Meltdown

From 2015

Capitalism has failed! This is the constant message that people have been hearing since the 2008 economic crisis. Politicians, economists, and mainstream media agree that free market capitalism is the culprit that caused such economic mess. Greed and excessive risk taking claimed to be inherent in the market are to blame.

"The crisis was the fault of libertarianism," an editor of a popular website actually believed this claiming that "'unregulated markets'" (p. 4) caused the problem. And since this is the case, that editor thinks that the 2008 crisis marked "the end of libertarianism" (ibid.).

Since capitalism and libertarianism were considered responsible for the 2008 economic trouble, any free market solution to the crisis was automatically dismissed and persisting to do so would be considered insane. The proposed remedy was greater government intervention in the forms of increasing the money supply, more debt, and bigger spending.

The Real Culprit

The problem with the above conclusion is that the real culprit escaped public attention and shifted the limelight into the market. And since the diagnosis of the crisis was mistaken, the proposed solution, instead of addressing the problem, would aggravate it even more.

For Thomas Woods, the reason people were misled was because almost nobody asked the right question. "Where did all the excess risk, leverage, and debt, not to mention the housing bubble itself come from?" (p. 2). Once this question was asked, the direction would be pointing not towards the market, but to government intervention in the market. And "the greatest single government intervention in the economy" (ibid.) is through the Federal Reserve System, which is the real culprit. This is the institution responsible for the "inflationary monetary policy," (p. 3) which causes the business cycle and for setting "artificially low interest rates of 1 percent" that placed "world's economies on unsustainable paths. . . ." (ibid.).

Thomas Woods anticipated in 2009 that "There is nothing the government or the Federal Reserve can do to improve the situation, and a great deal they can do to prolong it" (p. 7). For Woods, the crisis will never be solved unless people would understand how the world entered into this mess in the first place.

In Meltdown, Woods explains in layman's term "where the economy is and what should be done next" (ibid.). There is nothing new in his message. His ideas are old, but they are ignored.

Woods' ideas are common among the economists of the Austrian School. Hundreds of economists from this school have seen the crisis coming several years before it happened. Unlike the mainstream economists who subscribe to diverse versions of Keynesianism, very few of them have seen the crisis in advance. Woods mentioned that only about 10 or 12 among 15,000 professional economists in the US have seen the crisis coming.

Guide Questions:

1. Who were to blame for the 2008 crisis according to politicians, economists, and mainstream media?

2. What was their proposed solution? Explain further.

3. What was the problem with the dominant story about the 2008 crisis? What would be its future consequences if it is not corrected?

4. For the Austrian School and Thomas Woods, which institution is responsible for the 2008 global economic crisis?

5. Explain the role of the Federal Reserve System in causing the crisis.

6. Why do you think most mainstream economists failed to see the coming of the 2008 crisis?

The GSEs

The problem with those who propagate the dominant story about the 2008 housing bubble was their failure to identify the real source of the crisis. They mistakenly pointed the finger to free market capitalism. As in the past, the interventionist hand of the government escaped public notice.

In chapter 2 of Thomas Woods' book, Meltdown, he identified six culprits including the Federal Reserve. In this article, we will just deal with the first culprit, Fannie Mae and Freddie Mac.

Before we describe how the US government caused the housing crisis through Fannie Mae and Freddie Mac, let us first give a brief background to the crisis.

Thomas Woods narrates that from 1998 to 2006, there was a dramatic increase in housing prices. More houses were built and house flippers became a norm. In the third quarter of 2006, cracks in housing industry started to appear. Borrowers could no longer sell their houses for profit for price depreciation started.

The eruption of this bubble rippled to the financial sector for many in the financial industry "invested heavily in mortgage-backed securities" (p.12). Before the crisis hits, homeowners were applying for mortgage at their local banks and paid their monthly obligation. But when bankers sold these mortgages in "the secondary mortgage market to institutions like Fannie Mae," the latter repackaged these mortgages and sold them as "mortgaged-backed securities" (ibid.). Investors bought these products for credit agencies marked them with triple A rating, meaning, secured. But when homeowners started to default on their mortgages, foreclosures multiplied. And since increasing number of homeowners could no longer pay their mortgages, the value of "secured mortgage products" started to decline together with the companies that invested in them. Greedy lenders and foolish borrowers were blamed, but not the government.

