Fair Weather Friends of the Market
Many, it appears, have simply panicked. Starting late last summer, the financial markets began to exhibit tremendous volatility, officials at the Fed and the Treasury began to act as if imminent disaster loomed, and media commentators and reporters completely lost their composure. Even people who should have known better began to talk and to act as if the economy stood on the brink of complete collapse unless the government took unprecedented actions immediately. When one extraordinary action failed to calm the waters at once, another extraordinary action was taken, then another, and another.
We now look back on four months littered with ad hoc bailouts, new regulations, institutional takeovers, a gigantic bail-out statute, massive lending, asset exchanges, and loan guarantees never before made by the Fed and the Treasury – all on a scale that no one foresaw six months ago. We might understand that the big bankers and other financial masters of the universe who had got themselves and their mega-institutions into such deep trouble would have worked hard to create a sense of crisis and to exploit it as a pretext for cushioning their slide from the financial pinnacles — peaks so high that the air is thin and the brain does not function effectively, so that even such workaday necessities as due diligence are overlooked. Blessed with friends in high places, these financial titans snatched loot by the hundreds of billions while the snatching was good.
But why have free-market economists and other commentators expressed approval of this blatant piracy? It now appears, I am saddened to report, that these free-market experts were not so expert after all. Indeed, many of them seem to have failed to understand how markets work and how government actions can hobble or kill those workings. Many have talked as if they actually believe in vulgar Keynesianism or other crackpot ideas — about “systemic risk” where none exists or about “missing markets” for poor-quality assets that only a fool would try to sell privately when the alternative of a munificent government buyout shimmers on the horizon.
Despite the evidence of how counterproductive all of these frantic government actions have been, of how they have served above all to produce “regime uncertainty”about what the rules will be tomorrow or the next day, and thereby to paralyze private arrangements, the market’s fair weather friends are now clamoring for various species of government “stimulus” as soon as the Obama regime takes power. Of course, the Obamistas’ motives are purely political, as befits a pack of office holders and their lackeys, so it is pointless to indict them — a rattlesnake is not to be blamed if it strikes, because its nature impels it to do so. But why are well-known free-market economists going along with this nonsense?
Back in my days as a professor, I always endeavored early in the course to teach my students the fundamental importance not only of the first laws of demand and supply, but also of the second laws of demand and supply. Thus, the first law of supply states that the greater the price, the greater is the quantity supplied per unit of time, other things being equal. And the second law of supply states that the own-price elasticity of supply is greater, the greater is the time allowed for response to a change in price. The first and second laws of demand are expressed similarly, mutatis mutandis. Thus, although we can expect markets to respond to price changes, we must recognize that the responses take time; and the greater the time, the greater are the responses. Anyone who expects markets to restore a disturbed equilibrium instantaneously will be disappointed. People cannot discover the relevant changes, confirm and assess them, consider alternative arrangements of their affairs, and carry out those changes in an instant. The competent economist appreciates the necessity of patience in evaluating the market’s operation. Simply because the market does not appear to have reconfigured itself fully soon after a shock, we have no warrant to conclude that “the market doesn’t work anymore” or that “the market doesn’t work the way it used to.” Such statements manifest an economic crackpot, and economists who talk this way discredit their professional competence.
A clever riposte, of course, is the one that Keynes himself famously made in response to criticism of inconstancy in his views: “When the facts change, I change my mind. What do you do, sir?” Glibness, however, is a poor substitute for good sense, and Keynes’s critics were right to call him to account for his frequent shifts with the winds of events and intellectual fads. Nothing that has happened recently invalidates in the slightest the solid corpus of sound economic understanding. Indeed, such understanding allows us to comprehend how a variety of government policies created the incentives that, by various paths, led to the current difficulties; and such understanding informs us that piling new, equally foolish polices on top of the ones that got us into these straits is a recipe for short-term salvation at best, and for long-term troubles galore, even if the short-term “stimulus” should appear to have the desired effects.
Decent analysts know these things; I am not breaking new ground here. So, we can only shake our heads in wonder when we see well-known free-market economists and other formerly sound analysts and commentators embracing unsound and ill-considered positions. Among other things, we must appreciate that the sky is not falling, even if the news media and the politicians talk and act as if it is.
Yes, house prices have fallen substantially, but what did people expect – that the bubbled-up values achieved between 2001 and 2007 would be sustained forever or rise even more preposterously? We are witnessing a correction. If real estate prices have been driven up absurdly by easy credit, reckless lending, and silly expectations, then real estate prices must come down substantially. To act as if prevention of this correction represents the sine qua non of recovery is to begin one’s journey on the wrong foot. And to suppose that throwing taxpayer money mindlessly at real-estate-based securities or at people who cannot afford to make regular mortgage payments only portends a new and greater collapse of house prices later on.
