Thursday, August 13, 2009

The Real Cause of the Current Economic Crisis and Its Cure

The current economic crisis was caused by government intervention in the economy that thwarted the market process and prevented freely acting and cooperating individuals from assessing reality and taking appropriate action to improve their own well being. The main intervention was by the Federal Reserve Bank’s expansion of bank reserves, which led to an artificial lowering of the interest rate, which spurred massive malinvestment in longer-term production processes. These production processes eventually were abandoned because there were insufficient real resources available for their successful and profitable completion. The artificial lowering of the interest rate did not reflect the reality that real savings had not increased--the government had simply printed more fiat money. In fact, real savings decreased, because the lower interest rate reduced the incentive to save below that which would have existed in the absence of the intervention. Eventually this dichotomy between increased investment not funded by real savings revealed itself in business losses in these longer term investments.

The government guided much of the malinvestment into the housing sector through its purchase of subprime loans by it several housing finance banks—the FHA, Fannie Mae, and Freddie Mac—and other interventions such as the Community Reinvestment Act, although other sectors of the economy also expanded longer term production that was not supported by real resources.

The spectacle of lower credit standards for home loans, which now seem beyond the minimal level of prudence, are but consequences of excessive credit expansion made possible and encouraged by the Federal Reserve Bank and the promise of government finance banks to buy these loans from the originating institutions. The excess fiat money could not be prevented from entering the economy somewhere and touching off the Boom-Bust Business Cycle. The artificial Boom distorted the structure of capital and production so that the real desires of people are not being met. This malinvestment must be redeployed, where possible, and liquidated if it cannot be redeployed. The longer this necessary adjustment process is delayed—for example, by government’s current actions to reflate the Boom—the longer the readjustment process will take and more non-specific capital will be lost that could have been redeployed.

The cure for the Boom-Bust Business Cycle is 100% gold-backed money, a legal prohibition on fractional reserve banking, an end to central banking, and an end to legal tender laws. These actions will prevent future expansions of credit not funded by real savings. Such a monetary system is the only one compatible with our Constitution. The Constitution of the United States clearly charges the federal government with establishing a standard for the dollar and prosecuting counterfeiters (Article I, Section 8). The United States had a relatively free banking system from the demise of the Second Bank of the United States in 1837 until the formation of the Federal Reserve Bank in 1913. During this period it enjoyed the greatest increase in wealth and production in the history of the world despite the death and destruction of the Civil War from 1861 to 1865. The Boom-Bust Business Cycles that occurred during this time were caused by the expansion of credit via fractional reserve banking; that is, the issuance of money substitutes not backed by gold. In other words, banks counterfeited their own money for their own profit, but eventually their fraud was revealed in the marketplace and banking customers scrambled for specie (gold). This is the origin of the “bank run”. Had the federal government prosecuted fractional reserve banking as the fraud that it is, these Boom-Bust Cycles would not have occurred. Likewise, sound money and an end to fractional reserve banking will end Boom-Bust Business Cycles today.

The government’s attempt to solve and/or ameliorate the current crisis will only make matters worse, because it is attempting to solve the crisis with the very same policies that caused the crisis--namely, excess fiat money credit expansion. The government is compounding its errors by spending so-called stimulus money. This spending of even more money created out of thin air will lead to higher prices and possibly hyperinflation, if not rescinded. Since the government can spend only what it takes from the people, its increased spending will drive the people to poverty even if the spending is on what many might consider worthy infrastructure projects. Government must refrain from spending, just as individuals must, in order to pay down debt and allow the economy to recover on its own. Over two hundred years ago, Jean Baptiste Say explained that the unhampered market economy always tends toward equilibrium and becomes more stable, not less stable, over time.

In addition to the end of government-controlled fiat money production and the rescinding of profligate government spending, the government should refrain from regulating more of the economy. In fact, it should eliminate most of the regulations currently on the books and devote itself to its primary job of protecting life, liberty, and property. Freely acting and cooperating individuals are the best regulators of the market process. No new banking rules enforced by an army of new regulators can prevent the inevitable malinvestment from the expansion of fiat money credit just as all the regulators in the past were unable to recognize the consequences of the Boom-Bust Business Cycles of the past. Thusly, it is imperative that the Fed remove its almost one trillion dollars in excess bank reserves before these reserves can be converted into many multiples of new money via the lending process. It should do this by selling its assets at whatever low price (high interest rate) necessary to accomplish the task. Furthermore, the government should cease all attempts to bail out failed firms, especially large firms, for these actions merely destroy even more of the nation’s capital by funneling what resources remain available to profitable firms to those firms that have proven incapable of producing a profit. The still substantial assets of these failed firms will be sold to entrepreneurs who are more capable of placing them into profitable and productive use.

There is nothing that government can do to speed up or ameliorate the necessary corrections to the economy. It can merely prevent them from happening at a cost of an even greater correction in the future. It is crucial that such correction be allowed to take place before the economy is completely destroyed, as occurred in Germany under the Weimar Republic in 1923 and as happening now in several African nations, such as Zimbabwe, today. The Soviet Union collapsed, because its once formidable economy was denuded of capital via the same policies touted by our government as a cure for the crisis today.

A free market economy—the only economy capable of providing peace and prosperity for all—is not compatible with command-style money manipulated by government for political purposes. It is this dichotomy that will destroy our economy. The economy will either become entirely free or entirely unfree. At the present time we are rushing headlong into a complete loss of freedom, both in economic and political affairs, for the two cannot be separated.


  1. The government is a few decades past any romantic ideals such as a free market or democracy. Wake up dude.

  2. We don't have a free market in America. It is a welfare state in favor of entitlements for the rich, corporations, military contractors, health care providers, banks, and the agricultural industries (massive subsidies). All of these segments are out of control and need to be brought in somehow. Why for example have health care costs gone up 160% in the US since 1992 and only 35% in Japan (where every resident is required to have insurance)over the same period? The problems you mention are much deeper than housing and the Fed. These areas require structural reform if our country ever expects to be fiscally strong.

  3. The problem with a democracy is that a swinish and delusional electorate will elect swinish and deluded representatives. America has become swinish and delusional at the grass roots level. Americans believe that they alone, in all of human history, are entitled to something for nothing. Thus the blase indifference to the export of all means of earning a livelihood and a hatred of all taxation. The only solution to the current crisis is the repatriation of American jobs on the US mainland and the recapture of American markets so Americans can earn a livelihood. Don't hold your breath.