Economics Financial Crisis History The Opinionsphere

Theories of the Financial Crisis: The Government Did It!


The first person out of the box promoting the idea that the current financial crisis was actually caused by the government (specifically Democrats in the government – and even more specifically Barack Obama) was Rush Limbaugh. On the day Lehman fell (this crisis’s equivalent of September 11), Rush Limbaugh was already trying to exploit it for partisan gain – claiming “Capitalism Isn’t the Problem: Government Caused This Crisis.” On this date of crisis, Limbaugh had already unveiled in a near-complete form what was to become the Republican party’s position on the crisis. He embraced positions that had previously been associated with the Austrian School of Economics – but without much of the ideological baggage they had with them. He only embraced as much of them as was politically convenient – and he applied them only so far as they made Democrats look bad. He also began blaming Barney Frank for this crisis – something which many other right-wingers picked up on. Though I for one find it hard to see how this person who was a member of a Congressional minority had so much power to influence the entire economy and cause this severe crisis and the causal chain has never been made clear. At least to me.

Within a few days of the near-collapse of the financial system – with the crisis still causing panic – Limbaugh was already trying out names he could use to brand the crisis – from the “Democrat-Caused Financial Crisis” to the “Obama Recession.” None of them quite caught on as most people with common sense found it hard to blame Barack Obama for a crisis that occurred before he had won the presidency. But the right faithfully repeated this meme. (It has often seemed to me that Rush Limbaugh – with his vast influence via memes and love of pranks – is a forerunner of and competitor to 4chan.)

I need to say two things going into this: (1) for my analysis, I am merely standing on the shoulders of economists more knowledgeable than I – when it comes to economics especially, I am – clearly – just an interested amateur; and (2) I came to this issue biased against this theory of the financial crisis – although not with my mind closed to it. The best expression of why I started out biased against this idea is probably the analogy Tyler Cowen used while debunking it. Cowen invoked the legal principle of the “thin skull” – in which someone at fault is considered responsible for all the damage caused by their actions, even if a person without a thin skull would not have been seriously hurt by such damages. For example, if you were responsible for a car accident and the other party was injured seriously as they had a thin skull which was damaged much more than a normal skull when it banged into the side window, you would be responsible for even the extraordinary damages resulting from that individual’s medical condition. Cowen explains that those seeking to blame the government for the business cycle and/or the current economic crisis:

…are postulating a very thin skull for markets and then blaming government for the disaster which results from government’s glancing blow to that skull.

A surprising amount of the debate over what caused the current crisis centers around the causes of and solutions to the Great Depression. The reason for this is not because there is widespread disagreement about this among historians or economists – but because the Republican party has embraced recent revisionist histories to make their case against the current intervention. The traditional understanding – between Keynesian and members of the Chicago School is that the Great Depression was made worse by the application of variations of this “thin skull” theory – as Herbert Hoover heeded advice to do little or nothing to combat the financial crisis – preferring to allow the market to fix itself. As Paul Krugman describes (from a 1998 Slate column):

The hangover theory can do real harm. Liquidationist views played an important role in the spread of the Great Depression—with Austrian theorists such as Friedrich von Hayek and Joseph Schumpeter strenuously arguing, in the very depths of that depression, against any attempt to restore “sham” prosperity by expanding credit and the money supply.

But Amity Shlaes authored a recent history of the Great Depression to dispute this traditional understanding which had made her a hero of Republicans everywhere who have begun to cite her book more often than the Bible – almost. Shlaes passes herself off as an intellectual, but seems to be as partisan as Paul Krugman on his worst days. And her understanding of economics is quite shallow compared to the Nobel prize winner’s. Jonathan Chait in The New Republic took on Shlaes book – pointing out the holes in Shlaes revisions – how she attempted to blame liberalism for causing the crisis despite the fact that liberals had been out of power for the eight years before the depression started – and for the first three years after. She manages to pull this off by claiming that Herbert Hoover was a secret liberal interventionist – and blames Hoover’s meager attempts to stop starvation for undermining the recovery that her ideology maintains was imminent. Shlaes also fails to account for how we finally got out. As Chait explains:

[T]he classic right-wing critique fails to explain how the economy recovered at all. In one of his columns touting Shlaes, George Will observed that “the war, not the New Deal, defeated the Depression.” Why, though, did the war defeat the Depression? Because it entailed a massive expansion of government spending. The Republicans who have been endlessly making the anti-stimulus case seem not to realize that, if you believe that the war ended the Depression, then you are a Keynesian.

