Saturday, June 12, 2010

Book Review: Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse

Thomas Woods has written a brilliant book on the ongoing financial crisis: Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse (Washington, D.C.: Regnery, 2009). This book answers several important questions, including:
  1. What caused the financial crisis? Specifically, why should we pin much of the blame on the Federal Reserve?
  2. What is making the crisis worse?
  3. What should be done now?
Initially, here are some of Woods' insights that I found especially pertinent:
  • On rewarding government failure with more government power: "Following a familiar pattern, government failure has been blamed on anyone and everyone but the government itself. And of course, that same government failure is being used to justify further increases in government power" (p. 1).
  • On Obama's policy of "more of the same": "A first glance at Barack Obama's economic team confirms that all the talk of 'change' really meant more of the same--more bailouts, more government intervention, more addressing symptoms rather than causes--along with huge deficits and massive increases in government spending, which our leaders superstitiously believe can restore economic health" (p. 7).
  • On the primary culprit, the Federal Reserve: "The Fed's policy of intervening in the economy to push interest rates lower than the market would have set them was the single greatest contributor to the crisis that continues to unfold before us. Making cheap credit available for the asking does encourage excessive leverage, speculation, and indebtedness. Manipulating interest rates and thereby misleading investors about real economic conditions does in fact misdirect capital into unsustainable lines of production and discombobulate the market. Imagine that" (pp. 8-9). Elsewhere, he notes that the Fed is the "greatest single government intervention in the economy" (p. 2).
Woods first addresses what caused the financial crisis. He notes: "Blaming 'greedy lenders' or even foolish borrowers for what happened merely begs the question. What institutional factors gave rise to all the foolish lending and borrowing in the first place?" (p. 13) Woods pinpoints several culprits:
  1. Fannie Mae and Freddie Mac: These government sponsored enterprises (GSEs) purchased home mortgage loans from originating banks and received the stream of monthly payments from borrowers. They also bore the risk of default or would package loans into investments called mortgage-backed securities that would be sold to investors, who in turn received the payments and assumed the risk of default. The entities enjoyed special tax and regulatory privileges, came to have a hand in about half of the country's mortgages, and tried to extend advantages to minority and low-income home buyers. Because the entities were a reliable source of campaign contributions for Democrats, some have suggested that Democrats wanted to leave them alone rather than exercise oversight to ensure that these entities were carefully managed. The entities enabled more home loans to come into existence than would have otherwise been possible in a truly free market, including loans to borrowers of suspect creditworthiness.
  2. The Community Reinvestment Act (CRA) and affirmative action in lending: The Federal government mandated that political, rather than sound economic factors, should take precedence in lending decisions. Woods states that "credit history, down payments, and traditional sources of income ... were presented as dispensable obstacles in the way of increased home-ownership among society's least advantaged." Woods describes risk management within Fannie, Freddie, the CRA, the Federal Reserve, and other government entities, as "cavalier." These factors steered the Fed's newly-created money into the housing industry and created a bubble that would inevitably pop.
  3. The government's artificial stimulus to speculation: When home prices began rapidly and steadily rising, speculators entered the market hoping to secure easy profits. Artificially low interest rates (thanks to Fed-induced inflation), coupled with "cavalier" risk management in lending standards, paved the way for the bubble to be further inflated. The ARM and zero-down payment loans, enabled borrowers to enter the market with little or no "skin in the game," and the SEC-created cartel of ratings agencies gave high ratings to the mortgage-backed securities that represented packages of these risky loans.
  4. The "pro-ownership" tax code: The Federal government stimulated further housing demand by the deduction for home mortgage interest; the more one borrowed and the higher the interest payments, the more one could deduct on taxes. Also, various levels of government have provide incentives for builders to continue pumping up the supply of houses.
  5. The Federal Reserve and artificially cheap credit: Woods briefly summarizes the "Austrian business cycle theory," as follows: "When the Federal Reserve pushes down interest rates by increasing the money supply, it encourages a boom in the production of relatively longer-term projects: raw materials, construction, and capital goods in general. The boom in construction and real estate this past decade made possible by these low interest rates, is a good example. Unlike the production that genuine consumer demand stimulates, though, the Fed's artificial stimulus is not in line with real consumer preferences or the current state of the economy's pool of savings. It draws resources away from projects that cater to real consumer demand, and it encourages more and different kinds of projects to be undertaken than the economy can sustain. The necessary resources to complete these projects profitably do not exist. Neither the saved resources to complete them, nor the consumer base to purchase the finished products, exist in sufficient volume. Not enough people want or can afford half-million dollar homes. The prices these homes can fetch are far lower than initially anticipated. The bust comes" (p. 26). At the end of his chapter on the culprits, Woods quotes economist Gerald O'Driscoll's analogy of the Fed: "an arsonist watching a fire he set, expressing amazement at how such an event could have happened" (p. 34).
