What Made the Next Depression Worse
Walsh College Economic State of the Union
How inevitable is the continuing expansion of the domestic and international economy? Barring a major war and a major depression, and a policy response that repeats the errors of traditional countercyclical policies, I would say that continued world economic expansion is likely.
For an Austrian all too aware of how governments can foil prosperity, that may sound like an optimistic prediction. But consider. With the fall of socialism, the world economy has opened up as never before. New technologies have wrought new efficiencies. Private enterprise has become ever better at mass marketing to the benefit of everyone. The division of labor is expanding internationally. No matter how hard the government continues to try, it just can't seem to throttle the extraordinary power of the market economy.
And yet we cannot bar every contingency, particularly for the US. The economy is not depression proof. If the government and the Federal Reserve are willing to work hard enough, they can kill off even the most robust economic expansion. From an Austrian perspective, the likely scenario is that the Fed will attempt to forestall recession via credit expansion which distorts production structures and makes the recession even deeper.
I seriously doubt that our economic managers have learned enough about economics to avoid this fate. We still must grapple with the problem of the business cycle, which is a feature of the market economy insofar as it is fueled by fiat money managed by a central bank.
Let me begin, then, with some background on the Austrian business cycle theory. At the start of the Great Depression in Europe, the Austrian School, then still centered in Vienna, was well positioned to explain the cause and offer a way out. Mises's first statement of the core of the theory had been widely circulated in his 1912 book, The Theory of Money and Credit. It was still considered the definitive work. In this book, he explains how interest rates are not arbitrary constructs or prices of money dictated by central banks, but rather an integral part of the market economy that coordinates productivity, investment, and savings.
When these signals are manipulated by the central bank, they convey bad information to producers about the availability of resources. Producers invest for a longer time horizon than exists in the real economy and their clusters of errors create what appears to be a sharp rise in productivity and growth. But the boom turns to bust in the passage of time, as consumers run out of resources and projects are left unfinished. The low-interest rate policy had a good run of it, but eventually reality returns and the bad investments are washed out of the system.
But here is a complicating factor. Since the Great Depression, governments have hardly ever permitted recessions to take their market-driven course. Instead, they tend to pile artificial booms on top of economic busts, which can lead to very odd results. The examples are all around us.
The last economic crisis we faced was five years ago. The central banks of the world began to inflate by driving interest rates down to historically low levels. Adjusted for inflation, interest rates have been negative in Japan, Europe, and the US since early 2004. This proves very attractive for borrowers, and leads to reckless lending, waves of entrepreneurial errors, and sector-specific inflation.
Contrary to conventional wisdom, we have more to fear from the political response to recession than we do to recession itself. That's because the response usually consists in pumping ever more money and credit into the economy.
Part of the problem is intellectual. In the Great Depression, for example, people observed that banks were failing and immediately concluded that the problem was not enough liquidity. They observed that consumers were not spending and assumed they needed more money. They observed that businesses were having their credit lines cut and thought that more credit was needed.
As Murray Rothbard has shown, this was the path chosen by both Hoover and FDR in the early years of the Great Depression. And though it did not work, the inflationist remedy remained the policy response of first resort. In every case, the solution is the same: plug in the printing presses and let them perform their magic. Alan Greenspan, for example, has the reputation of an inflation hawk but consider that he has turned to the printing presses in every crisis that has come about during his tenure.
What is unseen is the hidden cause of the crisis, which is in the past. It is the expansion of money and credit that leads to imbalances that eventually turn booms to busts. What people have done in concluding otherwise is to confuse cause and effect, something akin to concluding that puddles of water on the ground are causing it to rain. To carry the analogy further, these same people might attempt to drain all puddles as a way of stopping the rain. We can laugh at such absurdities, but such fallacies are a common strain among social scientists trying to understand the business cycle.
In Mises's day, the rise of positivism meant a new fashion for collecting data and eschewing all forms of deductive theory. So despite many years of work, and growing acceptance of Mises's own theory, it was not only difficult to explain cause and effect, it was difficult to get even economists to look beyond the here and now to see the underlying causes. This was the first serious indication among the Austrians that the battle for the future of economics would in part be a battle over economic methodology.
Does good economics consist in collecting and manipulating data, organizing them in a manner to measure the extent to which any two random economic phenomena collide in time and thereby concluding that this statistical correlation can serve as a proxy for causation? This is the theory that led people to believe that it was a burst of technology that caused the dot com boom, or that the dot com bust was God's way of smiting greedy CEOs.
Really, this approach to business cycles is no more scientific than the approach a primitive witch doctor takes to healing, except that at least the witchdoctor has to take some responsibility for whether the patient lives or dies. The economists just wash their hands and walk away.
