TheTexan
07-10-2012, 12:33 AM
Money Meltdown, by Wes Riddle, September 2009
The United States has been in official recession since late 2007, and it is widely agreed that trouble began (or was at least exposed) with a precipitous housing downturn. By the end of 2008, we were experiencing a full-fledged increasingly global meltdown. Stocks now are down by more than a third—which is a nice way of saying that millions of people lost their shirts, as years of savings for retirement or investment have vanished. Over three hundred metropolitan areas in the United States are depressed economically. Texas is the biggest notable exception. The national unemployment average is almost ten percent, but because government has played fast and loose with statistics in order to hide information from the American people, you may be interested in knowing unemployment is really over 16 percent the way it used to be calculated as late as the 1970s.
The economic crisis has exposed some structural problems in the financial system worldwide. Banks in Europe proved no more resilient than in America. China turned out to be dependent on the west, at least for now—and fortunately foreign capital did flood back into the U.S. as the best safe haven available for uncertain times. We can describe it, but the question is what to do. The Great Depression happened too and despite shallow consensus on a few points, historians and economists argue vigorously over why it came about and whether New Deal policies and/or World War II pulled us out—even if they are never quite sure how. Some writers are dubbing the current crisis as the Great Recession. Others compare it to a so-called Long Depression affecting some areas from 1873 to 1896. The irony is that it is hard to expect things to improve unless we have some clue about how we got into the predicament. Unfortunately, there are a lot of very smart people who never did have a clue, giving the government advice and calling shots. Stupid is as stupid does.
Most government solutions tried so far or being contemplated are in fact interventions into the economy based upon a false premise that the free market economy failed. It may be countered, however, that it is government intervention that has messed things up so badly in the first instance, namely the Federal Reserve and its manipulation of the money supply and interest rates. The architects of the debacle are planning our recovery, while the competing voice of reason is largely gone missing from argument. Not only is the Fed ignored as a source of trouble by mainstream media, there is also strangely a veritable range of subjects excluded from national dialogue—the Fed and money to name two. Politicians aren’t going to save us this time, if they ever did, and one of the most important concepts the sovereign people better learn these days is called the “Austrian” business cycle theory. Austrian refers to the school of economics—and it was the only school to accurately predict the onset of our current crisis.
Thomas E. Woods, Jr., an academic of Austrian economic persuasion argues convincingly in his book, Meltdown that the financial crisis was not caused by the free market but by government’s intervention in the market. Moreover, the greatest intervention into the economy is America’s central bank, the Federal Reserve System. If this is true, the Fed must be looked at. Clearly we need to stop further government interventions likely to aggravate the problem or precipitate economic catastrophe. The government’s failure in this regard is being passed off and blamed on everything and everybody else except the government; worse, it is used to justify further increases in government power. Ask yourself where all the excess risk, leverage, debt and housing bubble came from. The answers that one gets like excessive risk-taking or greed beg the question. Liberals (who now prefer to be called Progressives) are not only continuing their attack on the foundations of the Republic by denying the Constitution, they are like termites eating away at the foundations of free market economy, about to take us with them to the basement. They are blaming “unregulated markets” for the financial crisis, having manufactured the crisis through very different means.
More bailouts, regulation and government will only make matters much worse and prolong depressed economic conditions around the country. In November 2008 German chancellor Angela Merkel warned correctly, if Washington’s policies create more money and encourage more borrowing, they sow “the seeds of a similar crisis.” Nonetheless, by the end of 2008 and thanks to the congressional bailout package, the American people were on the hook for 7.7 trillion dollars more. Then President Obama came into office riding the horse of more bailout, more spending, more debt, and more government regulation to stimulate the economy. He inherited a mess, but he feels duty bound to make it worse. Meanwhile nobody wants to talk about that large furry creature in the living room, whose name is the Fed and which for all intents and purposes is an arm of the federal government.
