In my previous post I explained how Austrian price theory renders both state-socialist central planning and free-market plutocracy unworkable; in the present post, I explain how Austrian price theory applies to boom-bust cycles in general and the present financial crisis in particular, and why those who blame the crisis on the free market have things precisely backward.
Recall that market prices are the mechanism that allows consumer rankings of consumption goods to determine choices among production goods; if consumers rank goods made from steel higher than goods made from rubber, steel prices will rise relative to those of rubber, thus encouraging economising of existing steel and increased production of new steel. (This is incidentally why anti-gouging laws are such a bad idea; they prolong the very shortages whose effects they’re trying to mitigate, by suppressing the price signals that function to end the shortage. When prices are legally prevented from rising during a shortage, that’s like sending out a signal into the market saying “hey everybody, no shortage here, no reason to economise on this item, no reason to increase production of this item, feel free to focus your investment elsewhere” – which is obviously the worst possible message to send.)
Interest rates are a kind of price also; they signal the extent to which consumers are willing and able to defer present satisfactions for the sake of greater future satisfactions. To take the standard example, if Crusoe makes a net he’ll be able to catch far more fish than he can with his hands, but time making the net takes away from time catching fish; if Crusoe can afford to defer some present fish-catching in order to make the net, then it’s rational for him to make it, but if instead he’s on the edge of starvation and might not be able to survive on reduced rations long enough to finish the net, he’d better stick to catching fish with his hands for the moment and save the net project for another day. Whether it makes sense for him to divert time and effort from fish-catching to net-making thus depends on how urgently he needs fish now – in short, on his time-preference.
In a free market, low interest rates signal low time-preference and high interest rates, high time-preference. If your time-preference (i.e. the urgency of your preference for present over future satisfactions) is low, then I would only have to offer you slightly more than X a year from now in order to induce you to part with X today; if it is high, then I would have to offer you a lot more than X a year from now in exchange for X today. The prevailing interest rate thus guides investors in their choice between short-term, less productive projects and those that are more productive but whose benefits will take longer to achieve.
But when central banks, through their manipulation of the money supply, artificially lower the interest rate, then the signals get distorted; investors are led to act as though consumers have a lower time-preference than they actually do. Thus investors are led to invest in longer-term projects that are unsustainable, since the deferred consumption on which such projects depend is not actually going to get deferred, so that the goods that the investors are counting on in order to complete their long-term projects are not all going to be there when the investors need them. Such unsustainable investment is the boom or bubble; the bust comes when the unsustainability is recognised and a costly process of liquidation ensues.
The Austrian theory of the business cycle is sometimes called an “over-investment” theory, but that’s misleading. The problem is not that investors over-invest across the board, but that they over-invest in higher-yield longer-term projects and under-invest in lower-yield shorter-term. That’s why Austrians talk about “malinvestment” rather than over-investment. The prevailing mainstream tendency to treat capital as homogeneous ignores the difference between higher and lower levels of production goods and thus fails to appreciate the costs of having to switch from the high to the low when the bubble bursts.
In additional to the general misallocation of investment between lower-order and higher-order inputs, monetary inflation produces further imbalances. When the central bank creates money, the new money doesn’t propagate throughout the economy instantaneously; some sectors get the new money first, while they’re still facing the old, lower prices, while other sectors get the new money last, after they’ve already begun facing the higher prices. The result of such “Cantillon effects” is not only a systematic redistribution of wealth from those less to those more favoured by the banking-government complex, but an artificial stimulation of certain sectors of the economy, making them look more inherently profitable than they are and so directing economically unjustified levels of investment toward them.
