"The End Crisis"?

When I talked about "An Unsatisfying Outlook" in my last post, Obstacles to Growth, I meant that the future is literally unknowable because it depends on human decisions not yet made -- and, secondarily, that potential outcomes include some particularly painful possibilities. In the paragraphs below, I want to expand on those themes by incorporating ideas from several outstanding articles I have just read.

The first article was published by John Mauldin, here, and originally by the authors at The Boeckh Investment Letter. Mr. Mauldin gives the authors, Tony Boeckh and his son Rob, nice introductions. Tony's credentials are extraordinary: he was the former Chairman and CEO of the firm which published the Bank Credit Analyst.

The Boeckh Investment Letter briefly, but importantly, places the 2009 events into their larger context, which the authors call the "debt super cycle." They explain that the US credit cycle originated in the 1950s and 1960s, "though some would take it back much further." When it comes to making sense of the world today, understanding this larger context makes all the difference. As the authors say, many people have argued that the crash of 2008 was a "… black swan event, meaning that it had an extremely low probability of occurrence." This idea results in a huge analytical mistake, because the opposite is true. Given the US government's ongoing credit expansion policies, the 2008 crash was inevitable.

The Boeckh Letter goes on to discuss "The Great Reflation Experiment of 2009." By their reckoning, it seems that the word "experiment" is quite appropriate:

"Private sector credit … maintained a stable trend relative to GDP from 1964 to 1982 … . After that, the ratio of debt to GDP rose rapidly for the 25 years leading up to the crash and is continuing to rise. …The magnitude and length of this rise is probably unprecedented in the history of the world. Even the credit inflation that was the prelude to the 1929 crash and the Great Depression only lasted five or six years."

I am not going to quote extensively from their report; readers interested in this subject should definitely read the letter in its entirety. My only significant quibble with the letter is: "In the short run, huge deficits and growth in government debt are necessary." I understand that the Fed's past mistakes have now created a situation with no good moves, but I am unconvinced that huge deficits will deliver a net benefit even if they avoid some extreme short run economic pain. Nevertheless, that is the authors' considered opinion and it leads them to conclude that ...

"… the Federal Reserve will have to monetize much of the rise in government debt, making it extremely difficult to unwind the explosion in the Fed’s balance sheet and consequent rise in bank reserves – the fuel that could be used to ignite another money and credit explosion."

As we will see, this last point ties into ideas from the second article I will be quoting. The Boeckh Letter goes on to offer "Implications for Investors," ideas well worth considering. What I want to comment on, however, is an idea that brings us back to my theme -- how unknowable and dangerous our economic future is thanks to the Fed's outrageous behavior . Consider the one significant risk these authors choose to mention:

"There is a major risk to our relative near-term optimism, and that is the U.S. dollar. Foreign central banks hold $2.64 trillion … The U.S. role as the main reserve currency country is compromised by its persistent inflationary policies and current account deficits … Foreign central banks fear a large drop in the dollar… They don’t want more dollars, and yet … To preserve their competitive position, they have to buy more when the dollar is under pressure … U.S. … Officials may talk of a strong dollar policy, but their actions always speak differently."

"The most likely outcome is a nervous dollar stalemate … The most important central banks will continue to … buy dollars to keep it from falling too sharply. However, this is a fragile, unstable situation and the dollar must fall over time. Investors need to diversify away from this risk."

Tony Boeckh is smart and experienced, and his "most likely" outcome is … well, probably most likely. But let's not quickly rush past his "fragile, unstable situation" remark, which is reminiscent of Ludwig von Mises' description of the inflationary process. As I quoted in Obstacles to Growth, Mises said that inflation's second stage begins when people …

"… become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly … Everybody is anxious to swap his money against 'real' goods, no matter whether he needs them or not, no matter how much money he has to pay for them."

"Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give anything against them."

Within "a few weeks or even days," said the great economist -- that qualifies as fragile and unstable in my book. Frankly, it would seem like the most important sentence in the Boeckh paragraph, above, is: "Investors need to diversify away from this risk." The Boeckh Investment Letter is excellent; they have good suggestions for investors and they explain the economic context with uncommon skill.

The second article I want to quote is Doug Noland's July 31, 2009 Credit Bubble Bulletin, "Facets of Bubble Analysis." I mentioned Doug Noland in my previous post and I always read his weekly bulletin. Noland has been studying the credit expansion process and writing about the resulting credit bubbles for many years. In my opinion, he is one of very few analysts who have a sophisticated handle on the nature and consequences of the modern credit machine.

Noland always begins his Credit Bubble Bulletin with a long compilation of financial and economic news items. That weekly compilation is always interesting, but be sure you get to the last few paragraphs where Noland presents his personal analysis -- that's where the payout is found. In this week's Bulletin, Noland explains in more depth than I can remember why he believes "we have entered an especially dangerous period of Credit excess and attendant Bubbles."

In my opinion, Noland's lead-off point deserves a little emphasis. He argues that economic analysts are making a mistake when they focus their attention on rising prices. How many times have you seen people try to define a "bubble" in terms of the price rises necessary to warrant that label? I read a recent article, in fact, that supported Greenspan's claim that bubbles cannot generally be detected until they pop -- and challenged disagreeing readers to predict the next bubble, thinking that an inability to do so proves his point! I agree with Noland, who argues that is not a productive way to think about the bubble phenomenon:

"Many see Bubbles in terms of an unsustainable overvaluation of asset prices. … I’ve always viewed Bubbles as a Credit phenomenon. Inflating assets prices are actually only one of many consequences of an overexpansion of Credit. … analysts should downplay asset prices while focusing keenly on underlying Credit and speculative dynamics."

That's the key point: inflating asset prices are just one of many credit expansion effects. Distorted relative prices and consequent malinvestments are the most immediate effect. And then, as I explained in The Fed's Low Interest Rates are Hurting Us, artificially low interest rates promote higher and higher leverage ratios because a credit expansion tends to hold borrowing rates constant no matter how great the demand. Noland says:

"Fundamental to the nature of Credit, expansion generally fosters more expansion. Credit excess begets only greater Credit excess. And Credit excess notoriously begets speculative excesses. … In today’s 'system' of unrestrained Credit, rising demand for borrowings does not dictate an increasing price for this Credit. Indeed, an unlimited supply of Credit will tend to satisfy rising demand at a lower price."

"The bottom line is that unrestrained Credit is inherently unstable, and few seem to appreciate the unique nature of today’s unfettered global Credit environment. … And the breakdown of U.S. discipline … has unleashed domestic Credit systems from China to Brazil. Never have 'developing' Credit systems (and currencies) enjoyed such freedom to inflate financial claims."

We certainly witnessed some unstable processes in the previous bubbles. The technology bubble offered lots of examples, as did the housing bubble. In 2009, however, we are faced with a little different situation. Runaway bank lending is not currently the problem, since powerful deleveraging forces are at work trying to undo some of the earlier excesses. As Boeckh's debt super cycle context makes clear, however, the credit expansion continues to create substantial systemic dangers. Consider Noland's additional insights, quoted in the paragraphs below:

"There are a number of reasons why the government finance Bubble is even more dangerous than the Wall Street/mortgage finance Bubble. First of all, the $2 TN or so of 'government' issuance over the past year is greater than the $1.4 TN peak total mortgage Credit growth during 2005 and 2006. I would expect another $2 TN next year and the year after."

In other words, this "government finance bubble" will dwarf all other bubbles that came before. And even more important, perhaps …

"Government debt enjoys the attribute of 'moneyness' in the marketplace to a much greater capacity than mortgage securities did during the boom. The risks associated with debasing this 'moneyness' are momentous."

"Moneyness" is a term Noland has been using for years, but I didn't fully understand his point until just recently. With this term, Noland means that investors trust these instruments to hold their value reasonably well, like money, and violation of that trust has consequences. Think about the financial carnage that occurred when AAA rated mortgage backed securities collapsed in value. Banks became inadequately capitalized, insurance companies were rendered insolvent, and pension funds found themselves undercapitalized relative to their liabilities. Government debt is obviously far more important than mortgage backed securities and the presumption of safety is universal. If the value of government obligations were ever to collapse, the consequences truly would be "momentous."

Some analysts, of course, will say that the value of government debt could never collapse. They would point to the incredible demand implied by current low yields. But, how much of the current demand is due to the money expansion itself? How much demand is generated by leveraged investors buying the government debt with virtually free money? And how far can this process go; is it impossible for the government to create an oversupply of debt? Noland thinks the credit dynamic could generate another round of unhinged speculation:

"And there is, as well, the dynamic where the greater the government finance Bubble inflates the more convinced the marketplace becomes that the Federal Reserve will do everything within its power to accommodate the debt markets (ultra-loose monetary conditions for the duration). And destabilizing speculation can return to all markets…"

The Boeckh authors make a similar point when they mention the potential to "ignite another money and credit explosion." Noland also comes back to a point he made in last week's Credit Bubble Bulletin: US government policies have now gone to the point where backing off the loose credit policies will be difficult to impossible. In fact, he sees this as an international dilemma:

"Central to the analysis of unfolding precarious Bubble Dynamics is my view that few, if any, policymakers anywhere around world will be willing to act decisively to tighten Credit conditions and address increasingly speculative financial markets."

In my opinion, we have to hope that this last fear will prove to be unwarranted. Never ending credit looseness on this scale cannot have a happy ending. We need to see some central banks around the world come to their senses. Most importantly, we need the US Federal Reserve System come to its senses before dollar holders around the world "… become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly."

If the Fed and other central banks fail to back off, we may have to contend with the potential that Marc Faber cites in a third article I have just read: his August 2009 The Gloom, Boom & Doom Report:

"I agree that more fiscal deficits and further expansionary monetary policies won't work in the sense of bringing back sustainable and sound economic growth that would benefit the majority of the population. Can such policies bring about another unsustainable boom a la 2002-2007? Yes, with the subsequent crisis being the end crisis, which will destroy the system economically, socially, and politically."

Obstacles to Growth

An important Federal Reserve official made some remarkable comments the other day:

"[R]esumption and acceleration of growth depends on removal of obstacles. By obstacles, I mean conditions that get in the way of a natural pace of growth."

"I see a number of obstacles whose removal will take some time. For example, the healing of the banking system will take time. Working off excess housing inventory will take time. The reallocation of labor to productive and growing sectors of the economy will take time. It will take time to complete the deleveraging of American households and the restoration of consumer balance sheets."

"In short, I believe the economy must undergo significant structural adjustments. We're coming out of a severe recession, and it's not too much an exaggeration to say the economy is undergoing a makeover. We must build a more solid foundation for our economy than consumer spending fueled by excessive credit …"

Almost sounds like an Austrian School economist, doesn't he? But he isn't. These quotes come from a July 20, 2009 speech by Dennis Lockhart, the President and Chief Executive Officer of the Federal Reserve Bank of Atlanta. Mr. Lockhart made it clear that he was speaking only for himself, not for the Federal Reserve System. The broader context of his speech also made it pretty clear that he stands shoulder to shoulder with his Keynesian colleagues. Still, I find these comments, and especially his last point, to be remarkable. He apparently believes our existing economy is based on "consumer spending fueled by excessive credit." By itself, this is quite a departure from Keynesian dogma. It fascinates me, however, that such an obviously intelligent and experienced man can say these things without asking, and answering, the obvious next question …

What Caused these Obstacles to Growth?

As I said in The Fed's Low Interest Rates are Hurting Us and The Trouble with Credit Expansions, the Federal Reserve is the principal cause of the boom bust phenomenon. The Austrian Business Cycle Theory explains in detail why artificially low interest rates, and the monetary expansion required to accommodate them, cause malinvestments functionally identical to Mr. Lockhart's "obstacles to growth."

I wonder how Mr. Lockhart explains the existence of excessive credit and over-leveraged consumers? If excessive credit is part of the problem, why does he maintain that restoring the health of the credit markets is the Fed's first priority? Does Mr. Lockhart really believe that a 0% Fed funds rate will establish a more solid economic foundation than the 1% policy of 2003 - 2004?

The Federal Reserve System systematically rejects responsibility for any part of these "obstacles to growth." In formal comments, no Fed official ever mentions "credit expansion" or even admits a connection between artificially low interest rates and excessive leverage. But what can we expect? As I explained in The Trouble with our Banking System, the Fed is running a banking cartel. Note that virtually all the Fed's recent actions have transferred bank losses to US taxpayers and other dollar holders. Fed officials keep telling us that the credit system's health must be their first priority, but the truth is simpler: the banking system's health and profitability is the Fed's only priority.

Mr. Lockhart's Outlook

Mr. Lockhart didn't present a terribly dire outlook for the economy, but he did focus some attention on those pesky "obstacles to growth":

"Often a deep recession is followed by a sharp rebound in business and overall economic activity. Unfortunately … I do not foresee this trajectory. I expect real growth to resume in the second half and progress at a modest pace. I do not see a strong recovery in the medium term."

"There are risks to even this rather subdued forecast. The risk I'm watching most closely is commercial real estate. … I'm concerned problems in commercial real estate finance could adversely affect the otherwise improving banking and insurance sectors."

"I will argue that growth is the natural state for the U.S. economy, and growth in the medium term will be slowed by structural impediments that must be removed or attenuated."

So, it's clear that Mr. Lockhart believes it will be a while before those structural impediments are "removed or attenuated." What's unclear to me, however, is whether Lockhart thinks they will be removed by natural market actions -- or Fed policies.

The Bailout -- Erecting More Obstacles to Growth

When we look at the 2009 US economy, we see market forces already working toward the elimination of Lockhart's "obstacles." House prices have fallen sharply, and eager buyers are beginning to take up some of the excess housing inventory. Some manufacturers have sharply reduced production to work off excessive inventories. Unemployment is still rising, but we also know that many people have already "reallocated" their personal labor from businesses that no longer need them to employers who are hiring. Significant adjustments are happening all through the economy -- so maybe the Treasury/Fed program is doing just what needs to be done?

Before we assume a causal connection, however, let's think about the economic bailout in relationship to this obstacle removal process. Lockhart says the economy needs a foundation more solid than "consumption spending fueled by excessive credit." But look what's coming out of Washington: the Fed and the Treasury are creating or guaranteeing trillions of dollars in new credit and pushing banks to "get credit flowing again." The Treasury is giving away $8,000 in borrowed money to anybody who will buy a house, and is directing the now federally-owned mortgage industry to loan more money at lower rates. If excessive credit and over leveraged balance sheets are among our "obstacles to growth," it's pretty clear that the bailout programs are slowing market adjustments rather than encouraging them.

Significantly, the Treasury and Fed programs are distorting prices throughout the economy. The Fed has spent hundreds of billions, at least, buying many types of financial instruments at prices the banks could not have obtained on the free market. These purchases have altered interest rates, interest rate spreads, bank valuations -- and distorted the nation's capital allocation process. Meanwhile, debt guarantees and housing-related giveaways are distorting house prices, mortgage rates, and income for builders, real estate agents, and others. Stimulus spending, with newly created money, also changes relative prices for goods, labor, and capital equipment in many sectors.

