Krugman's interventionist crusade

The high priest of interventionist economics

From his perch at the New York Times, Professor Krugman has been dispensing economic and political advice for many years. Unfortunately, he is to economics somewhat similar as Ben ('you have to buy financials here') Stein is to investments, in short, he is potentially capable of doing a lot damage.

For this reason alone, his views must be challenged from time to time, even though we poor bloggers do certainly not have his reach. My fellow blogger and friend Mish has recently done so , in a blog entitled 'Krugman still wrong after all these years'.

He certainly is, and i want to take the opportunity to add a few complementary thoughts to Mish's ruminations on the topic.

First of all, i would recommend this paper(pdf) by Daniel Klein and Harika Bartlett, in which Krugman's editorials have been analyzed statistically and then interpreted by the authors.

The verdict is clear: Krugman is propounding a social-democratic ethos , even though he curiously never admits it outright.
On the contrary, he presents himself as somehow being 'above ideology', while at the same time managing to be one of the most vocal and well known advocates for statism and interventionist policies in the economics profession today.

As the paper notes, if one thoroughly looks at e.g. his concern for the poor, it turns out that this concern is trumped by his support for statist intervention – this is to say, when the choice is between a policy of liberalization that clearly helps the poor and a continuation of a regime of regulation harmful to their interests, he will always favor regulation (by simply remaining silent on the topic).

His record of favoring markets apparently consists of a single assertion in one of his editorials which he purports 'not to be against the market' – a statement that is then thoroughly contradicted in almost every paragraph of the hundreds of articles he has written.
He has come out in favor of liberalization in exactly two cases in his writings for the NYT from 1997 to 2008, which comprised 645 editorials as of January 2008.

Krugman's political ethos is also marked by the 'social compact' chimera – he strongly supports democracy, because the act of voting in his mind legitimizes state coercion.
After all, you have a choice, so this theory goes. If you're not happy with the status quo, vote against it.
We all know however that this is not how it works in reality. You can not opt out, or vote against the status quo, because that choice is simply not presented in elections.
In the US specifically, the two party system is akin to a one party system with only slight shades of difference in emphasis regarding the types of statist policies that are supported.
In this context read Albert Jay Nock's very interesting and entertaining essay 'What the American votes for', in which he explains why he decided to abstain from voting, respectively only voted for people that were already dead.

Criticism without basis

Occasionally, Krugman will criticize the Austrians (whom he doesn't name – he calls them the 'liquidationists' instead – presumably short hand for everyone who thinks the state should not intervene to stem the bust), who in turn frequently criticize right back.

Curiously, Krugman does his utmost to ignore the Austrian school's arguments – it is as if he is aware he's being criticized, and given that the views of the Austrian school are lately gaining a certain degree of credence with the public, finds it necessary to publish an occasional criticism, but at the same time is studiously avoiding to actually read what they have written.

In his recent article on what he calls the 'Hangover Theory' , which can by implication only refer to Austrian Business Cycle Theory (ABCT), he once again roundly ignores arguments that have been sent his way quite some time ago already.

This can only mean one of three things:
A) he doesn't grasp the arguments (unlikely), B) he didn't read any of them, nor any of the classical works (possible i guess) , or C) he has read them, but now makes as if they didn't exist, thereby misrepresenting them by omission.

As Robert Murphy shows here by means of a little economic anecdote, Krugman simply ignores the role of capital (a failing of Keynesianism in general), and its intertemporal structure.
Now, he has either read Murphy's piece or he hasn't, but he sure does ignore it completely. Most importantly he ignores the point that during the boom, resources will be misallocated, which in turn leads to consumption of capital.

I urge everyone to read Murphy's article, as it lucidly explains why the view of the economy as an agglomeration of 'aggregates' is wrong – and how in an artificial boom, misallocation of capital along the production structure leads to capital being consumed and falling into disrepair.
As Murphy correctly remarks, it is vital to understand this part of the ABCT if one wants to sensibly contribute to the debate. It is the process of capital consumption – respectively consumption of the pool of real funding, or put in other words, previously accumulated wealth - that creates the illusion of the boom.

The master builder

Ludwig von Mises had numerous little common sense quotes and anecdotes in which he tried to paint an easy to understand picture illustrating such concepts.
With regards to capital consumption, he referred to consumption without preceding production (which is a side effect of the fiat money system's 'money out of thin air' creation) as akin to 'burning the furniture to heat one's home.'

One can do that for a while, and the house will be nice and warm for some time, depending on the amount of furniture available to burn. One day though, one will perforce run out of heating material, and voila – the home will grow cold (as a metaphor for the inevitable bust resulting from capital consumption).

Another von Mises anecdote that illustrates scarcity and the importance of correct – i.e., market-based - information in guiding entrepreneurial decision making, is the one about the master builder.

Imagine the Pharao charges you with building him a palace. At the outset, you are informed how many pieces of wood, hows many bricks, nails, glass panes, shingles and other building materials will be at your disposal.
In short, you seemingly have perfect information about the resources available to you.

However, someone made a mistake – there are in fact 20% fewer bricks available than you were led to believe. Some of the crew discover the mistake, but given that building the palace means a good time for everyone – they all have jobs, they're building a nice palace, everybody, including the builder seems happy – they decide to keep you in the dark about it.

You will of course succeed in erecting the foundation, and perhaps in building up to say, the first floor.
However, the building you have planned on the basis of this incorrect information will forever remain unfinished – at some point, the bricks will run out prematurely.

It follows that the earlier in the process you learn of the error, the better the outcome will be.
If you learn of it while still drawing up your plans, you can plan anew, and only some of everybody's time will be lost. If you learn of it after having built the foundations, there may still be time to change plans for a somewhat smaller, but still doable palace. If you learn of it one day before the bricks actually run out, it will simply be too late – a monument to malinvestment will have been erected – an unfinished palace.

The resources that have been used up in erecting this unfinished building have been used up, and while everybody had a 'good time' (the boom) while doing that, they are now faced with the fact of an unsalvageable and uneconomic project standing before them.

Relevance to the economy at large

The problem presented by an artificial credit boom to the whole economy is akin to this master builder problem. In this case, the artificially low interest rate is what creates a fata morgana – i.e. a crucial piece of misinformation – that leads businessmen astray, namely the illusion that more savings are available than there really are.

