A Secret History of the Boom and Bust This text is drawn from the keynote address
at the Sage Capital Management Conference in Houston, Texas, March 12, 2003.
The Austrian economists tell us that a price is more than a price. It is an objective expression
of subjective judgments concerning human wants now and in the future. It conveys information
to us about how we ought to conduct ourselves, where capital should be directed, how much
Which of what should be consumed now or later, which jobs to take and which to pass over?
In short, prices provide the roadmap to the successful navigation of the material world.
How striking it is to see stock prices respond so actively to the war on Iraq, the dominant
event of the day. Since the war began, prices rose in response to the prospect that the
war would end soon and sank on the prospect that the war will go on and on. What does
What does this price information convey? Most likely, it reflects it in co-ed sense that
this war would do nothing to bring us out of economic contraction and into recovery.
That is precisely true. Wars often result in severe setbacks, not only prolonging the
contraction but deepening it as well. To hear official voices talk, however, we have not
been going through the longest recession in the post-war period. Instead, we have been
through a 24-month slow recovery. It is also called a sagging economy with sound fundamentals.
Greenspan has made references to a soft patch in a foundation supposedly as hard as stone.
Indeed, in the effort to avoid using the term recession, the Federal Reserve has become
a business cycle phrase mill. Thus, according to the Fed, this is a soft economy, a subpar
economy, a skittish economy, an economy weighted down by weak expenditures, an economy of persistent
and weakness are my favorite and economy facing formidable barriers to vigorous expansion.
Call it what you want, but don't call it a recession. As for the D word, depression,
don't even think it. With the latest data on the producer price index, the commodity
price index and the increase in oil prices, we are starting to see what other torturous
linguistic devices are at work. It is not inflation, it is sector-specific price pressure.
In the old days, rising unemployment, sinking production and price inflation combined to
create what was called stagflation.
What will it be called this time?
Something rather ingenious, no doubt.
The National Bureau of Economic Research officially dates the contraction from March 2001, fully
six months before 9-11.
Not a day has gone by in the last two years when some commentator has neither denied we
are in a downturn, claimed we are already out of the contraction, or cited evidence
In fact, I believe our time will be recorded as a period of general economic meltdown.
How much worse will it get and how much longer will it last? We cannot know for sure, but
we do know that right now the government is doing everything in its power to make it worse.
Those of us who warned in the 1990s that the stock price mania could not last were accused
of spreading gloom and doom. Our warnings were considered self-eminently ridiculous
Because, of course, it was said that we were in a new economy, and such things as profitability
and earnings and savings were old hat and had no bearing on the cyber world being created
before our eyes. Only the Austrian School economists seemed to wonder what or who was
behind the frenzy. In contrast to the 1980s, when everyone was watching the money supply,
the markets were suspiciously uninterested in what the Fed was up to in the 1990s. It
They funded a bailout of Mexico, then a bailout of East Asia, then a bailout of a crazy Connecticut
hedge fund that believed it could predict the future by paying Nobel laureates vast
sums to concoct a mathematical model that perfectly predicted the past.
But still hardly anyone cared. The phrase money supply elicited yawns. The Wall Street Journal
meanwhile ran a few articles explaining why there is no longer any such thing as risk.
It was only the Austrians who seemed to take notice when money creation rates began to
to take off in 1995 and climb to 15% in late 1998 and 1999, taking the bull market on
its wildest ever ride. Monetary expansion rates settled down a bit in 2000, a trend
which at first seemed merely inauspicious, like a tiny tap on a domino lined up against
a thousand others. Once the bear market began, there was no turning back, no matter how much
the Fed inflated. Instead of stabilizing down where they had in Clinton's first term, money
Money creation rates shot up again, reaching an astounding 22% in December 2001 from a
year earlier, and then fell back down again, creating a double-dip bear market in the course
of a mere 24 months. In these numbers we find the secret history of the great boom and bust
of our time. Let me give a brief outline of why and try to explain why it is that so few
seem to pick up on it. At the dawn of the century of central banking, an economist named
Ludwig von Mises set out to rewrite the theory of what money is and how government can seriously
distort its workings. Among the puzzles he sought to solve was one that most economists,
including Karl Marx, had noticed, swings in business activity from boom to bust. Marx
said that cycles are endemic to capitalism and a sign of the final crisis that will sweep
in the age of socialism. In contrast, Mises found that the business cycle is a symptom
not of the free market, but of attempts to manipulate the market through unsound monetary
practices. Moreover, he found that these cycles are self-correcting, provided that the government
doesn't attempt to forestall the necessary correction that follows an artificial boom.
