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October 21, 2008

Trying to Get Something for Nothing
by Steve Saville

Below is an extract from a commentary originally posted at www.speculative-investor.com on 16th October, 2008.

As if Paul Krugman winning the Nobel Prize in economics isn't reason enough for us to be less-than-sanguine about the future, everywhere we look we see well-respected analysts advocating increased government regulation and spending -- effectively the same policies that transformed a financial crisis into a drawn-out depression during the 1930s -- while completely ignoring the root of today's problems.

The current predicament was not caused by insufficient government regulation and the risk of future disruptions will not be mitigated by increased government regulation. The mortgage market was already heavily regulated prior to the crisis, but had it been even more regulated and had the regulations severely crimped, rather than boosted, the abilities and desires of financial corporations to expand the supply of mortgage-related instruments, then the focal point of the boom would have shifted; however, bubbles would still have formed somewhere and these bubbles would subsequently have burst, leaving financial wreckage and major economic dislocations in their wake (the bust is always and everywhere a consequence of the preceding boom). The reason is that the boom was caused by the central bank fixing the price of short-term credit at an artificially low level for a prolonged period, thus encouraging trillions of dollars of investments and new business ventures that should never have seen the light of day. In effect, the central bank created an environment in which prudent lending practices were punished and reckless lending practices were rewarded.

With the central bank making it very cheap and easy for financial corporations to expand the supply of money and credit, investing/lending bubbles became inevitable. The only real question was: where will the bubbles form? That one of the biggest bubbles formed in the housing market set the scene for a more disastrous outcome because so few people ever view rising property prices as evidence of an inflation PROBLEM. Instead, a powerful upward trend in property prices is invariably viewed by the masses and by the monetary authorities as a sign of increasing real wealth. As a result, policy-makers will tend to let investment booms in the property market get further out of hand than, say, investment booms in the commodity market. This, in turn, is one of many reasons why the price of credit should not be set by a central planning agency.

Now that the investment boom has gone bust and the necessary adjustment process has begun, we are being told incessantly that the solution to the problems caused by massive increases in the supplies of money and credit is additional massive increases in the supplies of money and credit. And given that the private banking industry is no longer capable of driving the monetary expansion, we are being told that the central bank and the government must become even more involved.

The latest in a long line of policy moves designed to curtail the necessary adjustment process is the government's plan to provide capital directly to the banks. It seems that almost everyone is in favour of this idea, which suggests, to us, that few people appreciate the basic economic truth that the government has no capital. Any capital provided by the government to the banks will first have to be extracted from other parts of the economy via taxation or inflation or borrowing. In other words, the government's provision of additional capital to sick businesses can only happen at the expense of the more healthy parts of the economy.

Whether the advocates of increased government spending and the various other re-inflation policies realise it or not, at the root of their proposed 'solutions' to the crisis is the idea that it is possible to get something for nothing. It is axiomatic that an increase in production must precede a sustained increase in consumption; that saving is the basis of long-term economic growth; that no individual can become rich by spending more than he earns; and that no country can become wealthy, or recover from a recession, by consuming more than it produces. And yet, most commentators have deluded themselves into believing that you can get around the problem of inadequate real savings by simply increasing the supply of the medium of exchange, and that you can bypass the need for increased consumption to be funded by increased production by simply getting the government to spend like a drunken sailor.

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Steve Saville
Hong Kong

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