Crisis of government, not capitalism

The current economic crisis is caused by massive government interventions which are intended to override capitalism and supplement it with a more economically stable, better and fairer system.

These policies cause unintended negative consequences: the boom/bust cycle characterised in the upswing by seemingly endless capital gains, speculation, and debt; and in the downswing by shortage of credit, bankruptcy, unemployment and depression.

The dominant theory

The dominant economic theory that informs the response of western governments is that of John Maynard Keynes, who wrote in the 1930s.

Keynes assumed a tendency to economic recessions is inherent in the capitalist system. Government can and should fix the problem by stimulating economic activity by public spending; otherwise there’ll be permanent high unemployment.

Keynes’s theory in a nutshell says “a fall in aggregate demand [i.e. spending] means that businesses can’t sell as much, which means that factories can’t make as much, which means that people are laid off, which means that aggregate demand falls even further, which would cause permanent depression”.

The hallmarks of Keynesian ideas are talk of “injecting” money, “priming the pump”, “stimulus packages”, the economy “overheating”, wage rises causing inflation, setting the “policy levers”, and a supposed trade-off between unemployment and inflation.

Problems with Keynesian theory

Keynesian theory says that booms happen because “aggregate demand” is up, and busts happen because “aggregate demand” is down.

But when we ask why the aggregate demand is up or down, the answer comes: because during the boom the public are “confident”, while during the bust they have negative expectations.

So the first problem is, this is not an economic explanation: it’s a psychological explanation. And second, there is no evidence for the psychological phenomenon that is supposed to explain the boom or bust but the existence of the boom or bust itself. The argument is completely circular: Keynes’s theory fails to explain what it sets out to explain.

Also if the original problem we’re trying to fix is an economic slump - not enough wealth being produced - then it should be obvious that you can’t make wealth simply by spending money based on printing pieces of paper.

What we are witnessing during the government-stimulated boom is not wealth creation, it’s wealth re-distribution. It simply consumes capital, taking wealth from A and giving it to B. It is a glorified version of digging holes and filling them in again.

Keynes’s theory and its ethic of re-distribution has spread a “magic pudding” mentality through the whole society, encouraging people to look to profit from re-distribution instead of productive activity.

Governments have happily gone along with Keynes’ fallacies. It gives them a licence to levy a hidden tax by permanently inflating the currency. Governments love inflation for the same reason that you might like having lots of other people’s money spent on you and your pet projects. The difference is, governments can.

Where does the real wealth come from if during the boom you sell your house for a capital gain and buy real goods with the proceeds? The answer is, it comes from everyone in society who uses money - the pensioners, students, single mums, the kids who work at McDonalds, the homeless and unemployed, the farmers and shop-keepers, the factory workers, shop assistants and truck drivers. Government takes it from them by inflating the currency and gives it to people who speculate on real estate, or whatever is the capital good that’s in fashion in government policy.

The invisible hand of government

The problem with the “blame the market” theories of the financial crisis is that they see no connection between the fact that government has a monopoly control of the money supply, and its economic consequence.

According to these schools of thought:

There is no connection between the boom and bust on the one hand, and on the other, the cosy relationship by which government, through inflation, requires the banks to transfer money from the whole population to government, while, through inflation and regulation, protecting the banks profits.

No connection between the fact that government has for decades been regulating interest rates below the market rate, and the boom or bust.

No connection between government policies that have encouraged and required banks to lend hundreds of billions of dollars to tens of millions of people who can’t afford to repay, and the boom or bust.

No connection between government policies of “stimulating” the economy by pouring trillions of dollars based on nothing but thin air into favoured industries, and the boom or bust.

According to this line of reasoning, it is nothing but a strange coincidence that both the boom and bust arose in a government-favoured industry (housing), in government-sponsored enterprises (Freddie Mac and Fannie Mae), with money that government conjured out of thin air, for a government policy of “making housing more affordable” (sound familiar)?

All these have nothing to do with the boom or bust, which just arise mysteriously and spontaneously out of “unregulated capitalism”.

Yet prices are the steering mechanism of any market. By regulating the price of money, government has in fact been regulating the financial markets all along in their quintessential steering mechanism.

This is not a crisis of “unregulated capitalism”, it is a crisis of regulated capitalism, of interventionism, of government “economic management”.

Failure to predict

All the government institutions responsible for the crisis also failed to predict it. As recently as early 2008, the US Treasury was saying the economy is fine. And after all that, they still say they need a “stimulus package” to fix the problem!

To say mainstream economic theory lacks explaining power is an understatement.

What really causes recessions

The Austrian school of social theory both explains and predicted the boom/bust cycle. It has never been refuted.

