Recently I was asked a series of questions by a journalist wishing to write an article about the nation’s current economic situation.  What follows in this article and others following over the next week is one of those questions and my answer to it.

What are the kinds of questions policymakers should be asking as they evaluate economic stimulus proposals?

The main question that should be asked is “are we doing more good than harm.”

There is only one thing policymakers should do – attempt to create individual confidence in the economy and the banking system and stay out of individuals’ economic decisions.  If government would reduce taxes and regulations and enable the private sector to flourish, the economy would return to health much more rapidly than if government increases regulations, increases taxes, increases spending and thereby increases debt.

Government stimulus typically refers to increased government spending.   Where does government get the money it spends? From taxes.   When government takes money out of the hands of the private sector and chooses where this money should be spent, policymakers are saying they know better what to spend money on than do the people who labored and created the money. If government chooses not to increase current taxes, then its increased spending has to come from debt.  The government borrows which means that either taxes must be raised in the future to pay back creditors or the debt is “monetized” .  This  means the Federal Reserve buys the debt with dollars it prints from thin air which leads to inflation. Monetization is simply a hidden tax – inflation.

The second question that should be asked is “are we inducing uncertainty about the security of private property”.  When Paulson and Bernanke panicked, going from one policy approach to another and when they turned from buying toxic assets to bank equity, the private sector had no idea what was going on.  It, therefore, panicked as well.  People have to believe their property is secure, that the regime of security over that property is not changing, and  that property will not be confiscated. Much like the early 1930s, people today are not confident that their property is secure and that what they earn with their labor they will be able to keep. A poll in May of 1939 asked:
“Which of the following comes closest to being your prediction of the kind of economic structure with which this country will emerge after the war?”

1. A system of free enterprise restored very much along the prewar lines, with modifications to take care of conditions then current. [7.2 percent]
2. An economic system in which government will take over many public services formerly under private management but still leave many opportunities for private enterprise. [52.4 percent]
3. A semi-socialized society in which there will be very little room for the profit system to operate. [36.7 percent]
4. A complete economic dictatorship along fascist or communist lines.  [3.7 percent]

Source: (Robert Higgs, 2007, Depression, War, and Cold War: Studies in Political Economy Oxford University Press, USA (June 22, 2006) ISBN-10: 0195182928

90 percent of the respondents thought that the future was one of socialism or worse.  No one wanted to  invest in such an environment and this is what current policymakers should focus on avoiding.

It is now taken for granted that markets and capitalism are flawed and must be regulated and controlled, if not destroyed.    The message from the current economic crisis is clear. “It is the end of capitalism.”  Barney Frank tells us that “The private market got us into this mess; the government will have to get us out.”

Bashing markets is convenient and  politically popular. But to make the argument requires a willful disregard of facts.  The role of bankers and other market players in causing the current crisis is undeniable, but none of them would have undertaken their actions had it not been for the massive role played by government. The trigger for the financial meltdown was the U. S. sub-prime housing fiasco – a pure example of government failure and regulatory policy run amok.

Barney Frank in the House and Chris Dodd in the Senate pushed for loosened mortgage lending restrictions so first-time home buyers could qualify for loans they could never get before.  Reacting to these and other more significant policy changes, lenders such as Countrywide Financial in California set up units to service these so-called borrowers. On the brink of bankruptcy, Countrywide had $170-billion in mortgage assets, most of them subprime. (Interestingly, Chris Dodd  and members of Fannie Mae and Freddie Mac executive corps, received  below-market special mortgage loans from Countrywide.)

The Government Sponsored Agencies (GSEs) Fannie Mae and Freddie Mac, were forced by the democrats to increase the percentage of “affordable loans” they made. The Housing and Urban Department gave the GSEs a target of 42% of assets in the mid 1990s. The target increased to 50% in 2000 and 52% in 2005. In addition, for 1996 HUD required that 12% of all mortgages purchased by GSEs be special affordable loans — income less than 60% of the median in the area – then 20% in 2000, 22% in 2005 and 28% in 2008.