Does the Austrian account, as is often claimed, underestimate the ability of investors and entrepreneurs to recognise the effects of government policies and compensate for them? No. Even if you know that a given price represents some mix of genuine market signals and governmental distortion, you may not know how much of the price represents which factor, so how can you compensate for the distorting factor? (Likewise, if you know there are magnetic anomalies in the area that are throwing off your compass, that’s not terribly helpful information unless you know exactly where the anomalies are and how strong they are compared with earth’s magnetic field; otherwise you have no way to correct for them. And given that the direction of your compass’s needle is at least partly responsive to true north, you’re better off trusting it, despite its distortions, than simply abandoning your compass and proceeding by coin-flip.)
On the Austrian understanding, governmental inflation of the money supply, thereby artificially lowering interest rates, was the chief cause of the Great Depression. (Mainstream economists dispute this, holding that the Fed’s policy could not have been genuinely inflationary, since prices were relatively stable during the period leading up to the crash. But for Austrians the crucial question is not whether prices were higher than they had previously been, but whether they were higher than they would have been in the absence of monetary inflation.) Likewise, for Austrians the housing bubble that precipitated the current crisis was the product of the Federal Reserve’s low-interest policies of recent years. (An aside to address a frequent misunderstanding: on the Austrian view there is nothing wrong with low interest rates per se; indeed, low interest rates are a symptom of a healthy economy, since the more prosperous people are, the likelier they are to be willing to defer present consumption. But one cannot make an economy healthy by artificially inducing symptoms of health in the absence of their underlying cause. By the same principle, absence of scabbing on one’s skin is a sign of physical health, but if there is scabbing, one does not promote health by ripping the scabs away; advocates of minimum wage laws, take note.)
In the 1920s, while mainstream economists were claiming that stock prices had reached a “permanently high plateau,” Mises and Hayek were predicting a crash (as incidentally was my grandfather Charles Roderick McKay, who as Deputy Governor of the Federal Reserve Bank of Chicago protested against the Fed’s policy of artificially lowered interest rates, kept the Chicago branch out of the easy-money policy until centrally overridden, foresaw the likely results, and got the hell out of the stock market well before the crash); likewise, in recent years Austrians kept warning of a housing bubble while folks like Greenspan and Bernanke blithely insisted that the housing market was sound.
Now everyone these days is saying, quite sensibly, that in the present crisis we need to avoid the mistakes that lengthened the Great Depression; the problem is that this advice is useless without an accurate understanding of what those mistakes were. By Austrian standards, the current plan to inject more “liquidity” into the economy is simply treating the disease with more of the poison that originally caused it. Attempting to cure an illness by artificially simulating symptoms of health is, literally, voodoo economics.
Of course the Federal Reserve is not solely to blame; there are still further government policies that encouraged riskier loans. There’s been some media attention paid to Clinton-era changes in the Community Reinvestment Act, for example, that encouraged laxer lending standards in order to attract minority borrowers. The claim that this explanation is “racist” is confusing the reason why a given loan is risky with the reason why the loan, despite its riskiness, gets made; all the same, focusing on this narrow example misses the wider picture, which is that when the federal government sponsors massive credit corporations like Freddie Mac and Fannie Mae, it creates an expectation (whether codified in law or not) that the government is guaranteeing their solvency. Just as with the S&L crisis of the 80s, the expectation of reimbursement in the case of failure encourages riskier loans because the risk is socialised. (And beyond this are the still deeper factors that stifle affluence for the vast majority and so make it necessary for them to borrow money to buy a home in the first place; taking that necessity for granted requires justification.)
Even George Bush, in his speech on the crisis, recognised (or read words written by people who recognised) that the expectation that a bailout would be forthcoming if needed had helped to encourage riskier loans – though he seemed to miss the further implication that by going on to urge a bailout he was confirming and reinforcing the very expectations that had helped fuel the crisis – thus setting the economy up for a repeat of the crisis in the future.
