Understanding the Art of Economics

Fall 2009
Final Research Essays

Article 11 of 12

An argument in defense of free market capitalism in concern with the 2008-2009 recession and the structure of the United States’ economic system. This piece debunks Keynesianism and reveals major logical fallacies in the leftist school of thought. This paper is intended for American citizens, particularly those belonging to the academic and economics communities.

“The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups” (Hazlitt 2). These words, written by lauded economist Henry Hazlitt in his book, Economics in One Lesson (1946), are very relevant in today’s United States. Facing one of the worst economic crises in modern history, the nation is scurrying to find solutions to the mounting problems created by the collapse of the housing market. The Obama administration is passing massive stimuli and bailouts and is calling for more government intervention and regulations in order to control a market that they believe ran wild to create this mess. They are attacking capitalism by blaming it for the current problems, yet they fail to realize that it was anti-capitalist policies that inflated the crisis and that their currents actions are only furthering the damage. Their misguided response to the recession is the result of a failure to foresee the long term and widespread effects of certain policies; it is a failure in understanding what Hazlitt calls the “art of economics.” Upon an examination of history, economic laws, and the causes of this market downturn, it is clear that capitalism is not to blame, but it is the move away from it that has caused the problems the United States faces today. It is also evident that the interventionist policies currently being pushed by the left wing will only make things worse in the long run.

In order to decipher the causes of today’s problems, it is important to understand major economic theories as well as the policies that fall under them. A major driver behind the logical fallacies held by the current administration is the misunderstanding of what capitalism really means. As defined by Merriam-Webster dictionary, capitalism is “an economic system characterized by private or corporate ownership of capital goods, by investments that are determined by private decision, and by prices, production, and the distribution of goods that are determined mainly by competition in a free market” (Merriam-Webster). As clearly stated in the definition (and upheld by free market economists such as Ludwig Von Mises, Murray Rothbard, and F.A. Hayek), capitalism is against government intervention in the markets. Instead, it calls for the private sector to solve market problems with very little restraints from the government; it calls for a free market. 

A sizeable portion of the left wing is currently blaming free markets and capitalism for the issues that the United States is facing today. Many of these critics are believers in the Keynesian school of economic thought, a branch-off of capitalism, which opposes free markets and calls for the government to regulate the private sector. What they fail to realize is that the market during which the housing bubble arose and burst was far from free. Furthermore, an examination of economic data from the past few decades reveals that it was predominantly anti-capitalist parts of the market that created and inflated the problems that have led to the current recession. These malignant entities include the Keynesian-supported Federal Reserve (the central bank of the United States), large government sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac, and regulatory laws that dictated certain market outcomes. They in no way fall under capitalist theory and so, it is unjust to blame current economic problems on free markets (Sloss 1).

Among the most destructive and distortive government interventions leading up to the economic downturn were the actions of the Federal Reserve (the Fed). Established in 1913, the central bank’s primary purposes were to ensure market stability and stop bank runs. The institution has been given immense power in order to carry out these functions, namely the abilities to set the interest rate and control the inflationary and deflationary processes of the currency by printing money and serving as the backbone to the fractional reserve banking system (the main process through which United States currency is created.) Despite the colossal power in the hands of the Fed, it has failed to successfully fulfill its purpose. It has not created market stability as the United States economy has experienced recurring bubbles throughout the past century and it has not been able to prevent bank runs as they too have occurred in recent history (Kaufman 1).

The Federal Reserve not only failed to stabilize markets and banks, but economists from virtually every school of thought, including Keynesians such as economist Paul Krugman, agree that it drastically inflated the housing bubble, the trigger of this economic crisis, with dangerously low interest rates (Krugman 1). They also agree that the reason that banks have suffered runs recently is due to the severe overleveraging which allowed banks to spend and lend a lot more money than they actually had in reserves. This overleveraging was a result of the fractional reserve banking system that the Fed upholds and hence, the central bank directly supported it as well.

