February 18, 2009

Bailout Blues

By: AFF Editors

Barack Obama entered office backed by solid public support, the euphoria of his supporters, and even the heartfelt good wishes of many conservatives. But the economic catastrophe his administration faces may turn out to be more than even the putative savior of the world economy can handle: a deepening recession, mounting unemployment, an ongoing bank crisis, and the wipeout of trillions of dollars of stock market and real estate wealth.

The administration’s response is, to be sure, commensurate with these apocalyptic times. Obama has just successfully shepherded through Congress a gargantuan, $787 billion stimulus package of spending and tax cuts, in addition to the ongoing $700 billion bank bailout passed under Bush. The administration is even set to [widen](http://www.bloomberg.com/apps/news?pid=20601087&sid=aEdkX5L_LLno&refer=home) the scope of the bailout by putting more pressure on banks to lend and directing funds towards preventing home foreclosures. But banks remain reluctant to extend new credit despite the access to bailout funds and the Federal Reserve’s massive injections of funds into the system. Significant additional bailout money is likely, and the [nationalization of banks](http://www.nytimes.com/2009/01/26/business/economy/26banks.html?_r=2&pagewanted=2) is emerging as a real possibility. Meanwhile, the media [frets]( http://www.nytimes.com/2009/01/12/opinion/12krugman.html?_r=2) that the stimulus package might even contain too little spending. Note that this is being said of a plan for which descriptors like “largest ever” don’t seem to capture the enormity of it all. How did we get to this point?

We are told that capitalism is inherently unstable, that its inevitable crises must be met with interventionist countermeasures, and that new regulation will prevent future shocks. Many also blame greedy financiers, who irresponsibly concocted exotic derivatives that no one fully understood, and which were traded in ill- or un-regulated markets. The emerging anti-market consensus was crystallized last year by Slate’s Jacob Weisberg, who has proclaimed libertarianism to be [discredited](http://www.slate.com/id/2202489/) by the financial meltdown, now and forever.

In short, a consensus has emerged that the crisis was caused by an excess of capitalism, abetted by bubble-era irrationality, from which only vigorous government action can save us: public works spending, aggressive monetary stimulus, a willingness to bail out distressed industries, re-regulation, and goodness knows what else.

Where is the response of the supposedly free-market side of the ideological divide? David Brooks [bemoans](http://www.nytimes.com/2009/01/16/opinion/16brooks.html) the irrationality of markets and pegs blame for the financial mess on a cascade of psychological factors, which cannot possibly be grasped using tools of “classical economics.” In another column, he [embraces](http://www.nytimes.com/2009/01/30/opinion/30brooks.html) stimulus as a solution while criticizing the Obama plan’s unfocused character. National Review, meanwhile, expresses skepticism at the effectiveness of any stimulus, but has hardly taken a consistently hard line against government intervention. In fact, in one blog post, Rich Lowry criticized congressional Republicans who opposed the massive TARP bailout as [“extremely irresponsible.”](http://corner.nationalreview.com/post/?q=OWQ4OWEwYzE4NmFlNjI5MjM3ODJiY2FiMGRlYTEyOWU=) Are there any voices left who can raise a compelling defense of free-market capitalism?

Enter the dogmatically free-market Austrian school of economics, and the Austrian theory of the business cycle, which holds real explanatory power over the current mess and convincingly places blame for financial panics and recessions firmly at the feet of government intervention.

According to the Austrians’ theory (despite their name, which dates back to the early twentieth century, today’s “Austrians” are mostly found in the United States), boom-and-bust cycles are, at root, not the consequence of rampaging greed, psychological mania, or insufficient regulation, but are the inevitable consequence of an excess of bank credit, which is the result of Federal Reserve policy.

The primary means of Fed expansion of the money supply is through buying government bonds on the open market. When it buys these bonds, the Fed pays for them by adding credit under its member banks’ accounts. These credits are created out of thin air; they are newly created money. It is through these “open market operations” that the Fed controls interest rates. Member banks, in turn, are only required by law to keep a small fraction of their deposits in reserve, and are free to lend out the rest, which multiplies the effects of the Fed’s purchases.