The grain of truth in the otherwise ludicrous statist mantra that the financial crisis was caused by “lack of regulation” is that when you pass regulation A granting a private or semi-private firm the right to play with other people’s money, but then repeal or fail to enact regulation B restricting the firm’s ability to take excessive risks with that money, the ensuing crisis is in a sense to be attributed in part to the absence of regulation B. But the fatal factor is not the absence of regulation B per se but the absence of B when combined with the presence of A; the absence of B would cause no problem if A were absent as well. So, sure, there was insufficient regulation, if by “insufficient regulation” you mean a failure on government’s part to rein in, via further regulations, the problems created by its initial regulations.
So if the problem is caused by A without B, it might be objected, why must we adopt the libertarian solution of getting rid of A? Can’t we solve the problem just as well by keeping A but adding regulation B alongside it? The answer is no, because central planning doesn’t work; when one responds to bad regulations by adding new regs to counteract the old ones, rather than simply repealing the old ones, one adds more and more layers between decisions and the market, increasingly muffling price-system feedback and courting calculational chaos.
But, the objector may continue, what if we’re in a situation where we have regulation A but no regulation B, and where, further, repealing A is not politically possible but adding regulation B is – in that case, shouldn’t we push to add B? In some circumstances, depending on the details, maybe so; but the more important question, to my mind, is to which should we devote more of our time energy – tweaking the details of a fundamentally unsound system within the parameters of what is currently considered politically possible, or working to shift those parameters themselves? In Hayek’s words: “Those who have concerned themselves exclusively with what seemed practicable in the existing state of opinion have constantly found that even this had rapidly become politically impossible as the result of changes in a public opinion which they have done nothing to guide.”
Okay, some will say, maybe it was government, not laissez-faire, that got us into the mess; but now that we’re in it, don’t we need government to get us out? My answer is that government doesn’t have the ability to get us out. There’s just not much the government can do that will help (apart from repealing the laws, regulations, and subsidies that first created and then perpetuate the mess – but that would be less a doing than a ceasing-to-do, and anyway given the incentives acting on government decision-makers there’s no realistic chance of that happening). The bailout is just diverting resources from the productive poor and middle-class to the failed rich, which doesn’t seem like a very good idea one either ethical or economic grounds. The only good effect such a bailout could possibly have (at least if you prefer costly boondoggles without piles of dead bodies to costly boondoggles with them) is if it convinced the warmongers that they just can’t afford a global war on terror right now – but there’s no sign that they’re being convinced of anything of the sort.
If the price system were allowed to function fully, the crisis would right itself – not instantly or painlessly, to be sure, but far more quickly and with less dislocation than any government could manage. What the government should do is, in the final analysis, nothing.
But such a response would be politically impossible? Quite true; but what makes it politically impossible? Is it some corporatist bias on the part of the American people? Did Congress pass the bailout because the voters were clamouring for it? On the contrary, most of the voters seem to have been decidedly against it. The bailout passed because Congress is primarily accountable, not to the electorate, but to big business. And that’s a source of political impossibility that stems not from shiftable ideology but from the inherent nature of representative government. A government that was genuinely responsible to the people would hardly be a paradise (since the people are hardly free from ignorance and bias, and majority rule is all too often simply a mechanism for externalising the costs of majority preferences onto minorities) – but debating the merits of a government genuinely responsible to the people is purely academic, because such a government, whatever its merits or demerits, is impossible; you cannot make a monopoly responsive to the people. Other than the market itself, no political system has ever been devised or discovered that will subordinate the influence of concentrated interests to that of dispersed interests. Monopoly cannot be “reformed” it has to be abolished.
Now that is of course not to say that some governments can’t be less unresponsive than others, just as some forms of slavery can be less awful than others. One of the striking features of slavery in the antebellum American south, for example, is how much worse it was, on average, than most other historical forms of slavery; and if the abolitionists, despairing of the prospects of actually freeing the slaves, had focused their efforts on reforming American slavery to make it more like ancient Greco-Roman slavery or mediæval Scandinavian slavery, I’m not going to say that wouldn’t have been worth doing or wouldn’t have made a lot of people’s lives significantly better – but isn’t it setting on one’s political sights a tad low?