As a historian, I am all too familiar with the dangers of placing too much stock in contemporaneous sources. Present events and actions attract the most attention, leading to a myopic search for explanation. Causation is best determined from afar since the historian has a diverse group of hypotheses from which to choose and can evaluate subsequent events for corroboration. But one cannot fully discount contemporary analysis; it offers up a rich source for facts and, uncommonly, spot-on assessments. With this trepidation, I cautiously read Thomas Woods Jr.’s 2009 book Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse. Woods, an Austrian economist with the Ludwig von Mises Institute, sought to present an alternative to the previous and current administrations’ indictment of the free market on the charge of causing the present economic predicament.
The primary value in the book is re-locating the blame for the recession back where it belongs: government interference in the economy. He dismisses the Community Reinvestment Act, mortgage-backed securities, and credit default swaps for the noise that they are. These all had an impact on the depth of the recession but Woods’ identifies the singular perpetrator as the Federal Reserve.
The Fed manipulates interest rates in order to “stimulate” or put the brakes on the economy, depending on the direction they set the interest rates. The Austrians—and Woods here—correctly identifies that interest rates are effectively the pricing mechanism applied across time: how much is wealth deferred now worth in the future. In a free market, interest rates arise from individual savings preferences: if few people are willing to defer spending now, then the interest rate will increase due to diminished supply. They also may be induced to defer spending by an increased demand for money to lend. It’s a simple matter of supply and demand.
But the Fed’s increase of the capital stock does not represent deferred spending. It is an artificial adjustment to the supply without a corresponding increase in demand. This dislocation acts as a signal to businesses and consumers of capital that now is the time to undertake projects that are profitable only with cheap credit. Woods cites an apt analogy from Ludwig von Mises to illustrate this distortion:
Mises draws an analogy between an economy under the influence of artificially low interest rates and a home builder who falsely believes he has more resources—more bricks, say—than he really does. He will build a house whose size and proportions are different from the ones he would have chosen if he had known his true supply of bricks. He will not be able to complete this larger house with the number of bricks he has. The sooner he discovers his true brick supply the better, for then he can adjust his production plans before too much of the finished house is produced and too many of his labor and material resources are squandered. (69)
Woods also briefly covers the Austrian business cycle theory to illustrate that such economy-wide movements aren’t the fault of the free market such as it is. Their theory also posits that higher-order goods, like capital and wholesale products, are the most sensitive to interest-rate fluctuations while consumer goods are the last to respond. The recent boom and bust provides ample evidence of this observation, as capital-intensive industries were affected first and only recently have some consumer good manufacturers started to have trouble. The reason is solely due to money supply manipulations by the Federal Reserve.
Books of this nature always conclude with policy recommendations: it’s practically de rigueur. Refreshingly, Woods’ suggestions are entirely about how the federal government can extricate itself from money. He notes Mises’ observation that the “history of money is the history of government efforts to destroy money.” I have no beef with any of his ideas, which include abolishing Fannie Mae and Freddie Mac, getting rid of the Fed, and ending the system of fiat money that allows for hidden government spending.
This book is wonderful if for no other reason than introducing the reader to the Austrian School of economics, which is the most consistent defender of the free market in the economics profession. “Most consistent” here means that its defense of freedom rests on practical grounds—that liberty and economic freedom work well and much better than socialism. Woods’ book doesn’t go far enough: it’s not grounded in individual rights and the nature of man like John Allison’s talk was. But as an accessible, accurate analysis of the source of the current situation, it deserves a wide audience.
Also, the book has extensive endnotes that are worth reading in themselves.
Very good review. Austrian Business Cycle Theory is most eloquently elaborated in Jesus Huerta de Soto’s Money, Bank Credit, and Economic Cycles. It should also be noted that the Austrian School ultimately blames fractional reserve banking for causing the business cycle, central banking being a type of fractional reserve system. This explains the recessions that have occurred before the dawn of central banking.
Thank you for that recommendation. The endnotes are littered with references to that book so I was considering it but that cinches it. (Also, Woods does not believe that fractional reserve banking is a fraud. Further, he didn’t advocate the gold standard because he argued that the government has absolutely no business in stipulating one metal over another or how much a dollar might equal in gold. That was unusual in my experience with Austrians.)
Advocacy of a gold standard is not actually necessary, as Woods demonstrates. Strictly speaking, free market advocates want “free market money.” In actuality, the market would choose a parallel standard of both gold and silver. A government enforced gold standard is a good intermediate stage on the path towards free market money however so there’s nothing wrong with advocating a gold standard.
Thanks for the review. His analysis sounds flawless in economic terms, although the issue of the role of fractional reserve banking in fostering business cycles is an open one in my mind. (On the other hand, the legality of it under laissez-faire is not an open issue for me. Fractional reserve banking is not fraudulent as long as long as the banks’ customers know what they are getting.)