James Glassman’s influential arguments (in some circles) against any stimulus plan seem to have been inspired mainly by Shlaes’s flawed history.

Today’s crisis appeared at first glance (to most economists and us less enlightened citizens) to have been caused not by government interference but by private bankers controlling vast sums of money taking dumb risks with little government oversight. In time, other factors have come to the forefront, but this basic explanation seems right. Yet right-wingers and the Republican party continue to insist that government intervention was the cause – often out of what they see as a political necessity.

But on the other hand, there are some who seem to have less of a partisan interest in blaming the government for this crisis – and have embraced the Austrian School of Economics out of conviction rather than temporary partisan gain. Ron Paul, for example, blames both Democrats and Republicans for causing this mess. He seems to accept this “thin skull” logic and he has become an influential proponent of the Austrian school of economic thought. This school had its heyday in the 1920s as a result of Hayek, Mises, and others grappling with the issues of that time and perhaps most importantly discovering the business cycle. But this theory was largely abandoned as many saw it as responsible for worsening the Great Depression – as during the first years of the crisis, portions of the Austrian School’s prescriptions were tried. The theory was largely developed before the invention of central banks and while currency was still on the gold standard – but it had important insights in its time. Contemporary proponents such as Ron Paul tend to blame the changes to the financial system created to manage the boom-and-bust business cycle for causing the boom-and-bust business cycle. Yet this cycle has been part of capitalism since it’s inception – and has been managed since Great Depression by central banks and others using Keynesian theory and its successors relatively successfully. 

The appeal of this Austrian School of though though – aside from the partisan appeal for Republicans who are allowed to blame everything on liberals – is a moral one. It functions as a kind of religion-like palliative, telling a comforting story of sin and redemption. The Austrian business cycle tells of a recurring morality tale in which virtue is corrupted, until the sin of easy credit leads to the fall of the system. Then, the Market cleanses the world and virtue is restored to it’s proper place. The proper role of the economist in this is to act as a kind of priest – urging the people to stay true to this belief system in the face of adversity – to keep their faith that eventually the god of the Market will make everything better.

This fits well with the religious right of the Republican party – and perhaps this is why despite the theory’s rejection by most mainstream economists as outdated, it is gaining adherents among the Republican party, including the “rising star” Michelle Bachman.

[Image licensed under Creative Commons courtesy of elandru.]

9 replies on “Theories of the Financial Crisis: The Government Did It!”

[…] Even in the most traditional analysis, bankers got into this crisis largely because they were able to escape regulation. They created shadow banks, derivative products, and other complex financial instruments which were designed to evade any regulations in place. George Will and others will likely point to government-backed organizations like Fannie Mae and Freddie Mac as key causes in inflating the housing bubble – but it is difficult to actually make this case – as these institutions, for their size, weren’t that involved in the subprime mortgage market – and in fact were pushed to become involved by the enormous profits being made by the banks. What Will doesn’t want to acknowledge was that even in this most traditional analysis, the root of the problem is the misalignment of incentives rather than government distortions of the market. […]

Since the essayist above seems not to be an expert in economic theory (self admitted) and neither am I, I believe that we are on equal footing intellectually concerning economics. Unfortunately I completely disagree with almost every one of the authors conclusions and question most of his “facts” (although i do like his attack on Rush Limbaugh). I will leave to my betters the debunking of Paul Krugman (also see his 2001 column specifically calling for a bubble in housing and many of his other absurd statements here- But the one part of the essay i really wish to address is the following “Herbert Hoover heeded advice to do little or nothing to combat the financial crisis – preferring to allow the market to fix itself.” A more untrue statement has never been uttered. While this might be the common understanding, it is far from the truth. Let us just list the programs hoover initiated to combat the beginnings of the depression

“the Smoot-Hawley tarriff (hardly a free market proposition), Norris- Laguardia act, the reconstruction finance corporation (FRC), Federal Home Loan bank act, the Revenue act of 1932, direct loans in the amount of 300 million to states, his numerous public works programs (ex. The Hoover Dam!), etc.”

I thought that this myth was long gone, but i guess i was wrong. Even in Hoovers own words we see that he was an interventionist at heart. In his 1931 state of the Union, this is what he said:

“Many undertakings have been organized and forwarded during the past year to meet the new and changing emergencies which have constantly confronted us . . . to cushion the violence of liquidation in industry and commerce, thus giving time for orderly readjustment of costs, inventories, and credits without panic and widespread bankruptcies.”

