October 31, 2012

To Cure The Economic Hangover, Make Good Choices

By: Chuck Grimmett

The United States is in a mess right now. John Allison, retired chairman and CEO of BB&T bank and current president of the Cato Institute, provides an insider’s take on the causes, effects, and possible cures of our current recession in his new book, The Financial Crisis and the Free Market Cure: Why Pure Capitalism is the World Economy’s Only Hope.

Allison points to a “massive misinvestment in residential real estate” as the recession’s primary cause and lead the reader through the typically unseen consequences of this misinvestment in a way that would have made Bastiat proud. By treating housing as investment instead of consumption, Allison says, millions of workers learned the wrong skills, too many and too large houses were built, retail centers popped up that now cannot be supported, and no money is left over for new manufacturing plants. This massive reallocation of resources was fueled by a long series of government actions which provided incentives for a switch from investment to consumption. The main culprits, according to Allison’s analysis? The Fed, FDIC, Fannie Mae and Freddie Mac, and the SEC, and the policies they created.

Using history, economics, finance, philosophy, and politics, the new President of the Cato Institute spends the next 14 chapters skillfully explaining the role each of these government-made institutions had in creating and exacerbating the current-day disaster. His treatment of these complex issues is straightforward and eminently readable. His writing is lucid (rare in a scholarly treatment of these sort of issues) and each section is approachable. Don’t be worried if you aren’t a policy wonk or a political junkie–Allison explains everything he references, provides a brief but descriptive background on the policies he attacks, and employs useful analogies to make his points.

Next, Allison gives his opinion of what could have been done to prevent this current mess: Let insolvent firms fail. Full stop. A precedent should have been set in 1979 by letting Chrysler fail. Banks should not have been bailed out, stimulus packages should have never been dreamt of, and GM should not have been taken over.

That is all water under the bridge now. Those things would have needed to happen long ago in order to avoid this mess. So, what can we do to fix it? This is where I think Allison provides a unique perspective from having been inside the banking system for so many years. The first and most immediate change Allison suggests is to close the Fed. Or, at the very least, “make the dollar convertible in a fixed exchange rate to a quantity of gold.” He does point out that an entirely private banking system is the best solution (I refer you to the free-banking literature by Larry White), but a gold standard is probably more politically feasible at this time. Even a fixed inflation rate of 3% (like Milton Friedman advocated) is a better solution than the Fed’s constant short-term manipulation of the money supply. Next, banks need to be required to have more capital on hand and their Federal Deposit Insurance slashed so lending risk is shifted from taxpayers to the banks themselves. This is the only way they will learn discipline. The additional capital requirement seems to go against his later arguments for drastically reduced legislation, and I suspect a number of the free-banking advocates would take issue with this.

(It is worth noting, however, that banks currently have an incentive to be risky with their investments and keep less capital on hand, because they know they will be saved by the public purse. In a free-banking system, banks would be able to try different levels of capital reserves and it is likely, at least in my opinion, that the optimal rate would settle somewhere much higher than most banks currently hold.)

Allison goes on to argue that a number of regulations and regulatory organizations should be either eliminated or privatized. Fannie Mae, Freddie Mac, and the Federal Housing Authority top the list, and he works through the consequences of getting rid of them. This is to say, instead simply offering libertarian dogma, he has thoughtful reasons for why he holds that position with respect to  these particular institutions. In short, those who think we need many regulations fail to recognize that government bureaucrats are often motivated by destructive incentives, as public choice theory tells us. The only criticism I have here is that I wish he would have named more instead of merely saying, “90 percent of the regulatory burden.” Though, that would have turned the 254 page book into a 2054 page book, so I understand why they were left out.

If you find yourself asking, “How about some government reforms?” not to worry.  Allison covers those, too, again with explanations. If you are already in the free-market camp, you won’t be surprised by the list: Slash government spending, reducing regulation of business, lower tax rates at all levels, reforming Social Security, Medicare, and Medicaid, remove barriers to trade, and drastically relax immigration restrictions. If you are on the fence about free-markets, this section provides excellent arguments as to why we must restore true discipline to our political system.

Unfortunately, even with these changes, the next five years will be a period of slow growth and unemployment above the natural rate as the country recovers from its spending hangover. This is necessary for our economic recovery, and further bailouts and monetary manipulations will only make things worse. (Have you ever had another drink to “help” with your hangover? Hint: Don’t.)

If we are going to make long-term change in this country, Allison says, we also need a change in our philosophical outlook. Instead of redistribution, we need a full-scale defense of individual rights, and people have to live up to the high ethical standards necessary to support this. If the country does not stop going down its current path, the country could be broke in 20-25 years, and we will have a much bigger disaster than we currently face.

Rather than end on this bleak note, Allison ends his book with a rallying cry to principled action that leaves the reader hopeful for the future.

If you are looking for an excellent economic, financial, historical, and philosophical treatment of our current financial crisis, pick up this book. It won’t disappoint.

Chuck Grimmett is the Director of Web Media at the Foundation for Economic Education (http://www.FEE.org). Follow him on Twitter: @cagrimmett

Image courtesy of Big Stock Photo.

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