Essential reading

Tom Woods' book Meltdown is a must for anyone wanting to understand the current economic recession as well as economics in general. Woods deals with some very serious topics in a manner that anyone can understand, but he does not omit vital information to do so. As Ron Paul points out in the foreword, a precious few people critically inspect the current economic system; they assume that the system is solid and only in need of a little tweaking. And, unfortunately, they are dead wrong. What they claim will set the economy on the right course will only increase the mess we see today.

This book begins with a chapter entitled "The Elephant in the Living Room." It explains that people foolishly blame the free market for our problems while never even looking at the real culprit - government intervention. The following chapters deal with such topics as these: money and its purpose, the government-created "boom-bust" cycle, myths that have clouded over the real facts of the Great Depression, and what must be done to set things straight. Possibly the greatest truth revealed in this book is that increase in the supply of money does not increase wealth. Wealth is created only with the production of real products; no value can be created without labor. Money was created to simplify the barter process and as a representation of real products. Creating money out of thin air does not create anything of value. All of these principles are clearly stated and elaborated in this book.

Buy this book. It will help you understand how we got into the mess we are in and how we can get out. Highly, highly recommended.

Very Informative Book that everyone needs to read.

If you'd like to understand more about economics and why and how we got to where we are, this is the book to read. There is an anti-capitalism campaign going on to make us think that the free market is evil. We've been sold the fantasy that we can have a permanent boom. Woods gives the truth about how our political leaders (both Democrats and Republicans and hailed by the mainstream media) have interfered in the economy with "more regulation, more government intervention, more spending, more money creation, and more debt" to "fix" the problem and why this hasn't worked and won't work.

No Empirical Basis for the Authors' Bizarre Claims

The thesis of this slim volume is that "The current crisis was caused not by the free market but by the government's intervention in the market'' (2) Author Thomas E. Woods argues that "Fannie Mae and Freddy Mac, government-sponsored enterprises (GSEs) that enjoy various government privileges alongside their special tax and regulatory breaks, were able to draw far more resources into the housing sector than would have been possible on the free market." (2) In addition, says Woods, "the greatest single government intervention in the economy, and the institution whose fingerprints are all over our current mess [is] America's central bank, the Federal Reserve System.'' (2-3) Woods holds that Federal Reserve monetary policy artificially fosters high-level economic activity by maintaining artificially low interest rates, thus encouraging unsustainable credit expansions, the long-run effects of which are financial bubbles such as that of 2007. Moreover, instead of reacting to the financial crisis by allowing the free market to restore a normal interest rate structure, the Obama administration bailed out the financial sector by further flooding the market with artificially-induced liquidity, thus ensuring the perpetration of the crisis. They took this tack, says Woods, because the administration is in the pay of the securities and investment industry: "Congressmen who voted in favor of the bailout when it appeared before the House on September 29 had received 54 percent more money in campaign contributions from banks and securities firms than had those who voted against it." (5)

Woods acknowledges that not only the political influence of the securities and investment industry, but also dominant macroeconomic monetary theory, is involved in the perpetration of government policies that make financial crises inevitable. By contrast, Woods holds that the Austrian School of economic thought, founded by Ludwig von Mises and Friedrich von Hayek and others in the late nineteenth and early twentieth century, correctly predicted the sad events of 2007: "perhaps 10 or 12 of the country's 15,000 professional economists saw the economic crisis coming... but hundreds of economists who belong to Mises' Austrian School of economic thought sure saw it... And the primary culprit, from their point of view, is the Federal Reserve." (8)

Woods' recommendations for preventing future distress situations in the financial sector include setting a policy of non-intervention ("Let them go bankrupt", p. 147), abolishing Fannie Mae, Freddy Mac and other government-sponsored enterprises in the housing market, ending government manipulation of the money supply and either abolishing the Federal Reserve or seriously restricting its latitude for regulatory intervention.

How are we to assess Thomas Woods' claims? First, Woods is completely disingenuous and entirely misleading in suggesting that "hundreds" of Austrian-school economists foresaw the events of 2007. The truth is that Austrian school economists have a theory that says that excessive state intervention in interest rate formation leads to financial crises and thence to economic downturns. But they did not predict this crisis. Moreover, there have been periodic financial crises in American economic history, and only a fool would predict that we have seen the last of them (although Federal Reserve chairman asserted that he was completely dumbfounded by the crisis of 2007, and hence must have believed that credit crises were consigned to the history books). In this sense, any reasonable economists would have said in 2006 that there will be a financial crisis at some time in the future---which is neither more nor less than what the Austrians might have said.

