Tuesday, 9 February 2010

The Big Myth: Capitalism Caused the Crisis (University paper)

Economists and media from the mainstream have given the average person the belief that it was lack of regulation and laissez-faire capitalism that caused the financial crisis in the United States. Some other reasons have been cited too, but all have been within this major idea that the state failed to keep the financial institutions in check. It is interesting to note that people tend to ignore the government as a possible source of the problem. There are voices who condemn it, but not in the sense that government caused the crisis, rather that it failed to prevent it. On the other hand, economists from the Austrian School have put the blame on the state. They say that the reasons cited in the mainstream media are either honestly mistaken, or intentionally perverted. Knowing that the status of economy is essential to the well-being of humans, it is important to reveal the true causes of the economic crisis. My aim in this research paper is to look directly at the claim that capitalism caused the crisis and observe whether the United States is a capitalist country in the first place. Secondly, I want to present the causes of the crisis from the perspective of Austrian School and share it with you in a simplified manner.

Is America a Capitalist Country?

Contrary to popular belief, the United Stated ceased being a capitalist union in 1913 when the Federal Reserve (America’s third central bank) was enacted. Planned by a group of influential bankers, the Federal Reserve was granted the monetary control over the economy. In a capitalist society, money emerges from the free market as the involved individuals are free to choose their desired medium of exchange (Rothbard, 1990, p. 18-19). Instead, the creation of the Federal Reserve and the enactment of legal tender laws took that power away from the people and forced them to accept and deal with Federal Reserve-issued notes. Crony politicians who served special interests saw this as a new opportunity to expropriate wealth. Those who favored war used inflation to pay for it as they couldn’t impose higher taxes on the population (J.P. Koning, 2009). They paid the costs by simply printing more money at the expense of the purchasing power of the dollar.

When Franklin D. Roosevelt installed the New Deal, the U.S. steered progressively towards more collectivism and regulation with wage controls and subsidies for specific groups. This not only discredited the U.S. as a capitalist nation, it assigned them the very socialist attributes of big government interference in the economy.

The core of capitalism is classical liberalism, and within that, free trade. Emerging from the old mercantilist ideas, the U.S. never abandoned protectionism and even today imposes tariffs and quotas that impede the free movement of goods and therefore reduce their quality and diversity as well as increase prices.

Due to military engagements in different conflicts around the world, the U.S. government embarked on record-breaking spending with debt that spans from one generation to another. Government’s only sources of funding are taxes, borrowing or inflation. Taxes are politically hard to be levied each time the budget runs a deficit, therefore borrowing and inflation are the most desired tools. History shows that whenever the government engages in wars, it also borrows and inflates a lot to pay for its costs. Debt burdens the economy, while inflation destroys the purchasing power of the currency. It shows, therefore, that government’s political actions have considerable influence in the domestic economy. In capitalism, expanding wars and deficit spending at the current scale (that of U.S.) is simply impossible due to the restraints on the part of the free-market monetary system.

Even though in its original creation as well as its global image the U.S. may be considered a capitalist country, today at the time of the crisis, it clearly isn’t. Capitalism in the U.S. may exist as an ideology, but what is practiced is not capitalism. It’s rather a European-styled social-democracy characterized by bureaucratic decision-making on the part of individuals. Therefore, we can conclude that attributing the economic failure to capitalism is wrong, because C can’t cause B if C doesn’t exist there at all.

Explaining the Crisis

Austrian School economists, who are the prime defenders of capitalism, have therefore stated that U.S. is not a capitalist country. Then, one may ask, what are the causes of the crisis? With the combination of my personal knowledge and the research that I have conducted, I have narrowed down three major problems. They are the centrally-planned monetary system, the fractional-reserve banking system, and the role of state-sponsored housing agencies Fannie Mae and Freddie Mac. The crisis is a complex situation, but I believe that it was the dysfunction in these three areas that aggravated the meltdown.

