The 'year of the financial flame-out' …

… as Bob Prechter has christened 2008, so far proves to be somewhat depressing for supporters of the free market. Not only do we read that sales of Karl Marx' tedious tome 'Das Kapital' are lately taking off, we have also been witness to the depressing spectacle of Krugonomics being found worthy of a Nobel Prize (as an aside, we have no problem with Krugman being a 'Bush critic').

 

The latest event is a huge government summit dedicated to combating the financial crisis – a get-together of statists of all stripes, who, as a German newscast averred, 'want to put the financial system in chains' (this was uttered in an approving tone). So what are the ideas of these worthies? They want to 'stimulate demand and increase regulation', and -surprise – they 'agree that the IMF should play a critical role' in resolving the crisis.

In other words, doomed-to-failure Keynesian policy prescriptions combined with charging a bureaucracy that many had hoped was finally dying of its own accord with overseeing the unfolding debacle are seen as the panacea that will save us. Oh well. To be sure, there's a silver lining here and there. For instance, th e sudden popularity of Marx may not get anywhere. "There's a younger generation of academics tackling hard questions and looking to Marx for answers," Mr Schuetrumpf said. But he doubted their perseverance: "I doubt they will read it all the way to the end, because it's real ly arduous."

Well, thank God Marx is boring as hell; it's still astonishing that anyone, let along an 'academic' would look to Marx for answers. It has been almost 20 years since the murderous communistic system failed, but surely people do remember that this was inter alia the biggest bankruptcy of all time? Also, it seems that Krugman's Nobel prize 'can quiet some critics, but not all'. Phew. Unfortunately this isn't sufficient grounds for optimism; the press all over the world has miscast the crisis and beginning economic bust as a 'failure of capitalism and free market ideology', an idea eagerly embraced by politicians across the ideological spectrum (proving once and for all that support for the free market was never much more than lip service), who of course love nothing more than expanding the power of the state.

The battle cry of the day is 'we need more regulations'. Consider for a moment here that the EU bureaucracy had already produced almost 100,000 pages of regulations by the end of 2002 (i couldn't find an up-to-date count), a body of law governing commerce so complicated and convoluted that both compliance and enforcement seem nigh impossible. Between 1997 and 2005 alone, 12,000 new laws were introduced. Businesses across the EU have seen an entire additional bureaucratic jungle added to the one they already battled with in their home countries.

No wonder Europe isn't exactly known for vigorous economic growth – entrepreneurs are suffocating in red tape to an unprecedented extent (note that many of the regulations produce situations that can only be described as utter madness).

While the US can still point to a somewhat less regulated marketplace, make no mistake, economic freedom has been on the retreat for decades there as well. The most recent boom-bust cycle of course can be squarely attributed to government intervention in the markets, via a Federal Reserve that left interest rates too low for too long, and the government sponsored enterprises which with their access to cheap credit (on account of the formerly implicit, now explicit, government guarantee) were the major engines behind the housing bubble. So the people who now charge that the crisis is a 'failure of the free market ideology' should perhaps first show where exactly that free market was allegedly operating.

The above mentioned pow-wow of various heads-of-state has studiously neglected to confront the real reason for the crisis: namely the boom that preceded it. How come there was such an unsustainable boom? Did it drop from the sky unbidden? Not one of the things that should have been discussed have even been mentioned in passing – central banks and their credit and money inflation, too high and onerous taxation, enormous fiscal deficits, the disastrous over-regulation of commerce, trade barriers. Instead the talk centered on – more regulation. No genuine reform can be expected from these dunderheads; instead they're – unwittingly – paving the way for a depression.

In his 1969 essay 'Economic depressions: their cause and cure', Murray Rothbard recounts Ludwig von Mises' view on the subject:

"Mises, then, pinpoints the blame for the cycle on inflationary bank credit expansion propelled by the intervention of government and its central bank. What does Mises say should be done, say by government, once the depression arrives? What is the governmental role in the cure of depression? In the first place, government must cease inflating as soon as possible. It is true that this will, inevitably, bring the inflationary boom abruptly to an end, and commence the inevitable recession or depression. But the longer the government waits for this, the worse the necessary readjustments will have to be.