Second, Woods' implication of the GSEs in the subprime meltdown is seriously overdrawn. It is based on the notion that the government has implicitly guaranteed stockholders investments in the GSEs, putting them in a no-lose situation in which they can take great risks with subprime mortgages and reap the profits when things go well, but can offload their losses to the taxpayer when things go bad. However, Fannie Mae and Freddie Mac stockholders have been clobbered by the financial meltdown, and stock prices in these two institutions have fallen to near zero. Stockholders could not have plausibly expected that their stock values would be immune from steep decline.

Moreover, Federal regulations placed serious restraints on the ability of the GSEs to assume high-risk debt. Indeed, by definition these GSEs did not engage in subprime lending because their legal statutes prohibited them from issuing mortgages without substantial down payments and closely validated assurances concerning family income and wealth. Indeed, Fannie Mae and Freddie Mac began to recede from the forefront of mortgage lending when the housing bubble emerged in the years after 2003. Fannie Mae and Freddie Mac executives panicked when their positions in mortgage markets began to deteriorate, and they introduce questionably legal procedures ("expanded approval" for Fannie Mae and "A minus" for Freddie Mac) to recapture market share. But these efforts were basically unsuccessful because the GSE lenders were saddled with fixed-rate loan structures. The share of GSEs in the mortgage market faded rapidly in the latter years of the housing bubble.

Third, there is absolutely no empirical evidence suggesting that Woods' policy alternatives might work. There is considerable debate concerning the nature of credit crunches and the Austrian school story is perhaps in the running in explaining them (most economists think the Austrian explanation is bizarre and wrong-headed---Paul Krugman once compared it to the phlogiston theory in chemistry), but there is no support for the notion that an advanced capitalist economy would do better adhering to the gold standard and foregoing active monetary intervention. Moreover, there is widespread opinion among monetary economists, based on a century of experience in financial regulation, that an economic downturn is always a period of excess demand for liquidity, that the financial sector cannot supply such liquidity in a downturn, so the best monetary policy is to flood the economy with liquidity, to whatever degree is required to satisfy the demands of industry. This of course flies in the face of the Austrian theory that it is an excess of liquidity that leads to the downturn, but I believe the historical experience supports the conventional wisdom over the Austrian school.

The Austrian school has had many years to provide the evidence in favor of its model of the free market economy, and it has failed abjectly to do so. The Austrian school founders were notorious for their contempt for empirical evidence, claiming that economic principles are praxeological--self-evident and purely logical in principle, but subjective and highly complex in the human individual, and hence inaccessible to empirical analysis. This argument has little merit, in my estimation---I spend a good part of my time gathering and analyzing evidence concerning human (and other animal) behavior so as to better understand social dynamics and the realm of the possible in social policy. What the Austrians consider logical appears to the rest of the world (and most assuredly to myself) as the ponderous prejudices of free-market fundamentalists for whom science based on evidence is replaced by faith based on wishful thinking.

The lack of evidence for the Austrian theory does not mean that it is wrong. There is little evidence in favor of any of the competing macroeconomic theories (Keynesian and rational expectations schools being the most prominent). Indeed, to my mind these are not theories at all, but rather toy models so severely stripped-down from the complex reality of a market system as to bear no relationship whatever to the reality they purport to model. Of course, traditional macroeconomists do care intensely about empirically verifying their models, but they all are very poor predictors, rarely doing any better than simple extrapolations from the recent past.

The fact is that the evidence does not support any of the alternative macro models out there, which is why the Austrian policy prescriptions could possibly work. The fact is that they have never been tried. All modern economies use fiat money, have extensive financial controls, and intervene regularly in the operation of the market system. I prefer the standard approaches to monetary policy because they have worked in the past, and only a near-fanatical belief system, such as that cherished by the Austrian school, could believe that a free-market system without government intervention might work in the future.