According to this theory, government manipulation of the money supply produces three major unintended consequences: inflation, which in turn causes massive system-wide mal-investment, which causes the boom-bust cycle.

Inflation, the root of all the evil

Rising prices are merely the symptom of inflation. The cause is increasing the money supply.

Governments increase the money supply by adding tin to gold coins and using “legal tender” laws to pass them off at their face value and pocket the difference (old-fashioned method). The more sophisticated versions of the same thing are by printing more banknotes (a la Zimbabwe), and by lowering interest rates.

It is important to understand that when governments cut interest rates, they are increasing the supply of money, and causing inflation.

Inflation is not caused by greedy unions, or “excessive demand”, or the economy “overheating”. It is not some mysterious force of nature that we just have to get used to. It is caused by government increasing the money supply.

But inflation has much bigger consequences than just rising prices.

Massive system-wide mal-investment

Inflation causes mal-investment on a massive scale. It causes capital to go into projects that cannot be completed, and that must fail and be wasted.

Why? Because money functions to send important information signals about who wants how much of what, where, and when. Inflation hijacks these signals.

How? Imagine that a builder’s contractor, who supplies bricks, inflates the number of bricks by 10 per cent. The builder plans the building on the basis of the inflated number. He builds the floor, but when he comes to the top of the walls, it turns out there are not enough bricks to finish the job. The house can’t be completed. Most of the capital that went into the house has to be wasted in order for it to be converted into some other form that can be used for something else.

The boom/bust cycle

That is what happens on a massive scale in whole industries in an economy affected by government’s injection of new money. The rising prices deceive businesses into thinking that their goods are in demand. Capitalists invest in factories, machines, employment, and so on. People easily speculate on the general rise in prices, and making profits is easy.

But eventually it turns out that the increase in prices was not caused by an increase in real demand based on real wealth at all. It was just a bubble, caused by an increase in the money supply.

As a result, projects turn out to be unprofitable and unsustainable. Businesses go broke. They lay off staff. Unemployment rises. The economy goes into recession. A bust follows the boom.

Everyone decries the bust, but the damage is done during the boom. The bust is the process by which the market washes out the mal-investments, liquidates capital, and releases it for productive uses in accordance with people’s real demand and time preference.

The failure of central planning - again

When will we as a society learn that governments cannot make real wealth out of thin air simply by passing laws?

What we are witnessing in the global financial crisis is the fall-out of government attempts to make real wealth: housing - cheaper as if by magic, by inflating the currency. Given that original prime cause, no amount of regulation can contain the economic chaos it unleashes.

The moral and intellectual bankruptcy of governments’ economic management should be obvious. Instead of achieving their purpose of protecting the little guy from being exploited by the big banks and stabilising the economy, these interventions achieve the opposite.

They prey on the poorest and most financially unsophisticated. They doubly and triply entrench disadvantage. They confound the simplest ways of making wealth: working and saving. They privilege big corporations in feeding from the public trough. They allow government to collude with big banks and big business in milking the ordinary people to protect their privileges. They give government a share of the loot obtained by colluding with the banks to permit anti-competitive practices and unstable financial practices which in a competitive market would be selected out by bankruptcy.

They provide the cover for thousands of governmental interventions which restrict the little guy and choke small businesses to death. By destroying his livelihood, they make the little guy dependent on big business and big government. They encourage the entire society to try to get something for nothing through government taking it from someone else.

They politically reward vested interests, unproductive privilege, and political favourites. They promote unsustainable debt, economic disorder, and pure waste. They erode the values required for the production of all the wealth that is re-distributed, and have nothing to put in their place. Keynes’ policies of stimulation are self-defeating. They only worsen the problem they are supposed to fix.

But public discussion, lacking sound economic theory, falls back on the traditional, outworn, and meaningless name-calling and slogans of “left” and “right”, as if both sides of politics were not equally complicit in bailing out billionaires and encouraging the general plunder.

The underlying moral failure is not greed itself, it is intellectual sloppiness in clinging to theories that have been disproved in theory and practice, preferring slogans and bitterness to reason and understanding, while failing to take the initiative either to accept or refute sound economic theory with real explaining power.

When will we learn? Social co-operation can either be based on the public, or the private ownership of the means of production. There is no third way. The retreat into Keynesianism is as futile as a retreat into Marxism. The current crisis shows the inevitable result of government’s attempts at “economic management”. Each intervention inevitably fails, and becomes the pretext for still further governmental intervention, which in turn fails.

Interventionism - the current orthodoxy - is merely socialism by instalments - increasing government control and increasing chaos all the way.

There is no sound reason for governmental control of the money supply and it should be abolished. This would make for a better, fairer and freer society, and a more stable economy too.