It is the conceptual difference between money and real resources that trips up Krugman. He thinks if only someone – preferably, in his view, the state – were to spend money in the teeth of the bust, everything would be alright again. This ignores what has happened in the boom – scarce resources were misallocated due to false information on the true state of savings, and thus capital ended up being malinvested and consumed.

If we look at the policies enacted since the bust began, we see that they are all geared to keeping the disinformation that the boom was based on alive.

Once again, interest rates are being suppressed to an artificially low level. The state meanwhile is set to spend more money than at any time before in such a brief time span in peace time, on the idea that more spending is going to cure what too much spending has wrought.
However, the state can not add one iota to the pool of scarce economic resources that need to be optimally allocated if the economy is to recover.
We must always come back the the fact that the state does not have any economic resources of its own – it does not produce any. Instead, it must take them from those who do produce them.

Listening to Krugman, you'd think Austrians were a bunch of sourpusses begrudging everyone the good times of the boom, and then making things worse by being especially dour party-poopers with regards to the remedies thought to be necessary 'fix' the bust.
However, it is just realism and rigorous a priori reasoning that leads to their conclusions. Once the economy's pool of real funding has been damaged on account of an artificial credit boom, the priority must be to allow the production structure to readjust to reality, and that process, while painful, is also necessary.

The efforts of a coercive redistribution agency (the government) can not change that, and the printing of more fiat money can not either.
What the introduction of these factors does is to upset the market process.
They are deliberately used to induce booms (booms are politically popular until they go bust), in the hope that someone else will have to deal with the consequences (as is indeed the case; Bernanke gets to deal with Greenspan's legacy, and Obama with Bush's), and when those consequences inevitably arrive, they are used again in a futile attempt to keep those consequences at bay.

As long as the pool of real funding hasn't been damaged too excessively during a boom, a dose of monetary pumping can be expected to revive the illusionary boom – as has indeed happened several times in the past, most recently after the technology bubble flamed out.
The problem is that this only stores up even bigger problems for the future. We can all clearly see now that Greenspan's attempt to prevent the previous correction/bust from doing its work has led to an even bigger, more intractable bust in the present, but the interventionist caste still insists that we have to do the same thing all over again, only in larger dosage!

Once a boom turns to to bust, there are a number of facts that need to be faced:

1. there were not as many savings as thought, so capital was misallocated;
2. what the economy needs is as little interference as possible, since otherwise the danger is that even more capital will be misallocated.
3. the process of realigning the capital structure to reality is not painless, since it requires far fewer workers than are are needed when everything is humming.
4. the less interference there is, the faster it will be over.
5. to interfere means de facto to burden an already weakened economy even more – therefore, the more intervention, the less desirable the likely outcome (and it's not as if we didn't have any examples for that).

The pretence of knowledge

Lastly, look at how Krugman argues in favor of state intervention and spending to 'mitigate the bust'. His argument in favor of increased fiscal spending in Europe is summed up as follows:

dY/dD = (1-m)/[1 - (1-t)(1-m)c - t(1-m)]

Read the linked article for an explanation of the formula.

This is what Hayek referred to as the 'Pretence of Knowledge'.
Modern day economists seem to think that if it can't be put into a formula, then it can't be science. Economics is however a social science, not a natural one. It is about human beings, and the interactions of millions, nay billions, of human beings can not be pressed into neat little formulas.

This is not to say that one must completely abandon a formulaic approach to certain economic concepts (a graphic representation of a supply-demand curve surely has its place for instance), only that the 'ceteris paribus' type equilibrium which these formulas assume to be in place is not present in the real world.
The science of economics must proceed from sound a priori reasoning, otherwise it can not present the proper conclusions and provide policy recommendations.

It is this latter point that should worry us all. Krugman and other supporters of interventionist dogma are self-styled advisers to the political class, which in turn likes to hear nothing better than advice that prods it to intervene.
The courtier economists are thereby apt to doing a lot of damage, as mentioned in the opening paragraph.

Naturally, few economists would be prepared to admit that they actually don't know what to do. In this, the Austrian school is quite different. It essentially says: 'The entity that knows best what is to be done is the free market. Let it work'.
In other words, they have no 'policy recommendation' except - 'do nothing'.
When Ludwig von Mises was once asked what his first action would be if he were to be appointed 'minister of economics' he answered: 'Resign'.

It's not the type of advice one can easily make a living from. The interventionist courtier economist of Krugman's type on the other hand is asked to draw up plans, has the ear of the powers-that-be, gets to feel important , and gets paid nicely for his efforts.

Furthermore, as has been shown over and over again, the fact that intervention does not work is never seen as a reason to abandon it, but rather to come up with new, additional interventions purportedly designed to fix the unintended consequences of the old ones.
In this manner, the power of the state grows and grows – which is to the advantage of both the political class as well as its 'advisors' and everyone feeding at the state's trough (including many corporations; contrary to what one would think, most corporate entities are not in favor of a free market either – rather, they seek protection from competition in the form of anti-competitive regulations, respectively seek a slice of the tax payer pie that is doled out by the political class in its favors and vote buying activities).

What is to the advantage of the political class and its advisors and hangers-on is however as a rule to the disadvantage of everyone else.
If we want a sound economic policy, we must oppose Krugman's call for more intervention.

Hoover's heirs at work

A deepening global deflationary depression

No matter where one looks, the collapse in global economic activity and prices is astounding in its speed and ferocity.
A few examples, using manufacturing surveys, picked at random:

Between May and November, China's manufacturing PMI new orders index has crashed from 58,6 to 36,1.
The US manufacturing new orders index has meanwhile collapsed to a mere 27,9 – it stood at 54,3 as recently as July. The manufacturing PMI's prices component in the US has plunged from a 77 reading in August of this year to 25,5 in November, on the heels of the steepest decline in month-over-month headline inflation (deflation of 1% m-o-m) since the beginning of the CPI data series in 1947.
German new manufacturing orders have declined by 36,8% over just the past three months – with the most recent monthly contraction clocking in at an annualized pace of minus 48,2%.
In Japan, the PMI has declined to its lowest level on record – with the new orders index contracting to 27,3 from 44,1 a mere three months ago.

