Did Small Government Cause Our Current Problems?

Mises Daily by Robert Higgs

As soon as I saw the headline of an August 10 article by financial columnist Peter Cohan, I knew that something was terribly wrong. It reads: "How did the politics of small government lead to big government bailouts?" This is akin to asking, How did the extinction of the elephants lead to Barack Obama's election as president? If you make a claim of the form "A caused B," but A never happened, then you are wasting your time by delving into the historical details of a bogus relationship.

Yet we continue to see one example after another of what suspicious readers may be tempted to view as the Big Lie: that deregulation or other obliging government measures caused the present economic mess. I won't go so far as to characterize this claim as a Big Lie. Although some of its purveyors, acting out of partisan motives, surely know that they are blowing smoke, others may simply suffer from economic ignorance, analytical confusion, or loss of historical memory. In any event, the public is ill-served by commentators who purport to speak with authority about our current economic troubles, yet merely peddle this worse-than-sophomoric tale.

The Cohan article in question consists of so much nonsense that a full critique of it might be enough to compose a student's senior thesis. But the part that interests me right now is the claim that

the idea of small government … helped create the ineffective regulatory agencies which allowed all kinds of questionable practices to thrive in American business, especially in the world of finance. By helping create a record debt bubble, which thrived in an era of weak regulatory oversight, small government nearly ruined the global economy last fall.

So, there you have it in plain English. To repeat: "small government nearly ruined the global economy last fall." Cohan spares us any evidence that we actually had a small government at any time during the past 25 years. I would be especially interested in such evidence, inasmuch as I have written a number of articles and books brimming with evidence that in fact the governments of this country at every level were growing in size, scope, and power during those years.

Like Cohan, those who continually blame insufficient regulation for our present plight offer little or no evidence. They rely instead on the implicit assumption that if only the regulations had been much stricter, the bankers and other business-sector malefactors never would have perpetrated their evil deeds. This faith in the regulators is touching, to be sure, but it is also extremely naïve. We now have — and long have had — miles of regulations on the books and legions of regulators at work in scores of government agencies. What specific power did they lack? And had they been given even greater powers, budgets, and staffs, what enchantment would have transformed these ostensible guardians into smart, dogged champions of the public interest, rather than the time-serving drones and co-conspirators with the regulated firms that they have always been?

Somehow, no matter how many regulations are created and how many regulators are put on the government payroll, when these rules and enforcement agents fail to prevent a disaster, many people's response is to propose that the government write more regulations and hire more regulators. If these advocates of expanded government intervention had been in New Orleans as it was being submerged under Katrina's floodwaters, they no doubt would have proposed that the Corps of Engineers dynamite the remaining levies — to prove that they favored "doing something."

"Ironically," writes Cohan, "another Republican, Ben Bernanke … decided that in the midst of a catastrophic economic collapse … the prescription for the problem was the biggest government in American history." And thank goodness, too, he opines, because owing to all of the wonderful mitigation that the Fed's unprecedented actions have produced to soften and reverse this inexplicable, out-of-blue episode of financial panic and recession, "there is a good chance that historians will look back on Bernanke as the man who saved the world."

I can't speak for all historians, but I can guarantee that no such story will be disseminated under my name. On the contrary, by taking into account how the government and the Fed created necessary conditions for the financial bubble that burst last September — as many competent analysts have already shown — notwithstanding Cohan's disregard of their findings — we quickly appreciate that Bernanke's supposed world-saving would never have been deemed necessary had he and others in high government places not done so much to place the world in jeopardy in the first place.

Never one to linger over a single piece of nonsense when another beckons, Cohan proceeds without transition to the question, "How do we keep this from happening again?" To which his amazing answer is "The most important way is to change how bankers get paid." Oh, sure, that will turn the trick. Never mind the government's countless measures from the 1930s onward to steer money into mortgage loans to borrowers with little likelihood of repaying them. Never mind the massive efforts of the government-sponsored giants Fannie Mae and Freddie Mac to create secondary markets for rotten mortgage-related IOUs galore. Never mind the Fed's pumping up of the real-estate bubble by rapidly expanding credit and holding interest rates at absurdly low levels for years on end. Never mind all of this and a great deal more. Simply change how bankers get paid, and the sun will shine on us again.

"We [by which Cohan seems to mean the government] need to change banker's pay so that they only get rewarded if their risks are profitable," he declares, "and punished if they lose money." Some readers might find this idea appealing, if they don't spend much time thinking it through. In truth, however, the government already plays too large a role: if the government and the Fed did not stand in the background, ready and willing to bail out reckless bankers, the bankers would act a great deal more prudently, as would their boards of directors when deciding how to compensate the managers. Moreover, I venture to remind our financial guru — who is described as the president of a consulting and venture-capital firm, a management teacher at Babson College and the author of eight books — that how bankers get paid lies properly within the domain of the banks' boards of directors. It's really none of my business, or his.

In contrast, how the government and the Fed act is my business because they purport to act on my behalf, and even if they didn't so purport, they still act in many ways that harm me. So I'm entitled to hold them to account for their actions. As long as the Cohans of this world continue to blame private actors and "the idea of small government" for the economic disasters that the government and the Fed produce, however, we have little chance to clarify what can — and should — be done to remedy our plight and preclude serial repetitions of such destructive actions.

Not content with having embraced several stupendously erroneous and misguided ideas, Cohan plows to an equally dim-witted conclusion by declaring that besides setting the compensation of bankers, the government should establish "an independent government agency to create financial statements for companies and money managers." Sure. Let the government keep the accounts. After all, the government has a flawless record of keeping honest accounts and scrupulously avoiding multi-trillion-dollar Ponzi schemes such as Social Security, and pie-in-the-sky promises such as Medicare, which stretches to the limits of the known financial universe.

The Department of Defense, which since 1994 has been required by law to perform an annual financial audit, has yet to perform one. Each year a DoD accounting functionary dutifully testifies before Congress that the department's accounts are in such a mess that its records cannot be audited. Is this the kind of financial-accounting proficiency we want to impose on the private sector? Cohan thinks so.

