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David N. Mayer


The Myth of "Market Failure" - October 2, 2008



The Myth of “Market Failure”



            In response to the current panic on Wall Street, politicians – mostly Democrats, but also some Republicans, including GOP presidential candidate John McCain – have called for more government regulation and control over financial markets.  Rep. Barney Frank (D.-Mass.) gave the typical politician’s explanation of the credit crisis:  “The private sector got us into this mess,” he claimed.  “The government has to get us out of it.”  The New York Times editorialized that “This crisis is the result of a willful and systematic failure by the government to regulate and monitor the activities of bankers, lenders, hedge funds, insurers, and other market players.”  Socialist financier George Soros similarly asserted that it’s all a “crisis of capitalism.” 

            As a recent news article in Investor’s Business Daily has reported, these pundits have it partially right:  the Wall Street financial crisis is a crisis of capitalism – but not free-market capitalism, for financial markets are not free but have been subjected to pervasive governmental controls for decades. Rather, it is a crisis of what the article aptly calls “politically driven crony capitalism.”  Indeed, the Daily article added, “Democrats have so effectively mastered crony capitalism as a governing strategy that they’ve convinced many in the media and the public that they had nothing whatsoever to do with our current financial woes.”  (“`Crony’ Capitalism Is Root Cause of Fannie and Freddie Troubles,” Investor’s Business Daily, Sept. 23, 2008.)   

            It’s especially ironic that Barney Frank, chairman of the House Financial Services Committee and (as noted below) one of the leading opponents of Fannie Mae and Freddie Mac reform in Congress, should try to blame the “private sector” for the mess that he helped create.  As Jeff Jacoby writes in the Boston Globe, Frank’s “fingerprints are all over this fiasco”:  “If Frank is looking for a culprit to blame, he can find one suspect in the nearest mirror.” 

            In fact, politicians like Barney Frank are directly responsible for the current crisis in the U.S. financial system, for the crisis is the inevitable result of distortions in the credit market created by bad governmental policies – laws passed by Congress and regulations passed by entities created by Congress and staffed by Congress’s cronies.  The politicians may try to blame “deregulation” – meaning the partial deregulation of the banking industry in the late 1990s – for the financial meltdown, but they’re only trying to distract the attention of the news media and the public from the true cause of the problem:  the distortions that Congress and federal regulatory agencies have forced on financial markets.     

            These politicians are perpetuating a myth – the myth of supposed “market failure,” or of the failure of capitalism – which is one of the great myths on which the modern regulatory/welfare state has been built.  They disingenuously claim that alleged failures in the free-market system are responsible for social problems, as a justification for imposing governmental controls on the market; their claims are disingenuous because they overlook the bad governmental policies that were really responsible for the problems in the first place – policies that distorted the free-market system.  Then, when the new governmental controls fail to solve the problems – or foster even worse problems, as the unintended consequences of regulation – politicians call for even more controls, to “close the loopholes” in their regulatory schemes.  By perpetuating the myth, politicians and political activists seek to expand their control over the economy – to undermine capitalism and the economic freedom that it gives to Americans – and thus to transform the modern American “mixed economy” into a full-fledged socialist system.  That was the myth on which the New Deal regulatory/welfare state was built in the 1930s, and it’s the same myth that Demopublican/Replicrat politicians are using today expand to further expand governmental control over the economy.



The Current Crisis:  The Fannie and Freddie FUBAR


            Bad mortgages – real estate loans made to people who really couldn’t afford them – are at the heart of the current crisis, as a combination of falling house prices and mortgage defaults has virtually bankrupted many investment banks and other financial institutions (including such big-name firms as Bear Stearns, Lehman Brothers, Merrill Lynch, and AIG).  Again, politicians and their apologists in the news media would like us to believe that “greedy” mortgage brokers are to blame, but as libertarian political commentator Neal Boortz observes in a recent op-ed, “The truth is that most of the blame rests on political meddling in the credit decisions of these mortgage lenders.”  (Boortz, “The Rest of the Meltdown Story,” Sept. 19.)

            If one were to identify one or two root causes of the mortgage mess, the obvious culprits would be Fannie Mae and Freddie Mac, the entities created by Congress in 1938 and 1970, respectively, ostensibly for the purpose of making it easier for lower-income persons to buy their own homes.  As I noted in my “Summer 2008 in Review” essay (Aug. 28), Fannie Mae and Freddie Mac are veritable “Frankenstein monsters,” created by the “Dr. Frankensteins” in Congress, that have introduced massive distortions in the housing market:

“These strange creatures of the law (they’re quasi-private companies, owned by stockholders, yet also quasi-public, backed up by U.S. Treasury guarantees, a monopoly privilege that private mortgage companies do not have) now hold nearly half (over 40%) of the U.S. home mortgage market.  One result has been the rise in so-called `subprime mortgages’ – mortgages given to risky borrowers, that is, those with poor credit or low incomes – persons who really have no business buying homes they cannot afford – persons who probably would not be able to get a mortgage in a free market because they couldn’t find a lender foolish enough to take the risk.  Fannie Mae and Freddie Mac were created to fill this supposed `void’ in the market – that is, to provide risky, irrational loans to persons who do not deserve them.  What the creation of these Frankenstein monsters did was to distort the market for mortgages, resulting in not only a glut of mortgages but also a general inflation in home values.”