Interest rates are critical signals that tell businesses how much saving is available for investment in capital projects. When savings rates are low, the resulting high interest rates signal consumers’ preference for present over future consumption. Conversely, when savings rates are high, the resulting low interest rates show a preference of future consumption and a pool of savings available for investment. The low rates might then prompt business to invest in new projects, such as a new factory, subdivision, or online pet supply store. This is how the price of credit is set by the free market, resulting in the “natural” interest rate.

But when the Fed creates artificially cheap credit, businesses are misled into believing that riskier projects with more distant prospects of paying off will be profitable. A cluster of such projects will lead to a classic boom period, such as the dot-com bubble of the late 1990s. Cheap credit also leads to asset bubbles, such as the dot-com era stock market and the housing market in latter years. The distortions in the economy are exacerbated when consumers, believing themselves to be wealthier than they really are, decrease their savings and increase consumption.

Of course, there are also psychological aspects of the bubble economy that feed into the general irrationality, but this is more accurately seen as a follow-on effect of easy-money policies rather than as the cause of the bubbles.

The Fed can keep feeding the boom with continued low rates, but this only creates further mal-investments, and will deepen the inevitable crash when the irrationality of the boom-era projects becomes evident. When the party ends, bank credit contracts, unprofitable projects are liquidated, and economic resources shift to productive uses. Recessions, then, are a painful but necessary stage in the economy’s return to health.

The loose credit policies of the Greenspan years have led to consequences that fit in well with the Austrian view. During Alan Greenspan’s reign as chairman of the Fed, he maintained a loose monetary policy punctuated with [generous](http://en.wikipedia.org/wiki/Greenspan_put) injections of extra cash in times of crisis, such as the Asian financial crisis of 1997 and the collapse of the hedge fund [Long Term Capital Management](http://en.wikipedia.org/wiki/Long-Term_Capital_Management). This easy credit fed into the excesses of the dot-com era, which led directly to a stock market crash and recession in 2001.

Federal Reserve policy was also instrumental in inflating the housing bubble and creating the current recession. As the economist [Mark Thornton](http://mises.org/journals/scholar/Thornton13.pdf) points out, Alan Greenspan pushed interest rates down to unprecedented levels in the wake of the 9/11 attacks, which resulted in historically low mortgage rates. The fallout of the dot-com collapse led to massive losses, but the recession was mild, as the Fed’s easy money pumped up a real estate bubble just as the NASDAQ bubble unwound. The low rates led to increased borrowing for homes on a massive scale. House prices soared, but when reality eventually reasserted itself, they fell sharply, a process which culminated in last fall’s financial crisis.

Freddie Mac and Fannie Mae, which bought mortgages and resold them as securities under an implicit government guarantee, certainly abetted the housing bubble, as did the Community Reinvestment Act, which pressured banks into increased lending to disadvantaged groups at the cost of loosened lending standards. Perhaps these mechanisms helped to funnel cheap credit into the housing sector which would otherwise have created mal-investment elsewhere in the economy. But blame for the industry-wide decline in lending standards cannot be placed solely with the CRA: Lax credit standards are virtually inevitable when a massive amount of cheap money is looking for something to do.

Bolstering the Austrians’ credibility is the fact that Austrian school economists such as Mark Thornton, Frank Shostak, and Christopher Meyer warned of the housing bubble relatively early on in the process (in 2003-04). Likewise, Ludwig von Mises, the originator of Austrian business cycle theory, and his student F. A. Hayek warned of a coming depression during the boom years of the 1920s. Unfortunately, the parallels between the Great Depression and today’s troubles do not end there.

The Great Depression is often trotted out as an example of the failure of unfettered markets and the need for governmental regulation of the economy, and the same argument is being rehashed regarding today’s crisis. But like our housing bubble, the boom years of the 1920s were fueled with inflationary monetary policy. And just as in the 1920s, the current downturn is being exacerbated by misguided policy designed to alleviate the crisis.

The severity of recessions is determined by the heights reached in the boom period, but in the absence of government intervention, the adjustment process is relatively quick, and the economy can soon return to growth. As the economist Murray Rothbard taught, a serious recession in 1920–21 was met with a generally laissez-faire government response, the economy quickly returned to health, and it is now a historical footnote. The same can be said of the various panics and depressions of the 19th century.