The litany of global woes is long, with emerging market economies on average in even worse shape than the industrialized nation economies, on account of their dependence on commodity exports, and incipient debt crises in response to collapsing currency values. The problem, as usual, is that too much debt was denominated in foreign currencies, which are now soaring against emerging market currencies.

Certain repeat default offenders like Argentina have seen credit default swap spreads on their sovereign debt soar to the stratosphere (5,000 basis points in Argentina's case – which is to say, it costs more than half of an Argentinian bond's face value to insure it against default for just one year).

One could list many more economic indicators that are indicative of a deepening and accelerating crisis, but the above selection gets the point as such across, so I'm not going to list all the data here. However, if readers are interested in all the horrid details, here are a few links where more information can be obtained: Haver Analytics and the Institute of Supply Management are both recommended sources of economic data and charts.

The extensive global division of labor, record global trade and capital flows , just-in-time inventory management and instant communication have seemingly conspired to instantly transmit an economic shock wave across the world. Note however that the difference to economic downturns of the past is only in the speed of transmission – the truly large busts have always gone global, only the lead and lag times may have been slightly different.

By now the fact that the yearly decline of the S&P 500 index has at one point in November been the worst ever seems rather normal, especially as the biggest part of the decline happened concurrently with the sharpest deterioration in economic activity (the stock market is not a leading indicator of anything – it has been a coincident and sometimes lagging economic indicator since at least 1998).

'Reflation' is a dud so far

Meanwhile the efforts of officialdom to 'reflate' are going absolutely nowhere. While the Federal Reserve has expanded base money at its fastest rate since the early 1930's, the broad money measure MZM (money of zero maturity) has remained static since March of 2008.
Merrill Lynch constructs a measure it calls 'money outside banks', by simply deducting base money from MZM - this is another way of illustrating that banks are taking all the 'free' money they get from the Fed and the treasury and have decided to simply hoard it.


Merrill Lynch's "money outside of banks" measure, deducting base money from MZM click on chart for larger image

This is not only due to the fact that bank lending standards have tightened considerably since the beginning of the year (as recent PMI surveys reveal, nearly half of the survey respondents reportedly had trouble obtaining financing) , but there is now also a dearth of willing and able borrowers - not counting desperate borrowers, many of whom fail to get credit precisely because of tighter credit standards.

A brief excursion into history – the monumental failures of the Hoover administration

The current situation is so far very much analogous to 1930-1932, years in which the Federal Reserve pumped up base money to an unheard of extent, increasing its balance sheet more than five-fold (!) over 36 months. It is important to keep this in mind , because the falsehood that the 1930's depression was so bad 'because the Fed failed to pump' keeps being widely accepted and bandied about. It is simply untrue.

In fact, one would do well to remember that when the 1930's depression started, absolutely no-one expected the downturn to turn into such a catastrophic economic wipe-out.
The general consensus was that:
1. the still relatively new-fangled Federal Reserve would be able to avert a deep economic downturn due to its 'flexible currency' and
2. that Hoover's new deal type policies would do the same. Hoovers 'new deal'? Yes, you read that right. All the policies that were later christened the 'New Deal' under the leftist FDR were initiated by the allegedly conservative Hoover.

Hoover was one of the first big believers in government interference in the economy who made it to the presidency. He was appointed secretary of commerce in the Republican Harding administration – Hoover had jumped to the Republican party from the Democrats in 1920, as he felt the Republicans would win.
He initially put himself forward as a presidential candidate , but failed in the primaries, and then half-heartedly endorsed Harding. Note in this context that both former navy secretary F.D. Roosevelt and W.W.1 president Woodrow Wilson actually had envisioned Hoover as a potential Democratic presidential candidate, but he jumped ship on account of his well-developed political instincts and an equally well-developed opportunism.

It seems likely that a combination of factors led to Hoover's appointment to the secretary of commerce post by president Harding in 1921 (a post which he kept under Coolidge).
On the one hand, the Republican party's left wing wanted to see him in a cabinet post, and for another, Harding had to reward him for his support.
Reportedly, Harding actually detested Hoover, who struck him as the very control freak he actually was.

The originally rather nondescript post of secretary of commerce soon became elevated by Hoover's numerous attempts to interfere in the economy. Hoover became known as 'the secretary of commerce and under-secretary of everything else' in Washington. Commerce appropriated responsibilities belonging to other cabinet departments when Hoover thought them 'neglected'.

However, the 'Hoover danger' was kept in check under Harding, who refused to bow to Hoover's demands during the 1921 recession. Harding was the last US president to endorse a 'laissez-faire' approach toward recession, a commendable attitude that had characterized policy under his 19th century predecessors as well.

Therefore, Hoover's proposal to initiate public works programs and keep wage rates artificially high was not followed in the 1921 recession, which helped keep the downturn mercifully brief. To be sure, the 1921 downturn was scary. The rest of Harding's cabinet however distrusted Hoover's ideas, and they turned out to be correct – the economy soon recovered of its own accord. Luckily Hoover did not get the chance to make things worse.

He did get the chance eight years later, when he began to preside over the first three years of the Great Depression. Similar to the often repeated falsehood of the Fed's 'passivity' in the face of the downturn, Hoover is nowadays often described as a paragon of free market policies , whose inaction was responsible for the giant economic bust. This is however merely statist propaganda designed to obscure the facts – spread by revisionist left-leaning historians.

Let's hear Hoover himself on the topic (from his memoirs):

“...the primary question at once arose as to whether the President and the Federal government should undertake to investigate and remedy the evils. . . . No President before had ever believed that there was a governmental responsibility in such cases. No matter what the urging on previous occasions, Presidents steadfastly had maintained that the Federal government was apart from such eruptions . . . therefore, we had to pioneer a new field.”

In April of 1930, as the stock market hit its post crash recovery highs, Hoover was generally hailed as having averted the depression. This was ascribed to his decisive actions in keeping wage rates high, initiating public work programs and farm supports.
He put pressure on the Federal Reserve to inflate, which initially met with some resistance from then governor of the board Roy Young. Young however relented, and later decided to resign in August of 1930. He was replaced by a more enthusiastic inflationist, Eugene Meyer.