While these facts are commonly accepted, Keynesians fail to realize or acknowledge that capitalists do not support central banking institutions at all. This means that in a truly capitalist market, the Fed would never have been able to create these instabilities because it would have never existed. Instead, the market would set the rate competitively. There would never be artificially low rates that prop up untenable parts of the market or excessively high rates that suppress growth because the economic principles of supply and demand would dictate the availability of credit at sustainable levels (Sandelin 55). The supply-demand mechanism is the fundamental cornerstone of microeconomics and it is one that economists from every school of thought agree with (Mankiw 65). With an excess of credit, rates would go down and with a shortage of credit, they would go up. This would lead to stable growth instead of a pattern of bubbles and stagnation similar to what the Federal Reserve has created throughout its existence. The same would hold true for the monetary supply because supply and demand would stop excessive monetary inflation or deflation.

 The failure of the Federal Reserve is very apparent and the reason behind why it has failed is even easier to understand: no being has enough knowledge to judge the entire market accurately. This is because the market has virtually limitless variables including the non-quantitative variable of emotion. It is impossible for the Fed (or anyone) to set the best rate for the market because it is impossible to know what it is. Throughout world history, from Sweden in the 1600s to the Soviet banks to the Federal Reserve, central banks have only distorted markets due to their inability to accurately gauge them.

While Keynesians agree with capitalists in blaming the Federal Reserve for inflating the housing bubble, they fail to comprehend that the entity is not conducive to free markets. Capitalists are opposed to the system because it has historically failed to work and free markets provide a better alternative. Keynesians, on the other hand are still standing by central bank theory, blaming the Federal Reserve’s failures on former Fed chairman Alan Greenspan. Greenspan has publically vouched for free markets throughout his career and the left has used this as a means to tie the central bank’s shortcomings during his tenure with free markets. In doing so, they have neglected the definition of capitalism and hence, adhered to a logical fallacy that Greenspan’s actions fell under the umbrella of free markets. In reality, a capitalist economy would never even have a central bank.

Ironically, Keynesianism is one the theories that actually supports the idea of central banks. Maynard Keynes, the founder of the theory, clearly wrote in favor of having a central banking institution which regulates the markets and the currency. He also called for the government to intervene in markets during downturns of the business cycle and to regulate it in order to keep it stable (Hazlitt). In an attempt to do this, Keynesians fought for years to expand the Federal Reserve as well as other governmental regulatory institutions. Unfortunately, those pushes only led to more problems as many of those decisions ended up contributing to the housing crisis by propping up bad parts of the market.

Fannie Mae and Freddie Mac are two of those organizations and they were arguably second to only the Federal Reserve in the impact they had on the housing bubble. By law, these Government Sponsored Enterprises (GSEs) were forced to make certain loans to the banks regardless of how the banks were using the money. This meant that if the banks made risky decisions with GSE money, their losses would be covered even if the money was lost because the government would not let Fannie Mae or Freddie Mac fail. The government essentially insured risk for free. This prompted banks to make risky moves because they had nothing to lose. These unwise decisions are what have led to the credit crunch and billions of dollars in assets which are now considered toxic (worth less than the properties they represent.)

Keynesians point the finger at banks for making those unsafe decisions, but the corporations really can’t be blamed because companies act in the interest of profits. Even with regulatory agencies, a business always tries to raise profits. It is a fundamental proponent of the market economy. Fannie Mae and Freddie Mac only encouraged foolish decisions by offering a guarantee to the banks. In a capitalist system, these companies would have known that there was no government backing and hence, would have acted more responsibly because any money they lost would not be reimbursed. Their risky behavior was a symptom of the government’s involvement in the market, not a failure of capitalism.

Not only did Fannie Mae and Freddie Mac encourage bad behavior from the banks by backing loans, but they also dipped into the collateralized debt obligation (CDO) market by investing in it and propping it up. The CDOs were very risky investments and there was also a bubble in that market that eventually burst and led to severe losses for many investors including the GSEs. Fannie Mae and Freddie Mac not only collected losses, but also made the CDO bubble worse due to the sheer volume of resources that they pumped into the market and the fact that they acted as a buyer of the unstable assets (House of Cards). When the market collapsed, it was again the government that was forced to bail out these GSEs, something that would not have happened in a free market. The better alternative- the capitalist option- would have been to have Fannie Mae and Freddie Mac completely in the private sector, like the education loan backer- Sallie Mae. Sallie Mae was once a GSE as well; however, it was privatized in 1997. Since then, the corporation has experienced a lot more growth and it has made wiser decisions without government backing. The quality of the student loan market has also improved, with more competition and better choices for borrowers. As a consequence of privatization, Sallie Mae is thriving and is far from facing the sort of problems that Fannie Mae and Freddie Mac are up against today (Jaffee 6).

