Free Markets: caught up in my ideology or cause for real concern?

“The more laws and order are made prominent,
The more thieves and robbers there will be.”

- Lao-tzu, The Way of Lao-tzu 

We received a post from a reader–Richard–who responded to my Currency Currents missive titled, “Ben Proves Me Wrong.”  Richard’s view is probably quite valid for many people; and it seems to be the consensus reasoning for belief in the fantasy that Bernanke has saved us.   

Below I have re-printed Richard’s post in full.  Following that, I have printed my response.  I do actually agree with some of Richard’s points.  He makes some very valid points (I especially agree on his war economy comments; we could do much more at home and lower taxes if we were not instead morphing into Oceania (the world where Orwell’s character–Winston Smith–lived in 1984).  And I do agree that one can get caught up in ideology when it comes to investing, instead of just following the money.  Agnosticism in the economic world is likely the best way to stay in the market flow.  But just because you aren’t agnostic doesn’t mean you are wrong.  No matter what that publicity-chasing hubris-filled windbag of a man Richard Dawkins spews.   

That said, I think Richard puts too much faith in government and misunderstands some of the key virtues of the market.    

I want to thank Richard for sending such thoughtful criticism.  I hope he and you don’t consider my response too harsh.  But this whole area is a bit of a pet peeve for me.    

——

Richard:  Jack it seems to me that you are getting tripped up by your own economic ideology. 

From what I can fathom this ideology states:  

-that the free-market economics is the only intelligent solution to managing the economic forces in play. 

-That ultra-loose monetary policy of the Federal Reserve is suicidal. 

-That taxes should be zero. 

-That regulation is evil and unnecessary. 

Here’s my take: Free Market ideology is very Darwinian in nature. (This is ironic since most proponents of Free-Market economics don’t believe in the theory of evolution.)  

In theory, Free Market economics if practiced in its purest form, would most likely produce the most stable economic system. Like its natural world counterpart, the weak would be devoured by the strong and each participant in this economic environment would develop their own unique strategies for survival.  

Presumably the free market forces would keep the economic system in balance. Otherwise the largest players would devour the smallest players out of existence and threaten their own survival. 

However, in this mythical world it also implies that while the economic Eco-system would be stable, the sub-systems (like the American economy) would be highly unstable. New economic forces could and would wipe out the prevailing economic blocks. The question is: would even the most ardent free market proponent want to live in such a system? Probably not.   

Regarding point 2: In fact, Ben Bernanke’s ultra-loose monetary policy which has been roundly criticized by everybody saved the international economic system. If he hadn’t stepped in and did what he did, we would all be back to the barter system and international trade would have ceased to exist in 2008 when the system of credit totally seized up. 

Point 3: It may be true that taxes are a disincentive to entrepreneurial activity, but whether you or I like it or not there is no free lunch. Somebody has to pay for the gigantic military industrial complex, healthcare, education etc. And its the people with money that end up paying. So while you rail against the unfairness of zero interest rates and inflation on the savers and as you quite rightly point out they are a surreptitious tax on those savers.  

However, if Congress refuses to behave in a more responsible manner and levy the necessary taxes, then a tax will find its way into the system one way or another.  

Finally point 4:  Regulation is evil. It is indeed ironic that those who scream loudest about the unfairness of bailing out the banks are the ones who insisted that regulating these banks was totally unnecessary in the first place. If the banks had been properly regulated then we wouldn’t have gotten into the monumental mess. 

For all its faults and its huge indebtedness, the American system is still the most robust and flexible economic system around. It is also a system that does not shirk criticism and is not pigheadedly obstinate in the face undeniable truths and realities. 

Ben Bernanke and Hank Paulson are both committed Republicans, and yet when a crisis of overwhelming proportions hit the American Financial system they were both flexible enough and pragmatic enough to throw ideology out the window and do whatever it took to save the system.  

We can only hope that Europe has learned from America’s example.   

——

My Response:  First Richard, I would also accuse you of having an ideology, one of secular left that first looks to (or at the very least willingly tolerates), government for solutions.   

I believe your antagonism toward the “free market” is completely unjustified.  You seem quite hostile toward it; do you work for the government, or did you study economics at an Ivy Leagues School? :)

First, let me be clear.  It has been a very long time since we had truly free markets.  Since governments were formed, early in civilization, they have always had a hand in the market.  We don’t have free markets; we instead have “quasi free markets” and they seem to becoming more “quasi” by the day.   

You may not know this, but prior to the time Keynes proved to wanting governments they could mathematically justify their interventions through the “science of economics,” the study of economics was always considered “Political Economy.”  I share this as a bit of validation to the idea that the “unhampered, free-market boogey man” is a myth.   