In April of 1930, a round of back-patting by the interventionists, and glowingly optimistic forecasts of the imminent restoration of prosperity ensued – roughly similar to what we have seen in the months following the Bear Stearns rescue as it were, which was likewise marked by enthusiastic commentary in the press concerning the Federal Reserve's and the government's magical stimulus powers. See some of those comments here, here, here, here, and here.
Meyer really pushed the pedal to the metal, as the saying goes, and began to boost the Fed's securities holdings to an unprecedented extent, while slashing interest rates to 2% by the end of 1930.

By late 1930, the glow had however dimmed. Hoover, always a supporter of higher tariffs (one of his first actions as president was to hold a conference on tariffs – the conference was mainly concerned with how much to raise them in order to 'help' farmers), signed the Smoot-Hawley Tariff Act against the advice of almost every economist in the nation in mid 1930.
This piece of legislation abruptly aborted the brief stock market recovery – in a wave of panic selling, the market declined back to the 1929 crash low within a few weeks.
Nevertheless, Hoover felt the time for self-congratulation had come by October of 1930 (shortly before the stock market broke to even lower levels):

“I determined that it was my duty, even without precedent, to call upon the business of the country for coordinated and constructive action to resist the forces of disintegration. The business community, the bankers, labor, and the government have cooperated in wider spread measures of mitigation than have ever been attempted before. Our bankers and the reserve system have carried the country through the credit . . . storm without impairment. Our leading business concerns have sustained wages, have distributed employment, have expedited heavy construction. The Government has expanded public works, assisted in credit to agriculture, and has restricted immigration. These measures have maintained a higher degree of consumption than would otherwise have been the case. They have thus prevented a large measure of unemployment. . . . Our present experience in relief should form the basis of even more amplified plans in the future. “

Does this sound like a proponent of 'laissez-faire' to anyone? I didn't think so.

Hoover's method was to get big business to 'co-operate' with his plans, by threatening to make his plans compulsory via legislation. Also, there was a curious swing toward leftist policies in big business circles themselves in the early 30's. The natural enemies of central economic planning became curiously enamored of such socialist ideas (see the 'Swope plan' hatched by the then CEO of General Electric, which proposed a fascist cartelization of US industry, and was enthusiastically supported by the chamber of commerce).

1931 turned into a catastrophic year, with all indicators of economic activity plunging further. This spurred even more interventionism on both the administration's and the Federal Reserve's part.
Note that the money supply actually contracted in spite of the Federal Reserve studiously blowing up monetary reserves under its control.

There were several reasons for this. For one thing, the public – rightly – mistrusted the banking system, and began to withdraw deposits, converting them to cash. Cash in circulation accordingly actually rose significantly, but bank reserves not under the Fed's control declined still faster than the Fed could pump – as bankers themselves had ceased to trust each other (this sounds vaguely familiar, does it not?), and feared bank runs by depositors. Naturally the fractionally reserved banks all knew that none of them could withstand such a run, and so eyed each other with distrust.

Note in this context the following ominous recent chart:


Currency in circulation has suddenly begun to rise sharply from mid 2008 - the same happened in 1931-1932, as the public , increasingly wary of the banks, started to convert deposits into cash. click on chart for larger image

Furthermore, the banks saw no reason to extend new credit or buy securities. They rightly feared that such lending would expose them to more default risk, and they wanted to reassure rather than frighten their depositors. One of the decisive factors in this were the Fed's and the administration's attempts to prevent a liquidation of unsound credit by all means.
Needless to say, what the modern-day Federal Reserve is doing today amounts to exactly the same – by taking impaired mortgage securities off the banks books, it likewise prevents the liquidation of unsound credit. For reasons no-one has as of yet deigned to explain, this is somehow supposed to work better nowadays than it did in the 1930's.

Hoover forced the banks (with his usual 'co-operate or i'll legislate' threat) to agree to forming the NCC (National Credit Corporation), whose purpose it was to have the strong banks shore up the weak ones (sound familiar? It should).
The Banks contributed $500m. in capital, and the NCC could borrow up to $1bn. from the Federal Reserve (then enormous amounts).
He then hatched the plan to start a state-owned lending agency, the Reconstruction Finance Corporation (RFC), that was to lend to needy banks and businesses, and was intended to become the successor of the NCC. Hoover also leaned on mortgage lenders to delay foreclosures.

His late 1931 plans – to be enacted in 1932 – also included the formation of the Federal Home Loan Bank System, that would be able to discount mortgages and would be backstopped by the government and the Fed , and a vast expansion of the already vast public works program.

A note about the RFC: it was decided that it should be kept secret which organizations and banks received RFC loans , in order to 'avoid a weakening of public confidence' in such firms or banks (not surprisingly, the stench of corruption soon enveloped the RFC).
This is analogous to the Bernanke Fed refusing to disclose the precise nature of the mortgage assets it has bought from the banks – in spite of the fact that the tax payers are the involuntary owners of these assets, they are not to know what is being done with their money.

Interestingly, in 1931 the Fed provided large lines of credit to foreign governments as the crisis became acute in Europe as well (the UK and Germany were large recipients of such aid, and Austria and Hungary received somewhat smaller amounts)– shoring up their unsound credit positions as well ('unlimited swap lines' to foreign central banks anyone?).

As classical economists later argued, this contributed to growing mistrust in the dollar, and a consequent outflow of gold from the US. Since European governments, with Britain in the forefront, abandoned the gold exchange standard (not a true gold standard anymore), it was feared that the US may not be far behind. In late 1931, the Fed briefly hiked rates to reverse this outflow of gold, but this policy reversal didn't last long.
In the final quarter of 1931, the money stock collapsed by $4 billion in spite of the Federal Reserve leaning against the wind with large reserves increases, as cash in circulation exploded by $400 million – the public kept withdrawing deposits from the banks as confidence plummeted.

From early 1932 onward, the Fed continued with a massively inflationary policy, forcing interest rates down and expanding reserves under its control by large amounts. This further reduced the incentive for banks to actually lend out money – since the risks were high, they would have at the very least needed high interest rates to compensate for those risks, but the Fed created the exact opposite rate environment.
Furthermore, the Fed was still unable to prevent a fall in the money supply, although one would have normally expected its actions to lead to a large increase of same.

