A Free-Market Perspective

On the Financial Crisis

based on the 2009 book:

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.

1A Presentation by Peter Emmel to Osher Course “The Financial

Crisis of 2008,” 3/10/2010.

Range of Opinions

• “The business of government is business.”• US President Calvin Coolidge, 1924(?)

• “The trouble with socialism is socialism. The trouble with capitalism is capitalists.”

• Austrian Willi Schlamm, quoted by Wm. F. Buckley

• Now if the aerospace industry had told us after the 1986 Challenger disaster that the key to better performance was to turbocharge the engines and quit performing preflight inspections, everyone would have agreed they were crazy. Yet that’s essentially what the finance lobby has done over the past decade ...”

• Kevin Drum, in Mother Jones, Jan/Feb, 2010 (p.39) 2

Definitions

• Free-Market Economy

– Prices are set by supply and demand

– Government protects property rights and

polices fraud & coercion

– ... but is not otherwise involved in economy

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Definitions

• Austrian School of Economics

– European free-market theoreticians

– Spontaneous organizing power of the pricing system• Based on action by individuals

• Acting in their own economic interest

• In contrast to competing “equilibrium” models

– Notable proponents:• Carl Menger (1840-1941)

• Ludwig Von Mises (1881-1993)

• Friedrich Hayek (1899-1992)

• Murray Rothbard (1926-1995)

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Definitions

• Keynesian Economics

– Government intervention to maintain “full”

employment

• Using fiscal stimulus to spur demand

• And interest rates to control inflation

– Basis of most modern Western economies

– John Maynard Keynes (1883-1946)

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Definitions

• Supply-Side Economics

– Government stimulus to spur production

• By lowering barriers like regulation & taxes

• Consumers benefit through lower prices

– “Reaganomics”

– “Conservative Keynesianism”

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Meltdown by Thomas E. Woods

• Disclaimer:

– I don’t know how much of Woods’s thesis is correct.

– His book includes a generous amount of liberal-bashing.

– I’m not endorsing his viewpoint.

– But I think it contains enough truth to be worth considering as we watch our system respond to the 2008 crisis.

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Book Overview - 1

• Advocates US adoption of a free-market economy

• Explains how government intervention created & prolonged the boom

– (thru low interest rates)

• ... and will prolong the bust

– (through bailouts and excessive stimulus)

• Describes how free markets operate

• Counters the “myth” that de-regulation caused the crisis

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Book Overview - 2

• Presents the “Austrian Theory” of economics

• Interprets selected historical boom/bust cycles

• Explains benefits of “sound money” vs “fiat

money”

• Explains benefits of saving vs spending by the

public

• Lists prescriptions for correcting our approach to

the US economy

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Causes: Gov’t Intervention -1

• Federal Reserve created boom by artificially

holding down interest rates

– Rationale:

• Increase liquidity & cushion recessions

– Result:

• Encouraged risk-taking to earn higher returns

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Causes: Gov’t Intervention - 2

• Manipulated markets by designating favored

sectors

– Rationale:

• Deregulation (especially S&L, other financial)

• Anti-discrimination & “Ownership Society”

• Promote financial industry growth “Professional Exemption”

– Result:

• “Un-economic” credit and investment decisions

• Lack of transparency (securitization & OTC trading)

• Financial “products” ~40% of GDP

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Causes: Gov’t Intervention - 3

• Delays recovery by supporting busted investments

– Rationale:

• Keep “the system” from collapsing

– Result:

• Protects risk-takers from natural consequences

• Prevents healthy “sloughing” of “malinvestment”

• Concentrates economic power in fewer hands

• Brings political forces into economic decisions

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Contributors to Excess Credit

• Fannie Mae & Freddie Mac• Political revolving door

• Vehicle for social engineering

• Community Reinvestment Act• Legal leverage over lenders (anti-discrimination suits)

• Low Interest Rates Stimulate Speculation• Pro-ownership tax code

• ARM & Option-ARM mortgages - both prime & sub

• 25% of home purchases were for “flipping”

• Tradition of Federal Backstop• Fed & FDIC history of “saving the day”

• S&L bailouts; LTCM; 9/11; Tech Stock Bubble

• TBTF mentality; Moral Hazard

• Private profits; Public losses13

De-Regulation?

