Monday, November 17, 2008

Guest Article: Why We Should Take a Solutions Approach to the Crisis and Look at Some Things Differently

Why We Should Take a Solutions Approach to the Crisis and Look at Some Things Differently
By Peter Schiff, President of Euro Pacific Capital, Inc.
Author of The Little Book of Bull Moves in Bear Markets

I don't think we're going to see any light at the end of the tunnel until we have a clear, objective understanding of how we got into this mess in the first place. There is a tendency whenever major problems occur in the economy to place blame on external factors and to assume that the external factors can be prevented from causing similar problems in the future by expanding the government's regulatory powers. The problem I have with this kind of thinking is that it makes government bigger and more intrusive without ever getting at the root of the problem, which is usually the government itself. The other thing it does is reduce the sphere in which market forces move freely and would otherwise prevent the problem from recurring. Finally, as we face the challenge of rebuilding an economy, whatever lesson might have been learned from the government's role in the problem is lost on us because it was never brought to light in the first place.

The real estate meltdown provides an excellent example. Here we are about to give the Federal Reserve Board new powers to regulate mortgage lenders, appraisers, and other parties to a crisis that would never have occurred if the Fed hadn't taken upon itself the responsibility, better left to the free market, of determining what interest rates should be, particularly true with the absurdly low rates set after the bursting of the tech bubble and the tragedy of September 11, 2001.

The Fed's decision to set rates at artificially low levels to stimulate activity and growth in the real estate sector was directly responsible for the environment that naturally spawned such innovations as teaser rates, negative amortization loans, and other variations on adjustable-rate mortgages, which in turn had consequences that were extremely problematic. But the mortgage brokers and lenders weren't responsible for the root cause of the crisis, nor were the investment banks that securitized the mortgages, nor the hedge funds and institutions that purchased them. The Federal Reserve was. Yet the Fed is now being rewarded with additional powers to regulate Wall Street as well. So the fox ends up guarding the henhouse, which is bad enough, but anybody looking for the guiding lesson of the crisis probably wouldn't find it.

The real lesson is this: Interest rates represent the price of money (or more precisely, the price of credit). A government agency has no more business deciding what the price of money should be than it has deciding the price of a pair of tennis shoes. Why are we so surprised that central government planning works no better when it comes to setting the price of money than it does in setting prices for other goods?

The price of oil is being blamed on speculators, big oil companies, environmentalists, and other external factors -- but never on the Federal Reserve, which created the inflation that debased the dollars in which oil is traded and is thus principally responsible for increased oil prices. Priced in gold, which adjusts for inflation, oil has actually changed very little in price.

What worries me most, however, is the almost automatic backlash that attributes the present economic collapse to a failure of capitalism and free-market economics and turns it into an argument for expanded government. Never mind that government created a crisis that the free market would have avoided altogether; the problem with this case of mistaken identity is that it almost certainly will result in expanded government, much as the New Deal did during the Great Depression. Of course, the greater problem today is that we can barely afford the old New Deal, let alone the modern version we're about to be dealt!

The approach we need to take to our present crisis is not to expand government, but rather to understand government's role in creating the problem. The solution is to limit and control the power of government, not to create more unnecessary regulation to interfere with the free market forces that would have prevented the problem.

Thoughts on the Upcoming Presidential Election and How It Might Affect Our Economy

I think what we've learned from this historic economic breakdown is that it represents a colossal failure of government planning. When you have the government taking control of something as important as setting interest rates, this is the kind of disaster you get.

At this critical political juncture, are we going to compound the problem by giving the government even more power, making it even bigger, and putting it in a position to do even more damage? The alternative, of course, is letting the free market self-correct, which I believe in strongly but which is not, I'm afraid, the way Americans are inclined to lean in a time of economic crisis.

The impending failures of Freddie Mac and Fannie Mae, events I forecast in my book Crash Proof, in commentaries on my web site, and on television, and the government's intention to bail them out, is a huge step in the wrong direction. These quasi-governmental agencies, with their implied government guarantees, provided much of the air that inflated the housing bubble, and should be allowed to fail. Instead, they will be pumped up with more government money, compounding the fundamental problems in the housing market and worsening inflation.

