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The Continuing Economic Depression, Part 1


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More than three years ago, it became clear that the housing bubble was about to burst, and that the U.S. economy would be in for a very rough patch. In the three years since the collapse of the financial entities behind the mortgage boom, we have seen the U.S. government spend trillions of dollars in the hope of “stimulating” the economy back to life.

Today, unemployment hovers at about 10 percent, and long-term economic prospects are dismal at best. As U.S. government debt rises even as the ability of the government to pay it back diminishes, Americans finally seem to be understanding that this economy is mired in an out-and-out depression, and for all of the pronouncements coming from Federal Reserve Chairman Ben Bernanke and Barack Obama that “happy days are just around the corner,” it is obvious that things will stay bad for a long time.

The situation cries out for answers to three fundamental questions: (1) How did we get to this point? (2) Why does the depression continue? and (3) How can we restore a strong economy? Unfortunately, many of the supposed “best and brightest” among us cannot answer any of those questions with any veracity, yet they are the very people who are making the larger decisions that continue to doom us.

Part 1 of this article will show how we got here; part 2 will cover the other two questions. There is a theory that not only explains how we got into this situation, but also shows a way out, something that U.S. policymakers so far have ignored. The Austrian theory of the business cycle does both, but despite its explanatory power and wise counsel, American politicians and academic economists insist that that theory is “discredited” and that those who espouse it should be marginalized or ignored altogether.

Unfortunately ignoring the Austrians also dooms the economy, for the current prescriptions — spend into oblivion and create expensive new government programs — clearly are doing terrible economic damage.

The conventional account

How did we get here?

If one were to pose that question to the political science professors where I teach, they would answer it with the following: “Americans let the corporations convince Congress to deregulate the economy, and you see what we got. The markets got out of control because no one was regulating them.”

For that matter, Paul Krugman has been saying the same thing the past few years. Obama makes similar claims in most of his stump speeches, and mainstream journalists repeat that chorus and add new verses. The picture they present is this: If government agents are not watching every move of people both in financial markets and in business corporations, sooner or later, the players all en masse will run the economy over a cliff. Likewise, the same people are likely to say that Ground Zero for our economic malaise was put into place 30 years ago when Ronald Reagan “deregulated” financial markets.

The story that Krugman and others are circulating is that America’s economy was doing very well with a relatively small and highly cartelized banking system. However, they continue, in the mid 1970s some banks and financial organizations were chafing under the regulatory yoke and wanted to have more freedom to do things as they saw fit.

According to the modern critics, the election of Ronald Reagan in 1980 gave the deregulation forces the impetus they needed, and during the 1980s the Congress and the president began to untie the financial safety net that had protected the American economy since the New Deal. Furthermore, there were precursors to the collapse of the housing bubble, those being the savings and loan crisis in the late 1980s and early 1990s, and then the stock market bubble, which came after the Republican Congress loosened many of the restrictions set in the Glass-Steagall Act of the early 1930s.

Krugman claims that the highly regulated and highly stratified American financial system worked well, but conservative ideologues became involved and destroyed everything. In the end, the unregulated markets ran wild, creating a housing bubble and then collapsing altogether.

That is a most interesting account — except that very little of it is true. First, and most important, it was not conservative Republican ideologues who started rolling back the Great Depression-Era regulatory system, unless one believes Ted Kennedy was a conservative Republican. Second, and more important, the story of regulation, deregulation, and their aftermath is very different from the stump story being told by the political classes.

Michael Milken

During the 1930s, Congress essentially turned over much of its lawmaking powers to the executive branch; it also created and empowered regulatory agencies to organize firms in the financial, communications, and transportation industries into a series of cartels. The idea was that regulated firms would not engage in risky behavior, go out of business, and leave people unemployed.

By the mid 1970s, with the U.S. economy suffering through stagflation (increasing inflation and unemployment), entrepreneurs were finding ways to undercut the cartels, especially in banking and finance, and by 1982, a number of deregulatory acts were passed, which opened the economy to more opportunities and avenues for growth. However, there were two developments during the 1980s that not only created bad precedents, but also played an important role in the current economic collapse.

The first was the stand of the old Wall Street banking interests. They did not like entrepreneurial upstarts such as Drexel Burnham Lambert, which featured a brilliant investment banker named Michael Milken, who found ways to raise huge sums of cash for a number of start-up and expanded business operations that had been given the cold shoulder by the established banks. For example, when MCI decided to mount a challenge to the high-cost, lower-performing long-distance monopoly held by AT&T, the company turned to Milken to raise the capital funds by issuing “junk bonds” that paid high rates of interest.

