One of the most interesting and popular tenants of the influential Austrian School of Economics is the identification of the nature of what theorists call the "crack-up boom".  The process goes like this:  The government intervenes into the economy to stimulate growth.  It increases the money supply and artificially lowers interest rates and it increases spending on projects such as infrastructure or welfare programs.  The result is at first a burst of economic activity.  But as the increased money runs it's course, and the make work projects begin to ebb, the economy begins to slump again.

At this point the government has a choice:  Allow the economy to slump or to re-stimulate.  The problem is in order to regain previous levels of economic activity it takes more stimulation than previously.  If government injects a similar amount of stimulus, the "bang for the buck" grows less, and as production goes down, prices begin to rise due to more money chasing fewer goods.  So it must simulate more than the last time. As prices rise, interest rates rise.  As interest rates rise economic activity is curbed and the government finds itself with the same choice -- endure a recession or create more stimulation. Greater and greater amounts of stimulation leads to ever higher inflation and interest rates.

Like a drug addict each injection requires a greater dose to achieve the same high.  If the government fully commits to inflationary finance the economy goes into a final blow up i.e. the crack-up boom.  The result is eventually complete monetary and economic collapse as we have seen recently in Zimbabwe. This is why you can't buy prosperity.

America flirted with this path to "prosperity" during the late 60's and 70's.  We went from the spending on the "Great Society"  and monetization of debt in order to finance the Viet Nam war, to an overheated economy then recession; to increased money creation to stimulate the economy which led to sky high oil and home prices and to recession.  We then stimulated even more which led to double digit inflation, interest rates, unemployment and the inevitable crisis of 1980 and an even worse recession.  The decline of the dollar in international markets and the run into gold accompanied this period.  Then came the 80's.

A lot of people misinterpret the period from 1980 to 2007.  Many believe that we were employing the same kind of inflationary finance as in the 70's and that this has led us into a "crack-up boom" scenario today.  This is a mistake.  If inflationary finance worked we would not have achieved one of the most prosperous periods in history.  If inflationary finance worked it would be employed by every government in the world.  On the contrary, the prosperity of the 80's and beyond were built on contracting increases in money supply from double digit rates to low single digit levels; on lower tax rates, greater freedoms, and less government intrusion into the economy.  Free trade blossomed during this period and the dollar soared and gold averaged about four hundred dollars an ounce for a generation.  During the 70's, however, money supply and inflation rates grew progressively higher.  This led to a crashing dollar and a soaring gold price, just the opposite of the 1980-2007 period.

We had our share of typical capitalist booms and busts during that period but distinctly different from the crack-up boom scenario.  We had the stock market crash of '87, yet we recouped and went to new highs shortly thereafter.  We had the Asian Contagion and Long Term Capital crisis of the early 90's, but it was over quickly.  We had the dot com boom and crash and the toppling of major companies like Enron and World Com.  But, it was accompanied by one of the greatest periods of technological innovation and productivity known to man.  What we did not have was progressively higher inflation rates and higher interest rates and the resulting multiple recessions as we did in the 70's.  In fact we only had about three or four quarters of negative growth in the entire quarter century. The methods that characterize the crack-up boom can not create over twenty-five years of prosperity. So, what actually happened to bring us to the point we are today?  Was it a failure of capitalism?  Or was it a failure of government intervention?  Is this a generic recession or are we in the first stages of a crack-up boom being created as we speak?

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The present crisis is the result of massive fraud and deceit by the private sector in cooperation with, and encouraged by, the US Government.  By mortgage brokers and loan officers throughout America that concealed terms, and doctored documents; by appraisers that over valued homes in order to please their employers; by rating agencies that gave their stamp of approval to almost every financial instrument that came their way; and by acts of the US Congress and government agencies that sponsored and encouraged home ownership whether families could afford them or not, (sub-prime mortgages);  and by massive leverage allowed and promoted by the SEC which suspended long standing prudent lending policies.

The creation of securitized mortgages by the private market and the marketing of these packages through Fanny Mae and Freddie Mac led to an institutionalized lack of transparency of fraudulent loans.  The leverage rules were changed by the SEC allowing leverage to increase from an historic average of 10 -14 : 1 to whatever the market would bare.  This combination of private and public actions created the "toxic assets" we are dealing with today.  Low interest rates and money supply had little to do with our situation.  Fraud, deceit, and leverage had everything to do with it.  This is not new.  It has happed before, many times.  Nor is the present political reaction to this crisis new.  Economic crisis is usually met by calls for greater government control of the economy.

The world is in constant flux.  It is either moving toward greater freedom or greater government control.  America, after 25 years of unparalleled prosperity, became rich, complacent, and sloppy, which led to the present banking crisis and recession.   In 1907, America, which was on a gold standard, endured a banking panic much like the one we are experiencing today.   That led to the populist movement, again, much as we are experiencing today.  Within years we abandoned the monetary discipline of the gold standard and declared it a failure, declared our heroic "captains of industry"  to be "Robber Barons" and, over the next thirty years, instituted a government controlled banking system, and the greatest amount of government controls and regulations that this country has ever known.  The result was the illusion of the roaring twenties which culminated in the Great Depression.

Today, capitalism and freedom are under attack.  They are said to have failed.  Our business leaders are being cast as villains and government regulations and controls are being touted as the answer to all of our problems.

The fact is that free market capitalism has lifted more people around the world into prosperity than any other system known to man.  On this there is no argument. You will not get an argument from communist China who has seen over 400 million of its citizens lifted from poverty as it abandoned economic communism and moved toward free market capitalism.  You will not get an argument from the previous Soviet Union, who has for the first time in a century  tasted a little prosperity.  You won't get an argument from socialist Europe who has seen the standard of living of Eastern Europe soar as they converted from socialist rule to a more capitalist system leaving old Europe in the dust.  And you won't get an argument from the mid-east as they moved from the tents of the fourteenth century, toward the skyscrapers of Dubai.