In fact, early on in the housing crisis, most in government and on Wall Street were still so clueless that these agencies were actually touted as being the solution to the problem. In sharp contrast, I wrote in an August 2007 commentary entitled "It's a Shoo-In":

"In order to breathe life into the dying secondary market for nonconforming mortgages, some have suggested that Fannie Mae and Freddie Mac be allowed to buy jumbo mortgages. This overlooks the problem that many of these larger mortgages also feature adjustable rates that will likely show greater default levels when payments reset higher. Allowing Fannie and Freddie to buy larger loans now merely sets up a more expensive federal bailout down the road, as both of these entities themselves will likely need to be bailed out when the conforming ARMs they already insure go bad as well."

Bailing out Freddie and Fannie, as well as all schemes to bail out overextended homeowners and artificially prop up home prices are doomed to failure, and will only compound the problems they are attempting to solve. The recent failure of California-based IndyMac, a former leader in nontraditional mortgage lending, resulting in long lines of angry depositors, is but the tip of the iceberg. As more banks fail and the FDIC runs out of funds, the Fed's printing presses will be operating until they run out of ink.

Without getting into a contentious political discussion, I do see a parallel between the 1976 election of Jimmy Carter and the Reagan succession in 1980. Carter had taken office at a time when inflation and unemployment were issues. Voters were disenchanted by Gerald Ford and alienated by his pardon of Richard Nixon, whose abuses of power were still very much on their minds, and whose failed policies led to higher inflation and unemployment. The mood was very strong for a change from the traditional ways of Washington. The economy was so bad that Gerald Ford was even challenged in the primary by Ronald Reagan, who at the time was dismissed by the media and the party elites as too outside the mainstream to be electable. Carter ran as a Southern modernist and Washington outsider. He promised change and won. A similar situation exists today.

The Carter administration proved to be a turnoff and a disappointment for a majority of Americans, as the bad economy he inherited got even worse under his stewardship. As a result, the emergence of Ronald Reagan, an improbable candidate under normal circumstances, was actually welcomed as a timely alternative. Voters generally bought his mantra that government was the problem, not the solution, and he won the election. Reagan and Federal Reserve Chairman Paul Volcker took on double-digit inflation with double-digit interest rates, inflation was pronounced dead, striking air controllers were simply fired in a no-nonsense way, and the Reagan years generally got high marks. The mainstream world was now finally safe for a conservative promising limited government, provided his predecessor had exhausted the public's tolerance for big government. Unfortunately, Reagan never really followed through with his promise to rein in government spending, the consequences of which we are struggling with today.

Similar to Gerald Ford, John McCain had one challenger in particular whose message of limited government and sound money resonated with a small but organized minority. I am referring to Congressman Ron Paul, who, despite being marginalized by his other opponents and the mainstream media, struck a chord unheard elsewhere in modern politics, and managed to raise more money than any of the mainstream Republican alternatives.

The 2008 election features two candidates likely to make the current problems worse. Ironically, Barack Obama, whose policies would likely prove even more disastrous than McCain's, probably represents the lesser of the two evils. This is because Obama is perceived to be the candidate of big government, while McCain has wrapped himself in the false trappings of small government.

In the unlikely event McCain wins, he will be the Herbert Hoover of the modern era, completely discrediting capitalism in the minds of the electorate and setting the stage for a disastrous ideological counterreaction in the election that follows.
If Obama wins, however, while the economy will fare even worse, it will at least be clear that big government is to blame. By the end of Obama's term, the voters will have had such a bellyful of noxious government solutions that the mere thought of any more will put them squarely at the wheel of the porcelain bus. In such an environment, a Ron Paul type of Republican, dismissed as unelectable à la Ronald Reagan in 1976, may actually be in a position to capture the White House in 2012 and finish the job Ronald Reagan started.

Ultimately, we are going to need a free-market president, who understands sound money and Austrian economics and has the toughness, courage, and leadership talent to take the bull by the horns and begin the process of shrinking government, dismantling programs we can't afford, minimizing regulation and taxation so businesses can operate without competitive disadvantages, and generally taking the steps that will put us on a path to becoming a nation of savers and producers once again. If suffering though four years of hellishly misguided big government is the price we pay for true reform, it may in the end be worth it.

The above is an excerpt from the book The Little Book of Bull Moves in Bear Markets
by Peter D. Schiff, President of Euro Pacific Capital, Inc.
Published by John Wiley & Sons; October 2008;$19.95US/$21.95CAN; 978-0470383780Copyright © 2008 Peter Schiff

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