The Social Imperative of Sound Money
[This talk was delivered on September 13, 2008, at the Vancouver Mises Circle.]
This past week, the government announced that it would take Freddie Mac and Fannie Mae, the mortgage giants, under conservatorship, which is a nice way of saying that they will be nationalized.
We don't use the word nationalize any more. We can try an experiment and read the new term "conservatorship" back into history. In fact, we might say that Stalin and Lenin put Russia's industries under a kind of conservatorship. Or we might say that Mao pushed a kind of land conservatorship, or that Hitler's policy was one of national conservatorship. Marx's little book could be retitled The Conservatorship Manifesto.
You see, the government keeps having to make up new names for these things because the old policies, which were not that different in content, failed so miserably. The old terms become discredited and new terms become necessary, in an effort to fool the public.
It's as if a restaurant served a shrimp dish that gave all the customers food poisoning, and so now each night it serves the same shrimp but names the dish something new: crangon cocktail, prawn pasta, scampi salad, or what have you. No matter what they call it, it is still poison.
Such a restaurant would be out of business in a matter of days. People would not be fooled. But the government gets away with it mainly because we have no real choice about the matter, and because people are predisposed to believe the government far more than they should. It doesn't help that the media are willing to echo the government line on this, adopting every new phrase as if it were the gospel.
Hence the same is true of the word bailout, which you might consider unexceptionally descriptive of this move by the government to protect Freddie and Fannie from further losses. No, that word is not allowed either. President Bush told Fox the other day, "I wouldn't call it a bailout. I'd call it a stabilization."
We will soon put out a new edition of Mises's 1922 book Socialism. Maybe to keep up with the time we should call it Stabilizing Conservatorship.
What I also find striking is the way in which this move was announced. Let me read to you from the New York Times:
The Bush administration seized control of the nation's two largest mortgage finance companies on Sunday…. It could become one of the most expensive financial bailouts in American history.
Even the most sophisticated observers of our present scene had to blink their eyes in reading such words. Without debate, without votes, without anything other than an executive fiat, the White House just decided, on its own, to seize the mortgage market. Harry Truman, who seized the steel industry, would be proud. Actually, this is an action to excuse dictators the world over, past, present, and future.
This sort of thing makes a mockery of the Constitution and the very idea of freedom and the free market, to say nothing of the idea that we have a limited government. What's more, if we can believe press reports, President Bush had very little to do with the decision. It was the work of Henry Paulson, the secretary of the Treasury and former head of Goldman Sachs, working on behalf of the nation's most well-connected financial elites. Nobody elected this guy. Most Americans don't even know his name.
And look at how he throws around trillions of our money. The New York Times says that this is expensive. That's one way to put it. It makes the S&L bailout look like the warmup.
Freddie and Fannie carry about $5.3 trillion in mortgage commitments and another $2.4 trillion in financial exposure. The total cost of this operation is unknown; it could reach to $2 trillion, with untold amounts of future exposure.
These two New Deal institutions were founded to speed up the home ownership process for people that banks would otherwise consider unqualified. In time, under LBJ and Nixon, they were given legal permission to expand without limit — in the name of privatization, of all things.
The motive was a classic bipartisan effort: universal home ownership. The Left favored the redistribution. The Right favored the supposed moral virtue associated with the nuclear family and its suburban abode. Thus was born the greatest wealth transfer in American history outside Social Security and the warfare state.
In a free market with sound money, borrowing is connected with the ability to pay. At first, this is only available to the rich. As prosperity spreads, so does creditworthiness. Any government intervention designed to inject steroids in this process is going to end in what Rothbard called a cluster of errors.
It is completely disingenuous that so many people are today decrying the banking system's failure to discriminate between those who should and should not be carrying a mortgage. The banking system in a free market handles this just fine. Ferreting out the difference between those who can handle loans and those who cannot is a main job of the competitive system. The market precisely calibrates this. If one lender fails in its assessments of borrowers, another is there to correct the problem.
If you rush the process of prosperity, and insist that everyone who wants a loan should get one, you set up a situation in which there will be problems down the line. That is precisely what the regime has done. It created Freddie and Fannie to subsidize loans. It engaged in a phony privatization that secretly socialized losses. The legal status of these privately owned, publicly traded, and government-protected agencies was always unclear, but the markets had long assumed that they would be bailed out.
There was a moral hazard at the heart of this policy. But the real point is that the free market judgment about who should get what was being overridden. Surely, that is not a problem when it comes to promoting the alleged American dream! In fact, we are paying for this mistake a half century after the policy became a national priority. As the evangelical ministers like to say, the wheels of justice grind slowly, but they grind mighty fine.
There is only one problem with applying the principle to this case. There will be no justice. If justice prevailed, the losses would be borne directly by those responsible.
If we pursued a free-market policy from here on, the answer would not be complicated. The assets and liabilities of Freddie Mac and Fannie Mae would be auctioned today in the free market. It's true that many loans would be defaulted on.