Sallie Mae is not the lone case of a private enterprise outperforming and being better for consumers than its governmental counterpart. History has proven over and over again that the private sector is the best at creating sustainable and stable growth. It is the private sector under a laissez-faire (“hands free”) government that fueled the American industrial revolution and paved the way for the United States to emerge as an economic superpower in less than two centuries after its creation. It is also the free market approach that is currently boosting China and India to the frontier of the world economy.

Government intervention has never resulted in strong, long-lasting growth or prosperity because governments are not as efficient as markets in solving problems. They rely on bureaucracy and politicians to get things done; whereas, free markets revolve around concrete microeconomic principles. The laws of supply and demand dictate everything from labor to goods to services. The price mechanism would adjust itself until the market reaches equilibrium- the point where the demand curve and supply curve cross and also the point at which there is optimal surplus for the market. Taxes and regulations only skew these curves and create deadweight losses (losses of economic efficiency) in the market (Mankiw 163). Central banks and credit backers such as the GSEs encourage bad behavior and prop up failing institutions, making market conditions even less stable.

Throughout the last century, market distortions have increased considerably in the United States due to government intervention. As a result, market conditions have been less stable and deadweight losses have increased. From the Federal Reserve Act of 1913 to Herbert Hoover’s regulations and Franklin D. Roosevelt’s New Deal to Lyndon B. Johnson’s Great Society and George W. Bush’s massive government expansion, the United States has been far from capitalist for a long time. Unfortunately, it still continues to move away from the theory that made it the greatest nation in the world. The Obama administration is now pushing big government and market intervention at rates not seen since the New Deal. This country is far from capitalist and with every push away from it, economic conditions in the United States—as in every other nation that has moved away from it in the past- become worse.

The Great Depression is a clear example as to why moving away from capitalism creates more problems than it solves. It is one of the most infamous economic events in modern history, yet what many do not know is that it was government intrusions in the market and socialist (a stark contrast to capitalism) actions that made the depression so detrimental. The economic downfall began in 1929 with the stock market crash. Herbert Hoover, who had assumed the presidency months earlier, vouched for the free market, while at the same time acting against them (much like Greenspan did) by implementing regulations and price controls. His interventionist policies worsened the market crash and after four years of meddling in markets the economy remained weak and he lost the 1932 presidential election to Franklin D. Roosevelt. Often referred to as FDR, the new president was a supporter of Keynesianism. Under the influence of Keynes, Roosevelt passed the New Deal- a collection of government programs that he felt would help the market rebound. This massive market interference and job creation by the government was very similar to the recent stimuli and bailout plans proposed and enacted by the Obama administration and the Federal Reserve.

Although the effects of the Obama stimulus are yet to be seen, the New Deal led to severe losses in the market as it dipped drastically despite showing some signs of relief during the last year of Hoover’s presidency. The New Deal only took the market to new lows in terms of growth and led to the nadir of the Great Depression. It would take a world war and the restructuring of the world economy in order to get the United States out of the Depression. All FDR did was simply continue Hoover’s interventionist, big government policies, but at an exponentially greater level.

In contrast, Warren G. Harding acted very differently during the depression of the early 1920s. It is an economic period in American history that is often overlooked due to its short life, but in reality that crisis had the potential to be just as detrimental, if not worse than the Great Depression (Folsom 1). The difference was that Harding had faith in the free markets and allowed the economy to correct itself. As a result of his laissez-faire approach, the economy recovered in less than five years. Both depressions were in a span of about 10 years, meaning that market conditions and technology were very similar during both, but the outcomes were drastically different due to the differing approaches the government took in response to the downturns. The free market approach clearly worked, whereas the Keynesian approach only made things worse (Woods 1).

Not only did the New Deal extend and worsen the Great Depression, but it also created many new government programs that have turned into major problems. This includes, but is not limited to Fannie Mae and Freddie Mac. The New Deal may have seemed beneficial at first, but further scrutiny reveals problems in the approach. Governments throughout history from FDR and the New Deal to the Soviets to Japan in the early 1990s have tried to fix market problems only to make things worse.