Of course, the new New Deal idea of the Obama regime’s “creating jobs” by bankrolling infrastructure “investments” might as well come with a written guarantee attached that it will generate nothing but resource waste and the pork-barrel distribution of vast amounts of taxpayer money to satisfy the appetites of congressmen, local politicians, construction unions, and real-estate interests. Even if a road, a bridge, or a sewer system ultimately comes forth as a visible result, the unseen alternatives forgone are almost certain to have greater value for those from whom the grasping hand of the federal state has stripped the wherewithal to pay for the projects. Free-market analysts ought to understand such matters, which are scarcely arcane, and anyone who has watched the government’s responses to previous recessions, from 1929 to the present, ought to understand the present situation without remedial instruction from me.
Yes, unemployment has risen, as it always does during a recession. But the rate of unemployment last month was only 6.7 percent. During the Great Depression, the unemployment rate often exceeded 20 percent, and many workers who had jobs in those days had only part-time employment even when they wanted to work full-time. So, despite the numerous Chicken Littles running about excitedly, the present situation does not bear comparison with the mass unemployment of the 1930s; nor does the ample safety net that now stretches beneath the unemployed — a refuge that did not exist in anything like its present setup during that difficult decade. I do not belittle the problems that involuntary unemployment may pose for people even now, but it makes no sense for policy makers to burn the house down because they have discovered that a few rats have taken up residence in it.
Above all, policy makers, economists, other analysts, and news media commentators need to cultivate an understanding of and appreciation for the wisdom of the aphorism, “don’t just stand there, undo something.” The greatest mistake made in previous occasions of this sort has been to add new government burdens to the ones that helped to bring on the troubles in the first place; hence the ratchet effect in the growth of government. If only we had the wisdom to recognize a crisis as the most compelling occasion for getting rid of accumulated government burdens and idiocies, then we could throw the ratchet effect into reverse, with highly beneficial long-run consequences, including greater economic liberty and faster economic growth.
Unfortunately, many people are now urging exactly the opposite policy, joining their voices with those of the usual suspects who, like Obama's lieutenant Rahm Emmanuel, seek to exploit the prevailing sense of emergency to lock new government controls and burdens onto the economy in order to gain their political ends and solidify their state powers, at the expense of our purses and our liberties. I beseech these former friends of the market: please pause and reflect; do not allow yourself to be stampeded into support for measures that probably will not work as advertised even in the short run and will certainly prove counterproductive and oppressive in the long run. The sky is not falling; do not act as if it is or lend your support to those who recognize hard times as the perfect opportunity to realize their grandiose dreams of social engineering, wealth redistribution, and central economic planning.
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Bill Woolsey - 12/29/2008
In his initial blog post, Higgs refrained from naming names or providing citations to free market advocates who are supporting government intervention due to the
financial crisis. I have read a few
things by market oriented economists
somewhat sympathetic to the banking
bailout. Well..in truth.. Tyler Cowen has had many articles on Marginal Revolution that appear sympathetic to banking bailout.
I tried to summarize the concerns Cowen suggested, though it is filtered through what I could imagine causing serious problem. While I don't have a citation, a paraphrase of my recollection is that it takes a long time to build up a new banking system.
Walstad is responding to that claim. Why can't a "new" banking system be set up rapidly? As Walstad mentioned, they don't have to construct buildings, train new employees, or the like. It would seem that the biggest lag would be the bankruptcy process.
FDIC has a good bit of experience doing "bankruptcy" without an interruption of business.
Further, it would seem to me that small banks should be able to grow rapidly. Banks with weak loan and security portfolios are losing uninsured deposits. They cannot continue to fund as many loans as before. Credit-worthy borrowers are being cut off by their banks.
This process is (or was) concentrated in the shadow banking system. People weren't buying financial and asset backed commercial paper, directly or through money market mutual funds. There was no funds available to buy securitized loans. Obviously (well, not to me,) those who were borrowing and whose loans were being securitized, then, would not be able to get loans.
Keep in mind, of course, that those with uninsured deposits are moving funds, say, to T-bills. T-bill yields drop.
Those holding T-bills can break them up into 100k blocks and put them into insured bank deposits. (now it is 250k.) Banks receiving these funds can make loans to the firms that are being cut off by the larger banks.
Even if a small bank was heavily invested in mortgages before, they can grow out of their balance sheet difficulties. This, of course, is what happened in the S&L industry in the eighties. But if they really are expanding with good loans, it should work. (If they were buying up mortgage backed securities and making subprime and alt-A mortgages with the money, it would be close to the situation of the S&L crisis. Digging a deeper whole.)
It always seemed to me that FDIC reorganized banks and smaller banks should be able to rapidly expand to provide real intermediation services, even if many large banks are "frozen" because of solvency problems.
I believe, however, that some market oriented economists disagree and that is why they favor bailing out existing banks.