What level of crisis would be precipitated by such a genuine privatization policy? It's true that the press would be screaming bloody murder, and the big players in finance would suffer. But in time, the markets would revalue the resources and an important lesson would be learned. Sound loans would be picked up by financially responsible firms and carried to term. Home values would fall and many people would have to move to cheaper homes. We would then be back on sound footing again.
From an administration that purports to favor free markets, this possible solution was not even considered. Instead, they proclaimed their regrets that they would have to spread the costs of this error over the entire population. Instead of fixing the problem, however, they only worsen it, underscoring the principle that America will not tolerate failure in business, and the bigger the failure, the more likely it is to be bailed out.
Note that this socialistic bailout and nationalization — to use two forbidden words — were enacted by a Republican administration. Isn't it ironic that when you look back at the big upticks in government intervention over the economy, you often find Republicans at the helm.
As for McCain and Palin, they wrote in the Wall Street Journal that this bailout is "sadly necessarily" even as they promise reforms that will "require the highest standards of accounting, reporting and transparency ever demanded in government." Well, here's the thing: no one demands higher standards than the market itself, but you have to turn these institutions over to the market in order to elicit such standards.
Congress's role has been and will be to yammer. Only Ron Paul of Texas will have anything sensible to say about this fiasco. In fact, it was more than five years ago that Ron said the following:
If Fannie and Freddie were not underwritten by the federal government, investors would demand Fannie and Freddie provide assurance that they follow accepted management and accounting practices…. By transferring the risk of a widespread mortgage default, the government increases the likelihood of a painful crash in the housing market. This is because 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.
It's remarkable to observe that hardly anyone dares be against this policy. On the day following the nationalization — a day that will live in infamy — the Wall Street Journal editorialized against the Democrats and their reform efforts, but didn't actually oppose the bailout. The New York Times called it "a reasonable and reassuring move." The Los Angeles Times wrote that the bailout was "inevitable." Steve Forbes in his magazine wrote that "drastic action" had to be taken because a default would "have triggered the worst financial meltdown since the Great Depression."
It's interesting, isn't it, that all these people believe that waving the magic money wand can make reality just go away. That incredible superstition seems to be the official position of the entire US establishment. And we like to flatter ourselves into believing that we live in an age without illusions!
As for those who should know better, Greg Mankiw, author of the leading economics textbook, writes that because "it was likely to happen eventually" it is "better to get on with it." The supposedly free-market economics blog Marginal Revolution warns that without the bailout, "most of the U.S. banking system would be insolvent," failing to point out that a system that needs a bailout with fiat money is already insolvent. Econlog had lots of good thoughts, but didn't actually oppose the bailout.
The Cato Institute agrees that the Treasury had to bail out the mortgage industry because it "was forced to do so," and that Fannie and Freddie are indeed "too big to fail." The Heritage Foundation agrees that it was a "necessary step" and a "vital move toward reform."
Sure, these people have plenty of recommendations about what should have been done in the past, and lots of ideas about what should be done in the future. As for the present, they are ready to propagandize for the largest socialist operation in American history. In all of these latter cases, we are looking not at a problem of economic education but rather the courage to stand up to the state when it is needed most. They didn't do so after 9/11. And now they have caved again.
Part of the problem is the belief in the great myth propagated by Milton Friedman. As good as he was on many issues, he was not correct on his specialty of American monetary history. His view was that the Depression was caused by a Fed that failed to fully bail out the banking system. Ben Bernanke and many others are pleased to accept this view of history, and they are determined not to let it happen again. In fact, the Fed did attempt to bail out the banks, and was far too successful. This is the basis of the problem.
In the end, we are talking about a price system that has rendered a verdict on the housing market. Prices don't lie and there is nothing we can do to reverse them. Even the most powerful government in the world cannot do so. The attempt causes calamity. The Austrians understand this; it seems as if hardly anyone else does.
Pretty much alone in both predicting the calamity and actually opposing the bailout are those who have learned from the Misesian tradition, who have said plainly and clearly that this is a dreadful error, one that makes the United States more socialistic than China.
Let us address this claim that not bailing out the system, and not nationalizing the mortgage market, would lead to a financial meltdown on the level of the Great Depression. People talk as if the Depression were some sort of natural disaster that the government had to fight. In fact, it was the very fighting of the Depression that deepened it and caused it to last all the way through World War II. We have to understand that if we are to understand the real lesson of the Depression. Instead of letting prices fall and letting the bad investments wash out of the system, the government tried for years and years to keep prices high, employ people in make-work programs, and generally centrally plan the economy.
In 1920 through 1922, we had a financial meltdown just as bracing and systematic as the one in 1929. The difference was that the government didn't do anything to try to fix it. As a result, it solved itself and it is a forgotten event. Hoover and FDR, in contrast, attempted to use their power over the economy and monetary system to try to keep prices floating high and to keep liquidity in the banking system — precisely as everyone is attempting now. The result was to forestall the inevitable readjustment process.
