Meltdown a Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse by Thomas E Woods Jr

Meltdown A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse by Thomas E Woods Jr.

As author of the New York Times bestseller The Politically Incorrect Guide to American History, you would expect Thomas E Woods to be controversial and his latest book to be a thought-provokingly good read. As Senior Fellow of the free-market, laissez-faire Ludwig von Mises Institute in Alabama, he is a natural candidate to go hard-knuckle against the grain of those who preach intervention as a solution to the 2008-9 global recession.

Readers of Meltdown — at least those who know him — will be neither surprised nor disappointed at his challenging stance against bailouts, interest rate manipulation and just about every other weapon deployed so far in the battle to right the economy.

His basic argument: Why should government intervene in this crisis when it's the very act of intervention that has brought the US — and thus the world — to its knees?

His solution: Stop the bailouts, let banks and other firms go bust, get rid of the meddlesome Federal Reserve System, and let the free market sort things out.

And if we don't do what he recommends, he warns that the recession will both be deeper and take longer to resolve than it would otherwise.

"There is nothing the government or the Federal Reserve can do to improve the situation," he says, "and a great deal they can do to prolong it."

As Woods would be the first to admit, though his ideas may seem revolutionary, there's nothing new about them. They stem from the early 20th century economic theories of what became known as the Austrian School, of which Ludwig Von Mises (and later, the influential economist F A Hayek) was a key proponent.

A basic tenet of the Austrian School, as summarized by the author, is that government tinkering with the supply of money and credit starts the economy on an unsustainable boom that has to end in a bust. That's where we are now.

Applying this, the "Austrians" saw the Great Depression (and its lesser-known but still painful precursor several years earlier) coming. What is more, says Woods, they foresaw the current economic disaster, but no one took any notice of their warnings.

It's time, he says, that people started getting to know the Austrian school, so they can understand just how wildly we are heading off in the wrong direction — and hopefully do something about it in time to avoid more pain.

The Seeds of Destruction

The author does not dispute the role of the housing market collapse in bringing about the recession but he vehemently disagrees with many on how this came about. He identifies six "culprits":

1. Fannie Mae and Freddie Mac (the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation, respectively). These two government sponsored enterprises (GSEs) don't provide mortgages but buy loans from banks. In doing so, they free banks to lend yet more money, while often bundling their own holdings into mortgage-backed securities they sell to investors.

Becoming involved in politically-instigated moves to lower lending requirements to help "disadvantaged" groups, and with an implicit bailout guarantee from the US Treasury, the two organizations built up ever-riskier debt obligations.

2. The Community Reinvestment Act (CRA) and affirmative action in lending. This is a Carter-era law that opened banks up to crushing discrimination suits if they did not lend to minorities in numbers high enough to satisfy the authorities.

Naturally, the banks did what government regulators wanted. More importantly, "the same cavalier approach to risk assessment that informed the CRA pervaded the whole mortgage lending arena, thanks to other agencies that pushed the same destructive, loose-lending strategy on all American financial institutions."

3. The government's artificial stimulus to speculation. The push for easier mortgage access for low- and middle-income borrowers spilled over into the lending standards applied to higher income borrowers as well. Easier mortgages were available for everyone, including speculators, and when foreclosures began they occurred in both subprime and prime loans, not exclusively subprime, as has been supposed.

"Foreclosures came about not because of subprime mortgages but because of adjustable-rate mortgages — the ones Alan Greenspan had once urged people to use," Woods says.

4. The "pro-ownership" tax code. Renters and people who own their homes outright don't get to write off their housing costs, but mortgage borrowers do. And the more they borrow, the more they can write off. In some places, like Washington DC, there are additional tax credits for home buyers.

"This is not to suggest that any of these tax breaks are undesirable ..." the author argues. "Instead, they should be extended to as many other kinds of purchases as possible, in order not to provide artificial stimulus to any one sector of the economy."

5. The Federal Reserve and artificially cheap credit. Woods describes the Fed as "the institution whose fingerprints are all over the current mess." The organization started the housing boom, he declares, by increasing the money supply, thereby pushing down interest rates.

