“A great crash is coming, and I don't want my name in any way connected with it.” So said economist Ludwig von Mises when an Austrian bank offered him a job in 1929. The bank, one of Europe's biggest, collapsed in 1931.
In 1912, Mises had published “The Theory of Money and Credit”, in which he explained the cause of the boom-and-bust cycle. He had warned about the dire consequences of easy money and government spending in America as early as 1924.
When governments have the power to artificially fuel credit expansion – or “print money”, in simple terms – they distort the economic decisions of both producers and consumers. The former over-invest in assets, and the latter prefer spending to saving. Since investments ought to be made with surplus capital – i.e. savings – this distortion is as alarming as it sounds.
Not only does artificially cheap money mean bad businesses survive long after they ought to have failed, but what happens when they do fail? Savers can't lose their money, because it wasn't there to begin with. So you have a crisis, threatening banks, which motivates governments to bail out either the banks, or the failed businesses, or both, using money confiscated from citizens who did not make the investment mistakes. Government intervention causes the problem, and government's solution makes it worse. The self-correcting discipline of the market, enforced by the price mechanism, is out the window.
“Everyone looks smart for a while, but eventually the whole monstrosity collapses under its own weight through a credit contraction or, worse, a banking collapse,” is how Mark Spitznagel summed it up in the Wall Street Journal in 2009. It is well worth re-reading his excellent summary, to remind ourselves how we got here.
Until his death in 1973, Mises was the leading light of the Austrian school of economics, which includes economists such as “Road to Serfdom” author Friedrich A Hayek, the anarchist Murray Rothbard, and Henry Hazlitt, the author of the single best book you could prescribe to high school students, journalists and aspiring politicians: “Economics in One Lesson” (free PDF available here).
Unfortunately, Mises was ignored in his day, in part because a rising star, John Maynard Keynes dismissed him as “unoriginal”. Revealingly, however, Keynes would later (in his 1930 book “Treatise on Money”) admit that: “in German, I can only clearly understand what I already know – so that new ideas are apt to be veiled from me by the difficulties of the language”.
By 1936, deficit spending to stimulate employment and consumption had become the favourite means for politicians to play saviour of the people during economic downturns. Of course, if the people are broke, so is the government, because the government can only get money from the people. So it prints money, and borrows money. The former taxes even the poor, and the latter taxes them again when the time comes to pay it all back.
The idea that government could spend money that it hadn't been explicitly authorised to collect as tax first was a radical idea in the 1930s. That was when Keynes rode to the rescue with a fantastic new take on economics, entitled “The General Theory of Employment, Interest and Money”. It gave governments theoretical cover for central bank control over money supply and interest rates, and deficit spending into downturns to stimulate demand. In one fell swoop, Keynes had legitimised a whole range of extraordinarily powerful monetary and fiscal policy tools for governments.
Even free-market economists like Milton Friedman were taken in by the power of monetary policy.
For as long as these policies work, of course, “everyone looks smart for a while”. Some, like Alan Greenspan, the former Federal Reserve chairman, get called “maestro”. But they cannot work forever. And the problem isn't that Greenspan (and Bernanke after him) kept interest rates too low for too long. The problem was that they were in charge of interest rates in the first place.
All price controls cause shortages and surpluses, as central planners chase the “correct” price. The same is true for price controls on money, or credit. They cause surpluses and shortages we describe as booms and busts.
Unfortunately, those schooled in Keynesian economics, as government economists are, have a hard time questioning the orthodoxy of their textbooks. For their part, politicians are loath to give up the awesome power of printing money, so they're not likely to question the great Lord Keynes either.
Not so Austrian school economists. Mises wasn't the only one who predicted the future. More recently, the only US candidate for president with a clue about economics, Ron Paul, has done the same.
Everyone is clever with hindsight, but the campaign video below makes fascinating viewing because as early as September 2001, Ron Paul described the events of today in all their gory detail.