But after the inflation-fueled boom of the 1920s, Herbert Hoover’s response to the 1929 stock market crash was aggressively interventionist from the start, as is documented exhaustively in Rothbard’s book [America’s Great Depression](http://mises.org/rothbard/agd/contents.asp). Hoover has been painted by historians as sitting impotently on the sidelines amid the deepening crisis, but in fact, the exact opposite is true: He had an expansive understanding of the role of government during a crisis, and he quickly set about to take aggressive action to rescue the economy.

What he actually did, though, was to take measures that seem expressly designed to thwart recovery by interfering with the economy’s ability to reallocate its resources to serve productive ends. Moreover, some of Hoover’s interventions in the wake of the 1929 crash show ominous parallels with policies being enacted to deal with the current crisis. Hoover initiated a program that kept failing businesses, including banks, afloat through emergency loans. Sickly banks on life support were pressured to expand lending despite a shortage of savings and viable projects. Measures were taken to save mortgaged property from foreclosure. Massive public works projects such as the Hoover Dam were initiated while large companies were pressured to retain staff at above-market wages. Such employment-boosting measures only served to divert capital and labor that could have been used productively by private industry into wealth-destroying make-work projects. Repeated bailouts of industry, moreover, forestalled the market’s correction process by propping up failed companies, rewarding poor decision-making, and keeping additional resources tied up unproductively.

Such measures were expanded upon by Franklin D. Roosevelt’s New Deal, and the depression predictably ground on. Like Obama, and despite the vaunted “brain trust” of policy intellectuals serving in his administration, Roosevelt entered office without any coherent economic philosophy, and experimentally created a hodgepodge of interventions in an effort to gain some kind of traction on the economy.

In recent years academics have come to acknowledge the ineffectiveness of New Deal programs, but have largely failed to come to terms with the New Deal’s role in extending and deepening the downturn. Saying that government intervention was ineffective in bringing the economy out of the Depression is like saying that despite repeated blows to the head, the patient failed to regain consciousness: It’s true enough, but evades the problem of causality.

Can we expect to see repeats of Roosevelt’s more nonsensically counterproductive measures, such as the slaughter of 6 million pigs and the plowing under of 10 million acres of crops amid widespread hunger, undertaken as an attempt to support agricultural prices? We can indeed, if a proposal of a Wall Street Journal editorialist for the government to bulldoze “[surplus](http://online.wsj.com/article/SB120709588093381941.html?mod=todays_columnists)” homes is heeded. Expect renewed calls for the mindless destruction of wealth as the economy continues to sink.

In his inaugural speech, Barack Obama proclaimed that government should be judged by “whether it works.” Just so, and we should take this advice as we consider the likely effects of the stimulus bill and continuing bank bailouts. During the 1930s, Franklin Roosevelt, who enjoyed high popularity despite his dragging the nation through endless and miserable depression, somehow managed to escape being held to such a standard. Will today’s conservatives be able to hold our president accountable?

The tools to rescue the economy from recession are contained within the economy’s own self-corrective mechanisms, if only those in government could muster the discipline to refrain from intervening. Can conservatives articulate the case for an end to bailouts, destructive “stimulus” spending, counterproductive meddling, and the Fed’s incessant monetary pumping?

With Barack Obama’s soaring popularity, his solid Democratic majorities in Congress, and an atmosphere of crisis the passage of some sort of stimulus plan was probably inevitable. But the solid framework for understanding the economic crisis provided by the Austrian theory of the business cycle would provide a vastly improved intellectual grounding for a principled opposition than the inchoate, confused, and inconsistent defense of the free market we get from Republicans in the media and Congress.

Austrian economics, despite its focus on the free market as the only way to a stable and prosperous economy, enjoys scant popularity among establishment Republicans and movement conservatives. Part of the reason for this, perhaps, is its association with some antiwar “paleocons” and the insurgent presidential candidacy of Ron Paul. Moreover, spending, inflation and bailouts will always tempt those with access to the levers of power, regardless of party. But conservatives would be wise to resist the impulse towards intellectual tribalism and relearn the lessons of the Austrian school. With the tenets of true free-market economics, the causes of the economic crisis are brought into focus, as is the path to recovery.

-Mark Nugent is an attorney and Web designer living in Arlington, Virginia. He blogs at [spinline.net/blog](http://spinline.net/blog).