And as I added,

“What Congress has done with the housing market is literally a `SNAFU’ (that marvelous World War II-era military acronym for `Situation Normal – All Fucked Up’ – an excellent summary of federal legislation, in most areas.  Or better yet (to use another WWII-era apt acronymn), `FUBAR’ – `Fucked Up Beyond All Recognition.’” 

As the Wall Street Journal observed in a recent editorial, Fannie Mae and Freddie Mac “turbocharged the credit mania,” by buying the increasingly questionable mortgages originated by Countrywide Financial and others.  “Even as the bubble was popping, they dived into pools of subprime and Alt-A (`liar’) loans to meet Congressional demand to finance `affordable’ housing.  And they were both the cause and beneficiary of the great interest-group army that lobbied for ever more housing subsidies.”  (“A Mortgage Fable,” Wall Street Journal, Sept. 22.) 

            The Journal editorial’s reference to “Congressional demand to finance `affordable’ housing” identifies a second root cause of the mortgage mess, also a product of Congressional legislation:  the Community Reinvestment Act (CRA). This 1977 law (passed by Congress during the Jimmy Carter administration) has compelled banks to make loans to poor borrowers who often cannot repay them – with many of the recipients of these risky loans being members of racial minority groups or applicants who live in lower-income neighborhoods, people who supposedly were victimized by “redlining” or other alleged racially discriminatory practices.  Neal Boortz graphically describes the results of CRA mandates on the banking industry: 

“Political correctness won the day.  Washington made it clear to banks and other lending institutions that if they did not do something – and fast – to bring more minorities and low-income Americans into the world of home ownership there would be a heavy price to pay.  Congress set up processes [under the CRA] whereby community activist groups and organizers could effectively stop a bank’s efforts to grow if that bank didn’t make loans to unqualified borrowers.  Enter, stage left, the `subprime’ mortgage.  These lenders knew that a very high percentage of these loans would turn to garbage – but it was a price that had to be paid if the bank was to expand and grow. . . . These garbage loans to unqualified borrowers were then bundled up and sold.  The expectation was that the loans would be eventually paid off when rising home values led some borrowers to access their equity through re-financing and others to sell and move on up the ladder.  Oops.  [The bubble burst.]


“Right now this crisis is being sold to the American public by the left as evidence of the failure of the free market and capitalism.  Not so.  What we’re seeing is the inevitable result of political interference in free market economics.  Acme Bank didn’t want to loan money to Joe Homebuyer because Joe had a spotty job history, owed too much on his credit cards, and wasn’t all that good at making payments on time.  The politicians told Acme Bank to figure out a way to make that loan, because, after all, Joe is a bona-fide minority-American, or forget about opening that new branch office on the Southside.  The loan was made under political pressure; the loan, with millions like it, failed – and now we are left to enjoy today’s headlines.”


(Boortz, “ The Rest of the Meltdown Story,” Sept. 19.)  Boortz adds that among the community groups browbeating banks into making these bad loans was “an outfit called ACORN,” and that “one certain presidential candidate,” namely Barack Obama, “did a lot of community organizing for ACORN.”  Why aren’t we reading the whole story in the so-called “mainstream media”?  As Boortz explains, “Do you really expect the media to blame this mess on deadbeat borrowers and political interference in the free market when it is so easy to put the blame on greedy lenders and evil capitalists?”  Especially when Obama, Big Media’s favorite candidate in the presidential election, is “decidedly anti-capitalist.” 

            The CRA mandates – revised in 1994 by the Clinton administration and a Democrat-controlled Congress – have imposed on the banking industry what might be called “affirmative action” in the credit market for housing.  Like other so-called “affirmative action” (or, more accurately, racial-preference) programs in hiring or in college admissions, the result of such programs has been to harm the very people they were intended to help.  “Affirmative action” programs in hiring or admissions result not only in injustice to the individuals (typically, white males) who are not given preferences under these programs, but also unfairness to those who supposedly benefit, but who by being hired for a job or by being admitted into a college class in which they cannot adequately perform, are being set up for failure.  (See my essay, “Affirmative Racism,” Jan. 23, 2006.)  Similarly, the government-imposed CRA mandates have lured members of racial minority groups and lower-income Americans into mortgages they really can’t afford – millions and millions of them – ultimately resulting in the loss of their homes through foreclosure, as well as the shaky financial status of the institutions that extended these risky loans. 

            The inevitable collapse of this house of cards was foreseen by economists and others as early as the late 1990s.  Indeed, a September 30, 1999 article in the New York Times – ironically, the same newspaper that now blames the mortgage crisis on “the failure by the government to regulate” bankers and lenders – predicted exactly what has happened: 

“Fannie Mae, the nation’s biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people.  `Fannie Mae has expanded home ownership for millions of families in the 1990s by reducing down payment requirements,’ said Franklin D. Raines, Fannie Mae’s chairman and chief executive officer.  `Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market.’


“Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times.  But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry [bailout] in the 1980s.”