• Misnomer:

– Was really just a continuation of government

intervention ... with different beneficiaries

– Changes in rules encouraged ever more

malinvestment

• Real de-regulation:

– Remove the “TBTF” safety net, exposing risk-

takers to failure

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Woods’s Prescription

• Stop bailouts & let banks fail

• Abolish Fannie & Freddie

• Cut government spending

• Abolish the Federal Reserve

• Adopt commodity-backed money

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Things aren’t always what they seem to be

Someone sent me this w/ the caption “Sunrise at the North Pole”16

Critical Reader - 1

• Free markets depend on factors that aren’t

always achievable in real world:

• Many independent players

• Informed choice by buyers

• Minimal barriers to entry for new producers

• Capacity to absorb disappearance of failed

producers

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Critical Reader - 2

• How does free market deal with:

– “Natural” monopolies (utilities, highways, etc)

– The “Commons problem”• (quality of air, water, environment, natural resources)

– Capitalists’ push for growth & concentration of economic power

– Susceptibility of public to emotional campaigns• (leading to irrational choices against own best interest)

– Non-economic interests • (health, safety & security, military force, basic research)

– Anti-competitive interests • (intellectual property, deceptive advertising, fraud)

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Critical Reader - 3

• Natural roles of Government in economy

– Regulatory structure to promote competition in natural monopolies

– Rules that bring the cost of”commons” intothe economy

– Rules than limit the scale of individual producers

– Information to promote informed choice throughout economy

– Funding & “strategic shopping” for collective interests

– Rules that provide balance between proprietary interests & transparency

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Scary Pictures - CPI Inflation

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Scary Pictures - Money Stock M1

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Scary Pictures - Monetary Base

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Deeper Look: Money - 1

• Role: Medium of Exchange; Store of Value

• A given supply of money can support *any* amount of commerce

• (Overall Price Level) = (Money Supply) / (Aggregate of Goods & Services)

• Too much = Inflation; Too Little = Deflation

• Overall price increase is a *consequence* of inflation ... not its cause

• (but government always blames others)

• Discourages saving - things w/b more expensive in future

• Encourages increased risk - seeking returns to “beat inflation”

• Deflation not same as Recession or Depression• 19th century saw dramatic growth in US economy and living

standards ... but $1 bought more in 1900 than in 1800 23

Deeper Look: Money - 2

• In free market w/ constant money supply:

– Prices track supply & demand

– Rising prices in one sector are offset by falling prices in

another

• Control of money supply gives government the

power to mask trends

– Steady moderate inflation looks like growth

– Also reduces real cost of borrowing

– Inflation = Silent Thief of Savings

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Deeper Look: Money - 3

• Sound Money vs Fiat Money

– Commodity-backed money

• Redeemable for specie (gold, silver, etc.)

• Any extension of credit must be preceded by an act of saving

– Central Bank notes

• Not redeemable for anything

• No natural restriction on expansion of money supply

• “Adding to money supply cannot increase the amount of real

resources ... All it can do is make prices of real resources go

up.” (p128)

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Deeper Look: Money - 4

• Spend if you love America ???

– “A consumer is only able to buy things now because s/he has produced things in the past. Thus it is production that makes consumption possible.” (p.144)

– “We are much wealthier now than we were 300 years ago not because we consume more ... but because we can produce much more ...” (p.146)

– A higher savings rate slows economy in short run but it stores up future buying power ... to make business investments pay off

– Saving = the only legitimate source of investment capital

– International differences in saving rates (e.g. USA vs China) over time create massive shifts in relative economic power

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Deeper Look: Money - 5

• Political Forces on Central Bank

– Money buys access & legislative influence over rules

– Spending & tax code = gov’t rewards friends

• Federal reserve Act 1913

– Special-interest legislation masquerading as public interest

– Facility for rescuing troubled banks• ... but not for preventing them from doing things that get them

into trouble

– “The point of the central bank is to alleviate pressures that the free market would otherwise impose.”

• Jesus Huerta de Soto, quoted on p.17827

Deeper Look: Austrian School

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