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Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse Hardcover – February 9, 2009
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[Audio Review] Here, Woods offers a decidedly free-market, conservative approach to the worldwide financial collapse of 2008 09. He explains his take on what led up to the current economic crisis, who's really to blame (namely, the Federal Reserve System), and why government bailouts won't work. Woods's views will appeal to listeners concerned about how the financial crisis impacts them as well as to business leaders and investors wishing to be more enlightened about the crisis. Two-time Audie Award nominee Alan Sklar's (see Behind the Mike, LJ 3/1/09) solid, steady reading helps sustain interest. Dale Farris, Groves, TX --Library Journal --This text refers to an out of print or unavailable edition of this title.
From the Inside Flap
Is Capitalism the Culprit?
The media tells us that "deregulation" and "unfettered free markets" have wrecked our economy and will continue to make things worse without a heavy dose of federal regulation. But the real blame lies elsewhere. In Meltdown, bestselling author Thomas E. Woods Jr. unearths the real causes behind the collapse of housing values and the stock market--and it turns out the culprits reside more in Washington than on Wall Street.And the trillions of dollars in federal bailouts? Our politicians' ham-handed attempts to fix the problems they themselves created will only make things much worse.
Woods, a senior fellow at the Ludwig von Mises Institute and winner of the 2006 Templeton Enterprise Award, busts the media myths and government spin. He explains how government intervention in the economy--from the Democratic hobby horse called Fannie Mae to affirmative action programs like the Community Redevelopment Act--actually caused the housing bubble.
Most important, Woods, author of the New York Times bestseller The Politically Incorrect Guide to American History, traces this most recent boom-and-bust--and all such booms and busts of the past century--back to one of the most revered government institutions of all: the Federal Reserve System, which allows busy-body bureaucrats and ambitious politicians to pull the strings of our financial sector and manipulate the value of the very money we use.Meltdown also provides a timely history lesson to counter the current clamor for a new New Deal. The Great Depression, Woods demonstrates, was only as deep and as long as it was because of the government interventions by Herbert Hoover (no free-market capitalist, despite what your high school history teacher may have taught you) and Franklin D. Roosevelt (no savior of the American economy, in spite of what the mainstream media says). If you want to understand what caused the financial meltdown--and why none of the big-government solutions being tried today will work--Meltdown explains it all.
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The first question is: why were corporations allowed to choose their own auditors? The "free market" argument is that auditors will be diligent and truthful to preserve their "reputations." But if the audited firms hire the auditors, the relevant "reputation" will obviously be for giving the company favorable reports. The second question is: why did investors believe the auditors' reports when they knew (or should have known) that the incentives for the auditors are perverse? I have no answer for this. Ultimately, the problem is: who should appoint the auditors if not the audited firms? There are simple answers for other industries---e.g., zoning, health and safety regulations, tax reporting. Similar measures should be implement for financial auditing.
Update, July 2011: Much more empirical work has been done on this topic since my review, and it supports the position I took in this review. See Paul Krugman's summary (Google "Fanny Freddy Phooey") and follow the links therein to their sources. Ast it turns out, default rates on Fanny Mae and Freddy Mac were about the same as the average for all home mortgages, and about 1/3 as high on subprime mortgages.