Got a problem? Just give the government even more power, and our friendly, competent rulers will take care of everything. I shudder to think that columnists may actually get paid for spouting such childish twaddle.

Inflation and Deficits: Politicians Cause Inflation

by Walter Williams

With the massive increases in federal spending, inflation is one of the risks that awaits us. To protect us from the political demagoguery that will accompany that inflation, let's now decide what is and what is not inflation. One price or several prices rising is not inflation. Increases in money supply are what constitute inflation, and a general rise in prices is the symptom. As the late Nobel Laureate Professor Milton Friedman said, "(I)nflation is always and everywhere a monetary phenomenon, in the sense that it cannot occur without a more rapid increase in the quantity of money than in output."

Thinking of inflation as rising prices permits politicians to deceive us and escape culpability. They shift the blame saying that inflation is caused by greedy businessmen, rapacious unions or Arab sheiks.
Instead, it is increases in the money supply that cause inflation, and who is in charge of the money supply? It's the government operating through the Federal Reserve Bank and the U.S. Treasury.

Our nation has avoided the devastating hyperinflations that have plagued other nations. The world's highest inflation rate was in Hungary after World War II, where prices doubled every 15 hours. The world's second highest inflation rate is today's Zimbabwe, where last year prices doubled every 25 hours, a rate of 89 sextillion percent. That's 89 followed by 23 zeros. Our highest rate of inflation occurred during the Revolutionary War, when the Continental Congress churned out paper Continentals to pay bills.

The monthly inflation rate reached a peak of 47 percent in November 1779.

This painful experience with inflation, and collapse of the Continental dollar, is what prompted the delegates to the Constitutional Convention to include the gold and silver clause into the United States Constitution so that the individual states could not issue bills of credit. The U.S. Constitution's Article I, Section 8 permits Congress: "To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures."

The founders of our nation feared paper currency because it gave government the means to steal from its citizens. When inflation is unanticipated, as it so often is, there's a redistribution of wealth from creditors to debtors. If you lend me $100, and over the term of the loan prices double, I pay you back with dollars worth only half of the purchasing power they had when I borrowed the money. Since inflation redistributes (steals) wealth from creditors to debtors, we can identify inflation's primary beneficiary by asking: Who is the nation's largest debtor? If you said, "It's the U.S. government," go to the head of the class.

Inflation is just one effect of massive increases in spending.

Some might argue that future generations of Americans will pay for today's massive budget deficits. But is there really a federal budget deficit? The short answer is yes, but only in an accounting sense -- but not in any meaningful economic sense. Let's look at it. Our GDP this year will be about $14 trillion. If 2009 federal expenditures are $3.9 trillion and tax receipts are $2.1 trillion, that means there is an accounting deficit of $1.8 trillion. Is it the Tooth Fairy, Santa or the Easter Bunny who makes up the difference between expenditures and revenue? Is it a youngster who is born in 2020 or 2030 who makes up the difference? No. If government spends $3.9 trillion of our $14 trillion GDP this year, of necessity it has to force us to spend privately $3.9 trillion less this year. One method to force us to spend less privately is through taxation. Another way is to enter the bond market and drive up the interest rates, which put a squeeze on private investment in homes and businesses. Then there is inflation, which is a sneaky form of taxation.

Profligate spending burdens future generations by making them recipients of a smaller amount of capital and hence less wealth.

Economics focus

Cause and defect

Instrumental variables help to isolate causal relationships. But they can be taken too far

“LIKE elaborately plumed birds…we preen and strut and display our t-values.” That was Edward Leamer’s uncharitable description of his profession in 1983. Mr Leamer, an economist at the University of California in Los Angeles, was frustrated by empirical economists’ emphasis on measures of correlation over underlying questions of cause and effect, such as whether people who spend more years in school go on to earn more in later life. Hardly anyone, he wrote gloomily, “takes anyone else’s data analyses seriously”. To make his point, Mr Leamer showed how different (but apparently reasonable) choices about which variables to include in an analysis of the effect of capital punishment on murder rates could lead to the conclusion that the death penalty led to more murders, fewer murders, or had no effect at all.

In the years since, economists have focused much more explicitly on improving the analysis of cause and effect, giving rise to what Guido Imbens of Harvard University calls “the causal literature”. The techniques at the heart of this literature—in particular, the use of so-called “instrumental variables”—have yielded insights into everything from the link between abortion and crime to the economic return from education. But these methods are themselves now coming under attack.

Instrumental variables have become popular in part because they allow economists to deal with one of the main obstacles to the accurate estimation of causal effects—the impossibility of controlling for every last influence. Mr Leamer’s work on capital punishment demonstrated that the choice of controls matters hugely. Putting too many variables into a model ends up degrading the results. Worst of all, some relevant variables may simply not be observable. For example, the time someone stays in school is probably influenced by his innate scholastic ability, but this is very hard to measure. Leaving such variables out can easily lead econometricians astray. What is more, the direction of causation is not always clear. Working out whether deploying more policemen reduces crime, for example, is confused by the fact that more policemen are allocated to areas with higher crime rates.

Instrumental variables are helpful in all these situations. Often derived from a quirk in the environment or in public policy, they affect the outcome (a person’s earnings, say, to return to the original example) only through their influence on the input variable (in this case, the number of years of schooling) while at the same time being uncorrelated with what is left out (scholastic ability). The job of instrumental variables is to ensure that the omission of factors from an analysis—in this example, the impact of scholastic ability on the amount of schooling—does not end up producing inaccurate results.

In an influential early example of this sort of study, Joshua Angrist of the Massachusetts Institute of Technology (MIT) and Alan Krueger of Princeton University used America’s education laws to create an instrumental variable based on years of schooling. These laws mean that children born earlier in the year are older when they start school than those born later in the year, which means they have received less schooling by the time they reach the legal leaving-age. Since a child’s birth date is unrelated to intrinsic ability, it is a good instrument for teasing out schooling’s true effect on wages. Over time, uses of such instrumental variables have become a standard part of economists’ set of tools. Freakonomics, the 2005 bestseller by Steven Levitt and Stephen Dubner, provides a popular treatment of many of the techniques. Mr Levitt’s analysis of crime during American election cycles, when police numbers rise for reasons unconnected to crime rates, is a celebrated example of an instrumental variable.