Indeed, as John R. Lott, Jr., reports after quoting this Times article, the Clinton administration and Fannie Mae both bragged during the late 1990s “about how they had lowered the standards required to borrow money for homes to increase borrowing by groups that otherwise wouldn’t qualify.”  (Lott, “Plausible Deniability?”  Sept. 22.  The new rules instructed mortgage lenders to disregard financial common sense; they were told to extend mortgages to persons who lacked credit histories, to accept welfare payments and unemployment benefits as valid income sources to qualify borrowers for a mortgage, and to require little or no down payments.  For more on the new loan criteria fostered by Fannie Mae, see Lott’s analysis piece, “Reckless Mortgages Brought Financial Market to Its Knees,” Sept. 18.) 

            Over the past decade or so, efforts by some members of Congress (mostly market-oriented Republicans) to reform Fannie Mae and Freddie Mac, and thus to help avert today’s crisis, were repeatedly stymied by other members of Congress (mostly Democrats but including some key Republicans as well).  Investor’s Business Daily, in its September 23 article on “`Crony’ Capitalism,” explains why:  “Fannie and Freddie became massive providers both of reliable votes among grateful low-income homeowners, and of massive giving to the Democratic Party by grateful investment bankers, both at the two government-sponsored enterprises and on Wall Street.”  Meanwhile, Fannie and Freddie also became “a kind of jobs program for out-of-work Democrats,” including Franklin Raines and Jim Johnson, the CEOs under whom the worst excesses took place in the late 1990s to early 2000s, both of whom are high-placed Democratic operatives and advisers to presidential candidate Barack Obama.  Others who benefited by being brought into the Fannie-Freddie circle include Clinton administration official Jamie Gorelick and top Clinton aide Rahm Emanuel.   Raines, who took Fannie Mae’s helm as CEO in 1999, took in nearly $100 million by the time he left in 2005; Gorelick took $75 million from the Fannie and Freddie “piggy-bank.” The Daily article reports how effective Fannie and Freddie have been in “buying friends in high places”: 

“Fannie and Freddie had a reliable coterie of supporters in the Senate, especially among Democrats.


“`We now know that many of the senators who protected Fannie and Freddie, including Barack Obama, Hillary Clinton, and Christopher Dodd, have received mind-boggling levels of financial support from them over the years,’ wrote economist Kevin Hassett on this week.


“Over the span of his career, Obama ranks No. 2 in campaign contributions from Fannie and Freddie, taking over $125,000.  Dodd, head of the Senate banking panel, is tops at $165,000.  Clinton, ranked 12th, has collected $75,000.


“Meanwhile, Freddie and Fannie opened what were euphemistically called `Partnership Offices’ in the districts of key members of Congress to channel millions of dollars in funding and patronage to their supporters.

”In the space of a little more than a decade, Fannie and Freddie spent close to $150 million on lobbying efforts.  So pervasive were their efforts, they seemed unassailable, even during a Republican administration.”


The article also notes how Fannie and Freddie’s lobbying organization also bullied those who opposed them, including journalists, like the Wall Street Journal’s Paul Gigot, and GOP congressmen, “like Wisconsin Rep. Paul Ryan, whom Fannie and Freddie actively lobbied against in his own district.”  “Rep. Cliff Stearns, R.-Fla., who tried to hold hearings on Fannie’s and Freddie’s questionable accounting practices in 2004, found himself stripped of responsibility for their oversight” – by then-Speaker Dennis Hastert, a Republican.   Moreover, 

“President Bush, reviled and criticized by Democrats, tried no fewer than 17 times, by White House count, to raise the issue of Fannie-Freddie reform.  A bill cleared the Senate Banking panel in 2005, but stalled due to implacable opposition from Democrats and a critical core of GOP abettors.  Rep. Barney Frank who now runs the powerful House Financial Services Committee, helped spearhead that fight.”


(“`Crony’ Capitalism Is Root Cause of Fannie and Freddie Troubles,” Investor’s Business Daily, Sept. 23.)  It should be added that Congressman Frank continues to oppose any efforts to reduce Fannie’s and Freddie’s mortgage portfolios, even after taxpayers have had to pick up a bailout tab of hundreds of billions of dollars. 

            Interestingly, Senator John McCain at one time supported legislation to reform Fannie Mae and Freddie Mac.  In 2005, when McCain was one of three sponsors of a Fannie-Freddie reform bill, he warned: “If Congress does not act, American taxpayers will continue to be exposed to the enormous risk that Fannie Mae and Freddie Mac pose to the housing market, the overall financial system, and the economy as a whole.”  But Senator Harry Reid – now Majority Leader – accused the GOP of trying to “cripple the ability of Fannie Mae and Freddie Mac to carry out their mission of expanding home ownership,” and the bill went nowhere.  (“Saddest Thing About This Mess: Congress Had a Chance To Stop It,” Investor’s Business Daily, Sept. 29.) 

            Given this past record and considering how he’s now campaigning under the banner of “reform,” it’s especially disappointing to see McCain not even mentioning reform of these institutions that are at the heart of financial meltdown and instead supporting the Bush administration’s efforts to push a $700 billion Wall Street bailout scheme through Congress.  I agree with John LeBoutillier, of, and other political commentators who regard McCain’s actions with regard to the Bush bailout plan as a serious tactical mistake that may very well cost him the presidential election.  Rather than showing himself to be a true “maverick,” openly opposing the Bush administration bailout plan, McCain’s actions merely confirmed his status as an inside-the-Beltway Washington insider and also reinforced the Democrats’ charge that a McCain administration would be, in effect, a third term for Bush.  Even though Obama’s efforts on behalf of Fannie Mae and Freddie Mac – as well as his involvement with ACORN from his “community organizing” days in Chicago – put him squarely at the center of the root cause of the financial crisis (the bad mortgage loans that never should have been made in the first place), unfortunately, it seems Obama may succeed in his campaign’s strategy of denying any culpability in the crisis and in trying to straddle the fence by mouthing the rhetoric of  both sides in the Congressional debate. 

