The Old-School Liberal

“Freedom granted only when it is known beforehand that its effects will be beneficial is not freedom” — Friedrich Hayek

Posts Tagged ‘Austrian’

On the Wall Street Bailout

Posted by dagnygalt on October 3, 2008

The recent legislation passed in efforts to ease the tight credit markets may in fact create legislation which makes it more difficult for the economy to revive and sustain growth. Analysts and voters should consider the role of the Federal Reserve in keeping interests rates artificially lower than the naturally market set rate in encouraging mal-investment and ultimately significantly contributing to the unwise investments made by banks and lenders. In addition, government policies benevolently aimed to increase home-ownership among low and moderate income groups likely provided extra incentives for banks and lenders to invest in areas they normally would not have considered.

Over the past year we’ve seen our financial markets uncomfortable sway until in recent months we’ve seen the stock market plunge downward. Mistakes have been made and most people in the United States, and likely even the world, will experience the consequences of these mistakes. When discussing possible causes of the financial crisis, National Public Radio, CNN, MSNBC, and many more have repeatedly discussed the role of deregulation and greed as a cause of the crisis. I pose a question to them: “Do you really think that there was a sudden increase in the amount of pervasive greed in Wall Street in the past decade?” It is extremely unlikely that human nature among a specific group of people could have systematically changed without cause. Deregulation could certainly be a cause; however, one convinced of this cause should take an objective step back and examine the evidence.

Research has shown that low interest rates stimulate investment. (1) This is likely the reason the Fed kept the rate low for so long. However, much research has shown that interest rates artificially kept low also tend to encourage mal-investment. Harvard’s Joint Center for Housing Studies also explained in The State of the Nation’s Housing 2008 (2)  report how the Fed’s low interest rates encouraged the housing market bubble, an expansion of risky loans in subprime mortgage market, and ultimately lead to a derivation of complicated and very risky mortgages repackaged and purchased by large banks. In addition, an prevalent ideology existed (and still exists) among policy makers and legislatures that homeownership creates wealth. Thus, they create policies which incentivized banks to lend to people who the bank might not normally lend to because of risk. For example, the Community Reinvestment Act of 1978 mandated that banks lend to families that in many cases couldn’t afford the loan payments. Thus, the combination of government policy making and encouragement of home ownership among those who could not afford homes and artificially low interest rates ultimately lead to the bad investments (3) which are highly contributing to the economic problem our country currently faces.

The bailout plan was indeed deliberated over, which is good. However, given the urgency and the emotional pressure put on government “to act” may indeed have prevented policy-makers from analyzing the true causes of the crisis. In addition, regulation enacted through the bailout passed this morning may in not at all decrease the likelihood of mal-investment and instead create new unforeseen problems that will prevent the economy from competing globally.

In conclusion, I hope voters will recognize that the economic problems we face today may in fact be a result of poor government policies. In addition, we should be not allow our fear and emotion detract from our ability to see evidence clearly. In efforts to “do something” we may in fact not be doing what is in our best interest in the long run.

BLUE: Real Yr/Yr GDP Growth
RED: Real Effective Fed Funds Rate

Source: Compiled by Robert P. Murphy, http://mises.org/story/2728

1 The New York Federal Reserve http://www.newyorkfed.org/education/level.html
2 Harvard’s  Joint Center for Housing Studies,  The State of the Nation’s Housing 2008, at http://www.jchs.harvard.edu/son/index.htm
3 Sechrest, LJ. 2006. “Explaining Malinvestment and Overinvestment,” Quarterly Journal of Austrian Economics 6, 4:27-38.

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