Unfortunately, therefore, the structural adjustments now being made are based upon market prices that are severely distorted by the torrent of new credit. Businesses that owe their existence to this powerful new credit flow are being started or expanded. Entrepreneurs will acquire capital goods and hire labor to meet demand that exists only because of credit-funded stimulus programs. In short, much of the apparent economic growth will depend wholly or in part on the new credit expansion -- the government finance bubble.

We know that eventually this flow of credit must slow and eventually stop -- and the Austrian Business Cycle Theory tells us that new malinvestments will be revealed as soon as this happens. Using Lockhart's terminology, then, the bailout process is creating new "obstacles to growth" even as people are working hard to eliminate the obstacles previously discovered. For an excellent discussion of related issues see The Destructive Implications of the Bailout - Understanding Equilibrium by John Hussman.

An Unsatisfying Outlook

For as long as the "government finance bubble" expands, the reported economic data may line up well with the vision presented by Mr. Lockhart. As economist Frank Shostak said, "Observe that various economic data … are derived from monetary expenditure data. This means that the more money that is created, the larger the expenditure (in terms of money) is going to be. Hence, … [f]or instance, the so-called gross domestic product … reflects the rate of growth in money supply."

Tepid growth held back by "obstacles" could even turn out to be an understatement. With the Federal Reserve pumping hundreds of billions of dollars into the US economy and other central banks also extraordinarily loose, we could even "enjoy" another madcap mania. The only thing we know for sure, I believe, is that this new "government finance bubble" will end badly by precipitating a new financial crisis or significantly complicating our current crisis. Unfortunately, both theory and real world experiences suggest that the next crisis will be more serious than the last one.

Do I know how this is going to play out? Do I know whether we will experience a new mania, or what the object of the mania will be? Do I know what form the inevitable "bust" will take, or when the new bust will materialize? Most emphatically not!

In my opinion, those future details are unknowable. Oh sure, some people have opinions about these things, but on what basis? Look, this is not just a matter of complexity. Smart people with degrees in econometrics and access to super computers do not have an edge! The details of these future events depend on choices that will be made sometime in the future. If a person is bold enough to forecast these future economic details he is claiming to know in advance not only what the important decisions will be … but the choices key players will make. That, in my opinion, is impossible. We can, however, speculate about some of the key decisions ahead of us.

In that spirit, probably the most immediate and crucial decision will be made by the Federal Reserve governors: how long will they maintain this ultra-loose monetary policy stance? Doug Noland, who writes the very informative Credit Bubble Bulletin, believes that Ben Bernanke's promise to maintain the current policy for an "extended period" has already painted the Fed into an inescapable corner. Noland says: "This is the same type of policy commitment that fostered speculative Bubbles in mortgages, housing, private-label MBS and CDOs … From my perspective, this is the most dangerous Bubble yet." Noland believes that the "risk of bursting the government finance Bubble" is so great as to just about preclude tightening by the Fed.

Noland is obviously guessing; this is one of those decisions that has yet to be made. Just in case Noland's concern has merit, however, I suggest reviewing Ludwig von Mises' insights on this subject. Mises was not only a great 20th Century economist, but he experienced the German hyperinflation in 1923 -- the one that dropped the German Mark to zero and destroyed the middle class. In Human Action, in the chapter dealing with Indirect Exchange, Mises wrote a seemingly innocuous section entitled The Anticipation of Expected Changes in Purchasing Power (page 423). In this section, Mises said there were two stages of inflation ("inflation" in its original meaning: a growing quantity of money).

During the first stage, the inflow of money increases the prices of some commodities and services, but affects other prices on "different dates and to a different extent." Mises said the first stage may last for many years, with public opinion holding that the inflation will be temporary, and that prices will eventually drop. The second stage begins, however, when people "become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against 'real' goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give anything against them."

Mises also described this "crack-up boom" as a "flight to real values." Now, with US households deleveraging, US house prices still falling, stock and commodity prices still way below previous peaks, and all the government measures of "inflation" relatively subdued -- a flight to real values doesn't sound like a big risk. I would suggest, however, that it all depends on future decisions by some key players in China, Japan, Saudi Arabia, and other places -- and we just don't know what decisions they might make. Consider the announcement made this week by Chinese Premier Wen Jiabao. As reported in the Financial Times, China will begin to redeploy its $2.13 trillion of reserves to support overseas investments and acquisitions.

The Chinese seem to do everything with a lot of thought and without any obvious urgency, let alone panic. As the holders of over $2 trillion US dollars, Chinese officials must be among those who believe that US currency debasement is temporary. But now look at this article by Paul McCulley. McCulley quotes Bernanke's earlier advice for Japan and apparently believes the Fed should announce a deliberate policy of significant price inflation -- a deliberate policy of ongoing currency debasement. Would China's movement of reserves toward real assets become more urgent if the Fed's intention became that clear? Would other dollar holders join this movement? Could the drive to invest trillions of dollars into real assets become a panic? Who knows, but apparently Mises believed that is the key question. What decisions will be made by the people holding those trillions?

As I said above, there is no way to know what choices people will make as we move through the momentous decision minefield. Maybe the Federal Reserve will come to its senses, find another Paul Volcker, and stop this debasement? Maybe deflationary forces will overwhelm the Fed's dollar debasement, as some analysts maintain. Even if the dollar debasement continues, we don't know for sure that the Chinese or other dollar holders will begin a flight to real values. However … if it were to happen, the result could be total devastation for anyone who was unprotected -- "within a few weeks or even days," said Mises. For that reason, even without knowing its probability, I believe it is important for every investor to have an answer to the question: what will happen to me if the next Fed-created "obstacle to growth" is a crack-up boom?

Disclosure: At this writing I have long positions in precious metals, precious metal ETFs, and precious metal-related stocks.

The Fed's Low Interest Rates are Hurting Us

I would have thought that two back to back boom/bust cycles would have our Federal Reserve governors rethinking their dogma, but that does not seem to be the case. A federal funds rate of 1% created the housing bubble which is still rendering our banking system insolvent, throwing large numbers of people onto the unemployment rolls, and generally producing the most significant economic recession since the Great Depression.

So what is the Fed's prescription for our current ailments? Well, with this recession much more serious than the 2002 experience, the Fed has now dropped the federal funds rate to a record low of between 0% and .25%. Will these low interest rates help the economy recover from this deep recession? Will they cure our current difficulties and generate healthy new growth?

Based on my reading of economic principles, the answer is no. In fact, I believe our Federal Reserve is setting us up for more economic heartburn. Consider this quote from Marc Faber, an exceptionally astute, international economic commentator:

"This is where I have the greatest problem with US economic policy makers. I don't think they have ever recognised that the excessive, credit-driven expansion of the US economy was unsustainable in the long run and that, sooner or later, the current crisis was inevitable. But not only that! ... US economic policy makers are attempting to restore economic growth through essentially the same policies; ... In fact, I would argue that the large fiscal deficits and easy monetary policies will make sustainable, healthy economic growth next to impossible."

Marc Faber, The Gloom, Boom & Doom Report, July 9, 2009

In Are Low Interest Rates Beneficial, I explained why a naturally falling interest rate is indicative of a healthy, progressing economy. Let's now explore the nature of an artificially depressed interest rate, and why it harms us.

To Reduce Interest Rates, a Central Bank Floods the Economy with New Money

A central bank cannot just declare a lower interest rate. If our Fed, for example, could just forcibly reduce interest rates on loans to below market levels, we would find more people wanting to borrow and fewer people wanting to make loans -- we would have a credit shortage. This is an inexorable economic law that not even the Federal Reserve can ignore: a maximum price on a good causes a shortage of that good.

Whenever the Fed wants to lower interest rates, therefore, it must prevent a credit shortage by creating as much new money as the markets demand. Creating new money for this purpose was impossible when money was gold, but now … as the Federal Reserve Chairman Ben Bernanke himself said in 2002: "… the U.S. government has a technology, called a printing press … that allows it to produce as many U.S. dollars as it wishes at essentially no cost."

To drive bank lending rates lower, the Fed revs up its "printing press" via a credit expansion (as I explained in The Trouble with Credit Expansions). The Fed's purpose since inception has been to run a profitable banking cartel, and it has pursued that goal by creating an environment exceptionally hospitable to credit expansions. Economics Professor George Reisman, for example, commented in a recent blog post on the Fed's "… long-standing, deliberate policy … of reducing and even altogether eliminating reserve requirements." I presented arguments for this interpretation of the Fed in my earlier post , The Trouble with our Banking System.

To initiate or accelerate a credit expansion, therefore, the Fed only needs to move the federal funds target rate to below-market levels -- assuming, of course, that the banking system is solvent and people want to borrow. With a Fed Funds rate well below free market levels, banks have exceptionally easy and inexpensive access to bank reserves, allowing them to meet all credit demands. The Fed ensured that bank rates remained low by holding its Fed Funds Target Rate at 1% for an entire year, and then raising it ever so gently over another two years. One intellectually sound measure of the money pouring into the US economy over this period is the Austrian Money Supply chart provided by mises.org, here.

Below Market Interest Rates Mean Unbounded Credit

Credit availability increases with either a naturally or an artificially falling interest rate, but there is an enormous difference between the two situations. On a free market, with a naturally falling interest rate, new investment spending is limited to the increase in savings, which is equal to the reduction in consumption spending. With the central bank holding interest rates below free market levels, however, the economy may experience virtually unlimited borrowing and spending -- for as long as the central bankers keep reserves growing, and as long as the banks continue to find creditworthy borrowers.

Unlike a free market environment, the only constraint on a credit expansion is judgment: the judgments of borrowers and lenders. Federal Reserve officials could potentially exercise judgment, of course, but former Fed Chairman Alan Greenspan has repeatedly told us that Fed officials are unable to detect bubbles before they burst. In my opinion, this self proclaimed failing has more to do with the Fed's unacknowledged role as banking cartel leader, than a lack of judgment (see The Trouble with Our Banking System).

Many commentators in 2009 are suggesting that federal government regulators could have prevented the boom's excesses, but it's frankly silly to think that federal government employees would have gone against the desires of the Bush Administration, the Federal Legislature, and the Federal Reserve -- all of whom actively promoted the credit expansion boom. See my previous post Capitalism Did Not Fail Us for more on this point. Besides, how does it make sense to hire an army of regulators to look over bankers' shoulders when a higher, market determined, interest rate would automatically achieve a better, more consistent result?

Unbounded Credit Causes Malinvestments

When borrowers spend their new money, they increase market prices for the goods or assets they acquire, relative to what those prices would have been. When a lot of credit-driven buying is focused on the same good, such as houses, many people see the rapidly rising prices as an important market signal. In that event, people tend to borrow more money to participate in the apparent trend, further distorting relative prices. If the central bank keeps rates low even after such a dynamic develops, price distortions have sometimes reached fantastic extremes and triggered widespread economically dysfunctional behavior. Toward the end of the recent housing boom, for example, many house purchase decisions were entirely disconnected from personal income considerations -- and some business projects were launched without any realistic profit expectation.

From an entrepreneur's perspective, an artificially lowered borrowing rate creates apparent profit opportunities throughout the economy -- because the prevailing natural rate of return is initially available almost everywhere. As with a naturally lower rate, the artificially lowered interest rate makes durable goods and capital goods look undervalued. Artificially low rates, therefore, promote widespread investments in capital goods and durable goods producers -- just as the naturally lower rate does.

If time preferences remain unchanged during a credit expansion, consumption spending actually increases even as investment spending increases -- an oxymoron made possible only by the flood of new money. With consumption spending increasing, returns to retail and other late stage businesses improve, instead of falling as they do when interest rates fall naturally. The artificially lowered interest rate, therefore, actually prevents late stage businesses from releasing resources needed to make capital goods investments viable.

Because no sector is releasing resources, businesses throughout the economy find themselves bidding against each other for a share of the finite factors of production. Many credit-funded entrepreneurs, therefore, find they need to borrow more funds to pay higher than anticipated factor costs. As factor prices continue to rise, more and more credit is sought. With borrowing rates remaining low, the free market signals that would have alerted entrepreneurs to the fundamental problem are suppressed.

The illusion of booming business continues as long as the credit supply grows rapidly enough to meet all demands. As we saw during our recent booms, that can be a long time. Eventually, however, the credit growth must slow and then the malinvestments begin to appear.

Unbounded Credit Causes Excessive Leverage

The viability of a leveraged investment depends, of course, on borrowing money at a lower rate than the investment is expected to pay. As explained in The Interest Rate -- What is It?, free market forces tend to drive all laissez-faire interest returns toward one uniform rate (adjusted for risks). Capitalists pursuing the highest available rates of return move capital toward high returns and away from low returns, reducing the differences in the process. On a free market, therefore, opportunities to enhance investment returns with leverage are limited, fleeting, risky -- and therefore self-regulating.

An artificially lowered interest rate, however, completely changes the nature of leverage. Whenever the central bank holds the borrowing rate well below the natural rate of return, the stage is set for easy "wealth" acquisition. With assurances of a continuing interest rate spread, the total return from an investment is limited only by the amount of leverage employed -- and one doesn't need to be a gifted entrepreneur to achieve high returns. A person who borrows enough money at low rates can invest the proceeds in almost any business or financial instrument and make extravagant returns -- assuming no sudden change in interest rates or credit availability.

In a laissez-faire economy the profit motive is critically important and beneficial to everybody. When capitalist/entrepreneurs pursue higher returns, they are directing both their energy and capital toward meeting the most urgent consumer needs. A credit expansion boom, however, perverts the profit motive by driving the entrepreneurs and capitalists toward higher leverage.

During a credit expansion, capitalists naturally tend to leverage existing businesses and move more capital toward financial services where high leverage can be employed most effectively. It's no wonder, then, that we witnessed a financial sector expansion during the bubbles. Companies like General Electric and General Motors expanded their financial divisions to the point where they delivered a large share of the parent company's profits. We also saw tremendous growth in investment banking and the hedge fund industry, where significant leverage was often used to push fixed income investment returns to much higher levels.

It is clear that artificially depressed interest rates enabled and even directly caused most of the excesses which so many people are now blaming on "capitalism." In truth, however, the Federal Reserve is a central planning institution -- it is a creature of government and an anathema to capitalism.

Artificially Lowered Interest Rates Cause an Inevitable Bust

To meet all demands during a credit expansion, banks must grant more and more credit every year. This credit expansion treadmill, however, can't continue to accelerate forever. Eventually the central bank must raise interest rates, or risk an out-of-control inflation which could threaten the currency's survival. Every credit expansion boom, therefore, reaches the point where the pace of credit creation slows, and that point inevitably signals the beginning of the bust.