            Fannie Mae and Freddie Mac, those Frankenstein monsters created by Congress and reinvigorated by the Carter-Clinton era CRA mandates, are indeed at the heart of the story behind the current crisis in credit markets.  But other important contributing causes also derive from bad governmental policies – not from failures in market capitalism – as the Wall Street Journal editors noted in their September 22 editorial, “A Mortgage Fable.”  “Going back decades, but especially in the past 15 or so years, our politicians have promoted housing and easy credit with a variety of subsidies and policies that helped to create and feed the mania.”  These other government policies include: 

·        The Federal Reserve, whose “easy money” policies the Journal calls “the original sin” of this crisis:  “For too long this decade, especially from 2003 to 2005, the Fed held interest rates below the level of expected inflation, thus creating a vast subsidy for debt that both households and financial firms exploited,” resulting in the housing bubble. 

·        A credit-rating oligopoly.  As the Journal explains, “Thanks to federal and state regulation,” a small handful of the credit rating agencies pass judgment on the risk for all debt securities in our markets; yet many of their judgments were wrong – “The major government-anointed credit raters, S&P, Moody’s and Fitch – were as asleep on mortgages as they were on Enron.” 

·        Banking regulators, for – despite the politicians’ phony claims that banking “deregulation” is behind the crisis – “the banks that made some of the worst mortgage investments are the most highly regulated” (including Citigroup, whose “off-balance-sheet SIVs” were “blessed, or overlooked, by the Fed’s regulators,” while “the SEC tolerated leverage of 30 or 40 to 1 by Lehman and Bear Stearns”).  Meanwhile, “the lest regulated firms – hedge funds and private-equity companies – have had the fewest problems, or have folded up their mistakes with the least amount of trauma.” 


·        The Bear Stearns rescue, by Fed-Treasury intervention, which as the Journal reports, “only delayed a necessary day of reckoning for Wall Street”:  “While Bear was punished for its sins, the Fed opened its discount window to the other big investment banks and thus sent a signal that they would provide a creditor safety net for bad debt.  Morgan Stanley, Lehman, and Goldman Sachs all concluded they could ride out the panic without changing their business models or reducing their leverage.” 


            The erroneous charge by Democrats that “deregulation” is to blame for the financial crisis is clearly refuted by Peter J. Wallison, a fellow in financial policy studies at the American Enterprise Institute, in a well-written piece posted on (“Deregulation Not to Blame for Financial Woes,” Sept. 30.)  As Wallison notes, the only major deregulation that has occurred in the banking and financial industry over the past 20 or so years was the repeal of portions of the New Deal-era Glass-Steagall Act in 1999, which “has no relevance whatsoever to the financial crisis, with one major exception:  it permitted banks to be affiliated with firms that underwrite securities, and thus allowed Bank of America Corp. to acquire Merrill Lynch & Co. and JPMorgan Chase & Co. to buy Bear Stearns Cos.”  He adds, “Both transactions saved the government the costs of a rescue and spared the market substantial additional turmoil.”  The critical point, however, is, as Wallison notes, “None of the investment banks that got into financial trouble, specifically Bear Stearns, Merrill Lynch, Lehman Brothers Holdings Inc., Morgan Stanley and Goldman Sachs Group Inc., were affiliated with commercial banks, and none were affected in any way by the repeal of Glass-Steagall.”  Indeed, almost all financial legislation in the past 20 years – laws such as the Federal Deposit Insurance Corp. Improvement Act of 1991, adopted after the savings and loan collapse of the late 1980s – “significantly tightened the regulation of banks.” 

            The Bush administration’s proposed $700 billion bailout of Wall Street, despite whatever tinkering the Democrats and Republicans in Congress do as they try to hammer out a bipartisan compromise bill, is a terrible idea that will not solve the problem and indeed will make it worse.  The fatal flaw in the approach proposed by Bush Treasury Secretary Henry Paulson and Federal Reserve chairman Ben Bernanke is that it fails to deal with the underlying causes of the mortgage market mess:  it’s like trying to treat a gunshot wound, a serious wound with massive blood loss, by applying a band-aid. 

            In an excellent op-ed in the Chicago Tribune (“The case against a federal bailout,” Sept. 25), Steve Chapman aptly describes the Paulson-Bernanke plan this way:  “What they prescribe is for the federal government to buy $700 billion worth of lousy assets from banks and other lenders, exposing taxpayers to a potentially crushing liability.  This plan would nationalize the money-losing part of the financial sector, to the benefit of capitalists who have made spectacularly bad decisions – fostering more bad decisions in the future.”  As Chapman persuasively argues, the plan would “add to the liabilities of a government that is already living beyond its means”; it also would “give unprecedented power to a couple of officials” – namely, Paulson (or whomever succeeds him as Treasury Secretary in the next administration) – posing the risk of abuse and corruption “because the government has no way to gauge the value of what it will buy.” 