The housing crisis that erupted in 2008 could be traced to the interventionist hand of the government. The crisis was the inescapable consequence of government intervention in the market. And let us see how the US government did it.

Fannie Mae and Freddie Mac were "government sponsored enterprises" (p. 13). This meant that they enjoyed privileges that no private enterprises had. And besides, in case they would suffer trouble, the government was there to back them up by passing the financial burden to tax payers.

When these GSEs bought the mortgages from local banks, with funds in their hands, bankers returned to mortgage market making it easier for people to own houses, and thereby boosted the housing market. The fund that caused this boom was not a product of capital accumulation, but derived from special privileges enjoyed by GSEs. Hence the boom was artificial, and it diverted capital from a more productive industry into the housing market.

Fannie Mae and Freddie Mac could never cause the housing boom without the US government backing them up. Thomas Woods identifies the many privileges that these GSEs enjoy:

• with special tax and regulatory privileges
• traded on the NYSE
• considered as "government securities"
• considered low risk, and
• with $ 2.25 billion line of credit

"Fannie was also deeply involved in the politically instigated move to lower lending requirements in the name of helping 'disadvantaged' groups" (p. 15). So the housing industry was a hot political issue that time. The call of Republicans to regulate Fannie and Freddie was considered by the Democrats as an "attack on 'affordable housing'" (ibid.). Critics of Democrats saw that the party's hesitation to regulate Fannie was due to the fact that the latter was a source of political fund.

Ron Paul, the retired libertarian Congressman of Texas and two-time US presidential candidate captured the precise role of interventionism in the housing crisis:

"The special privileges granted to Fannie and Freddie have distorted the housing market by allowing them to attract capital they could not attract under pure market conditions. As a result, capital is diverted from its most productive use into housing. This reduces the efficacy of the entire market and thus reduces the standard of living of all Americans.

Despite the long-term damage to the economy inflicted by the government's interference in the housing market, the government's policy of diverting capital to other uses creates a short-term boom in housing. Like all artificially created bubbles, the boom in housing prices cannot last forever. When housing prices fall, homeowners will experience difficulty as their equity is wiped out. Furthermore, the holders of the mortgage debt will also have a loss. These losses will be greater than they would have otherwise been had government policy not actively encouraged overinvestment in housing" (pp. 16-17).

Guide Questions:

1. What do you know about Fannie Mae and Freddie Mac?

2. Briefly explain how the financial industry was affected by the housing crisis.

3. Who were the two primary scapegoats for the housing crisis?

4. Briefly explain the two primary advantages of GSEs over private enterprises.

5. Why is the housing boom artificial?

6. Enumerate the privileges that GSEs enjoy.

7. In what way the housing industry was used as a political battlefield?

8. Summarize in your own words Ron Paul's description of the role of the government in the housing market.

The Law, Speculation, and Rating Agencies

After identifying the role of GSEs such as Fannie Mae and Freddie Mac in the 2008 housing bubble, in this article we will see three more culprits: the law, speculation, and rating agencies.

The particular law we want to identify is the one made during Carter's time and revived under Clinton's administration. It is the Community Reinvestment Act.

This law coupled with political pressure from special interest groups, bankers were forced to lower lending requirements to provide easy access to housing loan for low-income borrowers. "Racial discrimination" was the favorite rallying cry during those years. As a result, lenders afraid to go against a popular political tide and legal threat were forced to conform to pressure and thereby loosened lending requirements.

Stan Liebowitz expressed an interesting observation about the absence of the most vital information in housing literature from 1990 to 2006. It was the connection of weaker lending standards to housing defaults.

And so the banks simply followed what the law mandated them to do. But when the housing bubble burst, the role of the CRA was denied.

Henry Cisneros served as the best example of a public bureaucrat who applied this weaker credit standard, and even used it in his private investment. In fact, he built around "428 homes for low-income buyers" (p. 19).