Two recent papers—one by James Heckman of Chicago University and Sergio Urzua of Northwestern University, and another by Angus Deaton of Princeton—are sharply critical of this approach. The authors argue that the causal effects that instrumental strategies identify are uninteresting because such techniques often give answers to narrow questions. The results from the quarter-of-birth study, for example, do not say much about the returns from education for college graduates, whose choices were unlikely to have been affected by when they were legally eligible to drop out of school. According to Mr Deaton, using such instruments to estimate causal parameters is like choosing to let light “fall where it may, and then proclaim[ing] that whatever it illuminates is what we were looking for all along.”

IV leagues

This is too harsh. It is no doubt possible to use instrumental variables to estimate effects on uninteresting subgroups of the population. But the quarter-of-birth study, for example, shone light on something that was both interesting and significant. The instrumental variable in this instance allows a clear, credible estimate of the return from extra schooling for those most inclined to drop out from school early. These are precisely the people whom a policy that sought to prolong the amount of education would target. Proponents of instrumental variables also argue that accurate answers to narrower questions are more useful than unreliable answers to wider questions.

A more legitimate fear is that important questions for which no good instrumental variables can be found are getting short shrift because of economists’ obsession with solving statistical problems. Mr Deaton says that instrumental variables encourage economists to avoid “thinking about how and why things work”. Striking a balance between accuracy of result and importance of issue is tricky. If economists end up going too far in emphasising accuracy, they may succeed in taking “the con out of econometrics”, as Mr Leamer urged them to—only to leave more pressing questions on the shelf.

No, the Free Market Did Not Cause the Financial Crisis

by Thomas E. Woods, Jr.

In March 2007 then-Treasury secretary Henry Paulson told Americans that the global economy was “as strong as I’ve seen it in my business career.” “Our financial institutions are strong,” he added in March 2008. “Our investment banks are strong. Our banks are strong. They’re going to be strong for many, many years.” Federal Reserve chairman Ben Bernanke said in May 2007, “We do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.” In August 2008, Paulson and Bernanke assured the country that other than perhaps $25 billion in bailout money for Fannie and Freddie, the fundamentals of the economy were sound.

Then, all of a sudden, things were so bad that without a $700 billion congressional appropriation, the whole thing would collapse.

In the wake of this change of heart on the part of our leaders, Americans found themselves bombarded with a predictable and relentless refrain: the free market economy has failed. The alleged remedies were equally predictable: more regulation, more government intervention, more spending, more money creation, and more debt. To add insult to injury, the very people who had been responsible for the policies that created the mess were posing as the wise public servants who would show us the way out. And following a now-familiar pattern, government failure would not only be blamed on anyone and everyone but the government itself, but it would also be used to justify additional grants of government power.

The truth of the matter is that intervention in the market, rather than the market economy itself, was the driving factor behind the bust.

F.A. Hayek won the Nobel Prize for his work showing how the central bank’s intervention into the economy gives rise to the boom-bust cycle, making us feel prosperous until we suffer the inevitable crash. Most Americans know nothing about Hayek’s theory (known as the Austrian theory of the business cycle), and are therefore easy prey for the quacks who blame the market for problems caused by the manipulation of money and credit. The artificial booms the Fed provokes, wrote economist Henry Hazlitt decades ago, must end “in a crisis and a slump, and…worse than the slump itself may be the public delusion that the slump has been caused, not by the previous inflation, but by the inherent defects of ‘capitalism.’”

Although my recently released book, Meltdown explains the process in more detail, an abbreviated version of Austrian business cycle theory might run as follows:

Government-established central banks can artificially lower interest rates by increasing the supply of money (and thus the funds banks have available to lend) through the banking system. This is supposed to stimulate the economy. What it actually does is mislead investors into embarking on an investment boom that the artificially low rates seem to validate but that in fact cannot be sustained under existing economic conditions. Investments that would have correctly been assessed as unprofitable are falsely appraised as profitable, and over time the result is the squandering of countless resources in lines of investment that should never have been begun.

If lower interest rates are the result of increased saving by the public, this increase in saved resources provides the material wherewithal to see the additional investment through to completion. The situation is very different when the lower interest rates result from the Fed’s creation of new money out of thin air. In that case, the lower rates do not reflect an increase in the pool of savings from which investors can draw. Fed tinkering, in other words, does not increase the real stuff in the economy. The additional investment that the lower rates encourage therefore leads the economy down a path that is not sustainable in the long run. Investment decisions are made that quantitatively and qualitatively diverge from what the economy can support. The bust must come, no matter how much new money the central bank creates in a vain attempt to stave off the inevitable day of reckoning.

The recession or depression is the necessary, if unfortunate, correction process by which the malinvestments of the boom period, having at last been brought to light, are finally liquidated. The diversion of resources into unsustainable investments out of conformity with consumer desires and resource availability comes to an end, with businesses failing and investment projects abandoned. Although painful for many people, the recession/depression phase of the cycle is not where the damage is done. The bust is the period in which the economy sloughs off the malinvestments and the capital misallocation, re-establishes the structure of production along sustainable lines, and restores itself to health. The damage is done during the boom phase, the period of false prosperity that precedes the bust. It is then that the artificial lowering of interest rates causes the squandering of capital and the initiation of unsustainable investments. It is then that resources that would genuinely have satisfied consumer demand are diverted into projects that make sense only in light of the temporary and artificial conditions of the boom.