It depends on your definition of FRB. I find that people subscribe to different definitions apparently.
Fractional reserve banking under a central banking system is the primary way that inflation is disbursed (and dispersed) throughout the economy. If banks were 100% reserve warehouses, then the central bank would have to helicopter drop money in a much more open and visible way.
Fractional reserve banking, as such, is no big deal—even today. The central bank and its monopoly on money is the problem.
If banks adhered to their monetary irregular deposit contracts (100% reserve) in the absence of a central bank than fractional reserve banking would indeed be at best a nuisance. But the reason why I bring up the inevitable problem of fractional reserve banking is because an astute Keynesian, aftering hearing that central banking causes the business cycle, would rebut that the business cycle historically predates central banking and that, therefore, central banking could not possibly be a sufficient condition for the rise of the business cycle.
Based on my observations, I think business cycles will happen in a laissez-faire world, with private banking and (likely) gold-based money. They will be much smaller, though, without the monetary “stimulus” provided by central banking, which can create gigantic cycles.
The cause of these natural, small disturbances or cycles is technological change and natural periods of optimism and consolidation that ensue.
Not to beat a dead horse but if the business cycle refers to the recurrent phases of economic growth and economic contraction, I think a purely laissez-faire capitalist society would relieve itself of such fluctuation. The reason why is as follows. Business cycles as we know them in our Keynesian state are caused by “artifical” bank credit expansion by the Fed, an increase in the supply of loanable funds unsupported by a preceding rise in savings. This rise in the supply of loanable funds decreases interest rates but since such credit expansion is unsupported by savings, the interest rate declines it causes do not reflect consumer valuations. Entrepreneurs see this decline in interest rates and now a whole fleet of business undertakings that were initially considered unprofitable now look profitable. Entrepreneurs thus take advantage of the interest rate fall by borrowing money and use it as financial capital to buy productive factors with which to embark on these newly profitable business undertakings.
Now all of this is caused simply by the advancement of false information. Its caused by credit expansion unbacked by increased savings which yield inaccurate interest rates, rates that do not reflect the real demand for and supply of credit. In a free market, interest rates will always reflect as accurate as possible the demand for and supply of credit. No entrepreneur would accept unreliable inflationary currency that offers faux interest rate signals. The business cycle is caused by false information propagated by methods which either wouldn’t exist in a free market al all or would exist only on the fringes along side things like loan sharking where its economic influence would be neligible at best. Bankers in such an environment would not be allowed to systematically violate monetary irregular deposit contracts and therefore inflate the money supply as they do today.
A minor point: Woods is an historian, not an economist. He just gave a fascinating lecture available for free on the Mises.org on the relationship between facts and theory.
http://mises.org/media.aspx?action=author&ID=424
Right, but…
The false information you refer to can occur through entrepreneurial actions. In particular, this is true when scientists and entrepreneurs develop a wonderful new technology. People invest in it in many ways, trying out many business methods, before the best way is sorted out by the market. That sorting out process can result in dislocations.
For example, there were (if I recall correctly) over 1,000 car companies at the turn of the last century. This sorted itself down to a handful. But, before that could happen, millions of dollars were raised in the capital markets and invested in sundry factories and processes. There was a natural boom. Then, as the winners emerged (Henry Ford, et al.), there was a consolidation period, or a bust.
From an informational perspective, it is not that different than the bad information supplied by manipulated interest rates. Most of those entrepreneurs had “bad” information. When the market revealed that it was bad, they had to close down, perhaps in many cases through bankruptcies and the liquidation of financial capital.
The important point here, though, is that this result is natural and good. There is no such thing as “perfect information” in the marketplace. However, what is perfect about a free market is that it allows success to be rewarded to the fullest extent possible, and errors and failure to result in liquidation. On a large scale, when this happens, the economy could experience small dislocations or cycles, but they would be much less severe than those caused by monetary manipulation.
Moreover, those dislocations are the result of a good and productive process whereby new technologies get rapidly incorporated into the economy.
I’m thinking that a primary cause of the bad information within the former car industry was probably the slow dissemination of financial and economic information coupled with sensationalist information. Information like that expires quickly. How do you know the real stock value of car company X if you invest from California and the exchange is situated on Wall Street?
To be sure, the market foments constant creative destruction (perfect competition is a neoclassical fantasy) but I don’t know if I would call it a business cycle since I’m guessing the contractions would be too few and far apart to legitimize such a categorization.
Also, by “business cycle” I mean a macroeconomic contraction, an economy-wide recession where the productive capacity of the entire economy shrinks for at least two whole fiscal quarters. The car contraction surely liquidated many mal-investments but I don’t know if it contribited to a macro-contraction lasting two fiscal quarters.
Also, historical examples are tainted inevitably by government intervention. I wouldn’t be surprised given everything I’ve read/seen if the government was involved somehow.