            Chapman cites a letter signed by over 160 economists, including at least two Nobel laureates, which summarizes their opposition to the plan, focusing on its disastrous long-term effects:  “If the plan is enacted, its effects will be with us for a generation.  For all their recent troubles, America’s dynamic and innovative private capital markets have brought the nation unparalleled prosperity.  Fundamentally weakening those markets in order to calm short-run disruptions is desperately short-sighted.” 

            Moreover, as Chapman notes, there’s no guarantee that any bailout plan will work.  Indeed, I’d argue, it’s fairly certain that any plan that fails to address the root causes of the bad mortgages – the existence of Fannie Mae and Freddie Mac, coupled with the Carter-Clinton mandates imposed on banks by the CRA – would be doomed to fail.  The only real solution to the problem must include real reform of Fannie Mae and Freddie Mac, aimed at their eventual liquidation and privatization; these Frankenstein monsters that have so distorted the mortgage market must be phased out.  As conservative commentator Thomas Sowell noted in a recent op-ed, “Phasing out Fannie Mae and Freddie Mac would make much more sense than letting politicians play politics with them again, with the risk and expense being again loaded onto the taxpayers.”  (Sowell, “Can Congress Fix a Problem It Caused?”  Sept. 30.) 

            In response to the Bush administration’s fear-mongering (the pronouncements by both President Bush and Secretary Paulson that Congress’s failure to enact a bailout would lead to a recession or even a depression), Steve Chapman argues, “But economic downturns are not to be avoided at all costs.  And one good thing about recessions is that they end, usually in a matter of months.  An intervention of this nature, by contrast, would have malignant consequences for decades to come.” 

            Another commentator who opposes any sort of bailout for Wall Street is Jeffrey Miron, a senior lecturer in economics at Harvard University and one of the economists who signed the letter cited above.  In an insightful article posted on, Miron argues that the solution to the problem is to allow troubled financial institutions to declare bankruptcy.  “The fact that government bears such a huge responsibility for the current mess means any response should eliminate the conditions that created this situation in the first place, not attempt to fix bad government with more government.”  Rather than meddling further with financial markets, Congress should “eliminate those policies that generated the current mess,” which means “getting rid of Fannie Mae and Freddie Mac, along with policies like the Community Reinvestment Act that pressure banks into subprime lending.” 

            Yet another commentator who opposes a bailout is Judy Sheldon, an economist and author of the book Money Meltdown: Restoring Order to the Global Currency System (1994).  In a provocative Wall Street Journal op-ed, ”Loose Money and the Roots of the Crisis” (Sept. 30), Shelton challenges the very existence of the central banking system – the Federal Reserve – maintaining that as long as the Fed continues to manipulate the money supply, the dollar’s stability and credibility will be undermined.   She notes, among other things: 

“Scapegoats are wonderfully convenient receptacles for our collective disappointment, but that's all. When credit markets seize up, when financial instruments disintegrate, when the dollar fails -- it's not because Alan Greenspan was not sufficiently omniscient. He wasn't, true. But no one ever was. No one ever could be.

“If capitalism depends on designating a person of godlike abilities to manage demand and supply for all forms of money and credit -- currency, demand deposits, money-market funds, repurchase agreements, equities, mortgages, corporate debt -- we are as doomed as those wretched citizens who relied on central planning for their economic salvation. . . .

"`There are numbers of us, myself included, who strongly believe that we did very well in the 1870 to 1914 period with an international gold standard.’ . . . Mr. Greenspan said it, rather emphatically, last October on the Fox Business Network. He was responding to the interviewer's question: `Why do we need a central bank?’

“Whatever well-intentioned reasons existed in 1913 for creating the Federal Reserve – to provide an elastic currency to soften the blow of economic contractions caused by "irrational exuberance" (and that will never be conquered, so long as humans have aspirations) – one would be hard-pressed to say that the financial fallout from this latest money meltdown will have less damaging consequences for the average person than would have been incurred under a gold standard.”


(Judy Sheldon, “Loose Money and the Roots of the Crisis,” Sept. 30.) 

            Advocates of the Bush administration’s Wall Street bailout plan, or one of its revised versions being considered by Congress, have engaged in fear-mongering, as noted above.  They have predicted panic in the stock markets, a “seizing up” (or freezing) of credit markets, leading to recession and even (most horrible of all) “a second Great Depression.”  Among the chief fear-mongers is Fed chairman Ben Bernanke, who supposedly is a student of history, particularly the Great Depression of the 1930s, about which he wrote a book, Essays on the Great Depression, published in 2000.  Bernanke, however, does not appear to be a very good student of history:  he fundamentally misunderstands the lessons modern policy-makers should take from the experience of the 1930s (as noted below).  And, like the other fear-mongers both in the Bush administration and in Congress, he grossly overstates the current financial crisis – a crisis that was created by Secretary Paulson’s “emergency” plan and the panic it stirred up on Wall Street. 