Mises concluded by looking carefully at the relationships among the financial sector,
money and banking, and the structure of production itself. On the free market, he said, the interest
rate reflects the extent to which people are willing to forgo current consumption for later
The more business and holders of money are willing to put off consumption, the lower
the rate will be. A low borrowing rate for business, which spurs investment, reflects
a high rate of consumer savings, which reflects a willingness of consumers to purchase the
products made in lengthy production processes. In testimony the other day, Greenspan claimed
the following, quote, Economists understand very little about how technological progress
occurs. Perhaps he should have said that he greenspan knows little about how technological progress occurs. At least as regards the Austrian economists, his statement is false. Within the framework of the freedom of exchange, entrepreneurs make judgments about what consumers might want in the future, including new technologies. Capitalists and investors assume the risk, employing private property. Investments that are profitable attract more resources, and those that yield losses are shelved.
This is the free market capital structure at work in a complex economy.
It is truly a miracle of coordination extending through all sectors and across a huge range
of time horizons with no central management and needing none.
It balances human needs with the availability of all the world's resources, unleashes the
amazing power of human creativity and works to meet the material needs of every member
of society at the least possible cost.
He does this through exchange, cooperation, competition, entrepreneurship, and all the
institutions that make possible capitalism, the most productive economic system this side
of heaven.
This system of capital coordination not only works without central management, government's
attempts to manage it create dislocations across sectors and across time.
Let us never underestimate the social benefits that flow from this seemingly technical mechanism.
The market economy has created unfathomable prosperity, and decade by decade, century
by century, miraculous feats of innovation, production, distribution and social coordination.
To the free market we owe all material prosperity, all leisure time, our health and longevity,
our huge and growing population, nearly everything we call life itself. Capitalism and capitalism
alone has rescued the human race from degrading poverty, rampant sickness and early death.
In the absence of the capitalist economy and all its underlying institutions, the world's
population would over time shrink to a small fraction of its current size with whatever
was left of the human race systematically reduced to subsistence, eating only what could
be hunted or gathered. The institution that is the source of the word civilization, the
city, depends on trade and commerce and cannot exist without them. And this is only to mention
and the Economic Benefits of Capitalism. It is also an expression of freedom. It is not
so much a social system, but the natural result of a society where an individual freedom is
respected, and where businesses, families and every form of association are permitted
to flourish in the absence of coercion, looting and war. Capitalism protects the weak from
the strong, granting choice and opportunity to the masses, who once had no choice but
but to live in a state of dependency on the politically connected and their enforcers.
But capitalism has many enemies, among them those who would attempt to gin up economic
production through loose credit. What Mises focused on in his book on money was the effects
of this particular attack on the free market, expansion of money and credit by the central
bank and in particular the attempt to drive down the price of credit to spur business
investment. Doing this through the interest rate requires injections of new money into
to the economy. One effect of this has been known for centuries. It causes prices to rise.
But the other effect Mises discovered. It subsidizes long-term capital investment in
a manner that cannot be supported by the patterns of consumption and saving. As one Austrian
economist put it, when the central bank drives down interest rates, it causes the economy
to bite off more than it can chew. The effect of artificially inflating the economy can
The monetary risk, for example, believe that so long as prices remain in check, there is no problem associated with money expansion.
The supply-siders, though sound on many issues, have an unfortunate faith in the power of loose credit to make bread from stones.
Mises developed his theory of money expansion in the late 19th century.
It was the first study of money expansion in the late 19th century.
Mises developed his theory throughout the 1920s and warned of the coming 1929 stock market crash.
His work was carried forward by F. A. Hayek throughout the 1930s. Hayek later received the Nobel Prize for this.
Indeed, the theory was widely embraced until Keynes dreamed up an alternative view that resurrected all the old fallacies about the miracles of money creation and centralized economic management.
Then the Misesian theory languished for decades until the current downturn.
Today it is getting new attention as the leading explanation of the insanity of the late 1990s and the current bust.
Only the Austrians said all along that reality would strike back.
The Fed and the administration have worked ever since, using the only tools that they have, regulation, spending and credit expansion, to reverse the course of the recession.
When I think of the Fed spreading money far and wide, I think of the government in Huxley's brave new world handing out soma pills or spreading soma vapors to distract people from reality, drugging them so that they will be content despite the surrounding disaster.
If they start to resist, out comes the soma until the crowds collapse in kisses and hugs.
It is always an illusion to believe that more money is the answer.
The federal funds rate is at a 40-year low, and that hasn't done the trick.