Adding fuel to the fire of the most recent boom was the so-called Greenspan put, the unofficial policy of the Greenspan Fed that promised assistance to private firms in the event of risky investments gone bad. The Financial Times described it as the view that “when markets unravel, count on the Federal Reserve and its chairman Alan Greenspan (eventually) to come to the rescue.” According to economist Antony Mueller, “Since Alan Greenspan took office, financial markets in the U.S. have operated under a quasi-official charter, which says that the central bank will protect its major actors from the risk of bankruptcy. Consequently, the reasoning emerged that when you succeed, you will earn high profits and market share, and if you should fail, the authorities will save you anyway.” The Financial Times reported in 2000, in the wake of the dot-com boom, of an increasing concern that the Greenspan put was injecting into the economy “a destructive tendency toward excessively risky investment supported by hopes that the Fed will help if things go bad.”

When things do go bad, pumping more money into the banking system, thereby lowering interest rates once again, only exacerbates the problem, because it encourages the continued wasteful deployment of capital in unsustainable lines that will eventually have to be abandoned anyway, and it forces healthy, wealth-generating firms to have to go on competing with bubble firms for labor and capital. When interest rates are made artificially low, they encourage the kind of investment that would normally occur only if more saved resources existed to fund them than actually do. Continuing to force interest rates down only perpetuates the allocation of capital into outlets that the economy’s current resource base cannot sustain.

In response to the dot-com and NASDAQ collapses and the modest recession that accompanied them in 2000 and 2001, that Alan Greenspan and the Fed chose to embark on a robust policy of inflation, an approach that culminated in lowering the federal funds rate (the rate at which banks lend to each other) to a mere one percent from June 2003 to June 2004. Already by early 2001 the Fed had begun to ease once again. That year saw no fewer than 11 rate cuts. The unsustainable dot-com boom could not, in the end, be reignited, and thank goodness – the resource misallocations in that sector were unhealthy for the economy. But the Fed’s easy money and refusal to allow the recession of 2000 to take its course led to an even more perilous bubble elsewhere. That was the only recession on record in which housing starts did not decline. Not coincidentally, that was also the moment at which people began to conclude that house prices never fall, that a house is the best investment one can make, and so on. By intervening in the market then, the Fed prevented the market from making a full correction, thereby perpetuating unsustainable investment and consumption decisions. In so doing it merely postponed what it was trying to avoid, and made the crash worse when it finally came.

Fiscal stimulus, meanwhile, merely diverts resources from the productive sector in order to fund money-losing enterprises arbitrarily chosen by government. These artificial expenditures, moreover, interfere with the market’s attempt to sort out genuine demand from bubble demand. “Stimulus” spending can in fact keep firms (construction companies, for example) in business that for the sake of genuine economic health need to be liquidated so their resources can be more sensibly employed in more urgently demanded lines of production.

The claim that “stimulus” spending is necessary to bring “idle resources” back into use also misfires, since it fails to consider why so many entrepreneurs – who have survived as long as they have on the market because of their skill at anticipating consumer demand – should suddenly have become, all at once, such poor forecasters that they’re all saddled with idle resources.

The reason for the idle resources is, obviously, some prior act of miscalculation. And what could have created such systemic miscalculation? Could it be the Fed’s artificially low interest rates, that distort entrepreneurial forecasting and encourage the wrong kind of investments at the wrong time?

Consider a restaurant owner who mistakes the temporary demand for his product deriving from the presence of the Olympics in his city with real, sustainable demand. Suppose he opens a new location to accommodate all this new demand. When the Olympics are over, he’s left with idle resources – labor with nothing to do and empty restaurant space for starters. Should we want to “stimulate” these resources back into activity? Of course not. They shouldn’t have been allocated this way in the first place. We should want the market, guided by the price system, to redeploy them into sensible channels.

The problem, therefore, isn’t that we lack enough “spending” or “demand,” and that we need government to fill in the “missing demand.” The problem is that in the wake of Fed-induced misallocations of resources we wind up with structural imbalances, a mismatch between the capital structure and consumer demand. The recession is the period in which the economy repairs this mismatch by reallocating resources into lines of production that actually correspond to consumer demand. The modern preoccupation with levels of spending instead of patterns of spending obscures the most important aspects of the question.

Had the market been allowed to work before the collapse, there would have been no housing bubble and no crisis in the first place. Had the market been allowed to work when the crisis hit, recovery would have been swift – as it was in 1920–21, when an even worse depression came to a rapid end without any open-market operations by the Fed, and without any fiscal stimulus. (In fact, the federal budget was cut in half from 1920 to 1922.)

What, in short, should we do now? Exactly the opposite of what our so-called experts, who in a sane world would be forever discredited, urge upon us.

Government: The Cause of – and Solution to – All Our Problems

by Thomas E. Woods, Jr.

In case you’ve ever wondered what it must have been like to read Pravda, reading the American media’s treatment of the financial crisis and our wise leaders’ expert management of it all has given everyone a wonderful opportunity. For instance, check out this piece from several days ago on Politico.

If you can’t bring yourself to click on the link, I’ll give you the headline: "Obama Would Regulate New ‘Bubbles.’"

Yes, you read that right. "Bubbles" just occur spontaneously. They have no cause or explanation. We need government to identify and destroy them.

Sometimes I wish our overlords would get their stories straight. First, Alan Greenspan – whom the New York Times once described, in its typical toadying, totalitarian fashion, as "the infallible maestro of our financial system" – told us it was impossible to tell if a bubble existed at any given time. Now we have Barack Obama insisting that not only can we detect bubbles, but we can also deflate them with sufficient dispatch to prevent them from causing any serious economic disturbances.

How are we peons to decide between the competing views of our infallible maestro on the one hand and the man who would be FDR on the other?

I shouldn’t be so cynical. It is not for us to question how our overlords intend to distinguish between genuine growth in some industry on the one hand and bubble conditions on the other. Just to be safe they may have to quash all rapid growth wherever it occurs. Perhaps they can cut off credit to an entire sector of the economy, or levy industry-specific taxation. (Anyone who thinks this type of discretion and micromanagement might be exercised with political motivations in mind, or for any purpose other than the common good, is almost surely a good candidate for surveillance in our progressive commonwealth.)