The Centrally-planned Monetary System

Like other countries, United States too has a centralized monetary system. The Congress “oversees” the almost independent Federal Reserve system (known as “the Fed”) in its quest for “stability of prices and maximum employment.” Macroeconomists within the Fed, usually adherents of Keynesianism, come from an economic background that says that providing the economy with more credit leads to prosperity – regardless whether it is achieved through genuine savings or newly-printed money out of thin air. In addition, monetarists such as Milton Friedman have suggested that the Fed keeps a fixed money-growth rate, ranging between 3-5%. This means that the money supply should increase annually to “accommodate the need” for more liquidity, in order for economic activity to take place more comfortably. But does the injection of new money help smooth the economic activity? According to Austrians, not only it doesn’t, it is counter-productive.

Money does not constitute wealth in itself; money is simply a medium of exchange, facilitating the trade of already existing real goods and services (Mises, 1949, p. 398). Just because there is new money in circulation, it doesn’t mean that there are new goods available too. Goods have to be produced in order to be consumed, while money can’t be consumed. It can only be exchanged for other consumable goods in the future. When new money is created out of thin air, a process known as the “counterfeiting process” takes place (Shostak, 2008). That is, the receivers of new money have the means to exchange nothing (worthless paper notes) for something (actual consumable goods). The new money in their hands does not add to the pool of goods in the economy, it simply redistributes the existing number of goods from real wealth generators to them. While the first receivers benefit because they can buy at existing prices – and these are usually the big financial institutions – other people suffer the consequences of increasing prices or lower purchasing power due to the increase in money supply (inflation). Because the new money is meant to be lent to commercial banks as a loan, the action of printing new money can also be called an expansion of credit. The real problem with easy credit, however, is that it decreases the interest rate, which is an indicator of time preference, which in turn is an indicator of people’s preferences concerning saving vs. consumption (Hoppe, 1994). A higher time preference means people are interested in having their goods available for consumption now, rather than save for an investment in the future (Mises, 1949, p. 483-486). When time preference is high, and therefore the demand for money is high, the interest rate (the cost of acquiring additional credit) is also high. Therefore, a high interest in a free market is an indicator of people’s increased consumption. Inversely, a low interest rate is an indicator that people are saving and that there will be sufficient demand for products or services that are offered in the future (Mises, 1949, p. 458-459). Observing the importance of interest rate, you may notice that this indicator is crucial to businesspeople when they make their investment decisions. And this is true, the interest rate along with prices are the most important signals that entrepreneurs keep in mind while going about their daily business activity. Common sense tells us that entrepreneurs will not make long-term investments if people are consuming now (and the interest rate is high), because it means that people haven’t saved enough to consume entrepreneurs’ products in the future. Inversely, again, if the interest rate is low, this serves as an indication that people are saving and that long-term investments are justified.

When the Fed wants to inject their newly-printed money into the economy, they lower their own interest rates (rates at which commercial banks borrow from them overnight). Commercial banks in turn, as a result of acquiring new “cheap” credit from the central bank, lower their own interest rates too because this appears as a good business opportunity for them. This act is known as the aggressive lowering of interest in the market by the Fed.

What happens when Fed aggressively lowers the interest rates? They send the wrong signals to producers. Remember, the interest rate is people’s balance between consumption (now) and saving (future). But because the changes in interest rate haven’t occurred independently, that is by allowing consumers to expose their preferences themselves, the new interest rate is not a true reflection of people’s consumption or saving for that matter. In this sense, the Fed has fooled the producers. Their indicator of savings is now misleading, because it doesn’t reflect the true preferences of individuals. Entrepreneurs have been misled into thinking that savings by individuals are taking place when exactly the opposite may have happened. In the U.S., for example, the rate of consumption prior and even after the recession was one of the biggest in the world, while savings were at a record low. This is exactly where the problems begin.