Here is the core of the problem flowing from credit induced booms by central banks [this gets a bit esoteric, but if you can get through this I think it will be worth it–you will understand clearly why the central bank (directed by the Federal government) is the crux of the problem [our emphasis] …  

This is taken from Murray Rothbard’s book, “America’s Great Depression“:  

The ‘boom-bust’ cycle is generated by monetary intervention in the market, specifically bank credit expansion to business. Let us suppose an economy with a given supply of money. Some of the money is spent in consumption; the rest is saved and invested in a mighty structure of capital, in various orders of production.The proportion of consumption to savings or investment is determined by people’s time preferences–the degree to which they prefer present to future satisfactions. The less they prefer them in the present, the lower will their time preference rate be, and the lower therefore will be the pure interest rate, which is determined by the time preferences of the individuals in society. A lower time – preference rate will be reflected in greater proportions of investment to consumption, a lengthening of the structure of production, and the building-up of capital. Higher time preferences, on the other hand, will be reflected in higher pure interest rates and a lower proportion of investment to consumption. The final market rates of interest reflect the pure interest rate plus or minus entrepreneurial risk and purchasing power components. Varying degrees of entrepreneurial risk bring about a structure of interest rates instead of a single uniform one, and purchasing power components reflect changes in the purchasing power of the dollar, as well as in the specific position of an entrepreneur relation to price changes. The crucial factor, however, is the pure interest rate. This interest-rate first manifests itself in the “natural rate” or what is generally called the going “rate of profit.” This going rate is reflected in the interest rate on the loan market, a rate which is determined either going profit rate.  

[Note: The FOMC actually has the hubris to believe they can set the proper rate of interest.  It is to laugh!]  

Now what happens when banks print new money (whether as bank notes or bank deposits) and lend it to business? The new money pours forth on the loan market and lowers the loan rate of interest. It looks as ifthe supply of saved funds for investment has increased, for the effect is the same: supply of funds for investment apparently increases, and the interest rate is lowered. Business men, in short, are misled by the bank inflation into believing that the supply of saved funds is greater than it really is. Now, when saved funds increase, businessmen invest in “longer processes of production,” i.e., the capital structures lengthen, especially in the “higher orders” most remote from the consumer…  

[Note: Remember,during the central bank credit-induced boom from 2001-2007, before the credit crunch, how US consumers were leveraging to the hilt and buying like drunken sailors even though savings rates were heading into negative territory?  If you remember that then you see the impact of artificial credit on consumer preferences.]  

… If this were the effect of a genuine fall in time preferences and an increase in saving, all would be well and good, and the new length and structure of production could be indefinitely sustained, but this shift is the product of bank credit expansion. Soon the new money percolates downward from the business borrowers to the factors of production: in wages, rents, interest. Now, unless time preferences have changed, and there is no reason to think that they have, people rush to spend the higher incomes in the old consumption-investment proportions.  In short, people rush to reestablish the old proportions, and demand will shift back from the higher to the low orders. Capital goods industries will find that their investments have been in error: that what they thought profitable really fails for lack of demand by entrepreneurial consumers. Higher orders of production have turned out to be wasteful, and the malivestments must be liquidated.  

The “boom,” then, is actually a period of wasteful misinvestment. It is the time when errors are made, due to bank credits tampering with the free market. The “crisis” arrives when the consumers come to reestablish the desired proportions. The “depression” is actually the process by which the economy adjusts to the waist and errors of the boom, and reestablishes efficient service of consumer desires. The adjustment process consists in rapid liquidation of the wasteful investments.  

Some people don’t know that the first time the government stepped in (in the semi-modern world) to “save the nation” after a business cycle bust was the Great Depression.  And boy did they do a good job of making things worse.   

Prior to the Great Depression, the government took a hands-off approach to busts and let the recession burn out.  These usually proved to be sharp but brief affairs.  Why?  Because it allowed the quasi-free market to clear out the dead wood, setting the stage for healthy growth with new players; those who made mistakes were gone.     

So, if you wish to prolong the depression, just continue the policies from your playbook and pretend the central bank is the solution, our secular savior, not the cause of the problems in the first place–taken from Rothbard:  

  1. Prevent or delay liquidation.
  2. Inflate further
  3. Keep wages up
  4. Keep prices up
  5. Stimulate consumption and discourage saving*
  6. Subsidize unemployment

Our central bank and government continue to tell us to fear the deflation boogey man.  In fact, they have an implicit policy to create inflation during these periods.  Their inflation only hurts savers’ purchasing power and bids up the costs of many consumer goods, further impoverishing the consumer who they say they are trying to help.  

“It is, moreover, a common myth among laymen and economists alike, that falling prices have a depressing effect on business. This is not necessarily true. What matters for businesses is not the general behavior prices, but the price differentials between selling prices and costs (the ‘natural rate of interest’).  If wage rates, for example, fall more rapidly than product prices, this stimulates business activity and employment.  