A chain of responses followed. Due to easy credit terms, the demand for housing increased. This provided the environment for speculators to flock into housing market. The price of houses artificially appreciated. This multiplied speculators, not only from low-income buyers, but also to higher-income borrowers. Speculation became viral. The two most notorious examples of this were house-flippers and market-timers.

Private rating agencies also had their share of responsibility in the housing bubble. They failed to do their duty due to SEC regulations. Like the bankers, they were also afraid to go against a popular political propaganda that caused them not to do their job.

Personal Response

Reading this section of the book causes me to reflect on the stock market in the coming months. I suspect that as an outcome of the decision of the European Central Bank to inject $1.3 trillion into global economy until the end of 2016, this will motivate speculative stock trading. I think that this new money supply will find its way into stock market. This is advantageous for those who do both stock trading and investing, but detrimental to savers and those who depend on fixed salary.

At the moment, I am seeing an unusual price appreciation in consumer products, in banking sector, and other related sectors of the economy. This happened during the first round of QEs from the Federal Reserve, and it appears that is now being repeated in 2015 as a result of ECB announcement. Is this another bubble in the making?

As for rating agencies. I wonder how many stock brokers would give a "buy" rating on firms and yet would do otherwise in their actual transactions. I saw company reports from 2006 to 2015 of one firm rated as "buy" in August 2007 and in the succeeding months, but after a year and 3 months, its price per share sunk down from 62.50 to 11.25. Even if you will use averaging, I wonder how could "experts" advice their clients to invest long-term when the latter's equity lost 80% of its total value after investing for three years.

Guide Questions:

1. Why were bankers forced to lower their lending regulations?

2. What was the observation of Stan Liebowitz on housing literature from 1990 to 2006?

3. How did Henry Cisneros implemented this lower lending standard in his private investment?

4. Describe the spread of speculation as a result of government easy credit. Give two examples of speculators. Define each of them.

5. Why private rating agencies failed to do their job?

6. What do you think would be the impact of the $1.3 trillion stimulus package from the ECB? How would it influence the stock market?

7. How about stock brokers' rating? Do you trust them?

Tax Code, The Fed, and Its Monetary Policy

So far, in reading chapter 2 of Meltdown, we already identified four responsible sources for the 2008 housing bubble: government-sponsored enterprises, the law, speculation, and rating agencies. In this article, we will add two more: tax code, the Federal Reserve and its monetary policy.

Tax Code

In explaining the role of tax code, Tom Woods identifies it as just one example of government's numerous programs to motivate people to borrow and buy houses that artificially increased the demand for housing. Other programs include favors that developers enjoyed such as "free land" and "new roads". The US government did this "at the federal, state, and local level" (p. 24).

Tom Woods is in favor of "tax breaks". However, for him, this should be indiscriminately applied, unlike the one used that popped up the housing market. Two examples of arbitrary implementation of tax code include "a $5,000 credit" for "first-time homebuyers" and exemption from capital gains tax if someone "bought a house for $5000,000 and sold it for $1 million" (p. 25). But if you invested similar amount in the stock market or in a business, capital gains taxes applied to you.

The Federal Reserve and Its Monetary Policy

A complete understanding of the business cycle is impossible without seeing the role of the Federal Reserve. This is the common blind spot among mainstream intellectuals. In explaining business booms and busts, they left out governments and central banks. They failed to see that increase in the money supply pushes down interest rates that creates business boom. The construction and real estate bubble can be traced back to this root.

The increase in money supply, popularly known as credit expansion, quantitative easing and stimulus package does not come from saving or capital accumulated through time, but creates demands not based on genuine consumer demand, and that is why it is described as artificial. It is therefore not accurate to call this system free market for it originates from government interference. This act diverts resources from one sector of the economy into another sector.

In times of boom, it is difficult to distinguish sound projects from unsound ones. The money created from 2000 to 2007 found way into the housing market and made it grow. "Get-rich-quick scheme," excessive optimism, and taking risky decisions became popular. When the housing bubble burst out, the speculators were singly blamed, but the Fed escaped public attention.

