Counterproductive Solutions to the Credit Crisis
In his economic treatise Human Action, Ludwig Von Mises made the basic, but important point that “Monetary calculation is the guiding star of action under the social system of division of labor.” He noted that it is up to the businessman “to distinguish the remunerative lines of production from the unprofitable ones.”
Von Mises of course wrote his essential book amidst the Bretton Woods era when the world enjoyed the relative stability of the dollar standard; the dollar linked to a fixed gold price of $35/ounce. Since the U.S.’s mistaken decision in 1971 to leave the gold standard, money, previously insignificant except as a facilitator of the all important beneficial exchange of goods, has become a distortive variable in commerce. Though it was once the “compass of the man embarking on production,” the gyrations of currencies today often retard production and trade due to the mal-investment that frequently results when money values lurch in either direction.
We saw this in the late ‘90s when the Fed’s failure to accommodate the capital gains cuts led to what many considered a deflationary dollar. As the dollar’s value drove commodities to modern lows, equities, including nascent Internet companies, were the big winners. With the dollar’s gold price well below its 10-year average, there was a rush away from the “real” into less tangible asset classes that promised greater returns than commodities crushed by the dollar.
But as is always the case, reality caught up to the money illusion. Companies new and old eventually collapsed under the weight of dollar debt that grew in real terms amidst a falling price level that was falling due to the rising dollar. Importantly, the companies that hit hard times, from Enron and Worldcom to eToys and Webvan, were allowed to fail.
Even though the various equity markets subsequently fell in ways that make today’s home-price moderation look positively tame by comparison, the federal government mostly stayed out of the way such that price discovery could occur, and capital could be redeployed such that the economy quickly recovered from what was an historically shallow recession. Better yet, those who ignored the gloom surrounding Internet companies at the market’s nadir made big money to the extent that they snapped up the various dotcom survivors at fire-sale prices.
Moving to September of 2001, the tragedy that was 9/11 set in motion the dollar’s escape from deflationary territory. With the world a much riskier place due to terror fears, the dollar price of gold began to rise in such a way that companies benefited from a reduction in their real debts. The latter moderation of dollar strength combined with the 2003 Bush tax cuts led to a rising economy and stock market by the spring of 2003.
The problem by 2003 was that neither the Bush Treasury nor the Greenspan Fed communicated to the markets any kind of desire for a stable dollar price. Worse, increased terror fears in concert with a Bush Administration that seemingly welcomed a weaker greenback (as evidenced by tariffs on steel/lumber/shrimp alongside a protectionist stance against China) turned the dollar reflation into an eventual dollar rout.
As the dollar weakened, a reverse of what happened in the late ‘90s occurred. The falling dollar led to what Von Mises referred to as a “flight into real goods.” Commodities are of course priced in dollars, and with the latter sagging, commodities, including housing, began an impressive run. Sure enough, an investment in property or gold since 2003 has handsomely outperformed the various equity indices over the same timeframe.
But just as investment can be distorted amidst a rising currency, the same can occur when the currency is losing value. Profits attract capital, and with housing and commodities on their aforementioned run, savers and equity investors lost out as capital was redeployed to the “real.” Furthermore, as Keynes pointed out, amidst devaluation the "practice of borrowing from banks is extended beyond what is normal."
The above is what we experienced in recent years, and much as markets eventually corrected for mal-investment in the equity sector during the strong-dollar equity boom, home prices have moderated in recent times as markets corrected for the money illusion wrought by a weak dollar. The problem today is that unlike what happened after the stock-market collapse earlier in the decade, the federal government is going out of its way to soften the economic impact.
This is remarkable on its face considering how little in percentage terms home prices have reversed compared to equities back in 2000-01. Worse, government efforts to slow the process by which markets achieve price discovery will necessarily push back the eventual recovery from our downturn. Left alone, markets would reprice housing possibly in a downward direction such that more capital could be redirected toward job-creating entrepreneurs.
When we also consider the sad collapse of Bear Stearns, the Federal Reserve’s attempts to cushion its fall will similarly retard the economic adjustments necessary for the economy to resume a productive path. Indeed, massive liquidation of assets made necessary by troubled times speeds the process by which properly priced assets settle into the hands of those who see value where others do not.
What’s clear is that taxpayer dollars are now being deployed to allegedly normalize the impact of the economy’s slowdown on consumers, homeowners, and now banks. The irony here is that economies are most reliant on capital to grow, but with politicians ever eager to access the money of others to show “compassion,” hundreds of billions of dollars will be siphoned away from the productive economy to fund the short-term and counterproductive desires of the political class.
All of which brings us to President Bush, Treasury Secretary Paulson and Federal Reserve Chairman Bernanke. Though all profess to having free-market leanings, they’ve crafted solutions that will slow the economy’s recovery through retardation of the price-discovery process. Worse, their solutions are the equivalent of a doctor performing plastic surgery on a patient in need of heart surgery. The dollar’s lurch downward in recent years to a high degree explains the dislocations we’re experiencing today, yet to a man, neither Bush nor Paulson nor Bernanke seems concerned in the least about the dollar’s fall.
They should be concerned. Due to its status as the world’s reserve currency whereby two out of three dollars are overseas, the greenback’s value is the most important price in the world. When it’s in freefall, investment distortions and the economic calamities of the likes we’ve witnessed always result. And just as the picture of Senator Reed Smoot and Representative Willis Hawley to this day is symbolic of a major legislative mistake (the Smoot-Hawley Tariff Act) that brought on a severe economic downturn, we can only wonder if history books in the future won’t frame Bush, Bernanke and Paulson as the architects of non-market solutions to economic problems that turned natural market corrections into something much worse.