In the United States, the Great Depression presented similar difficulties. There were very few economists here who understood the theory, and so a void was left for Keynes, who told the government everything it wanted to hear. He said the core problem lies with too little money, too little government spending, too little central management of investment. After many decades of hearing economists tell how government should curb its appetite for power, this new message was much welcome. Corrupt politicians the world over celebrated!
Benjamin Anderson and Henry Hazlitt battled it out in the early 1930s, but they too confronted an establishment anxious for fast solutions to endemic problems, and the rise of an economic profession that was increasingly impatient with deep theoretical understanding. What sold in the intellectual world then was superficiality. So Keynesian solutions were tried, and failed, in a repeated pattern from the 1930s until our own times.
Only the Austrians seem to be willing to take a careful look at not only what is seen but also what is unseen. Mark Thornton has shown that it was only the Austrians who seemed to understand that something had gone very wrong in the mid and late 1990s, and foresaw that the dot com boom was essentially unsustainable.
As a result, more people are paying attention to the Austrian theory now than ever before. In fact, a leading post-Keynesian was recently accused by a colleague of being an Austrian, and he quickly denied it. But then he added: "The Austrian theoretical framework seems to be the only tool at hand. And when all you have is a hammer . . ."
I always imagine what Mises would say if he heard these words, nearly 100 years after he first came up with his explanation for the business cycle. How such knowledge would have brought him solace in those difficult years of total Keynesian dominance. It goes to show you that if you are willing to wait and be patient, the truth will win out in the end. Mises believed in this principle. We should too.
I've already mentioned what the world economy has going for it: the expansion of the division of labor, technological advance, and economies that are opening up to trade and investment. The dollar is still the dominant currency the world over, which gives the US economy in particular a competitive advantage. We have been able to enjoy the comparative nirvana of low-priced consumer goods while depending on foreign markets to absorb the dollars created domestically.
But related to this last point, let's talk about the downside. The falling dollar on international exchange portends an ominous change for the US. The factors that permitted the US to export inflation have come under challenge. The Euro can be a viable competitor to the dollar in the future. With shrinking demand for dollars, the US could find itself with genuine inflation on its hands. There are already signs of this on the way, with rising commodity prices and oil prices.
As Antony Mueller has pointed out, the three most essential price systems of the modern economy are unusually sensitive to political manipulation: the oil price, the interest rate, and the exchange rate. This doesn't mean that the Fed and the government can dictate them but it does mean that these prices respond especially rapidly and dramatically to political error.
It would be very easy to drum up a scenario in which the US economy falls into a tailspin, with the dollar losing its position as the world standard, interest rates soaring, housing prices collapsing, inflation taking off, and the economy left with few means of recovery given the high debt load and low savings rate of the American family. Whether and to what extent this is a likely scenario I do not know, but it does seem clear that until something is done to stop the spending and debt generated by Washington, D.C., there will be a high price to pay.
Now, in my ideal world, the US would take the path long recommended by the old liberal tradition. We would have free trade with the world, establish a gold standard that defined the dollar as gold and otherwise ending central banking, and bring about completely free domestic markets. This is the Austrian version of utopia, and it has two key advantages: it would bring about the most productive economy in the history of the world, and it would also serve as the best guard to freedom.
Tragically, however, the Bush administration has brought us no closer to that ideal. Instead it has pursued a huge range of interventions in the market process that may seem uneventful now but could matter far more should the economy once again fall on bad times.
Economic downturns are precipitated by credit expansions and contractions but monetary policy cannot alone account for the length, breadth, and shape. This is inspired by other factors. The Hoover and FDR interventions in the early stages of the Great Depression made matters worse by preventing a downward wage correction, by interfering with the right of Americans to engage in foreign trade, by bailing out bankrupt banks, and otherwise inhibiting the operations of the market.
In those days, politicians waited for economic downturns before wrecking the market. Nowadays, they are glad to intervene for any reason anytime. Republicans are no better than Democrats in this regard, despite the formers' professed love of free enterprise.
I here offer what I regard as Bush's top ten economic errors, which might be the very errors that will make the next depression far worse than it needs to be.
Number Ten: Martha Stewart Jailing. This was just a disgrace. This great entrepreneur was guilty of nothing but being beloved, famous, and rich. When the Justice Department couldn't get her for insider trading, of which she was not guilty under any conceivable definition, the government changed the charges to obstruction of justice, which really comes down to being willing to defend yourself. If you claim you are not guilty, you open yourself up to prosecution for being wrong. The real point of this case, I believe, was to put a great American entrepreneur in her place, and inspire fear and loathing across corporate America. This isn't just my opinion. This was a point made by the New York Times, in the hope that her jailing would intimidate the whole of the American business class.