Allan Walstad - 12/28/2008
My reference to Chapman was confusing. I was responding to his medicine metaphor, but in regards to your arguments rather than his. Sorry.
Bankrupt banks have assets, such as mortgages. Bankruptcy and restructuring permits those mortgages to be re-negotiated where feasible, otherwise foreclosed on with highly discounted re-sale. I don't buy the idea that the "banking system" goes up in smoke. Buildings are still there, deposits are insured by the feds, assets exist but just not sufficient to cover liabilities under current ownership.
I actually see some merit in the idea of a quick inflation to stimulate activity, if you've managed to get yourself into a real depression. That would be something like using an electric shock to defibrillate the heart. You don't do that for a bad cold. And in economics, if you don't have a Federal Reserve screwing around with the money supply to start with, if you have hard money (or free market money) and firm Constitutional barriers to government interventionism, I see no obvious reasons for depressions anyway.
Regarding the problem of deflation and real interest, the same hazard potentially affects any transaction which by contract extends over a period of time. If you get now and give later, and if the demand for what you're giving goes way up, you have a problem. It's your problem. We've had a century of the Fed's tinkering with the money supply to "stabilize" the economy, which has accomplished just the opposite. Enough.
Suggestion: Any defender of free markets who advocates monetary or fiscal interventionism to deal with this crisis ought to include, in every such editorial, equal space devoted to demanding sweeping reform to limit or terminate future government meddling in the market.
Bill Woolsey - 12/28/2008
I think you misunderstand the argument for an inflationary cure. The proposal is to increase the price level. This transfers money from all creditors to all debtors. That would include from bank depositors to banks. But then, also, from banks to those owing money to banks, in particular, those who borrowed to purchase homes.
The advantage of this approach is that some of the losses are imposed on depositors in financial institutions that made bad loans. One disadvantage is that the versions I have seen propose that home buyers and the owners of the banks that made the loans bear none of the losses. Further, the losses to depositors aren't imposed in proportion to risk. For example, those who sought marginally higher yields by investing in money market mutual funds that invested in asset backed commerical paper, commerical paper baked by subprime or alt-A mortgages. More standard bank deposits were protected
by 10% capital, more or less, and while bank portfolios were (and are) heavy on mortgates, there are lots of other assets too. And, of course, the inflationary transfer would hurt those who are invested in corporate bonds financing activity far removed from housing.
To me, this inflationary solution only looks reasonable relative to near Great Depression collateral damage (and you don't have to get too close to that to make the inflatioanry losses look better.) And, of course, having future taxpayers bailout banks, and then everyone else, financing public spending to create jobs, and generally have a new new deal. In other words, what we are likely to get.
Why flood banks with money? Because the Fed has a legal monopoly on the issue of base money. If the demand for base money rises (meanign that people want to hold more of it,) the market process that ajusts the real supply of base money to the demand is a decrease in the price level--both final goods and services and resources like labor. The change in the price level has the opposite effect on contracts as described above. Contracts must be renegotiated because of failure to properly account for a rise in the purchasing power of money rather than changes in the real economy. Moving to a lower price level involves deflation, which because of the zero lower limit on nominal interest rates disrupts credit markets with high real interest rates.
My view is that the banks should be flooded with money now to avoid I don't favor trying to generate inflation to "solve" the problem. I agree that the moral hazard issue is important, and people who invested into a specultive bubble need to lose money with the losses fucused in the usual way, first, the immediate investors, then those who lent to them, then those who lent to them.
If it turns out that zero nominal interest rates means that purchasing all outstanding T-bills would leave the market still hungering for more base money, then it is time to look to more radical alternatives--things that the Fed has been doing for the last year.
Allan Walstad - 12/27/2008
"I think that those of us who reject these arguments need to explain what is wrong with them."
A couple of things come to mind: wholesale robbery, moral hazard, locking-in of failed institutional arrangements.
I read Chapman's piece, in which he compares inflation to medications which, despite potentially harmful side-effects, may be necessary if you're sick enough. But is flooding money into failed banks a necessary stern medicine, or is it a counterproductive palliative? Perhaps bankruptcy and reorganization are the real medicine.
I also can't help wondering, if resources are diverted to failed private firms, what happens to the plans of those on the losing end of such transfers?
Another question: Where, if not here, do we dig in our heels and say no, this crisis caused by government meddling in the economy will not be the excuse for yet more government intervention?
I'd like to see some answers to those questions.
Bill Woolsey - 12/27/2008
A modern market economy requires a banking system
A banking system that is insolvent cannot fulfill its role.
A modern market economy with an insolvent banking system will produce at very low levels of output and employment--somewhere between that of the 1981 recession and the Great Depression.
The market process of founding new banks and having them grow until there is a new solvent system is very slow. Perhaps a decade long process.