Now and again it crosses my mind, how in the world our representative government can be so silent and so inept. Then again, according to the Center for Responsive Politics the securities and investment industry contributed $53 million to congressional and presidential candidates in the 2008 cycle. That places the industry second behind lawyers. Congressmen who voted for the bailout one year ago happened to receive 54% more in campaign contributions from the banks and securities firms than those who didn’t. Americans have notoriously bad memories, and that really is a shame. Of all the things President Obama said he expects of school-aged children in his address to them, critical thinking and historical memory got short shrift. They aren’t as important as the many technical and lab problems that need solving. Just so long as the little precious stays patriotic and doesn’t drop out, and drinks the stuff the state serves up. Some things are settled, like evolution and money laundering on a grand scale.
The government was going to buy all those bad (“toxic”) assets from banks, remember? Well, the approach was abandoned entirely, and a few months later the government said it had to prop up consumer debt, since millions of Americans faced rising credit card rates and reduced access to the credit they needed (for everyday purchases!). Not sure where cash for clunkers fit into the overall economic picture. It may have encouraged a few more green cars on the road, our big transition to technology to save the planet. Most the money went to overseas car producers, however. Now health care reform is the rage, and is sold to us not only as a cure for what ails you but also for ballooning deficits! Meanwhile that large furry creature next to Pelosi, whose name is the Fed, claps loudest of all at Obama’s speeches.
The Federal Reserve System, a.k.a. the Fed was created by an act of Congress. Its chairman is chosen by government appointment. The organization is endowed with monopoly privilege and is dedicated to the most far-reaching form of centralized economic planning. Instead of planning steel and concrete production quotas, say, as in the old Soviet Union, the Fed plans the money and interest rates. The consequences necessarily reverberate throughout the whole economy. We don’t talk about it, because it was the Fed’s policy of intervening in the economy to push interest rates lower than the market would set that was the single biggest contributor to the financial crisis. Making cheap credit available encouraged the excessive leverage, speculation, and indebtedness the government now blames on the free market. Manipulating interest rates misled investors about real economic conditions, misdirected capital into unsustainable lines of production, and desynchronized the entire market. The Fed’s intervention into the economy gave rise (as it has before) to a boom-bust cycle making us all feel rosy pink and prosperous until the inevitable crash—which of course the free market gets blamed for.
In terms of stakes, however, they couldn’t be any higher. As Peer Steinbrück, German finance minister said, as a result of the current crisis America stands to “lose its status as the superpower of the global financial system.” Indeed, a lot of people welcome that development, while others don’t hope for it but point out the fundamentals are not sound for a debt-ridden, over-consuming, under-producing American empire—the fall of which is not inconceivable. International economic crises have a way of upending the geopolitical order, hastening the fall of established powers and the rise of new ones. In The Post-American World (2008), Fareed Zakaria argues that modern history’s third great power shift is upon us. The rise of the West in the 15th century and the rise of America in the 19th were the previous two. Zakaria says the transition now has less to do with American decline and more to do with “the rise of the rest.” That may be so, but America’s leadership seems intent on hastening the day.
For far too long American leaders have been anything but representative, and not at all consultative with the American people concerning their doom. One wonders what the government will do when the entitlement crisis hits and the federal government is put on the hook for tens of trillions of more dollars, as millions of baby boomers retire with high expectations. The President says he’ll tackle that looming crisis once health care is overhauled. In other words, spend now and then spend again later. The problem is that government lacks all understanding and a modicum of imagination. When they try to print their way out of the gargantuan levels of debt afflicting us over the next decade, they will have debased the U.S. Dollar forever.
The financial crisis began when mortgage defaults increased substantially, triggering a chain reaction throughout the financial sector. The standard account explains the mechanics well but not the causes. Housing prices started to fall in the third quarter of 2006. People having trouble making their mortgage could no longer simply sell or refinance. Meanwhile the banks had sold many of their mortgages to other institutions like Fannie Mae, which in turn bundled them together into mortgage-backed securities. The financial system was heavily invested in these mortgage-backed securities, so default on home mortgage loans suddenly threatened a much wider field. One of the associated scandals in all this is that ratings agencies consistently gave AAA ratings to the securities. Institutions and people who thought they were investing prudently, even conservatively, were misled by ratings that had little bearing on actual risk exposure. At least six culprits in terms of causes of the housing crash can be identified.
