“We have outlived the short-term and are suffering from the long-run consequences of [Keynesian government] policies.” –Ludwig von Mises
In 1918, at the end of the First World War, Randolph Bourne wrote his famous line, "War is the health of the state." Now, 90 years later, in the midst of a financial world war, we can expand that quote to say, "A Wall Street crisis is the health of the state."
What! The SEC under Republican “conservative” Chris Cox bans short selling.
The Bush adminstration and Congress seek to create a new Resolution Trust Corp. to buy up and eventually liquidate bad investments in real estate.
Congress wants to extend Federal deposit insurance on money market funds.
In sum, the Federal government is engaged in a massive intervention in the financial markets to keep the market from collapsing. The result is nothing less than a collectivist state. Collectivism is not quite socialism, where the government owns and operates the economy. Rather, it requires businesses to be regulated for some theoretical "common" good. It is free in name only because the government so heavily regulates private enterprise.
Financial crises and economic turndowns tend to increase the power of the state.
— The Great Depression brought us the Securities and Exchange Commission and the The Glass Steagall Act, which created the Federal Deposit Insurance for bank deposits and separated banking and brokerage businesses.
–The scandals of Enron and Worldcom brought us Sarbanes-Oxley Act, the draconian and expensive accounting rules, in 2002.
It’s uncertain at this point what kind of straight jacket Wall Street institutions and Main Street investors will face when Congress and the Fed get through this crisis.
Who is the Real Culprit?
Part of the problem is that most of the media and government officials don’t understand the true cause of this crisis. Judging from recent statements by the presidential candidates (both Obama and McCain) and business leaders (such as Donald Trump), they are blaming this entire crisis on greedy corporate leaders, speculators and short sellers. Keynesian economists blame it on the “inherent instability” and “animal spirits” of greedy capitalists engaging in excessive speculation and leverage in enticing new but unregulated financial instruments, such as subprime ARMs (adjusted rate mortgages), CMOs (collateralized mortgage obligations) and CDOs (credit default swaps).
The real culprits, however, are government agencies (Congress, Fed, SEC) which created the boom-bust excesses in real estate in the first place. Congressional leaders constantly promoted through new legislation home ownership by high-risk borrowers (sub-prime lending).
The recently government-imposed “mark-to-market” accounting regulations didn’t help either. It forced mortgage companies and banks to write down mortgages to zero simply because they couldn’t be sold, even if they were still being paid by customers. As a result, we’ve seen financial tornadoes causing institutions to be downgraded and in some cases to completely collapse.
Governments both here and abroad attempted to heat up the economy through easy money, beyond the natural capacity of technology, saving, and capital formation. The broad-based money supply (M2) grew by double digit rates in developing countries and even faster in emerging markets (Russia, India and China). The Fed cut short-term interest rates to 1% in 2004, far below the natural rate of interest, and thus caused an artificial boom in real estate, junk bonds, and other assets.
Now we are witnessing the unintended and perverse consequences of their contrived agenda. Yes, there was corporate greed in response to the bad incentives created by government agencies. Normally, as Adam Smith and other classical economists point out, the commercial society moderate the passions of greed, but when government intervenes, greed can get out of hand.
Inflation and easy money are never neutral in its effects. Followers of Ludwig von Mises and Friedrich Hayek of the Austrian school of economics have long warned about the risks inherent in artificially stimulating the economy by cutting interest rates below the natural rate and inflating the money supply. It can cause an unsustainable surge, destabilize the economy in unexpected ways, and threaten a wholesale depression and crash on Wall Street. Today the Austrian theory of the business cycle offers the best explanation of what’s going on. (For more information, see my book “Vienna and Chicago, Friends or Foes?”)
Real Financial Reform
What’s the solution to this crisis?
First, let’s return to sound money. The Fed should stop shifting back and forth from easy money to tight money, from lowering interest rates to raising them. The Fed and other central banks must adopt a systematic policy of stable money. The price of gold should be a good barometer in providing monetary stability and genuine growth.
Second, the government should be reluctant to come to the rescue of every major corporation or bank. When the state socializes losses, it creates what economists call “moral hazard,” which encourages businesses and banking institutions to take on excessive risk in their ventures, knowing that the government will cover up their mistakes. Government guarantees, including insurance on bank deposits and brokerage accounts, can be costly, encouraging irresponsible behavior in the future.
I was glad to see the Bush administration refuse to bail out Lehman Brothers. In the 1990s, the giant investment banking firm Drexel Burnham Lambert was allowed to go under, and the economy survived and prospered. It’s an important lesson.
It would also be great if the new president would preserve the 15% tax break for dividends and long-term capital gains, and reduce the corporate income tax, following the trend in Europe and Asia. These measures would help strengthen the dollar and create jobs. But with Obama leading in the futures markets, the outlook for tax breaks for investors isn’t good.
These are real changes. While waiting for them to be implemented, investors should ride out the storm by investing conservatively, being well-diversified both here and abroad, and holding a safe haven in cash and gold.
The latest crisis won’t be the last. That’s why I’ve decided to hold an Anti-Davos Anti-Establishment "World Economic Summit," at the five-star Atlantis Hotel & Resort, in Paradise Island in the Bahamas, January 28-30, 2009; Steve Moore, editorial board member of the Wall Street Journal, will be our keynote speaker. Other speakers include myself, Peter Schiff, Eric Singer, Peter Zipper, Keith Fitz-Gerald, Frank Seuss, Jon Golding, Lou Petrossi, Ron Holland, and many more. For more information, and to sign up, call Tami Holland at 1-866-266-5101 or go to www.freedomfest.com.