Heidegger

The Rescue Package Will Delay Recovery

Daily Article by Frank Shostak | Posted on 9/29/2008

In his testimony to the Congress on September 24, Fed Chairman
Bernanke urged the legislators to quickly approve the bailout of the
financial sector with a package of $700 billion. Bernanke echoed
Treasury Secretary Paulson’s view that the bailout expense, while hefty,
is needed to remove from banks’ balance sheets the mortgage-linked
assets, which are paralyzing the flow of credit.

I think it’s extraordinarily important to understand that as we have seen
many previous examples in different countries and in different times that
choking up of credit is like taking the lifeblood away from the economy.

Most experts came out in strong support for the package. Without the
rescue package, many large institutions that are “too big to fail” could go
belly up. Many believe that the consequences of all this could be very
severe to the real economy.

It is true that the financial system must be rescued; it must be rescued
from the institutions holding bad debt that are currently draining capital
while waiting for a bailout and adding little in return. It is they that are
preventing wealth-generating activities in the financial sector and the
other parts of the economy.

The Essence of Economic Adjustment

Conventional thinking presents economic adjustment ó also labeled as
“economic recession” ó as something terrible, even the end of the world.
In fact, economic adjustment is not menacing or terrible; from an
economic point of view, it is nothing more than a time when scarce
resources are reallocated in accordance with consumers’ priorities.

Allowing the market to do the allocation always leads to better results.
Even the founder of the Soviet Union, Vladimir Lenin, understood this
when he introduced the market mechanism for a brief period in March
1921 to restore the supply of goods and prevent economic catastrophe.
Yet for some strange reason, most experts these days cling to the view
that the market cannot be trusted in difficult times like these.

If central bankers and government bureaucrats can fix things in difficult
times, why not in good times too? Why not have a fully controlled
economy and all the problems will be fixed forever? The collapse of the
Soviet Union’s centralized system is the best testimony one can have that
controls don’t work. A better way to fix economic problems is to allow
entrepreneurs the freedom to allocate resources in accordance with
society’s priorities.

In this sense, the best rescue plan is to allow the market mechanism to
operate freely. Allowing the market to do the job will result in some
activities disappearing all together while some other activities will in fact
be expanded.

Take, for instance, a company that has six profitable activities and four
losing activities. The management of the company concludes that the four
losing activities must go. To keep them alive is a threat to the survival of
the company; these activities rob scarce funding from profitable
activities.

Once the losing activities are shut down, the released funding can now be
employed to strengthen the winning activities. The management can also
decide to use some of the released funding to acquire some other
profitable activities.

This is precisely what the government rescue package prevents from
happening. The government package is not going to rescue the economy,
but it will rescue activities that the economy cannot afford and that
consumers do not want. It will sustain waste and promote inefficiency,
draining resources from growth and efficiency. Remember: government
is not a wealth generator; it can only take resources from A and give them
to B.

Can the Rescue Package Prevent Economic Disruptions?

Some supporters of the package are of the view that the package is
necessary in order to prevent economic disruptions. They mean by this
that various phony activities should be kept alive by wealth generators
for a little bit longer until a proper system is established. By “proper,”
they mean more controls.

For a while, the government’s package can appear to be working; this is
because there is still enough real savings to support both profitable and
unprofitable activities. If, however, savings and capital are shrinking,
nothing is going to help, and the real economy will follow up with
further declines.

Hence the rescue package cannot prevent so-called economic disruptions.
If anything, government intervention would make these disruptions much
worse. Again, a better alternative is to let the market do the job. The
market’s ability to make swift adjustments without much drama was
vividly illustrated only a few weeks ago when the very large investment
bank, Lehman Brothers, was allowed to go belly up. The world did not
come to an end. Instead, this was a healthy development. A money loser
was eliminated from the market. This freed up resources to promote
growth.

One could have made the case that when Lehman was on the brink it was
too big to fail ó assets of $639 billion and employing over 26,000
people. Yet in a few days the market, once allowed to do the job,
reallocated the good pieces of Lehman to various buyers and the bad
parts have vanished. It was poetry.

Likewise Merrill Lynch, which was bought by the Bank of America, will
see the good parts of it reinforced while the useless parts are likely to be
removed.