Two additional points behind this fiasco. The original case concerned an anti-cancer drug that was made by the company in which she held stock, ImClone. The corporate stock took a dive after the FDA barred the drug, but later tests revealed that the drug was everything the company said it was.
Also, in sweet revenge, Martha Stewart handled herself in jail with great dignity and now goes on to greater heights in her commercial endeavors. All power to her, but the costs are still there: investors are more cautious, corporate America is more cautious, and ever more live in fear of their DC masters. A fearful and oppressed business class is a very bad omen for continued economic expansion.
Number Nine: Unrelenting Protectionism. The Bush administration began its campaign for old-fashioned protectionism with a disgraceful tariff on steel that did nothing to help the industry but much to harm American business by vastly raising the costs of steel. After incredible protest, the Bush administration finally declared victory and repealed its tariff, but only while adding more tariffs and protections for timber, shrimp, clothing, and a hundred other items in the USTR's daily operations, all of which have the same theme: the rest of the world had better buy our stuff, but the US government has no obligation to stop taxing American consumers to benefit well-connected US companies.
I'm especially concerned about the Bush administration's obsession with what it calls intellectual property rights. I'm as sorry as the next guy that merchants on the streets of Beijing are selling illicit copies of The Incredibles and the complete ninth season of Friends. But I do not believe it is the job of the US government to go abroad with the goal of slaying these particular monsters. Patents are government grants of monopoly privilege. They are a bad enough policy at home but it amounts to an egregious form of imperialist mercantilism to use the foreign policy powers of the US to stop it.
Number Eight: The Social Security Reform Hoax. Genuine privatization would be a grand idea. But that is not what the Bush administration proposes. Not anywhere close. They are proposing to partially convert the existing tax and spend system into a forced savings program. This is not choice but rather a species of socialism. The forced investments would be fed to approved funds with approved companies and be guaranteed a rate of return.
So in the end, Bush-style privatization would partially socialize the most important sector of the American capital markets, and we aren't talking about small change. And how would this transition be funded? Bush has suggested that he would be willing to lift the FICA cap, which would mean the worst tax increase in US history. Debt, taxes, inflation—take your pick. The costs are in the trillions.
Number Seven: Government Spending. You will notice that Bush has lately been talking like a budget cutter. He is going to rein in government spending, he says. Well, I suppose everyone has known about the great uncle who swears he is going to cut back on his drinking but somehow keeps ending up at the dry-out farm. He is the first president since John Quincy Adams not to veto a single bill during his first term in office. Total federal government spending is up by 30% in his first term, which is three times the rate of growth wrought by that bad old big spender Bill Clinton. Since 2001, the government has hired an additional 140,000 civilians for its ranks.
In an anomalous manner, government revenue has been falling for some six years. Now, the response in a household to this type of trend would be to cut back. But the government has the exact opposite response. It has become more profligate even as its revenue stream is not producing what it might have expected. But beware: the bills will be paid somehow someday. All we know for sure is who will be doing the paying.
Number Six: Failure To Repeal the AMT. There have been no shortages of warnings about the Alternative Minimum Tax. This sneaky little prosperity killer will snag another 3 million taxpayers this year, and another 30 million by the end of the decade. Now, this all results from some tiny change in the tax law that dates back to the Nixon years, which means that no one alive is willing to take any responsibility for it. But no one in Washington is complaining about it either, the Republicans least of all. Bush was in a good position to stop the nonsense, but did nothing about it. Not only that: Bush's latest budget actually rescinds some exemptions that congress had granted in recent years.
Number Five: Prescription Drug Benefit. This is the largest expansion of federal welfare since the Great Society. New estimates put the cost at $700 billion over ten years but we might as well round up and say an even trillion. To think: when Congress voted on it, they believed it would cost only $400 billion. Now I'm always a bit amused by these claims that Congress is shocked! shocked! that a government program costs more than it was supposed to.
I find it even more befuddling why congress would be all for a program that only costs $400 billion but draws the line at $700 billion. This is like a burglar leaving the last bit of jewelry in a safe on grounds that to take it too would be akin to theft. In any case, this program is a calamity. And so we have, in the name of allaying high drug prices, a vast artificial increase in demand. There were other ways to lower the costs of drugs but because it might mean denying pharmaceutical companies some revenue, the Bush regime decided to socialize their profits instead.
Number Four: Failure to Rein in Fannie/Freddie. We may very well have a housing boom on our hands. Housing prices have doubled in some markets from 2001 through 2004. The median price of a single-family home has risen from $145,000 to $183,600. The boom is caused by artificially low interest rates but facilitated by two federally chartered private institutions that are effectively too big to fail. They have doled out mortgage welfare for so long and to so many, that most Americans no longer know what it means to have to scrimp and save for a house.