This disastrous event had parallel in the past. Woods mentioned the 1819 Panic and the "credit-induced boom from 1914 through 1920". Quoting Fred Garlock, Woods describes the 1914 to 1920 period as characterized by extravagance, speculation, unusual profits, business boom, and "borrowing for the purpose of relending" (p. 28).

Personal Response

I am not familiar with the US story of credit expansion from 1914 to 1920. I thought Woods was referring to Germany's experience during WW1 that ended in 1921 to 1923 hyperinflation. But he was referring to American history.

Reading this section of the book, it remains fresh in mind what the Federal Reserve did after the housing bubble. It issued a series of QEs. After 7 years, the European Central Bank joined the QE party by purchasing 50 billion euros per month until September 2016. Switzerland anticipated this action that caused it to disconnect itself from the European monetary union.

The impact of the 2008 housing bubble was not only confined on US shores. It rippled throughout the global economy. How about the effect of ECB's QE? Will it not find its way into the Asian market? If it does, what will be the extent of its impact on different sectors in Asian economy?

One news article states that the impact of ECB's QE will be felt in Philippine stock market this March 2015. Is this a development that investors and traders to celebrate? Or is this leading to the path of illusory growth?

How I wish that the US "Audit the Fed movement" be realized in our time. I also want to see it shutdown.

Guide Questions:

1. Briefly describe the role of tax code in the growth of housing market?

2. Why is this growth a bubble?

3. Why is it important to understand the role of the Fed in explaining business boom?

4. How would you characterize the business boom period?

5. Do you think that the monetary policy used by both the Fed and the ECB beneficial to nations' economies? Why?

Blaming Financial Deregulation and the “Too Big to fail” Mentality

Another pretext the Obama administration used to shift the attention of the public to Bush administration is financial deregulation. Since deregulation is what the current administration wants the American public to believe that was responsible for the economic meltdown, what is needed is greater "government oversight." For Woods, to emphasize financial deregulation as the reason for the collapse of the housing market obscures the real issue for the "lenders were doing exactly what the federal government and its central bank wanted them to do" (p. 29).

Both the Democrats and the Republicans were guilty of abandoning the "traditional lending practices" (ibid.). In the case of Bush administration, it was responsible for the removal of the required down payment "for 150,000 new homeowners" (ibid.). Such action is part and parcel of the realization of the American dream that would include increasing number of the American people. So deregulation is actually out of the question for it was the president himself who gave approval to riskier lending practices.

Nevertheless, the financial regulators prior to the bursting of the real estate bubble were all in agreement about "the fundamental soundness of the system" (p. 30). Both Allan Greenspan and Ben Bernanke and two other unnamed Fed economists shared the perspective that the housing bubble didn't exist. Moreover, "some of the major financial institutions" think that the growth of the real estate industry was actually based "on real factors" (ibid.). Again for Woods, blaming deregulation is misleading for one can traced the hand of the US government everywhere prior to the collapse of the housing market with its consent to the action of the Federal Reserve in increasing the money supply and reducing the interest rates.

"Too big to fail mentality" became popular after the crisis. This idea does not allow giant financial firms to go bankrupt though their practices and continued existence would actually harm the economy. "Bailout" was the name of the game and Alan Greenspan was exalted as its great champion. For Woods, bailing out these firms simply meant transferring the financial burden to the unsuspecting taxpayers.

Greater government regulation and bailout are the hailed solutions to the housing crisis. Woods believes that the US government would consider other tools to solve the crisis except the solution that comes from the market.

Another card allowed by the government to utilize was the offer of financial assistance to distressed homeowners. The government GSEs that shared the responsibility in the crisis, Fannie and Freddie offered homeowners a financial aid to avoid foreclosure. This aid includes "reductions in principal owed, lower interest rates, and a longer payoff term" (p. 33). However, those who resort to minimize their loss through responsible decision such as transferring to smaller houses would not be included in this assistance program.

And so after 7 years, the best solution the US government could come up with is the same action that caused the crisis in the first place. And so in the coming years we could not expect for a genuine global economic recovery but an expansion of the crisis.