On September 18, 2008, Washington Mutual, the largest US saving and
loan bank, was forced into liquidation. The bank had $307 billion in
assets and $188 billion in deposits. What prompted the closure are heavy
losses on its $227 billion book of real-estate loans, of which a large
portion was in subprime mortgages.

The bank lost $6.3 billion in the nine months ending June 30. Against this
background, and coupled with customers withdrawing $16.7 billion over
the past ten days, government regulators decided to close the bank.

Observe that this was the largest US banking failure. Note that the closure
of the bank didn’t result in the end of the world. JP Morgan Chase bought
some of the good assets of Washington Mutual for $1.9 billion.

On this, Jeffrey Tucker made the following
observation,

But as wonderful as the daily shifts and movements are, what really
inspires are the massive acts of creative destruction such as when old-line
firms like Lehman and Merrill melt before our eyes, their good assets
transferred to more competent hands.Ö This is the kind of shock and awe
we should all celebrate. It is contrary to the wish of all the principal
players and it accords with the will of society as a whole and the dictate
of the market that waste not last and last. No matter how large, how
entrenched, how exalted the institution, it is always vulnerable to being
blown away by market forces ó no more or less so than the lemonade
stand down the street.

Most commentators have accepted that the root problem of the current
financial crisis is the lack of proper control over mortgage lending. But
the out-of-proportion explosion in the mortgage lending didn’t occur out
of the blue. Without the aggressive lowering of interest rates by the Fed,
mortgage lending couldn’t have exploded. The Fed lowered the
federal-funds rate target >from 6% in January 2001 to 1% by June 2003.
The 1% was kept until June 2004.

The loose monetary stance prepared the ground for various false activities
that wouldn’t have been around without the loose stance. If authorities
had kept strong controls over mortgage lending, while at the same time
creating money out of thin air, the excesses would have popped up in
some other sector. The banks would have ended up having plenty of bad
non-mortgage-related assets.

The Fed’s loose policies are the crux of the problem. So rather than
blaming the symptoms, what is required is to let the market work and
close all the loopholes that allow the creation of money and credit out of
thin air.

Can Making Banks’ Balance Sheets Look Good “Fix” the Economy?

Recall that Treasurer Paulson and the Fed chairman are of the view that
once banks’ bad assets are removed, the banks are likely to move ahead
and start lending. We suggest that making the balance sheet look pretty is
not going to alter the essence of the problem, which is the poor state of
capital and savings to support such high lending activities.

The essence of a sound credit market is not lending money as such but
lending the real stuff that people require by means of money. Without the
real stuff ó the preceding savings and subsequent productivity to fund the
lending ó no lending is possible.

Decades of nonproductive consumption (consumption that is not backed
up by production) that emerged on the back of loose monetary and fiscal
policies have severely damaged the store of wealth that serves as the
foundation for credit markets. If this is the case, it will be futile to
try to
boost lending by pushing more money into the banking system. More
money cannot generate real wealth. If it could, world poverty would have
been eliminated a long time ago.

When the market is allowed to take charge, the relationship between
savings, lending, and productivity will be brought into proper
perspective. At last we will know which activities are genuine and which
are phony.

Does the Fall in Stock Prices Cause an Economic Slump?

The proponents of government intervention maintain that one cannot
allow the market to take charge since this will cause a drop in stock
prices, which will be bad for the economy. Within the confines of this
way of thinking, it is not surprising that Bernanke and Paulson panicked
on September 18, once a large money-market mutual fund ó the Reserve
Primary Fund ó was on the brink.

They argue that were it not for the Fed’s injecting $105 billion and the
subsequent announcement of the rescue package, the stock market would
have had a massive fall. They also believe that the massive monetary
injection prevented a run on money-market mutual funds and prevented a
major disaster.

They further believe that if people had taken the money out of their
money-market mutual funds, banks wouldn’t be able to secure money to
fund credit cards and various consumer and business loans. This in turn
would have paralyzed the economy.

So let us think about this. Say that people take their money from the
money-market mutual funds. What happens then? They will have placed it
somewhere else, mostly likely with commercial banks. Hence money
wouldn’t disappear and banks could continue to fund activities as before.