I am often asked why macroeconomic theory is in such an awful state. The answer is simple. The basic model of the market economy was laid out by Leon Walras in the 1870's, and its equilibrium properties were well established by the mid-1960's. However, no one has succeeded in establishing its dynamical properties out of equilibrium. But macroeconomic theory is about dynamics, not equilibrium, and hence macroeconomics has managed to subsist only by ignoring general equilibrium in favor of toy models with a few actors and a couple of goods. Macroeconomics exists today because we desperately need macro models for policy purposes, so we invent toy models with zero predictive value that allow us to tell reasonable policy stories, the cogency of which are based on historical experience, not theory.

I think it likely that macroeconomics will not become scientifically presentable until we realize that a market economy is a complex dynamic nonlinear system, and we start to use the techniques of complexity analysis to model it. I present my arguments in Herbert Gintis, "The Dynamics of General Equilibrium", Economic Journal 117 (2007):1289-1309.

Economic Evangelism

Meltdown, written by Thomas Woods Jr., examines the popular topic of what caused the latest recession and describes how government's intervention and political agenda were to blame. This book, however, uses simplistic applications of Austrian School of Economic thought to explain complex processes that involve the irrational economic decision maker, the human being.

The first part of the book does a good job of describing the housing policies that were a weakness in developing a strong economy. The usual culprits of government sponsored enterprises (GSE's) are listed as causes of the recession. It misses, however, international forces and private sector mismanagement in the pursuit of profits that also caused the recession. Fannie Mae and Freddie Mac, and the Community Reinvestment Act no doubt contributed to the housing bubble. What is ignored is the 2 trillion dollars of Chinese foreign investment that ham strung any effort to raise interest rates during the making of the housing bubble. Also ignored are the rating agency's poor risk evaluations in the pursuit of profit by turning BBB- ratings into AAA ratings.

Meltdown then describes the problem of moral hazard and the financial assistance the government provided to save the corrupted system. One of the topics that is particularly amusing in light of the recent Goldman Sachs charges is Wood's description of short-selling as being unpatriotic. I thought that short selling is a legitimate investment strategy and still do. In the Goldman Sachs case, I find this to be another example of the private sector justifying better government regulation of financial services. A registry like the DOW would require greater transparency and would have disclosed Goldman Sachs' efforts to design a fund that was destined to fail.

According to this book, current economic growth and recessions are caused by the central bank's action in the economy. In the chapter on "How Government Causes the Boom-Bust Business Cycle", Wood's describes the low interest rate period in this century's first decade as the work of the federal reserve, ignoring any international influences. The federal reserve's objective is to maximize growth while managing inflation. This chapter ignores the fact that there was little inflationary pressure during this period so the fed should not have raised interest rates. Raising interest rates would undermine confidence and could have caused a recession.

The next chapter of the book examines how government made the Great Depression worse instead of mitigating it. I have no argument about the policies of FDR that prolonged the Depression. Fortunately the world has a central banker in the US who is familiar with this subject and has acted on the lessons learnt from this period in history. Bernanke has supported credit markets so consumer confidence can continue at levels that will mitigate the economic damage that unregulated financial markets have created.

Wood's takes the reader into the history of money in his next chapter and discusses government manipulation of money and the negative consequences. He doesn't discuss the positive consequences learnt from history. Part of this discussion examines inflation and the theory of cost-push inflation. The criticism is that if gasoline increases in price then people will have less to spend on other goods and therefore there is offsetting deflation in other goods due to higher prices for necessity goods. There are two problems with this. 1) Petroleum is used in so many other goods that their price would also increase and 2) Workers will demand higher wages to meet higher costs of goods and this will cause prices to increase while fixed income citizens will have their incomes eroded.

In conclusion I think this book is a vehicle for a "point of view" rather than an unbiased explanation of the causes of the recession. If you hold a libertarian view on how society should be organized then you will like this book. If you are looking for a balanced view on what caused the recession, educate yourself on some basic economics or read the Big Short.

Mark.

Insights from one of the handful of ecomomists who clearly foresaw the financial collapse

Insights from one of the few ecomomists who clearly saw the financial collapse coming - and wrote extensively about the real estate bubble in plenty of time to save your own investments.

What a pity that so many readers failed to read Tom Woods' earier books and numerous articles posted on Austrian economics websites. Such as [...].