The first is the Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac). These large corporations officially known as government-sponsored enterprises (GSEs) buy loans from banks on the secondary market. Fannie and Freddie receive the stream of monthly payments associated but also bear the risk of default. The originating bank has funds to go back into the mortgage market and make new loans. The process spurs mortgage lending and inflates home prices. The process is also artificial, i.e., not market based, because of special privileges and the implicit guarantee of solvency granted by government to Fannie and Freddie. Even so, their role in the economy was small until the 1990s, so the economic distortion was relatively low. By the time the housing bubble burst, however, those agencies had a hand in half of all home mortgages—three-quarters of newer ones. This was caused by the Clinton Administration pressuring these agencies to take on risky loans, in order to increase home ownership among poor and minorities despite bad credit ratings.
Second the Community Reinvestment Act (CRA) also received new life by the Clinton administration. It was a Carter-era law that opened banks up to discrimination suits if they did not lend to minorities in sufficient numbers to suit bureaucrats. The political establishment in the 1990s pressed for lower lending standards, such that, the old credit score frameworks were cast aside. Government used one of the twelve regional Federal Reserve banks, the Boston Fed to spread easy lending criteria by means of a so-called discrimination study. It mattered more that one was minority, than whether one could afford the house. Left-wing groups like ACORN helped to “enforce” the policy. Political pressure caused subprime and adjustable-rate mortgage loans to increase.
The third culprit of the crisis is government’s overall stimulus to speculation. Government through the Fed made banks so flush with reserves to lend, that lending innovations like no down payments proliferated. Underwriting standards in general declined, even for high-income borrowers and speculators. Many more people bought houses on a speculative basis than before, betting that prices would continue to rise. Speculative home buying accounted for one-quarter of home purchases at the time the housing bubble popped. When foreclosures skyrocketed, it initially involved this speculative group who had used the flexible, no-money-down mortgages hoping for a quick profitable resell. No money down made walking away easy.
Number four is the tax code, which government blatantly uses for social engineering schemes and incentivizing certain behavior. Hundreds of little programs affecting consumers and developers encouraged people to build and buy homes, channeling artificial demand into the housing sector. The federal government takes 35 percent of the average worker’s income in taxes but gives it back if one engages in certain activities. It’s sort of a public twist on trickle down economic theory. For instance, invest in the stock market through an IRA or 401(k) and shield some money from the taxman. Pay premiums to a health insurance company through an employer and you can deduct it. The biggest deduction by far for most families is the home mortgage interest deduction. Government thereby introduces strong incentive to buy rather than rent, as well as to borrow in order to buy.
Fifth is the Federal Reserve and artificially cheap credit. This had the biggest impact simply because it is so pervasive in its distortion to the economy. An increase in the supply of money and credit starts the economy off on an unsustainable boom. Pushing down interest rates by increasing money supply, the Fed encourages production of longer-term projects, such as construction. This is quite a bit different than stimulus provided by real consumer demand. More and different projects are started than the economy can sustain. When not enough people can afford McMansions, the price each one fetches is far less than anticipated and a bust comes to the real estate market. The Fed started the boom that gave rise to this latest bust, by increasing the money supply through the banking system. In the wake of September 11th and just over a year after the dot-com bust, the Fed sought to reinvigorate the economy through a series of rate cuts culminating in a target federal funds rate of just one percent for a year (June 2003 to June 2004). The supply of money increased dramatically, such that, more dollars were created between 2000 and 2007 than in all the rest of our country’s history! The money and credit found its way to the housing market, where lax lending standards made excessive home purchases and speculation in homes seem like smart financial moves. The quasi-government agencies Fannie and Freddie channeled money the Fed was creating into the housing market.
Finally a “too Big to Fail” mentality deserves some blame, as certain actors in financial markets operated in the confidence and even assurance, that they would not be allowed to fail and that the American people would absorb their losses if they got into trouble. Letting major firms in or out of the financial sector go bankrupt, would do more quickly to jolt the financial sector into being prudent, than all the regulatory tinkering and bailout money in the world. It wasn’t unregulated markets that caused the current crisis.