Politicians in Congress fueled the explosion. The incestuous relationship between Congress and the GSEs has not been made clear.  For years, Fannie Mae and Freddie Mac– right up to their seizure by the U. S. government earlier this year – were everywhere.  They funded politicians’ interests, kept mortgage interest rates low and became government-backed agencies for trillions of dollars in risky mortgage lending.  Look at who received the greatest campaign contributions from the GSEs and you will see who was unwilling to rein them in.

Between 1995 and 2007, the combined balance sheet of Fannie Mae and Freddie Mac, including Mortgage Backed Securities (MBS), rose from $1.4-trillion to $4.9-trillion, an annual increase of almost 15%. About $1-trillion dollars of Fannie/Freddie activity involved exposure to subprime and lower-grade mortgages. The loosened standards meant that investors could purchase several homes with out having any “skin in the game”. Housing prices shot up. This gave rise to even greater use of credit, as speculators and buyers piled onto a credit and ownership machine that seemed to offer no risk and guaranteed gains. Not all funding came via government and regulatory overreach. Hundreds of billions were raised through new mortgage based securities and other risk-distribution vehicles by private players, as these mortgages, issued under no lending standards, were packaged and then sold as AAA-rated securities. AAA rating? Who gave them this sterling rating?   Essentially the government did.

There are only three rating organizations approved by the SEC:  S&P, Moody’s and Fitch and these three earn money by favorable ratings. Lack of genuine market competition in the ratings business, meant that the ratings firms, became part of the social program. The view that subprime mortgages issued under lax standards to low income Americans were no more risky than prime mortgages, especially when they were packaged into large agglomerations became widely accepted. Ratings inflation ensued, with AAA and other high ratings accorded to all manner of high-risk mortgage products.

Crucial to the story is the role of the Federal Reserve under Alan Greenspan. Mr. Greenspan’s low-interest rate policy -which brought the Fed funds rate to 1% through much of 2003– helped push home values up even higher. As values rose, the lax lending standards started to look even better.

The mortgage and financial crisis now sweeping the world is the product of a colossal build-up of unintended consequences brought on by government policy and regulation. What we are witnessing today, as governments pile on massive new rounds of intervention, is a growing pyramid of government failures. It is not a failure of free markets; it is a failure to have free markets.  Solving the problem by enlarging government’s role in the economy is the road to socialism, not the road to salvation.

Anyone who has been on Drudge Report the last few days will know of the Obama-Rush feud in which Obama asked congressional minority leaders to stop adhering to Rush’s advice and politics. Well Rush has responded to the President’s criticisms through National Review Online being that his show doesn’t operate on weekends. Without going into the specifics of the response, one particular phrase really stood out for me:

“Obama was angry that Merrill Lynch used $1.2 million of TARP money to remodel an executive suite. Excuse me, but didn’t Merrill have to hire a decorator and contractor? Didn’t they have to buy the new furnishings? What’s the difference in that and Merrill loaning that money to a decorator, contractor and goods supplier to remodel Warren Buffet’s office?”

Why didn’t I think of that? This perfectly demonstrated the utter inconsistency in how the left seems to approach economic matters. Subscribing to this crude Keynesian framework of all marginal deficit spending will entail a multiplier effect which will be the catalyst of “priming the pump” of aggregate demand.

I am not really qualified to comment on the validity of the multiplier effect and whether the inflationary pressures along with mounting debt are worth the tradeoff. In another post, it might be necessary to point out the additional public choice issues that arise such as bureaucratic inefficiencies in determining highest values at the lowest costs, rent-seeking problems, incentive problems, red tape, bloated oversight, and other governmental problems that, even if the Keynesian theory is entirely true, would limit its effectiveness.