Some projects are terminated because another increment of credit is unavailable, and some projects are shut down simply because profitable completion is obviously not feasible. Much of the demand entrepreneurs try to meet during a boom is itself dependent on the accelerating flow of credit, and rising interest rates tend to slow that growth -- even as supply is expanding. Ultimately, however, there are simply insufficient real resources in the economy to allow all projects to be profitably completed.

The end result is capital consumption, conspicuously visible in the unfinished business projects, and in the idle factories, ships, freight cars, trucks, and other capital equipment.[1] Following a boom, therefore, we have a distorted structure of production and a clear need to let the markets reallocate resources to those sectors which have consumer demand supported by real income -- not credit.

But what happens when the Fed doesn't permit the markets to reallocate resources and rationalize the economy? What if the Fed, instead, simply drops interest rates to even lower levels and pumps new money into the banking system's balance sheet? Well, … we are about to find out.

Notes

[1] For example: Mish Shedlock: Trucks Sit Idle; Rail Traffic Horrific, and January ends with grim news on stocks, jobs, shipping (scroll down the page for this one).

Are Low Interest Rates Beneficial?

Our economists and central bankers repeatedly tell us in words and deeds that low interest rates are good for the economy, especially when in recession. For example, here is a public statement by Professor Mankiw, the prominent Harvard economist:

"Recessions result from an insufficient demand for goods and services -- and so, the thinking goes, our central bank can remedy this deficiency by cutting interest rates. Lower interest rates encourage households and businesses to borrow and spend. More spending means more demand for goods and services, which leads to greater employment for workers to meet that demand."

Quoted by Marc Faber, The Gloom, Boom & Doom Report, June 3, 2009

Considering his credentials and position, this is an amazingly simplistic statement. The good professor is listing just the immediate consequences of his policy recommendation. He doesn't mention that the central bank can lower interest rates only by flooding the economy with new money. He doesn't mention that savers and persons on fixed incomes will suffer severely, even as borrowers benefit. He also doesn't answer an obvious question: if greater demand for goods is achieved via borrowing, what happens to that demand when the lending slows down or ends?

So I really wonder, …

Why Do Our Economists Prescribe Low Interest Rates?

The idea that a low interest rate is beneficial has a long history -- so long that tracing its origin may be impossible. Thanks to Böhm-Bawerk's magnificent work, Positive Theory of Capital, however, we have solid economic theory that explains the connection between low interest rates and a progressing economy. In my opinion, these Austrian School arguments are excellent, and I want to share their essence in the following paragraphs.

Interestingly, this theory has been ignored by the mainstream economic establishment since at least the 1930s. I wonder why? The answer isn't hard to find: the same theoretical constructs which so convincingly demonstrate how a naturally falling interest rate benefits an economy also show that an artificially lowered interest rate harms the economy. For those who believe in government market interventions, therefore, these theories are quite inconvenient -- and therefore ignored.

I explained some of the problems with interest rate manipulation in The Trouble with Credit Expansions, and I will extend that exposition in future posts. But first, let me explain why …

A Naturally Lower Interest Rate Indicates a Progressing Economy

What is the distinction between a naturally and an artificially falling interest rate? I presented the key to this question in The Interest Rate - What is It?. In that post I explained the Austrian School position that the natural, or "pure" rate of interest as Rothbard called it, is determined by the population's time preference. If the time preference falls, the interest rate will also naturally fall. If , on the other hand, the central bank forces lending rates lower by pumping money into the economy, the result is artificial and both time preferences and the natural interest rate remain unchanged.

To understand why a naturally falling interest rate indicates a healthy economy, we need to trace all the significant effects of falling time preferences -- a lower interest rate is only one such effect. As a reminder, "time preference" is just the label economists put on man's universal tendency to value a present good more highly than the same good in the future. A person's time preference is said to be falling if the intensity of that preference is dropping relative to what it was before.

Time preferences are revealed only through human actions, and when a person's time preference falls, he wants to spend a smaller part of his income on present goods (i.e. consumption) and a larger portion on future goods. This shift in spending creates market forces which tend to reallocate resources from the retail sector into capital goods-producing sectors -- and this is the ultimate reason why a falling time preference generates beneficial results.

But I am getting ahead of myself. Before I can tell that story, I need to mention some …

Assumptions that Apply to this Theoretical Discussion

For one thing, these arguments assume an economy based on capitalism -- with characteristics I first listed in Laissez-Faire Capitalism Would Have Prevented the Crisis:

"… [capitalism] harnesses the division of human labor like no other economic system, allowing it to flourish and directing its growth into those fields that fulfill the most pressing consumer needs. It does this not by issuing directives, but by automatically establishing meaningful incentives. Capitalism presumes privately owned production factors, people who are free to act in their own self interest, and markets on which both consumer and capital goods are freely exchanged."

Another key idea I will refer to is the Austrian School's "structure of production" concept, which I first introduced in The Interest Rate - What is It?:

"The Austrian economists describe capitalistic production as occurring in successive stages, each stage producing capital goods until the final stage, which produces consumer goods. Since the only purpose of production is the ultimate delivery of consumer goods -- goods that meet definite human needs -- the Austrian economists measure a stage's position in terms of its 'distance in time' from the point of delivering consumption goods. They refer to stages closest to the consumer goods as 'later' stages and those which are farther away as 'earlier' stages."

Now, back to an analysis of falling time preferences. Since the immediate effect is less spending on consumption goods and more spending on future goods, let's deal with these two effects separately.

The Consequences of Reduced Consumption Spending

The primary effects are easily seen. Retail sales fall off and that will tend to reduce consumer goods prices and retail business earnings. After a bit of delay, retailers will tend to "release" some quantity of labor and other production factors. Wage rates and factor prices will therefore tend to decline.

Secondarily, we can also see that retailers will tend to buy fewer capital goods from earlier stage producers -- such as wholesalers, freight transporters, and manufacturers. Prices for those capital goods and services will therefore tend to decline, depressing earnings in those sectors as well. To whatever extent their sales decline, and the situation appears to be lasting, all of these relatively late-stage businesses will tend to cut back on their use of labor and other factors of production.

To some indeterminate extent, therefore, falling consumption impacts business returns all along the structure of production. At each stage in turn, businesses find their earnings diminished and they therefore buy less from the preceding stage, while using fewer complementary factors of production. But these business reductions do not happen mechanically, or strictly sequentially, because entrepreneurs may see what is happening and correctly anticipate lower sales -- and perhaps take mitigating action. Furthermore, as we consider earlier and earlier stages of production, the short term impact diminishes toward zero because those capital goods producers are separated by many years or even decades from the consumer markets.

The end result, therefore, is that business returns are reduced with the greatest impact in the late stages of the productive structure. Those businesses seeing significantly reduced sales and lower earnings free-up many kinds of resources -- labor, retail space, office space, warehouse space, transportation services, and many other factors of production. However painful the experience may be for the people involved, this step is obviously essential if the markets are to reallocate resources from late-stage production to capital goods producers. There is no other option.

So far, falling time preferences look more like an economic disaster than a beneficial development -- but we haven't yet considered …

The Consequences of Spending More Money on Future Goods

With people wanting to spend more money on future goods, lending markets are immediately impacted. Other things being equal, bond prices rise -- and that of course means lower interest rates. As presented in The Interest Rate - What is It? however, there is another less visible time market. This is the market in which entrepreneurs and capitalists buy factors of production to produce goods for future delivery. With generally falling time preferences, capitalist-entrepreneurs will spend their additional savings on factors of production. But entrepreneurs will also acquire other people's savings -- directly through new stock and bond issues and indirectly via banking intermediaries. Entrepreneurs will ultimately spend all of the new societal savings because the interest rate will fall to whatever level is necessary to equate savings and borrowings.

To understand the impact on the economy therefore, we need to know how entrepreneurs will use these new savings. Entrepreneurs are, by definition, those people who are highly skilled at detecting opportunities -- they do not mechanically reinvest their income or new capital in existing businesses. They are constantly looking for price mismatches where they can buy factors of production at one price and then expect to sell the resulting product later to yield something better than the normal interest rate return. Their success or failure in this endeavor depends on their ability to correctly anticipate future prices for goods they propose to produce.

So, let's think about the investment landscape confronting entrepreneurs immediately after a drop in the population's time preference. First of all, there is more money available for investment, and more debt financing available at lower interest rates. Secondly, most late-stage businesses have falling sales and earnings. This information alone ensures that entrepreneurs will evaluate earlier stage business opportunities. But that is not the whole story; other facts reinforce this motivation. Since very early-stage capital goods producers are relatively unscathed by the fall off in consumption, their current returns look generous in comparison to the lower borrowing rate. Furthermore, the lower interest rate makes early-stage capital goods look undervalued in relationship to consumer goods prices. This undervalued relationship holds true even with the lower consumer goods prices -- because the capital goods' contributions are discounted over many years at the lower interest rate.

Individual entrepreneurs obviously make independent and widely varying investment choices. Some make wise and profitable choices, others fail in their role. Nevertheless, it seems clear that falling time preferences create a set of market conditions which are guaranteed to bias entrepreneurial attention toward earlier stage opportunities within the structure of production. To the extent that these new investments are successful therefore, the structure of production will become more capitalistic. The new or expanded capital goods producers will tend to absorb the slack resources that reductions in consumption make available.

If time preferences and other economic data were then to remain stable, the economy would trend toward an equilibrium in which the structure of production is somewhat "longer", i.e. there are more capital goods-producing stages further from consumer goods sales. Equilibrium conditions are never actually reached in the real world, but if they were, returns to all businesses would approach one uniform, lower rate of interest.

Conclusion

With a more capitalistic structure of production, the economy would be more productive after time preferences declined and the reallocation of resources was completed. Since an increase in economic productivity can deliver either more goods or more leisure, or some of both, it seems like a value-free statement to say that an economy with falling time preferences -- and therefore falling interest rates -- is "progressing."

The presentation above is my attempt to package the most important ideas into very few pages, hoping to provide a brief glimpse into this rather well developed Austrian School theory. For an in depth treatment of these subjects, I highly recommend Murray Rothbard's Man, Economy, State (see the five chapters on Production).

The Trouble with our Banking System

The modern US banking system came into existence with the passage of the Federal Reserve Act in 1913. This legislation established the Federal Reserve System as the central bank of the United States with monopoly privileges to create and manage the nation's currency as it saw fit. After almost 100 years of experience with the Federal Reserve, most contemporary economists, it seems, can't even imagine our economy without a central bank.

The Federal Reserve's objectives were spelled out in the 1913 Act: "… to promote effectively the goals of maxi­mum employment, stable prices, and moderate long-term interest rates.” The Fed's current web site goes on to discuss the expected benefits of its monetary stewardship:

" When prices are stable and believed likely to remain so, the prices of goods, services, materials, and labor are undistorted by inflation and serve as clearer signals and guides to the efficient allocation of resources and thus contribute to higher standards of living. Moreover, stable prices foster saving and capital formation, because when the risk of erosion of asset values resulting from inflation—and the need to guard against such losses—are minimized, households are encouraged to save more and busi­nesses are encouraged to invest more."[1]

Of course, swallowing this line is a bit difficult for anyone with knowledge of economic history. Twenty five years ago, in 1984, Murray N. Rothbard noted an interesting fact:

"Since instability, inflation, and depressions have been far worse since the inception of the Federal Reserve, many economists have concluded that the Fed has failed in its task and have come up with various suggestions for reform to try and get it on the correct track." [2]

Since the early 1980s, our central bankers proudly note, the Consumer Price Index has fallen steadily to levels that are currently very low. Nevertheless, the remainder of Rothbard's statement appears to be just as valid in 2009 as it was in 1984. There may not be many economists criticizing the Fed itself today, but reformed bank regulation is now being discussed as one government response to our latest economic crisis.

So why is it that the Federal Reserve has been unable to perform its price stabilization and counter cyclical duties? Something sure seems to be amiss. After all, it was Alan Greenspan himself who told us the Fed couldn't be expected to identify a bubble before it broke. Does the Fed need to be fixed?

The Federal Reserve System has been a Rousing Success

Murray Rothbard, Ludwig von Mises' brilliant and prolific student, offered an alternative explanation for these concerns back in 1984. After studying the Federal Reserve System's history at length [3], Rothbard concluded that the Fed had in fact accomplished its intended purpose. Continuing from the quote above, Rothbard explained:

"It is possible … that the current critics of the Fed have missed the essential point: that the Fed was designed to meet very different goals. In fact, the Fed was designed by the banks as a cartelizing device. … Just as other industries turned to government to impose cartelization that could not be maintained on the market, so banks turned to government to enable them to expand money and credit without being held back by the demands for redemption by competing banks. In short, rather than hold back the banks from their propensity to inflate credit, the new central banks were created to do precisely the opposite. Indeed, the record of the American economy under the Federal Reserve can be considered a rousing success from the point of view of the actual goals of its founders and those who continue to sustain its power."[4]

If that seems like a shocking conclusion, just consider the undeniable fact that bankers and government officials have long considered banking to be the road to personal wealth for themselves -- and unconstrained spending by government:

"Give me control of a nation's money and I care not who makes the laws."

- Amschel Rothschild

"I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered."

- Thomas Jefferson

"It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning."

- Henry Ford

"This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard."

- Alan Greenspan, 1966

These historic quotes make the potential for abuse rather clear, and the truth of Rothbard's statement is easily seen when one examines the Federal Reserve's history.

History of the Federal Reserve System

One excellent, entertaining book on the subject of central banking, and the Federal Reserve System in particular, is The Creature from Jekyll Island, by G. Edward Griffin. Mr. Griffin's book provides a wealth of information about money, banking, and central banking in general, but his story is focused on the history of the Federal Reserve System. The book's title derives from the location of a super secret meeting held in 1910 -- at a private resort on Jekyll Island, Georgia. The participants at this meeting included a US Senator, the Assistant Secretary of the US Treasury, and top level representatives from the biggest New York City banks.

In his book, Mr. Griffin backs up the following statement with extensive documentation:

"The purpose of this meeting … was to come to an agreement on the structure and operation of a banking cartel. The goal of the cartel … was to maximize profits by minimizing competition between members, to make it difficult for new competitors to enter the field, and to utilize the police power of government to enforce the cartel agreement."[5]

This meeting, its purpose, and its clandestine nature gradually leaked out over the years. To mention just one such instance, Frank Vanderlip, one of the participants, published an article in the Saturday Evening Post in 1933 in which he described the extraordinary security measures the Jekyll Island participants took to avoid detection. As Vanderlip admitted in this 1933 article: "If it were to be exposed publicly that our particular group had got together and written a banking bill, that bill would have no chance whatever of passage by Congress." [6]

To understand what the Federal Reserve conspirators were up against, we need to realize that this was the fourth central bank chartered in United States history. The first three central banks lost their charters because a majority in Congress became convinced that they were harming the country -- or at least convinced that is what voters thought. In that era, the big New York bankers were so unpopular that the Federal Reserve proponents, both in banking and in government, went to great lengths to create the illusion that the bankers hated the proposed legislation.