In their quest to free us from economic instability, our betters may find it necessary to institute new rules. It is our job to accept these new rules with docility and thanks. These rules might have to be kind of sweeping, perhaps on the order of nobody may do anything. In liberal times that could perhaps be modified to nobody may do anything without asking permission. True, we could then wind up with a lengthy debate about whether asking permission itself counted as doing something, such that we’d need to ask permission in order to ask permission, in an endless regress. We’d then be back to the original nobody may do anything, which is probably the safest place to be anyway.

Or perhaps our rulers could shut down the electrical grid from time to time. I’d like to see those greedy fat cats inflate a bubble without any electricity!

Now the possibility that the government itself could be the primary culprit in the generation of asset bubbles is of course not merely rejected; the very idea cannot even be entertained. The great progressive institutions of government and central banking the causes rather than the solutions to our problems? Impossible!

Everyone knows Bad Things happen in the economy because of wicked speculators and grasping businessmen. If someone were to ask whether the Federal Reserve’s creation of $8 billion out of thin air every week on average for four solid years might have had a tiny bit to do with the housing bubble, well, we’d have to remind such a cynic that the Fed was created in order to give us macroeconomic stability. Our present crisis was caused by excessive "leverage," you see – though we won’t bother asking where major economic actors managed to get all this credit in the first place. That might lead people to ask hard questions about the Fed yet again, and as we’ve seen, the Fed is our Wonderful, Stabilizing Friend.

It is true that Anna Schwartz, the famous monetarist (and not an Austrian economist), recently observed that asset bubbles cannot form without loose monetary policy by the central bank to fund them. "If you investigate individually the manias that the market has so dubbed over the years, in every case, it was expansive monetary policy that generated the boom in an asset. The particular asset varied from one boom to another. But the basic underlying propagator was too-easy monetary policy and too-low interest rates that induced ordinary people to say, well, it’s so cheap to acquire whatever is the object of desire in an asset boom, and go ahead and acquire that object. And then of course if monetary policy tightens, the boom collapses." (Schwartz also rejects former Fed chairman Alan Greenspan’s "attempt to exculpate himself" for the housing bubble.)

Schwartz is here echoing what Austrian economist Ludwig von Mises said decades earlier. A sudden drive for a particular kind of investment will raise the prices of complementary factors of production as well as the interest rate itself. In order for a mania-driven boom to persist, there would have to be an increasing supply of credit in order to fund it, since investments in that sector would grow steadily more costly over time. That could not occur in the absence of credit expansion. The dot-com and housing bubbles can both be explained by artificial credit expansion, say such economists.

If we are to believe these economists, the best way to prevent future asset bubbles would be to stop the Fed from creating so much money out of thin air in the first place. Better still, we should abolish the Fed altogether, since in the view of these economists it is entirely superfluous to a market economy.

Again, though, our trust should be in princes. After all, Austin Goolsbee, an economic adviser to the president, assures us that Obama will be on the lookout for both bubbles and busts. The president, Politico notes, is "prepared to intervene to make sure that kind of red-hot growth doesn’t occur. And he’s willing to do it with added government regulation if needed to prevent any one sector of the economy from getting out of balance – the way the dot-com boom did in the 1990s and the real-estate market did earlier this decade." See, those things just happened! No cause. They just happened. And government will protect us from them.

Mark Zandi, a former economic adviser to John McCain, adds that "policymakers always intervene in a downturn. So it is necessary for policy makers to take action against bubbles. You’ve got to be symmetrical in your policy." What we need, says Zandi, is a "systemic regulator" who will decide whether or not bubbles exist and then take appropriate action. (See how much different a McCain administration would have been on the economy?)

Naysayers may point out that the Fed’s own economists denied that a housing bubble existed, and that, as we observed earlier, Greenspan himself believes it’s impossible to detect bubbles at all. But surely one more regulator, a big, giant, super-duper regulator, should be able to get things right.

Some people say the market is the best regulator. After all, the free market doesn’t pump up the money supply and push interest rates down to levels that promote unsustainable bubbles. The free market punishes reckless risk-takers, while it is government that bails them out (and thereby encourages them to take greater risks in the future). It was the Fed, not the free market, from which the "Greenspan put" – the implicit promise to bail out major Wall Street players – emerged. The Financial Times warned that these guarantees were encouraging dangerously risky investments. The free market makes no such guarantees, and thereby cultivates a more cautious class of entrepreneur.

But enough with these naysayers. I for one welcome our new overlords. Every American citizen could stand to learn from that model of filial piety, Britney Spears, who urged, "I think we should just trust our president in every decision he makes and should just support that, you know, and be faithful in what happens."

Amen.

Did Greenspan Cause The Housing Bubble?

Jeffrey Rogers Hummel and David R. Henderson

His role is exaggerated.

Critics across the political spectrum are having a field day blaming the current economic crisis on former Federal Reserve Chairman Alan Greenspan, who they allege carried out an excessively expansionary monetary policy following the recession of 2001. But a careful examination of his record shows little support for this view.

Greenspan, however unintentionally, came close to freezing the domestic monetary base. He therefore still stands out as the only truly successful chairman of the Fed, which, by the way, is one good reason among many for abolishing it. We simply can't depend on his like coming to the fore again, as Ben Bernanke's disastrous tenure is making clear.

Why do people now believe Greenspan was an "inflationist?" Mainly for one reason: they note the low interest rates from 2002 to 2004. But this ignores the simple fact that interest rates can change as a result of real factors involving supply and demand. As Greenspan, among others, has repeatedly (and again recently) demonstrated, these unusually low interest rates were due primarily to a massive flow of savings from emerging economies in Asia and elsewhere.

Although the broader measures of money have become an unfashionable way to gauge monetary policy, their behavior during the period of low interest rates should still make us skeptical of the idea that Greenspan had opened the floodgates. The annual year-to-year growth rate of money with zero maturity (MZM) actually fell from over 20% in 2001 to nearly 0% by 2006.

