A way out of the economic crisis

Thomas E. Woods Jr: Stimulus spending raids the private sector for money-losing ventures. . .

Thomas E. Woods

For years, the authorities told us everything was fine. Former Treasury secretary Hank Paulson said the world economy was in the most robust shape he had ever seen it. There was no housing bubble, said the Federal Reserve’s economists; rising housing prices were the result of real factors and more or less sustainable. Those who warned that much of the apparent prosperity was illusory and that a crash was inevitable were laughed at and dismissed.

It’s impossible to devise a way out of the economic crisis without first understanding how it occurred. Our policymakers, none of whom saw it coming, have no idea what caused it. Most of their proposals, as a result, have involved treating symptoms rather than addressing root causes.

This article is an extremely truncated look at the causes and solutions to this crisis. My new book Meltdown explains all this, in layman’s terms, at greater length. I intended it as an antidote to the atrocious economic advice we’re hearing from those who claim the free market has failed and that our wise rulers must rescue us.

The housing boom and bust is directly attributable to the Federal Reserve System, which is not a part of the free market. Created by Congress, the Fed enjoys government-granted monopoly privileges without which it would be nothing. Without the Fed, banks would have run out of loanable funds when the public demanded an abnormal number of homes. Interest rates would have shot up, thereby ending speculation in real estate. The Fed made sure this healthy process did not occur. The bubble and its madly inflated prices continued onward.

F.A. Hayek, who belonged to the Austrian school of economic thought, won the Nobel Prize in economics for showing how interventions by a central bank (like the Fed) into the economy create only apparent prosperity instead of real growth. This phony prosperity has to end in a bust. Note the implication of Hayek’s argument: It’s not the free market but intervention into the free market that causes the problem.

Instead of coordinating production across time, interest rates tampered with by the Fed become the source of discoordination. Investors begin projects that will not, in the aggregate, all be able to be profitably completed. Consumers, meanwhile, misled into thinking themselves wealthier than they really are (they were sitting on a forever-appreciating $500,000 house, right?), go on spending binges that later catch up with them, and that they would not have engaged in if the Fed had stayed out of the economy and allowed them to see their true financial condition clearly.

The market needs to be left alone to sort out which of the activities funded during the bubble years is a genuine, wealth-generating activity, and which is a bubble activity that can survive only as long as the monetary spigots are flowing. For the sake of American prosperity, the latter activities need to be discontinued immediately.

Government refuses to allow this process to occur. “Stimulus” spending raids the private sector for funds to spend on money-losing ventures, thereby weakening the wealth generation process. (If they weren’t moneylosing, private firms would be engaging in them already.) And it interferes with the market’s attempt to reallocate resources rationally in the wake of an artificial boom.

Monetary stimulus — or, more bluntly, creating money out of thin air — is no better. That’s what caused the problem in the first place. Merely creating more of the medium of exchange cannot repair the real, structural problems in the economy caused by the artificial boom. It can only encourage further distortions and wealth destruction.

Japan got more than a decade of the economic doldrums thanks to its government’s disastrous program: eight stimulus packages, interest rates forced to zero, partial nationalization of the banking system, zombie companies propped up and bailed out. The list should sound familiar.

When the U.S. economy fell into depression in 1920, a depression whose first 12 months were worse than the first 12 months of the Great Depression, the federal government was largely passive. In fact, the federal budget was actually cut in the face of the depression (a course of action we’re told today would be disastrous), and the Fed, for its part, essentially stayed out. By the summer of 1921, recovery had already begun. That wasn’t supposed to happen, according to today’s economic orthodoxy.

Let failing firms go bankrupt so they can stop clogging the production process and their assets can be taken over by more competent actors. Forget monetary and fiscal stimulus. Let prices of all goods, housing included, go to wherever supply and demand converge; any other policy amounts to waging a war with reality — a war government is unlikely to win.

And stick to this program. The business community is so uncertain about future government policy that it’s no wonder so little long-term investment is going on. The same phenomenon plagued the country in the 1930s. According to economic historian Robert Higgs, businesses held back from investing because of what he calls “regime uncertainty,” a real concern about future government policy that could damage business profitability. Now that would be change we can believe in.

Thomas E. Woods Jr. is a senior fellow at the Ludwig von Mises Institute and the author of nine books, including “Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse.”