Later in his life, Rexford Tugwell (part of Roosevelts “brain trust”) even admitted that “practically the whole New Deal was extrapolated from programs that Hoover started.”

So i do not believe that anyone can actually say that Hoover was a “do nothing” president. In fact most people rightly believe that he cause the panic of 1929 to become the great depression, but it was not through his inaction, but conversely to his intervention. Hence the reason why it continued to even greater depths under roosevelt.

Continuing in my theme of exposing the fallaciousness of this article, the simile that the author drew to austrian economics to a religion is beyond comprehension. Using the authors mendacity i can draw the same simile to liberals or neo-conservatives to the state or military respectively. “It functions as a kind of religion-like palliative, telling a comforting story of sin and redemption. ‘All we need is a savior in our president to take on the evil banks and redeem us all with the new holy scripture, the US Code.'” See how ridiculous that is.

If one actually sits down and thinks about the austrian business cycle theory, one might actually see how logical it really is. Again, i am no expert and i could be getting one or two things wrong but to my understanding the ABCT states the following:

Easy credit flows into the system through EITHER fractional-reserve banking or through the Federal Reserve (central bank) OR both. (hence why we had disruptions before the creation of the central bank with franctional reserves and the national banking system, pre 1917). This leads to a mal-investment by entrepreneurs who believe that this money is a real signal that people want to spend their money as opposed to saving, not a false one set into motion by the whim of either bankers or the head of the central bank. When it is finally realized that this false credit expansion (inflation), was not based on real reserves (savings) the crash happens.

In other words the printing of money cannot cause prosperity. Money was supposed to represent real, tangible goods (a marker for them to use a poker reference). When the amount of money (paper markers, aka federal reserve notes), represents more goods than what is actually there, there is a problem. The amount of resources available cannot meet the tickets given to represent them. Projects that should never have been started (like the thousands of homes in Las Vegas) cannot be finished (or sold at the price perceived) and assets must be liquidated in order to clear out all of the bad investments. People think about money not in terms of tangible goods, but in terms of numbers. This view should be changed.

And just to comment on the above belief that bankers caused this crisis because of lack of oversight. I agree that bankers and their defenders did cause this crisis, but it wasnt due to lack of regulation. The amount of regulations for the banking industry rivals only those of the medical profession and fills at least two 1,000 page volumes of code. Banks could not leverage themselves that much without two things. 1) The easy money/credit given to them from the central bank, and 2) A lender of last resort that would pull them out of the whole they dug themselves. The fed is to blame for this particular crisis (as it was to blame for the great depression, as most modern economist agree – they just disagree as to how they failed), as it left interest rates too low for too long (as even Tim Geitner has gone on to say). More regulation are not the cure. Banks will always find a way around them and lord knows they have the power to make congress change particulars to fit their needs. No, the solution lies in taking away their printing press and hold them to 100% reserves (aka take away legalized fraud and make banks function like any other business on earth). Until then we will always see booms and busts.

Lastly i just want to say that the belief that WWII got us out of the depression is also wrong. I will post just two quotes to defend my statement…

“War can really cause no economic boom, at least not directly, since an increase in wealth never does result from destruction of goods.”

“War prosperity is like the prosperity that an earthquake or a plague brings.”

The problem with the Thin Skull idea is that prices are the key to the market functioning properly. As Ludwig von Mises showed in the socialist calculation debate and communist countries everywhere showed in practice. If you distort the money supply you distort prices. This causes massive economic problems. Similarly we all know price controls cause surpluses or shortages – so if there are price controls on money and interest rates we should also expect surpluses and shortages. 2 2 = 4 regardless of whether we’re adding apples, oranges or dollars.

By analogy let’s say you put competent pilots in a plane and ask them to fly across country in a jumbo jet. However as they’re flying the windshield gets foggy, and the instruments go haywire. The plane will probably crash, but it may not if the pilots are lucky. Is the plane’s fragile nature to blame? Or it is the lack of visibility? Now if the government mandated they use windshields that get foggy and instruments that go haywire isn’t the government to blame?

Prices are what give visibility and allow different actors on the market place to coordinate. If people are flying blind that isn’t the markets fault. In fact all the crazy stuff that went on was the market attempting to deal as best it could with a huge increase in the money supply. Sure they ‘failed’ but in the same way the the free market failed to defend hirishima from an a-bomb. The market was able to re-build the city once the government intervention in the form of WWII ended.

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