Should We Absolve the Fed?

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Are supporters of the free market engaged in special pleading when they identify the federal government and its central bank, the Federal Reserve, as the most significant factors behind the financial crisis? Absolutely, says Bruce Ramsey in the August issue of Liberty magazine.

Ramsey’s argument comes in the context of a review of two books: Paul Muolo and Matthew Padilla’s Chain of Blame: How Wall Street Caused the Mortgage and Credit Crisis and my own Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse. He likes the Muolo and Padilla book better, because in his view it merely tells the story. Since my book applies a theoretical apparatus to the events of the past several years, it is a case of ideology masquerading as analysis.

How, according to Ramsey, is a good book written? “You immerse yourself in the facts, see what the connections are, and let the story itself tell you what the explanation is. This is what Muolo and Padilla try to do. It is what many libertarians ought to learn how to do.”

Consider yourselves rebuked, all you libertarian propagandists out there.

The way we are supposed to proceed, according to this view, is to look around, try our best to collect the raw data of what happened, and then write it all down.

Ludwig von Mises had another view. “History,” he wrote, “cannot be imagined without theory. The naïve belief that, unprejudiced by any theory, one can derive history directly from the sources is quite untenable…. No explanations reveal themselves directly from the facts.” “Historical experience,” he wrote elsewhere, “is always the experience of complex phenomena, of the joint effects brought about by the operation of a multiplicity of elements…. The u2018pure fact’…is open to different interpretations. These interpretations require elucidation by theoretical insight.”

The stunted and superficial approach Ramsey recommends, on the other hand, would lead us to the unfruitful (if unfortunately conventional) conclusion that margin trading led to the stock market crash of 1929. That’s what we get from immersing ourselves in the facts, as he puts it, and letting the events themselves tell us what the explanation is.

Now yes, there was margin trading, and yes, there was the stock market crash of 1929, but the more interesting question looks beyond this trivial observation to the root cause — namely, how was so much margin trading able to take place, and why were lenders so ready to give so many people the use of so much of their money for such purposes?

Likewise, although I’m sure Ramsey could draft an interesting study of the dot-com boom and bust of the late 1990s, the finished product would be more a series of human-interest stories — interesting in themselves, to be sure — about the spectacular rises and falls of particular firms than a rigorous investigation of the fundamental causes of the whole episode. Don’t get me wrong: there is without a doubt a place for studies that delve into the minutiae of a particular business cycle. But what makes (for instance) Murray Rothbard’s book America’s Great Depression so valuable is that it makes sense of the minutiae with reference to a sensible theory. We should want to understand the phenomenon of the business cycle. But it is futile to expect the full understanding to jump out at us from a series of figures and charts or from a collection of anecdotes. It is only by means of economic theory that we can make sense of the figures and charts, which in the absence of theory are altogether inscrutable.

Getting down to specifics, Ramsey is not at all satisfied with my treatment of the ratings agencies. He writes, “Woods says that the private rating agencies are u2018an SEC-created cartel,’ with the unstated but obvious-to-a-libertarian implication that no defender of the private sector is obliged to defend them. Problem solved!”

Here I must refer Ramsey to Larry White’s article in the forthcoming (vol. 21, nos. 2—3) issue of Critical Review, “The Credit-Rating Agencies and the Subprime Debacle.” Professor White may enjoy a certain immunity to insult that I for some reason lack, so maybe Ramsey might consider his evidence with an open mind. White’s thesis is, in summary: “A combination of their fee structure, the complexity of the bonds that they were rating, insufficient historical data, some carelessness, and market pressures proved to be a potent brew. This combination was enabled, however, by seven decades of financial regulation that, beginning in the 1930s, had conferred the force of law upon these agencies’ judgments about the creditworthiness of bonds and that, since 1975, had protected the three agencies from competition.”

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Ramsey alleges that I essentially let the private sector off the hook while searching around for causes of the crisis that originate with government or its monopoly central bank, the Federal Reserve. I do not quite understand this accusation, given that one of the book’s central points is that imprudent and reckless firms should be allowed to fail in order to shift resources away from their obviously incapable hands and into the control of more sensible market actors. In calling them imprudent and reckless and arguing that resources should be yanked away from them, I thought I was criticizing them.

It is true, though, that I am more interested in getting to the root causes of the crisis than I am in dwelling lovingly on story after story of foolish loan origination. Maybe stories like that are interesting to someone, but they sure aren’t to me. I am not seeking to excuse people who did stupid things. I’m trying instead to show that the regulatory and banking regimes that exist in the U.S. provide ample incentives for financial institutions to behave as they did. Therefore, any attempt to prevent future crises by focusing on micro-level regulation instead of systemic reform is bound to fail. It is the system itself, which departs radically from the free market, that gives rise to these violent swings and encourages riskier behavior than would exist otherwise.

