Tuesday, September 30, 2008

The Bush Bailout and What's Wrong With It

In the 1930s America experienced an economic crisis, which has come to be known as the ‘Great Depression.’ This crisis did not occur out of the blue, nor was it caused by a series of runs on the bank.

It was caused by government intervening to cushion the consequences of imprudent investments.

Leading up to the Great Depression, the American economy had experienced massive growth. Much of this growth was illusory, propelled by investment in companies exceeding their actual profits. Because many companies had a value higher than their earnings (in some cases no earnings at all), people began to grasp that their shares weren’t worth as much as they paid. The banks realized this too, and so they began to call loans.

Now naturally when banks begin to call bad loans, this creates losses. But this is not a bad thing. In a free market, loss as well as growth are necessary components for stability, since bad business practices are then allowed to suffer their natural consequences. However, instead of letting things to take their natural course, the government stepped in to try to fix things. From 1923-29, the American money supply was increased 61 times by the Federal Reserve. This amplified inflation which accelerated the boom market, perpetuating the illusory sense of prosperity. Naturally the new money supply encouraged more imprudent investments.

Things could only be put off for so long and in February of 29 the stock market ceased to expand, causing Wall Street to collapse.

President Herbert Hoover (picture on left) responded by doctoring the market again. In ‘31 he launched the greatest peace-time deficit spending program in history to try to prop up the economy. Because money has to come from somewhere, it was the tax payer who had to foot the bill. Thus, in ‘32 Hoover launched the largest peace-time tax hike in America’s history. To pay their taxes, people had to remove massive amounts of money from the banks, which increased the burden the financial institutions were already under, creating a vicious cycle.

Alexander Solzhenitsyn once remarked that “If we don’t know our own history then we simply have to endure all of the same mistakes and all of the same sacrifices and all of the same absurdities over again times ten.” Nowhere is the truth of Solzhenitsyn’s words more evident than in America today, which is like a replay of the events of the Hoover administration.

During America’s recent economic boom, the Federal Reserve deliberately kept interest rates low in order to encourage investments. As in the 1920’s, this distorted the market because it allowed entrepreneurs to engage in malinvestments - investments which failed to take into account actual resource availability.

The artificial sense of prosperity led to many Americans to invest in homes they could not afford. Gambling on the idea that house prices would keep rising indefinitely, they counted on selling or re-financing their homes before the bill came due. Banks allowed this to occur by giving out sub-prime mortgages. (A ‘sub-prime’ mortgage is a type of loan granted to individuals with poor credit histories.) As can be expected, when the house market levelled out, many simply had no way of paying. As a consequence, currently 9% of all Americans with mortgages are either behind on their payments or in foreclosure.

The nature of politics in America has also contributed to the financial crisis. It is candidates who promise the most ‘goodies’ who get elected and voters rarely ask, “Where is the money for that going to come from?” When unforeseen expenses, like the war in Iraq or hurricane Katrina, are added to the cost of all the entitlements, pensions and programs government has already committed to pay, there is only one place for the money to come from: debt.

Given the irresponsible pattern of spending and investment from both the public and private sector, it should come as no surprise to find the American economy going belly up. The question is: will the United States learn from the stock market crash of ‘29 and allow bad investments to suffer their natural consequences, or will government try to artificially prop up the economy? It is the later course that the Bush administration is pursuing. According to current proposals, the American taxpayer will have to pick up the bill for a $700 billion bailout, in which government will buy toxic loans and mortgages from hurting financial institutions. This will increase the national debt ceiling to at least $11.315 trillion, bringing the federal deficit to 79% of the American economy. That equals nearly $2,300 for every man, woman and child in the USA.

By removing the consequences of bad business practices, the government is setting a terrible precedent. The Bush administration as well as presidential candidates, Barack Obama and John McCain, are trying to cure the problem by the very means which brought it about. If the market had been allowed to be truly free rather than being doctored with by the Federal Reserve, then interest rates would have reflected reality and discouraged malinvestment. It is perhaps asking too much to expect the government to have learned its lesson and be willing to finally take a “hands-off” approach to the economy, whatever the short-term consequences might be.

Not all members of government have been so blind. Congressmen Ron Paul (pictured left) has argued that what is needed is the liquidation rather than the purchasing of toxic debt. Commenting on the proposed bailout, the Texas representative said: “It's the same destructive strategy that government tried during the Great Depression: prop up prices at all costs. The Depression went on for over a decade. On the other hand, when liquidation was allowed to occur in the equally devastating downturn of 1921, the economy recovered within less than a year…. By doing more of the same, we will only continue and intensify the distortions in our economy – all the capital misallocation, all the malinvestment – and prevent the market's attempt to re-establish rational pricing of houses and other assets.” (Visit Ron Paul's blog HERE)
Solzhenitsyn (picture on right) was correct: if we don’t know our own history then we simply have to endure all of the same mistakes and all of the same sacrifices and all of the same absurdities over again times ten.

In this case, times billions.

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