The thesis of this slim volume is that "The current crisis was caused not by the free market but by the government's intervention in the market'' (2) Author Thomas E. Woods argues that "Fannie Mae and Freddy Mac, government-sponsored enterprises (GSEs) that enjoy various government privileges alongside their special tax and regulatory breaks, were able to draw far more resources into the housing sector than would have been possible on the free market." (2) In addition, says Woods, "the greatest single government intervention in the economy, and the institution whose fingerprints are all over our current mess [is] America's central bank, the Federal Reserve System.'' (2-3) Woods holds that Federal Reserve monetary policy artificially fosters high-level economic activity by maintaining artificially low interest rates, thus encouraging unsustainable credit expansions, the long-run effects of which are financial bubbles such as that of 2007. Moreover, instead of reacting to the financial crisis by allowing the free market to restore a normal interest rate structure, the Obama administration bailed out the financial sector by further flooding the market with artificially-induced liquidity, thus ensuring the perpetration of the crisis. They took this tack, says Woods, because the administration is in the pay of the securities and investment industry: "Congressmen who voted in favor of the bailout when it appeared before the House on September 29 had received 54 percent more money in campaign contributions from banks and securities firms than had those who voted against it." (5)
Woods acknowledges that not only the political influence of the securities and investment industry, but also dominant macroeconomic monetary theory, is involved in the perpetration of government policies that make financial crises inevitable. By contrast, Woods holds that the Austrian School of economic thought, founded by Ludwig von Mises and Friedrich von Hayek and others in the late nineteenth and early twentieth century, correctly predicted the sad events of 2007: "perhaps 10 or 12 of the country's 15,000 professional economists saw the economic crisis coming... but hundreds of economists who belong to Mises' Austrian School of economic thought sure saw it... And the primary culprit, from their point of view, is the Federal Reserve." (8)
Woods' recommendations for preventing future distress situations in the financial sector include setting a policy of non-intervention ("Let them go bankrupt", p. 147), abolishing Fannie Mae, Freddy Mac and other government-sponsored enterprises in the housing market, ending government manipulation of the money supply and either abolishing the Federal Reserve or seriously restricting its latitude for regulatory intervention.
How are we to assess Thomas Woods' claims? First, Woods is completely disingenuous and entirely misleading in suggesting that "hundreds" of Austrian-school economists foresaw the events of 2007. The truth is that Austrian school economists have a theory that says that excessive state intervention in interest rate formation leads to financial crises and thence to economic downturns. But they did not predict this crisis. Moreover, there have been periodic financial crises in American economic history, and only a fool would predict that we have seen the last of them (although Federal Reserve chairman asserted that he was completely dumbfounded by the crisis of 2007, and hence must have believed that credit crises were consigned to the history books). In this sense, any reasonable economists would have said in 2006 that there will be a financial crisis at some time in the future---which is neither more nor less than what the Austrians might have said.
Second, Woods' implication of the GSEs in the subprime meltdown is seriously overdrawn. It is based on the notion that the government has implicitly guaranteed stockholders investments in the GSEs, putting them in a no-lose situation in which they can take great risks with subprime mortgages and reap the profits when things go well, but can offload their losses to the taxpayer when things go bad. However, Fannie Mae and Freddie Mac stockholders have been clobbered by the financial meltdown, and stock prices in these two institutions have fallen to near zero. Stockholders could not have plausibly expected that their stock values would be immune from steep decline.
Moreover, Federal regulations placed serious restraints on the ability of the GSEs to assume high-risk debt. Indeed, by definition these GSEs did not engage in subprime lending because their legal statutes prohibited them from issuing mortgages without substantial down payments and closely validated assurances concerning family income and wealth. Indeed, Fannie Mae and Freddie Mac began to recede from the forefront of mortgage lending when the housing bubble emerged in the years after 2003. Fannie Mae and Freddie Mac executives panicked when their positions in mortgage markets began to deteriorate, and they introduce questionably legal procedures ("expanded approval" for Fannie Mae and "A minus" for Freddie Mac) to recapture market share. But these efforts were basically unsuccessful because the GSE lenders were saddled with fixed-rate loan structures. The share of GSEs in the mortgage market faded rapidly in the latter years of the housing bubble.
Third, there is absolutely no empirical evidence suggesting that Woods' policy alternatives might work. There is considerable debate concerning the nature of credit crunches and the Austrian school story is perhaps in the running in explaining them (most economists think the Austrian explanation is bizarre and wrong-headed---Paul Krugman once compared it to the phlogiston theory in chemistry), but there is no support for the notion that an advanced capitalist economy would do better adhering to the gold standard and foregoing active monetary intervention. Moreover, there is widespread opinion among monetary economists, based on a century of experience in financial regulation, that an economic downturn is always a period of excess demand for liquidity, that the financial sector cannot supply such liquidity in a downturn, so the best monetary policy is to flood the economy with liquidity, to whatever degree is required to satisfy the demands of industry. This of course flies in the face of the Austrian theory that it is an excess of liquidity that leads to the downturn, but I believe the historical experience supports the conventional wisdom over the Austrian school.