The banks and the public both kept the 'monetary transmission mechanism' perfectly broken. Cash in circulation continued to increase sharply, and reserves not under the Fed's control continued to fall faster than it could expand the ones it did control.
Hoover constantly railed against bankers' unwillingness to lend – specifically, he complained that his version of the TARP, the RFC (which eventually grew to 8 times its original size!), bolstered bank capital, but banks would still not inflate credit! Does this not also sound familiar? Barney Franks, actually most of Congress, is making exactly the same complaint these days.

It is worthy of note that under Hoover, government's share of the economy grew mightily, as Hoover produced the by far largest peace-time deficit the US had ever experienced up to that point (this is to say, not only in absolute but also relative terms compared to GDP). This alone should disarm anyone who pretends that Hoover favored a free market approach – not only did government revenue dwindle, but expenditures shot up in unprecedented fashion. In the 1932 presidential campaign none other than Franklin D. Roosevelt accused Hoover of being an 'unconscionable spendthrift'(!), while his running mate, John Garner accused Hoover of 'leading the country down the path of socialism'. They were of course correct, but it clearly was a case of the kettle calling the pot black.

Hoover's follies didn't end there.
Faced with a growing deficit, he unwisely concluded that the time for raising taxes had come. Obama-like, he thought it was a good idea to soak the rich, an idea FDR later enthusiastically expanded upon. Conservative, 'free market' Hoover raised the normal tax rate from a range of 1-5% to 4-8% and the top marginal tax rate from 25 to 63%. He also introduced a sales tax on a large number of products and services (including postal rates), raised the corporate tax rate by 1%, doubled the estate tax, restored the gift tax (at 33%) and eliminated a range of exemptions and tax credits.

Then he pushed the New York Stock Exchange into restricting short selling by February 1932 – a witch hunt was started in the form of a Senate investigation of the exchange and various 'sinister pools of bear raiders' who allegedly 'forced securities below their true value' (as Hoover himself put it).
Does this also sound familiar? It should. This is precisely the argument used by the SEC chairman Cox when he restricted short selling of financial stocks just prior to the October market crash.

Will it surprise you to learn that after Hoover had successfully bullied the exchange to outlaw short-selling that the DJIA suffered its biggest downturn of the entire 1929-1932 bear market?
The market declined by 65% from the enactment of the restriction to its eventual low in the summer of 1932. Maybe SEC chairman Cox should have taken a brief look at the effects of this historical short selling ban before engaging in the same folly.

Why Hoover's modern-day heirs will fail

The above historical information is largely sourced from Murray Rothbard's book 'America's Great Depression' , which I encourage everyone to read. It can be downloaded for free here(pdf).

The purpose of recounting the historical depression episode is to point out the many parallels that already exist between the interventions government enacted back then and those it is enacting now. Specifically, the artificial preservation of unsound credit and malinvested capital , coupled with grand plans to 'invest in infrastructure' (public works) and enact other types of 'stimulus spending' are eerily similar.

The things the Bernanke Fed and the treasury are doing are very similar to the things the Meyer-led Fed and the RFC engaged in – and it is encountering precisely the same problems. Banks are unwilling to lend, and borrowers are unwilling or unable to borrow, so a theoretically highly inflationary expansion of the money base and the Fed's balance sheet has so far failed to entice any broader inflationary effects.

Meanwhile the activities of the GSEs Fannie Mae and Freddie Mac under 'conservatorship' , whereby they have begun to once again expand their balance sheets in spite of the fact that this is obviously economically unsound (they keep producing record losses for one thing) and various government plans to prevent foreclosures and 'persuade' creditors to weaken their claims by threatening them with the requisite legislation, are likewise reminiscent of the same approaches during Hoover's administration.
Hoover's RFC is a close cousin to Paulson's TARP – it did essentially the same thing, namely provide government money to weak banks.

Obama meanwhile proposes to actually raise the minimum wage – which is reminiscent of Hoover's policy of preventing wage rates from falling in alignment with other prices. This policy practically guarantees rising unemployment.

The 1920's boom that led to the sharp increase in malinvestment that eventually produced the bust, was a boom during which 'stable prices' were a central Fed policy, just as they have been throughout the 1990's and the 2000's.
Thus, a large increase in economic productivity allowed the Fed to inflate the money supply willy-nilly, which prevented the fall in the general price level that would have occurred absent such inflation.

The policy of 'stable prices' was in reality a policy of inflation, and allowed the other effects of inflation, chiefly the amassing of malinvestments and the creation of artificial, non-wealth generating activities, to proliferate.
Furthermore, while the general price level appeared stable both in the 1920's boom under Benjamin Strong and the modern day boom mostly under Alan Greenspan , securities and real estate prices increased sharply, encouraging the credit boom further (whereby rising collateral values formed the basis for more credit creation).

Another feature of both booms was that consumer credit exploded, with consumers lulled into complacency by the seeming 'soundness' of their balance sheets.
The ensuing consumption boom is precisely what damaged the economy's production structure in both cases, by misleading business-men about sustainable levels of demand. The expansion in credit increasingly encouraged exchanges of 'something' (real resources and goods) for 'nothing' (money out of thin air, created by the Fed and the fractionally reserved banking system), depleting the pool of real funding while the respective booms proceeded.

One thing that is different today is that the Fed has become even more 'flexible', its currency even more 'elastic'.
Hoover never intended to abandon the gold standard – this was a step too far even for him.
The modern-day Fed has no such restraints to worry about. Note in this context that what we have heard from the horse's mouth – Bernanke himself – regarding possible Fed actions to 'combat deflation' is absolutely hair-raising stuff. Over half of these suggestions have already been implemented (the following quotes are from his famous speech “Deflation: Making Sure "It" Doesn't Happen Here” :

“The Fed must expand the scale of its asset purchases or, possibly, expand
the menu of assets that it buys.”
“The Fed could find other ways of injecting money into the system–for
example, by making low-interest-rate loans to banks.” He notes the Fed
could “offer fixed-term loans to banks at low or zero interest, with a wide
range of private assets (including, among others, corporate bonds,
commercial paper, bank loans, and mortgages) deemed eligible as
collateral.”
“The government could…acquire existing real or financial assets.”
“If the Treasury issued debt to purchase private assets and the Fed then
purchased an equal amount of Treasury debt with newly created money, the
whole operation would be the economic equivalent of direct open-market
operations in private assets.”
“Lowering rates further out along the Treasury term structure” either by
“holding the overnight rate at zero for some specified period” or by using a
“more direct method, which I [Bernanke] personally prefer” would be to
announce “explicit ceilings for yields on longer-maturity Treasury debt.”