As Griffin says: "To cover the fact that a central bank is merely a cartel which has been legalized, its proponents had to lay down a thick smoke screen of technical jargon focusing always on how it would supposedly benefit commerce, the public, and the nation; how it would lower interest rates, provide funding for needed industrial projects, and prevent panics in the economy." Senator Aldrich, who attended the Jekyll Island meeting, laid out the plan with uncharacteristic clarity when he spoke on the record to the American Bankers Association: "The organization proposed is not a bank, but a cooperative union of all the banks of the country for definite purposes."[7]

Reading The Creature from Jekyll Island some years ago was an eye opening experience for me. After taking another look while writing this post, I may read it again.

Okay, so the Fed is Running a Secretive Cartel; What's the Problem?

The historic quotes above make it pretty clear that a banking system can endanger our wealth. The confiscation mechanism is simply commercial banks' proclivity to create new currency "out of thin air." Look at the result: by the government's own calculations the dollar has lost something like 95% of its purchasing power since the Federal Reserve Act was signed into law in 1913. Rothbard and Griffin are explaining to us that this dollar devaluation did not happen in spite of the Federal Reserve's efforts to ensure price stability -- it happened because the Federal Reserve was created to facilitate the ongoing credit expansion. But there are more problems.

Consider the Fed's impact in 2009. The Fed's ultra low interest rate policy has devastated the income of retirees and savers of all ages, and the Fed's record-breaking money creation -- to bailout bankers -- is certain to dramatically continue the dollar's devaluation in future years. But there are still more problems.

As I have previously argued in The Trouble with Credit Expansions, our problems with monetary inflation do not end with a rising CPI. Under normal circumstances, in fact, the bigger problem is relative price distortions and resulting malinvestments. Long running inflationary booms distort investments and unsustainably skew the nation's productive structure (see The Interest Rate - What is It? for a discussion of the Austrian structure of production concept). The inevitable result is a recession, elevated unemployment rates, and many disrupted lives. But even those problems are not all.

Inflation, i.e. an increase in the money supply, has been a long running human scourge with many debilitating consequences. Here is a quote from Henry Hazlitt which I first posted in Unintended Consequences:

"It [Inflation] discourages all prudence and thrift. It encourages squandering, gambling, reckless waste of all kinds. It often makes it more profitable to speculate than to produce. It tears apart the whole fabric of stable economic relationships. Its inexcusable injustices drive men toward desperate remedies. It plants the seeds of fascism and communism. It leads men to demand totalitarian controls. It ends invariably in bitter disillusion and collapse."[8]

So What Can We Do?

Eliminating central banking's pernicious effects is obviously desirable, but doing so will be excruciatingly difficult -- so many people benefit from the confiscated wealth. Legislators and other government officials benefit because they can spend just about any amount of money they choose -- and we all know that politicians find many ways to skim off some of that money for their personal benefit. Bankers and investment bankers benefit as well, of course -- as do many other people in the broader money management industry. Even supportive economists benefit from the largess because government, the Fed, and the financial industry employ thousands of people with advanced economics degrees -- and shower University programs with research grants, funded "chairs," and other financial benefits. Those economists who rise to auspicious university positions also become candidates for high level and powerful positions advising government bureaucrats and politicians. A select few even end up sitting on the Federal Reserve's governing board.

Adding to the difficulty for those of us who want to stop the Fed's predations, the public at large loves inflationary booms. People are quick to accept rising asset prices and effortless wealth creation as the norm; it's only the bust that people abhor. The central bankers understand this human weakness and use it to their advantage -- by taking credit for the booms and then blaming bursting bubbles on everyone but themselves. For nearly 100 years this strategy has worked exceptionally well, and now we are treated to the spectacle of the Federal Reserve brazenly transferring trillions of dollars from taxpayers to bankers -- all for our benefit, of course.

The only hope, it would seem, is education and a growing public awareness. Congressman Ron Paul is one of very few politicians who both understands the nature of the banking system and wants to stop its destructive behavior. Toward that end, he has been the only member of Congress to ask the Fed Chairman seriously pointed questions, and just recently he proposed legislation, HR 1207, that would require an independent audit of the Federal Reserve System. With 165 co-sponsors now, maybe this is one way to gain a little bit of public awareness -- but there is a very long way to go.

References and Notes

Most notes for this post refer to two publications:

("Creature"): The Creature from Jekyll Island, A Second Look at the Federal Reserve,
G. Edward Griffin
Fourth Edition, 2002
Available from the author's web site, the catalog link is here.
Amazon also seems to have a few of these books still available.

("Cartelization Device"): The Federal Reserve as a Cartelization Device, The Early Years, 1913 - 1930
Murray N. Rothbard, 1984
Published as Chapter 4 in:
Money in Crisis: The Federal Reserve, the Economy, and Monetary Reform
Edited by Barry N. Siegel, Pacific Institute for Public Policy Analysis

Notes:

[1] Federal Reserve, Official web site, Monetary Policy and the Economy

[2] Cartelization Device, page 89

[3] See, for example, A History of Money and Banking in the United States, The Colonial Era to World War II.

[4] Cartelization Device, page 90

[5] Creature, page 8

[6] Creature, page 11

[7] Creature, page 19

[8] Henry Hazlitt, Economics in One Lesson, page 176

My Experiences with a Kindle 2

This post is off topic, but I want to share my impressions of Amazon's Kindle 2 book reader. I have only been using the Kindle for a couple of months, but it is now part of my daily routine and I am happy I decided to try it. Here are a few random observations.

The reading surface is as good as they claim, in my opinion. Reading the Kindle is much like reading from paper. The Kindle does have a layer of transparent plastic over the surface, of course, so I think it is a little more reflective than paper. For that reason, I sometimes find myself adjusting my viewing angle to eliminate the glare -- but this is never a problem.

The Kindle can supposedly contain as many as 10,000 books, but I don't know how a person could ever manage even a tiny fraction of that. You can sort the list of books and documents in a couple of ways, but there is no folder system and you can't change file names to create some structure. Nevertheless, I love having many books in one small device. The Kindle is much lighter than even a single economics tome, and I now always have a variety of books with me.

Book availability in Kindle format is getting to be pretty good. The most popular books all seem to be available, of course, but that is not all. Somebody recently recommended an old science fiction novel to me, but Amazon showed it out of print with just a few used books available for $100! At first it didn't even occur to me to look for a Kindle version, but much to my surprise -- there it was for $9.99! Most Kindle books are available for that price, it seems, but I bought a couple of popular but no longer current novels for just $5.99. Even low volume books are starting to appear in Kindle format. Both Human Action and Man, Economy, and State are now available, for example.

Buying a book is fast and easy. Connectivity is available wherever you have cell phone coverage. You just go to the main menu, select the Kindle Store, peruse the store -- or type in a search string to find a particular book. Most books, or maybe it's all books, allow you to download the first chapter, or two, for free. If you decide to buy, a few more clicks has the book on your Kindle in about two minutes. Even the 900 page Man, Economy, State was downloaded within a few minutes.

Speaking of downloads, you can also email attached Word documents, and a few other file formats, to an Amazon address. Their system automatically converts the file and downloads it to your Kindle in a couple of minutes -- at a cost of 15 cents. They will do this with Adobe PDF files on an "experimental" basis, but in my experience it fails to provide a usable Kindle document most of the time.

I don't use this feature much, but Kindle also provides a text to speech feature. The synthetic voice seems to be quite good, although certainly not as good as listening to a book recorded by a human speaker. If this appeals, you can use the Kindle to read most any book or document to you.

The built in dictionary is a terrific feature. Just move the cursor up to a word and a short definition quickly appears at the bottom of the screen. The full definition is available with one button push.

You can also insert comments at particular text locations and use the cursor to highlight text with an underline. When you are reading a book with highlights, you can press "Menu" and select "My Notes and Highlights." This feature allows you to see your highlights in order -- and you can immediately go to the relevant text location by clicking on a link. Any text so highlighted goes into a file called "My Clippings" and you can access that file from a computer via a supplied USB cable, allowing you to download snatches of text to your computer.

I like the Kindle a lot and recommend it wholeheartedly, but I do have two cautionary notes. The first is that the Kindle doesn't work particularly well for a book with heavy graphics. You can read simple graphics satisfactorily, but even then it’s a problem whenever the text is referring the reader to a diagram -- it's just not that easy to flip back and forth from the text to the diagram. For that reason, Kindle is not ideal for your only copy of Man, Economy, State, for example.

The other caution is that the Kindle is a bit fragile. It once slipped off my lap and landed flat on its display, on hard tile. That killed the Kindle. Amazon has a special price of $200 to replace a broken Kindle, so I guess something similar has happened to other people, too. I didn't lose my books; they can be conveniently downloaded again at no cost from your individual archive. Amazon does sell a maintenance plan that will replace a broken Kindle, once. Instead of that insurance plan, however, I just bought a good cover with a fastener -- and I now try to stay very alert.

My bottom line is that I like the Kindle experience and hope that eventually every book will be available in this format.

Exhibits 1 and 2

These are the Exhibits referred to within the preceding post: The Interest Rate - What is it?

The Interest Rate - What is it?

If you do a Google search on something like ... interest rate definition ... you get a lot of superficial information, things like: the interest rate is the cost of borrowing money, it is the compensation to the lender for forgoing other useful investments, and so on. It's all true as far as it goes, but it doesn't go nearly far enough.

The rate of interest is perhaps the most important market-determined price within a capitalist economy. The interest rate balances the demand for and supply of future goods, and a naturally changing interest rate creates conditions essential to maintaining a sustainable structure of production.

When a central banker boldly disregards the laws of economics and manipulates interest rates as he sees fit, he disrupts this natural economic balance and sets up the economy for recession. When a central banker goes to the extremes adopted by Alan Greenspan and now Ben Bernanke, the result can be massive capital consumption that undermines years of economic progress -- as we are now witnessing.

Modern Interest Rate Theory

The modern explanation of interest was provided in 1884 by Eugene von Böhm-Bawerk, a student of Carl Menger's and one of the first economists after Menger to be identified with the Austrian School. Böhm-Bawerk introduced this important subject with characteristic clarity and brevity:

"Present goods are as a general rule worth more than future goods of equal quality and quantity. That sentence is the nub and kernel of the theory of interest which I have to present."

-Eugene von Böhm-Bawerk, Positive Theory of Capital, pg. 259

In those few words, and the brilliant presentation that followed, Böhm-Bawerk gave us the key to understanding one of economics' most important phenomena -- a phenomenon that the 18th and 19th century classical economists utterly failed to explain.

Time Preference and the Determination of Interest Rates

The pricing relationship noted by Böhm-Bawerk is explained by human "time preference." Time preferences are like all human preferences: they are personal, subjective, and observable only when revealed by human action. Because time preferences vary from one individual to another, and even within the same individual at different times, it is only natural that "time markets" evolved -- markets on which people can exchange future goods and present goods for agreed upon discounts.

As with any good, we can conceptually construct individual supply and demand schedules by assuming knowledge of a person's value scale: a simple, ordinal ranking of future and present goods in the order preferred by that person. If we then aggregate individual supply and demand schedules and plot the data as a function of the interest rate, we see the familiar graphical price determination from "Econ 101" (See Exhibit 1 in the next post). For a thorough explanation of this interest determination process, see Murray N. Rothbard, Man, Economy, State, pg. 375.

This interest theory fits perfectly within Menger's price determination framework. Extending it to include the interest rate required only one new insight: that a person's "value scale" ranks future goods as well as present goods.

The Pure Rate of Interest

For centuries, people have been aware that businesses in the aggregate produce a positive interest return. The classical economists puzzled over this fact because their theories showed that free market competition logically drives business profits toward zero. It was not until Böhm-Bawerk published Positive Theory of Capital that economists had an adequate explanation: capitalists receive an interest return because they exchange present goods for future goods.

When a capitalist invests in a business venture he exchanges his money, a present good, for all of the factors of production necessary to produce a specific quantity of goods in the future. Thanks to Böhm-Bawerk's insight, we know that the capitalist will not pay more for the factors of production than he expects to receive from the sale of his future goods -- discounted according to his time preference. Competition, therefore, does not drive the capitalist's expected return to zero, but instead to a market determined interest rate.

In a laissez-faire economy, profit seeking capitalists would tend to drive all interest rates --loan rates and business returns -- toward one uniform "pure" rate of interest that depends only on time preference. In the real world, of course, this general equilibrium result is never reached because of constantly changing economic data -- but this tendency is always operative and important.

It's easy to see how this works: if any single business segment or loan market consistently delivers a higher return, it stands to reason that capitalists will invest more money there and less money where the return is chronically lower. These actions raise the cost of factors in the high return segment, while simultaneously reducing the cost of factors in the low return segment -- bringing the two returns closer together. Even in the real world, then, we can expect any return differences to be systematically reduced by these natural market forces. As we will see, this tendency profoundly impacts the structure of production.

The Structure of Production

A society becomes more prosperous by evolving and maintaining a productive structure that employs capital goods: everything that people produce for the purpose of supporting future production. That includes completed goods inventories, partially completed goods, buildings, tools and machines, stockpiled raw materials, … absolutely every good that is not yet in the consumers' hands and ready for immediate consumption.

The Austrian economists describe capitalistic production as occurring in successive stages, each stage producing capital goods until the final stage, which produces consumer goods. Since the only purpose of production is the ultimate delivery of consumer goods -- goods that meet definite human needs -- the Austrian economists measure a stage's position in terms of its "distance in time" from the point of delivering consumption goods. They refer to stages closest to the consumer goods as "later" stages and those which are farther away as "earlier" stages.

Although greatly oversimplified, it's helpful to think of a capitalist-entrepreneur controlling each stage in the structure of production. Applying the business model used earlier, each capitalist buys the necessary factors of production -- including capital goods from immediately earlier stages. After creating his products, the capitalist-entrepreneur then sells those products to next-stage capitalists. In the last stage, of course, the products are sold to consumers. To illustrate, let me just name a few familiar production stages that immediately come to mind:

• Retailers buy products from wholesalers and sell individual items to consumers.
• Wholesalers buy bulk goods and sell store-sized lots to retailers.
• Manufacturers buy parts and other materials and sell assembled products to wholesalers.
• Metal fabricators buy sheet steel and other materials to fabricate parts.
• Steel plants buy iron ore, nickel, and other elements and sell sheet steel to fabricators.
  
  

If we continue to extend this list, we eventually get to stages that are enormously remote from consumer good deliveries. Think of ore mines, and then think of the geological studies and exploration that go into finding the next ore mine. We can think of all these activities as additional productive stages -- very early stages which take place decades before ore is found and processed into consumer goods sitting on a retailer's shelf.