  6. The "too big to fail" mentality: The Federal government creates moral hazard when it establishes a regulatory and policy structure that enables corporations to make risky bets, reap the profits if their ventures turn out, but socialize the losses if their projects fail. The solution: "Make perfectly clear once and for all that there will be no bailouts, no looting the public, on behalf of any firm, period. That 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" (p. 32).
Next, Woods addresses the bailouts and other measures the government is pursuing to make the crisis worse, all in the name of curing the crisis, of course:
  • Our ostensibly wise leaders such as Fed Chairman Ben Bernanke assured us in May 2007 that the subprime market would not significantly impact the rest of the economy and financial system. Bear Stearns had to be bailed out in March 2008, and by August 2008, Bernanke and Treasury Secretary Hank Paulson were busy assuring everyone that we had a "strong" economy. Not long thereafter -- within a few weeks and months -- these leaders were proven magnificently wrong, and they had to demand new and greater powers, ostensibly to fix all the problems they created but failed to foresee.
  • Paulson allowed Lehman Brothers to fail, supposedly because he wanted to avoid moral hazard in the marketplace (described above). However, the very next day, he bailed out AIG to the tune of $85 billion.
  • Rather than bailing out the "too big to fail" companies, the government could allow the squanderers to fail so that resources could be reallocated to wiser managers. Woods notes that "discontinuing activities that destroy wealth and drain resources away from healthy, competent firms is a step forward for the economy" (p. 40). However, as we know, the government has thwarted this process of reallocation through the bailouts and artificial stimulus for asset values that need to fall (e.g., housing prices are stimulated through tax credits, allowing defaulting borrowers to stay in their homes rather than putting these houses on the market, etc.).
  • "The economy needs time to restructure itself, for market participants to sort out which investments are sound and which are squandering capital, and for asset prices to be brought back into line with reality, in order for rational economic calculation to proceed once again" (p. 42). Instead, we are relying on the "'collected experience' of people who for years had been ludicrously mistaken in their assessments of the economy, whose statements and proposals changed from week to week, and who obviously hadn't the slightest idea what was happening" (p. 43).
  • On regulation and deregulation, Woods wisely supplies a nuance in his free-market thinking: "Any 'deregulation' of the banking system that permits the banks to take greater risks while maintaining government (that is, taxpayer) insurance of their deposits [i.e., moral hazard] is not genuine deregulation from a free-market point of view. ... But a mixture of liberalizing banks' risk-taking ability while maintaining a government guarantee may be the worst of both worlds" (pp. 46-47).
  • The system we have created "artificially encourages indebtedness, excessive leverage, and reckless money management in general" (p. 47).
  • The bailout system encourages companies to profit by the political, rather than economic, means. The politicians can advance their careers by "looting the general public to bail out some wealth destroyer," and in the absence of such opportunities, the politicians "would hardly know what to do with themselves" (p. 54). The state creates uncertainty so that businesses don't want to sell off assets at realistic market prices when the possibility exists that the state will step in to buy the assets at inflated prices. This clogs the markets and perverts the profit-and-loss system so that businesses have guaranteed profits, while losses go to the taxpayers. Moral hazard has been institutionalized.
  • The government cannot foresee the unintended consequences of its interventions, and neither can it foresee the beneficial results of letting the market sort out real asset values and profitable projects. The government tries to give us something for nothing, to shortcut the process of true wealth creation.
Woods devotes a chapter to boom-bust cycles, arguing that these are not created by capitalism, greed, or deregulation, but by the institution and system of government itself -- specifically, the central bank. He points out that, according to Austrian business cycle theory, interest rates coordinate savings and investment. As people save more of their resources and defer consumption, there is more to invest in long-term capital projects, and interest rates go down; people are demonstrating a preference to defer present consumption in favor of the long-run. However, when the Federal Reserve artificially injects credit into the economy and lowers interest rates, the market is distorted and projects that would not have been otherwise undertaken suddenly appear to be viable and profitable in the long-run. Yet, reality must eventually set in, and the projects are demonstrated to be unsustainable. This is when the government decides to step in with bailouts, more credit expansion and other interventions to delay the needed corrections: falling prices, a temporary freeze-up on lending markets, losses for unsustainable projects and enterprises, and reallocation of resources from the wasters to those who can profit by the economic means. Capital is squandered and resources are wasted as the government pursues more and bigger bailouts. Importantly, many businesses and projects fail at once, and this "cluster of errors" -- as opposed to the more general failure of businesses and projects here and there that we might expect in the economy -- comes about because of the damage from artificially low interest rates during the economic "boom."