The sooner the depression-readjustment is gotten over with, the better. This means, also, that the government must never try to prop up unsound business situations; it must never bail out or lend money to business firms in trouble. Doing this will simply prolong the agony and convert a sharp and quick depression phase into a lingering and chronic disease. The government must never try to prop up wage rates or prices of producers' goods; doing so will prolong and delay indefinitely the completion of the depression-adjustment process; it will cause indefinite and prolonged depression and mass unemployment in the vital capital goods industries.

The government must not try to inflate again, in order to get out of the depression. For even if this reinflation succeeds, it will only sow greater trouble later on. The government must do nothing to encourage consumption, and it must not increase its own expenditures, for this will further increase the social consumption / investment ratio. In fact, cutting the government budget will improve the ratio. What the economy needs is not more consumption spending but more saving, in order to validate some of the excessive investments of the boom.

Thus, what the government should do, according to the Misesian analysis of the depression, is absolutely nothing. It should, from the point of view of economic health and ending the depression as quickly as possible, maintain a strict hands off, "laissez-faire" policy. Anything it does will delay and obstruct the adjustment process of the market; the less it does, the more rapidly will the market adjustment process do its work, and sound economic recovery ensue.

The Misesian prescription is thus the exact opposite of the Keynesian: It is for the government to keep absolute hands off the economy and to confine itself to stopping its own inflation and to cutting its own budget.

It has today been completely forgotten, even among economists, that the Misesian explanation and analysis of the depression gained great headway precisely during the Great Depression of the 1930s — the very depression that is always held up to advocates of the free market economy as the greatest single and catastrophic failure of laissez-faire capitalism. It was no such thing. 1929 was made inevitable by the vast bank credit expansion throughout the Western world during the 1920s: A policy deliberately adopted by the Western governments, and most importantly by the Federal Reserve System in the United States.

It was made possible by the failure of the Western world to return to a genuine gold standard after World War I, and thus allowing more room for inflationary policies by government. Everyone now thinks of President Coolidge as a believer in laissez-faire and an unhampered market economy; he was not, and tragically, nowhere less so than in the field of money and credit. Unfortunately, the sins and errors of the Coolidge intervention were laid to the door of a non-existent free market economy.

If Coolidge made 1929 inevitable, it was President Hoover who prolonged and deepened the depression, transforming it from a typically sharp but swiftly-disappearing depression into a lingering and near-fatal malady, a malady "cured" only by the holocaust of World War II. Hoover, not Franklin Roosevelt, was the founder of the policy of the "New Deal": essentially the massive use of the State to do exactly what Misesian theory would most warn against — to prop up wage rates above their free-market levels, prop up prices, inflate credit, and lend money to shaky business positions.

Roosevelt only advanced, to a greater degree, what Hoover had pioneered. The result for the first time in American history, was a nearly perpetual depression and nearly permanent mass unemployment. The Coolidge crisis had become the unprecedentedly prolonged Hoover-Roosevelt depression."

The parallels between what happened in the boom-bust cycle of the 1920s and 1930s and the events of today are eerie. Once again a huge credit inflation has turned inevitably into a giant bust, and once again governments are trying to avert the bust by inflating even more, by massively raising their deficits, by propping up failed enterprises, and suffocating an already over-regulated marketplace with even more regulations.

Rest assured that as the bust progresses, their interventions will continue to grow in scope and extent, in a desparate attempt to keep a system alive that is doomed to failure a priori.

The biggest mistake made in post WW2 economic history was to cut all links of the currency system with the vestiges of the gold standard – this removed the only remaining check on the expansion of government debt and the associated expansion of money and credit more generally. It is also seldom discussed that the Federal Reserve removed another important brake of unchecked credit expansion in the mid 90's by allowing banks to use the 'sweep' method to lower their reserve requirements.