Guide Questions:

1. Why blaming financial deregulation obscures the real cause of the housing bubble?

2. Prior to the collapse of the housing market, what was the popular opinion among regulators?

3. What is "too big to fail mentality"? How is it being implemented? And what is the real nature of such implementation?

4. So far, what solutions the US government agreed with in order to address the 2008 crisis?

5. What do you think should be the market solution?

6. With the existing US government solutions, what do you think will happen to global economy in the near future?

The Bailout Bonanza!

Prior to 2008 global economic crisis, American officials assured the public that there was nothing to worry about the state of the economy. This was the message of both Henry Paulson, the US treasury secretary and Ben Bernanke, the chairman of Federal Reserve. The popular financial advice was "Don't panic. Don't stop investing. Don't stop borrowing to buy homes. Spend like you're Paris Hilton. Everything is just fine (p. 38)." But after the advice was proven wrong, these officials instead of losing credibility were even demanding greater power.

And so the demand for greater power was granted. It was believed that bailouts can solve the world's economic troubles. The US government took over Fannie Mae and Freddie Mac, which "held $5 trillion in mortgage liabilities" (ibid.). What came next was the "Bank of America's purchase of Merrill Lynch" (p. 39) with the influence of course of the Fed. And then the US treasury secretary came up with "ten financial institutions to work out a bailout for Lehman Brothers" (ibid.). But the solution did not work out and so the "Lehman Brothers was ultimately allowed to go bankrupt" (ibid.). However, the bailout magic continued. AIG received a total of $125 billion bailout, which the New York Times describes the initial bailout of $85 billion as "'the most radical intervention in private business in the central bank's history'" (p. 40). The government was hailed as the savior of corporations at the expense of the productive sector of the economy, the taxpayers.

With the exception of the Lehman Brothers, which situation was beyond recovery, the popularized reason why the identified firms were not allowed to go bankrupt was to prevent the domino effect of their collapse upon other firms that would seriously harm the economy.

In reality, it was the act of bailing out these firms that harm the economy. Allowing them to go bankrupt would result into an opportunity for the economy to recover through market forces. For Thomas Woods, bailing out those firms "discourages rather than encourages capital formation and economic recovery" (p. 41).

To make the situation more serious, as if the previous bailouts were not sufficient enough to ruin the economy, a bill, "the Emergency Economic Stabilization Act of 2008" was passed. This bill gave the US treasury secretary the authority to buy $700 billion in assets "'at any time'" (p. 42).

Guide Questions:

1. What does it tell about the current system when those in authority who failed in their public pronouncement were entrusted with greater power rather than losing their credibility?

2. What was the perceived solution to global economic crisis? Briefly explain your personal understanding of this solution.

3. Who were the firms that the US government bailed out? What was the justification for doing so?

4. What do you think would be the long-term impact on global economy of this bailout bonanza? Why?

Four Popular Tools to Solve the Economic Crisis

In addition to bailout, the US government took four more tools from its arsenal to solve the financial crisis. Prohibition on short-selling is the first of these four.

Short-selling is the exact opposite of "buy low and sell high" strategy used by investors. Instead, traders "sell high and buy low" and they do this by borrowing stocks from a broker and sell them from their perceived "overvalued" price and buy them again when the price is down. These traders then return the borrowed stocks and keep the gain for themselves.

Thomas Woods is opposed to this kind of restriction. He thinks that traders are doing service to investors by giving them important information about sound firms. Without this information, investors might place their money on unsound firms. This wastes scarce resources and deprives sound companies of the necessary funds to finance their projects.

Regulators do not like short-sellers for the latter exposed their failure to do their job to identify companies, which resort to fraudulent accounting practices to exaggerate profitability and fool investors. This is the reason why short-sellers are doing great service for the good of economy by alarming investors.

Another tool to aid the economy was the increase of insurance of depositors' money "from $100,000 to $250,000" "without considering the soundness of the bank's finances" (p. 45). For Woods, this was an additional "layer of moral hazard" for such action on the part of the FDIC removes from the banks the "need to become more cautious and conservative" (ibid.). Woods notes that in reality, the FDIC can only insure .5% of all the depositors' money. And so in case banking crisis occurs, the ultimate solution is to return to the old trick of printing USD.