In other words, the Fed must inflate at all costs, precisely when the economy needs the opposite. Naturally it makes no sense whatsoever to attempt to keep malinvested capital in place and create additional malinvestments on top of it.
There is a natural limitation to all the governmental efforts to 'reflate' in the form of the economy's subsistence fund. Its size is finite, and it has been weakened by the previous large credit expansion. Remember that 'money out of thin air' allows people and businesses to bid for resources and goods without first producing any resources themselves. This by necessity must weaken those sectors of the economy that actually produce wealth, since they have to compete for these resources.

Furthermore, what the government is doing is to merely redistribute existing resources when it enacts 'economic stimulus' packages and 'public works' programs. It is irrelevant how worthy some bureaucrat with incomplete information deems a certain infrastructure spending project to be – the fact remains that the resources employed in this state-directed spending must be removed from where they are employed prior to such state-directed spending.

The government has three possibilities to raise funds to engage in its spending: it can tax, it can borrow, and/or it can print money.

The former two amount to a straightforward redirection of existing resources from a market-based allocation process to a government-directed one. The only way this could possibly be beneficial would be if we actually believed that government directed resource allocation process is to be preferred over the market-directed one, because it has been proven beyond the shadow of doubt that government bureaucrats are better at this than the market.
If one believes that, it would be time to cast a quick glance toward North Korea to see what happens when government is the only agency engaged in resource allocation (It is no coincidence that a complete takeover of the economy by government is only possible in conjunction with a terrible tyranny).

The third possibility, namely a policy of inflation, i.e. of printing money out of thin air (Bernanke's department), can obviously only lead to more of the same that has actually brought us to this juncture: a misallocation of resources and consumption of scarce capital as the pool of real funding sustains further damage.
It is to be expected that the policy of inflation, which is now being openly pursued (the Fed admits that its mooted, $800bn. purchase of MBS and ABS, which has begun last week, will 'add to bank reserve assets' - in other words it amounts to outright monetization, euphemistically known as 'quantitative easing'), will continue to flounder for a good while as capital-impaired banks refuse to lend money in view of the heightened risks of doing so.

At the same time, the massive 'guarantees' (such guarantees are only worth something as long as not too many people call on their fulfillment at once) provided by the FDIC have made the prospect of bank runs a fairly remote one, so an important check on banker recklessness does effectively not exist, or is severely weakened.

In addition, it can already be gleaned from Bernanke's comments that a much greater monetization effort (of 'private assets' which the treasury buys via the Fed monetizing treasury debt) would eventually ensue should the current efforts continue to fail in igniting 're'-inflation.

So the possibility that wider inflationary effects eventually become visible in the data (via growth in broader money supply measures re-accelerating) can not be ruled out. While the traditional modus operandi, whereby the Fed 'transmits' its monetary pumping via the commercial banks lending and creating new deposits, that then are re-lent, ad infinitum (the famous 'money multiplier') may continue to fail just as it has in the 1930's, the non-traditional methods may well meet with 'success' (if you define success as doing more damage to the economy's production structure, that is). This largely depends on the central bank's determination.

Wealth can of course not be increased by one iota through such efforts – if and when more money units circulate, the existing money units become worth less, and the many negative consequences of an inflationary policy manifest themselves.

The economic bust, and the – current - deflationary manifestations of this bust, are necessary to liquidate and redirect malinvested capital. Keeping such malinvested capital on artificial life support leads as we have seen to nothing but unintended consequences. This is why the massive interventions already implemented and those yet to come are doomed to fail and actually are a very good reason to remain pessimistic about the future.
Contrary to what Bernanke claims, it is not the sudden frugality of consumers that has 'created the recession' - it is the damage done to the economy's production structure that is at fault, and this has been a consequence of previous policies that furthered too much (unbacked) consumption.

It makes no sense for government to try to avert the liquidation of unsound credit positions. This will only prolong the misery, as banks continue to have every reason in the world to distrust both each other as well as the economy's capacity to right itself.

Finally, the fall in prices that has recently occurred, is actually a small reason for hope, as Lew Rockwell points out here. There is no good reason to try to prevent it , as is claimed by the government.

We are not 'all dead in the long run'

1. The long run becomes the here and now

In response to the classical and Austrian critique of his advocacy of state intervention in the economy, J.M. Keynes once uttered the following 'witticism':
'In the long run we are all dead'.
The criticism was that government intervention , while possibly capable of alleviating the short term pain of economic downturns for a while, was apt to store up ever bigger problems for the long term.
The government could 'paper over' economic crises up to a point by attempting to resurrect an inflationary boom with interest rate cuts and deficit spending, but this would distort the economy's production structure further, until at some point in the future, an economic bust of exceedingly great magnitude would inevitably ensue.
In short, payment for foolish economic policies could not be delayed forever; the damage done by government's tinkering with the economy would eventually be revealed.

Today, we seem to have arrived at the point where the heretofore mythical 'long run' has suddenly transmogrified into the all too real 'here and now'.

Our once vaunted banking system is on the brink of insolvency, and economic activity has begun to contract at a speed and ferocity that has not been experienced in at least 28 years, threatening to get even worse. That episode of 28 years ago, mind you, was coupled with a deliberate and extreme tightening of central bank policy intended to rein in run-away inflation. This stands in stark contrast to the current 'zero bound' monetary policy along with both the biggest Fed balance sheet expansion and the speediest expansion in base money ever.

J.M. Keynes is indeed dead; we, alas, are still alive - reaping what he helped sow.

2. Deceptive stability

Central planning of interest rates combined with the occasional fiscal bail-out or stimulus scheme has for some time now been believed to have brought about the elusive goal of 'economic stability'.
Who does not remember the gushing over the 'Maestro' Alan Greenspan and his 'when in doubt, cut interest rates' policy, once dubbed the 'Greenspan put' by stock market traders?
In reality, Greenspan lent a helping hand to the creation of the biggest credit bubble in history , all the while lulled into dangerous complacency by the seeming 'absence of inflation' (this is to say: the absence of sharply rising prices for goods and services – asset prices 'inflated' willy-nilly of course).

