Why can’t the government find the right way to bail out the financial system and the housing market? Historian Tom Woods has a provacative answer: it’s a fruitless war against reality. No matter what steps we take, prices will fall to their market levels. What’s worse, all the attempts to prevent this are just making things worse by creating chaos in the markets.
Earlier this week we ran an extended excerpt from Woods’ important new book, Meltdown.* It’s the first book we’ve seen that takes the perspective of Austrian economics and applies it to the current crisis. The first section showed how the Federal Reserve had helped create the worst financial crisis in generations. Today’s excerpt deals with the ham-handed attempts to “solve the crisis.”
If you want to read more from the New York Times bestseller, Meltdown, click here for a free chapter.
Government efforts were supposed to increase “confidence” in the system. But the course of action the Treasury and the Fed took and continue to take has been so erratic and extreme that the net effect seems to have been greater uncertainty. From day to day no one knows what will happen next, what new rules will be made, what sectors will be targeted for bailouts, and so on.
This is one of the problems that dogged Franklin Roosevelt throughout the New Deal: his administration was so erratically interventionist that businessmen understandably held back from investing, unsure of what it might do next.
Even before the bailout package proposed in September and the government purchase of bank stocks, the Fed had begun massive lending to banks in exchange for collateral of dubious value. These earlier bailouts had been going on since 2007 and intensified in 2008.
One of the most insidious consequences of the string of bailouts of the financial industry is that the American government can never credibly say that no such bailouts will ever be contemplated again. Why not? If they did it this time, why not again and again in the future? The financial industry will continue on its way in the knowledge that the big players are, in the opinion of government, “too big to fail,” and so will be far more cavalier about risk than they would otherwise be.
People who are good stewards of wealth are thereby forced to subsidise people who are disastrously poor stewards of wealth. It should be obvious that all the “regulation” in the world cannot prevent risky investments in an environment like this, in which moral hazard has been practically institutionalized.
And it isn’t just the financial industry and American big business that are affected by moral hazard; ordinary Americans feel its effect as well. If people see that instead of foreclosure, homeowners who don’t pay their mortgage receive a federal bailout, they are more likely to be careless and reckless in their own financial planning and in the timely payment of their own mortgages. If homeowners have reason to believe that the government will provide them with easier terms than their bank does, they may be tempted to stop making their mortgage payments altogether, thereby increasing the number of bad loans the federal government will have to take over. The process feeds on itself.
Ultimately, the Treasury and the Fed have been trying to prop up asset prices—i.e., keep things expensive—the best they can, hoping thereby to improve the financial health of the holders of those assets. Of course, this makes things worse for the people or companies who don’t hold these assets—such as aspiring homebuyers.
Government loans to failing financial firms—and similar private loans made under government pressure—are intended to prop up these prices. But the authorities are trying to put out a fire by turning off the smoke alarm. The fall of stock prices is not the cause of problems in the economy. Stock prices are merely a reflection of the economy’s condition. Artificially inflating them treats the symptom rather than the cause—the usual government response to economic crises. Financial bubbles need to burst, so that the inflated prices of the assets involved, like housing, can fall to their market prices—that is, the price on which the natural, unimpeded forces of supply and demand would converge.
The U.S. government wants to do something like the opposite: propping bubble prices up and keeping them at levels above what the market would assign, and guaranteeing the difference itself.
The federal government’s war on reality cannot succeed. Prices that seek to come down are going to come down.
[*Editors note: Tom Woods and I are old friends. My brother Tim Carney edited this book when he worked for the publisher, although he has since left. The publisher is an advertiser on Business Insider and Clusterstock. They have sponsored this edition of the book club.]