Entrepreneurs, thinking that there is genuine demand for their investments, start building new projects. They usually take place in the long-term industry, the profit of which needs years to emerge. They can be anything, ranging from simple services to those of housing and cars, as was evident in the U.S. These are artificial economic activities that spring up on the back of an aggressive lowering of interest rates and a sudden availability of cheap credit (Shostak, 2003). They are simply bad investments, or malinvestments, without a future profit. There is no sustainable demand for them, people haven’t saved for them, entrepreneurs have misallocated their resources. If they knew the real free-market interest rate, these malinvestments wouldn’t have taken place massively (Mises, 1949, p. 571-573; F.A. Hayek, 1931, p. 9-23). This is otherwise known as a bubble – the emergence of false economic activity under the artificial stimulation of new cheap credit. Bubbles are times of happiness, because prices are inflated and there is a sense of prosperity all around as people feel richer. When the Fed lowered its interest rate in 2001 to 1% and kept it at that level until 2004, the housing market in the U.S. was booming. The problem with bubbles, however, is that they are short-lived, and that the price for them has to be paid sooner or later. The great Austrian scholar who first proposed this theory, Ludwig von Mises, claimed: “Credit expansion can bring about a temporary boom. But such a fictitious prosperity must end in a general depression of trade, a slump” (Mises, 1981, p. 21). The longer they are pushed to exist, the more bad investments will have taken place, and therefore the more severe will be the price of liquidating them. But why isn’t the bubble continued, so that prosperity can remain intact, one may ask? The reason for that is simple. Because bubbles can only emerge under inflationary circumstances, the continuous increase in the money supply poses an upward pressure on prices, which, if not stopped, can lead to hyperinflation (picture Zimbabwe). So the Fed, after a period of inflation, in order to avoid hyperinflation, stops the printing presses and increases the interest rate. What happens afterwards?

After the interest rate is increased, and there’s a sudden liquidity shock (the cheap credit isn’t flowing as investors are accustomed), these false activities come under enormous pressure (Shostak, 2007). All malinvestments made during the boom, those in the real estate industry for example, have a hard time existing because there is no genuine demand for them. Easy credit that kept these investors happy isn’t there anymore to offset this missing demand. Investors start to realize that their decision-making has been wrong and that their investment has been misled by the false interest rate. Take the financial institutions in the last recession, for example, who due to easy credit approved loans to borrowers who had a bad record of paying them back (sub-prime borrowers). As these bad-record borrowers began to default on their loans, these reckless institutions fell in a domino-effect style. This happened because credit had changed hands many times, meaning that many layers of individuals and financial institutions were involved with lending and borrowing along the same unsustainable lines of cheap credit. The bust set in the U.S. when the Fed increased the interest rate from 1% in 2004, to around 5%. As of now, over 120 banks have become insolvent and all other malinvestments will have to be liquidated in the face of reality which revealed no genuine demand for them. Accompanied with bankruptcies, the most hurtful side-effect is unemployment. Many people had to be laid off as businesses facing a slumping demand sought to cut costs. As prices fell and the values of houses plummeted, financial institutions were worse off as their collaterals were mortgage-backed securities. This liquidation process of bad investments is called a recession (or a depression if it is too severe). The bubble has popped – a bust is underway. The famous Austrian economist Joseph Schumpeter called recession a “cold douche” for the economy, because it serves as a wake-up call to the illusory prosperity that people perceive during artificial economic booms. Contrary to popular belief, recessions are necessary natural market processes that try to liquidate investments in the wrong lines, i.e. malinvestments (Mises, 1949, p. 556-559). A recession, therefore, is the natural tendency of the market to clear itself and bring things back to normalcy.

These fluctuations between bubbles and busts are known as business cycles, and the Austrian Business Cycle Theory (ABCT), though neglected, appears to me as the best explanation available. It is therefore Fed’s tampering with the interest rate and its loose monetary policy that leads investors into making bad investments which spur a sense of prosperity temporarily, but eventually have to be liquidated while causing a recession in the process.