For this reason it is important to think twice before supporting bigger government. It is time for Americans to realize that more socialism and more government will only mean more problems in the long run. Many policies of the Bush and Obama administrations in response to the current crisis are already starting to backfire. For example, the bailout of the “Big Three,” has not helped the auto industry much. Chrysler is expected to file for bankruptcy soon and GM has seen little improvement. It is important to note that in order to give these funds to these companies; the government hurt successful parts of the market by taxing them in order to pay for bailouts. Not only did this prop up bad parts of the markets and reward companies that made poor decisions, but it stopped basic microeconomics from being able to correct market problems. Letting unproductive parts of the market fail would mean that the successful competitors of those entities would simply grow to take over the market share. This would mean that although some jobs may be lost when a company fails, other competitors would end up expanding and rehiring many of those people. By propping up failing companies, some jobs may be saved, but the risk of those companies still failing remains. The cost of this is that successful companies are taxed and unable to grow, meaning that they cannot hire new workers. Their stagnation may end up costing the American taxpayers a great deal of money while worsening market conditions at the same time. It is time to rethink the role of government and to realize that the government propping up dying parts of the market has and will always harm markets in the long run.

Bailouts and stimuli may seem great at first glance, but they always come at a cost- one that future generations usually have to pay. The people pay for it through economic losses, taxes, and the loss of freedoms that comes with taxes and regulation. From a political standpoint, market intervention may be appealing because spending a lot of money and meddling in markets makes it seem like one is doing something valuable in the eye of the unknowing public. When the facts are analyzed though, it is apparent that this is just not true. Free markets are the most efficient way to solve market problems and they are the path to prosperity. History has proven it and sound economic principles clearly support it.

Capitalism has always been about free markets and recent failures caused by government intervention in markets cannot be blamed on it. It is as simple as that. True capitalism calls for limited government, not central banks and excessive market regulators. The United States has been drifting away from capitalism for decades, but it is time to realize that this shift has only created more problems. Moving back to the fundamentals of capitalism will once again usher in a prosperous time for this great nation. It is time to rethink the models of Keynes and to remember the great words of wisdom from the founding fathers and free market capitalists such as Henry Hazlitt, F.A. Hayek, and Murray Rothbard. It is time to rethink the art of economics and remember the ways of the past.

"Capitalism." Merriam-Webster. 15 Feb 2009 <http://www.merriam-webster.com/dictionary/capitalism>.

Carden, Art. "The Myths of Capitalism's History." Mises Institute. 11 May 2009. Ludwig Von Mises Institute. 11 May 2009 <http://mises.org/story/3455>.

Colonna, Marina. Money and Business Cycles. Brookfield, VT: Edward Elgar Publishing Limitied, 1994. Print.

DiLorenzo, Thomas. "The New Deal Debunked." The Free Market: The Mises Institute Monthly 24.1111 2004 Web.11 May 2009. <http://mises.org/freemarket_detail.aspx?control=515>.

Feldstein, Martin. "The Tax Rebate Was a Flop. Obama's Stimulus Plan Won't Work Either.." Wall Street Journal 06 August 2008 Web.10 May 2009. <http://www.nber.org/feldstein/wsj080708.pdf>.

Folsom, Burt. "Why the New Deal Failed." Accuracy in Academia. 2002. Accuracy in Academia. 11 May 2009 <http://www.academia.org/campus_reports/2002/summer_2002_3.html>.

Galbraith, James. Unbearable Cost: Bush, Greenspan and the Economics of Empire. New York, NY: Houndmills, 2006.

Hazlitt, Henry. Economics in One Lesson. New York, NY: Harper and Brothers, 1946. Print.

Hazlitt, Henry. The Critics of Keynesian Economics. Princeton, NJ: D. Van Nostrand Company, Inc., 1960. Print.

"House of Cards." Hulu. CNBC. 14 Apr 2009 <http://www.hulu.com/watch/59026/cnbc-originals-house-of-cards>.