"This new money and credit overwhelmingly found its way into the housing market, where artificially lax lending standards made excessive home purchases and speculation in homes seem to many Americans like good financial moves," he notes.

The frenzy was exacerbated by repeated Fed denials that the housing boom was a bubble.

6. The "too Big to Fail" mentality. Some players in the financial and manufacturing markets were able to operate in the knowledge that they would not be allowed to fail and that, one way or another, the American public would absorb their losses.

Inevitably, Woods argues, this reassurance influenced the way they behaved. For a start, they were more inclined to take risks, knowing that they would be considered too big to be allowed to go under if their strategies failed.

Letting a few major firms go bankrupt would "do more to jolt the financial sector into being sensible and cautious instead of reckless and irresponsible than all the regulatory tinkering in the world."

Bailouts Under the Microscope

Looking more closely at the build-up to the bailout fiasco, the author recalls the optimistic statements about the health of the economy made in 2008 by then Treasury Secretary Henry Paulson and Fed chairman Ben Bernanke.

"You would think that anyone who fed the public such lines through the first eight months of 2008 would have lost all credibility — and probably his job," Woods remarks. "But not only did Bernanke and Paulson retain their positions as the stock market melted down in September, but these men, who were proven so wrong in their assessment of the situation, also demanded unprecedented new powers to fix it."

Americans were told all kinds of horror stories about what would happen if Congress did not agree to the urgently demanded bailouts — decimation of retirement plans, the collapse of housing prices, the inability of businesses to be able to make payroll, and so on.

But the bailouts didn't seem to save the economy at all, he suggests, and the fears were actually fulfilled regardless. The stock market continued to plunge, and in the ensuing weeks and months, the ongoing bailout mania struck an increasingly skeptical American public as little more than a giant black hole for

money and resources.

"By the end of the year, everyone, from insurance companies to automakers, was lining up for a share of the loot," he adds. "The profit-and-loss system ... was beginning to mean guaranteed profits for business and losses for taxpayers and wage earners."

The consequences were insidious. The handouts to the big three automakers sent the message that although mismanagement at an average size firm would be punished with losses, gross mismanagement on a gigantic scale would be rewarded with credit and funds purloined from innocent third parties.

"People who are good stewards of wealth are thereby forced to subsidize people who are disastrously poor stewards of wealth," the author declares.

When the bill comes due, the wealth-producing sector of the economy will be that much poorer and all the production and investment that those funds might have brought about will be lost forever in exchange for propping up firms that deserved to go bankrupt.

Whatever the government chooses to do, Woods concludes, the result will be to divert resources away from wealth producers, dry up healthy economic activity and reduce the pool of resources from the private economy to use towards recovery.

Government Intervention and the Boom-Bust Cycle

Woods now puts the theories of the Austrian School in the spotlight, recalling that F A Hayek won the Nobel Prize for Economics in 1974 for his explanation of the boom-bust cycle.

Hayek's ideas are based on the work of von Mises who held that central banks are the root cause of the cycle because they manipulate interest rates, putting them out of sync with what is really happening in the economy and what the free market would dictate.

Woods delivers a simple lesson: Interest is the price people pay or the income they earn for borrowing or lending/saving money respectively. These two sides of the equation influence each other on the basis of the laws of supply and demand. When the supply of money from savers rises, the cost of it — aka interest rates — falls. If the supply falls because people are saving less, the price — interest rates again — rises. This is the free market at work.

The neatness of this equation is that if consumers are saving more, they are obviously spending and consuming less. With interest rates being low and consumption thus trimmed back, firms use the opportunity to borrow at low cost to invest in long term projects that will meet future, increased consumption.

But when the central bank — in the American case, the Federal Reserve — increases the supply (in order to lower interest rates), it is not using savers' money. Rather, it seems to create money from nothing — by printing dollar bills or creating balances — and firms are misled into borrowing to invest. However, the author argues, if rates have been artificially lowered, the necessary resources have not actually been saved by the public and some projects won't get completed.