            Talk of a 1930s-style panic is just that – talk – intended to scare Congress into hasty, misguided action.  As economist David R. Henderson notes in an insightful commentary on, “Bernanke’s Hype” (Sept. 28), credit markets – outside those particular companies that overextended themselves on bad mortgages – seem to be functioning fine; just call your local mortgage loan broker or realtor to see if people are still getting new home loans.  When the U.S. House of Representatives on September 29 wisely voted 228-205 against passage of the Wall Street bailout bill, the stock market did indeed drop significantly – the Dow Jones industrial average dropped a record 778 points, about 7% -- but that drop was just a fraction of the 22.6% stock market crash in October 1987.  Just a day later, the stock market rebounded, up by 485 points by the close of business on September 30 – and thus immediately putting the lie to President Bush’s hysterical assertion that “The consequences will grow worse each day” if Congress fails to pass bailout legislation.  The volatility of Wall Street is understandable, but what’s good (or bad) for stockholders isn’t necessarily good (or bad) for the economy as a whole, as law professor Ilya Somin recently observed on the Volokh Conspiracy blog: 

“I’m not much moved by populist rhetoric about how the interests of `Main Street’ are at odds with those of `Wall Street.’  This, however, is one of the rare cases where such clichés have a measure of truth.  If Congress were planning to pass a bill providing, say, a $100 per share subsidy to stockholders at the expense of taxpayers, no doubt stock values would rise in anticipation and then precipitously if the plan were unexpectedly voted down.  That is essentially what happened here.”


(Ilya Somin, “Why the Stock Market Drop Doesn’t Prove that Congress Was Wrong To Reject the Bailout,” Sept. 29.)  

            As Professor Somin notes, following the much-more-severe 1987 stock market crash, the economy swiftly recovered, “in part because policymakers were wise enough to let failing firms go bankrupt and free up their resources for use by more efficient industries.”  Sadly, however, this isn’t the 1980s – and policymakers, though twenty years older, are not any wiser.  Perhaps it’s appropriate that the Senate version of the bailout bill, which the Senate approved by a 74-25 vote on October 1, contains a provision mandating insurance companies to provide mental health coverage:  one would have to be crazy to believe that this bailout will solve the financial crisis.  


 The Crisis of the 1930s: Shattering “New Deal” Mythology


            Those doomsaying politicians and commentators who see parallels between the current financial crisis and the Great Depression of the 1930s actually have it partially right:  There are important parallels, as well as important lessons to be drawn, from the experience of the 1930s.  But the parallels and the lessons are not those claimed by today’s policy wonks. 

            During the debate over the Wall Street bailout legislation in Congress, both Democrats and Republicans raised the specter of Herbert Hoover and of President Hoover’s supposed laissez-faire, or “do nothing,” approach to the financial crisis of the early 1930s.  Supporters of today’s bailout bill, for example, warned that this was, in their words, a “Hoover” moment; and that if Congress did not act promptly, the meltdown on Wall Street could turn into another Great Depression – a “Great Depression II” as Jim Cramer, NBC’s wacky financial guru ominously has warned.   

            This story about Hoover’s supposed inaction – a myth that distorts Hoover’s true record as president, as noted below – is part of a greater myth about the Great Depression and the New Deal, a myth that’s popularly accepted as historical truth because, unfortunately, it has been propagated by most American history textbooks since they were, essentially, rewritten by supporters of the New Deal in the late 1930s.  Here’s the common version of the myth:  The great stock market Crash of October 1929 – itself a product of “market failure,” the failure of free-market capitalism – precipitated a series of bank failures that led to the Great Depression, with its associated problems of deflated money, business shutdowns, and massive unemployment.  President Hoover, supposedly a doctrinaire believer in “laissez-faire” capitalism, did nothing to help avert the Depression, which worsened because of Hoover’s inaction.  Then, following his victory in the 1932 presidential election, Franklin D. Roosevelt became president, riding into office on a white horse, and pushed through Congress in a mere hundred days his landmark “New Deal” legislation, which eventually saved the day, by helping the nation recover from the Great Depression.  “The only thing we have to fear is fear itself,” FDR bravely declared, and the American people were heartened to see a presidential administration that finally was “doing something” about the “crisis in capitalism.”  The huge expansion of the national government – with the creation of a massive federal regulatory/welfare state, with such programs as Social Security, unemployment insurance, subsidies for business and agriculture, and “alphabet agencies,” regulatory commissions such as the Federal Communications Commission (FCC), Federal Power Commission (FPC), Securities and Exchange Commission (SEC), and so on – all this was the necessary price Americans had to pay, to “modernize” the United States and to “save” American capitalism from itself. 

            Virtually every part of this story is mere myth – falsehoods perpetuated by supporters of FDR’s New Deal to justify it and the “revolution” in wrought in American government – which turn the true history of the 1930s on its head.  What really happened in the 1930s is, in all important aspects, virtually the exact opposite of the story told by the New Deal myth.  Rather than demonstrating “market failure” and the efficacy of governmental regulation to “solve” the alleged problem, the true story of the Great Depression and of the New Deal in the 1930s shows the folly of governmental interference with free economic markets. 