Starting with Böhm-Bawerk, and continuing with Mises and other economists, the Austrians have argued that when a society is accumulating capital, market and technological forces tend to lengthen the productive structure by adding additional stages that produce capital goods further and further removed from consumer goods delivery. As discussed in the "The Pure Rate of Interest," above, we should expect the interest rate return in all of these stages to tend toward one uniform rate; in equilibrium that rate would be the pure rate of interest.

The Rate of Interest and the Structure of Production

To understand the impact of central bank interest rate manipulation, we must first explore the relationship between the interest rate and the structure of production as it would exist in a laissez-faire economy.

When a population's time preference falls, for example, people want to spend a smaller part of their income on consumer goods and a greater part on future goods. To represent that change in the diagram above, the "Demand for Future Goods" line would shift to the right and the "Supply of Future Goods" curve would shift to the left: the equilibrium pure interest rate would therefore fall. (See Exhibit 2 in the next post).

With less money being spent on consumption, consumer goods prices would fall -- and that would mean a lower return to capitalists at the last stage of production. Because of their diminished income, those capitalists would buy fewer factors of production and fewer capital goods from the preceding stages of production. In subsequent periods, then, buying cutbacks would cascade along the structure of production tending to eventually reduce the returns to entrepreneurs in all stages.

The situation as described may look bleak, but we haven't yet talked about the other important changes. Most importantly, with lower time preferences people would spend more money on future goods. In addition, with a lower interest rate capitalists would be willing to pay more for factors of production in relationship to their expected future income.

With a greater volume of savings seeking investments, falling incomes in the late stage businesses, and the effects of a lower pure interest rate, capitalist-entrepreneurs looking for opportunities find their choices skewed toward the early stages. The reduced income in late stage businesses also frees up labor and other productive factors that new investments in early stage opportunities require. These changes all work toward reestablishing a uniform, but lower, interest return across all productive stages. If those investments in early stage businesses are successful, the new productive structure becomes more capitalistic and is soon producing more goods than before the change in time preference. If time preferences remain constant, therefore, people will still spend the same smaller percentage on consumer goods but that expenditure will buy them more goods than they had before. All of these synchronized changes occur as a result of individual decisions; no central plan is needed to adjust market prices or "stimulate" anything.
Rising time preferences, on the other hand, would raise the pure interest rate and reverse the effects discussed above. With more consumption spending, later stage business, such as retail, would have higher relative returns than earlier stages. In this case, the earlier stages far from consumption goods would receive less investment or would be abandoned altogether. A society with a rising time preference must partially liquidate its capital stock to keep its productive structure balanced. Once again, however, the necessary adjustments require nothing more than capitalist-entrepreneurs following their own best interests.

Conclusion

This post just sketches a few important Austrian School ideas about capital and interest. There are many sources for people wanting to understand these theories in depth, but I recommend interested readers start with Rothbard's Man, Economy, and State.

In future posts I will build on the ideas presented above and in the previous post The Trouble with Credit Expansions to demonstrate more explicitly why central bank interest rate manipulation contributes to false booms, malinvestments, and capital consumption.

Irving Fisher Beguiles John Mauldin

Many people know John Mauldin. He is a frequent speaker on investment topics and has written several books. John also publishes a well respected, financially oriented e-letter that is distributed to well over one million recipients every week. Irving Fisher, (1867 - 1947), is still well known for his economics research in the 1920s and the 1930s.

Much as I respect John Mauldin and his impressive accomplishments, his letter for April 24 included some ideas that I feel compelled to rebut. I obviously can't reach Mauldin's audience, but I just feel a need to go on record opposing his thoughts concerning Irving Fisher's so-called "equation of exchange" and its alleged monetary policy implications.

If that sounds like a boring post -- please hold on for one minute! Mauldin begins his presentation by saying "This is an important equation, right up there with E=MC^2". Imagine that! An economics equation mentioned in the same sentence with Albert Einstein's break-through insight that led to nuclear energy and atom bombs! If that doesn't snap a person wide awake, what economic topic will ever do so?

John Mauldin Presents: The Equation of Exchange!

Here is Mauldin's presentation:

“MV=PQ. This is an important equation, right up there with E=MC^2. M (money or the supply of money) times V (velocity -- which is how fast the money goes through the system …) is equal to P (the price of money in terms of inflation or deflation) times Q (roughly standing for the Quantity of production, or GDP)”

"So what happens is, if we increase the supply of money and velocity stays the same, and if GDP does not grow, that means we'll have inflation, because this equation always balances. But if you reduce velocity (which is happening today) and if you don't increase the supply of money, you are going to see deflation."

Mauldin is hardly alone in his thoughts on this subject. Anybody who has been reading economic comments for awhile will have frequently seen this equation, applied in pretty much the same way. But I take exception.

A Harmless Heuristic Device?

At one time I believed the equation of exchange was a relatively harmless, heuristic device that usefully suggested the directional relationship between prices, the quantity of money, and the total volume of goods. Eventually, however, it became apparent that many people were referring to this equation as if it were literally true -- a situation that still stresses me out every time I see it.

After reading Murray N. Rothbard's seven page demolition of Fisher's equation of exchange (see Man, Economy, State, pg. 831), I agree wholeheartedly with his conclusion that it deserves to be "expunged from the economic literature." The equation of exchange may be heuristic, but its lessons are perverse and illogical -- as I attempt to show with my severely condensed version of Rothbard's critique, below.

Problems with the Transaction-Level Equation

According to Rothbard, Fisher began by writing his equation for a single transaction:

“[T]he total money paid is equal in value to the total value of the goods bought. The equation thus has a money side and a goods side. The money side is the total money paid. . . . The goods side is made up of the products of quantities of goods exchanged multiplied by respective prices.”

-- Irving Fisher, The Purchasing Power of Money, 1922

One problem with this statement is that there is no equality between the value of the goods and the value of the money. Exchanges take place precisely because one participant values the money more than the goods and the other participant values the goods more than the money.

Another problem is that the "equation" contains no price determination information whatsoever -- and Fisher's stated goal was to investigate "the causes determining the purchasing power of money." Price determination is very well understood in economics, and Rothbard tells us that Fisher's other writings made it clear he bought into that prevailing theory. Very briefly stated, price determination begins with individuals subjectively valuing specific quantities of a good against specific quantities of money. Money prices then emerge as people make exchanges which meet the value criteria for both buyers and sellers. Fisher's equation embodies none of that insight, leaving us with a mere tautology: the transaction price is calculated by dividing the quantity of goods exchanged into the quantity of money exchanged!

Worse Problems with the Economy-Wide Equation

As pathetic as the equation of exchange is at the individual transaction level, it offers even less when extended to an entire economy -- a gigantic leap of imagination! It seems that Fisher himself probably ran into insuperable problems because he just kind of threw it out there in a single sentence:

“The equation of exchange is simply the sum of the equations involved in all individual exchanges.”

It doesn't take much reflection to see that this uninteresting tautology becomes absurd when it is summed across all individual exchanges. Mauldin himself gave us a (possibly unintended?) heads up when he defined the Q parameter as follows:

"Q (roughly standing for the Quantity of production, or GDP)"

"Roughly" indeed! Neither Fisher nor Mauldin can wave his hands and make this absurdity go away. How do we add up the physical quantities produced, even roughly? As Rothbard suggested, try adding up just four transaction quantities:

10 pounds of sugar
1 hat
1 pound of butter
1 television set

If you think there may be a solution to that problem, then try adding in a telephone call, a legal conference, a Broadway performance, and a consulting engagement. The lack of a common unit is not a minor conceptual glitch.

Q cannot "roughly" stand for GDP, as Mauldin suggests. GDP is defined as the MONETARY VALUE of the goods and services produced within the economy, and the common unit is dollars. But in this so-called equation of exchange, Q must represent the physical quantity of goods because price is separately accounted for by P. As a numerical value, Q is a meaningless and indefinable concept. Q is neither a precise nor a rough representation of anything -- unless you want to say that it represents a very long list of quantities, each expressed in different and incompatible units.

If it is impossible to define the variables, how can anybody call this foolish symbolic expression an “equation,” let alone compare it with E=MC^2? Mauldin's statement is laugh-out-loud preposterous.

Invalid Equations Lead to Erroneous Conclusions -- and Bad Policies

Bad things happen when people draw conclusions from invalid equations. Consider Mauldin's statement: "So what happens is, if we increase the supply of money and velocity stays the same, and if GDP does not grow, that means we'll have inflation, because this equation always balances."

"Because this equation always balances"! Amazing: "we" add some money (M) to the economy and, bingo, the "average price level" (P) rises to keep the equation balanced -- never mind that P cannot even be defined, let alone measured. Our contemporary economists haven't let that stop them, however. They substitute a simple weighted price index for P, giving them a number which they can easily calculate. The P substitute necessarily ignores the vast majority of goods and services produced in a large economy, but nevertheless our Federal Reserve System tends to behave as if this index were in fact the mythical P -- and as if the equation of exchange actually did "always balance."

So why is this a problem, you might ask. Isn't this approach, perhaps, a reasonable approximation? Well, no, not at all. This way of looking at things leads to horrendous policies. For example, the Fed tends to repeatedly adopt expansionary monetary policies and then observe that the price index, the P substitute, does not rise. Our Fed governors then conclude that V must be dropping or maybe Q is rising. Either way, the central bank often takes a falling or even a relatively steady price index as a green light to add more, and more M.

The problem with all of this is that "we" adopt policies while ignoring what is really going on in the economy. New money always enters the economy through particular individuals who want to spend the money on particular goods. Since the desired goods are rarely if ever represented in the price index, the new money rarely causes the P substitute to rise -- and so the Fed feels free to continue loose monetary policies. But a lack of rising prices, measured by the price index, does not mean that the new money is having no adverse impact on the economy. As I explained in The Trouble with Credit Expansions, the bigger problem with money growth is that it immediately changes relative prices and therefore alters individual economic decisions across the economy.

The changed behaviors are driven by and dependent upon the money expansion. When that expansion slows, as it eventually must, we find malinvestments throughout the economy and liquidation of bad investments is then perceived as a recession. If this foolish reliance on the equation of exchange and the price index continues long enough, it results in serious Unintended Consequences.

One final footnote -- Irving Fisher was the economist who infamously declared that the stock market had likely attained a "permanently high plateau" -- shortly before the 1929 crash. Fisher went on to lose most of his wife's family fortune in the ensuing Great Depression.

I Want to be a Consumer

The following poem was originally published by Patrick Barrington in the April 25, 1934 issue of Punch, two years before John Maynard Keynes published his General Theory. Henry Hazlitt republished the poem in his book The Failure of the 'New Economics,' An Analysis of the Keynesian Fallacies, and that is where I first read it.

This poem has been widely distributed on the internet, so you may already have seen it. If not, however, please enjoy it. I think this little ditty explains the ultimate consequences of the Keynesian economic philosophy better than any serious essay ever could.

I Want to be a Consumer

"And what do you mean to be?"
The kind old Bishop said
As he took the boy on his ample knee
And patted his curly head.
"We should all of us choose a calling
To help Society's plan;
Then what do you mean to be, my boy,
When you grow to be a man?"

"I want to be a Consumer,"
The bright-haired lad replied
As he gazed up into the Bishop's face
In innocence open-eyed.
"I've never had aims of a selfish sort,
For that, as I know, is wrong.
I want to be a Consumer, Sir,
And help the world along.

"I want to be a consumer
And work both night and day,
For that is the thing that's needed most,
I've heard Economists say,
I won't just be a Producer,
Like Bobby and James and John;
I want to be a Consumer, Sir,
And help the nation on."

"But what do you want to be?"
The Bishop said again,
"For we all of us have to work," said he,
"As must, I think, be plain.
Are you thinking of studying medicine
Or taking a Bar exam?"
"Why, no!" the bright-haired lad replied
As he helped himself to jam.

"I want to be a Consumer
And live in a useful way;
For that is the thing that's need most,
I've heard Economists say.
There are too many people working
And too many things are made.
I want to be a Consumer, Sir,
And help to further Trade.

"I want to be a Consumer
And do my duty well;
For that is the thing that's needed most,
I've heard Economists tell.
I've made up my mind," the lad was heard,
As he lit a cigar, to say;
"I want to be a Consumer, Sir,
And I want to begin today."


Henry Hazlitt,
The Failure of the 'New Economics,' An Analysis of the Keynesian Fallacies,
page 133.

The Absurdity of it all: "Stimulating Consumption"

The Global Crisis

A significant global recession is now well upon us, with falling growth rates in the high flying Asian economies and contracting economies in the United States, Britain, Spain, Germany, Singapore and many other countries. The causes remain controversial, of course -- but not in my mind. I explained my understanding of the crisis in a series of earlier posts, principally: How the Government Caused the Crisis and Unintended Consequences. Those posts focused on events in the United States, but the principle is the same around the world.

Some of the hard-down economic statistics are now about as low as they have ever been and rates of change appear to be bottoming. That development has brought out a few optimists, and some are already calling a stock market bottom and an end to the recession this year.

I venture no opinion about the stock market, but I believe there are more malinvestments to be revealed with more real-economy consequences. More troubling to me, I believe that government "recovery" actions around the world will prove to be tremendously destructive and inevitably cause more serious economic dislocations in the future.

Economists to Governments: Stimulate Consumption

Influenced by Keynesian doctrines, mainstream economists want governments actively intervening in their economies with public works projects, business bailouts, and "stimulus" spending. As any quick internet search reveals, economists are promoting these ideas to the governments of the United States, China, India, The United Arab Emirates, Korea, The United Kingdom … just about everywhere. In this post I will deal with just one of these many interventionist prescriptions: "stimulating consumption."

To give me an explicit target for this essay, I quote Paul Krugman on government stimulus goals and methods. Since Dr. Krugman is a Professor of Economics at Princeton, a recent Nobel Laureate, and a New York Times columnist, it seems reasonable to accept his stimulus article as authoritative. In a January, 2008 column, Dr. Krugman said: "The goal of a stimulus plan should be to support overall spending, so as to avert or limit the depth of a recession. If the money the government lays out doesn’t get spent — if it just gets added to people’s bank accounts or used to pay off debts — the plan will have failed."

It is revealing, I believe, that Professor Krugman makes no attempt to explain why we should expect government stimulus to help. He does not explain, for example, in what sense a stimulus plan will "support overall spending." Is he asserting that it will increase total spending … or change it in some other unspecified way? Why he thinks such support will "avert or limit" a recession also remains a mystery. Will it generate new uses for idle capital goods or lasting employment for unemployed people? Will it move the market pricing structure toward a new equilibrium? Or is he perhaps just calculating that the published GDP numbers will rise? In any event, it appears that Professor Krugman considers the answers to these questions as either obvious or long-since settled.

But the Benefits are Not Obvious

Far from being an obvious benefit to an economy, even a cursory analysis of this consumption stimulus idea reveals serious doubts. At a fundamental level, this Keynesian idea that we should increase "aggregate demand" is an absurdity that I hope to pursue in future posts. In this post, however, I take a narrower view and demonstrate that "government money" given to consumers does not beneficially impact the economy.