It got little notice at the time, but sometime in the mid 1990's, the fractionally reserved banking system got a big additional shot in its happy-go-lucky inflationary credit expansion arm, when the Federal Reserve decided to tolerate so-called 'sweeps', whereby banks would sweep monies from demand deposits into 'zero interest bearing CDs' overnight, letting demand deposits masquerade as savings deposits. Since savings deposits require far lower reserves than demand deposits, such reserves were then freed up to inflate credit further.
Not coincidentally, it was around this time that broad money supply measures began to go parabolic, along with the ratio of total credit market debt to GDP (or the ratio of total credit market debt to any other yardstick one was inclined to compare it to, from personal income to corporate profits to, you name it).


Money of zero maturity, a broad money supply measure. click on chart for larger image.

For many years, a falling savings rate and a concurrent sharp rise in consumption-related debt was rationalized away by mainstream economists. Absurd increases in first share prices and then house prices were considered to represent 'an increase of wealth' , which had magically replaced the need to actually save.
There was no need to worry about the growing mountain of debt, they would say; after all, you only needed to look at the other side of the consumer's balance sheet, where all that 'wealth' had piled up, as if houses and stocks had been watered with 'super-gro'.

Here and there a party-pooper would ask, yes, but what if these elevated prices were to fall one day?
Such objections were routinely shouted down : Can't happen! It has never happened! House prices always go up! And so do share prices, in the long run.
They do? But.....aren't we supposed to be 'all dead in the long run'?

All of a sudden, this seeming 'permanent plateau of prosperity' and growing phantom wealth has given way to one of to the greatest bouts of economic instability in living memory, and – oops! – house prices are falling, and so are share prices – with over $30 trillion in stock market capitalization having disappeared globally.
The balance sheet looks all bent out of shape now, as the debts remain big as ever and are going sour at a rapid clip, taking down lenders and borrowers alike.


3. Keynesian policies come natural to politicians

It is only natural that politicians have eagerly adopted Keynes, and that consequently, the entire establishment has eventually sanctioned his theories to the exclusion of nearly all contrary ideas.
To become a member in the 'pantheon of establishment-approved economic theorizing' you have at the very least to be a Keynesian-in-drag, as in for instance, the form of a supply-sider (the moment you raise the slightest doubts about the need for central planning of money and interest rates, you instantly become an irredeemable pariah in the economics profession).

Note that Keynes did not come up with any radical new ideas – he basically adopted and adapted the ideas of German socialists, who had long before him advocated massive state involvement in the economy. His main achievement was to give governments around the world a philosophical/pseudo-scientific fig leaf for pursuing exactly the policies they always wanted to pursue.

The political life-cycle is partly to blame . If one's main job is to get as many votes as possible in the next election, one can hardly be expected to worry about the long term impact of one's economic policies – especially given the fact that due to the lag times involved , few people actually realize how cause and effect are related in economics.
Furthermore, the contingent of the citizenry interested in growing the power of the state grows along with the state – and if one thing is absolutely certain, it is that a true 'laissez-faire', free market oriented policy is not conducive to the growth of the state.

Nowadays there seems to be a growing consensus that Greenspan's attempt to inflate away the last big bust is partly responsible for our current dilemma.
And yet, what is being done to 'fight' the current bust? Don't look now, but they're doing exactly the same thing again ,only bigger.
This, in a word, is insanity.

Naturally, one had to be truly comatose not to realize that Greenspan's 1% Fed Funds rate helped to ignite the mortgage credit bubble and the associated bubble in real estate prices, so it's not as if this represents a great revelation – what is interesting is only that it is being discussed in the media at all.

The most recent glimmer of hope on that front came from an unexpected source – the chancellor of Germany, Angela Merkel.

To the aghast invocations of imminent doom from interventionists around the world were she not to recant immediately, or even better, retroactively, she recently defended Germany's decision to refrain from joining the global 'stimulus package' orgy whole hog thusly:

“Excessively cheap money in the US was a driver of today’s crisis,” she told the German parliament. “I am deeply concerned about whether we are now reinforcing this trend through measures being adopted in the US and elsewhere and whether we could find ourselves in five years facing the exact same crisis.”

One can imagine the reaction of the menagerie of bail-out clowns – what? Five years? That, in terms of the political life cycle, is the 'long run' in which we're allegedly all dead. It is definitely further away than the nearest election. Such a daring look beyond one's own nose is considered impolitic.

(it must be noted though as an aside that Mrs. Merkel is very reticent to lower taxes, as demanded by Mr. Seehofer, leader of the CSU, a party allied with her CDU; just to make sure there's no misunderstanding: I'm not a big fan of Mrs. Merkel – i merely note that it is a hopeful sign that an establishment figure of her stature speaks out critically on the money pumping issue. It may have to do with Germany's socio-economic memory – the inflation of the Weimar regime and all that flowed from it is embedded in the German psyche as a deeply negative experience).

4. What to do, and what to hope for

As an individual who understands the current situation one can only watch with growing dismay and desperation as governments the world over are practically falling over each other trying to repeat Japan's mistakes of the 1990's, and Hoover's and FDR's mistakes of the 1930's. It's almost as if there were some sort of competition on about who can implement the most insane and costliest 'solutions' from the interventionist cook-book in the fastest and most grandiose manner.

There is little to no chance that governments will suddenly get free market religion, short of a collapse so total that they are wiped out in a collective global bankruptcy. Mind you, we should not necessarily wish for that, for a number of reasons (more on that will follow in a future blog).

Current events have a certain deterministic quality – more intervention is certainly on its way , and so is its long term result, economic depression – one can only try to prepare for it on a personal level, on the general principle that one should hope for the best and prepare for the worst.
Do not count on government promises to bail you out when push comes to shove – unless you're a Wall Street banker, chances are your role will be that of a cow to be milked. A paymaster who has no say in the proceedings (since there is no-one you can vote for who is not in principle aboard with the interventionist schemes).