During that same time, growth of the M2 money supply (includes currency, checking accounts, time-related deposits, savings deposits and non-institutional money-market funds) fell from over 10% to around 2%, and M1 (currency plus checking accounts) growth fell from over 10% to negative rates. Admittedly, the Fed's control over the broader monetary aggregates has become quite attenuated, for reasons elucidated below. But even the year-to-year annual growth rate of the monetary base, which the Federal Reserve directly controls, fell from 10% to below 5% between 2001 and 2006.

The real key to what was going on is revealed by the components of the monetary base. It consists of reserves held by the banks and other depositories, either in their accounts at the Fed or as vault cash, plus currency in circulation among the general public. Between December 1986, eight months before Greenspan became Fed chairman, and December 2005, nineteen years later, the monetary base rose from $248 billion to $802 billion (figures are not seasonally adjusted). True, that doesn't sound like a freeze, but virtually the whole increase was in circulating currency.

During those same 19 years, total bank reserves (including all vault cash) grew from $65 billion to $73 billion, for an average annual growth rate of a mere 0.65%. In some years, aggregate reserves rose, in others they fell, with the major bump surrounding the year 2000. Total reserves are also the one monetary measure with growth showing a temporary uptick into 2003, when interest rates were down.

Currency in circulation exploded even faster than the base, at an annual rate of 7.54%. But most of this new cash went abroad, as a stable dollar became an international currency. These growing foreign holdings of Federal Reserve notes became an additional factor increasing money demand and keeping U.S. inflation in check during the 1990s. On the other hand, Greenspan's virtual freezing of reserves is the most salient yet ignored feature of his tenure. After adjusting for currency going abroad, it means he approximated a de facto freezing of the domestic base.

Greenspan also helped deregulate the broader monetary aggregates: M2, MZM, and M3 (the broadest measure of money). The Depository Institutions Deregulation and Monetary Control Act of 1980 had begun phasing out interest-rate ceilings on deposits and modified reserve requirements in complex ways.

Combined with subsequent administrative deregulation under Greenspan through January 1994, these changes left all the financial liabilities that M2 adds to M1--savings deposits, small time deposits, money market deposit accounts, and retail money market mutual fund shares--utterly free of reserve requirements and allowed banks to sweep a large portion of M1 checking accounts into M2 money market deposit accounts. M2 and the broader measures became quasi-deregulated aggregates with no legal link to the size of the monetary base.

One result, which the late Milton Friedman noted in 2003, is that fluctuations in the velocity of M2 were automatically offset by fluctuations in the amount of M2. Interestingly, this is exactly what monetary economists George A. Selgin and Lawrence H. White predict would happen under free banking, that is, a market-determined monetary system without any government involvement.

They argue that free banking would automatically adjust the quantity of money to changes in velocity. If velocity rises, signaling a fall in money demand, market mechanisms would cause banks to reduce the quantity of money they created. And if velocity falls, signaling a rise in money demand, banks would enlarge the quantity of money.

Thus, during the dot-com boom of the '90s, M2 velocity rose as people shifted into stocks. But this was perfectly offset by the declining growth rate of M2, which fell to near zero between 1994 and 1996. Assorted Fed-watchers reached opposite conclusions, depending on which variable they focused on.

Those who looked at M2 warned that Greenspan's policies were deflationary, while those who looked at the higher growth rates of the base and M1 predicted higher inflation. Both were wide of the mark, but not because of Greenspan's miraculous central-bank discretion; the result was a product of market process, and when the collapse of the dot-com boom burst the M2 velocity bubble, it induced a new spike in M2 growth.

If Greenspan almost froze total reserves, why, in a growing economy, wasn't there deflation? The reason is the free market's enormous capacity for innovation. Because bank reserves in the U.S. paid no interest until October of last year, banks had a strong incentive to economize on their use. Each dollar of reserves was standing behind more and more dollars of M2.

So what caused the current financial crisis? Economists will probably not know the full answer until many years from now. Minor blips in total reserves under Greenspan may have played some role. Because Greenspan only imperfectly implemented Milton Friedman's proposal of freezing the monetary base, without intending to do so, his policy may have ended up slightly too discretionary. But that possibility hardly justifies the widespread claim that the Fed could have pricked or prevented the housing bubble.

Jeffrey Rogers Hummel is an associate professor of economics at San José State University and the author of Emancipating Slaves, Enslaving Free Men: A History of the American Civil War. David R. Henderson, a research fellow with the Hoover Institution and an associate professor of economics at the Naval Postgraduate School, is the editor of The Concise Encyclopedia of Economics (Liberty Fund, 2008).

Obama the Socialist and the Cause of Poverty

Obama the Socialist and the Cause of Poverty
By Jacob Hornberger

Obama the Socialist

Amidst all the devastation from the latest economic crisis, there have been some really funny moments. Among the most humorous has got to be what happened recently with President Obama and the New York Times.

I recently referenced an article by Washington Post columnist Harold Meyerson in which he expressed shock that people are actually calling President Obama a socialist because of his massive stimulus package, bank bailouts, and tighter government regulation. All this government involvement in economic activity, Meyerson says, just consists of free-market mechanisms designed to help revitalize America's free-enterprise system. He says that it's not socialism and interventionism that are at the root of the current crisis but rather America's capitalist system.

Well, guess what then happened! The New York Times conducted an interview with Obama in which the reporter asked him to respond to suggestions that he is a socialist. Obama laughingly responded, "The answer would be no" and then, according to the paper, added that he was "making some very tough choices" on the budget.

And now the really funny part happens. About an hour-and-a-half later, Obama actually calls the reporter back and says that he wants to give a fuller answer on the socialist question. He wanted to point out that "large-scale government intervention in the markets and the expansion of social welfare programs had begun under his Republican predecessor, George W. Bush."

Now, if you're not rolling in the aisles from laughter at this, then you've got to be either a conservative or a liberal rather than a libertarian.

Here's what happened, as any clear-thinking libertarian will tell you.