Woods points out that the Fed injected massive amounts of credit to resolve the dot-com bust between 2001 and 2004. Housing starts did not decline during the dot-com bust, which was the first time on record this happened during a recession. The Fed's injection of credit created conditions for a massive run-up of housing prices, which represented a misallocation of economic resources that would need to be corrected in the form of lower housing prices, economic recession, and reallocation. Given that Austrians were some of the few economists who predicted the inevitable collapse, the theory demonstrably has great explanatory power and also exonerates the free market, according to Woods. We must blame the Fed and government interferences, rather than the market itself.

Woods devotes a chapter to debunking myths about the Great Depression, pointing out that Hoover and FDR were both interventionists; that the 1920-1921 depression was just as severe initially but that it self-corrected much more rapidly in the absence of any government and Fed intervention; and that Austrians had correctly predicted the Great Depression in contradiction to other schools of thought that claimed the economy was fundamentally sound and that the boom could last long into the foreseeable future. Woods deals with the dangerous myth that "war brings prosperity" by pointing out that during war, consumers suffered from "rationing, declining product quality, the complete inability to purchase things like new homes, cars, and appliances, and an increase in the work week" (p. 104). War benefits the state, while the private sector is more prosperous in peacetime.

Woods pinpoints several problems with our current monetary system:
  1. a 95% decline in value of our dollar since the Federal Reserve's inception in 1913
  2. insidious expropriation of wealth so that the government need not tax or borrow; it can simply inflate secretly and depreciate our currency in order to increase spending, gain more control, and buy votes
  3. the boom-bust cycle's inherent instability and miscalculation within the economic system
  4. the existence of alternative systems that would eliminate moral hazard for the elites, as they are now enabled to bail out their failing friends in defiance of popular opinion
  5. a flourishing of reckless risk-taking and leveraging
Money comes about naturally and spontaneously in a free market because people recognize benefits of "indirect exchange" rather than barter; they can trade, in a roundabout way, their products or services for a highly marketable commodity that they can later trade for the products and services of others. The most highly marketable commodity in an economy becomes its money. But the government steps in to monopolize money creation in its own hands; fiat paper money can only come about through a parasitic means, as when the government establishes legal tender laws and confiscates the previously used commodity (e.g., gold), because no one in their right mind would trust government-issued, easily-depreciated paper if there was an alternative, sound, proven, and highly marketable commodity available to use as money. Governments assert sovereignty for themselves and loot the population through inflation, which can and has historically been criticized on both economic and moral grounds. A free market commodity money restricts the state's theft and gives the people freedom; thus, the state's hatred for gold and silver.

The government uses various means, including legitimizing "fractional reserve banking," establishing central banking, providing deposit insurance to prevent bank runs, and so forth. The Federal Reserve, created by a small group of special interests within government, banking, and the economics discipline, provides "special privileges for one particular industry at the expense of the rest of society" (p. 120). The Fed controls our money supply, manipulates interest rates, serves as "lender of last resort" to banks, buys and sells government debt to expand and contract the money supply and to finance the government's destructive interventions, and sets the required reserve ratio for bank deposits. Through all of these means the Fed can create inflation, which drives up prices, hurts people on fixed incomes, provides an artificial stimulus for economic activity, redistributes wealth to the politically well-connected, discourages savings, creates moral hazard because the central bank can bail out its friends in time of need, leads to the business cycle; and, finally, all of these problems can be blamed on the "unregulated free market" so that the state gains more and more power because of the crises it creates.