I would hope that with today’s electronic information dissemination and financial product innovation, a laissez-faire capitalist economy would be incredibly sensitive and responsive to mal-adjustments and mal-investments, so much so that contractions would be marginal.
Woods is one of the Institute’s chief historians I believe. He’s written on the Constitution and U.S. history. Ari Armstrong has critiqued Woods’s historical convictions, especially those regarding the Civil War.
“I would hope that with today’s electronic information dissemination and financial product innovation, a laissez-faire capitalist economy would be incredibly sensitive and responsive to mal-adjustments and mal-investments, so much so that contractions would be marginal.”
This is true, but it is important not to accept, even implicitly, the unreal standard for judging a free market propounded by those who think it is “imperfect” and needs to be fixed. The root of these ideas is that information is costless, that market participants magically gain all relevant facts and, by implication, there are no errors.
Such a state of affairs does not exist and is an unreal standard to judge any economic system.
I don’t think we can really know how large the dislocations would be in a laissez-faire world. They would be smaller than what we experience today, and we would be experiencing them in the context of a vastly wealthier society, and one whose standard of living was growing at an incredibly fast rate.
But such dislocations, to the extent they occur, are no more problematic than the fact there is crime, or that businesses fail, or that there are days when the weather is bad. To even begin to demand that they magically “go away” (as the Keynesians and maybe even some free market advocates do) is to demand the unreal.
Woods explicitly looks to history for support for the Austrian business cycle theory. Unfortunately, I’ve returned the book to the library already so I can’t dig out the specific evidence regarding pre-Fed panics. I remember at least one had its proximate cause in actions by the Second Bank of the United States (an early attempt at a central bank). I also seem to remember that the Panic of 1893 was brought about by bimetallism and some other money manipulations, but I’d have to check that in some books at home.
“I also seem to remember that the Panic of 1893 was brought about by bimetallism and some other money manipulations, but I’d have to check that in some books at home.”
Anti-capitalists and anti-Austrians always cite the Panic of 1893 as a failure of Austrian theory because the Austrian Credit Cycle supposedly doesn’t account for it, something I find doubtful.
If governments didn’t grant special privileges to banks in the 19th century by legalizing their failure to abide by the terms and conditions stipulated within the monetary irregular deposit contracts they entered into then the threat of bank runs would have compelled banks to act prudently and abide by their deposit contracts. Panics and bank runs would subsequently fade away.
I have always thought that depth of the capital pool is a strong contributor to business cycles, and that the deeper the pool, the less dramatic such cycles tend to be.
19th century America, being a far shallower capital pool — i.e. far fewer investors, with less capital than now — means that the supply of capital is relatively small, and easily depleted or lost in bad ventures. When there’s only two banks in town and one fails, that’s a big loss. When one business venture is a huge success, the resulting boom is similarly large relative to the economy as a whole.
As an economy grows, however, the pool of capital (including the number of potential sources) outgrows these things. Hurricane Katrina, as big as it was, and as exacerbated as it was by government, wasn’t even enough to burst the bubble we now know was brewing in 2005.
In fact, what we are now seeing is that while our economy has outgrown natural disasters, there is one man-made disaster that has scaled up with it and remains fully capable of destroying it completely: government.
Jim,
Unusually large financial capital pools are indicative of ex nihilo credit expansion. If capital seems unbiquitous as it shouldn’t then somethings up.
There’s an op-ed by George Selgin (an outstanding defender of free banking) indicating that government meddling was an issue prior to the Federal Reserve System.
For an exhaustive look at the history of banking, I recommend Richard Salsman’s book, “Breaking the Banks: Central Banking Problems and Free Banking Solutions.” He shows exactly how banks were free to issue private money during the “free banking era” during the three decades prior to the Civil War, but were still subject to state restrictions on branch banking. There were a variety of other restrictions on banks and, after the Civil War, on the issuance of money. It was by no means a laissez-faire period, but in important ways it was much more free than today.
Given that, the financial performance of the banks should have been better, and Richard shows that it was. Capital ratios were much higher and we never had a financial panic as large as the Great Depression, nor a period of sustained inflation like we had in the 1970s. In fact, the only periods of inflation were when we went off the gold standard, for example during the Civil War.
Richard covers the whole history of banking from the early 1800s (and possibly before, I can’t remember) until the date he published the book in 1990. He backs up his work with data on all the key financial ratios that describe the financial performance of the banks in each era during this period.
Yes, I would second Salsman’s book also. I just went to edit your comment in order to add our Amazon affiliate link and saw that there was only one review of the book. And it was mine and it was from 1997. Crazy!
What is meant by “free banking?” I’ve heard some refer to banking in the absence of government intervention as “free banking.” Others refer to fractional reserve banking in the absence of government intervention as “free banking.”
Michael,
I guess that would depend on whether fractional reserve banking is inherently fraudulent or not which seems to be a hotly contested issue among free marketers.