America was founded on the principles of a free market. What "free market" meant was that market activity was free from government control. That is, "free market" didn't mean less government control or regulation of market activity, it meant free of government control or regulation.

It also meant no income tax. People were free to keep everything they earned. It also meant no welfare programs. That is, there were no government programs in which people were taxed in order to give the money to other people.

In the late 1800s and continuing into the early 1900s, philosophical attacks began being leveled at the philosophy of economic liberty. The chief attackers were the Progressives, who were copying socialist and regulatory ideas from European socialists and interventionists. Some of the attacks were successful, as reflected by the Sherman Anti-Trust Act, the 16th Amendment, the Federal Reserve (which caused the 1929 stock-market crash), and minimum-wage laws in some of the states.

For decades, the advocates of economic liberty were able to stem the tide. But with the stock-market crash in 1929 and the Great Depression, the socialist and interventionist tide overwhelmed America like a tsunami. Franklin Roosevelt seized upon the crisis to revolutionize America's economic system. Seizing upon the economic principles of both the socialists and fascists, the primary mission of the federal government became taxing some to give to others and regulating economic and business activity. The era of laissez faire had come to an end.

But Roosevelt was a brilliant politician. He understood that Americans generally had a deep revulsion against socialism and fascism. So, he simply convinced them that all his welfare-statism and interventionism, including Social Security, the SEC, the NIRA, and the FHA weren't socialistic or fascistic but instead simply free-market mechanisms to save America's free-enterprise system.

It worked. And that's the way it's been ever since. No matter how many socialistic and fascistic policies were adopted over the years, they were always to be considered "free-market devices" to improve America's free-enterprise system. The public schools, which themselves are a model of a socialist enterprise, reinforced people's mindsets by year-after-year repetitive indoctrination: "America has a free-enterprise system. America has a free-enterprise system."

For a while, Republicans resisted the trend, fighting for the principles of economic liberty on which America was founded. But realizing that they were unlikely to regain the reins of power by hewing to principle, Republicans finally threw in the towel and joined the socialist-fascist bandwagon. In doing so, they followed the script -- that all this socialism and fascism that they were now embracing were really the free market in action.

Thus, it is easy to understand why Obama is confused, confounded, and troubled by the allegation that he is a socialist. All his life he has been taught that he's pro-free-enterprise, that America has a free-enterprise system, that all these welfare-state, regulatory programs are free-enterprise, and, perhaps most important of all, that those free-enterprise-loving Republicans believe in all this too.

It has been the libertarians, of course, who have pierced through this life of the lie and this devotion to unreality. Unlike Republicans and Democrats, we recognize that Roosevelt didn't save free enterprise with his socialism and fascism. He destroyed it. Thus, unlike the Republicans and Democrats, we libertarians don't find ourselves exclaiming during the current economic crisis, "Oh, my gosh, free enterprise has failed again." Unlike them, we understand that it's their socialism and fascism that have failed again and that the only real solution lies in restoring the principles of economic liberty on which our nation was founded, which would include at a minimum the repeal of all welfare-state and regulatory programs and departments and the abolition of the federal income tax and the IRS.

The Cause of Poverty

Liberals are saying that President Obama isn't really a socialist because he doesn't favor complete government ownership and control of everything, which is the strict definition of socialism. Since he "only" favors massive government involvement in some things, such as education, healthcare, mail delivery, transportation, retirement, employment, airports, money, bailouts, subsidies, grants, banks, insurance companies, the stock market, occupations, the drug war, and trade restrictions and immigration controls as well as progressive income taxation and equalization of income -- well, according to liberals, all that makes Obama "free enterprise" instead of socialist.

I wonder what Fidel Castro, who also favors all those things, would say about that.

Lost in all this debate on whether Obama is a socialist or not is one simple but important point: It is the dead hand of government that is the cause of America's economic woes. That means that the more that Obama does to restore wealth and prosperity to America with his increases in borrowing, spending, and printing money, the worst things are going to get.

The situation is akin to someone suffering from arsenic poisoning. He goes to the doctor and asks for an antidote. The doctor prescribes more arsenic.

What liberals, who purport to love the poor, needy, and disadvantaged, fail to recognize is another important point: It is the dead hand of the state that is the cause of poverty. Or to be more precise, it is massive government involvement in economic activity that prevents or inhibits a society from becoming wealthy. Call it socialism, fascism, welfare-statism, central planning, inflationism, wealth equalization, or just massive government involvement in the economy, the fact remains: the heavier the hand of government in people's pocketbooks and business activity, the poorer people will be.

Consider my hometown of Laredo, Texas. It is located adjacent to the Rio Grande. On the other side of the river sits Nuevo Laredo, Mexico. It's actually one great big metropolitan area, separated by a river.

Yet, the standard of living of people in Nuevo Laredo is markedly lower than that of those living in Laredo. It's a phenomenon that one cannot help but notice the minute he crosses the border into Nuevo Laredo. People in Nuevo Laredo are a lot poorer than those in Laredo.

I'll bet that most Americans would never ask themselves that simple one-word question that they used to constantly ask when they were children, before they had it drummed out of them in those government-run schools their parents were forced to send them to: "Why?" Why are people in Nuevo Laredo significantly poorer than those in Laredo?

After all, if one travels to the American city of St. Louis, he'll find that the standard of living of people in East St. Louis, Illinois, is about the same as that in St. Louis, Missouri. That city is separated by the Mississippi River rather than the Rio Grande. Could that be the difference?

No. The reason that people in Nuevo Laredo are so much poorer than people in Laredo is this: The dead hand of the state is much more prevalent in Mexico than it is in the United States. As bad as things are in the U.S. with respect to taxes, welfare, regulation, inflation, and bureaucracy, they are 1,000 times worse in Mexico. While we have Big Government in the United States, Mexicans have Mega Government.

That's the reason people are poorer in Mexico than they are in the United States. It's also the reason that people in North Korea are poorer than those in Mexico. The dead hand of the state is more prevalent in North Korea than it is in Mexico.