But price hikes cut both ways: they are great for the seller but terrible for the buyer. Most of us fall into both categories, so we develop a dependency relationship with price hikes. We need to learn to think of rising prices as something unnatural and unwelcome. Entrepreneurial profit is a great thing, but constantly rising prices on this scale suggest a market distortion. If a depression comes, and the industry has to be bailed out, or if mortgage rates rise dramatically in the near future, we will have a calamity on our hands.
Number Three: Signing and Enforcing SOX. At the end of the dot com bust, some people in Washington developed the idea that corporate America is run by crooks who spend all their time cooking the books. Now: imagine politicians in Washington complaining about anything run by crooks who cook the books! In any case, their answer was a series of show trials for CEOs and CFOs that completely overlooked how the business cycle had changed accounting standards.
That was followed by the passage of the Sarbanes-Oxley Act, which gave the federal government complete supervisory authority over the accounting of every publicly listed company and enforced criminal penalties against CEOs and CFOs that sign off on audits that government disputes.
The costs have been unthinkably large: in the hundreds of billions. Accountants report spending nearly all their time complying with it, and some critiques have compared this bill with FDR's National Industrial Recovery Act, given how much it empowers government to manage affairs that were once left to the discretion of the private sector.
And don't you just love the theory behind these regulations, which supposes that large publicly listed companies have no strong incentive to keep good books. It only takes a moment's thought to realize that the investor class is the most sophisticated watcher of business, and business has every incentive to provide whatever information is needed or wanted by investors. It was the markets, not government, that discovered the anomalies at Enron and the high-profile cases. All government regulations end up doing is forcing companies to waste resources complying with edicts rather than serving stockholders and consumers.
Number Two: Markets By Force. As a lover of free markets, I'm embarrassed that the Bush administration has said that part of its goal in invading Iraq and bringing total chaos and massive death to that country was to give them a capitalistic economy. In fact, the Bush administration still enforces price controls on gasoline in Iraq, still forbids free trade, still excludes free enterprise communication and airline companies from setting up shop, and still refuses to allow Iraqis control over their own oil. However, even had the US really brought about free enterprise in Iraq, militarism and war is not the right way to do it. The way to bring markets to the world is not by war and force, but by trade and example.
I suggest we take with a grain of salt all claims by the Bush administration that it is seeking to expand markets around the world. If it really sought to expand markets, the place to begin is right at home. Instead, we've seen the opposite. It is closing markets, harassing successful entrepreneurs, and hobbling enterprise through high regulations.
Number One: the Appointment of Ben S. Bernanke, formerly of the Fed, to be the chairman of the Council of Economic Advisers. Please listen to his words from a speech given in 2002, given in the context of trying to settle down people's fears of the economic future:
The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.
Well, these comments certainly do calm fears that deflation is in our future. But what he seems incredibly sanguine about is the effects of inflation. Already, inflation amounts to a daily robbery of the American consumer. Even in these supposedly low inflation times, price indexes have doubled since 1980. What this means is that one dollar in 1980 purchases only 50 cents worth of goods and services today. There are no long lines at gas stations and we aren't panicked for our future, but we are still being robbed, only more slowly and more subtly than in the past.
The Bernanke appointment is certainly a wake up call for anyone who has a benign view of the Bush administration's economic priorities. Indeed, we might as well say that, long term, this could be the most egregious decision that the Bush administration has made.
An inflationist Keynesian and an aggressive advocate of printing-press economics, Bernanke is the sort of crank who becomes famous in history for having destroyed whole countries. He is utterly and completely dedicated to the idea that paper money will save the world, with no downside. I shudder for our future if he becomes head of the Fed. Yet this appointment is probably a pathway to Greenspan’s job, as it was for Greenspan himself.
Now, I'm not predicting another depression any time soon. But I will say that if one comes, all these Bush policies are going to make a depression less easy to recover from. They all work to make the economy less responsive to human ingenuity, harm the manner in which prices convey accurate information to entrepreneurs, and make it more difficult for individuals to put their financial houses back in order.
But just because the depression isn't here yet, let us not wait to decry all these policies for what they are: violations of free-market ethics and true spirit of American enterprise.
The beauty and glory of economic science is that it consists in a series of laws and principles that do not change according to time and place. The prescription for prosperity and stability and human economic flourishing is always and everywhere the same: freedom of association, freedom of contract, freedom of enterprise, freedom to trade across borders without penalty, sound money that is redeemable in something besides paper, private property rights, wages and prices that adjust by market conditions, and a legal structure that shores up these institutions rather than undermines them.
If the United States were to establish such conditions, my cautious optimism about the future of world economic health would turn to wild enthusiasm, because the US would once again become a beacon of liberty to the world, in precisely the manner that the best thinkers among the founding generation imagined it would be.