Economic news of late has been pretty good or at least encouraging. Stocks are going back up, and first time jobless claims are down from what was expected. There are always little rallies in the midst of bear markets. The Dow rebounded to historic highs during the early period of the Great Depression. Don’t be fooled by the rim of a precipice. The bailouts didn’t save the economy. They may have made things worse, even if they staved off a day of reckoning. The problem we’re in is systemic and no longer a matter of pumping in sufficient stimulus. The Treasury Department formed a new office called the Office of Financial Stability. Legitimized and armed by its Orwellian title, the charter has the federal government seeking ownership in banks. The Federal Reserve System combined private banks with government regulation at its start in 1913, but now we are nationalizing the private banks. Hugo Chavez, Venezuela’s president, reportedly said “Bush is to the left of me now… Comrade Bush announced he [is buying] shares in private banks!”
Of course this government ownership does not mean any more responsible approach to anything, and it won’t reduce risk taking any more than it can stop a mistake. Rather, according to Harvard economist Jeffrey Miron, “Government ownership means that political forces will determine who wins and who loses in the banking sector. The government, for example, will push banks to aid borrowers with poor credit histories, to subsidize politically connected industries, and to lend in the districts of powerful members of Congress.” It is more of the same that put us into this financial crisis, only an order of magnitude worse. Unchecked, it will lead to destruction of Middle America. The bailouts thus far have slowed recovery by delaying the de-leveraging process at banks and removing a sense of urgency from financial firms. Other industries have lined up at the door for money and gotten some. The profit and loss system in some respects has been jettisoned for a system of guaranteed profit for business and loss for wage earners. Mismanagement is rewarded with taxpayer funding, and bad managers still get their bonuses.
Government loans to failing financial firms, is terribly ill advised. If one peels away the onion, the government is trying so desperately to keep things expensive! It wants to prop up asset values and keep both stocks and home prices high—as if this will help the holders of those assets. The fall of prices is not the cause of economic problems but rather, a symptom that reflects conditions in the economy. Bubbles need to burst. Instead, the government is intent on propping up bubble prices above what the market will support, and guaranteeing the difference with taxpayer finance. The way an aspiring homeowner must do these days is to drive further into debt for his American dream home, instead of being allowed to pay the low market price it is worth. It is as if the government wants citizens enthralled and burdened with debt just so it can bail them out.
Falling prices, no less than prices rising under normal healthy economic conditions, are simply the market’s way of rationally valuing assets, correcting for economic distortions created from whatever source, including the government’s past intervention and the rapid expansion of the money supply emanating from the Federal Reserve since 2000. Unfortunately, the government’s effort to pour funds into the economy and keep prices artificially high will touch off a round of inflation. There is likely to be an explosion in consumer prices because of the bailouts. Since late 2008, the Fed created 3 trillion new dollars and added the money to its balance sheet, but this acts as a base for banks to create ten times that much based on the multiplier. In order to avoid the predictable outcome, the Fed may try to contract the money supply but this will give rise to more instability. With the entitlement collapse coming and with it, the insolvency of Social Security and Medicare, the same process will likely play out to the tune of tens of trillions of dollars more. Things will then get much worse.
The sooner we allow the market to coordinate production and consumption, the quicker this economy will be allowed to heal. The sooner the government begins to control its appetite for spending and start to reduce budget deficits, as well as the national debt over time, the freer and more prosperous the American people will become. America’s central bank, the Federal Reserve, set this particular boom-bust cycle into motion—and it is bigger than anything we’ve ever seen. Since there is no known shortcut for creating real wealth through government edict, what went up is definitely coming down—one way or another.
