Mises Daily Articles
Austrian Theory for Everyone
Thomas E. Woods's Meltdown may be the very first book aimed at an intelligent layman that is at once systematic, analytically sophisticated, and an easy read. It is an enjoyable study of the causes, probable consequences, and ways out of present severe economic problems. In terms of content, this book of a little over 180 pages does a thorough job of covering and putting into proper light a range of relatively technical questions in relevant economic theory and history. This is not a small accomplishment, and it bears witness to the extraordinary analytical prowess, erudition, and outstanding literally skills of the author. Those qualities make the book something of a unique phenomenon in the landscape of popular books on economics and finance.
The thrust of analysis that the book follows and the main conclusions it aims to establish are best summarized in a few short sentences: It's not "capitalism." It's not "greed." It's not "deregulation." It's an institution created by government itself — the Federal Reserve System and its policy of credit expansion.
To understand the unique characteristics of the present crisis that has already engulfed the entire economic-financial fabric of the American society, Woods suggests beginning with an analysis of the housing-market bubble. A sober look at its causes quickly exonerates the usual suspects — "executive greed", "excessive risk-taking" and the like.
Woods points out that to blame "the crisis on 'greed' is like blaming plane crashes on gravity" and that "'excessive risk-taking' simply begs the question." It is almost self-evident that both "greed" and "excessive risk-taking" are extremely limited in their explanatory powers, for they cannot account for the weight of specific facts and institutional circumstances that determined the unique path the housing bubble travelled. Instead, Woods chooses a far more promising avenue by asking two crucial questions:
"What institutional factors gave rise to all the foolish lending and borrowing in the first place?"
"Why did banks have so much money available to lend in the mortgage market — so much indeed that they could throw it even at applicants who lacked jobs, income, down payment money, and good credit?"
With respect to institutions, Woods's painstaking analysis lays the blame at the door of governmentally created and supported agencies, legislative acts, and certain community-activist groups whose only lasting contribution was, in effect, to neutralize and override the automatic, built-in market mechanisms to prevent the kind of reckless lending and excessive risk-taking that everyone is now blaming on the market itself (pp. 11–35).
In what follows, I will look at just two of the culprits that Woods deals with rather thoroughly:
Fannie Mae and Freddie Mac, of the notorious "government-sponsored enterprises" (GSEs) fame, are institutions whose only practical significance seems to have consisted in devising and promoting schemes to socialize losses while privatizing profits. In essence, what they did was to virtually eliminate the various risks of private lending by purchasing the mortgages at wholesale, repackaging them as triple-A-rated mortgage-backed securities and throwing them onto the broader securities market. This way, the entire system, from private lenders to Fannie and Freddie to securities firms, was systematically stripped of all the natural private incentives that, under normal circumstance, would be present to balance financial risks along the entire chain.
The long and unholy history of the Community Reinvestment Act, whose very purpose was to push affirmative action into lending practices, adds another important element to the dismal picture. The act enabled certain community groups, such as ACORN, to effectively bully banks and other lending institutions into making massive mortgage loans to preferred low-income minorities. What those groups did, in their blind zeal to help low-income families regardless of the means, contributed greatly to an ever-higher level of financial risk, which eventually ended up destroying the lives and property of their intended beneficiaries — and many others besides.
But even all the institutional factors combined, significant as they are, would run out of steam if it were not for sustained efforts on the part of the main culprit — the Fed and its policy of aggressive credit expansion. The beginning of the housing bubble roughly coincides with Fed's entering an exceptionally vigorous phase of credit expansion in 2001, with no end in sight.1
As Dr. Woods convincingly shows, the Fed's massive expansion of credit is the real key to the whole story. It was the credit expansion that provided the necessary means to sustain the inherently unprofitable lending schemes for such a long time — schemes that would otherwise have been impossible. Furthermore, our author describes and explains in great detail the mechanism that carried the virus from the subprime market to all other segments of the housing market and to the financial system as a whole.
Today, the collapse of the financial sector is affecting the broader economy with mounting bankruptcies and with reductions in production, income, and employment on a scale unseen since the Great Depression. How do we account for the sequence of events? What theory can give us an integrated story of what is happening to the US economy? In the remainder of the book, Woods explains the nature and role of money in a modern division-of-labor system of production and exchange, and introduces and defends the Austrian business-cycle theory to make sense of it all.
Just as in the case of the housing market, Woods identifies and shows beyond a doubt the culpability of the Fed in creating problems in the broader economy. Quite simply, if it were not for the Fed, no wild swings in economic activity could ever take place. No domestic or worldwide technological and productivity breakthroughs, however wide ranging and revolutionary, no sudden shifts in consumer preferences, however unanticipated, no capricious swings in "animal spirits" on the part of individual investors and businessmen could ever have the power and the wherewithal to lift spending to new heights of seemingly unprecedented prosperity and, then, suddenly, send the whole economy into a downward spiral of across-the-board reductions in spending.
