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Market Failure?

Mises Daily: Thursday, October 08, 1998 by

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Comedian Steve Martin once did a standup act in which he asked the audience in an incredulous tone, "You mean, you don't remember when we had nuclear war and the earth was wiped out?" The audience would laugh, as expected, since the entire idea was ridiculous.

While Steve Martin isn't writing columns about the current global financial dealings, he might as well be writing the script that a number of so-called experts have been peddling. William Greider, for example, has been polluting the print media from the liberal Washington Post to the ultra-leftist Nation with a diagnosis that borders on economic malpractice. His partner in crime, Robert Kuttner, who writes a Business Week column, is no better in his diagnosis of and prescription for the ailing system.

Writes Greider, "Authorities are clinging wistfully to the reigning free-market orthodoxy, as it breaks down before their eyes. The proposition that utterly unregulated markets rule society more wisely than sovereign governments is being smashed by reality." Kuttner's recent articles claim that somehow we have been duped to "worship" free markets. Like Martin's phantom nuclear war, Greider and Kuttner imagine that we have been living in a laissez-faire, free enterprise world financial system that is on the verge of collapsing because the Asian and Russian economies have been operating in a 19th century economic time warp.

Before we examine the present state of the financial world, let me say that had we been operating these last 10 years by the rules of late 19th century international finance, the current mess would never had happened. Far from having caused the crisis, the practice of laissez-faire would have helped prevent it. The idea that "sovereign governments" are going to put the pieces back together again holds as much water as Steve Martin's fractured history of nuclear war.

The present predicament is not the product of free markets; rather, it is the result of a lethal mixture of politics (call that "sovereign governments"), central banking, and the International Monetary Fund. Any leg of this unholy triad can be enough to bring a healthy economy to its knees; the combination of all three will always bring calamity.

The sudden collapse of world markets after years of go-go growth begs an explanation. First, we point out that the world has been in the process of a boom, much of which has been caused by unwarranted government intervention in the international monetary system. Central banks in Asia, along with our own Federal Reserve, have drastically increased available credit reserves this decade through purchase of government securities and by artificially holding down interest rates. The flush of credit has encouraged bankers and other investors to make loans that in a normal market would be deemed too risky.

As we have seen, when central banks increase reserves, the new money must flow somewhere. During the past decade, world stock markets and real estate markets have absorbed much of the newly-created cash, thus the explosion in their values. New money poured into risky investments temporarily was able to hide the fact that many of these loans could not be paid back. When the day of reckoning came, it turned out that these banks have been holding hundreds of billions of dollars in bad loans.

In other words, the boom - like all booms - could not be sustained, since it was being fueled by cheap money. The Grim Reaper has arrived at the door of the Asian banks, and while our situation here is not as desperate, no doubt the stock and real estate markets are going to suffer.

The second and third legs of the recession triad, politics and the IMF, introduce what economists call moral hazard into the mixture. Asian economies for decades have engaged in "crony capitalism," that is enterprises which are in political favor find themselves first in line for new loans. The problem arrives when these shaky enterprises seek more loans, not for capitalization, but rather just to stay afloat. In Asia, and especially Japan and Singapore, there are thousands of these kinds of firms.

(If this description brings to mind the business and banking practices in Arkansas, the comparison is wholly unintentional. However, when the former President Suharto's friends looted Indonesian banks, it does remind us of how then-Gov. Bill Clinton and his allies emptied the assets of a Little Rock savings and loan, the genesis of the Whitewater investigation.)

When such international bank failures occurred in the past, the IMF was always there to propose "bailouts," which is a euphemism for good money thrown after bad. Furthermore, such bailouts can only occur by taking capital from healthy institutions and transferring it to the very governments whose practices caused the problems in the first place. Of course, the IMF does not stop there. It then "requires," as part of its loan terms, governments receiving such loans to raise taxes and engage in other measures that are almost guaranteed to choke off an economic recovery.

The questions on nearly everyone's lips are: "How will this episode end? Will we have world-wide recession or depression as occurred in the 1930s?"

The answers depend upon how governments and financial leaders react to the current crisis. To make the right policy choices, we need a history lesson.

The Great Depression was not caused by the stock market crash; rather, it was the result of a series of public policy blunders. In 1930, Congress passed the single worst piece of economic legislation in our nation's history, the Smoot-Hawley Tariff which effectively ended the world trading system. The Hoover Administration - even as bank failures were already shrinking the nation's money supply - urged business and labor unions not to allow wages and prices to fall. This was a prescription for disaster, as prices and wages must be permitted to adjust in order to reflect current realities.

Not satisfied with those measures, President Herbert Hoover and the Republican Congress pushed through a massive tax increase, done, they said, in order to calm nervous markets. The doubling of taxes was the final blow to any economic recovery. When Franklin Roosevelt took office, his New Deal simply kept the depression alive. First, he attempted to arrange the entire U.S. economy into a series of cartels through the National Industrial Recovery Act, he fixed agricultural prices at artificially high levels, then forced violent unionism on businesses in hopes of raising wages. It is no wonder that unemployment levels did not fall below double digits until the start of World War II.

In other words, the Great Depression happened not because Herbert Hoover "worshipped" free markets, but rather because he and his successor did everything they could to thwart the market system. Today, President Clinton and his advisors are calling for a "Global New Deal," a euphemism for further government control of markets, which will give us even more "crony capitalism," IMF bailouts, and artificial manipulation of interest rates by central banks.

If the powers that be are serious about the international financial crisis, they need to put free markets to work, not stifle them through regulation and inflation. Those investments which cannot survive the current climate must be allowed to be liquidated and those resources be transferred to those uses which are economically viable. This is the most humane course of action precisely because it will do the least amount of damage and allow for a recovery to begin more quickly and more equitably.

Greider, Kuttner, and others are mistaken. The ghost that governments and international financiers have been worshipping bears no resemblance to either Adam Smith or Ludwig von Mises. Rather, that image that appears in the mirror is none other than that of John Maynard Keynes, the man who devised the very international financial systems that have failed so miserably.

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William L. Anderson is a Mises fellow and graduate student and PhD candidate in economics at Auburn University.