Still another solution was "foreclosure holidays" (p. 46). For Woods, this would aggravate the problem for this would entice the marginal borrowers to stop their mortgage payments. This would result to lesser credit, thereby depriving the common man to avail a mortgage loan, an unfortunate outcome that will be blamed on free market's "inefficiency".

And finally, we come to more regulation. For Woods, it is crucial to understand the basic framework how this talk on regulation and deregulation is taking place, which is the act of transferring the risk of unsound companies to taxpayers. Woods indicates that this debate on "deregulation" is actually anomalous for how can one talk of it when the government allows firms to make riskier investments with the guarantee of taxpayers' money. This is not deregulation. Genuine deregulation entails the removal of monopoly and free competition. For Woods, the real problem is "a system that artificially encourages indebtedness, excessive leverage, and reckless money management" (p. 47). And so the passing of Sarbanes-Oxley, which demands higher financial requirement from firms would actually prevent the creation of new firms. This would protect big firms from competition and that's why Woods believes that they would join the "choir" of those who are singing for more government regulation. Woods agrees with Michael S. Malone that this kind of regulation would result into further economic anomalies. Quoting Malone, Woods describes these results:

"'. . . fewer new companies are going public; economic power is being concentrated in the hands of fewer companies; competition is reduced; new wealth is less widely distributed; the rich are getting richer; fewer talented people want to join entrepreneurial ventures; and corporate boards are getting more stupider and more paranoid'" (p. 48).

Guide Questions:

1. Enumerate the five mainstream solutions to economic crisis. Briefly explain each.

2. Why is it that restricting short-sellers would harm the economy?

3. Are depositors' money completely safe in the bank? How many % of it is actually insured. How can FDIC keep its insurance policy in case of a bank collapse?

4. How would foreclosure holidays shift the blame to free market?

5. Identify the long-term results of more government regulation.

Separation Between Money and State

We will skip chapters 4 and 5 of Thomas E. Woods Jr.'s "Meltdown: A Free Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse" for these chapters describe about the business cycle and the Great Depression in the 1930s. The business cycle chapter in particular is a discussion of F. A. Hayek's concept, which I think is better considered using the book of Hayek's intellectual mentor himself, Ludwig von Mises. I am referring to the "Human Action" specifically Chapter 20 Sections 8 and 9. I summarized this topic in three articles:

· The Monetary Credit Theory of Business Cycle

· Impact of Business Cycle

· Disproportionality Doctrines as Explanations of Business Cycle

Our primary concern in the present article is about money. In particular we want to talk about the separation between money and State. We have been told that in the past, the separation between church and state was a great accomplishment that prevented numerous abuses. Likewise, living in an interventionist age, the blogger agrees that a new kind of separation is needed in our time for citizens of nations to live in freedom, peace and prosperity. This is the separation of money and state.

For most people, this idea is next to impossible. Governments and central banks will not allow this to happen not unless citizens become economically informed. This ideal can only be achieved if an intellectual revolution would occur as a result of people's search for an answer once the existing interventionist crisis reached its ultimate end.

I think Chapter 6 of Thomas Woods' book will help us understand how to achieve the identified separation. Woods explains this by exposing two popular myths and by introducing fundamental economic and monetary concepts.

Two Popular Myths

The first myth is economic. It has something to do with the role of the Federal Reserve. It is difficult to break the spell of this myth for almost everybody is asking for it. This is how Woods describes this myth: "We need the Fed to push down rates so there can be more borrowing and lending. Then we'll be prosperous" (p. 126).

The problem with this superstition is that the Fed itself has no resources of its own to lend, except the USD coming from the printing press. This kind of credit does not come from people's saving. It is just being created out of paper and ink.

The second myth is monetary. The focus of this fallacy is hostility towards commodity money such as silver and gold. It has at least five different versions. Woods enumerates them as follows:

1. "Gold and silver aren't flexible enough. We need money that is more flexible." The key in understanding this fallacy is to know how the term "flexibility" is used by those who are hostile to commodity money. Once you understand this term, you will also see that being "inflexible" is in fact a virtue of gold and silver.