Since term savings deposits have much lower reserve requirements than demand deposits, banks 'sweep' the unused funds in demand deposits into non-interest bearing CDs, temporarily transforming them into savings deposits. Ever since this became the norm, the banking system has been de facto insolvent (which is to say, it could not possibly survive a run on deposits).

Governments are now injecting huge amounts of money into the banking system, but are faced with the fact that the credit intermediation process has broken down. Neither are banks willing to lend, not are potential borrowers very eager to borrow. Instead, banks are hoarding this money, as they expect even more writedowns to hit what is left of their capital in coming months. This is of course a reasonable expectation, as the corporate default rate has only just begun to tick up, and consumer credit defaults, including mortgage defaults, are likely to continue to climb.

As Frank Shostak explains in his essay 'Good and Bad Credit', it is really the state of the pool of real funding that determines if monetary pumping can seemingly 'work'. Money created out of thin air merely dilutes the money already in circulation, it can not create one iota of wealth or real resources. As long as the pool of real funding (explanation of the term can be found here) is still expanding, monetary pumping will divert resources into economic activities that are not really self-funding and create no wealth – an illusory boom ensues (with the recent housing boom representing a pertinent example).

It is important to realize that the pool of real funding is put under pressure by such an artificial credit-induced boom. In other words, there comes a point in time when the pool of real funding is exhausted, and begins to stagnate or shrink – namely once one boom too many has diverted so many resources and led to capital consumption on such a great scale that the 'point of no return' has been reached. While the subsistence fund is not directly measurable, we can guess when it has begun to stagnate or shrink by observing what happens when the central bank lowers rates and begins with monetary pumping.

If there is no effect (most immediately the effect should be visible in financial markets, which tend to discount the future), i.e. the boom fails to be reignited, then we have reached this point.

In short, it will not matter how much money out of thin air is thrown at the banks when real resources are not available in an amount sufficient to allow for the resurrection of bubble-like activities. This brings us back to what Rothbard wrote: once one is in this situation, it is necessary for the structure of production to be realigned with the new reality, and consumed capital needs to be rebuilt. A bust becomes inevitable – with the consolation being that the bust is the economy's method of achieving these objectives, i.e. it is the economy's way of healing itself, and laying the foundations for renewed growth.

Obviously, any government interference with this process can ipso facto only be harmful. If one thinks things through, it becomes clear that contrary to widespread misconceptions, government does not possess a tree on which resources and capital grow, and it has not bunkered any of these things in a warehouse somewhere either. It can only take resources from someone else and shift them around. It perforce must take them from those sectors of the economy that still produce wealth (the bankrupt entities it tries to bail out are obviously consumers of wealth), in other words, this centrally planned shifting around of resources will weaken those sectors of the economy that are still healthy.

It does not matter in this context whether government crowds out private sector borrowers by borrowing the money used in these wealth transfers or whether it acquires the money by taxation – the effect is the same.

There is of course a third option, which will no doubt play an increasingly important role going forward – government can, vía the central bank, simply print money up. This will be limited by the so-called 'bond vigilantes' putting in an appearance at some point, but in the meantime, is apt to do untold economic harm.

The Federal Reserve has in recent weeks roughly doubled the size of its balance sheet, and the growth of high-powered 'base money' over this period stands at a roughly 130% annualized rate. Students of economic history take note: from 1929 to 1932, the annualized growth of base money was 98% and free bank reserves were increased by over 400%. This will come as a surprise to those that have heard the false claim (which for reasons unknown gets repeated over and over again) that the 'Fed failed to pump enough money into the economy in the early 1930s'. The Fed did in fact do what it is doing now – it slashed interest rates to the bone, and pumped furiously. Only, it did not help, as the pool of real funding had suffered too much damage in the 1920's credit boom.

Today, we find ourselves at a very similar juncture – just as leftist propaganda held in the 1930s that 'the free market had failed', prompting massive government intervention that turned a sharp recession into a depression, so we are today at a point where the same propaganda claim is being made, and governments once again respond by intervening in the market at an unprecedented scale. To expect a different outcome, is, to paraphrase Einstein, 'the very definition of insanity'.

 


 

 


 

 

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