writings and threw the 73-year old Jesuit in prison for making this argument public, an idea I am sure has come to the minds of Congressman Ron Paul's opponents in Washington.)
Conventionally, in the United States, bad credit is achieved through the process of open-market operations and fractional-reserve banking, which became much more damaging when the United States got off the gold standard in 1971. You should all know how this works. The Fed simply makes the banks increase their excess reserves and reduce their bond holdings, and the banks loan out this money. This money then circulates and creates wealth. When it is spent and redeposited into the banking system, the banks only keep a fraction of the deposits and loan out the difference. As this process plays itself out over and over again, the money supply increases by a much larger factor than the initial injection caused by the Fed.
This is an unsustainable boom. There is economic growth, but it is characterized by wealth redistribution (which favors those who spend the new money first), monetary inflation, and a reduction of purchasing power. But this is the result of bad credit, and it is bad because it creates economic output that no one can purchase because they haven't been saving. Eventually, firms realize that their inventories are rising and they need to slow down economic activity. They lay off workers, and there is a downward pressure on prices that results when firms try to sell off their excess output.
And so, the market liquidates, and corrects, clearing out the malinvestments that were made during the boom. But this is painful, and so, around this time, those ignorant of economics and a few bad apples then clamor for — guess what? Another round of bad credit to ignite another unsustainable boom.
All these rounds of bad credit result in what the great Austrian economist, Ludwig von Mises, called
wavelike movements affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, [and it] is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.
Now it is quite possible to have economic activity resulting from good credit. This results when banks' excess reserves increase due to individuals' decision to save. Consumers in general become more future oriented and reduce present consumption in favor of future consumption. Again, the banks' excess reserves increase, but they increase due to a fundamental change in the nature of the economy, meaning the preferences of consumers — not on the basis of what economic planners in Washington wish the economy were doing.
Again, firms expand their output and economic activity increases and there is an increase in the creation of wealth. But this time, because the credit is savings induced, individuals can actually purchase the output. Since there is no overproduction of goods, there is no need for the economy to liquidate and correct. Economic growth is sustainable. In this situation, the Nobel laureate Friedrich Hayek wrote that "there is no inherent reason why [savings-induced growth] must necessarily be followed by a shrinkage in the structure of production."
In truth, what we have in the United States is a mixture of both kinds of credit. Some people are always saving. Even though personal savings rates are low, retirement savings is rather high. These funds fuel economic activity in a good way. But the Fed is always manipulating the money supply, and no matter that the textbooks say it adjusts banks' credit on the basis of the business cycle, in truth it increases the money supply on a continual basis, constrained only by changes in the government's narrow measure of inflation. SUNY Buffalo finance professor Michael Rozeff recently analyzed the data and found that "[f]rom 1918 to the present, there are at most a handful of brief periods, lasting perhaps 10 years in total, in which the Fed did not inflate the currency."
Rozeff concluded, "The Fed was set up to inflate, and that is what it does."
When measures of the monetary aggregate M3 made this inflation tax even more obvious than normal, the Fed's response was to discontinue measuring M3. Despite this, there is always a pool of real saving in the economy that results from some individual decision to forgo consumption and be future oriented. Up until recently, the infusion of good credit often countered the negative effects of the bad.
Let's look at the last real economic correction that occurred in the United States. This was in 1982. Most of you here, I know, were still glimmers in your parents' eyes at the time. Nonetheless, knowing this piece of economic history is important. Like today, this was a recession that many were likening to a depression. Like today, it followed several years of unrestrained Fed-injected credit. The unemployment rate was in the double digits. The stock market was tanking. Again, there were news stories emphasizing the end of capitalism and the need to reinvent America. What happened?
Two things, primarily. The first was a decision by the establishment to bow to economic realities, and so the Fed sucked credit from the banking system, in an effort to bring inflation under control. Measured increases in official price levels did come down throughout the 1980s. But the resulting high interest rates that this occasioned caused many to choose saving over consumption. Much of the significant economic growth that occurred over the next two decades resulted because it was savings induced, the result of good credit. These high interest rates also quickened the reallocation of capital that characterizes a market correction. This hurried along the correction process and the liquidation that is crucial to it.
The second was a decision by Ronald Reagan to eschew intervening in markets to save industries that would otherwise have been liquidated. Reagan's record is not perfect in this area. He was, after all, a politician. There was a highly publicized bailout of Harley Davidson, and the steel industry remained protected at a time when it really needed correction. One can only imagine what shape the Big Three automobile firms would be in today if they were forced to deal with the union problem back then.
Despite these important exceptions, Reagan generally allowed market forces to reallocate capital. At the time, this decision was not popular and it contradicted the views of many mainstream economists, many of whom (including Paul Samuelson) predicted the 1980s would be a time when the Soviet Union would surpass the United States as an economic power. Because much capital was reallocated in response to market forces, and because it was savings induced, much of the economic growth that followed corresponded to economic reality and not political desire. This also fueled the subsequent economic expansion.
Economics really trumped politics after this episode, and it became obvious that the state actually hindered the functioning of a healthy market. The public sector became something of a joke, especially in the 1990s.
The situation today seems to be that the political class refuses to let this happen again. Alan Greenspan's tenure at the Federal Reserve was to inject money at any time the economy showed an inclination to correct. When bad investments are allowed to resist market correction, they only make a later inevitable correction more severe. It is too bad Greenspan never had any children. I can only imagine how he would react if (say) a high-school daughter came home after a drinking binge and the beginning of a hangover setting in. If his monetary policy is any indication, instead of putting her to bed and letting her body correct, he would slip her a few more shots of gin to get the buzz going again.