As economist Murray Rothbard noted, the established financial interests got their way when U.S. Attorney Rudy Giuliani found creative ways to charge Milken with “crimes,” using regulatory violations that Giuliani and others admitted were a stretch. Wrote Rothbard,

The genius of Michael Milken was to find a way to make the free market work, a way around the roadblock of the Williams Act [which limited corporate takeovers]. He also made an end-run around the Old Guard banks and blue-chip bond dealers with his new concept: financing takeover bids by issuing high-risk and therefore high-yield bonds, misleadingly called “junk” by their blueblood competitors.

Once again, the Wall Street elite turned to their buddies in Washington: after orchestrating a frenzied and hypocritical media campaign against Mr. Milken’s high earnings, they succeeded in sending to prison the most creative financial innovator of our time.

The Milken affair also had a major effect on the nation’s savings and loan institutions, which had been deregulated in 1982. Unfortunately, Congress effectively set up inefficient institutions that stayed alive because of political connections.

After Congress changed the tax law in 1986, real-estate portfolios lost value, and in 1989 the bottom fell out. What made things worse was that Giuliani’s abusive Milken prosecution led Congress to panic and demand that S&Ls sell off all of their “junk bond” holdings, despite the fact that for many of the thrifts, the “junk bonds” were performing better than any of their other assets. It came as no surprise, then, that Congress’s interference (goaded on by the media) in the financial system created a huge disaster, a foretelling of the greater disaster that would happen two decades later.

“Deregulation” and the boom

This is not ancient history and neither is it irrelevant to the present situation. We have seen time and again that when faced with real problems in the financial sector that were due to earlier regulatory intervention, Congress took off some of the shackles, but then created perverse incentives that invited the very kind of behavior that one wishes to avoid in financial markets.

There were two unfortunate developments in deregulation. First, Congress increased the amount by which bank deposits were insured from $40,000 to $100,000, creating moral hazards that encouraged some banks to engage in risky financial behavior. Second, the government also made it clear that it would bail out firms deemed “too big to fail.” (While no firm is “too big to fail,” I do not have the space to cover that subject here.)

There is no doubt that the U.S. economy improved drastically during the 1980s, but political developments that followed the growing economy have made long-term prospects worse. One development was Giuliani’s Wall Street prosecutions. While cheered on by the media, intellectuals, and Milken’s established Wall Street competitors, the prosecutions sent two sinister messages.

One message was that the government would find a way to criminalize routine business and financial transactions — and the public would cheer, even though it meant the government effectively was closing doors for entrepreneurs. The other, which political classes made clear to Wall Street, was that political ties — and financial contributions sent to Washington — trumped real entrepreneurship. Both messages would prove fatal to the U.S. economy.

While people remember the 1990s as a time of prosperity, the real picture is mixed. The economy boomed in the late 1990s, but the boom was fed by wild monetary expansion by Alan Greenspan’s Federal Reserve System, as well as by unwarranted optimism about the bourgeoning high-tech sector. As the stock market roared to record values, the pundits claimed that the politicians had created the “new economy,” one that was recession-proof. The popping of the stock bubble and the subsequent recession of 2001 gave the lie to “new economy” delusions.

For all of the claims that Bill Clinton’s administration was “moderate” and even “pro-business,” two developments said otherwise. First, the government turned its antitrust guns on Microsoft, claiming that the company’s “bundling” of its software with its popular Windows operating system “harmed” consumers, and tied up the company in court for years.

Second, the Clinton administration strongly ramped up environmental regulations, bypassing congressional intent and reinterpreting laws according to environmentalist dictates. The restrictions did not have an immediate impact, but would have a detrimental economic effect later, long after Clinton left office.

After the tech bubble burst in 2000, the economy veered toward an inevitable recession. In many respects, that was an opportunity for the new administration of George W. Bush, who could have denounced Greenspan’s bubble and tried to set the U.S. economy back on a sound track. Instead, Bush resorted to the “hair of the dog” plan, with Greenspan flooding the economy with cheap dollars.

The low interest rates found their way to the housing market, and the sad story of the housing bubble followed. The housing bubble did not happen just because Greenspan’s and later Ben Bernanke’s Federal Reserve System forced down interest rates; it happened also because of a gaggle of federal programs aimed at promoting home ownership.

It is important to point out here that the claim by Paul Krugman and others that this was just the “unregulated” free market at work simply is not true, as the government had its hands everywhere in the housing boom. Government programs and government-backed loans and mortgage securities flooded huge amounts of money into housing.

Like all bouts of inflation, the “good effects” came first. People could refinance their houses at lower interest rates, borrow thousands of dollars of what seemed to be “free” money, and then purchase consumer goods. Because the U.S. dollar had become the world’s “reserve” currency, producers all over the world accepted American money and shipped goods to this country. During this period, China’s central bank took dollars and then purchased U.S. Treasury debt. But the façade of trading green pieces of paper for goods could not be sustained.