Jaffee, Dwight. "Reining in Fannie Mae and Freddie Mac." Securities and Investment. 26 Apr 2005. Cato Institute. 11 May 2009 <http://www.cato.org/pubs/regulation/regv29n3/v29n3-3.pdf>.

Kaufman, Wendy. "IndyMac Collapse Fuels Fears About WaMu." 17 July 2008. NPR. 11 May 2009 <http://www.npr.org/templates/story/story.php?storyId=92642046>.

"Keynes, John Maynard." Gale Encyclopedia of U.S. Economic History. Vol. 1. Detroit: Gale, 1999. 534-536. Gale Virtual Reference Library. Gale. 11 May 2009 <http://go.galegroup.com/ps/start.do?p=GVRL&u=umd_um>.

Koppell, Jonathan. “Hybrid Organizations and the Alignment of Interests: The Case of Fannie Mae and Freddie Mac.” Public Administration Review 61.4 June 2001 468. Web. 10 May 2009. <http://search.ebscohost.com/login.aspx?direct=true&db=ehh&AN=5191103&site=ehost-live>.

Kregel, J.A.. "Post-Keynesian Theory: An Overview." Journal of Economic Education 14.4 1983 32-43. Web.10 May 2009. <http://search.ebscohost.com/login.aspx?direct=true&db=ehh&AN=5422110&loginpage=Login.asp&site=ehost-live>.

Krugman, Paul. "Greenspan and the Bubble ." Editorials/ Op. Ed.. 29 Aug 2005. The New York Times. 11 May 2009 <http://www.nytimes.com/2005/08/29/opinion/29krugman.html>.

Ladenburg, Thomas. "Herbert Hoover and the Depression." Digital History 2-3. 16 Feb 2009 <http://www.digitalhistory2.uh.edu/teachers/lesson_plans/pdfs/unit9_7.pdf>.

Lingle, Christopher. "The Return of the Keynesians." Ideas on Liberty. March 2003. Foundation for Economic Education. 11 May 2009 <http://www.fee.org/pdf/the-freeman/feat11.pdf>.

Mankiw, Gregory. "The Market Forces of Supply and Demand."Principles of Microeconomics. 5th ed. 2008. Print.

Marglin, Stephen. "Why Economists Are Part of the Problem." Chronicle of Higher Education 55.25 27 February 2009 B7-B10. Web.10 May 2009. <http://search.ebscohost.com/login.aspx?direct=true&db=ehh&AN=36792489&loginpage=Login.asp&site=ehost-live>.

Rothbard, Murray. America's Great Depression. Auburn, Al: Ludwig Von Mises Institute, 1963. Print.

Sandelin, Bo. A Short History of Economic Thought. 2. New York, NY: Routledge, 2008. Print.

Skousen, Mark. "Japan and the Macroeconomic Debate." From the President's Desk: Ideas on Liberty. March 2002. Foundation for Economic Education. 11 May 2009 <http://www.fee.org/pdf/the-freeman/skousen0302.pdf>.

Sloss, Dakin. "Capitalism Did Not Fail: An Objectivist's Perspective." The Stanford Progressive. May 2009. The Stanford Progressive. 11 May 2009 <http://progressive.stanford.edu/cgi-bin/article.php?article_id=343>.

Wilkinson, Will. "Obama's Self-Immolating Capitalism." The Cato Institute: Individual Liberty, Free Markets, and Peace. 19 March 2009. Cato Institute. 10 May 2009 <http://www.cato.org/pub_display.php?pub_id=10058>.

Woodbury, Denise. "Economic Systems." Encyclopedia of Business and Finance. Ed. Burton S. Kaliski. Vol. 1. New York: Macmillan Reference USA, 2001. 275-278. Gale Virtual Reference Library. Gale. 11 May 2009 <http://go.galegroup.com/ps/start.do?p=GVRL&u=umd_um>.

Woods, Thomas. "Beware of Obamanomics." LewRockwell.com. 2009. 10 May 2009 <http://lewrockwell.com/woods/woods112.html>.

Yellen, Janet (2009) "The Mortgage Meltdown, Financial Markets, and the Economy," The B.E. Journal of Economic Analysis & Policy: Vol. 9 : Iss. 3 (Symposium), Article 3. <http://www.bepress.com/cgi/viewcontent.cgi?article=2230&context=bejeap>