The Fed and Financial Madness: Crossing the Rubicon (Again)

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In two recent columns about the rise of the paramilitary police, the inestimable Will Grigg wrote that in the area of "law enforcement" becoming a virtual occupying army, that Rubicon was crossed a while ago, and we must bear the consequences for it. Today, I write about another Rubicon that has been crossed, that dealing with the financial system that seems now to be in permanent meltdown.

It began with the government’s intervention in the Bear Stearns meltdown last spring, and the Fannie and Freddie bailouts. It then went to the infamous $700+ billion "bailouts" of financial institutions, the Federal Reserve System’s purchase of AIG stock, and the recent promise by the Fed to purchase commercial paper of mutual funds. With the U.S. Department of the Treasury looking to take equity positions in banks and the willingness of Congress and the executive branch to further expand the government’s actions, it seems that there is no stopping this state-run juggernaut.

Although much has been written on this page about the government’s recent actions, I believe that some issues must be further explored. Most people to whom I speak, be they libertarians, conservatives, or outright liberals, are uncomfortable at best with what they are seeing, even if they are not held back by the belief that government should not intervene into certain economic affairs of private enterprise. The problem is that most of them cannot articulate why they are skeptical; some libertarians and conservatives seem to believe instinctively that government has no business doing such things, though some are willing to accept this "yes, but…" measure.

Liberals tend to take the position that government is like the Great Eye in the Sky who looks down upon humanity, and as long as people behave, the Great Eye will permit them to carry on. However, once the underlings begin to misbehave, then the Great Eye must intervene and set things straight. The underlying belief here, of course, is that the government (or, Great Eye) knew along the "proper" course of action, but was just humoring himself (or herself, as we don’t know the true sex of the Great Eye) while humans were at play.

Thus, we hear from people like recent Nobel Laureate Paul Krugman, who has declared that the government intervention and increased financial regulation to follow (which means that the government will increase the various financial "safety nets" that got the markets into trouble in the first place) is what is currently needed, along with huge doses of new government spending:

While the manic-depressive stock market is dominating the headlines, the more important story is the grim news coming in about the real economy. It’s now clear that rescuing the banks is just the beginning: the nonfinancial economy is also in desperate need of help.

And to provide that help, we’re going to have to put some prejudices aside. It’s politically fashionable to rant against government spending and demand fiscal responsibility. But right now, increased government spending is just what the doctor ordered, and concerns about the budget deficit should be put on hold.

It gets even better:

…there’s not much Ben Bernanke can do for the economy. He can and should cut interest rates even more — but nobody expects this to do more than provide a slight economic boost.

On the other hand, there’s a lot the federal government can do for the economy. It can provide extended benefits to the unemployed, which will both help distressed families cope and put money in the hands of people likely to spend it. It can provide emergency aid to state and local governments, so that they aren’t forced into steep spending cuts that both degrade public services and destroy jobs. It can buy up mortgages (but not at face value, as John McCain has proposed) and restructure the terms to help families stay in their homes.

And this is also a good time to engage in some serious infrastructure spending, which the country badly needs in any case. The usual argument against public works as economic stimulus is that they take too long: by the time you get around to repairing that bridge and upgrading that rail line, the slump is over and the stimulus isn’t needed. Well, that argument has no force now, since the chances that this slump will be over anytime soon are virtually nil. So let’s get those projects rolling.

For those who might recognize the Keynesian language, Krugman is describing the so-called liquidity trap (which Murray Rothbard demolishes in America’s Great Depression), and the only way to bust out of this "trap" is for government to spend (and spend, and spend). If you don’t believe me, read on:

Will the next administration do what’s needed to deal with the economic slump? Not if Mr. McCain pulls off an upset. What we need right now is more government spending — but when Mr. McCain was asked in one of the debates how he would deal with the economic crisis, he answered: "Well, the first thing we have to do is get spending under control."

If Barack Obama becomes president, he won’t have the same knee-jerk opposition to spending. But he will face a chorus of inside-the-Beltway types telling him that he has to be responsible, that the big deficits the government will run next year if it does the right thing are unacceptable.

He should ignore that chorus. The responsible thing, right now, is to give the economy the help it needs. Now is not the time to worry about the deficit.

This creates one of those head-shaking moments. The Beltway is a source of fiscal conservatism? John McCain is a fiscally-responsible legislator? Apparently, Krugman and the rest of us do not occupy the same planet.

Krugman’s editorial benefactor, the New York Times, also wants to save the economy — and capitalism with it. In a recent unsigned editorial, we read the following:

…the United States government now owns stakes in the nation’s biggest banks. It controls one of the biggest insurance companies in the world. It guarantees more than half the mortgages in the country. Finance — the lifeblood of capitalism — has to a substantial degree been taken over by the state.

Even Alan Greenspan, the high priest of unfettered capitalism and a former chairman of the Federal Reserve, conceded this week that he had "found a flaw" in his bedrock belief of "40 years or more" that markets would regulate themselves. "I made a mistake," he said.

This, according to the Times editorial board, is a good thing. (One can resist an LOL moment with the "high priest of unfettered capitalism" moniker given to a former central banker, as though the Fed is compatible with free markets.) Of course, the editorial goes on to demand regulation of just about everything, more government spending and guarantees of "equity of opportunity."