This would be like a house builder thinking he has 20% more bricks than he really has and setting out to build a home that is too big. The economy is like the housebuilder. Forcing interest rates lower than the free market would have set them makes economic players act as if more saved resources exist than actually do. The housing boom is a classic example, directing enormous resources into construction.

"But the economy is on a sugar high," says Woods, "and reality inevitably sets in. Some of these investments will prove to be unsustainable and will have to be abandoned, with the resources devoted to them having been partially or complete squandered."

So, artificially low interest rates provoke a boom that is not based on increased wealth. When the bust follows, the author argues, the government or central bank seeks to reinflate it with exactly the same mechanism, in effect prolonging the downturn. This, he says, is evident in the Japanese economy where more than a decade of enforced low interest rates have failed to refloat that country's economy.

Nor do other interventions, such as a public works, stimulate recovery. Instead, they deprive the private sector of resources, divert them towards firms that may actually not be in good health and need to be liquidated, and they artificially drive up interest rates if the projects are funded by government borrowing.

As an illustration of the failure of these mechanisms, Woods cites the case of the Great Depression, which he claims has been widely misunderstood or misreported by historians and the media. For instance, contrary to popular opinion President Hoover was not a free-marketeer but, in fact, the architect of the Depression through a policy of "unprecedented intervention." And the subsequent interventionist and public works actions of Roosevelt did not bring about a recovery. Only time and market forces did that.

"In short, the Hoover-Roosevelt program refused to allow the economy's bubble to deflate. It tried to prop up unsound business positions. It diverted capital from a private sector starved of real savings into uneconomic public works projects that contributed nothing to long-term economic adjustment," Woods claims.

"It interfered with the free movement of prices and wages, thereby obstructing the economy's attempt to reallocate resources according to genuine consumer preferences and to re-establish a sustainable level of prices."

The parallel between the Great Depression and the current crisis is not seen as exact but near enough to provide lessons for today. In both cases, an inflationary credit boom brought about by the Fed's lowering of interest rates, led to a massive resource misallocation and a distorted capital structure.

In both cases, too, the Fed tried to inflate the previous booms back into existence then grew frustrated when banks refused to lend out the new money it was pumping in. And in both cases, the federal government tried to prop up prices instead of allowing them to fall to a level that made sense in light of economic conditions and people's valuations of goods and assets.

"If we want a repeat of those (Great Depression) years or if we want a share of the fate of Japan of the past 18 years we should implement exactly the same policies that gave the world these two disasters," the author declares.

Monetary Policy as Culprit

The Federal Reserve's principal weapon in manipulating interest rates is increased money supply, which causes rates to fall. And since the initial recipients, chiefly banks and other lending institutions, are only required to hold a small proportion of the funds they receive in reserve, they are able to leverage this additional money 10-fold. They can't print notes of course, but they can create loans backed just by the fractional reserves they are obliged to maintain.

For example, if the Fed wants to increase the money supply, it buys, say $1 billion in bonds from a bond dealer by effectively writing a check on itself. This $1 billion didn't exist beforehand; the Fed created it. Since banks are only required to maintain a 10% reserve, the receiving bank in this case can now lend out $10 billion, which also didn't exist beforehand.

Of course, in reality, there is no new money. Wealth cannot be created in this way and the consequence of seeming to create it out of thin air is a decline in its value — inflation, as we know it. We may seem to have more money but it actually buys less and we are no better off.

This was not so in the days when commodities — precious metals, mainly gold — were the currency or when banknotes where effectively receipts redeemable on demand for gold. Gold cannot be produced to order, thus inhibiting the central bank's ability to increase the money supply, force down interest rates and cause inflation. Not surprisingly, the author argues, governments prefer a system in which paper money cannot be redeemed into anything.

The author favors a return to a commodity (gold) backed money supply but acknowledges there are so many unfounded criticisms of the system — the bulk of the metals, the cost of such a system, and a perceived lack of flexibility — that the possibility is not likely to get on the agenda any time soon.