The sufferring caused by something like a repeat of the Great Depression would be too great. The political consquequences too dangerous.
All the banks are insvolvent now.
Therefore, the banking system must be bailed out. The insolvent banks must be made solvent with taxpayer funds.
Or, more recently, the banks must be bailed out by an increase in the price level, transferring funds between all creditors to all debtors.
I think that those of us who reject these arguments need to explain what is wrong with them.
The commercial banking system as a whole was heavily invested in mortgages and mortgage backed securities. Some measures show a 30% drop in housing prices. While I doubt that all of the thousands of banks are insolvent, bankers have every incentive to lie. And the banking industry is quite concentrated, so that even if a small fraction of banks are insolvent it could be huge fraction of the banking industry.
I am certain that a modern market economy requires money. Measured by the dollar value of payments, nearly all money is generated by the banking system. (Measured by fund in deposits that are formally checkable after close of business, it is substantially less than the monetary base.)
However, as long as there is some money (say, the monetary base) then the real supply will adjust the the real demand through changes in the price level. _Is it reasonable to depend on this market process
Independent of its relationship to the payments system, banks serve as financial intermediaties. Consider a bank using 1 year C.D.s to fund 5 year installment loans to purchase cars. Or 1 month C.D.s to finance 60 day loans to finance purchases of inventory by retailers. If banks cannot provide these services, the production of goods and services will drop.
If insolvent institution can no longer undertake this activity, can solvent institutions expand (or new ones be created) to rapidly provide the intermediation services that were provided?
I think that people who invested into the housing bubble need to take losses. The owners of the banks and investment banks that lent to those investing into the housing bubble need to take losses. The people who lent to the shadow banking system, need to take losses. (They were receiving slightly higher returns by holding deposit like instruments,lending to institutions that held very little capital.
On the other hand, while I favor a little disinflation in the long run, I don't think this is the time to do it. So, the Fed's task should be to keep total spending in the U.S. growing about 5% a year. It seems likely that the insolvency of major banks will be associated with an increase in the demand for base money. The Fed should supply that demand. Of course, it will have too in order to keep aggregate expenditure growing 5% each year.
Meanwhile, FDIC should reorganize insolvent banks as fast as it can. The reorganized, now solvent banks, as well as the solvent (or currently believed to be solvent) banks should be able to expand to take advantage of profitable opportunities for intermediation.
To the degree that the insolvencies in the banking system means that profitable opportunities for intermediation are not undertaken, and total production is hampered, then the reduction in the growth of output, or actual decreases, should result in higher inflation. Real wages and real incomes should fall despite nominal incomes continuing to growth at 5%.
If the Federal Reserve buys up all the T-bills, then, it will be time to look to unconventional means. We aren't there yet.
I have never supported closing down the Fed or FDIC "cold turkey." I think that the popping of a real estate bubble with widespread bank insolvencies would be an especially bad time to go cold turkey on lender of last resort and deposit insurance.
As for the longer run, and aggitation for deregulation and privatization, there is work to be done. I find the
performance of the shadow banking system troubling. Has there been much work on a free banking system and widespread insolvency?
Robert Higgs - 12/26/2008
I can't speak for the others, but I was not kidding in anything I wrote here. I don't believe any central government involvement whatsoever is necessary for the successful functioning of a free-market order. Of course, in the past, everywhere, governments have intervened to some degree, but that intervention does not demonstrate that it was necessary, only that it occurred. It occurred for the same reason that robbery occurs even in a system based on private property. No one insists that you cannot have a private-property system unless it is sustained by robbery, to my knowledge.
The declaration that government intervention has been necessary in order to "save capitalism" is nothing but a misleading turn of phrase, akin to saying that destoying the village was necessary in order to save it. To the extent that the government intervenes, to that extent the free-market order is displaced or destroyed. No kidding.
Arnold Shcherban - 12/26/2008
You must be kidding us, jents!
If government never interfered into financial and other business markets, the capitalism itself would have been
finished long time ago.
One has to completely lose one's historical memory (and mind) to assert
the perpetual self-correction of capitalist economic and social system, in absence of any (and not of just some, but essential) central governmental intervention.
Robert Higgs - 12/26/2008
I understand your point, Keith, but I am inclined to identify a few other days as even worse, for example, September 17, 1862, and July 2, 1863.
Keith Halderman - 12/26/2008
I very much agree with what you are saying about Coolidge. I believe you could make a case that the day his son died was the worst day in American history.
Allan Walstad - 12/25/2008
I started reading Amity Shlaes' history of the Great Depression yesterday, and I've already come to the conclusion that it might well have been avoided if Coolidge had run for another term. The market correction of inflated stock prices would have been allowed to work itself out in a year or two. No interventionism, no price and wage propping, no Smoot-Hawley. How different history might have been.
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