What is so amazing about what Rush has pointed out is that Obama is entirely correct about being angry with Merrill Lynch and yet the President doesn’t seem to make the connection with his greater stimulus. Government does not possess the ability to effectively identify value. This is because value, with the exception of clearly defined public goods, can only be understood by its profitability. Lowering unemployment cannot be understood as a virtue in itself- it must be tied to productive growth. The tribes of thousands of years ago always had full employment- every single person worked, and yet it would be ridiculous to call those times prosperous relative to ours.

But to view every single marginal dollar spend as equal is complete economic ignorance. North Korea, for example, in an act of proving economic and social prowess, created plans to federally finance a massive epic building (I forget the name). They employed thousands of workers and tons of capital and resources. In the end because of no market price mechanism for conveying the best way to produce this building at the lowest price, it was never completely finished and is considered one of the ugliest sky scrapers ever constructed. But people had jobs!!! – all at the expense of foregone resources, squandered capital, and wasted tax dollars. By and large the American plan doesn’t include much public design of projects so it’s not entirely analogous (or maybe it does? I don’t know. If that is the case it will be even worse). But nonetheless, how is the government to know where to throw the money? If its goal is to get people working again, shouldn’t Obama praise Merrill Lynch for stimulating the decorating business so they can hire more people and those people can spend money in other industries and then they can hire more people and so on and so on as the multiplier theory tells us.

But Obama nailed it. Dollars can be wasted. A dollar spent doesn’t necessarily increase economic value and most of the time doesn’t. Hopefully he will display this same brilliance when it comes to his dear stimulus.

(I am in a huge hurry writing this and only have 15 minutes so I hope it sounds logical. If anyone doesn’t understand a certain point its probably not you but me and I will fix it later)

What do Venezuela and the USA have in common?  Nationalization, of course.  Over the last month the United States media has fallen into a nationalization frenzy.  Last night I saw a CNBC news story called “Banks of America.”  Today, perusing online news websites I’ve found stories titled “What if Uncle Sam takes over your bank?” (WSJ), “Rescue of banks hints at nationalization” (New York Times), and “Don’t insure the banks – nationalize them” (International Herald Tribune – The Global Edition of the New York Times).  What scares me is the how casually the word “nationalize” is thrown around; as if it is a daily occurrence that we need not worry about; as if it is for our own good.

Other countries have nationalized industries as well: USSR, Cuba, China, UK, and most recently Venezuela.  The USSR and UK eventually became largely privatized as a result of the failures of socialism and China is on its way to a freer economy, but Venezuela is the perfect example of nationalization in today’s world.  Hugo Chavez, the President/Dictator or Venezuela, has nationalized virtually every large industry in Venezuela over the span of his rule.  This has led to a lack of incentive for workers, which leads to lousy production.  When a company doesn’t produce it goes out of business, things aren’t so simple for a government.  When a government doesn’t produce goods to sell it produces currency to meet its obligations, which is just what Venezuela is doing.  As a result, Venezuela has been experiencing inflation in the 30% range, which has led to disastrous consequences for its citizens.  This lack of production also inevitably leads to shortages.  In the USSR people averaged waiting in line for two hours per day because of all the shortages and lack of incentives.

In Venezuela nationalization was glorified and welcomed by most of the citizens.  The scary part is that we are beginning to see that in this nation today.  Nationalization has never made anything better in this nation.  Consider the Postal Service.  Have you ever tried waiting in line at a Post Office and dealing with the Postal employees and compared it to doing the same at a UPS Store?  This is only one small example, but it is an important one.  Employees at the Post Office have absolutely no reason to expedite the line beyond leaving work sooner if it is late in the day.  They have set hours, set lunches, set raises, set promotions, and virtually nothing they do will change any of that.  Their only motivation to work is to not get fired.  By contrast, employees of private companies have every motivation to work hard and be seen as a “star.”  They stand to make more money, have better hours, gain more benefits, and simply move up in the world by working hard and better serving their customers.

