Tue, 23 Sep 2008

A lot of ruin in a nation

There is a lot of ruin in a nation. Here is the $20 Austrian economist's version of what has happened, and what will happen:

When I say "only", "all" and "no", I am exaggerating for the sake of understanding. It's easier to understand how things work when you take them to their limits.

Free markets respond to their version of planning: prices. For this to work, prices need to be accurate. The supply of money needs to be constant (no, Mr. Bernanke, not inflating at whatever you guess to be the growth of the economy; constant). Government needs to not frick with things. No policy-based taxation, quotas or tariffs. No minimum or maximum prices. No bailouts of companies "too big to fail." No rules against monopolization.

If these rules are observed, then companies that make their customers happy will succeed, and those that do not will fail. When no company makes their customers happy, customers will not spend money. They will save their money, instead. This will drive down the cost of money. Companies will have more money available to them to create new products that make customers happy. Alternatively, when all companies are making their customers happy, the cost of money will go up, and only those customers making their customers happiest will be able to afford new investment.

What happens when those rules are broken? First, if you create new money which has no value to buy with it, you have made the cost of money go down temporarily. This leads companies to invest in new products, which they expect customers to be willing to buy with the money they've saved ... only this new money didn't come from saving. It was created from nothing. It was a lie.

What has happened in the U.S. is that the Fed created new money starting in 1997. This led to the dot-com boom. People spent money to create businesses they thought would be huge hits. They thought there was lots of new money to build businesses and later buy the products. There wasn't. Same thing in 2003. It was very cheap to borrow money and build houses. The homebuilders did very well. Unfortunately, they were building them for people who hadn't really saved, and couldn't really afford them.

Every time the central bank creates a boom, it MUST be followed by a bust. The boom creates incorrect investments, and the bust consists of revaluing those investments to their new, lower value. Companies go bankrupt and their assets are sold off. Homeowners cannot pay their mortgage and lose their house (which isn't such a bad deal for them since they had no money down, were renters before and will be renters again).

Government bail-outs interrupt this process by stopping the revaluing. Only when the assets have been revalued, and sold off, will the economy recover as those assets are applied to new productive purposes. Prices are information and communication; interfering with them by applying arbitrary value is just another form of government censorship. It destroys market planning and substitutes central government planning (and we all know how well THAT works).

Where did the Fed get the money from to do these failouts? By printing up new money. This is EXACTLY the wrong thing to do. It will send the wrong signal to companies and individuals. It will be that much longer before assets get repriced.

Banning shorting of financial stocks is more censorship. If you have money, and think a stock is going to go down, and you short a stock, you borrow somebody's stock and sell it. That drives the price down, which reduces other people's interest in shorting the stock. It also brings tomorrow's price into the present. If you're wrong in your guess, and the stock price goes up, you lose your money and cannot make these bets again. If you're right, and the stock goes down further, you have done the market a service and you get rewarded for it.

Prices are speech.

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