In further support of this last point, Woods marshals weighty assistance from eminent scholars such as Anna Schwartz — a leading expert on monetary theory and Milton Friedman's co-author for many years — who famously explained why "manias" cannot serve as explanations of the economy-wide boom-bust sequence and why it is necessarily the
too-easy monetary policy and too-low interest rates that induced ordinary people to say, well, it's so cheap to acquire whatever is the object of desire in an asset boom, and go ahead and acquire that object. And then of course if monetary policy tightens, the boom collapses. (p. 85)
And here we enter the field of business-cycle research. There are a number of competing theories that purport to describe the key phases in any business cycle, to explain their causes and offer an analysis of consequences and public policy recommendations to prevent them from happening again. Among all leading schools of economic thought, one can distill two broad sets of business-cycle theories. The first set includes theories that essentially seek to unearth inherent flaws of one kind or another in the very logic of a capitalist system of production and monetary exchange. Marxism and Keynesianism are the two outstanding representatives of this first group. The Austrian School denies that the market itself contains any inherent systemic tendencies that give rise to wild system-wide swings in spending, production, and employment. According to the Austrians, only the presence of a sufficiently potent outside mechanism, forcibly imposed upon a free market, is capable of throwing the entire economic system out of full-employment equilibrium for a protracted period of time. And, equally important, only further interventions into the natural self-correcting mechanism of a free market can prevent the economic system from reclaiming the full-employment equilibrium again.
To establish this central thesis, Woods discusses a wide range of issues and objections with admirable analytical sophistication and extensive historical knowledge. He does not dodge difficult questions but meets them head on with an integrated logical analysis and solid empirical data.
For example, one of his main points is that recessions need not be long and severe: if the market is allowed to proceed quickly, it will weed out whatever misallocation and underutilization of productive resources the system may be confronted with. The discussion of the "forgotten" 1920–1921 depression — which, while severe, was extremely short by comparison — serves as an important piece of historical analysis to prove the proposition (p. 94–95).
On the other hand, it was precisely President Hoover's alleged "laissez-faire" economic policy of stable wages and prices that prevented freedom of competition from operating and thus prolonged and deepened the Depression needlessly. It may help to point out that Rexford Tugwell, one of FDR's key advisors, openly admitted that
New Deal programs were just a series of extrapolations from what Hoover had already been doing. FDR took Hoover's efforts to prop up prices and wages and institutionalized them. (pp. 98–102)
Instead of letting prices and wages fall, money-wage rates skyrocketed by 13.7 percent in 1937 and thus effectively brought about a "kind of depression within the depression."
Woods effectively addresses the claim, which is still seriously considered even by economists of repute such as Paul Krugman, that it was massive government involvement in production and distribution during World War II that "finally provided a fiscal stimulus adequate to the economy's needs" (p. 103).
Armed with a consistent theory and extensive historical knowledge to back it up, in the last part of the book Woods offers a well-defined bundle of necessary economic reforms to get out of the present crisis.
In terms of immediate economic policy, perhaps the single most important element is to restore freedom of competition in product and labor markets, i.e., prices and wages should be set free to fall and adjust to the reduced volume of productive spending that the destructive cycle of credit expansion and contraction has brought about. Indeed, lower prices and wages are a necessary condition for a full and speedy recovery of all kinds of productive spending. Contrary to the fallacious doctrines of the mainstream neoclassical/Keynesian orthodoxy, lower prices and wages would encourage, not reduce, net investment and thereby restore business profitability on the road to economic recovery and full employment.2
Furthermore, in order to make the transition less painful and minimize the undesirable reductions in real wages, a genuine "stimulus package" would have to include slashing large portions of wasteful government spending and, most importantly, avoiding any additional fiscal stimulus altogether. It is in the very nature of any and all (artificial) fiscal stimulus that not only are such plans not in the position to increase productive spending; they will actually reduce it, thus rendering economic recovery and a return to full employment that much more difficult.
Hence, it is only government intervention, in whatever form, that can permanently prevent market participants from reducing unnecessary consumptive expenditure in favor of the much urgently needed productive expenditure. Ease the wasteful burden of government consumption and there will be a surge in spending for capital goods and labor.
These are the necessary steps to overcome the present crisis. But is there anything of a positive and lasting nature in Woods's philosophical and economic ideology that would guarantee permanent full employment, rising real wages and would avoid the reoccurrence of the disastrous boom-bust cycles?
If there is to be any hope of achieving a free and prosperous society, one of our top priorities must be to get rid of a monetary system that contributes to artificial money creation and credit expansion and thus to recurring boom-bust episodes in production and employment. Abolish the joint partnership of private fractional-reserve banking and central banking and establish in its stead a genuinely free-market monetary system that is both economically sound and morally defensible.
- 1. George Reisman estimates the amount of newly created checking deposits that were created during the 2001–2008 period as being 70 percent of the total amount of checking deposits that were created since the inception of the Fed in 1913 until 2001.
- 2. For a fuller and best analysis of why lower prices and wages are so crucial, see George Reisman's Capitalism: A Treatise on Economics, pp. 778–784, 881–884.