Thus, we are fed a pundit diet that tends to vacillate between the need to "save capitalism" or just do away with it altogether and go whole hog into socialism. With basic government control of financial markets — and there is no other way to describe what it happening — we are looking at something pretty close state ownership of the markets.

In reading not only the media pundits, but watching Congress in action, it seems that all sense of restraint has been lost. While we are told that the actions in the financial markets are serving as "lubrication for the markets" or "clearing up an accident on the financial freeway," the reality is much, much different.

First, and most important, the government is not "injecting capital" into troubled banks and financial firms; it is diverting capital from productive uses to non-productive uses. The determination on who is to be bailed out and who is permitted to fail is done with a political calculus. Furthermore, the only means by which this can be done is for the Fed ultimately to "monetize" the bonds issued by the U.S. Department of the Treasury, something that people other than central bankers, Princeton University economists, and New York Times editorialists call inflation.

The government’s actions are not re-establishing faulty credit markets; they are trying to cover for the huge malinvestments made by these financial institutions, and by so doing are penalizing the firms which made good choices and did not drink the Sub-Prime Kool-Aid that so many on Wall Street were imbibing. Unfortunately, by rewarding the firms that made bad choices, the government also is punishing those companies that did the right thing.

Second, we need to do away with the notion that government brings gravitas and stability to the markets. The last time I checked, government was a political institution. (The Big Lie that government provides adult supervision is yet another myth that came from the Progressive Era when people believed that a wise class of professional bureaucrats would arise and replace the disorderly and dishonest capitalists.) That means that government agents that influence the investment decisions of the banks and brokerage houses will pull an extraordinary amount of weight — and will direct investment to where it will be politically popular.

The Austrian concept of economic calculation comes to the fore. Ludwig von Mises wrote that without a price system, along with profits and losses, a socialist economy would falter, as it would lack the mechanism to determine where the various factors of production should be directed. Indeed, the performance of the socialist economies, beginning with the former U.S.S.R., pretty much went according to what Mises predicted.

Mises stressed that prices had to reflect the demand and relative scarcity of the factors in question, and there had to be profits and losses to determine which products that consumers would most highly value. That could not be accomplished outside a private enterprise economy. (Mises admitted that a mixed economy would have more success, as there would be real prices, but the government sector would be much more inefficient in its use of factors of production, a situation that is blatantly obvious to any observer.)

What has been missing from the equation during the latest financial meltdown is the role of losses in providing valuable information to the markets. In a true private enterprise economy, those who experience losses either will change the direction of their activities or go out of business.

Unfortunately, the losses in the financial sector have provided government with an excuse to intervene not only by using borrowed money to purchase the near-worthless assets of the firms, but also for government agents to provide leverage in future decision making by banks and investment firms. Lest anyone think this means investment organizations will be making more rational and sound decisions in the future, I would point to the example of Fannie Mae and Freddie Mac, which while technically private have operated as quasi-government agencies.

For all of the praise that Paul Krugman and others have showered on "Fannie and Freddie," in truth they existed for political reasons, and any economic calculation that went on with them was political in nature. First, they provided campaign cash for politicians that supported them and second, they were a repository for political operatives like Franklin Raines and Jamie Gorelick, who managed to walk away from Fannie Mae with more than $100 million between them.

Thus, we should not be surprised that much of the financial downturn has centered upon these two "mortgage giants" which operated with the implicit guarantee that the taxpayers would cover their losses, which is what has happened. The Freddie and Fannie mortgage securities turned to ashes, and the rest was history. (For a comprehensive look at the Fannie and Freddie shenanigans, read this series of editorials and editorial page articles from the Wall Street Journal. No, the WSJ has been wrong on a lot of aspects of the current meltdown, but to their credit, the people there did understand what was happening with Fannie and Freddie.)

Some of the biggest critics of private markets and private enterprise in general, including Sen. Charles Schumer, Rep. Barney Frank, and Sen. Christopher Dodd, also have been the most staunch supporters of Fannie and Freddie. Furthermore, because of their positions in Congress, they will be able to directly intervene in the decisions of private investment firms and banks, given their high positions on congressional committees that oversee banking and finance, they will be the "men behind the curtain" as this brave, new finance system unfolds. (All of them hold very safe seats in Congress and are going to be major players for many years to come.)

Lest people believe that a government running $500 billion budget deficits can inject new capital into the markets, rejuvenate them, and act responsibly, a reality check is needed. These latest interventions are not the end; they are just the beginning. By crossing the financial Rubicon armed with the idea that Fed-created "liquidity" can solve any financial problem, the government has unleashed something that certainly is not going to be contained by the present administration and Congress and absolutely not by the one-party government that voters are preparing to give this country on November 4.

In its "Rescuing Capitalism" editorial, the New York Times declared:

The next government must re-establish some notion of equity of opportunity. Investment is desperately needed in health care, education, infrastructure. The social contract and the government’s role in it should be examined anew. Addressing these challenges will be an enormous task — especially amid the bitter recession that most economists expect over the next year or so. But they must be faced. Fixing finance is merely the start.

Keep in mind that the government is not "rescuing" the financial system and certainly not capitalism; it has punished firms that made good investment choices and has rewarded people who made the errors. However, no one in a decision-making capacity is listening, anymore. After having thrown more than a trillion non-existent dollars at Wall Street and the banks, we can be assured that the government will throw trillions more to "invest" in other failed government enterprises.