As I suggested in an earlier post, Is Economics Like Religion?, it behooves us all to challenge economists who do not explain their logic in terms that an intelligent and interested layman can understand. I think this is particularly important in Krugman's case because he is publicly arguing that President Obama's massive and unprecedented "recovery" budget is too small to get the job done.

Funded via Taxes or Government Borrowing

If a government raises its stimulus money via taxes or borrowing, it is quite obvious that the so-called stimulus money is simply taken away from one group and given to another. How is money shuffling going to "support overall spending"? The only thing such a "stimulus" will do is create winners and losers via the political process and perhaps shift demand from certain goods to a different set of goods -- because different people are deciding how to spend the money. Common sense tells us that a "stimulus" program funded in this way will do nothing positive for the economy.

Funded via Newly "Printed" Money

Given the obvious impotence of taxing or borrowing for purposes of "stimulation," it seems that the consumption stimulus advocates must be proposing that governments just "print up" some new money. If that is what they are thinking, wouldn't it be a good idea for them to say so?

Even with newly created money funding the stimulus, however, it's easy to see that these government programs contribute nothing positive to the economy. I find it helpful to look at this question from the production side. Consumption and production are symmetrical: nobody can consume a good unless somebody first produces it, and nobody can buy a good unless somebody sells it. A producer has only three possible uses for his good: (1) use the good for his personal benefit, (2) exchange the good for money, or (3) hold the good hoping to get a better price in the future. In a modern exchange economy, however, we can ignore the first use. In all large volume production operations, producers necessarily assign no value at all to retaining product for their own use -- because all goods have a declining marginal utility. How many cheese graters or Cuisinart food processors can a person use, anyway? And they manufacture millions of them.

In a modern economy, therefore, absolutely everything produced is sold. All perishable goods are sold immediately at the market price. Producers may, however, hold some durable goods off the market for a time -- speculating on a future price increase. The same is true for producers' goods as well as consumer goods -- and also for services. All apartments, for example, are rented at the market rate or held vacant for a speculatively higher future rate.

In the case of perishable goods, it's clear that with or without a "stimulus" program, all production will be sold immediately. Stimulus checks funded by newly created money, therefore, can accomplish only one thing with respect to perishable goods consumption: raise prices above the free market level. Exactly the same conclusion holds for the many, many durable goods that are routinely sold out at market prices.

Even in situations where producers hold a portion of their production off the market the conclusion is similar. To see this, recognize that these producers are taking a voluntary, speculative action. They could have offered for sale their entire production, or a larger percentage of their production -- and taken whatever the market price turned out to be. Instead, however, these producers decided they might be able to get a better price at a later time. Automobile manufactures, or dealers, are a prime example in 2009. If stimulus checks allow such producers to immediately sell a higher percentage of their production, that simply means the stimulus money raised the market price for that quantity of goods above what it would have been on a free market.

For every type of good, therefore, a consumption stimulus funded with newly "printed" money will simply raise goods prices higher than they would have been on a free market. It's true that a few people might benefit if the stimulus money enables the sale of some products that producers would otherwise have held off the market -- but those benefits come only at the expense of others who must pay higher prices for those goods and eventually higher prices for all goods. Even when "stimulus" is funded by "new" money, therefore, it seems that government interventions end up harming more people than they help.

Longer Term Money Printing Effects

Some stimulus advocates might argue that with higher goods prices and smaller durable goods inventories, producers are motivated to produce more goods in future periods. Producing more goods might entail hiring additional labor, buying more raw materials and other factors of production -- maybe even building additional production facilities. If those investments are inspired by the stimulus, economists might argue, it will have done its job and put the economy back into a growth mode.

According to the Austrian Business Cycle Theory, however, such developments would be detrimental, not helpful. If higher prices and sales are driven by stimulus money, companies will likely find that sales begin to shrink as soon as the government program slows. When sales of these products fall off, the stimulus-inspired investments will be revealed as malinvestments. A large stimulus program, therefore, can simply setup the economy for another recessionary episode.

In the United States, the "recovery program" is so large and impacts so many economic sectors that it is obviously distorting relative prices all across the economy -- for goods, for financial instruments, and for companies. Those relative price distortions, together with interest rates artificially maintained at a level far below free market levels, could potentially lead to a bull market and other false-boom activities. In the end, however, we will discover new malinvestments and find that we have squandered even more capital. See my previous post, The Trouble with Credit Expansions, for further explanation of this point.

Conclusion

A little government "stimulus" here and there only causes a little economic damage, and we can hardly expect politicians to give up that game. When big-government politicians, economists, and well-connected executives team up to a create government spending program on the scale we see in the US today, however, the situation becomes more serious. Not only will the government's plan fail to deliver meaningful benefits, but it will create the conditions which lead to our economy's next crisis -- one that we can reasonably expect to be more extreme than the current global recession.

Is Economics Like Religion?

Last month the following comment was posted on this blog: "Economic theory reminds me of religion, in that it often presents a wrong way and a right way, gaining converts from dissenting persuasions."

I take this comment seriously, because … well, frankly, this is an opinion I once held. After all, what is an intelligent layman supposed to think when he sees professional economists holding divergent and even totally contradictory views? If economics is a science, why doesn't logic drive most economists toward the same position, or at least similar positions? Are economic opinions, like religious convictions, based on nothing but faith?

It took a little reading into economic theory (see Suddenly, Economics Mattered), but it didn't take me long to convince myself that logic is just as applicable and important in economics as it is in the physical sciences. I found other explanations for the divergent and contradictory economic ideas out there.

Why Bad Economics is so Popular and Enduring

In the opening paragraphs of his Economics in One Lesson, Henry Hazlitt says "Economics is haunted by more fallacies than any other study known to man. This is no accident." Hazlitt explains:

"The inherent difficulties of the subject would be great enough in any case, but they are multiplied a thousandfold by a factor that is insignificant in, say, physics, mathematics or medicine -- the special pleading of selfish interests. While every group has certain economic interests identical with those of all groups, every group has also … interests antagonistic to those of all the other groups."

-- Henry Hazlitt, Economics in One Lesson, page 15

It is inevitable that some people will try to use government's coercive power to live well at somebody else's expense. For any group to achieve that goal in a democracy, however, it must develop crafty and convincing arguments -- arguments which give the enabling politicians effective cover. It really wouldn't do for such a group to use this little tongue-in-cheek speech from Frédéric Bastiat's essay, Government:

"I am dissatisfied at the proportion between my labor and my enjoyments. I should like, for the sake of restoring the desired equilibrium, to take part of the possessions of others. But this would be dangerous. Could not you facilitate the thing for me? Could you not find me a good place? or check the industry of my competitors? or, perhaps, lend me gratuitously some capital, which you may take from its possessor? … By this means I shall gain my end with an easy conscience, for the law will have acted for me, and I shall have all the advantages of plunder, without its risk or its disgrace!"

-- Frédéric Bastiat, The Bastiat Collection, Volume 1, page 99

No, indeed. We will never see the pleadings of labor, management, retirees, teachers, bankers, … or a thousand other groups laid out with such clarity. To get their way, these groups all need sophisticated arguments from labor economists, auto industry economists, and other specialists who use their Ph.D. credentials, their obscure and erroneous assumptions, and their pretentious mathematics to baffle both Congress and taxpayers.

I believe politicians and government workers constitute the most dangerous collection of such "pleaders." These people choose to live wholly as tax consumers. Even worse than that, however, they truly enjoy telling the rest of us what to do. Not only do many of them produce nothing of value, but they interfere with genuine producers.

To more effectively argue their case, politicians and government workers are naturally drawn toward the economic fallacies that have served to bolster governments' power and scope so well over the centuries. A few examples should make this point clear:

Public works programs create jobs; low interest rates generate growth; wealth is distributed unfairly on the free market; minimum wage rules benefit all workers; government spending promotes economic growth; full employment requires inflation; deflation is a horror that must be avoided at all costs; tariffs protect Americans; exports are good for us and imports are bad; foreigners selling goods "below cost" hurt Americans; saving is bad for the economy; rising gasoline prices are due to greed and gouging; …

This list could be extended almost indefinitely. The items in vogue change from time to time, but favorite fallacies are endlessly recycled. The public finds many of these ideas to its liking, of course, fallacies or not. Nevertheless, politicians are always trying to find new and better ways to explain government programs: their benefits, their necessity. The result, of course, is a strong and growing demand for economists and economic analyses that support the intended government actions.

And now we come to an indisputable economic law: if a government wants analyses supporting a particular political goal or action, somebody will gladly meet that need. If the President wants to spend a few trillion dollars to expand government's scope and power, he is sure to find highly credentialed professors who will "prove" the efficacy of his decision -- and some who will even say something like: "Good idea, Mr. President, but you should increase your spending proposals dramatically to ensure the desired result."

In a world such as this, we have to engage in this battle of ideas.

Citizen Economists

An intelligent citizen cannot afford to throw up his hands in resignation and accept whatever ideas are presented as "economic policy." Here is what Ludwig von Mises thought about this subject:

"… economics cannot remain an esoteric branch of knowledge accessible only to small groups of scholars and specialists."

"There is no means by which anyone can evade his personal responsibility. Whoever neglects to examine to the best of his abilities all the problems involved voluntarily surrenders his birthright to a self-appointed elite of supermen. In such vital matters blind reliance upon 'experts' and uncritical acceptance of popular catchwords and prejudices is tantamount to the abandonment of self-determination and to yielding to other people's domination. As conditions are today, nothing can be more important to every intelligent man than economics. His own fate and that of his progeny is at stake."

-- Human Action, Scholars' Edition, page 874

In 2009, as we watch our "self-appointed elite of supermen" squandering trillions of dollars, it seems to me Mises' call to action has never been more important. To participate in the debate, or to even to have an opinion on these matters, absolutely requires some economic understanding.

Achieving such an understanding might at first seem unrealistic or even impossible, especially to anyone who has ever glimpsed the esoteric mathematics in a contemporary economics paper. From that viewpoint, Mises' admonition might appear as practical as a suggestion that every thinking person must understand Einstein's General Theory of Relativity.

This comparison, however, is an illusion created and jealously maintained by our mainstream economic establishment. Becoming one's own "citizen economist" is not nearly as daunting as our "experts" would like us to believe. All one needs, in my opinion, is an appreciation for logic and clarity of thought -- and enough confidence to realize that these self-important economists are worthless if they can't clearly and convincingly explain themselves to laymen.

Unintended Consequences

In How Government Caused the Crisis I explained my belief that the U.S. government deliberately encouraged the housing boom with loose monetary policy, housing-favorable tax codes, and many other policies promoting house purchases and credit. With artificially low mortgage interest rates throughout the period, the boom turned into a mania and the frenzied activity achieved the administration's political goals: it kept the reported GDP data and the stock market moving up for several years.

Unfortunately, however, we can also now see that the housing mania produced a horrific number of unintended consequences: millions of non-performing mortgages, high home foreclosure rates, escalating personal bankruptcies, collapsing mortgage backed security valuations, corporate insolvencies, bank failures, government seizures, rising unemployment, and emergency government expenditures in the multiple trillions of dollars. These cascading disasters caused a recession which, by many measures, has already become the worst since the Great Depression.

It is axiomatic, however, that things always look darkest at the bottom. There aren't many right now, but a few optimists are noting that this has already been a relatively long recession, that some production statistics can't get much lower, that commodity prices are beginning to rebound, and that the stock market wants to rally. Since optimism about the US economy has been a winning bet for a long time, a few smart, experienced analysts are thinking that we may have already seen the bottom.

I recognize that the optimists could be right, and I hope they are. It would feel so good to believe that our economy is mending, that jobs will soon be more plentiful, that retirements will be bountiful, and that Americans will continue to enjoy a very high measure of freedom and personal liberty. I look forward to the day when that is my view. For now, however, there are still some major issues that leave me convinced that more unintended consequences will plague us for at least a few years.

A Big Boom Means a Big Bust

We have lived through a huge credit expansion boom, one for the record books. Every major currency in the world is now a "fiat currency" not backed by any commodity -- and therefore each currency is limited in quantity only by the issuing government's sole discretion. It is also true, I believe, that every banking system in the developed world is a fractional reserve system. With fractional reserve banking and fiat currencies, the potential for global monetary inflation (i.e. injecting more money into the economy) is greater now than at any previous time in history. This potential, together with widespread acceptance of inflationary economic doctrines, gave us what was perhaps the biggest, broadest, and most dangerous credit expansion in world history.

Why do I say a credit expansion is dangerous? It comes from my understanding of the Austrian Business Cycle Theory (ABCT) and the simple observation that government actions are becoming wilder, more expensive, and more out of control with every passing week. In my opinion, the ABCT is the key to understanding risks in this environment because it alone has permitted economists and analysts to anticipate and explain major economic busts. For example, Ludwig von Mises anticipated the Great Depression in the late 1920s, when one of America's imminent economists was saying the economy was on a "permanently high plateau." Similarly, Peter Schiff and other Austrian-influenced analysts predicted the current crisis even as our mainstream economists were still maintaining that the economy was strong and the banking system solvent.

The ABCT is a rich, multidimensional theory based on microeconomic analysis of price incentives; it's a bit too complex to fully explain within a blog post. The essential point, however, is that monetary inflation, usually a credit expansion, creates an artificial economic boom. The inflation lowers interest rates below the free market level and distorts relative prices within the economy. As a direct consequence, entrepreneurs initiate many projects that cannot be profitably completed -- Austrian economists call these "malinvestments." See The Trouble with Credit Expansions for a bit more ABCT insight.

When the credit expansion inevitably slows, the many malinvestments are revealed and the bust phase begins. The bust is inevitable because it is simply the necessary process of liquidating bad investments, converting assets to their next best employments, and reallocating labor and other resources to their best uses. When markets have been left to their own devices, this corrective process has never taken longer than a couple of years. It is just a matter of logic, however, that longer and more extreme booms will accumulate more malinvestments and the corrective process will therefore adversely impact more people and probably take a longer time.

Given the size and global scope of our preceding boom, I have to believe that we will see a lot more malinvestments come to light before this recession is over. It's impossible to know where all of these bad investments will turn up. If a human being could know these things, then a planned economy might be practical -- but nobody can know how the economy should be structured or exactly where it might be maladjusted. There are, however, some additional malinvestments already coming into view. For example, according to some specialists such as Andy Miller, most commercial real estate operations will experience a major downturn -- a sure sign of preceding malinvestment.

So, the scope and size of the preceding boom strikes me as one important reason for not jumping on the optimists' band wagon just yet. Unfortunately, however, there is another reason which seems to be much more significant.

