Ludwig von Mises Institute scholars on our economic problems

Misis Institute explains why the Fed's zero percent interest rate policy won't work, and will create a future inflation trap, leading to another economic crisis.

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The Federal Reserve Bank has now undertaken unprecedented measures intended to "stimulate the economy." The federal funds rate is now set at 0.0 to 0.25%. This move by Federal Reserve Chairman Bernanke should be considered alarming for several reasons. First, this interest-rate reduction indicates that Federal Reserve economists are genuinely panicked regarding current economic conditions. Given that Chairman Bernanke and his staff are better informed than even most economists (let alone the public) and capable of differentiating good news from bad, this is cause for concern. Second, this interest-rate reduction indicates that Chairman Bernanke and his staff are incapable of differentiating between good policy and bad policy. The Federal Reserve is pursuing a policy of inflation out of an erroneous fear of deflation. This is not to say that deflation is itself unlikely, but rather that the consequences of deflation are not what Chairman Bernanke expects.

Misis scholar shows that not only did the housing market experience a bubble, but so did the commodities market. Remember when investors were fleeing the falling dollar into commodities? Oil prices were rapidly rising? A nice chart shows this bubble began about 2005, and like the housing market, is now correcting. Author predicts government attempts to keep the correction from occuring, to stop deflation, will lead to New New Deal (that's no great prediction) and another depression.

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For this reason I will use the peak of 249.9 at the end of July 1974 as my baseline. From this point to the end of January 2006, there was a 25% increase in commodity prices. Over this 31.5 year period, this is an annualized rate of 0.8%. In the 2.4 year period between the end of January 2006 and the peak at the end of June 2008, there was an annualized rate of increase of 22%! This is hardly consistent with the preceding three decades and is not a reasonable rate of growth. If we look at the annualized growth rate between the end of July 1974 and the end of October 2008, after the fall in prices, the growth rate is a much more modest 1.1%. Based on the historical average this "corrected" growth is approaching the normal market variation. This correction is a drop in demand, rather than a contraction of the money supply, but in the same way an overinflated balloon must pop, the demand was never sustainable from the outset. Much of the demand in commodities as well as other assets was based on the pyramid-scheme belief that another buyer, hungrier than the last, was just around the corner. As with all such schemes, someone finally decides they are done with the game, and the downward spiral begins. If the scheme was built on credit or margin, the fall is all the more precipitous.

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The same mistakes that were made during the Great Depression are being made now. The call to prop up prices will grow to a din as the self-interests of businesses push themselves on the Federal Reserve and Treasury. This desire for price controls is no different from the mercantilist policies of colonial Britain, which forced the British populace to pay the higher prices of British producers, to the boon of the businesses and the pain of the populace. Talk of today's "illiquid" assets is just a resistance by the owners of those assets to sell them at the market-clearing price. I assure you, I'll buy a mortgage for one dollar! The business and economics establishment will soon call for a new New Deal, and all the socialist policies of FDR will be dusted off and respun to the unwitting public, and the years that follow will be ones of pain, high prices, and a real fall in the standard of living. As long as our central government has the ability to dole out these favors, there will be special interests lining up to receive them.

It's interesting that he compares these bubbles to pyramid schemes, which is exactly what the house flipping craze was, because another Mises scholar uses Madoff as a metaphor for the financial crisis, the strategy for recovery (dropping interest rates to zero), and even social security. Like Madoff's operation, all of these government programs are pyramid schemes. Trying to get something for nothing by paying dividends today that future investors must pay off until they cost goes so high they collapse.

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There is a saying in the world of Austrian economics about the business cycle. The puzzle is not to explain business failures. Those are part of the normal course of life, and the sign of a healthy economy. The puzzle is to explain the "cluster of errors" that appears at the beginning of a recession. How could so many have been so wrong about so much at the same time? The business cycle is a system-wide failure, not merely the mistaken judgment of a few. So it is with Modoff's scheme. The mystery isn't how one person was able to fool a few. The scheme in which yesterday's "investors" are paid off with the money of today's victims is known in all places and probably all times—and it always goes belly up to the originator's complete disgrace. It is a classic example of how moral laws are self-enforcing in the world of economics. The critical difference this time is that Madoff ran his scheme during an economic boom, a time when people's normal sense of incredulity is put on the shelf. This is part of the grave cultural distortion introduced by funny money. Money is the most widely demanded good in society, and the Fed is making new quantities of it not as a reflection of new real wealth, but purely as an administrative decree. There is a sense in which funny money literally drives everyone crazy, leading to what is sometimes called the "madness of crowds." Guido Hulsmann explains it all in his remarkably timely and revealing new book: The Ethics of Money Production. With artificial stimulation from the credit machine, multitudes are willing to believe in something that cannot possibly be true. In Madoff's case, it was that he could, even in falling markets, earn 15-20% a year without risk. Why not? Most everyone believed in some version of the myth. We believed that house prices would go up and up despite the reality that houses are physical things that deteriorate from the instant they are finished, just like cars or computers or anything else. Why did we believe this about houses? Again, you have to look to the fraudulent money system to see why. And we believed that we could all become millionaires by putting our money in the stocks of companies that weren't actually earning money or paying dividends, companies whose wealth was entirely based on infusions of cash from the stock market which in turn were based on the belief that others would buy the stocks and so on. In other words, we believed that something out of nothing was possible, and anyone who didn't believe it was a chump. It’s exactly what people believed during the other great inflations of history.

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The left is big on attacking the salaries of investment bankers, and they were indeed outlandish. But these too represented not a unique problem, but more evidence of inflationary finance. In a bubble economy, the money chases what is most fashionable, and financial services qualified. So the salaries were market. What was wildly distorted was the market itself. Now let's talk about government finance during these years. The market tried to correct itself from 1999-2001, but the government wouldn't tolerate it. Instead, it used every sign of downturn as an excuse to keep the illusion going, creating billions and billions in new dollars. The Fed drove interest rates lower and lower despite the non-existence of savings available to back them up.

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Madoff's scheme played into the belief that wealth was not something to work for, but something to scheme for. It could be generated by playing your cards right, hooking into the right networks, and finding the right "investments." The people with whom he dealt had, it turns out, some internal sense that there was something a little bit shady about the whole operation. But they dispensed with this sense when the fat checks arrived, and concluded that whatever was making this perpetual motion machine operate, it did work.

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But listen: the government right now is using the same tactic to convince you that it is saving you from the recession. The whole scheme partakes of the same sense of denying reality that characterized Madoff's scheme. And I'm not just talking about Social Security, which is almost an exact replica of the Ponzi version, except that at least Charles Ponzi didn't force people to give him money. I'm speaking of something broader. The entire financial system that is propped up by the Treasury and the Fed is based on the same idea: that something out of nothing is possible. So they will jail Madoff. Wall Street would flog him if it could. He is disgraced for all of history. But meanwhile, the likes of Bush, Bernanke, Paulson, Obama, and all the rest are still riding high, even though their scheme is far larger and more egregious. Most of us like to believe that we wouldn't have been tricked by Madoff. But are you being tricked by the elites who claim that they can conjure up a trillion dollars to stabilize our economy by clicking a few buttons on a computer screen? Most people are. Certainly the press seems to have bought it. Many people were outwitted by Madoff. Many more people are today being outwitted by the government and its central bank. And it will all end in disgrace and disaster, only on a far, far grander scale.