If large money-market funds were to go under, some of their assets would
be sold and the shareholders would suffer losses; this however, cannot
provide justification for the Fed to pump money and to introduce a
rescue package. Monetary expansion and a rescue package do not undo
the bad investment decisions of the money-market-mutual-fund
managers. Why should people who didn’t risk investments in the fund
pick up the tab?

A fall in asset prices, including stocks, and a run on financial institutions
are just symptoms and not the cause of anything. The key factor behind
the current difficulty in the credit markets is the lagged effect coming
from the Fed’s tighter stance between June 2004 and August 2007, when
the federal-funds-rate target was raised from 1% to 5.25%.

The tighter stance started to undermine various bubble activities that had
emerged from the previous loose stance. A tighter stance slowed the
diversion of real savings from wealth generators towards bubble
activities. Without an adequate supply of real funding, these activities
started to crumble. Obviously, then, banks that have been providing
support to these activities by providing loans have ended up holding a
large amount of bad assets.

As a result, bank stock prices started to come under pressure. With a time
lag, bubbles in the various other parts of the economy are also likely to
come under pressure, and this again is going to hurt financial stocks. So
the fall in economic activity is not the result of a fall in stock prices,
but
rather comes on account of the tighter Fed stance that throttled the supply
of real savings to non-wealth-generating activities.

Would the stock market have come under pressure if the Fed had kept the
interest rate at 1% for an indefinite period of time? A prolonged loose
stance would have given rise to a much greater amount of nonproductive
bubble activities. As a result, the pace of real wealth generation would
have continued to slow, and consequently the growth momentum of
profits would have come under pressure. In response to this, commercial
banks would have become more cautious in their expansion of credit out
of thin air.

All this in turn would have undermined the existence of bubble activities.
Bubble activities cannot stand on their own feet; once the rate of growth
of the money supply slows down, the pace of the diversion of real
savings towards false activities follows suit. As a result, the survival of
these activities is threatened.

>From this we can infer that a fall in non-wealth-generating activities ó
also labeled an economic slump ó is not due to a fall in the stock market
as such but to the previous loose monetary policy that has weakened the
pool of real savings.

The
central-bank policies aimed at preventing a fall in the stock market
cannot prevent a fall in the real economy. In fact, the real economy has
already been damaged by the previous loose monetary stance. All that the
fall in the stock market does is inform us about the true state of economic
conditions. The fall in the price of stocks just puts things in a proper
perspective. The fall in the stock price is just an acknowledgment of
reality.

Conclusion

Only a few weeks ago, we saw that the liquidation of a large bank such as
Lehman Brothers and the sale of Merrill Lynch did not cause massive
disruptions. In fact, the adjustment was swift and almost invisible. The
reason for the smooth adjustment is that the market was allowed to do its
job. If government and Fed bureaucrats had tried to intervene with
bailouts, the whole process would have taken much longer and would
have been very costly in terms of real resources.

[VIEW THIS ARTICLE ONLINE]

________________________

The events taking place in the financial market offer an illustration of the
soundness of the Austrian theory of money, banking, and credit cycles,
andMises.org is your source not only for analysis of
these events but also the economic theory that helps explain what is
happening and what to do about it. There are many thousands of articles
available, and also the full text of thousands of books as well as journal
articles. It is impossible to draw attention to the full range of literature
one can use to understand the crisis.

However, below we offer a brief look into the topics most discussed in
these times, with extended treatments of each in the sidebar.Mises.org
also offers both a blog and a community forum for reading and
discussing them all.

It’s never been more important to spread a sound view of money and
banking, not only as a protection against the fallacies of “stabilization”
and “reflation” but also as way to see what kind of reforms are essential
now.

Fannie Mae and Freddie Mac

* Freddie Mac: A Mercantilist Enterprise,
by Paul Cleveland, March 14, 2005 * *
Fannie Mae: Another New Deal
Monstrosity, by Karen De Coster, July 2, 2007 * *
How Fannie and Freddie Made Me a
Grumpy Economist, by Christopher Westley, July 21, 2008 * *
Who Made the Fannie and Freddie Threat?
By Frank Shostak, March 5, 2004 * *
Are Fannie and Freddie Too Big to Fail?
By Frank Shostak, September 17, 2008 * *
Fannie Mae Distorts Markets, by Robert
Blumen, June 17, 2002 *