The Fractional-Reserve Banking System

Centuries ago, coinage and money printing was done privately, not by any state-controlled institution like the central bank (Rothbard, 1990, p. 16-17). Because no legal tender laws existed to bar people from using whatever medium of exchange they wished, people opted for commodity money – gold or silver. Gold had been used in transactions for centuries as it was a naturally chosen medium of exchange. It didn’t come into usage through coercion but by its ability to store value so well. However, carrying gold and using it in everyday transactions is inconvenient, so people started thinking of ways to accommodate this problem. This is when the first banks emerged. The original service that these first banks provided was that of warehousing, the safe-keeping of gold. In addition, these banks provided the solution to the problem of carrying gold around – through gold certificates. People would deposit their gold in these banks, and have certificates issued on par with the amount of gold in deposit. The issued certificates were completely redeemable in gold, and because gold was money, so were the certificates (Rothbard, 1990, p. 24-28). Certificates were the first paper money, which we use today.

With the passage of time, however, bank owners saw a new source of wealth – that of counterfeiting. They realized that if they issued certificates with higher face value than there was gold in their deposits, they would have more money at their disposal. So instead of issuing a certificate of 10 ounces of gold which they had in possession, they counterfeited it into a 12-ounces certificate. This is when the first inflation started. However, because the entire monetary system was privatized – it was on the hands of competing individuals – the free market worked its way into bankrupting banks that engaged in these practices. The newly counterfeited certificates increased the supply of money, so the prices of goods went up dramatically. As more banks engaged in this practice, price fluctuations became even more severe. People soon realized something was wrong. Fearing for their wealth, they again searched for salvation in the preciousness of gold. They used their right and power to redeem their certificates back into gold. When this happened massively, banks that had issued more certificates than they actually had gold in their possession went bankrupt. Although people suffered when they found out they were less wealthy than they thought, the new banks never engaged in similar practices again because the rigorous free market kept a close eye on them (Rothbard, 1990, p. 33).

This system of banking went on for centuries, before it was finally seized by the archaic state – the king. Kings used taxes to fund their military campaigns as well as their lavish lifestyle. But because every time they levied higher taxes they faced the prospect of revolts from the population, they hated the need to acquire more funds in such a manner. Looking for other options to satisfy their exquisite demands, they turned to banks (Block, 1976, p. 104-105). They said that money was too important to be left to individuals, and that they should nationalize it and keep it under the control of the state (then absolute monarchy). After nationalizing the banks and stamping their images on the gold coins, they did exactly what bank owners once did. They inflated the currency, issuing more certificates than there was gold in their deposits (Block, 1976, p. 105-108). This is when fractional-reserve banking was legitimized.

Hand-in-hand with the centralized monetary system, fractional-reserve banking is another government-created loophole that causes problems within the economy. Henry Ford once famously said, “It is well that the people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning” (Brainy Quote, 2009). Today, all banking is fractional-reserve banking. This means that the two original services of banking, warehousing and loan intermediation, are now intertwined and used as one. Customers who deposit their money for warehousing purposes (security, ATM, online payments), have their deposits used for loans (without their knowledge or consent) and only a fraction of it kept in the bank. As the required-reserve ratio is usually around 10%, if one decides to deposit $100 in the bank, the bank will only be obliged to keep $10 and is free to lend out the rest. When a bank decides to give the excessive $90 as a loan to, say another bank, it is assigning them a claim for money that is not theirs. When the depositor returns to demand his money, the bank uses the money of other depositors to pay him back, exactly the same way that a pyramidal Ponzi scheme works. This is a problem in times of crisis however, because many people suspicious of the financial institutions go to collect their deposits en masse, causing bank runs. Faced with the severe need to pay back their clients with deposits, banks are desperate for borrowers to return their loans. Since in periods of crisis this not only doesn’t happen in time, it usually doesn’t happen at all, banks are left with no other option but to either borrow more money from somebody else or simply tell their customers they don’t have it. In this scenario, every bank is looking for a borrower to finance its debt, so no bank is available to lend to another. Either way, their bankruptcy is looming. Far worse, this problem is aggravated by what is known as the multiplier effect. Those excessive $90 used for loans, may have been loaned again, meaning $9 have been kept and the rest given out. If the required-reserve ratio is 10%, this process can generate up to 900 new dollars backed by only $100. Numerous claims to the same money that belongs to one person only are created, therefore holding not only the initial lender liable, but everybody else involved in the lending process (Rothbard, 2008, p. 94-104). In a cash-strapped economy nearing crisis, this has devastating effects. In fact, fractional-reserve banking is the brainchild of central banking. The Fed, also known as the “lender of the last resort” because it can print money whenever it wants to lend to these banks, is the only reason why fractional-reserve banking manages to stay alive. In a free market, as it happened during the middle ages when bank owners counterfeited the certificates, the modern fractional-reserve banking would have crumbled. Along with the loose monetary policies of the central bank, the fractional-reserve system is the prime inciter of business cycles and therefore one of the causes of the last financial crisis in the U.S.