2. "Precious metals are too bulky." This can be easily dismissed for debit cards can be "used with a precious metal money" (p. 131).

3. "A gold standard is too costly; paper money is les expensive to produce." The mistake in using this line of reasoning is the failure to see the real cost of paper money, which is the enrichment of the political and bureaucratic class at the expense of the taxpayers.

4. "There isn't enough gold or silver to facilitate all the transactions of a modern economy." Woods disagrees with this for he believes that sufficient quantity of gold or silver exists to facilitate market transactions. Furthermore, he does not believe that increasing the money supply will benefit the economy apart from the growth in the quantity of products and services. In fact, he cited the experience of the Americans during the 19th century that a relative "constant money supply" was matched with the increase in goods and services. This resulted to lower prices and growth in the purchasing power of people's money, and thereby also increased the American's standard of living.

5. "The supply of gold cannot keep up with the growth in business activity." This is just an extension of the previous myth. For Woods, there is no need to increase the money supply just to offset the fall in prices. Doing so, is the primary cause of the business cycle.

Fundamental Economic and Monetary Concepts

Reading chapter 6, you will see Woods complains about the exclusion of critical monetary issues from mainstream discussion. He identified five of them:

1. The existing monetary system has depreciated 95% of the value of the USD.

2. The existing monetary system is an indirect way of expropriating the people.

3. The existing monetary system with the power of the Federal Reserve to control interest rates is the cause of the business cycle.

4. That there is a need for a new monetary system and policy

5. That the kind of monetary policy we need is the one that will discourage "reckless leveraging and risk-taking."

The central concept that Woods argued throughout the book is that the current banking system and its monetary policy is the source of economic instability and miscalculation. After exposing the above two myths, we will now identify the fundamental economic and monetary concepts that Woods wants to introduce.

The first concept is about the source of money. Money is not a government creation. It originated from the market. And since at present, we are all used to paper money, Woods argues that for it to have value, it must have a connection to commodity money.

The second concept is about the process how governments arrived to its present monopoly of money. Woods explains this process in three stages:

1. It all starts with the market's use of commodity money.

2. The circulation of paper notes started as a substitute of commodity money.

3. The government confiscates the commodity money.

For Woods, such act of confiscation is a "violation of private property rights" and "it always involves the threat of violence" (p. 113).

Roman Catholic scholasticism championed the third concept. Two examples of popular thinkers from this school include Nicholas Oresme (1323-82) and Juan de Mariana (1536-1624). They condemned the act of monetary debasement as a violation of the 8th commandment.

The fourth concept is about the qualities possessed by gold and silver that qualified them as money: durability, divisibility, and relatively valuable. Other Austrian economists add scarcity and transportability.

The fifth concept is about the connection of commodity to liberty. Woods echoed the argument of Joseph Schumpeter that "a commodity standard was the only monetary system compatible with freedom." The other face of this argument is that under the existing fiat monetary system, tyranny is winning the day.

The sixth concept is about the Federal Reserve. Woods does not believe that the Fed was established for the good of the American public. Instead, it was a "special interest" institution disguising as working for public good.

The seventh concept is about the confusion regarding the meaning of inflation. I don't want to elaborate on this further for I already wrote about this topic. You can find it here:

• US Congressman Ron Paul on Inflation
• Invisibility and Economic Consequences of Inflation
• The Intelligent Woman's Guide to Inflation
• Monetary Policy and Philippine Economy Part 3 - Mises' Lecture
• Monetary Policy and the Philippine Economy - Biblical Critique of Inflation
• The Role of Hyperinflation in the Rise of Hitler into Power - Notes from Hazlitt's "Lessons of the German's Inflation"

The final concept is about deflation. This is what most economists are afraid of today. Contrary to popular belief, Austrian economists like Thomas E. Woods Jr. does not believe that falling prices result to economic difficulties. Instead, he affirms that falling prices is either "the natural outcome of a progressing market economy" (p. 135) or an indication of depressed economic condition after a series of inflationary measures has been stopped.

