The Canadian Red Ensign

The Canadian Red Ensign

Saturday, May 5, 2012

GTN Tory Classics No. 6: Boom and Bust

The following essay, “Boom and Bust”, was the second in the seven-part series on economics I wrote in 2009. The year previously the American subprime mortgage crisis which had been brought on by the bursting of the real estate bubble had escalated into a much larger financial collapse. The American economy had begun to tank and it was dragging the global economy down with it. What caused this? Has it happened before? Is there a way out of this crisis? Can this sort of thing be prevented in the future?

These were the questions that were foremost in people’s minds at the time. In February of 2009, Regnery Publishing released a book by Dr. Thomas E. Woods Jr., a paleolibertarian (1) historian on the faculty of the Ludwig von Mises Institute, entitled Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse. I had read this book about a month and a half before writing this essay. I thought – and still think – it was the most sensible thing I had read on the subject. I lent my copy out a number of times and bought another copy as a Christmas gift for a relative later that year.

This essay was written not as a review but as a recommendation of Woods book and of the Austrian School’s explanation of the business cycle. I do not agree with the Austrian School about everything, not being a philosophical liberal (2), but of all the free-market economic schools I find myself agreeing the Austrians most often.

(1) A paleolibertarian is someone who is culturally conservative and politically/economically a classical liberal or anarcho-capitalist.

(2) A philosophical liberal believes that human beings are first and fundamentally individuals and that all social institutions and groups are created by individuals for individuals and should operate on a voluntarily contractual basis. A philosophical conservative believes that society is organic, that the family comes before the individual, that the most important social relationships are permanent rather than voluntary and contractual, and that many if not most social institutions should be modeled after the family rather than the business deal.

Boom and Bust

By Gerry T. Neal
June 2, 2009

Once upon a time, in a land far away, some people discovered the secret to getting rich fast. Their houses, they discovered, had gone up in value since the day they bought them, so they sold them off at a profit, bought a new house, and started the process over again. The idea caught on and pretty soon people had forgotten that the purpose of houses was not to generate money but to provide homes for them and their families.

Not everyone was happy in this land, however. Some people were shut out of the action because they could not afford to buy a house. Furthermore they were not good candidates for bank loans – they had no collateral, worked low-paying jobs at best, and did not have enough for a down payment even if they were granted a mortgage. With the prices of real estate going up, their situation appeared hopeless.

But then someone got the idea that the ruler of their country ought to do something about this. Appointing himself the representative of the poor people he went to the ruler and complained. “Its not fair!” he said. “These people are being discriminated against because they are poor and because of the color of their skin. Everybody has the right to own their own house. You need to make sure these people get their houses – if you don’t I’ll throw a big stink and call you racist. Now what are you going to do about it?”

This threat terrified the ruler who promised to do something about it immediately. So he sat down and thought about what he could do. Then he called a press conference and announced that he was starting a program which would enable the poor to own their own homes. He ordered the banks to give mortgages to poor people from “disadvantaged minority groups” without demanding a down payment. To ensure the banks cooperation he asked his friends Fanny and Freddie to help him out.

Fanny and Freddie had an interesting business. They went to the banks and bought out their mortgages, i.e., they paid the banks the equivalent of the money they had loaned out in mortgages so that the mortgage payments would come to them instead of the banks. They then put all these mortgages together into large funds and sold off shares in these funds on the securities market.

Everybody lived happily ever after, right?

Well, not exactly. One day the prices of houses stopped going up. This not only threw a monkey wrench into people’s get rich schemes, it left many of them with mortgages that were worth more than their house. And so the defaults began. It got so bad that Fanny and Freddie went broke and asked their friend the ruler to help them out. The ruler decided that the best way to help them out was to buy their business from them and cover their losses with tax money.

Then several of Fanny and Freddie’s friends in the financial industry asked for the same consideration.

And after the ruler had bailed them out, everyone else came asking for a handout too.

At this point, the people were so fed up with way the ruler was mishandling things they got rid of him and chose a new leader. They chose a young, charismatic, new leader, who promised that he would give them “change”. And when that young man was secure in office he did exactly the same thing as the old ruler.

So what can we learn from this story?

It was the involvement of government that turned this situation into a major fiasco. It would seem then the obvious lesson to take from this is that government “solutions” to economic problems only make the situation worse.

This is exactly what economists of the Austrian School have been telling us for over a century now. These economists saw the not-so-fictional crisis described above coming in advance. They also saw the Great Depression coming. Perhaps its time we paid more attention to what they are saying.

The Austrian School of Economics began at the University of Vienna in the late 19th Century with economics professor Carl Menger. Its most famous representatives, however, would be 20th Century economists Ludwig von Mises and Friedrick August von Hayek. Mises is the author of, among other books, Human Action the most exhaustive treatise on Austrian economic theory available. Hayek is the Nobel Prize winning author of the best selling and much more readable The Road to Serfdom. In North America their theories have been promoted primarily by libertarians like the late Murray N. Rothbard and Lew Rockwell.

Austrian economists consider themselves to be liberals in the classical (19th Century) sense of the term. Their thinking displays both the strengths and the weaknesses of classical liberal thought. Foremost among those weaknesses is their tendency towards the belief that people matter only as individuals, that the interests of families, communities, and any other “groups” should be subservient to the interests of individuals. Foremost among their strengths is their belief in small, limited, government and maximum personal freedom.

The Austrians developed the best theoretical defense of the free market against state economic planning in all of its various forms that we have. This defense is based on the subjective theory of value, the idea that in a market situation the value of a good or service to both seller and buyer, is not something that can be objectively determined based on the intrinsic quality of the good or service but is based entirely on how much the seller and buyer value the good or service in relation to what they are willing to accept/give up in exchange for it.

But the Austrians’ uncanny ability to predict economic crises like the Great Depression and the current situation is due to their theory of the business cycle.

The conventional explanation of the business cycle, in which a boom period of economic expansion is followed by a bust period of economic contraction, is that it is an inevitable product of the free market.

The Austrians say otherwise. The business cycle, they say, is caused by banks, especially government chartered central banks. Banks lend money to investors and entrepreneurs out of the money people place in savings accounts. The interest rate on these loans is supposed to be an indication of how much people are saving as opposed to spending at a given time, giving investors/entrepreneurs an indication of what kind of ventures are likely to succeed. But when a bank starts lending out of its pay-on-demand reserves, what is known as fractional reserve banking takes place. This artificially lowers the interest rate giving the impression that people are saving more than they are, tricking investors into putting their money into projects appropriate for a period of savings. This leads to economic booms in the areas this money is being invested in – booms that must inevitably give way to busts.

Non-Austrian economists, especially Keynesians, scoff at this theory.

But none of them ever saw an economic disaster coming in advance.

For more on this subject I recommend Dr. Thomas E. Woods Jr.’s excellent book Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse (Regnery Publishing: Washington D.C., 2009). It is a small book, brief and written for the economic layman. It is must reading for anyone wishing to understand what is going on in the current economic crisis.

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