The economy is in free fall and we may be facing another Great Depression. In response, the government is scrambling to spend its way back to health. Is this really the best solution? Brian Saint-Paul spoke to Thomas Woods Jr., author of the New York Times bestseller, Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse.
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Brian Saint-Paul: The popular media is blaming the economic collapse on the free market and “laissez-faire capitalism.” And yet these same commentators seem largely ignorant of what a laissez-faire economy actually involves. So first things first: What is free market capitalism?
Thomas Woods Jr.: Well, it’s not nearly as scary as people think it is. Free market capitalism simply involves the free exchange of property between individuals. The idea is that you’re free to enter into contracts with other people. These contracts are reached on a voluntary basis; both parties must consent to the terms. The system proceeds along the lines of mutual respect. In other words, the free market is civilized behavior, institutionalized: You can’t initiate physical force against somebody else to make him do something — you have to get his consent.
It’s a system based on private property and free exchange. And that’s really it.
So government intrusion into the economy — say, pressuring banks to make loans they would not normally make — is not a feature of a free market economy?
No, because that involves the threat of physical force. If the bank doesn’t comply with the demands, then they can be fined, they can go to jail, etc. With a free market approach, people make deals on the basis of mutual respect. If they’re deemed to be credit worthy by certain traditional criteria, they get the loan. But in a free market, they don’t get a loan by asking the town bully to physically force the banker. That involves violence and the free market eschews all violence.
On a related point, a free market economy is not centrally planned?
Right, it doesn’t have ideological commitments like, say, creating an “ownership society.” It’s nothing more than the summation of individual exchanges. So in the same way, it would be wrong to say that the free market ‘poorly distributes wealth.’ The free market doesn’t distribute wealth at all — there’s no distribution mechanism whatsoever.
Again, we’re talking about nothing more than the voluntary exchange of property titles.
In your book, you identify a number of culprits in the financial meltdown — contributing factors to the disaster, but not the main cause. For example, you argue that Democratic-led efforts to increase lending to low-income earners was not a primary cause. Why is that?
Because I don’t think the numbers support it. The scope of the sub-prime mortgage problem has been exaggerated. Of course, those things didn’t help. In the effort to make homes more affordable to low income families, they did discard things like the traditional down payment requirement. We also saw the rise of ‘liar loans,’ where you could approach a lender and make up an income, and no-one would verify it. The Adjustable Rate Mortgage is another factor, though there can be some merit to that in some circumstances.
But when you combine these all together and make these loans available to people who would be called sub-prime, there’s almost no way to limit it to that. More and more people began using these types of mortgages, so the ready availability of very easy mortgage terms spilled over into the non-minority, non-low income market. It gave an artificial stimulus to speculation in homes, and made it seem as if the quickest way to become wealthy is to buy several investment properties, because everyone believed they’d appreciate forever. And of course, you could buy them on easy terms.
So this seems to be a bigger contributing cause than the sub-prime issue because the default problem is much more severe among prime Adjustable Rate Mortgages than it is among sub-prime mortgages. These are the mortgages that are most likely to have been purely speculative, and this unsustainable wave of speculation crumbled at the first sign of a housing collapse. People just walked away from these mortgages. They had no stake in them.
So this was more of an issue with speculators than ‘predatory lenders’?
Right. I hasten to add that I don’t think speculation is a bad thing, but when you’re in the middle of an asset bubble, people who don’t belong in speculation get drawn in. They get caught up in a kind of mania where they think they can do no wrong — not at the stock market, not at flipping houses. I think that’s what happened here.
Most mainstream commentators are blaming the collapse on a simple lack of regulation over the markets.
If we’re going to argue that the mortgage market itself needed to be regulated, then what about Ben Bernanke? He told us himself that his own regulators looked into the mortgage market and found it to be perfectly healthy — in fact, healthier than ever. So what do you do when the regulators miss it? You need to have something else.
Second, the Federal government wanted banks to be making these loans. Banks were only doing what every layer of government and the Federal Reserve itself wanted. So what regulator would dare stand up to the entire political establishment? Such an individual would be driven out of town, denounced, etc. “Aren’t you just a heartless monster who doesn’t want poor people to have affordable homes?” — that would be the claim. It would require a regulator of superhuman courage and integrity to say something other than what the regime wants to hear.
Finally, the apparent risks financial institutions were taking with these mortgages didn’t actually seem substantial at the time. That was due to the myths of the housing bubble: home prices always increase, a house is the best investment you can make, and you can hardly ever go wrong flipping a house. These myths made it seem as though investments in housing weren’t all that risky. Houses continued to appreciate, so the banks weren’t left with some unsellable thing that had dropped 50 percent in value. The Federal Reserve’s own economists said that this was not a housing bubble and that these high prices are sustainable and based on real factors.
So the investment was made to seem safe because of what the Fed was doing in pumping up the housing market.
Ok, but that’s housing. What about the financial markets?
The short answer is that the entire system, from the Federal Reserve on down, encourages risky behavior. The Fed can create money out of thin air. When it floods the economy with it, people naturally use it in a riskier way than they would in other circumstances.
I like the example that Peter Schiff uses. He says imagine a Kindergarten class where the teacher gives pixie sticks and soda pop to all the kids, and then leaves the room for a few minutes. When she comes back and finds the classroom trashed, who do you blame? So the Fed ought not be doing these things, and we shouldn’t have the implicit presumption that Alan Greenspan will come riding to your rescue if things go bad. Many investors seemed to believe this. There is built into the system an institutionalized degree of moral hazard.