The problem is that instead of dollars being used for future payment in real goods and services from the United States, the debt merry-go-round continued. Foreign holders of U.S. bonds were paid not even from U.S. tax receipts, but rather from the sale of newly issued U.S. government bonds, often purchased by the same foreign central banks. While U.S. consumers enjoyed inexpensive Chinese goods such as cell phones and computers, the Chinese in return were receiving green paper with the promise to pay in more green paper. It was a Ponzi scheme that would have made Bernie Madoff proud.

The sham economy (or what Peter Schiff has called a “phony economy”) came to an end in 2007, as inflationary pressures brought up interest rates and it became abundantly clear that housing prices could not keep rising. In the summer of 2008, both the Federal Home Loan Mortgage Corporation (FHLMC), known as Freddie Mac, and the Federal National Mortgage Association (FNMA), commonly known as Fannie Mae, both collapsed financially, and at that point, the housing bubble officially was over.

Both of those entities purchased mortgages at their present value in the secondary markets, created securities for them, and then sold them to other financial entities in order to pump more money into mortgage markets. Both Fannie and Freddie also guaranteed close to half of the mortgages in the United States, which in effect made taxpayers the co-signers of a lot of risky loans.

It is hard even to describe the madness that was the housing bubble, and much of Wall Street enthusiastically drank the Kool-Aid that Fannie and Freddie served them. People with incomes of perhaps $50,000 a year were buying houses for up to half a million dollars, using interest-only mortgages with low “teaser” rates in the hope that future housing price increases would enable them to either sell their houses at a profit or renegotiate their mortgage rates downward.

At the height of the housing boom, Fannie and Freddie had a combined leverage of about 75 to 1, debt to equity. The rest of the financial sector that had jumped into housing was not much better off, and that debt/equity structure could hold only as long as people were able to make their monthly mortgage payments. Once the “teaser” rates went up and people had to start making principal payments on their mortgages, they were finding their house payments took up more than half of their take-home pay, which clearly was not sustainable.


When that pyramid collapsed, so did a huge chunk of investment, and a number of Wall Street firms were teetering. In September 2008, U.S. Secretary of the Treasury Henry Paulson, who had been the CEO at Goldman Sachs before going to Washington, demanded that Congress vote a $700 billion bailout for the troubled firms.

Paulson’s argument, which also was taken up by both political conservatives and liberals, was that unless troubled firms were bailed out, Wall Street would collapse, the nation’s financial situation would descend into chaos, and the economy would fall into depression. Politicians from Sarah Palin to Barney Frank echoed the same message, and Congress dutifully followed by giving in to Paulson’s demands.

This was a critical moment, but not for the reasons given by the bailout’s proponents. The bailout itself saved nothing, except a few high corporate salaries. Instead, it not only put off the “economic day of reckoning,” but it also guaranteed that the economic downturn would be longer and more painful than it should have been.

The Austrian theory of the business cycle, developed by Ludwig von Mises and F.A. Hayek, fully explains not only how the economic collapse came about, but also what must be done to bring about an economic recovery. According to this theory, when monetary authorities hold interest rates to artificially low levels, they trigger a slew of investments (or malinvestments) that cannot be sustained over time.

Indeed, in the early stages of the boom, borrowed money finds its way into the hands of people who spend it on consumer goods or things like cars and boats. However, the façade of prosperity cannot last and here we are; the Austrian theory of the business cycle further predicts that a crisis will arise, because these easy-credit-driven malinvestments ultimately will fail.

Was it the free market that gave us this mess? Certainly Paul Krugman and the political classes claim that to be so. However, there are a few points that need to be made in defense of the markets.

First, and most important, the spectacular failures of firms such as Enron in 2001 and the Wall Street financial houses in 2008 came with the demise of easy credit, which was the result of Federal Reserve policies (which are continuing still). Yes, Federal Reserve and government housing policies did encourage the creation of private mortgage firms, but had the government not been following financially irresponsible strategies for temporarily “boosting” the economy, Enron and others would not have been able to operate as highly leveraged as they were, and certainly the real-estate market would not have been operating at white-hot levels.

Second, the portions of the economy that directly benefited from loose federal credit policies were also the areas that fell the hardest when the bust finally came. There is a connection, even if some economists don’t want to recognize it. Free markets can be efficient, even when working with malinvested resources, but they cannot create something from nothing.

Third, even the best-run markets are no match for government failures in money and finance, and as long as government has a monopoly on monetary creation and policy, there will be financial crises. The role that government played in setting up the crisis cannot be ignored, and to assume that government can “restore prosperity” by doing exactly what it did to cause the crisis in the first place is sheer madness.

The U.S. economy got to its current position not because free markets failed, but because government policies created conditions for unsustainable booms that turned into busts. In the next part of this article, I will explain why the depression conditions remain, despite the government’s spending of trillions of dollars to abate the downturn. I will also explain what needs to be done in order to bring back a real prosperity.

Part 1 | Part 2


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