So what can we hope for? It's a fairly distant hope, mind you, but it's always possible that Keynesian interventionism ends up discredited in the public's eye, on account of its assured failure.
One should not let an opportunity pass to discredit it. In economic matters, the press is unfortunately positively infested with statism, and that includes most of the so-called 'conservative' press.

In fact, i have been quite dismayed when at a recent hedge fund conference in Vienna a bunch of professional investors likewise loudly proclaimed their economic ignorance by demanding more government intervention!
A professor of economics who somehow had found his way to the conference was found singing from the same hymn sheet; one thing he said is worth mentioning:
The authorities, he averred, must engage in just the right amount of monetary and fiscal pumping, i.e. not too little, but also not too much , to keep all sorts of unintended consequences from rearing their head.

Full stop. Let's point out what should be obvious:

They always have this problem, and it is exactly the same problem that the Soviet Union's GOSPLAN agency had when it tried to determine how many nails, screws or hammers it should produce - a central planner can never know what the 'just right amount' should be – this is precisely why we're in the trouble we're in now!

The only possible solution to the crisis is not intervention, it is also not more, or faster, or 'better' intervention – it is to do nothing.
Let the market fix itself.

5. Judge them by their results

Yesterday, Bern Bernanke held a speech at the Austin chamber of commerce, that received some attention as he basically announced that the Fed was about to go down the 'quantitative easing' path in earnest.
A J.P. Morgan economist, Michael Feroli, promptly christened him 'Bernanke-san' in a research note.
From the Bloomberg article on the speech:
"„One option is for the Fed to buy “longer-term Treasury or agency securities on the open market in substantial quantities,” Bernanke said. “This approach might influence the yields on these securities, thus helping to spur aggregate demand.”"

Why would anyone want to 'spur aggregate demand?' Oops, i forgot – our monetary crank-in-chief is a dyed-in-the-wool Keynesian. He actually believes there's something wrong with demand all of a sudden. It's, don't you know, an 'animal spirits' induced calamity that has befallen consumers. The very people who normally are insatiable, are now mysteriously 'demand deficient'.

The economic model on which this notion is based has absolutely nothing to do with reality - it assumes that goods for consumption can somehow be plucked from a tree, if only they are 'demanded'.
Just drop some cheap fiat money in someone's lap (if necessary, from a Friedmanite helicopter, so that that someone goes to Circuit Ci..,err, Best Buy, where he then demands his third plasma screen , even if he doesn't need one. Presto, demand deficiency problem solved, the economy is healthy again!

Good grief. It might work if we could get something for nothing, but alas, not otherwise.

The markets greeted the Bernanke announcement thusly: the already severely dislocated government bond market (which recently has made a parabolic move in the wake of the Fed announcing that it would buy up $800bn. in MBS and ABS) continued to blow off – and the S&P index , for want of a better word, crashed by 8,9%, with financials in the index getting crushed by 17% - their biggest one day decline ever.

Bernanke, the alleged expert on the Great Depression (all the books worth reading about that time have apparently managed to escape his attention), presumably knows what government bond yields did in that period; or what they did during Japan's slo-mo depression of the past 20 years.

Did it help? Was 'aggregate demand spurred'?

In the q&a after the speech the depression actually was talked about. Bernanke sotto voce announced his firm belief in the conceit that has befallen just about everyone: namely that policy makers would 'of course not repeat the mistakes that were made then'.

This is what contemporaries have always believed of the interventionist institutions of their day whenever a bust started to unfold. In 1873, the powers of the treasury secretary – who surely had a plan – were believed to be capable of averting the calamity – a 20 year long depression promptly ensued.
In 1929, the Fed was firmly believed to be able to avert the downturn - after all, this institution with its 'flexible currency' built on sound scientific principles could not possibly fail at the task.
Well, they believe it again. You could say, Bernanke actually believes his own bullsh*t.

Not only is he already repeating all the mistakes made back then, he has already made new ones on top of them, and is set to make even more. The difference is only in the details, not in the substance. He is doing what the Fed did in the 1930's, only on a much grander scale. Why anyone would expect a different outcome will remain a mystery for now, but you can be sure that there will be no shortage of excuses.

Let us briefly look at the result of the interventions to date. After $8,5 trillion in bail-outs and bail-out pledges , we have:

the biggest one year decline in the stock market in all of history; the biggest decline in real estate prices since the great depression; a complete collapse of the structured finance market; an economic contraction that is so fast and deep that it promises to make the history books as one of the worst on record.
(we are showered with scary economic numbers from all over the globe daily, but just to name one example illustrating how big the catastrophe already is: the Baltic Dry index that measures international shipping rates has suffered a 95% plunge from its highs).

This is what we've got so far, for a $8,5 trillion price tag. Not exactly a satisfactory result you say? You bet.

Due to the ad-hoc manner in which the interventions to date have been implemented (whereby the Fed and treasury seem to be constantly trying to outrun a widely feared implosion of the otc derivatives markets), a great deal of uncertainty has been imparted to the markets. Of the 'what will they think of next'? type. The whole process lacks both predictability and credibility, as Linda Rowley notes in an excellent article here.

A final note: the downturn is the end result of the previous boom. The biggest credit and malinvestment boom ever, as one must keep stressing. There is no way of averting or avoiding the bust. It has to happen. It may be painful, but underneath the pain, the economy is actually healing and repairing itself. It makes no sense to intervene, as every attempt to avert the bust will only delay this healing process.
Anyone with an ounce of common sense should be able to see that an artificial lowering of interest rates in order to 'spur demand' and 'spur lending' can not be the proper cure for an economy groaning under the weight of an imploding credit bubble, where many are already up to their eyeballs in too much debt.

Given the fact that the bust can not be averted, our societal goal should be to see to it that it passes as quickly as possible, without fresh malinvestments being added atop the old ones.
This can only be achieved if government keeps its hands off the economy. Bernanke's idea to suppress interest rates across the yield curve is completely useless voodoo-economics trash, to put it politely.
It has all been tried before and it has never, ever helped, and never will.


Voodoo economist Bernanke


...and 'We're all dead in the long run' Keynes, the man whose prescriptions governments keep following religiously, in spite of incontrovertible evidence that they have always failed. They don't work in practice, because they don't work in theory either.