So, why do we have a Federal Reserve at all? This gets to the nub of the author's

criticisms. The popular but naïve view is that when the public cried out for banking reform in the early 20th century, their public spirited representatives, eager to pursue the common good, devised wise and appropriate legislation that brought the organization into being.

Nothing in that scenario is true, says Woods. The Federal Reserve Act of 1913 was special interest legislation masquerading as a public spirited measure. It was created by bankers for bankers.

"The truth of the matter," he adds, "that bankers themselves drafted the Federal Reserve Act in a private meeting almost sounds too cookie and bizarre to be taken seriously."

A Recipe for Salvation

The US doesn't have to be bogged down by recession for years, if the free market is allowed to transition the country out of the current mess. It is already trying to adjust prices downward, the author points out, and what could be wrong with that? Won't lower real estate values, achieved through free-market mechanisms, achieve precisely the desired effect of putting home ownership within reach of more potential buyers?

And if banks choose not to extend credit in risky directions that they might previously have pursued or if badly run firms go out of business (as painful as that might be in the short term), are these not also for long-term good?

It is time, too, to kill off the idea that stimulating consumer spending is the way out of recession. The net effect of a tax policy that raises taxes on wealthier Americans while lowering them for the less wealthy will almost certainly be to encourage spending at the expense of saving (which, remember, drives investment without inflation).

Behind every government stimulus effort is the belief that consumer spending drives the economy, the author notes. Whenever a recession hits, we are urged to rush out and empty our wallets.

"But what is supposed to happen next, when, the following day, Americans have no more money to spend?" he asks. "That's left unexplained."

Austrian business cycle theory suggests the last thing we should do in a recession is to stimulate consumption. After all, it was over-consumption that caused the downturn in the first place.

The fact is that we can't consume unless we first produce — that is, not only to produce the things we need, but also to employ us in the production process so we earn the wherewithal to consume. Thus it is increased production that will stimulate recovery — but only after the shakeout of inefficient companies.

So, here, according to Woods, is what needs to be done:

 Let firms go bankrupt and pass on their assets and capital equipment to those who can use them effectively. Do not fear — think Enron: bankruptcy of the largest energy company in the nation had no effect on the economy at all. And don't think lending would falter if banks were allowed to go under. Banks are just intermediaries between lenders and borrowers, and the intermediation would happen in some other way.

 Abolish Fannie and Freddie. They created this situation in the first place. The US government needs to get out of the real estate business. Put the GSEs in bankruptcy and auction off their assets to private mortgage guarantors.

 Stop the bailouts and cut government spending. This activity is siphoning off resources from real wealth generators. "Problems caused by excessive spending and indebtedness cannot be cured by more spending and more indebtedness."  End government manipulation of money. Central planning of the money supply and interest rates has failed. Fiat paper money (i.e., money not backed by a commodity such as gold) allows the dollar to be inflated. "When Americans had a legitimate commodity standard, they had a money that held its value."

 Put the Fed "on the table" (i.e. up for debate). The central bank is seen as an unnecessary and disruptive intrusion into the marketplace, yet its policies are somehow never a subject for public debate. "The Fed postures as the great rock of stability in the American economy, but it is responsible for more economic instability than any other institution."

 Let interest rates float. In the short term, the Fed should stop running special auctions to influence rates.

 End the monopoly of money (by the Fed). Some people have called for the return of the gold standard, which allows the free market to decide on values. Better yet, allow people to choose "the medium of exchange that suits them best and that most reliability performs the function of money." Repeal laws that require acceptance of the dollar as legal tender.

Conclusion

The kernel of Thomas Woods' thesis is that the current recession has been caused by government inflation of the money supply and manipulation of interest rates and credit, which misdirected spending and produced an unsustainable boom. Now, he says, we are trying to use precisely the same mechanisms to extricate ourselves.

Instead, we should let things take their natural course, painful as that might be, and sideline the organizations and policies that brought the troubles upon us.

For the future, the best way to avoid the bursting of economic bubbles is not to initiate those artificial booms in the first place.