Government Actions Will Prevent a Recovery

Our government, and most other governments around the world, have made one thing perfectly clear: they are not going to accept the natural market corrections that would lead to a rapid, market-based reallocation of resources -- and therefore an economic recovery. Our government officials do not like the market solution. They do not want to see large businesses failing, they do not want asset prices falling, they do not want a large number of home foreclosures. Our government officials engineered the inflationary boom and they liked it very much. Now they want to "get credit flowing again."

I am not going to recount the many familiar Treasury and Fed programs employed, but they are all aimed at dropping interest rates, increasing bank reserves, keeping lending institutions in business, and encouraging or coercing those institutions into lending more money. The scale and expense of these programs started out as breathtaking and have now moved on to the point where I have lost all feeling in my extremities -- these government actions and power grabs have left me totally numb.

Our government interventions are increasingly undermining the market forces which are responsible for the productivity that we know markets deliver (see Laissez Faire Capitalism would have Prevented the Crisis). Bailouts are impairing profit and loss motives, government takeovers are putting non-producing bureaucrats in charge of production, "toxic asset" purchases are distorting financial asset prices and misallocating trillions of dollars. The far below market interest rates and unlimited government finance for selected firms is ensuring more malinvestments and capital consumption on a gigantic scale. The low interest rates are also harming retirees and savers of all ages -- and distorting the country's capital formation process. The planned "stimulus" expenditures will divert entrepreneurial attention from the important business of meeting the most urgent consumer needs to the strictly political task of meeting the government's needs.

This government attempt to "get credit flowing again" is in reality an attempt to pick up the credit expansion where it ran out of steam. But consider the situation in 2009: the Fed itself reports that bank credit issued this year is running about 9% above the incredible volume of credit issued during 2008. What possible sense can we make of these people who refer to that massive, ongoing bank credit as having "dried up"? Our government officials, and their economists, obviously fail to understand that businesses are failing because real resources are inadequate to support all the bubble activities started during the preceding boom. See The Trouble With Credit Expansions for a better understanding of this point.

Whether the government can somehow rekindle the credit expansion, or not, we are now experiencing massive monetary inflation that will continue to distort relative prices, but in new ways and with consequences that are still difficult or impossible to anticipate. What we can absolutely count on, however, is that additional malinvestments will be revealed whenever the Fed's massive money printing operations begin to slow.

We know the Fed's printing will end. As Ludwig von Mises said, an inflationary process will stop either when the monetary authority comes to its senses, or, if not, when the currency is destroyed in a hyperinflationary catastrophe, a "crackup boom," he called it. Inflation is a serious scourge, one that has inflicted misery on countless victims throughout history. This is not hyperbole. I find the following Henry Hazlitt comment to be absolutely chilling, especially when I think about how many of these characteristics we have already experienced firsthand.

"It [Inflation] discourages all prudence and thrift. It encourages squandering, gambling, reckless waste of all kinds. It often makes it more profitable to speculate than to produce. It tears apart the whole fabric of stable economic relationships. Its inexcusable injustices drive men toward desperate remedies. It plants the seeds of fascism and communism. It leads men to demand totalitarian controls. It ends invariably in bitter disillusion and collapse."

Henry Hazlitt, Economics in One Lesson, page 176

In the space of one decade, I believe U.S. leaders have in one giant leap brought us perilously close to the conditions described in the Ayn Rand quote on the sidebar, which I repeat below for emphasis:

"When you see that trading is done, not by consent, but by compulsion -- when you see that in order to produce, you need to obtain permission from men who produce nothing -- when you see money flowing to those who deal, not in goods, but in favors -- when you see that men get richer by graft and pull than by work, and your laws don't protect you against them, but protect them against you -- when you see corruption being rewarded and honesty becoming a self-sacrifice -- you may know that your society is doomed."

Ayn Rand, Atlas Shrugged, page 413

First with the Bush administration, and now the Obama administration, we are watching economic leadership operating with just the barest pretense of knowledge, to use F.A. Hayek's memorable phrase. Our government's crisis management methods are tragically ill-advised and certain to lead to larger, less tractable crises than we now face. Consider this week's rather odd diplomatic development: European Union President Mirek Topolanek, from the Czech Republic, publically said that the U.S. stimulus program is the "Road to Hell." How in the world, I wonder, did the United States of America elect leadership that is so far to the "political left" of the European Union and the Czech Republic?

It pains me a great deal to draw this conclusion, but our government is determined to prevent a recovery -- and that is the second major reason why I can't see a near term recession bottom. First we have to see sanity return to Washington, D.C.

(Note: the immediately preceding post, The Trouble with Credit Expansions, provides a little more insight into the Austrian Business Cycle Theory.)

The Trouble with Credit Expansions

This post is intended as a companion piece for Unintended Consequences. It provides a bit more insight into the Austrian Business Cycle Theory (ABCT).

Credit, per se, does not cause any economic problem. In fact, a society becomes more prosperous by saving and investing in capital goods -- to make future production more productive. Credit is an essential part of that process, allowing savers to transfer their unused resources to entrepreneurs. Credit extended for consumption does not increase future production and therefore does not enhance a society's wealth -- but it does not cause a boom/bust cycle as long as total new credit does not exceed available savings.

A credit expansion, however, is different. Fractional reserve banks are allowed by law to lend a large fraction of their demand deposit balances. When a bank lends money from a demand deposit account, both the depositor and the borrower in effect possess the money at the same time -- the loan actually creates new money. With newly created loan money adding to system-wide demand deposits, a fractional reserve system can sustain an iterative, long lasting credit expansion. With a central bank setting low reserve requirements and periodically adding to reserves, the potential for monetary inflation is almost unlimited.

Mainstream economists generally favor monetary inflation in small doses because they believe it boosts "aggregate demand," which, according to their doctrines, improves economic growth. Some central banks, in fact, use "inflation targeting" -- deliberately seeking to keep consumer price increases in the neighborhood of 2%, say. The only concern mainstream economists seem to have about monetary inflation is its potential for raising the CPI to excessive levels.

The Austrian economists believe this is a terribly flawed policy. CPI increases typically lag way behind monetary inflation, sometimes not showing up until many years later. As any control systems engineer can explain, it's very difficult to control a system by referring to an indicator that has a long and variable lag. Another more serious problem with such a policy, however, is that inflation distorts bank lending rates and relative prices within the economy. Relative price changes are the more fundamental and immediate danger for two reasons. Unlike CPI changes, relative price distortions begin the instant that borrowers begin to spend their new money -- and relative price changes immediately impact consumer, investor, and entrepreneurial decisions.

One the most insidious credit expansion effects comes from artificially lowered interest rates. Entrepreneurs are constantly estimating future goods' prices in relation to current prices for the corresponding factors of production. An entrepreneur will tend to launch a project if, in his best judgment, he can buy production factors now and produce a good which will sell upon completion for a price sufficient to cover his costs and meet his required rate of return. With a bank lending rate below normal market rates, entrepreneurs find a lot more opportunities meeting their criteria -- but this is an illusion.

As entrepreneurs borrow money and initiate projects, their newly minted money adds to the monetary demand for capital goods and other factors they need, driving up these prices. When other entrepreneurs see rising capital goods prices, low interest rates encourage them to increase the production of those capital goods. As explained by the ABCT, in fact, below free market interest rates provide an especially large incentive for projects producing high order capital goods and long lived durable goods -- such as houses and automobiles.

All of this economic action certainly looks attractive to the politicians and economists who want to light a fire under the economy, but it is unfortunately a mirage. Even a very large economy like the United States has a finite amount of real resources available: commodities, labor, intermediate products and other existing capital goods. With below market interest rates, entrepreneurs kick off more projects than can be supported by the existing real resources (note: a free market interest rate would prevent this from happening, just as it would have prevented the house buying mania, as explained in Laissez Faire Capitalism Would Have Prevented the Crisis). With too many projects started, entrepreneurs use their borrowed money to bid against each other for the inadequate supply of real resources -- raising their prices. As a result, many entrepreneurs find their costs higher than expected, casting doubt on the projected rate of return. Because interest rates remain low, however, many entrepreneurs obtain additional credit financing and push ahead. Since entrepreneurs are still bidding against each other for inadequate resources, their need for credit continues to escalate as this process continues.

As a boom goes on, the new money begins to impact relative prices in a widening circle of more distantly related goods. Rising product prices make some sectors look more profitable to entrepreneurs, and that works as it should in a market economy: it draws capital, labor, and other resources toward the production of those products. The credit-inspired demand for houses, for example, led to a high demand for furniture, kitchen appliances, hardwood floors, swimming pools, and so one. The excessive number of mining projects led to booming demand for Caterpillar tractors, drill rigs, assay equipment, etc.

With rising demand for their products, and below market interest rates, more and more firms borrow money to build additional production facilities, regional offices, new retail facilities, and so on. With interest rates remaining low in spite of spiraling demand for credit, credit requirements grow exponentially.

Boom Leads to Bust

A bust begins as soon as the credit expansion can no longer grow fast enough to meet all the perceived needs of those credit dependent projects. Some projects fold when they are unable to obtain more credit, others drop just because the high resource prices have rendered them unprofitable. To provide one current example, metal mines are the quintessential "high order good" -- meaning that below market interest rates make them look like particularly attractive projects. So what has happened in that industry during the current boom/bust cycle? Well, for a couple of years, mining projects were bedeviled by shortages of drilling rigs, assay labs, and skilled mining personnel -- real resources. Many such companies obtained more and more money from banks and equity investors to push their projects forward, but were then ultimately stopped by physical shortages.

A bust begins in earnest when the exponential growth in credit demand begins to exceed what can be provided by even a financial system designed and tweaked to provide unlimited credit. People who are unable to get enough credit to keep their projects alive perceive this development as a "credit crunch." As we have seen, however, the problem is inadequate real resources -- more credit cannot solve this problem. As also pointed out in Unintended Consequences, the Fed reports that 2009 bank credit is running about 9% above the amazing sum of credit issued during 2008, but we still see our government officials talking about a "frozen" lending market -- and the need to "get credit flowing again."

As a bust gathers steam, we witness the market's automatic attempt to clean up uneconomic projects. A business losing money cannot continue without bankrupting its owners. If the government provides funds to keep it going, then all of society is losing value, consuming its capital, and becoming less prosperous. If we let market prices adjust as necessary, the "clean up" never takes that long. A major bust is very painful, but if all prices are determined by market forces they will automatically direct everybody toward the best use of his or her labor, capital, and other resources. Uneconomic businesses will be liquidated, because they have to be. People working in shrinking industries will seek other employment because they must. Capital goods will find their "next best" employment. (A humorous, but excellent example of converting a capital good to another use is: Play With Our Cats, thanks to David Gordon.)

This, then, is the Austrian economics business cycle story -- as well as I can tell that story in a blog post. An intoxicating boom is caused by what seems to be a persistent human desire to force interest rates lower, and that is inevitably followed by a sobering bust. Unfortunately, our 21st century government leaders think their job is to prevent citizens from ever waking from their drug-induced stupor.

Book Review: Meltdown

Thomas E. Woods, is an historian, an experienced author, and a man with a strong grasp on Austrian School economic theory. He published a marvelous new book this year, called Meltdown. I have it listed on my sidebar in the "Business Cycle Specific" category, but I want to give it more visibility in this post.

In my opinion, Meltdown is an extremely important and timely book. Woods wrote it to explain the current economic crisis and, in particular, to combat numerous fallacies that government spokesmen, media pundits, and even economists are spreading far and wide. Representative Ron Paul wrote the introduction to Woods' book, and said "There is no better book to read on the present crisis than this one, and that is why I am delighted to endorse and introduce it."

Meltdown is a quick, 160 page read. Within that very compact space, however, Woods explains the nature of the crisis and its many causes in a breezy style that any thinking person can easily follow and understand. I am particularly impressed by the way he builds toward a common-sense understanding of the Austrian Business Cycle Theory by layering rather intuitive ideas, further illuminated with straightforward examples. During the nine years that I have been reading Austrian School economics books, I have read many, probably most, efforts to explain the Austrian Business Cycle Theory -- and this is the best I have seen.

This book is no doom and gloom affair. Woods isn't attempting to predict the stock market direction or venture any ideas about what the economy will look like in the future. In fact, he argues from both historical data and theory that, if our government would only behave differently, the necessary market adjustments would be completed quickly and our economy would rebound after a relatively brief recession. On the other hand, Woods demonstrates that government actions so far parallel those taken by Hoover and then Roosevelt during the Great Depression -- something we should all understand and try to change.

I sincerely hope that many people will read this book and carefully evaluate the ideas it contains.

How Government Caused the Crisis

(Part of a series of posts. If you want to read them in order, start here.)

To understand the real reason for this crisis, we need to look back at the conditions which existed just preceding the housing boom. In the 2000 to 2002 time frame, we were all dealing with the bursting technology bubble and the economic dislocations it caused for each of us. A recession was inevitable because we all needed to take a little time to sort out post bubble realities and make appropriate adjustments to our consuming, working, investing, and entrepreneurial activities. We all do that almost unconsciously, of course, by simply reacting to the market prices we see for consumer goods, wages we are offered, and prices we must pay to launch business ventures.

That's what people were doing following the technology bust, but what about the government? The government's needs are remarkably simple: win the next election, stay in power, take more wealth out of the nation's producers, and win the next election. Did I mention win the next election? Well, that's why the government didn't want to accept the impending recession. Voters, after all, get a little cranky when economically distressed. So the government adopted its standard recession-fighting procedures: promoting personal consumption. Of those policies, the most conspicuous policy was then, and always is, massive monetary easing. For all eternity, it seems, governments have believed that pushing more money into an economy will avoid or moderate a recession. And so, in 2001, the Fed began to rapidly reduce its Fed Funds target rate and grow banking reserves as necessary.

The Fed never knows exactly where its easy money will impact the economy, but at some point it must have become apparent that a housing boom was underway. From the perspective of government and Fed leaders, in other words, their stimulus and monetary policies were "working." That hope was confirmed by the extremely mild recession and the apparently bottoming stock market. Our political leaders, quite naturally, wanted these conditions to continue and grow stronger.

To secure the political benefits of a booming economy, our leaders knew full well that they could not leave the financial markets on their own. They understood market dynamics well enough to know that a booming demand for mortgages would raise interest rates, and it didn't take an economic whiz to see that rising mortgage rates would quickly end the nascent housing boom. A free market result, in other words, would have snatched the housing-driven, boom-time economy away from our political leaders -- leaving them to take responsibility for a deeper recession.

To ensure that the housing boom remained on track, our political leaders pulled out all the stops. The Fed set the short term interest rate target at 1% and expanded bank reserves fast enough to keep it there for a solid year. Government kicked in with other housing-aid programs such as down payment assistance, the "Ownership Society" promotion, and many others mentioned in earlier posts. With short term interest rates next to nothing, the banks' cost of funds was close to zero. Bankers could also see that the Greenspan Fed consistently protected the large banks' solvency and supported the financial "innovations" that expanded total system lending capacity. Greenspan even weighed in with a personal recommendation to house buyers: take out a variable rate mortgage to reduce monthly payments, he suggested. The bankers felt safe and confident. With the Fed ensuring practically unlimited loan funds, the bankers aggressively competed on both mortgage rates and lending standards - and our political leaders got exactly what they wanted: low mortgage rates "forever" -- and a long-running housing boom. And, did I mention it? The sitting president won reelection.