During the 1990s, the Bank of Japan tried again and again to manufacture a recovery through absurdly low rates, but that didn't work either.
There is no evidence from either theory or history that pounding interest rates into the ground can create anything resembling a sustainable prosperity.
And yet people believe it, or want to believe it, because it seems better than the alternative.
The entire affair illustrates the underlying reality of American political and economic life.
The State's ability to create money and credit. All other powers of government, regulatory,
fiscal, even military, pale in comparison to this. Despite that, the Fed is the least
controversial institution in American political life. Apart from Ron Paul of Texas, no national
politician understands how it works. When Greenspan comes before Congress, he is treated
like a minor god. If this worship is ever tempered with skepticism, it is on grounds
Mises distinguishes three varieties of inflationism, that is the demand that the state work with
the banking industry to flood the economy with credit.
The first is naive inflationism, which sees no real downside to monetary expansion.
The second is inflationism intended to reward debtors at the expense of creditors, and the
third sees disadvantages to an expansionary policy but believes that the advantages outweigh
them. The U.S. is right now in the grip of the worst form, naive inflationism, which
as Mises says, quote, demands an increase in the quantity of money without suspecting
this will diminish the purchasing power of money. It wants more money because in its
eyes the mere abundance of money is wealth. Fiat money, let the state create money and
and make the poor rich and free them from the bonds of the capitalists."
And here we are today enduring the longest recession in post-war history, a Nasdaq off
75% from its highs and a Dow off 40% and the government is still issuing buy signals.
Imagine if you had used George W. as your portfolio manager. You would have bought stocks
when he became president, held onto them through 9-11 and then bought more and more afterwards.
Incidentally you'll notice that the official rationale for buying stocks has changed, whereas
Because once it was said you could buy because the economy is on a permanent growth path,
after September 11th it was said you should buy to display your patriotism.
If that isn't a sell signal, I don't know what is.
Of course no one in his right mind would let the President of the United States manage
his stock portfolio.
Why then do we trust his government to spend wisely the 2.5 trillion dollars it will extract
from the private economy this year?
Of course we don't really trust the government to do that, but we do not have much choice
The money is taken from us by force and is thereby, by definition, directed towards uses that are not those which owners would have chosen. This is power, not market, at work.
What is striking to note, however, is that all the ways in which power is not only destructive but also ineffective against the market economy.
The government did not know that firms such as Enron and Worldcom were unviable.
All the regulators put together could not anticipate the consequences of what private traders alone were to discover, that these businesses had widely overextended themselves.
Leaving aside questions of ethical lapses of these companies, the most significant lesson we should learn from their collapse is that the market economy has built within it a fabulous internal check against illusion.
Companies that could not sustain themselves and their own merits were simply abandoned by investors.
It counts towards the enduring shame of the Bush administration that attempted to blame
the market for the bust of so many companies rather than having given credit to the market
for having discovered the problem in the first place and then having done something about
it. But as FDR demonstrated after the Depression, there are political points to be made by skewering
the private sector in order to distract from the failures of the public sector. The alleged
crime the Bush administration seized on was a counting fraud, even though it is not at
It is not at all clear that what WorldCom, Enron, Computer Associates, Global Crossing
or Quest did, often with the blessing of respected auditors, amounts to that at all. In each
case the accusation was similar. Their books counted spending as profitable investment
before the revenue was in the bag, and when the economic tables turned, their optimistic
predictions proved unsound and even, in retrospect, absurd.
WorldCom was the worst case of the bunch, which is why the government has made such
No one disputes the facts. Worldcom's expenses for last mile leases on other companies' communications
networks were rising very quickly. Managers wanted to move these expenses off of the profit
and Law Statement and onto the balance sheet, thus reflecting a more profitable appearance.
Now understand that there was no lying going on and no graft or theft or anything else
of that nature. What we have here is an imprudent reclassification design to impress investors
who at the height of the bubble demanded nothing less. Unless you're an accounting whiz, there
is no way to say that this is a priori evil. In any case, it didn't fool anyone. Many skeptics
This drew attention to the crazy finance of WorldCom's books. But in the boom times made
possible by the Fed, most people didn't care. Most of the other cases of corporate fraud
that came under the microscope were far less serious than WorldCom, and none are obvious
cases of theft or fraud. Mostly it was just bad forecasting reflected on optimistic accounting
methods. The supposed damage caused by their behavior was that their dressed up books kept
their stock price rising even as the financial condition of the company deteriorated. That's
That's probably true, but it's also a short description of what it means to be in a bubble
economy.
If this is fraud, the entire economic boom was fraud.