Ramsey will object that he recognizes the role of the Fed, and that in his review he rebukes (very mildly, compared to the vitriol he sees fit to unleash on Meltdown) Muolo and Padilla for failing to mention the Fed’s cheap credit. This won’t do. The Fed, and the structure of the commercial and investment banking sectors to which its perverse incentives give rise, are not mere adjuncts to the main story that we may slightly criticize, but generally excuse, popular writers for overlooking. We have a system in which credit can be created out of thin air, and we’re going to pretend this is a mere sideshow of a story that involves the gigantic accumulation of debt?

Ramsey makes much of the “private lenders” supposedly at the heart of the crisis. But once central banking and irredeemable paper money are introduced into the picture, it is only in the most trivial sense that we can refer to a “private” banking system. What we have now is a kind of corporatist system that has never in history emerged spontaneously within the peaceful nexus of social cooperation, and has always been imposed by force. It is a system shot through with moral hazard, artificially elevated risk tolerance, bailout expectations, artificially cheap credit, and special protections against failure. There is nothing laissez faire about it.

In Money, Bank Credit, and Economic Cycles, Jesús Huerta de Soto offers numerous reasons not to call ours a “private” system (the words are his, the numbering mine):

  1. The entire system rests on the government monopoly on currency.
  2. The management of the whole system is performed by the central bank, as an independent monetary authority which acts as a true planning agency with respect to the financial system.
  3. Banks are commonly excluded from the general bankruptcy proceedings stipulated in mercantile law and are instead subject to administrative law procedures such as intervention and the replacement of management.
  4. Bank failures are prevented by externalizing the effects of banks’ liquidity crises, the costs of which are met by the citizenry by loans from the central bank at prime rates or non-recoverable contributions from a deposit guarantee fund.
  5. The system is based on the privilege which permits banks to create loans ex nihilo by holding only a fractional reserve on deposits.
  6. There is little or no supervision of government intervention in bank crises. In many cases such intervention is determined ad hoc, and principles of rationality, efficiency, and effectiveness are disregarded.

“Deregulation” in the context of such a system can actually be worse than the status quo. Genuine deregulation, in which government removes itself and its perverse incentives from the banking industry altogether, is one thing, but deregulation of this kind is never on the table. Instead, “deregulation” usually involves allowing banks to make more reckless decisions than before, while keeping the lender of last resort in place and continuing to insure their deposits. Regulation and deregulation, in other words, are beside the point. It is the system itself that is the problem. According to Guido Hülsmann, in his indispensable book The Ethics of Money Production:

The banks must keep certain minimum amounts of equity and reserves, they must observe a great number of rules in granting credit, their executives must have certain qualifications, and so on. Yet these stipulations trim the branches without attacking the root. They seek to curb certain known excesses that spring from moral hazard, but they do not eradicate moral hazard itself. As we have seen, moral hazard is implied in the very existence of paper money. Because a paper-money producer can bail out virtually anybody, the citizens become reckless in their speculations; they count on him to bail them out, especially when many other people do the same thing. To fight such behavior effectively, one must abolish paper money. Regulations merely drive the reckless behavior into new channels.

One might advocate the pragmatic stance of fighting moral hazard on an ad hoc basis wherever it shows up. Thus one would regulate one industry after another, until the entire economy is caught up in a web of micro-regulations. This would of course provide some sort of order, but it would be the order of a cemetery. Nobody could make any (potentially reckless!) investment decisions anymore. Everything would have to follow rules set up by the legislature. In short, the only way to fight moral hazard without destroying its source, fiat inflation, is to subject the economy to a Soviet-style central plan.

We can imagine a scenario in which government imposes a $1 price ceiling on Porsches, and people rush out frantically to buy them. Naturally resources would be misallocated and wasted as a result. In telling this story, would Ramsey really want us to focus on the avarice of the individual buyers, instead of on the political regime that made the scenario possible?

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Ramsey, in short, misses the forest for the trees. In that respect he resembles Alan Greenspan himself, who once declared his inability to discern any kind of common pattern between the various boom-bust cycles in American history. “There is always something different,” Greenspan said, “something that does not look like all the previous ones. There is never anything identical and it is always a puzzlement.”

In fact, there is something identical — namely, artificial credit expansion. It is evident throughout all the nineteenth-century panics, and we likewise find it in the depressions and recessions of the twentieth and twenty-first centuries. Other features of the cycle may vary — there may be a spectacular rise in tech stocks in one case and in real estate in another — but this factor is consistently present.

It is bad enough to look at our financial sector and claim to see a free market, as opposed to the corporatist cartel we actually have. It is even worse to then criticize someone for (1) refusing to call this witches’ brew the private sector, and (2) rejecting the idea that shenanigans emanating from this quarter should count as demerits against the free market. I would expect analysis like this from Newsweek and the New York Times. I’d hope for something a little more serious in Liberty.

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