The U.S. Federal Reserve failed to let the recession of 2000 take its course and decided to create trillions of dollars out of thin air. The recession that year is the only one on record that did not see housing starts decline. The Fed’s monetary policy led directly to the housing bubble and onset of our current crisis. The Fed intervened and postponed what it was trying to avoid, making the crash worse when it came. There’s a developed country in Asia we ought to pay more attention to, in terms of what works and what doesn’t economically. Its people have great work ethic and are highly educated, yet it is mired in economic difficulty and indeed has been for more than a decade and a half. Lesson learned: it matters what the government will or will not do in this type of financial crisis that we are facing. Some policy measures will absolutely prolong a bad economy. Japan empirically proves the free market case and cautions us to stop clowning around.
Historian Thomas Woods, Jr., relates how Japan fed its economic boom during the 1980s with inflationary credit expansion—increasing the money supply through the central banking system while at the same time keeping interest rates artificially low. Japan actually pushed interest rates to zero, thereby obstructing market correction of the malinvestments. When the bust came, it came hard. Then it lasted so long because of what the Japanese government did after that. Namely, the Japanese government resorted to interventionist tools in order to “kick start” their economy and do better than what the market supposedly could. During the 1990s it launched at least ten fiscal stimulus packages worth more than 100 trillion yen, and this ballooned their national debt—exactly what we are doing today to fix our own mess.
To get banks lending again, Japan pumped money into the banking system at the rate of nearly 300% per year for three years, but this led to a 4.5% decrease every year in bank loans. Public works programs were extensive but did not broadly stimulate the economy. Ironically, we are following a very bad example of what not to do and pursuing failed Keynesian interventionist policies, instead of recurring to American experience and best American instinct. In 1920-21 the U.S. and Japan both faced recession too. Japan opted to intervene and suffered seven years of industrial stagnation because of it. Meanwhile the United States allowed its economy to readjust by keeping government spending and taxation low and reducing public debt. The result was recovery. Unfortunately the Fed began to pursue an inflationary policy for the rest of the decade, thus setting up another boom-bust cycle—that one resulting in the Great Depression. Instead of a quick liquidation and return to prosperity, Presidents Hoover and Franklin Roosevelt pursued policies to prop up prices and wages.
A lot of people attribute World War II to the eventual recovery, but the U.S. recovery coincided with abandonment of New Deal programs in the 1940s. A new, New Deal these days is certain to prolong economic difficulties. If war and spending on munitions really makes a country wealthy, the U.S. and Japan can do the following to help each other out. Have their respective fleets meet in the Pacific and evacuate naval personnel (to avoid the loss of life normally incident to war). Then sink the two fleets plain and simple. Both countries can celebrate how much wealthier they’ve become by devoting labor, steel and a million other diverted inputs to the production of things that get destroyed, things civilians can’t use, and things that lay at the bottom of the ocean. Then just repeat the process. Although facetious, the example points to a central fallacy entertained by the current U.S. administration: the idea that spending alone, regardless of what for, gives rise to prosperity.
Neither does consumer spending drive an economy, if the spending doesn’t make any sense. And that’s what we’re talking about: economic nonsense made out of distortions to the economy fueled by reckless credit expansion in which profit, loss and value become virtually impossible to judge. Distortions result because the government acquires its resources through seizure, unlike the private sector, which acquires them through voluntary means. Even when the government gives one something, it is akin to an assault because the action still lacks voluntary means, as well as market feedback. If it is money, the government had to have taken it from someone else directly, or else from everyone indirectly by printing it and devaluing people’s assets. The purpose of production in the free market is to satisfy real consumer demands, but politically motivated or arbitrary diversions of resources cannot accomplish that purpose.
Investment adviser Peter Schiff compares an artificial boom in the economy to a circus coming to town. Say the circus arrives and its employees and the public, who come to visit the circus, begin to patronize the restaurant across the street. This may go on day after day, night after night for weeks. The restaurant owner may conclude the situation is permanent. If he adds on an addition, doubles his kitchen staff or opens up another location entirely, he will have tragically miscalculated when the big tent folds. Extending cheap credit to him afterwards misses the point and makes matters worse. His expanded restaurant will become a bubble activity that works only under the most phony of conditions. Moreover in an artificial boom created by the Fed, you may as well send in the clowns and watch them do the kabuki—because all firms and businesses, and the whole economy are affected.