The blogger agrees with Thomas E. Woods Jr. that unless people will understand the identified fallacies and the basic concepts discussed in chapter 6 of his book, American economy as well as the global economy will continually sink deeper into economic abyss. The journey to freedom, peace and prosperity will only start once the tie between money and state is disconnected.

Guide Questions:

1. How did Thomas Woods explain the concept of separation between money and state?

2. What are the two popular myths? Briefly explain each.

3. Enumerate the five versions of monetary myth.

4. What are the five critical monetary issues excluded from mainstream discussion?

5. What is the central argument of the book?

6. Enumerate the 8 fundamental economic and monetary concepts introduced in this chapter. Briefly explain each.

The Path to Economic Recovery

Contrary to mainstream story, the global economy has not recovered from the 2008 crisis. Instead, it was expanded even more. Once central banks stop these QEs, the real situation of the economy will be exposed. And so the best alternative at this point is to address the problem following the free market way to recovery. In any case, economic pain is unavoidable.

The free market solution will lead to the reduction in asset prices and debts. The primary obstacles to this solution are the interventionist policies of the government in the form of bailouts and increased taxation of the wealthy. Such policies discouraged saving and are rooted in the myth that increased consumption is good for a struggling economy. However, for Austrian economists, to stimulate consumption in the midst of recession is not only foolish, but will aggravate the situation even more. Better listen to these economists if we really want to find the way to economic recovery.

In the last chapter of Thomas E. Woods Jr.'s book, "Meltdown: A Free Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse," the author offers concrete steps to recovery from a free-market perspective. We can reduce these steps into four:

1. Allow firms to declare bankruptcy. This solution should first be applied to Fannie and Freddie, which Woods calls as "zombie companies." These state-sponsored enterprises have already brought so much distortion to mortgage market that should be stopped.

However, this bankruptcy solution is avoided due to two baseless fears. One is related to the perceived negative impact on the economy once firms disappeared. Woods corrects this misconception. He argues that in case of bankruptcy, firms will not disappear. Instead, there will be a change in ownership of assets from incapable to capable hands. Woods cited Enron to prove that "its bankruptcy in 2001 had no effect on the economy at all, and even energy markets barely noticed it" (p. 147).

The second fear is about the loss of credit. This is the justification in bailing out banks. Woods thinks that it is unnecessary for in our time, it is now easier to raise capital outside the banking system. He identified selling bonds, issuing stock, and borrowing overseas as examples.

2. "Stop the bailouts and cut government spending." Excessive consumption and too much debt caused the 2008 crisis. It cannot be cured by continuing the same practice. Bailouts and increase in government spending are just the other faces of persisting in excessive spending and borrowing. This too must stop.

3. Demand transparency from the Fed. Though Woods did not directly recommend to end the Fed, I think he is happy to see its abolition. He does not like this institution for its impact on US economy is the exact opposite of its official purpose. He sees it as a source of economic instability, "unnecessary," "disruptive," and intrusive to the market economy. And the Americans can only realize the destructive impact of the Fed on US economy if its records will undergo public scrutiny. The Fed must identify the recipients of its bailout program and the collateral backing up such loans.

4. Keep the government away from the monopoly and manipulation of money. Again, I think this serves as the primary reason for the abolition of the Fed for it is through this institution that the US government is actually monopolizing and manipulating the monetary system. Various proposals have been made as a replacement. The goal in mind is to keep the government away from money for Woods sees no role for government to "play in the monetary system that can confer any kind of social benefit" (p. 154). Citing Ludwig von Mises, Woods narrates:

". . . the history of money is the history of government efforts to destroy money. If ever there was a monopoly with which government could not be trusted, this is it. The temptation to debase the money and impoverish the people in order to benefit favored constituencies, hoping most people won't know the source of their declining standard of living, is too great" (ibid.).

This ends our study of Meltdown.

_____________________

Source: Wood, T. E. Jr. (2009). Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse. Washington, DC: Regnery Publishing, Inc. 194 pages.

Published between 6 January to 27 June 2015. The original is here.