The Housing Bubble

* The Real Cost of a Full Bailout, by Don
Rich, August 22, 2008 * *
The Subprime Mortgage “Crisis” Will Fix
Itself, by Steve Berger, May 30, 2007 * *
Did the Fed Cause the Housing Bubble?
By Robert Murphy, April 14, 2008 * *
The Mortgage Market Mess, by
Christopher Westley, May 17, 2007 * *
Housing Bubble: Myth or Reality? By
Frank Shostak, March 4, 2003 *

Inflationary Finance

* What’s Behind the Financial Market
Crisis? by Antony Mueller, September 18, 2008 * *
Our Financial House of Cards, by George
Reisman, March 25, 2008 * *
Will Central Bankers Become Central
Planners? by Robert Blumen, July 31, 2008 * *
Inflation is a Policy that Cannot Last, by
Thorsten Polleit, March 14, 2008 * *
The Widening Safety Net, by Christopher
Mayer, March 19, 2004 * *
The Fed’s New Tricks Are Creating
Disaster, Frank Shostak, March 18, 2008 * *
The Fed’s War on the Middle Class, by
Mark Thornton, June 4, 2008. *

Community Reinvestment Act

* The CRA Scam and its Defenders, by
Thomas DiLorenzo, April 30, 2008 * *
Regulatory Sneak Attack, by Thomas
DiLorenzo, September 16, 1999 *

Short Selling

* Short-Sale Restrictions Are an Exercise
in Naked Power, by Robert Murphy, August 11, 2008 * *
The Social Function of Futures Markets,
Robert Murphy, November 29, 2006 * *
Don’t Sell Short Selling Short, April 6,
2007 *

The Austrian Theory of the Business Cycle

* The Idiocy of Wall Street, by Don Rich,
September 24, 2008 * *
The Fed is Culpable, by Hans F. Sennholz,
November 11, 2002 * *
Skyscrapers and Business Cycles, by Mark
Thornton, August 23, 2008 * *
Economic Outlook 2008: Darkening
Clouds, Dominick Armentano, January 2, 2008 * *
Business Cycle Primer, Llewellyn H.
Rockwell, Jr. February 8, 2001 * *
Economics Depressions: Their
Cause and Cure, by Murray Rothbard *

Who Predicted This?

* The Financial Apocalyptics are Back,
Robert Blumen * *
Sowing the Seeds of the Next Crisis,
Thorsten Polleit, April 25, 2006 * *
Credit Crisis: Precursor of Great Inflation,
by Thorsten Polleit, February 7, 2008 * *
Mr. Bailout, by Anton Mueller, September
30, 2004 * *
America’s Unsustainable Boom, by Stefan
Karlsson, November 8, 2004 * *
Who Predicted the
Bubble? Who Predicted the Crash? By Mark Thornton, July 14, 2003 *

What To Do

* Don’t Bail Them Out, by Llewellyn H.
Rockwell, Jr., September 10, 2008 * *
How to Avoid Another Depression, by
Mark Thornton, September 10, 2008 * *
Taking Money Back, By Murray N.
Rothbard, June 14, 2008 * *
Beware the Alchemists, by Ludwig von
Mises, February 3, 2006 * *
Reflation in American History, by H.A.
Scott Trask, October 31, 2003 * *
Money and Freedom, by Joseph Salerno,
February 2, 2002 * *
The Case for a Genuine Gold
Dollar, by Murray Rothbard *

Books to Distribute

The
Theory of Money and Credit, by Ludwig von Mises* *
America’s
Great Depression, by Murray Rothbard* *
The
Mystery of Banking, by Murray Rothbard* *
Prices and
Production, by F.A. Hayek * *
Causes
of the Economic Crisis, by Ludwig von Mises* *
Austrian Theory of the Trade Cycle and Other
Essays, Ludwig von Mises et al. * *
Understandin
g the Dollar Crisis, by Percy Greaves* *
The Case
Against the Fed, by Murray Rothbard * *
Money, Bank Credit,
and Economic Cycles, by Jesus Huerta de Soto* *
History of
American Currency, by William Graham Sumner* *
Banking and
the Business Cycle, by C.A. Phillips* *
Fiat Money
Inflation in France, by Andrew Dickson White*

Posted on Sunday, October 5th, 2008 at 6:00 am
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