Sunday, September 28, 2008

The Bailout: Hey Buddy Can You Spare $700B?

Before I start here are two links to helpful explanations of the economic "crisis." Both come from the Ludwig von Mises Institute. The first, titled The Bailout Reader, lists various articles on their web site. The second, titled The Housing Bubble in 4 Easy Steps, explains how the Fed's manipulations of the interest rate contributed to the housing market bubble. See more below but first I'd like to make a comment on what passes for explanations in the media and among many politicians.

When a systemic problem surfaces like this we need to look at something that leads people to act in a certain way. The popular "explanation" is to lay the blame at the greed of Wall Street and bankers. Question: why didn't bankers greedily loan money to poor folks before the passing of the Community Reinvestment Act during the Carter era and the strengthened enforcement imposed by the Clinton administration? If bankers didn't act this way previously we need to look at a deeper, more plausible reason than greed. Answer: because the change in laws and its enforcement dictated these poor loan choices. Before these laws went into effect the bank's underwriters knew that the rate of default on the loans would make this practice unprofitable. In fact, the people who pushed for these laws did so because the argued banks were "redlining" [not loaning to certain groups of people] and therefore needed to be encouraged [i.e., forced] to do so.

Returning back to the Ludwig von Mises Institute to which I refer at the beginning. I was lucky enough to go to Grove City College for my degree in chemical engineering. Why? At the time I was not aware of Grove City's strong free market economics department, headed by Hans Sennholz, an advocate of the Austrian school of economics. This school, which includes Friedrich Hayek (author of The Road to Serfdom) and Ludwig von Mises, proposed a theory of money, banking and business cycles at odds with the Keynesian model. I happened to become friends with several older students (including Robert Bidinotto) who were taking economics. Out of curiosity I started to monitor Sennholz's classes. What he said made sense so I sat in as many of his classes (with Sennholz's permission) as I could. Sennholz even offered to award me a minor in economics if I paid the school for the credits (which unfortunately I couldn't afford).

I'm probably doing it an injustice in trying to summarise the Austrian approach but in essence they argue that government attempts to foster economic growth by controlling and manipulating the money supply and interest rates ultimately create boom-and-bust cycles that are much more extreme than would occur in an economy where interest rates responded to market signals. Having centrally controlled interest rates leads to mis-investment as businesses plan their future and expansion plans on false information. The analogy which I've drawn in an earlier post is similar to government setting price controls. The inevitable result of government price controls leads to shortages or overstock because no bureaucrat, no matter how brilliant, can predict better than the pricing system of a free market.

The Austrian economists also argue against other attempts by the government to "steer" the economy via legislation. Their arguments are based on economics while others argue that it is immoral for politicians to redistribute wealth by using the full enforcement power of government to ensure we abide by its edicts.

The current financial situation perfectly illustrates both follies of artificially depressing interest rates while forcing banks to make loans to people who normally wouldn't qualify. These policies have resulted in the exact opposite outcomes as the stated intentions of its advocates. Instead of boosting low-income neighbors it will cause them to deteriorate (while leading to frantic calls for even more government "solutions" to fix the problems caused by previous government policies). In a way their egalitarian goals are accomplished but by an opposite mechanism. Instead of helping improve the economic welfare of their intended beneficiaries, the actions of egalitarian motivated politicians makes life more difficult for the middle class, thus pushing them down.

Anyway, I hope you check out the two links at the beginning of this post. Their explanations of what happened makes much more sense than the conventional explanations.

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