Wednesday, 7 November 2012

Government's Monetary and Fiscal Policies are the Main Source of Economic and Financial Instability

In 1999 Mark Skousen wrote the following article (quoted in full) titled Are Financial Markets Inherently Unstable? in The Freeman journal (p 53),
"There is an urgent need to recognize that financial markets, far from trending towards equilibrium, are inherently unstable." -GEORGE SOROS
In the aftermath of the collapse of emerging economies in Asia, eastern Europe, and Latin America, many prominent economists and speculators, from Paul Krugman to George Soros, have called for government intervention in financial markets. Recommended policies include monetary inflation and currency controls. The foundation of such state interference is the belief that free markets in general, and financial markets in particular, are inherently unstable and require strict government regulation. The fathers of this thesis are the British economist John Maynard Keynes and his principal heir, Hyman ~ Minsky, who devised a "financial instability hypothesis." Minsky, a Harvard-taught economist, wrote many books and articles during his academic career of nearly 50 years, most of which he spent at Washington University in St. Louis. He died in 1996. According to Minsky, Keynes's general theory of the economy was really a financial theory of uncertainty and expectations. According to this thesis, the capitalist economy is primarily ruled by Wall Street, which is fundamentally fragile and destabilizing owing to excessive debt, lax government rules, and businessmen's "animal spirits" and "waves of irrational psychology." (Conservative economist Allan H. Meltzer of Carnegie Mellon University makes the same point.2). In the Keynes-Minsky model, full employment in an unregulated market economy is not a natural equilibrium point, but a transitory moment in a business cycle. Euphoric expectations lead to an overleveraged condition where the rate of credit expansion exceeds the rate of profit in the economy. Eventually, the boom turns into a debt deflation and depression.
 
Long-Run Damage by Government Intervention
To stabilize the business cycle, Keynesians favor big-government capitalism where central banks and the International Monetary Fund play major roles as lenders of last resort. Keynes advocated the "socialization of investment" and taxes on short-term trading. However, Minsky rightly pointed out that interventionist policies validate the existing fragile financial structure and allow the problems to deepen. He warned that "Once borrowers and lenders recognize that the downside instability of profits has decreased there will be an increase in the willingness and ability of business and bankers to debt finance." Larger and more frequent interventions become necessary to fend off debt deflations and recessions. Minsky correctly criticized neo-classical economics for largely minimizing the impact that financial markets can have on economies: "The neo-classical synthesis became the economics of capitalism without capitalists, capital assets, and financial markets." My only problem with Minsky is that he mistakenly blames the market itself for its instability.

Mises's Non-Neutrality Thesis
To understand the root cause of financial and economic instability, we need to go back to Ludwig von Mises's "non-neutrality" thesis in his breakthrough work The Theory of Money and Credit. Mises pointed out that monetary intervention (easy money policies and artificial lowering of interest rates) is the principal source of uncertainty, false expectations, and excessive debt-leverage in the economy and on Wall Street. Under a stable monetary system, a laissez-faire economy would suffer occasional financial mishaps, bankruptcies, and down-days on Wall Street, but there would be no systematic "cluster of errors" that currently characterize today's global economy. Fortunately, most economists now recognize that government's monetary and fiscal policies are the main source of economic and financial instability in the world today. In fact, more and more college textbooks teach up front that the economy is relatively stable at full employment; this is known as the "long term growth model." The short-term Keynesian model is taught at the end of the textbooks, where government intervention is recognized as a destabilizing factor in the economy and the chief cause of the boombust cycle. See Roy Ruffin and Paul Gregory's Principles of Economics and N. Gregory Mankiw's Economics. Maybe George Soros needs to take a refresher course from these textbooks.
Unfortunately, as opposed to wages, real economics knowledge is not sticky as advocates of the Keynesian model have been on the front pages of main stream media now for years once again. Many economists and politicians come to believe in government/central bank intervention when an economy heads for the worse (e.g. 2000, 2001 and 2008 and ever since), even when the boom was created by easy money and low interest rates (as is normally the case). And as long as governments and central banks have monopoly on setting interest rates and the ability to create fiat money through the fractional reserve banking system, this will always be the case. And as long as that is the case, booms and busts will continue to occur as the temptation to use these "tools" for short term imaginary gains are simply irresistible. Hence, republican vs democrat is a trivial issue while free markets vs crony capitalism, big government and central planning is not.