Hitting closer to the truth, the New York Times called D.C.'s anti-business frenzy
quote, the vital center of the administration's strategy for reducing the political vulnerability
for the White House, unquote.
In other words, the Republicans are up to their old trick of behaving even worse than
the Democrats in order to keep the Democrats from coming to power.
If you disagree with this approach, you must be some sort of libertarian utopian who doesn't
understand the need for compromise.
The underlying assumption was the view that it is always a terrible thing for a business
to go under, when in fact it is not.
It is merely a reflection of human preference as expressed in buying and selling decisions.
The only alternative to going under in some cases is to operate uneconomically, but that
is precisely what the government has in mind for the steel sector last year.
Recession, inefficiency and bankruptcy are not the only man-made disasters which the
government threatens us. Hardly a day goes by when the government doesn't issue some
maniacal warning but impending terror attack, and the sense of uncertainty and confusion
that follows can only forestall recovery. How much is real and how much is propaganda
or merely bureaucratic risk aversion? We cannot know. They recently urged us to buy duct tape
to seal the windows in our house in order to protect ourselves from chemical warfare.
They also told us they may use nuclear bombs against enemies real and imagined.
When the warning was given in February, gullible Americans cleaned out the stores of duct tape.
Buried in the news a week later was the fact that the person who gave the tip that led
to the orange alert was lying.
Of course, the revelation didn't do the government much harm, and the crisis environment that
the tip engendered is much good for our masters who want to keep us in a relentless state
of insecurity and therefore dependent on them.
That helps them keep doing what they want to do anyway.
For example, spend money and inflate it with the debts thereby incurred.
Politicians say they must run deficits of hundreds of billions of dollars to a verdant
impending calamity that will make 9-11 look like a warm-up.
They say this, but they've yet to issue a sell signal.
The government continues to downplay the economic calamity before our eyes while talking of
the prospects for a calamity that can only be solved, they say, by using the biggest
big government program of them all, war.
At the end of the Cold War, many of us hoped that normalcy would return, that the US would
once again become a peaceful commercial republic. But Bush the Elder had a different idea. He
decided to bomb Iraq and impose sanctions that would last 12 years, kill untold hundreds
of thousands, inspire terror plots all over the Muslim world, provide a new rationale
for why the US must continue to squander hundreds of billions a year on military public works
Program.
We were often told we must go to war because some swarthy foreign head of state is not
a big fan of the US President.
In 2003 the person fitting that description is Saddam Hussein.
Before then it was Mullah Omar, a few years earlier it was Milosevic, before that it was
some ward healer in Somalia, moving backward in time we had to take other strongmen in
Panama and Haiti.
The story goes on and on.
It seems that the US government is addicted to conflict, it just can't seem to give it
up.
Now, I know there will be plenty of disagreement when I say we ought to be trading with Iraq,
not bombing it.
But let's at least be clear what we are talking about when we refer to the U.S. military machine.
The U.S. will spend $400 billion on its military this year, and that does include VA hospitals,
most spine, the atom bomb building in the energy department, the military part of NASA,
or the Pentagon's huge black or secret budget.
The second highest military budget in the world is Russia's.
Going down the list, next come China, then Japan, then the UK. You have to tick through
27 countries and add their total spending together to equal what the U.S. spends per
year. Not since the Roman Empire has a single country been so militarily dominant.
Let's look at the relative strength of the U.S. versus Iraq in particular. Quantitatively
before the war, Iraq spent one quarter of 1% of what the U.S. spends on its military.
Qualitatively, the Iraqi military machine was already crippled with no spare parts for
its ancient equipment. The soldiers are teenage conscripts in rags with old rifles. The idea
that this is a fair fight is a joke. Those who worry about Iraq overarming itself ought
to look a bit closer to home. As for the shooting war, some military commentators have compared
its ease to drowning puppies. Thanks to a combination of misrule and punishing sanctions,
The long-time emphasis of the old liberal tradition with regard to war is this. Even the victor loses. We lose resources. We lose tax dollars. We lose trading relationships and goodwill around the world. Most of all, we lose freedom. And therein lies the fact that the United States faces a difficult foe, the desire of a people not to be invaded by a foreign army, and the unpredictability of political forces.
The biggest cost of war to us, for there is no way the US can maintain a free market that
is the foundation of prosperity while at the same time attempting to create a global military
central plan. Big government abroad is incompatible with small government at home. To the extent
we cheer war, we are cheering domestic socialism and our own eventual destruction as a civilization.