            The great stock market crash on “Black Thursday,” October 24, 1929, was important, but it did not precipitate the financial crisis that led to the Great Depression.  Historically, the stock market is inherently volatile; it rises and falls as the business cycle goes through periods of prosperity (“bull” markets) and retrenchment (“bear” markets) – that’s an inherent feature of a free-market system.  The 1929 Crash, in real terms, although significant, wasn’t the greatest one-day decline in the history of the New York Stock Exchange; that happened more recently, in 1987, when the Dow Jones average lost 22.6% in share value in a single day – without precipitating a depression (in spite of, rather than thanks to, the Federal Reserve, as noted below). 

            The 1929 crash was a symptom, rather than a cause, of the economic difficulties of the time – difficulties that were rooted in the “boom” decade of the 1920s.  Bad federal government monetary policies – policies (including the Federal Reserve System’s actions that greatly increased the U.S. money supply) that resulted in an over-expansion of credit markets – caused both the boom of the 1920s and the “bust” in 1929 and thereafter, as the speculative bubble burst and markets tried to adjust.  Business activity actually had peaked in August 1929, two months before the stock market crashed.  As the late, great free-market economist, Milton Friedman, explains: 

“The crash reflected the growing economic difficulties plus the puncturing of an unsustainable speculative bubble.  Of course, once the crash occurred, it spread uncertainty among businessmen and others who had been bemused by dazzling hopes of a new era.  It dampened the willingness of both consumers and business entrepreneurs to spend and enhanced their desire to increase their liquid reserves for emergencies.


“These depressing effects of the stock market crash were strongly reinforced by the subsequent behavior of the Federal Reserve System. . . .”


(Friedman, Free To Choose (1980), p. 79.)  Indeed, as Friedman shows, the Fed’s perverse policies following the 1929 crash – resulting eventually in a huge, 30% contraction in the U.S. money supply – were the actual cause of the Depression.  “The combined effect of the aftermath of the stock market crash and the slow decline in the quantity of money during 1930 was a rather severe recession.”  It turned into a depression, as a banking crisis emerged in the fall and winter of 1930 (marked especially on December 11, 1930, when the doors closed on the Bank of the United States, the largest commercial bank that had ever failed up to that time in U.S. history); runs on banks throughout the U.S. led to the failure of over 350 banks during the month of December 1930 alone; the pattern was repeated in the spring of 1931, when a second banking crisis developed.  The Fed exacerbated the problem by actually “raising the rate of interest (the discount rate) that it charged banks for loans more sharply than ever before in its history,” in response to Britain’s abandonment of the gold standard.  The effect in the United States was to worsen the depression:  the Fed’s actions were “highly deflationary – putting further pressure on both commercial banks and business enterprises.”  Not until 1932, under heavy pressure from Congress, did the Fed finally undertake large-scale open market purchases of government securities, to help offset the blow it had given to the struggling economy; but the Fed terminated the program when Congress adjourned, and the banking panic of 1933, with another series of bank failures, ensued. 

            President Herbert Hoover was guilty of inaction, but mostly with regard to the bank failures.   During the “interregnum” between Franklin D. Roosevelt’s election on November 8, 1932 and his inauguration on March 4, 1933, “Hoover was unwilling to take drastic measures without the cooperation of the President-elect, and FDR was unwilling to assume any responsibility until he was inaugurated.”  As panic spread in the New York financial community, Hoover refused to declare a banking holiday on Hoover’s last day in office, although New York and other states did so on FDR’s inaugural day; to avert further runs on banks, FDR finally proclaimed a nationwide bank holiday on March 6.   As Friedman summarizes the sorry record of the Federal Reserve System during this period, 

“The central banking system, set up primarily to render unnecessary the restriction of payments by commercial banks, itself joined the commercial banks in a more widespread, complete, and economically disturbing restriction of payments than had ever been experienced in the history of the country. . . .


“At the peak of business in mid-1929, nearly 25,000 commercial banks were in operation in the United States.  By early 1933 the number had shrunk to 18,000.  When the banking holiday was ended by President Roosevelt ten days after it began, fewer than 12,000 banks were permitted to open, and only 3,000 additional banks were later permitted to do so.  All in all, therefore, roughly 10,000 out of 25,000 banks disappeared during those four years – through failure, merger, or liquidation.


“The total stock of money showed an equally drastic decline.  For every $3 of deposits and currency in the hands of the public in 1929, less than $2 remained in 1933 – a monetary collapse without precedent.”


(Friedman, Free To Choose, p. 84.) 

            With regard to the Depression generally, it’s simply false that Hoover failed to act – and quite unfair to Hoover (and unfaithful to the true historical record) to blame Hoover’s supposed “laissez-faire” policies for worsening the Depression.  Nevertheless, Hoover does deserve blame – not for what he didn’t do, but for what he in fact did do, in response to the financial crisis of 1929-30.  

            Herbert Hoover was not a doctrinaire believer in “laissez-faire”; only in contrast to modern politicians – or to his successor, Franklin D. Roosevelt – can Hoover justly be so considered.  Rather, Hoover was part of the “Progressive” wing of the Republican Party who believed it was appropriate for government to use its powers to foster economic development.  For example, as a Progressive, Hoover as Secretary of Commerce during the Harding/Coolidge presidency helped create the Federal Radio Commission, predecessor to the FCC, which substituted government regulation for the laissez-faire policy (actually, a policy of industry self-regulation) that had prevailed in the radio industry in the early 1920s. 

