Market myths

The current financial crisis is causing the conspiracy theorists and self-taught economists to emerge from all the dark corners and crawly undersides of the political landscape. I am not going to pick on any one blog post, because the errors are too common. But I think it's worth explaining why some of the more lunatic theories are wrong.

Item One: The Iraq War did not cause this problem

Iraq is probably contributing somewhat to headline inflation. But it is contributing by making oil somewhat more scarce, thanks to production shortfalls and hoarding by speculators. Real factor scarcity does not create the kind of inflation that touches off asset price bubbles. Only inflation of the money and credit supplies, by giving speculators money to borrow and spend on their favorite asset, has the (arguable) power to create these financial manias.

Nor does the government's borrowing create these bubbles. If anything, it mitigates them by soaking up excess capital from the markets and thus raising interest rates higher than they would otherwise be. Essentially, the government took money out of the housing market and used it to blow things up in Iraq. Bad for Iraq, but probably good for the financial markets.

Item Two: The Bush tax cuts also did not cause this

As noted above, government budget deficits do not create financial manias. What the tax cuts gave to the economy in terms of stimulus, they took back in the form of higher interest rates.

Moreover, there's a strong argument to be made that the Bush tax cuts actually exerted some downward pressure on house prices. That's because when the tax rates fell, the value of the mortgage interest tax deduction also fell. Some of the money that people got back in the form of lower taxes probably went to the housing market, but you have to net out the amount of money leaving the housing market as the tax deduction became less valuable.

Item Three: Being on the gold standard would also not have prevented this mess

There are a lot of hucksters out there writing books and newsletters telling people that a gold standard (or some other commodity currency) is the cure for all their worries. The way they tell it, "hard" currency is a sort of broad-spectrum economic snake-oil, the ginseng of the financial markets. Only adopt their plan, they beseech, and America will no longer be plagued by exchange rate fluctuations, government profligacy, trade deficits, inflation, speculative mania, financial panics, or indigestion. This is triple-distilled balderdash.

There is nothing wondrously transformative about pegging your currency to the atomic weight of 196.97, or any other magical metal. America managed to have a regular supply of speculative booms and spectacular busts throughout the nineteenth century despite the soothing presence of gold in our money supply. The international gold standard in the 1920s and 1930s was marked by speculative mania, catastrophic deflation, competitive devaluations, massive exchange rate and trade imbalances, and of course the worst economic contraction in living memory. The depth and duration of which, I must point out, many economists attribute to America's fierce determination to defend her currency.

A little closer to home, you might look at Argentina--Paul Blustein's excellent book is a good place to start. Argentina's dollar peg was essentially a commodity currency--they didn't control their money supply, and got a contractionary monetary policy when their economy was in recession. Nothing about a dollar peg forced the government to stop borrowing, the bankers to stop speculating--or people from suffering when the government was forced off the peg.

Item Four: Among the many other things that did not cause the current crisis was the repeal of Glass-Steagall

A little history: Glass-Steagall was a major act of the mid-thirties, which set up the FDIC to insure and regulate banks, and split off commercial banking operations from investment banking. In 1980, the feds repealed one of the act's major provisions, Regulation Q, which had allowed the regulation of interest rates on banks. This is why you now get a competitive interest rate on your bank account instead of a free toaster when you open an account. In 1999 Gramm-Leach-Billey repealed the separation of investment banking and commercial banking, which is why JP Morgan has a big enough balance sheet to buy Bear without fear of failure.

Neither of these provisions created securitization, which got going in the late 1970s and early 1980s (a decent history can be found here, or you could just read Liar's Poker again). They also didn't create the march into ever-more-exotic financial instruments in the late 1990s and of course, our current decade.

Item Five: The collapse of Bretton Woods--also not a cause of the current crisis!

See above. Commodity/pegged currencies have exchange rate problems too, notably worsening balance-of-trade problems when currencies within the fixed-rate system become over or undervalued. Like, say, having the Chinese propping up the dollar to keep their exports competitive . . .

Item Six: The long twilight of American economic might is not yet upon us

Decade-long recessions like Japan's, or long declines like Argentina or Britain's (pre 1990) are caused by structural problems in the real economy that keep resources from being allocated efficiently: Argentina failed to industrialize, Britain was hostage to moribund state-owned firms. We could develop those sorts of problems, but as of now, America is admirably adept at moving capital and killing off our dead companies. We may have a nasty, nasty recession, but it's not yet time to brush up on your subsistence farming skills.

Later, if I have the strength, I'll muster a defense of fractional reserve banking.

Update Before the Austrians crawl out of the woodwork to yell at me, yes I know that not everyone who supports the gold standard is a crank, though I still find arguments in favor of it wholly unpersuasive. But the arguments being advanced as to the role of fiat currency in the current crisis are bizarre. If anything, a gold standard would have increased the inflow of money from Asia, which was one of the major factors inflating the bubble.