[Note: The implicit weak-dollar policy and pumping of dollar credit into the world has raised the price of key raw materials pushing up the costs to business.]  

“Deflation of the money supply (via credit contraction) has fared as badly as hoarding in the eyes of economists. Even the Misesian theorists deplore deflation and have seen no benefits accruing from it. Yet,deflationary credit contraction greatly helps to speed up the adjustment process, and hence the completion of business recovery, in ways as yet unrecognized…. In short, we can hope the depression is not more consumption but on the contrary less consumption and more savings (and a, concomitantly, more investment).”  

Is some degree of regulation necessary in markets?  Yes. Of course!  But it should be limited and circumspect if the objective is to foster a more dynamic growing economy, one that presents opportunity for all participants instead of a select few. I think you will find that people who like the market are usually the most competent and the least corrupt among us.  They prefer the challenge of competition to the righteousness of a regulator. They have faith in their own abilities. They understand the magic of self-interest in a market economy.  

I put others who prefer government intervention to quasi-market solutions into four different boxes:  

  1. True believers:  Honorable people who have seen the evidence but believe government intervention is the best policy to solve problems in that we have these tools available and they should be used accordingly.  The benefits of intervention into the market outweigh the potential costs to this group. 

  2. Ignorant:  Those who don’t understand the market. [Those who never took Econ 101; those who are genetically predisposed to prefer government over individualism, and those who received an economics degree at one of our elite institutions would be examples of this.]

  3. Incompetent:  They are afraid to compete on their own abilities and understand if they seek market protection they will achieve more; effectively by stealing from others. [A good example here would be a public school teacher who doesn’t give a damn about the kids, and hides behind the Teachers Union for protection, and whose pay is based on tenure, not competence.]

  4. Corrupt: They clearly understand the market system and extol its virtues when it suits their needs, but ultimately are hand-in-glove with regulators (government) when it helps their interests.  [Warren Buffet would be a good example of this type.  He seems both corrupt and duplicitous.]

Before the so-called “crisis of capitalism” we had an alphabet soup of state, local, and federal regulatory bodies overlooking and imposing social ideals across the broad spectrum of financial services companies. What good did all that regulation do for us?  Of course the fall back excuse is “it wasn’t the proper regulation.”  If we had “proper regulation” that “ugly capitalism” wouldn’t have been allowed to get out of control.   

Regulation lags market action.  Sooner or later market players will learn how to trump regulation, by hook or by crook.  In fact, I would say that most regulation deposits the seeds of corruption and destruction of the future it was designed to secure. If you believe regulation is the key to economic success, ask yourself why the Soviet Union hasn’t been the most dominant economic power since at least 1930?  

Too much government creates mafia government.  Payoffs are expected.  The government becomes the professional protection racket.  Instead of Guido and Nicky the Knife, we get K-Street lobbyists, mandatory union membership, and government “licensing” to protect ourselves from the vagaries of the market. Instead of paper bags full of cash (and there is that too) it’s called “campaign contributions.”  Have you ever noticed that the financial industry is a pretty big donor to all members of the government mafia–especially to a guy named Frank and another named Dodd?  Have you ever wondered why no one within the financial industry, of those shown to be completely corrupt, have never made it to prison?  That is the protection racket of regulation at its finest.  

It is arguable and highly probable to me that super regional banks and insurance firms could have stepped up and taken the place of the Citis/AIGs.  Let solid bankers who understand lending and credit, those who never agreed with or produced weapons of mass destruction in order to generate inordinate fees (aka derivatives completely devoid of understanding once released in the real world), take on the responsibility of back-stopping financial markets.   

Interesting again, the guys complaining about regulation “just not being right,” those calling for more government intervention to solve our problems (aka the Committee to Save the World–Greenspan, Rubin, and Summers), were the very team that did most to hamper efforts to rein in most risk of derivatives. Of course, now, the one piece of regulation that would really put the banking system on firmer footing–the “Volcker Rule” forcing banks to abandon risky trading with taxpayer money being a backstop–is being challenged by all the same people who were ringing their hands over either “not enough” or “not the right kind” of regulation that caused the credit crunch.  Hmmm … a shock I tell you; a shock it is!  

As to your concern about so-called “stable economic blocks” that would be threatened by the free market, guess what–that is exactly what free markets would and should do.  It is called “creative destruction.”  Instead, what we get with all the government interference is protection of the old order–the political moochers are “protected” from forces that would render them obsolete because they are either not competent nor did they risk their investment capital on new ideas and new techniques to remain competitive.   

Government wastes resources.  Markets generally find the most efficient use for them …  

… or maybe I’m wrong!