They believed that the low prices were the cause and not the effect of the recession. Does that error sound familiar? In other words, the Great Depression only became the Great Depression because the government followed exactly the same policies that the Bush administration is following now with regard to the mortgage market.
It makes no sense to warn that we will repeat the past if we do the same things that actually made the past as bad as it was. To avoid another Depression-sized downturn, we need to avoid the mistakes of the past, among which were the policies that attempted to keep failing firms and industries afloat in difficult economic times.
What should have happened in 1929 is precisely what should happen now. The government should completely remove itself and let the market reevaluate resource values. That means bankruptcies, yes. That means bank closures, yes. But these are part of the capitalistic system. They are part of the free-market economy. What is regrettable is not the readjustment process, but that the process was ever made necessary by the preceding central-bank and other interventions.
Let me state this very plainly: I do not believe for one second that if the government fails to nationalize Freddie and Fannie that the world as we know it will come to an end. Those who are saying that are trying to scare the population, the same as with every other major demand by the regime. It was the same with NAFTA, the WTO, the war on terror, the war on bird flu, the nationalization of airport security, and everything else.
If the government did nothing but sell off the assets of the mortgage giants, we do not know for sure what would happen, but the market has a way of finding value and readjusting. I would expect about 18 months of difficulties. Banks would fail just as many businesses in the free market fail every day. Housing prices would fall more, just as all market prices are subject to change. But the process of readjustment would be smooth and rational. And we would all stop living a lie and believing an illusion.
Contrary to what the blogging heads say, there is nothing that makes this nationalization inevitable. If we had leaders who had courage, who understood economics, who could think about the long run, we would let the market handle the entire process, come what may. I guarantee that this solution is a better one than creating another trillion or so to bail out failing enterprises.
And yet this is not just another longing for courageous leaders. We can't hope for that. We need a guarantee. We need a system that would make it impossible for government to do these things even if it wants to. That system is called sound money. Think about the preconditions that made it possible for the Bush administration to decide one evening to dump a trillion plus to guarantee three-quarters of the home mortgages in this country. It is a system that is premised on the government's capacity to print unlimited amounts of money.
If it could not do that, no one would be talking about conservatorship. No one would be talking about guaranteeing the liabilities of the automotive industry either. War on Afghanistan, on Iraq, on Russia, and troops in another 100 plus countries, would be out of the question. These wouldn't be issues. If government had to tax people directly for all its spending priorities, we would see Washington's ambitions in every area scaled back dramatically. Every suggestion of a new program would be met with the demand as to how it would be funded.
Fiat money with central banking, on the other hand, tempts corrupt politicians and bureaucrats, and it also further corrupts them. It is the great occasion of sin of our public life. The tragedy is that their use of the printing press not only corrupts them; it imposes dreadful and intolerable costs on the rest of society, in the form of price inflation and business cycles.
We've seen the corruption grow worse over time. We are living now in the 37th year of fully fiat money with central banking. The politicians of the past were a bit reticent to use all the power they had. They are becoming ever more brazen. The sense of shame seems to be gone forever, their consciousness completely papered over by the ominous power they possess. The pundit class is following them, believing that there are no limits.
In truth, all these bills must be paid. To realize that is to realize the necessity of radical reform. It can be overwhelming to contemplate the glorious results of a full gold-standard reform. Inflation would stop eating away our purchasing power. The business cycle would be tamed. International trade would not be disrupted by wild swings in currency values. But of all the benefits, this one is the greatest: it would stop arbitrary rule, dead in its tracks. It would force the government to curb its ways. It would shore up our freedoms.
For this reason, the policy of sound money is very much linked with morality. The Hebrew scriptures, in the nineteenth chapter of the book of Leviticus, warn: "you shall have just balances, just weights…"
The twenty-fifth chapter of Deuteronomy issues a similar warning: "You shall not have in your bag differing weights, a large and a small."
Proverbs says the same: "A false balance is abomination to the LORD: but a just weight is his delight."
Another passage says, "Diverse weights, and diverse measures, both of them are alike abomination to the LORD."
All of these relate in some degree to the need for sound money and condemn the act of fraud and monetary debasement. The consequences of monetary sin cannot be contained to the sinners only. They are spread out all over the whole of society, destroying its economic basis and corrupting its morals. They foster crazed illusions that we can magically generate wealth through the act of printing money, and the attempt to do so has catastrophic consequences. As Mises wrote, "Inflation is the fiscal complement of statism and arbitrary government. It is a cog in the complex of policies and institutions which gradually lead toward totalitarianism."
I find it sickening that there are so few voices outside the Austrian School that will stand up to this policy. And I fear that the consequences of this policy will be felt for many decades into the future. There is still time to reverse course. There is nothing inevitable about despotism. We are not being forced down this road. We can embrace freedom. If we understand that freedom is inseparable from sound money, we can embrace that too. Until then, we will continue to place our trust in the political establishment to do what is right. Call me a gold bug if you will, but I trust hard money far more than our rulers. And that, ultimately, is the choice we must make.
Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.