The Role of Fannie Mae and Freddie Mac

When the U.S. government enacted the two federal housing agencies, Fannie Mae and later Freddie Mac, they wanted to realize the impossible promise of providing every American with a house. Because not everybody can own a house, the sustainability of these low-income people must require the expropriation of others. Fannie Mae aims to provide different financial institutions the available funds to lend to people who want to buy houses. Freddie Mac performs the same service, but in the secondary market of mortgages. They are quasi-private, both a stockholders’ corporation and a government-sponsored enterprise (GSE). Government sponsorship is offered in two ways: first by guaranteeing for their securities and then by regulatory exemptions that other private firms have to obey. Their securities are listed as government securities, so they appear less risky than they really are because their premiums are not a reflection of the market. “The financial markets have long believed that the GSEs would be bailed out no matter what. And so this put them in a completely different position from a company like Enron, which the markets watched closely” (Rockwell, 2008). In addition, Congress passed the Community Reinvestment Act in 1977, which pressures lending institutions to lend to low-income or “discriminated” groups

Now as a result of easy credit, the intensity of loans provided by these agencies grew. With rising prices, people started buying homes more for commercial than personal use. The conditions for granting these loans were extremely easy to fulfill, so thousands and thousands of people who had virtually no chance of paying back their loans were given funds. The only collateral required was (a house), that was not even properly valued. “Such assets […] were then packaged into opaque securities […] They were sold on to pension funds, banks, and others whose gullible investment managers also did not understand them and failed to carry out the rigorous analysis […]“ (Stewart, 2008). Government sponsorship encouraged this practice as it made it seem safe, both for the borrowers and investors who expected the government to bail out the housing agencies in case of trouble.

In socializing the cost, the U.S. government in no way offered “cheap” housing. It simply took away income from some people to provide (through these housing agencies) to others who couldn’t afford homes. Not only did this lead to the expropriation of the tax payer, it also caused this excessive lending and artificially booming prices in the housing market, which was already heavily regulated and subsidized. Because these are government sponsored entities, they are outside the reach of the regulating force of the free market. Whenever they engage in risky practices, they are supplemented by additional taxes rather than being subject to bankruptcy. In the recent crisis, however, their weakness was exposed as well. The monopoly of the housing agencies destroys the competition in the market and keeps prices artificially high. It also encourages reckless lending on the back of an “inflationary promise” (I’ll support you because I can always print money). If these agencies were abolished and the free market was left to clear, many more people would be able to afford houses.


Instead of accepting the tone of mainstream media, maybe people should try harder to understand the real causes of the crisis because it affects them personally. Basic knowledge in economics is useful, and with the material provided to date, it can be attained quickly. One should understand that standing aside and watching the government deal with the crisis is not going to help because the solution provided by them is more of the same problem. The monetary system is very important for the economy and so far government’s control of it hasn’t offered us the stability that it promised. Furthermore, politicians are always keen to use the legitimacy of the state in exercising coercive forces to bend it for their own interests. This means that not only can the government go wrong, it can go wrong intentionally. The United States was built on the principle of freedom, individualism, self-responsibility and voluntary contracts. These principles made it great to the extent that even after the state surpassed its limits laid out by the Constitution, the American Dream never died. Maybe it’s time for people to start looking for solutions with the government out of the picture, and the individual at the forefront of liberty.


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