In summary, the cheap money with which the Federal Reserve flooded the market in the aftermath of the dot com crash did nothing for the recovery, but fuelled the “expanding real-estate bubble, churned by the $3.2 trillion of debt maintained by the … government-sponsored enterprises”.
Unlike the ratings agencies, which downgraded them mere days before their collapse, Ron Paul knew Freddie and Fannie spelt trouble seven years earlier.
“This [real-estate bubble] will burst, as all bubbles do. The Fed, the Congress, or even foreign investors, can't prevent the collapse of this bubble. … It would be too much to expect the Fed to look to itself and its monetary policy for an explanation, and assume responsibility for engineering the entire financial mess we're in.”
And again, in 2007, “you can't solve the problem of inflation with inflation”.
He refers, of course, to the collapse of the dollar. Because the Fed increases the supply of money faster than the supply of goods and services, the value of money declines. This is “inflationary monetary policy” is a deliberate strategy on the part of government, to encourage spending and discourage saving.
The effect of this is what we observe as price inflation. In the chart below, I documented this effect, using official consumer price statistics. Note how the dollar was relatively stable over the long term during the 19th century, but collapsed in the 20th century, with the advent of Keynesian economics.
Compare this to a typical measure of money supply. Unfortunately, records only go back to 1959:
(As an aside, it should be noted that economic statistics are notoriously unreliable. Inflation, for example, is officially quite low. However, the official data exclude most of what we spend our money on: food and energy. Real inflation is much higher than the government will admit. Money supply is itself a difficult beast to measure. There's much dispute about what constitutes “money”, what constitutes “credit”, how much “velocity” matters, and what ought to constitute an accurate money supply measure. Even GDP is in principle impossible to determine accurately. However, such uncertainties do not hide the trends over time, which serve to confirm the common-sense principle: If you print money, you devalue the currency, and if you're broke, stop spending.)
The acrimonious blame game that plays itself out on the world's television screens is not edifying, but it may prove useful if it puts the brakes on government profligacy.
To avert a limited default – Treasury Bills were never in any danger – politicians in Washington reached a deal. It's not much of a deal, with far too little and far too late by way of spending cuts, but it was a compromise of sorts, between those who were wrong all along, and a new insurgency of small-government advocates.
Barack Obama started his speech on Monday night with an unintentional joke. He appealed to Warren Buffett's opinion that the US was worth a quadruple-A rating. A day later, Buffett's company, Berkshire Hathaway, got a rating downgrade of its own. Poor speechwriter.
Then Obama blamed his failure to achieve his own objectives – which is what the term “compromise” appears to mean to him – on the fact that his opposition drew a line in the sand. In accusing his opponents of intransigence and of putting the interests of their party before those of the country, it has clearly not occurred to him that the people who said, “enough is enough” did so because they thought that's exactly what the country needed.
It is possible that they're wrong, but if so, it is Obama's duty to argue the point, not to play the man. His inability to do so is revealing about the weakness of his own position.
The Tea Party is in many ways reminiscent of the anti-Bush rebels known as the Netroots, who were so ably co-opted by Howard Dean and John Kerry, and who eventually put Barack Obama in the White House. Like the Netroots on the Iraq war a few years ago, the Tea Party is a group that has had enough of what they see as economic mismanagement, and is clamouring to hold its government to account.
It is in fact a very diverse group. I met several of them recently. Some were religious social conservatives of the kind one would expect if you read The New York Times, but others wanted pot legalised, gay marriage approved, and God banned from public life. There were exceptions, but the majority were not foaming-at-the-mouth crazy, as they are so often portrayed by critics in the media and in politics.
They're not partisans so much as independent swing voters. Many, for example, are vehemently anti-war, and oppose US involvement in both Iraq and Afghanistan. As for their association with the Republican Party, witness this poster at FreedomFest 2011 in Las Vegas:
(The mystery man is the Gipper himself, Ronald Reagan.)