The Austrian school has had many years to provide the evidence in favor of its model of the free market economy, and it has failed abjectly to do so. The Austrian school founders were notorious for their contempt for empirical evidence, claiming that economic principles are praxeological--self-evident and purely logical in principle, but subjective and highly complex in the human individual, and hence inaccessible to empirical analysis. This argument has little merit, in my estimation---I spend a good part of my time gathering and analyzing evidence concerning human (and other animal) behavior so as to better understand social dynamics and the realm of the possible in social policy. What the Austrians consider logical appears to the rest of the world (and most assuredly to myself) as the ponderous prejudices of free-market fundamentalists for whom science based on evidence is replaced by faith based on wishful thinking.
The lack of evidence for the Austrian theory does not mean that it is wrong. There is little evidence in favor of any of the competing macroeconomic theories (Keynesian and rational expectations schools being the most prominent). Indeed, to my mind these are not theories at all, but rather toy models so severely stripped-down from the complex reality of a market system as to bear no relationship whatever to the reality they purport to model. Of course, traditional macroeconomists do care intensely about empirically verifying their models, but they all are very poor predictors, rarely doing any better than simple extrapolations from the recent past.
The fact is that the evidence does not support any of the alternative macro models out there, which is why the Austrian policy prescriptions could possibly work. The fact is that they have never been tried. All modern economies use fiat money, have extensive financial controls, and intervene regularly in the operation of the market system. I prefer the standard approaches to monetary policy because they have worked in the past, and only a near-fanatical belief system, such as that cherished by the Austrian school, could believe that a free-market system without government intervention might work in the future.
I am often asked why macroeconomic theory is in such an awful state. The answer is simple. The basic model of the market economy was laid out by Leon Walras in the 1870's, and its equilibrium properties were well established by the mid-1960's. However, no one has succeeded in establishing its dynamical properties out of equilibrium. But macroeconomic theory is about dynamics, not equilibrium, and hence macroeconomics has managed to subsist only by ignoring general equilibrium in favor of toy models with a few actors and a couple of goods. Macroeconomics exists today because we desperately need macro models for policy purposes, so we invent toy models with zero predictive value that allow us to tell reasonable policy stories, the cogency of which are based on historical experience, not theory.
I think it likely that macroeconomics will not become scientifically presentable until we realize that a market economy is a complex dynamic nonlinear system, and we start to use the techniques of complexity analysis to model it. I present my arguments in Herbert Gintis, "The Dynamics of General Equilibrium", Economic Journal 117 (2007):1289-1309.
Woods provides an analysis of the Great Depression, and though he criticizes both Hoover and FDR, he also challenges the view that WWII helped the US emerge from depression. Rather, he states the US private economy functioned more effectively after WWII and private sector growth actually ended the Great Depression.
It seemed to me Woods is critiquing an ideal, closed economy that does not exist in the US. For example, he states on pg. 128 that "Credit has to derive from real saved resources. Nothing can be lent that someone has not first saved." This ignores globalization and the movements of investment money between nations. Woods does not use the term `globalization' nor discuss its effects anywhere in Meltdown. He does not attempt to analyze other potential view of US economy outside his ideology and its assumptions, which I began to suspect are limited. He does not account for global capital flows, which allowed the US to run up huge debts while China and Japan hoarded surpluses. Woods discusses the Japan meltdown in detail, but does not mention the Swedish banking crisis of 1992, which economists have cited as an example with applicability to the current US financial crisis. Woods gratuitously slights Keynes without explanation or reference to context. In doing so, he must take for granted his readers are firmly opposed to Keynesian economic ideas. Woods states consumer driven economies cannot succeed the long run, which seems to be true, and makes a case for more production of US goods. Yet he also states capital intensive industries are more affected by economic downturns. So, would the current crisis have been worse if the US had more manufacturing industries? Meltdown does not grapple in any depth with this question.
Meltdown is thought provoking, and it's easy to accept Woods's prima facie arguments. I think because Meltdown omits any discussion of globalization, international capital, and trade deficits that Woods has gaping holes in his case.