Sorry, but Capitalism Did Not Fail

The current world-wide economic and financial crisis does not represent a failure of capitalism or of markets. It is the result of mistakes made by the U.S. Federal Reserve, aided and abetted by Congress and the Administration. Here’s an analogy that illustrates what happened.

In April, 2001, Private Sector Architects draws up plans for a three-story house. The prospective owner hires Capitalism Builders to construct it. The Free Market Sawmill is chosen to supply the lumber. The project is scheduled to take eight years. Construction begins.

Every night, men from the U.S. Bureau of Standards sneak into the Free Market Sawmill and the offices of Capitalism Builders and replace all of the rulers and tape measures. Some days the inches get longer, but most days they get shorter. By March, 2008, the inch is only 25% of what it was seven years before.

As a result, the two-by-fours being produced by the Free Market Sawmill in 2008 have only one-sixteenth the load-bearing capacity of 2001 lumber. Some workers express concern because the latest two-by-fours are looking pretty flimsy. However, when checked, the boards still measure two inches by four inches.

In September, 2008, a group of school children is taken on a tour of the just-completed third floor of the house. The building collapses, causing many injuries. The Krugman Blame Bureau surveys the wreckage and declares that Capitalism and the Free Market have failed.

Capitalism and the free market can only do their job if the government supplies constant, reliable units of measure. This is why Article I, Section 8 of the Constitution of the United States says: “The Congress shall have Power…To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures”. The Framers seemed to understand that the dollar is a unit of measure, just like the foot, the pound, and the second.

In April, 2001, the price of gold was $255/oz. In March, 2008, it peaked at $1011/oz. The dollar, which is our unit of market value, had lost about 75% of its real value in seven years. (Today the gold price is around $950/oz.)

What does the free market do in the face of an unstable unit of measure? It tries to cope.

The classic way for a private entity to protect itself from inflation is to buy real assets with borrowed money. This is what drove the recent housing and commodities booms. For a long time, it made perfect economic sense to build houses (real assets) at a frantic pace and finance them with borrowed money. Between at least 2004 and 2007, anyone who didn’t borrow to buy real assets was a sucker—they were allowing themselves to be victimized by inflation while others profited from it. America as a whole benefited to some degree because much of the money was borrowed from foreigners.

All of the financial instruments now derided as “toxic assets” were developed as part of the private sector’s effort to protect itself from the inflation that the Federal Reserve visited on the world economy. Before 1971, while the dollar was still anchored to gold, there were no “derivatives”, no “tranches” of this or that, no Credit Default Swaps. There was no need for such things, and there was no economic driving force to pay the enormous costs of creating and managing them.

Now the companies that manufactured and held today’s “toxic assets” are being denounced as fools or even criminals. However, if the Fed had not stopped the inflation when it did, these organizations would look like geniuses today. If the Fed had permitted the price of gold to rise to (say) $4000/oz by (say) 2015, all of the derivatives strategies would have paid off and all of the condos in Las Vegas would have been successfully “flipped”.

An unstable dollar puts the private sector in an impossible situation. People hate inflation. It makes them angry. They feel like they are being robbed—because they are. When the markets experience inflation and expect more inflation, they will start trying to protect themselves from it. The longer the inflation goes on, the more real resources the private sector will spend trying to defend itself against it. The most recent inflationary “bubble” was allowed to go on for a long time.

While defending against inflation makes sense for individuals and firms, the allocation of real resources to inflation hedges makes the overall economy less efficient. This effect is visible in numbers published by the Bureau of Economic Analysis. The misallocation of investment into inflation hedges (mainly housing) reduced 2007 GDP by at least $1.6 trillion, or 12%. The cost of the recession caused by stopping the inflation and unwinding the inflation hedges will be even higher.

Unfortunately, the government is now trying to solve a problem created by printing too much money by printing even more money (plus tax increases, plus economic-superstition-based “stimulus” borrowing and spending). This will not work.

What will work is the Constitution of the United States. On February 3, Congressman “Judge” Ted Poe (TX-02) introduced H.R. 835. This bill would require the Federal Reserve to “regulate” the value of our money by making the dollar equal in value to 0.002 ounces of gold. The Fed would do this by using its Open Market operations to establish and maintain a gold price of $500/oz. H.R. 835 would also give a powerful supply-side stimulus to the economy by providing “first year expensing” for all capital investment.

Once the integrity of the dollar (and the Constitution) is restored, the markets can begin to right themselves. Stabilizing the dollar is an essential ingredient in any recipe for economic recovery.