Then there’s the Too Big To Fail doctrine, which encourages risky behavior. And finally, we have deposit insurance which means that nobody cares about the soundness of banks anymore. They care more about which plasma TV they’re going to buy than they do about the place where they’re putting their money. Instead of having a hundred million people keeping their eyes on the banks, the responsibility falls to a small number of regulators in Washington, D.C.
So you’re saying that the “breakneck deregulation” we’ve heard so much about is largely a myth?
Most of the alleged deregulation people complain about is completely phony. Suppose you have a government monopoly like the post office and say, “Ok, we’re going to deregulate the Post Office. From now on, the Post Office can charge $100 for a stamp.” That’s not really deregulation. Full deregulation would say, “We’re going to deregulate the mail business so that no-one is prevented from entering it by regulatory barriers.” Now that would be real deregulation. Try selling $100 stamps in that arrangement and see how that goes for you.
What we’ve had in recent years is phony deregulation. Banks are allowed to engage in riskier behavior than they were before, but the government will continue to guarantee their deposits with deposit insurance. How is that deregulation? In effect, you can do riskier things but the public is still on the hook for your errors. Real deregulation would say that you can do risky things, but you’re on your own. We haven’t had that. We’ve had the worst of all possible worlds.
Much of your book involves the leading role the Fed has played in the crisis. First, what is the Federal Reserve? Most people don’t realize the planning role it plays in our economy.
The Federal Reserve is the central bank of the United States. It has some regional banks, but it’s by-and-large a centralized system. It serves a couple purposes — it can act as the lender of last resort to institutions in financial trouble. But more significantly, it can increase and decrease the supply of money in the economy. Of course, as people have been saying for years, maybe we don’t need a Soviet-style Commissar in charge of money and interest rates. If we believe in the free market, why should we have an institution whose manipulation of the supply of money can artificially push interest rates one way or the other? Why don’t we trust the free market to set the interest rates as we do any other price?
The Fed is a non-market institution whose interventions in the free market, far from stabilizing it (as it supposedly does), actually destabilizes it.
And that explains the boom/bust cycle?
Friedrich Hayek is the Nobel Prize-winning economist people should be listening to, not Paul Krugman. Hayek argued that the source of the business cycle in the economy is the central bank’s manipulation of interest rates. (Before someone objects that there were business cycles before there was a Federal Reserve system, I’ll simply note that I address that in the book.)
Hayek’s argument was that interest rates can come down in two possible ways: First, people save more, and rates come down because banks have more money to lend. Second, the central bank could force them down artificially. Hayek’s point is that there are dramatically different economic consequences that flow from these two choices. When they fall voluntarily, the market coordinates production successfully, because when I save more, I’m implicitly telling the economy that I’m putting off some of my consumption for right now. And it so happens that when interest rates are low, businesses take the time to engage in future-oriented projects. This is how the market coordinates production across time: When people defer consumption for the future, that’s the time when it’s most profitable for businesses to engage in future-oriented projects.
Secondly, the fact that I’m saving and not consuming releases resources that then provide the material so that businesses can complete their investment projects. So this is all sound and good.
But if interest rates are brought down through artificial means, the public has not indicated that it intends to defer its consumption. So you have businesses involved in long term projects or engaged in product development at a time when people are demanding more products at the present.
Furthermore, forcing down the interest rates by flooding the economy with money does not create any additional resources. You have the same resource pool that you had before, but you now have more investors drawing from it, trying to complete their investment projects. They soon discover that the necessary resources don’t exist in sufficient quantities to do that.
If this is all true, then why do Hayek and the Austrians represent a minority position, while Paul Krugman and the Keynesians enjoy establishment favor?
There’s a mutually reinforcing aspect to this. First, Austrian economics has not been taught, so therefore the next generation won’t teach it. I think it’s getting a lot more exposure now, because it has so much explanatory power with regard to what’s just happened.
Second, Austrian economics does not tell the government what it wants to hear. I know this will shock people, but in my view, the government is not necessarily committed to the pursuit of truth alone. Rather, it will promote economists who say what it wants to hear. Politicians want to be told that you can spend your way to prosperity; you can print your way to prosperity. They don’t want to hear about the limitations that exist.
There are some criticisms of Austrian theory, of course, but I find them to be poorly thought out. They’re often thrown out casually by people who are annoyed with the Austrian view, but who may not have really studied it. Paul Krugman, for example, is contemptuous of the theory, but when you read his material on it, it’s clear that he doesn’t understand it.
We’ve had bailouts and stimulus packages, and possibly more of both in the near future. If you were to look into a crystal ball, where are we going to be in 20 years? Where is all of this heading? Will we reach a point of total economic collapse? Or will we wind up as the newest Euro-style state?
It seems to me that the best-case scenario is a kind of European third-way stagnation: high unemployment, anemic growth (if any), and a whole bunch of people scratching their heads and wondering why this is happening. That could be our fate.
Of course, it could be worse. It may turn into something like what Japan endured in the 1990s and beyond — though at least Japan had some domestic savings as a cushion. Or there could well be a complete collapse of the system, with the dollar destroyed. This is all conditional, because it depends in large part on what the government does. Its cure is almost sure to be worse than the disease.
I’d love to think that if a collapse came, people would say, “Obviously, intervention doesn’t work, so let’s try what the Austrians have been suggesting.” But I think instead a demagogue would rise up to say — as usual — that the problem is not enough government involvement, and that he’s going to rescue us.
That’s the most likely outcome.