Woods says that the notion that Fed inflation leads to prosperity is "one of the great economic superstitions of our time" (p. 126). In order to have prosperity, an economy needs a pool of real savings that is created when producers defer consumption; this provides a base of real resources that can be invested and transformed into capital for longer-term production. The Fed cannot create prosperity through inflation.

Woods addresses several anti-gold fallacies, including: gold and silver aren't flexible; precious metals are too bulky; a gold standard is too costly; there isn't enough metal to facilitate transactions; and the supply of gold cannot keep up with the growth in business activity. He then provides a note on deflation, arguing that falling prices are not the economic nemesis that many within the establishment make it out to be. Importantly, he points out that true deflation is a decline in the money supply, not a decline in prices, the latter of which could be a result of deflation or a beneficial result of greater productivity.

Woods concludes with a discussion of what should be done now. He confronts the notion that consumer spending drives the economy, arguing that this is true only in the sense that consumer preference helps firms decide what to produce, with what methods, and in what quantities. However, wealth is not generated through spending, contrary to the popular myth that spending is key to economic prosperity. Gross Domestic Product is not a good measure of economic health because it "leaves out all the higher and intermediate stages of production that take place on the way to producing final consumer goods" (p. 143). Consumption, or using things up, does not drive prosperity; rather, production, which makes consumption possible in the first place, is necessary. Prosperity is enhanced when businesses produce something people want.

Woods notes: "Stimulating more consumption will only widen the mismatch between resources invested in higher-order stages of production geared toward future production on the one hand and demand for consumer goods in the immediate present on the other" (p. 144). "Consumptive expenditure uses up, exhausts, and destroys; productive expenditure provides for its own replacement in the form of an increased supply of goods in the future" (pp. 145-146). The stimulus packages, for example, simply encourage us to consume without providing replacement resources for the future.

We take this process for granted, but had people before us failed to save and sacrifice, we would not have the capital and productive capacity to enable us to consume. Imagine if our forebears had stimulated consumption and discouraged savings, investment, and production; we would be much poorer for it. Think of the legacy we are leaving for future generations with all our reckless debt and consumption. The picture the statists have created for us is quite bleak.

In summary, Woods suggests the following solutions:
  • Let the failed business fail. Bankruptcy is good and necessary; the assets and capital continue to exist and can simply be reallocated to wiser managers.
  • Abolish Fannie and Freddie. Don't "attempt to fix bad government with more government," in the words of Jeffrey Miron (p. 148). In light of the discussion above regarding these institutions, it should be obvious that abolishing these GSE is a necessary step to restore economic health.
  • Stop the bailouts and cut government spending. In short, most of the time we would be well-advised to "do exactly the opposite of what the New York Times calls for" (p. 149).
  • End government manipulation of money. The Fed created "the most bloated asset bubble the world has ever seen. It has encouraged the diversion of resources into an unsustainable structure of production that must be rearranged amidst inevitable bankruptcies and liquidations" (p. 150).
  • Put the Fed on the table. It creates instability and is an unnecessary and disruptive intrusion, according to Woods. Some, including Jim Rogers, have predicted that the Fed will be abolished. Ron Paul has called for its abolition in books and bills before Congress. The Fed creates moral hazard as a permanent institution and is very secretive about its dealings; it needs to go.
  • Close those special lending windows. Give the market a chance, and get rid of the bailouts.
  • End the monopoly on money. If you really believe in the "free market," you should trust the market to provide money. Some would even suggest ending any "standard" for money and letting the market decide, i.e., rather than imposing a "gold standard" or "silver standard." The key is freedom and "separation of money and state," in the words of Hayek.
Woods' book effectively and entertainingly sets forth the story behind the crisis, the current interventions, and the necessary solutions to restore economic freedom and prosperity. This is an indispensable resource for understanding, on a very relevant and practical level, the subject of economics, which the great economist Ludwig von Mises calls "the main and proper study of every citizen."

posted by C.S. Hayden @ 12:29 PM 0 Comments