This explanation shouldn't really come as a big surprise to anybody. Government's intervene in markets because they do not want to accept the free market result. After all, if governments were always happy with free market outcomes why would they intervene? That's why we have so often seen governments set minimum or maximum prices, for example, and that's why we see governments establish central banks with the power to set (or indirectly control) interest rates and the quantity of money.

This crisis was not caused by a psychological perturbation that "just happens" in unfettered markets. This crisis did not spring up naturally as a feature of (non-existent) laissez faire capitalism. The government created a housing boom because it needed a booming economy to satisfy its political goals, and now we are face to face with the boom's unintended consequences. Those consequences are mounting up pretty fast, so our leaders need to be real sure that voters do not pin the blame on them. They need a scapegoat and that is why they are putting forth this cockamamie story about "excessive laissez faire capitalism," or the lack of government regulation.

If our leaders can pull this off, they not only avoid getting blamed by angry voters, but they get a pass on the next round of government growth. To "protect" us from the horrors of unregulated capitalism, they will need countless billions in additional resources - and they will obviously get it. But look who they are really taking care of: banking system executives, the bank bond holders, and selected businesses that are well known for their large political donations or their large organized labor constituencies.

In truth, we haven't seen yet the full scope of unintended consequences from the housing bust. More than that, we now have the government and the Fed trying that "push consumption" stunt yet another time, with short term interest rates now dropped to approximately zero. As I will discuss in future posts, Austrian School theories show that these policies will inevitably cause additional economic malinvestments and capital consumption, further harming United States citizens and especially its tax payers.

Laissez Faire Capitalism Would Have Prevented the Crisis

(Part of a series of posts. If you want to read them in order, start here.)

As explained in the last post, laissez faire capitalism cannot be blamed for the financial crisis for the simple reason that our economy does not even resemble an unfettered free market system. That is the first level of defense against the government's official line, but there is a much stronger case to make. The simple fact is this: if laissez faire conditions HAD existed in the United States, free market forces would have stopped the housing boom before it created the financial crisis we are experiencing.

To correctly identify what would have happened under laissez faire capitalism, we need to reexamine why free markets work as well as they do -- and they do work quite well. Remember: even people who think capitalism periodically flies off its rails agree that free markets do an unparalleled job of producing consumer goods in super abundance. How could anyone with experience in a developed country believe otherwise?

The reason for capitalism's productivity is that it harnesses the division of human labor like no other economic system, allowing it to flourish and directing its growth into those fields that fulfill the most pressing consumer needs. It does this not by issuing directives, but by automatically establishing meaningful incentives. Capitalism presumes privately owned production factors, people who are free to act in their own self interest, and markets on which both consumer and capital goods are freely exchanged. When these conditions exist in their unfettered form, everybody in the economy has incentives to produce -- and incentives to cooperate within organized society. As Ludwig von Mises said in Human Action, "Society does not tell a man what to do and what not to do. There is no need to enforce cooperation by special orders or prohibitions. Non-cooperation penalizes itself." Adam Smith, of course, called this effect the "invisible hand."

With this understanding in mind, let's try to visualize how free markets would have responded to accelerating demand for houses. We can never predict how far market prices will move, but the direction of a price change follows from simple supply and demand considerations. If the demand for houses rose suddenly, house prices would obviously rise to a level which momentarily equalizes supply and demand. If demand continued to accelerate, house prices would necessarily rise further and, in the United States, buyers would need more and larger mortgages. With escalating demand for mortgage financing, Banks would raise their mortgage rates. If housing demand continued its upward trajectory, banks would raise deposit interest rates and seek other sources of funding. As demand continued to get even stronger, the cost of additional loan funds would increase sharply as people with higher and higher time preferences were persuaded to save. With more mortgage requests than they could approve, banks would naturally demand large down payments and tighten their lending standards.

As these trends developed in finance, builders would respond to rising house prices with more projects. Wages for construction workers and building specialists would rise as builders competed for resources. Similarly, prices for building materials, specialized equipment, and other necessary goods would rise for the same reason. In response to high market prices, builders would economize on expensive resources and suppliers would scramble to produce more of the highest profit margin products.

The increased demand for houses would necessarily be accompanied by falling demand for other goods. Producers of those goods would therefore consume fewer resources of all kinds, and some people working in those industries would seek the higher wages available now in the building industry. Without this complementary fall off in demand for other goods, home builders would be unable to acquire the resources they need as they try to meet the dramatic growth in consumer demand.

This is what a free market does. Free market prices provide incentives to people throughout an economy to produce the most urgently needed goods and services. The free market is at its best when sudden changes in consumer demand require adjustments to existing production systems and a reallocation of resources. Only free markets can quickly accommodate a sudden change like this and keep the division of labor economy functioning efficiently.

But, realistically now, how long would housing demand have continued to accelerate in the face of rising interest rates? People buying houses for shelter would have quickly found that some combination of higher house prices and higher interest rates made buying unaffordable compared to renting. House buyers with an investment motive would have soon discovered that high down payments and a sufficiently high mortgage rate kills their profit opportunities. Similarly, builders would have found that some higher interest rate renders their planned projects unprofitable. Isn't it quite obvious that the recent mania would have been impossible in an environment of rapidly rising interest rates?

The unavoidable conclusion is this: not only was laissez faire capitalism not the cause of this financial crisis, but, had it existed, laissez faire capitalism would have prevented the housing boom's excesses. Unfettered free markets would have prevented builders from constructing millions of unneeded and now vacant housing units. Free markets would have prevented bankers from issuing mortgages to millions of borrowers who cannot meet their financial commitments. Without those perverse mortgages, Wall Street would not have been able to sell trillions of dollars worth of mortgage backed securities to victims around the world. No matter how irrational home buyers or bankers became, laissez faire capitalism would have avoided the worst aspects of the current crisis by penalizing stupid decisions early on.

Even stronger than that, I believe a mania cannot occur without monetary inflation. It's easy credit that allows people to pay irrational asset prices, and it's rapidly rising asset prices that lure people away from productive enterprises toward purely speculative ventures. This is a big subject, however, and our contemporary economists think they can settle these kinds of questions empirically. Without getting heavily into that debate, however, let me mention just one well known book by a mainstream economist: Manias, Panics, and Crashes by Charles P. Kindleberger. Kindleberger was a Harvard economist, and he would not have supported my thesis, but he did devote a whole chapter to inflation. That chapter, "Fueling the Flames: Monetary Expansion," opens with this sentence: "Speculative manias gather speed through expansion of money and credit or perhaps, in some cases, get started because of an initial expansion of money and credit." In my opinion, his later statements in this chapter represent a futile attempt to dilute the evidence that manias are dependent on inflation and inflation is dependent on government policies.

The crisis we now face was possible only because our government took actions to suppress normal market responses. Without low mortgage interest rates continuing throughout this housing boom, the damaging excesses could not have happened. But exactly how and why the government achieved this result is the subject of the next post.

Capitalism did not Fail Us

(This post is part of a series. If you would like to read them in sequence, start here.)

The idea that our crisis was caused by an excessively laissez faire ideology is preposterous. I don't understand how any responsible person can even put forward this idea, and I haven't seen anybody yet advance an argument beyond quoting an authority such as John Maynard Keynes or Alan Greenspan.

Laissez faire, by definition, means an economy in which all means of production are privately owned and the government avoids economic intervention beyond what is necessary to maintain order and protect persons and property. By contrast, the 21st century United States government seems omnipresent and almost omnipotent. (For considerable detail on this point, see economist George Reisman's article The Myth that Laissez Faire Is Responsible for Our Financial Crisis.)

Just a few facts presented by Reisman should convince most people that our contemporary economy is far removed from the laissez faire ideal. For example, government spending amounts to about 40% of national income. There are fifteen federal cabinet departments, nine of which exist for the purpose of controlling the behavior of persons who are involved in housing, transportation, healthcare, education, energy, mining, agriculture, labor, and commerce. These cabinet department interventions, moreover, are further amplified by more than a hundred federal agencies and commissions.

It's difficult to see how anybody could even argue that the government's oversight role has recently declined. The Federal Register page count may have dropped a bit early in the Reagan presidency, but Reagan has been out of office for more than 20 years! In terms of absolute numbers, according to Reisman, the Federal Register contained 73,000 pages at the end of 2007. If inadequate Federal oversight caused capitalism to spin out of control, what in the world would be sufficient oversight? Would 150,000 pages of regulations do it? A million?

Remember, too, that the Sarbanes-Oxley Act was signed into law in 2002, adding enormously to reporting requirements for publicly held companies. Since this law was written in response to year 2000 era corporate scandals it seems that we might do well to question the efficacy of new regulations. Finally, on the regulation issue, one would have to take a look at all the state and city level regulations that have likely been piling up higher and higher in recent decades.

Over and above these obvious market interventions is an even more important issue that mainstream economists never discuss. Money, arguably the most important commodity in the economy, is created and distributed by a government sponsored system that doesn't even resemble a free market. The Federal Reserve System ("Fed") was created by a government act in 1913, and given monopoly control over money. The Fed uses its powers to promote banking system profitability and to meet whatever political goals are dictated by the Federal Government. In particular, note that the Fed dropped short term interest rates rapidly starting in 2001 and left the rate at 1% for a year. Since interest rate and monetary changes powerfully impact incentives throughout an economy, this government intervention by itself invalidates the suggestion that we had a laissez faire economy. For more information about the Fed's market controlling powers and the government's motives for creating this institution, read this paper by Murray Rothbard: The Federal Reserve as a Cartelization Device .

If these points are not enough, also consider the many government institutions, tax laws, subsidies, and other interventions which were specifically designed to promote credit/and or to disrupt market forces in the housing industry. We have the FDIC which guarantees bank deposits. We have Fannie Mae, Freddie Mac, and the FHA which facilitate mortgage lending at below free market interest rates. We have had several programs designed to make mortgage loans available to people who would not qualify on the free market. We had the Bush administration pushing its "Ownership Society" program. Tax laws were adjusted over the years to heavily favor mortgage debt and capital gains through home ownership. All of these government actions were specifically designed to promote home ownership and mortgage availability.

So, here is a thought experiment. If the United States Government had deployed more bank regulators in 2002, what actions would they have taken? We have already seen that the Congress and the Executive branches of government were firmly on record as favoring more mortgage loans to less qualified people. Numerous government programs promoted below market interest rates for different home buying groups. Alan Greenspan even recommended that buyers take out variable rate mortgages to further reduce their house payments. In this environment, what would those extra bank regulators have done? Would they have countermanded the President, the Congress, and the Fed Chairman by requiring bankers to act prudently? Anyone who thinks so has probably never worked in a bureaucratic institution.

As I said in the beginning of this post, the idea that laissez faire thinking and inadequate regulation caused this crisis is preposterous. It is an idea not supported by the facts. It is completely and utterly wrong.

(Click this link for the next post in this series)

So, What Happened?

(This post is part of a series. If you want to read them in sequence, start here.)

Everything was going so well there for a while. There we were, Americans on top of the world, doing the high value work in technology and marketing, raking in the bucks. The Asians were doing our low margin manufacturing for us. "We think, they sweat," as so many pundits loved to claim. It was all a marvelous new paradigm in 2000. Until it wasn't.

But then our central bank Maestro, Alan Greenspan, got on the job. He dropped interest rates to 1% and left them there for a year. He flooded the economy with new money, and ... what do you know? Suddenly everybody was buying bigger homes, with better appliances and granite counter tops. It seemed like everybody had multiple LCD televisions, pools, and fancy cars. Here in Florida, I felt like I was in the slow lane, not having a McMansion with my own boat dock.

Even as the party began to slow down a bit, our government and monetary policy leaders kept telling us the banking industry was sound, that our economy was strong. In the early days of the crisis, our leaders steadfastly said that the subprime problem was "contained" and wouldn't cause the larger economy any difficulty. That wasn't very long ago, but now the news is suddenly full of bankruptcies, bailouts, store closings, collapsing sales reports, ... and hundreds of billions, even trillions, of dollars lost.

Are our governmental authorities still soothing our fears? Are they confident that the economy will soon be doing well again? Not at all! Now we see the spectre of the president, his Treasury Secretary, the Chairman of the Federal Reserve System, and assorted Congressmen warning us in shrill voices that an economic catastrophe may befall us if the government does not take extraordinary actions. Now the media is filled with news about the zero interest rate policy, corporate bailouts, nationalizations, and "stimulus" spending on a never before seen scale. How can problems of this magnitude take us by surprise? What has caused this sudden reversal of fate?

The official line from government officials, mainstream economists, and even a number of well known private enterprise gurus is that capitalism just failed us. They all admit that capitalism can deliver lots of goods and services efficiently, but they also believe that unregulated capitalism just periodically goes off its rails, so to speak.

The story they want us to buy is that laissez faire ideologues reduced government oversight of industry and banking to a dangerous degree, and that is why our capitalist system spun out of control. Economist Robert Shiller, for example, says it was A failure to control the animal spirits. All this may sound plausible, but after looking at our actual economic system and considering arguments presented by Austrian School economists, I am convinced that this official line is not only implausible but dead wrong.

To say that people were swept up into a mania is to state the obvious, and beg the question. WHY were people drawn into so many bad investments? Why were they willing to pay too much for risky securities? In short, how did so many home buyers, entrepreneurs, bankers, and Wall Street financial geniuses make so many bad decisions at the same time?

The Austrian School economists, most notably Ludwig von Mises and F.A. Hayek had the answers, and their brilliant explanations are available for any curious person to read and understand.

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Suddenly, Economics Mattered

It seems that nobody really cares about economics ... until it matters.

As a college undergraduate studying math and physics, I took three Economics Department courses to meet a social science requirement. As I recall, we used Paul Samuelson's textbooks without a supplemental reading list. What a pity; Paul Samuelson totally extinguished my interest in economics and I didn't think about this subject again for more than 30 years.

In 2000, however, economics was rather forcefully brought back to my attention. Like many people, I was stunned by the sudden reversal from technological euphoria to an environment dominated by crashing markets, failing corporations, fraud, fear, and seemingly unprecedented government activism. Just as troubling, the talking heads on television neither anticipated these events nor could they explain to my satisfaction what was happening. I needed answers.

My first new exposure to economics happened when an investment newsletter writer, I can't remember which, mentioned that he liked Ludwig von Mises' book Human Action. I bought a copy of the 900 page tome. It was hardly bedtime reading, but for me it was a page turner. For the first time I found economics presented as a marvelously coherent and meaningful science. Almost immediately, these stunning market and economic reversals became more understandable.

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