Monday, October 13, 2008

Why the bailout didn't work

From Vox Day at Worldnet Daily

Why the bailout didn't work

Posted: October 13, 20081:00 am Eastern© 2008

Since Treasury Secretary Henry Paulson announced his three-page plan to rescue the Wall Street banks on Sept. 23, the Dow Jones Industrial Average has fallen 2,937 points, or 26 percent. An estimated $7 trillion in paper wealth disappeared from U.S. stock markets last week, a figure equivalent to 53 percent of American GDP. The financial crisis, which the $810 billion dollar bailout was supposed to avert, has spread to stock markets throughout the world. The Russian and Indonesian markets have been suspended while the country of Iceland appears to have gone bankrupt, owing $275,000 worth of debt for every man, woman and child in the island nation.

Some economists claim Paulson acted too late. Others assert that his actions were too conservative, although they can't seem to specify precisely how much more money was required over and above the $810 billion figure. Still others declare the bailout will work, it merely hasn't been put into effect yet. They are all wrong, and they are wrong because they do not understand the fundamental nature of the problem. They are analyzing the symptoms of the disease rather than the disease itself, and in doing so, are ironically prescribing as medicine the very poison that is killing the patient.

Conventional economists of the sort who get quoted on CNBC and Fox News will usually mention the terms "liquidity crisis" and "restoring confidence." These terms tend to betray the ideological bias of the economist and indicate that he is a neo-Keynesian who views the situation through the macroeconomic perspective of the updated Keynesian model that has been dominant in economics for most of the last 80 years. (Chicago School monetarists are also concerned with liquidity issues, but we'll leave them out of it for the purposes of this column.)

The essential problem is that the administration is attempting to enact a Keynesian solution to an Austrian problem. The Austrian School teaches that monetary inflation, which in this case was primarily caused by the Federal Reserve's decision to keep interest rates artificially low to prevent the economy from going into recession in 1996, 2001 and 2003, creates inflationary booms that lead to the severe misallocation of capital resources. As the Austrian logic predicted we would, we saw two such booms in asset prices, the first in the stock markets, the second in the real estate and commodity markets.

Millions of people profited from the asset inflation, and trillions of dollars were directed into areas of the economy they would not have otherwise gone, such as second homes and investments in companies selling dog food over the Internet. The problem is Austrian theory also teaches that inflationary expansions are always followed by deflationary contractions which clear out all of the resource misallocations that occur during the expansionary period. The Dutch tulip mania of 1637 is a good example of resource misallocation, when a single tulip bulb was known to have sold for the modern equivalent of $35,000. Such misallocations can occur for diverse reasons, but the usual cause is easy credit and low interest.

America is currently suffering from severe capital misallocations quite possibly more extreme than the 17th century Dutch, since its money supply has been inflating steadily for decades, and at an increasing rate. Compounding the problem is the fact that this inflation has reduced the value of savings and people were given incentive to consume rather than save, so the nation has no savings pool from which investment into productive capital might be made. Instead, the nation has substituted foreign investment, which can and will be withdrawn whenever it is required elsewhere.

The administration is attempting to deal with the credit crunch, which is the natural result of banks refusing to lend money, by making more money available. The problem, however, is not that there is simply no money, but rather that banks, having learned how many of their investments were worthless, are rightly concerned about making more of the same mistakes. Imagine if you had been burned on the purchase of 100 swamp properties that turned out to be worth nothing. Are you going to buy 10 more plots of swampland simply because someone gives you money equal to one-tenth of the money you'd lost already?

The liquidity crisis has already entered a stage that Austrians describe as "pushing on a string." The various financial authorities can push as hard as they want by further cutting interest rates and utilizing other expansionary monetary policy measures, but the string will remain limp. Ironically, the so-called student of the Great Depression, Ben Bernanke, failed to learn the only important lesson about the historical Federal Reserve. The failure of the 1930s Fed was not due to any refusal to expand the money supply and encourage bank lending, but because events were beyond its control.

America and the rest of the world has foolishly attempted to deny economic gravity. Now, it will learn that most basic of rules: That which goes up must eventually come down.

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