Don’t be scared into submission by the constant fear mongering that goes on in the media and government.  The government uses fear to get the people to agree to things that they would never otherwise agree to.  It used to be war and now it is socialism.  Nationalization is the exact definition of socialism, and socialism requires a police state to operate and inevitably ends in the bankruptcy of the state and the demise of the people.  Read your history books, my friends.  Socialism never works in the long run.

By now we are all aware of the $700 billion bailout to the financial institutions by the United States Government.  However, what most of us are completely unaware of is that this isn’t the first time that banks have been bailed out.  In 2008 JP Morgan Chase received billions of dollars of federal money to purchase Bear Stearns and an additional $25 billion because of the financial trouble they had encountered.  Ironically, it was JP Morgan himself that had orchestrated the bailouts of old.  Even more ironically is that JP Morgan had led a group of private Wall Street bankers in bailing out the United States Treasury.

In 1895 the United States was in the grip of the Panic of 1893.  The Treasury was nearly out of gold to back the money it had been issuing and it needed help.  Who better to turn to than the private market?  The United States government approached JP Morgan and requested his help in lending gold the United States.  Morgan organized a group of Wall Street financiers to purchase $65 million (1895 dollars) worth of gold and lend it to the Treasury.  The group was successful and everything worked itself out in the free market, leading to further American prosperity.

In 1907 the free market was left with a new challenge, rescuing failing banks.  Some large banks had begun failing, including the Knickerbocker Trust.  Eventually, these banks and the United States government turned to the market for help.  Naturally, they turned to JP Morgan.  Mr. Morgan and his associates again organized a “bailout,” but this time it would be for the banks.  Morgan arranged for his companies and numerous other entities including companies and wealthy individuals to lend the struggling banks their money.  One of those banks included what is today Citi.  Numerous companies and individuals, most notably John D. Rockefellar, the richest man of the time, agreed to lend their hard earned money to failing banks in an effort to stabilize the banking system.  It worked beautifully.  The entire banking system recovered and the free market flourished.

Then came 1929.  The Federal Reserve had been established in 1913 and control of the stability of banks was left in their hands, not in the hands of the free market.  After the panic of 1929 there were runs on banks and the Federal Reserve did not know how to adequately help them the way JP Morgan and his associates had in the past.  Banks failed left and right and this began the Great Depression.  As a result the free market was dealt a heavy blow by FDR and his New Deal policies that restricted freedom.  These policies greatly extended the Great Depression and left the free market hampered in a way that would not allow it to return to the valor and greatness that it had seen prior to 1913 and later the FDR administration.

The free market works and government does not.  There is a reason that the Panic of 1907 is not called the Great Depression.  Likewise, there is a reason that there is fear that today’s recession will snowball into a second Great Depression.  We must not rely on big brother to help us.  Rather, we should rely on ourselves to escape the economic problems we see today for we will collectively do a far better job than the government could ever do.

Rely on yourselves, not your government.

Democrats in Congress and Barack Obama have recently been pushing an $825 billion “stimulus package.”  This in addition to the already mammoth $700 billion bailout package that actually ended up being closer to $1 trillion.  What the dems plan to do with the additional $825 billion is yet to be seen, but there is much talk of putting billions towards programs that have nothing to do with “stimulus” such as renewable energy and healthcare.  The whole idea behind a government stimulating an economy is egregious.  The government simply plans to spend $825 billion in order to improve the incomes of Americans.  The outrageous part of all of this is that nobody seems to think to the very short next step of “Where is this $825 billion coming from?”  Well, it is coming from the incomes of those Americans that the dems are trying to improve the incomes of!  This could be compared to me offering to give you $10, but all I need is to tax you $20 – the extra $10 goes towards my salary, transaction costs, some programs I’m fond of, and other wasteful measures.  Would it not be simpler to let you just keep your $20?  The government giving away money in order to “stimulate the economy” is just another ploy to win votes and ensure that the people of this gullible nation believe that their government knows better than they do personally and is an all-powerful benevolent force.  We don’t need another God – we need government.