            “Far from `doing nothing,’ Herbert Hoover initiated a violent implosion of world trade and prices by signing the infamous Smoot-Hawley tariff on June 17, 1930,” notes Alan Reynolds (a senior fellow at the Cato Institute) in a recent op-ed (“The Hoover Analogy Flunks,” Sept. 29.)

Quoting a leading bank economist at the time, Reynolds explains why the draconian Smoot-Hawley tariff was Hoover’s “crowning financial folly”: 

In a world staggering under a load of international debt, which could be carried only if countries under pressure could produce goods and export them to their creditors, we, the great creditor nation of the world, with tariffs already too high, raised our tariffs again. . . . Protectionism ran wild over the world.  Markets were cut off.  Trade lines were narrowed.  Unemployment in the export industries all over the world grew with great rapidity, and the prices of export commodities . . . dropped with ominous rapidity.”


To this disastrous protectionist policy, Hoover also added a disastrous tax policy, asking at the end of 1931 for a temporary tax increase, saying it was “indispensable to the restoration of confidence.”  As Reynolds notes, Congress went along with Hoover’s proposal in June 1932, raising the top income tax rate from 25% to 63% and quadrupling the lowest tax rate from 1.1% to 4% -- the biggest increase in marginal income tax rates ever – which not only failed to restore public confidence in the economy but also failed to provide the revenue Congress needed to pay for federal programs.  “Revenue from the individual income tax dropped from $834 million in 1931 to $427 million in 1932 and $353 million in 1933.”  (FDR in the 1932 election actually campaigned in favor of a balanced budget, criticizing Hoover’s administration for deficit spending.) 

            Moreover, “New Deal”-style programs of government intervention in the economy actually began under Hoover’s presidency, as Murray Rothbard shows in his book America’s Great Depression (4th ed. 1983).  What Rothbard calls the “Hoover New Deal” considered of a series of Hoover administration measures that aimed at providing “relief” from the economic downturn but which actually delayed recovery and aggravated the depression.  These included the Reconstruction Finance Corporation (RFC), which lent money to shaky businesses, thus preventing or delaying the liquidation of unsuccessful enterprises and recapitalization of successful ones; as well as other measures intended to help businesses and workers but which really only led to more bad investments, unsalable surpluses, permanent mass unemployment (subsidized through unemployment insurance), and a discouragement of savings (through food stamps and other spending programs, intended to provide relief but which also stimulated consumption). 

            Under FDR’s “New Deal,” of course, such programs were expanded and became coercive, as the federal government shifted from being a “partner” with private enterprise, as Hoover had supported, to being a regulator.  Under FDR’s signature program, the National Industrial Recovery Act (NIRA) – wisely ruled unconstitutional by a unanimous Supreme Court in Schechter v. United States (1935) – FDR’s New Deal turned quite literally into “economic fascism,” as Rothbard calls it.  The NIRA created a federal regulatory agency, the National Recovery Administration (NRA) – which, appropriately enough, adopted as its symbol a blue eagle, the ancient symbol of fascism – which was empowered to draft codes, forcing major industries to adopt rules of “fair competition,” recognize the rights of employees to unionize and to bargain collectively, abolish child labor, and establish “fair” labor standards (including minimum wages and maximum hours).  (In Schechter, the Court found these code-writing powers of the NRA to be a violation of constitutional separation of powers; it also found that the NRA’s regulation of labor practices and other activities not within interstate commerce violated Congress’s power under the Commerce Clause.  Unfortunately, following the so-called “New Deal revolution” that occurred on the Court in 1937 and in the years following, the Court later allowed both Congress and federal regulatory agencies to exercise virtually all the powers the NRA had exercised in 1935 – and many more powers, too.) 

            In sum, the Great Depression occurred not because of the failure of the capitalist market system but because of a wide range of failed government policies, including the inflationary policies of the Treasury and the Fed during the 1920s, the currency deflation of the Fed in the early 1930s, the Smoot-Hawley Tariff of 1930, and the “New Deal” programs of both Hoover and FDR, including such giant boondoggles as the RFC and the NRA. 

            Many economists and business historians who have studied the era of the Great Depression have concluded – as the historical record also verifies – that far from facilitating recovery, FDR’s “New Deal” programs actually exacerbated and prolonged the Depression.   For example, unemployment rates soared to a height of 25% as the decade of the 1930s progressed and as FDR’s programs added to the market distortions that kept people out of work.  A number of excellent books have been published in recent years, all reaching this general conclusion; these include Gene Smiley’s Rethinking the Great Depression (2002), Jim Powell’s FDR’s Folly: How Roosevelt and His New Deal Prolonged the Great Depression (2003), and Amity Shlaes’ The Forgotten Man: A New History of the Great Depression (2007).  I heartily recommend all of these excellent books, particularly Powell’s, which thoroughly discusses not only the devastating impact FDR’s New Deal programs and policies had on the American economy but also, in a superb chapter on “FDR’s Supreme Court,” discusses how the Court, filled with Roosevelt appointees in the years after 1937, subverted the Constitution and its protections of individual liberty. 

            The lesson is clear:  Government should get out of the way so free markets can work.  That means, no matter what the “crisis,” government should not bail Wall Street, or Main Street, or even Elm Street – it will only create worse nightmares. 


  | Link to this Entry | Posted Thursday,  October 2, 2008 | Copyright © David N. Mayer