Tea Party types differ on much, but what they share is a recognition that Keynesian economic policies – with the central bank printing money to fund endless stimulus and bailout packages – only inflates bubbles. Keynesian remedies cannot prevent economic collapse. More debt is not the solution to too much debt. Printing more money isn't going to make money more valuable. Future prosperity comes from private productivity, not wealth redistribution. The government cannot create jobs, but can only ever move capital from one person to another, with the consequence that for every job “created”, at least one is lost elsewhere in the economy.
These are valid criticisms, stated often before by the likes of Hazlitt, Hayek and Frédéric Bastiat. The latter's pamphlet, “That Which is Seen and That Which is Not Seen” was published in France in the middle of the 19th century, but reads like it was written last week. It remains a great plain-language guide to the key economic questions of today.
If last Friday's downgrade becomes known as the “Tea Party downgrade”, my advice to them is to wear the badge with pride.
That's not to say that some of the left's complaints are entirely baseless. When they berate Standard & Poor for sloppy work, they're not wrong. The ratings agencies' complacency is born out of a poisonous relationship with government, after all, which requires companies to use their service no matter how unreliable it turns out to be. That's why they can get away with not downgrading Fannie and Freddie until the writing is on the wall, and with downgrading the US 10 years after Ron Paul declared the dollar to be in trouble. Anyone who believes a government-mandated ratings agency is an idiot, and deserves to lose their money.
Some criticisms of individual Tea Party members may also hold water. Some hold views on social issues with which I'm deeply uncomfortable. However, an inclination to liberty is not consistent with litmus tests about personal, religious or moral questions.
More importantly, those views are not relevant to economics, and they certainly do not concern us much here in South Africa. They do not undermine the validity of the economic critique that the US, Europe, and much of the rest of the world, is broke, and that you can't spend your way out of bankruptcy.
Yet, for having predicted that the dot com crash would be followed by a housing crash, and then an even bigger sovereign debt crash – while the politicians who were actually in charge were blithely “rolling the dice a little bit more” – these are the people now being blamed for supposedly causing the crisis? That is absurd. As one wag said, it's like blaming the smoke alarm for waking you up.
Perhaps it is naïve to think that the mainstream media, government economists and politicians will re-examine the economic principles on which their house of cards is built. As Ron Paul has been saying for years, the problem can be solved, but he doesn't expect it will be. He expects more of the same old tired stimulus remedies: debt, piled upon debt.
This means that those who now warn of a double-dip recession are the optimists. Having failed to predict the first dip, they're now only halfway the W, yet already they're assuming that it will all end with a happy recovery. In denial much?
True, the US will likely respond with yet another round of money-printing. Fragile flowers that they are, they won't call it such a crass name, lest they appear as mad as Robert Mugabe. They'll delicately call it a third round of quantitative easing, or QE3. This will artificially prop up markets for a while. But ultimately, the dominos will fall. Greece, Italy, Portugal, and Ireland are mere canaries in the coal mine.
To return to a productive, wealth-creating economy, a far more drastic re-evaluation of the relationship between government and the market is needed.
The Chinese know this. They are talking of a new “reserve currency”, consisting of a basket of existing currencies. The IMF has been floating one of Keynes's stillborn plans, a supra-national single currency know as the bancor.
This will only postpone the inevitable, however. It will merely shift the deficit spending authority to someone else, with even less accountability to the people harmed by their policies. Fiscal responsibility and economic stability will only return once governments lose the power to print money entirely.
There's a very good reason why the gold price has gone through the roof. Government cannot just print more gold whenever it sees a new public works project to fund, or a new special interest lobby to subsidise.
If the facts of Ron Paul's predictions weren't enough, the astonishing gold boom of the last decade is proof positive that he was right in 2001. It is hard to see how anything other than a return to the gold standard, which removes arbitrary spending power from governments, can end the global sovereign debt crisis.
Keynes himself once admitted that “in the long run, we're all dead”. Well, the long run is here. He is, indeed, dead.
But I'm still alive, and I'm saving up my Krugercents. DM
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