The debate between those that want to move toward greater freedom and those that want to move toward greater government intervention in the economy is clear.  Those who want a greater role for government believe that the world will become a fairer place to live; that government can run things like health care, education, and the financial system, better than the private sector.  Their problem is that there is no good example of this ever being achieved in any society.  The world of greater government controls and regulations while promising greater security, fairness, and order, actually leads to a grayer world.  One of  less innovation, less success, and less prosperity.

Freedom also comes with a price.  Capitalism creates great wealth but, when left free of any government intervention, its discipline is harsh.  A world where free markets rule requires total individual responsibility.  There are no safety nets.  If you fail, you fail.  If a business or industry fails, it disappears from the economic landscape with all its consequences.  And manias do not disappear with freedom. No one knows why people  suddenly value a tulip bulb at the same price as a house, or why investors value a share of stock at a hundred times earnings -- but they do.  Panics, crises, and recessions exist and always will under capitalism, but they are sharp and short lived.  Neither does a gold standard eliminate bank runs, or booms and busts.  But it will cap the amount of leverage and upside speculation in the system and therefore contain the downside bust.

Those advocating a completely free society where free markets are devoid of government intervention and control must deal with the fact that there will always be more criminals, fraud, and irresponsibility under freedom than the "order" of controlled societies.  However, in more controlled societies, there are more victims. The difference is that when a criminal commits a crime the victims are limited to the criminal's reach, whereas when a government imposes a social, economic, or monetary policy that initiates force or coercion, the entire society is the victim.

The difference between a mixed economy and a free one is that given a completely free society the degree of mistakes and mal investment are less than those in a world of government intervention.  Problems are not able to mount to the degree that government intervention allows them to.  Problems are resolved quicker and stability and prosperity are restored quicker. Government controls and regulations tend to mask problems and allow them to grow and fester to a far greater degree. Under freedom,

A free society produces a dynamic economy.  A controlled society produces a static economy.

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In the nineteenth century, the heyday of the gold standard and capitalism, there were many panics and recessions.  Yet, there  was never a Great Depression and the degree of prosperity that was achieved was the greatest that the world ever knew.  Inflation and deflation occurred but were limited, and at the end of a century under the gold standard, a dollar bought about what it did at it's beginning.  Today, that dollar is worth 95% less than it was a hundred years ago.

Government intervention begets government controls and regulations.  When you replace the automatic workings of the gold standard with a government controlled fiat standard, you must regulate and control things like money supply and financial leverage, since the discipline of the market has been replaced with the discipline of the government.  When you remove the free market from banking, education, and health care, you must regulate it because you have prevented market forces from doing so.  You set up a choice.  Either you regulate more and "better", or you deregulate and re-learn how to live without government "protection".  You learn the virtues of savings, insurance, and to rely on a good police force whose job it is to seek out and prosecute fraud and criminal activity.

Today we find ourselves in the middle of a financial crisis and recession.  But there is nothing about this recession that is much different from any other recession.  It is the financial panic and banking crisis that is different.  Fix the banking system and you cure the recession.  This whole crisis and the resulting recession is due to the fact that the packaging of loans became popular and some sub-prime loans, were sold together with prime loans.  Normally the market would re-price suspect loans.  They would be discounted by the market to a price that the market could clear.  But because they are in a package, they are not visible to the market.

And there's the rub. There is no way that the market can identify and price these suspect loans.  There is no way for the market to know how many bad loans there are, or to what degree they should be discounted.  The market hates uncertainty and we have plenty of it today.  The problem in a nut shell is that there is no market for these securities.  What you can't see or define you can not deal with -- hence, panic selling and the de-leveraging of everything.  The solution is to break these suspect loans out of their packages and then let the market price them.

It could be argued that the inability of the market to perform this function amounts to  structural damage.  I am open to that argument.  It is possible that the market will not be able to resolve this problem.  If that is the case then the fed, as banker of last resort, should absorb these loans.  The cost to do this is high, but infinitely smaller than the price we are paying today in terms of bailouts, handouts, loss in home values, stock values, and economic recession.

Our government, at present thinks it is heading off a modern day depression by spending money on bailouts of all distressed industries.  It thinks that make work projects are the answer.  It thinks that by throwing money at health care, education, the auto industry, the environment, energy and any other "worthy" endeavor, it will stimulate growth.  It thinks it can avoid creating inflation and/or higher interest rates that will lead to a renewed recession.  It is experimenting with the powers of fiscal and monetary stimulation.  It intends to stimulate the economy just enough to avoid a serious economic downturn and to eventually cut government spending and monetary growth just enough in the future to avoid inflation.

If history is any guide we will enter a short period of economic growth followed by a renewed recession.  Hopefully the experiment will end there. The problem is that the price tag of the stimulation package amounts to 9 trillion dollars over the next 10 years.  This means we will need to either borrow it , which will lead to higher interest rates, monetize it, which will lead to higher inflation, or tax it.   All roads lead to recession.  There is no buying off recession.  And there is no compromising or conning reality.  A price must be paid.  Once we realize this, we will be forced to settle for a more prolonged recession than is politically acceptable.  This is what Franklin Roosevelt learned.  After ten years of make work programs and monetary stimulus, we were no better off than we were at the beginning of his term.  If we refuse to allow the markets to clear and mend themselves, and if we fight off recession with greater and greater doses of money creation and spending, then we will force ourselves to relive the 70's or the 30's... or worse.  I trust we have learned that lesson by now and will ultimately avoid it.  If not, the crack-up boom awaits.

Paul Nathan
Paulnathan.biz