It is time we address some fundamental issues about money. First, money didn’t originate with government. It originated amongst people who needed a way to exchange their goods indirectly, instead of through direct barter all the time. One could make a hat and want a basketball, and trading a hat for a basketball might even work, but one quickly finds that having a practical medium will make the myriad of exchanges so much easier. So money is that medium of exchange that gives rise to complex economies. Historically it has been many things, including seashells, berries, gold and silver. Interestingly, only with a pre-existing or inherited array of barter prices (relative sense of assessed value unique to the given society) are people able to substitute money for barter. Money moreover is a useful commodity in its own right and must be, to function effectively as a medium. While paper per se might be close to worthless, the paper money replaces or substitutes for a preexisting commodity money through government fiat and legal tender laws. In our case, Federal Reserve Notes replaced gold and silver, but even then the paper money was redeemable for a given weight of the actual commodity for most of our history. Indeed, a successful paper system will always insist on the paper money being redeemable in its commodity version. Only in this way can the money retain its assessed value and confidence be assured.
Secondly, precious metals work well as money because they are durable, inherently valuable, and easily divisible. Gold is so valuable that most daily transactions people make would be in silver coins—copper for smaller transactions. Private bank notes or checks would represent the same thing. That is, if our paper were tied to its original commodity version! The U.S. government, however, severed that connection, not surprisingly because it favors the ability to increase money without restraint. In so doing, the dollar has lost 95% of its value. Under a commodity standard, if the government needs money it would have to resort to borrowing or taxation. These are obvious and transparent to the people. By de-linking the paper money supply from gold and silver, the government prints money and so skirts political and fiscal accountability through the means of inflation.
Third, as the great economist Joseph Schumpeter said, only the gold standard is compatible with freedom precisely because it places restriction on the government’s ability to expand credit unabated and hence, places natural limit on the government’s ability to seize power. Schumpeter considered gold to be a kind of economic check and balance, more effective than the political sort, because he knew if we lost having our paper currency tied to the commodity then government would be able to deceive all political checks and balances. The Federal Reserve Act of 1913 was special interest legislation at its worst, conceived to favor the class of bankers and politicians. This favoritism comes at the direct expense of the people. The Fed controls the money supply and also moves interest rates up or down. It operates as a lender too (nice when you control interest rates), and it can purchase literally any kind of asset it wants; albeit, the Fed normally buys up government bonds—hence underwriting the government’s design on unrestricted power, indeed with a profit motive to do so!
Fourth it is the Federal Reserve System, which is exclusively responsible for price inflation—by definition this is true, because only the Fed can increase the money supply. Moreover, inflation is the Fed’s great game not only giving rise to boom and bust, but also producing profits for a favored few by exploiting the broader society. When the government inflates the money supply, new money enters the economy at discrete points. The earliest recipients include politically favored constituencies, i.e., banks and firms with government contracts—actually, wherever the government spends its money. These parties receive the money before inflation pushes prices upward. In effect the economy doesn’t know how much the money supply has been increased, so prices haven’t yet adjusted. Of course, by the time the new money makes its way through the economy, prices will have risen—but not until the privileged firms make purchases at the previously existing price level and silently loot those they buy from. When the average person gets his new money, through higher wages or lower borrowing costs, the prices have already risen. The value of his money was diluted before it reached him.
To continue along these same lines, consider that the money in your possession is actually compensation for a good or service you provided. If you buy a dozen apples, you do so with proceeds from a good or service you provided in the past. Indeed, you can only buy apples or anything else, because you provided someone else something they needed. However, in the case of a privileged business firm or bank with new money courtesy of the Fed, it comes out of thin air and not from the sale of a previous good or service. So when they spend new money, they actually take from the existing stock of goods without providing anything in exchange. They are benefited as it were, at the expense of the rest of society. As economic historian Thomas E. Woods, Jr., puts it, “The analogous case under a system of barter would be one in which, instead of trading my bread for your orange juice, I just take your orange juice!”
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