Greenspan also used the Fed's monopoly on the creation of bad money to create moral hazards that would prove damaging. The bubbles that he fueled during his tenure are one example. Another was recently pointed out by the great Alabama-bred investor, Jim Rogers of Investment Biker and Quantum Fund fame, who noted in BusinessWeek last month that Greenspan's 1998 decision to bail out Long-Term Capital Management has proven especially nefarious. LTCM was (and is) a multibillion-dollar investment group, operated by Greenspan's friends, which Lew Rockwell called "a crazy Connecticut hedge fund that believed it could predict the future by paying Nobel laureates vast sums to concoct a mathematical model that perfectly predicted the past."
When LTCM's mistakes caught up with it, Greenspan orchestrated a bailout, justified by the now familiar — although false — specter of systemic risk. Rogers noted the moral hazard this action caused, as well as how it hindered the otherwise corrective power of the market in the years to come. Said Rogers: "If [LTCM] had been allowed to fail, Lehman and the rest of them would've lost a huge amount of money, their capital would've been impaired, and it would've put a terrible crimp on Wall Street. It would have slowed them down for years. Instead of losing capital, losing assets, and losing incompetent people, they [simply] hired more incompetent people."
What we have today is the LTCM bailout writ large. Interest rates are kept as low as possible, reflecting the continued reliance on bad credit to solve problems created by previous injections of bad credit. What's more, the Federal Reserve has injected new money in the economy well past the point at which people want it. Excess reserves are growing at record rates today because the people just aren't responding to the new, bad credit like they did in the past. This is spelling the end of mainstream monetary theory today for similar reasons why dominant fiscal theory ended in the 1970s.
But the federal government doesn't appear ready to let this happen. When market forces react in ways predicted following a period of overproduction resulting from bad credit, the state blames markets themselves and claims the right to socialize large segments of the economy. The government can claim to own most of our houses through its ownership of Fannie and Freddie, making it, in a sense, the largest single owner of housing since the Soviets. Today, either the Fed or the Treasury own AIG and preferred shares of hundreds of banks; and they may assume de facto ownership over several hedge funds before this is over. It is not consoling that this was once predicted as inevitable — by Karl Marx.
Note as well that interest rate and inflation policies today are exactly opposite to those of the early 1980s. There is little incentive to reallocate capital to more productive uses when interest rates are kept low. Why invest in long-term bonds when the return is not much better than short-term bonds, given the present risky environment? Furthermore, the money that the banks are holding because they can't lend it out will surely prove inflationary if it ever is.
In historical terms, the amount of money comprising the monetary base today is simply unprecedented. Any unsustainable growth that the new money may generate must be inflationary, if only because the government injects bad credit into the system much more easily than it removes it. This is serious business, and it explains why the Georgia and Montana legislatures have bills before them today allowing them to conduct business in gold and silver. This makes perfect sense if you believe that the tradeoff for trillions of dollars of bad credit over the last year, which again is simply unprecedented, will be the ruin of the dollar.
Furthermore, the government today is protecting firms that would otherwise be shut down. Much of this is waste that is not even measured. For instance, can you imagine what would have happened if Enron was deemed too-big-to-fail back in 2001? Capital that might otherwise have gone to more productive hands instead would have gone to that corrupt firm. Its bad decisions would have been rewarded, and the moral hazard that intervening would have created would have ensured more waste in the future. And yet, this has become official policy applied to AIG, CountryWide, CitiGroup, Goldman Sachs, Dutsche Bank, Merrill Lynch, Barclays, HSBC, Royal Bank of Scotland, Morgan Stanley, Wachovia, Bank of America, and Lloyds Banking Group — to say nothing of Fannie and Freddie and General Motors and Chrysler. We all work for Wall Street and Detroit, in one way or another.
Clearly, allowing these firms to fail — or at least internalize their losses — would have been painful, but just the same, important for economic health in the future. The correction in 1982 was painful too, but it was crucial for the good economic times that followed. Are we better off today because risks are socialized, making us a little less like America and a little more like France?
Clearly not, and each day more and more people are grasping that obvious point. As this continues, the craziness will stop and sounder minds will reassert themselves. This has always happened in the past. And we can decide whether it happens sooner (as in the 1980s) or later (as in the 1930s). It is not as if economists have not figured out how to create wealth, and in this respect property rights and free markets always trump wealth redistribution and central planning. This is an intellectual fight that is done and over.
So let's keep in mind that when President Obama claims that "economists agree" or "economists endorse" his crazed plan for trillion-dollar budget deficits for the next several years, he is referring to a select group of perhaps 100 well-entrenched Keynesian and Chicago school academics who are paid well to fashion theory that benefits the state. This episode is their last hurrah. This reminds me again of Hayek who was Keynes's principal intellectual opponent in the 1930s and who, over his lifetime, saw strong market economies eventually emerge from bleaker economic times than today's.
Hayek truly admired America. He used to say that although Americans were as susceptible to economic fallacies as were Europeans, Americans were more practical when it came to the world of ideas, saying that they were more likely to drop bad ones when it became clear that they weren't working. Europeans, in contrast, would cling to them as a result of intellectual or national pride, or due to bureaucratic necessity.
Well, America has been adopting policies lately based on some pretty bad ideas. Yes, we have had some bad apples running and advising government who seem overly giddy about this crisis — the prospect of a new New Deal, and their starring roles in it. But when the effects of these policies continue to hinder recovery, these policies will first be resisted, then changed, and when they are, we will again see a renewed appreciation for the fruits of sound money and constitutionally restrained government.
When it happens, we may feel like the astronomer who just watched a big meteor veer away from the earth. Hey, it could happen. And those of us who study economics will know why.
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This talk was delivered at the Berry College Omicron Delta Epsilon installation dinner in Rome, Georgia, on April 2, 2009.
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