Perhaps, however, you do not need persuading on any of these matters. I know many people
I reject this posture. For one thing, I am firmly convinced that the government has reached too far. When you consider the full range of social, economic and international planning on which it has embarked, you can know in advance that this cannot work. Government is not God, nor are the men who run it impeccable or infallible, nor do they have a direct pipeline to the Almighty. The method they have chosen to bring about security and order is destined towards failure.
The war against terrorism is a good example. Everyone in Washington is terrified of the
next attack. To shore up the war there has been no shortage of rhetoric, no expenses
spared on arms escalation, there is no lack of will. The effort has the aid of plenty
of smart people. It is backed by threats of massive bloodshed. What is missing is the
essential means to cause the war to yield beneficial results. With all the millions
of potential terrorists out there and the infinite possibilities of how, when and where
Where they will strike, there is no way the state can possibly stop them.
Behind terrorism is political grievance.
This is not speculation.
That is the word of the terrorists themselves from Timothy McVeigh to Osama bin Laden to
the suicide bombers.
The pool of actual terrorists, like the pool of the poor in the war on poverty, is limited
and can be known and they are the ones the state focuses on.
But the pool of potential terrorists and potential poor people is unlimited and unleashed by
by the very means the state employs. Hence, not only does the state not accomplish its
stated goals, it recruits more people into the armies of the enemy, and ends up completely
swamped by a problem that grows ever worse, as the target population is able to make a
mockery of the state through sheer defiance. In the war on poverty, as more and more were
added to the ranks of the poor, and the intended beneficiaries of the programs themselves began
to mock the state's benevolence, people began to speak of the failure and collapse of the
of Great Society. Of course the welfare state still exists, but the moral passion and ideological
fervor are gone, in the same way we will soon be speaking of the collapse of the war on
terror. Bin Laden is still on the loose and everyone knows there are hundreds or thousands
of replacement Bin Ladens out there. Terrorism has increased since the war began, Israel
suffers daily and in constantly changing ways in which even the most famous and empowered
and intelligence and military units cannot anticipate or prevent.
But can't the state just kill more, employ ever more violence, perhaps even terrorize
the enemy into passivity? This cannot work. Even prisons experience rioting. A bracing
comment from Israeli military historian Martin Van Creveld, quote, the Americans in Vietnam
tried it. They killed between two and a half and three million Vietnamese. I don't see
Without admitting defeat, the Americans finally pulled out of Vietnam, which today is a thriving
stock market. Can the U.S. just back out of its war on terror? Wouldn't that mean surrender?
It would mean that the state surrenders its role, but not that everyone else does. Had
the airlines been in charge of their own security, 9-11 would not have happened. In the same
way that the free market provides for all our material needs, it can provide our security
needs as well. The war on terror is impossible, not in the sense that it cannot cause immense
amounts of bloodshed and destruction and loss of liberty, but in the sense that it cannot
finally achieve what it is supposed to achieve and will only end in creating more of the
same conditions that led to its declaration in the first place. In other words, it's
a typical government program, costly and unworkable, like socialism, like the war on poverty, like
the war on drugs, like every other attempt by the government to shape reality according
The next time Bush gets up to make his promises of the amazing things he will achieve through
force of arms, how the world will be bent and shaped by his administration, think of
Stalin speaking at the 15th Party Congress, promising, quote, further to promote the development
of our country's national economy and all branches of production, unquote. Everyone
applauded and waited in blood, pursuant to that goal, but in the end, even if he did
did not know it, it was impossible to achieve. Mises was so brilliant when it came to issues
of money and credit, also saw the need for a thriving economy to operate amid an environment
of peace. War, he said, is harmful not only to the conquered but to the conqueror. Society
has arisen out of the works of peace. The essence of society is peacemaking. Peace and
not war is the father of all things. Only economic action has created this wealth around
Our age is dominated by the state and its errors. The state is given us recession and
war, while liberty is given us prosperity and peace. Which of the two paths prevails
in the end depends on the ideas we hold about freedom, capitalism and ourselves. May we
never forget the great truth that our founding fathers worked so hard to impart. Tyranny
destroys while liberty is the mother of all that is beautiful and true in our world.
I make no apologies for being a champion of prosperity and its source, the free market
economy. It is what gives birth to civilization itself. It is fashionable to reject concerns
about the economy as narrow and uninteresting, a merely bourgeois interest. This attitude
comes to prevail we have great reason to be concerned about our present age. If on the
On the other hand, we can educate ourselves about the workings of economic forces, and
the way in which they are the foundations of freedom and peace, we will not only emerge
from this recession prepared to enter into a new growth path, we will have gone a long
way to protecting ourselves from future assaults on our right to be free.