All this should provide a clue for liberals, who are supposedly interested in helping the poor. If one wants to raise standards of living for people, the solution is not to increase taxes, spending, borrowing, and regulation but instead to slash them, such as by abolishing the income tax and the IRS and by completely separating the economy and the state. That's the way to help the poor.

Alas, however, liberals move in precisely the opposite direction -- higher taxes, borrowing, spending, welfare, regulation, bailouts, and stimulus plans. Even worse, they continue to force children into those government-run schools where they learn to memorize, regurgitate, and conform to this destructive nonsense rather than learn how to critically analyze and challenge it.

Did the Fed Cause the Housing Bubble?

Don't Blame Greenspan

By David Henderson

It's become conventional wisdom that Alan Greenspan's Federal Reserve was responsible for the housing crisis. Virtually every commentator who blames Mr. Greenspan points to the low interest rates during his last few years at the Fed.

Martin Kozlowski

The link seems obvious. Everyone knows that the Fed can drive interest rates lower by pumping more money into the economy, right? Well, yes. But it doesn't follow that that's why interest rates were so low in the early 2000s. Other factors affect interest rates too. In particular, a sudden increase in savings will drive down interest rates. And such a shift did occur. As Mr. Greenspan pointed out on this page on March 11, there was a surge in savings from other countries. Although he names only China, some of the Middle Eastern oil-producing countries were also responsible for much of this new saving. Shift the supply curve to the right and, wonder of wonders, the price falls. In this case, the price of saving and lending is the interest rate.

But how do we know that it was an increase in saving, not an increase in the money supply, that caused interest rates to fall? Look at the money supply.

Background

The Fed Didn't Cause the Housing Bubble (03/11/09)
By Alan Greenspan

Since 2001, the annual year-to-year growth rate of MZM (money of zero maturity, which is M2 minus small time deposits plus institutional money market shares) fell from over 20% to nearly 0% by 2006. During that time, M2 (which is M1 plus time deposits) growth fell from over 10% to around 2%, and M1 (which is currency plus demand deposits) growth fell from over 10% to negative rates.

The annual growth rate of the monetary base, the magnitude over which the Fed has the most control, fell from 10% in 2001 to below 5% in 2006. Moreover, nearly all of the growth in the monetary base went into currency, an increasing proportion of which is held abroad.

Moreover, if the Fed was the culprit, why was the housing bubble world-wide? Do Mr. Greenspan's critics seriously contend that the Fed was responsible for high housing prices in, say, Spain?

This is not to say that the Greenspan Fed was blameless. Particularly disturbing is the way the lender-of-last-resort function has increased moral hazard, a trend to which Mr. Greenspan contributed and which current Fed Chairman Ben Bernanke has put on steroids.

But to the extent that the federal government is to blame, the main fed culprits are the beefed up Community Reinvestment Act and the run-amok Fannie Mae and Freddie Mac. All played a key role in loosening lending standards.

I'm not claiming that we should have a Federal Reserve. We simply can't depend on getting another good chairman like Mr. Greenspan, and are more likely to get another Arthur Burns or Ben Bernanke. Serious work by economists Lawrence H. White of the University of Missouri, St. Louis, and George Selgin of West Virginia University makes a persuasive case that abolishing the Fed and deregulating money would improve the macroeconomy. I'm making a more modest claim: Mr. Greenspan was not to blame for the housing bubble.

Mr. Henderson is a research fellow with the Hoover Institution, an economics professor at the Naval Postgraduate School, and editor of "The Concise Encyclopedia of Economics" (Liberty Fund, 2008).

What Savings Glut?

By Gerald P. O'Driscoll Jr.

Alan Greenspan responded to his critics on these pages on March 11. He singled out an op-ed by John Taylor a month earlier, "How Government Created the Financial Crisis" (Feb. 9), for special criticism. Mr. Greenspan's argument defending his policy is two-fold: (1) the Fed controls overnight interest rates, but not "long-term interest rates and the home-mortgage rates driven by them"; and (2) a global excess of savings was "the presumptive cause of the world-wide decline in long-term rates."

Background

How Government Created the Financial Crisis (02/09/09)
By John B. Taylor

Neither argument stands up to scrutiny. First, Mr. Greenspan writes as if mortgages were of the 30-year variety, financed by 30-year money. Would that it were so! We would not be in the present mess. But the post-2002 period was characterized by one-year adjustable-rate mortgages (ARMs), teaser rates that reset in two or three years, etc. Five-year ARMs became "long-term" money.

The Fed only determines the overnight, federal-funds rate, but movements in that rate substantially influence the rates on such mortgages. Additionally, maturity-mismatches abounded and were the source of much of the current financial stress. Short-dated commercial paper funded investment banks and other entities dealing in mortgage-backed securities.

Second, Mr. Greenspan offers conjecture, not evidence, for his claim of a global savings excess. Mr. Taylor has cited evidence from the IMF to the contrary, however. Global savings and investment as a share of world GDP have been declining since the 1970s. The data is in Mr. Taylor's new book, "Getting Off Track."

The former Fed chairman also cautions against excessive regulation as a policy response to the crisis. On this point I concur. He does not directly address, however, the Fed's policy response. From the beginning, the Fed diagnosed the problem as lack of liquidity and employed every means at its disposal to supply liquidity to credit markets. It has been to little avail and, in the process, the Fed has loaded up its balance sheet with dubious assets.

The credit crunch continues because many banks are capital-impaired, not illiquid. Treasury's policy shifts and inconsistencies under both administrations have sidelined potential private capital. Treasury became the capital provider of last resort. It was late to recognize the hole in banks' balance sheets and consistently underestimated its size. The need to provide second- and even third-round capital injections proves that.

In summary, Fed policy did help cause the bubble. Subsequent policy responses by that institution have suffered from sins of commission and omission. As Mr. Taylor argued, the government (including the Fed) caused, prolonged, and worsened the crisis. It continues doing so.

Mr. O'Driscoll is a senior fellow at the Cato Institute. He was formerly a vice president at the Federal Reserve Bank of Dallas.