Son of Why the World Is Not About to End

So, it’s Tuesday afternoon and the birds are singing outside my window as a chill September breeze slides over my arms. Cars on Springfield Avenue drive by full of gasoline that’s down to $3.50 per gallon and readily available. People all over town go to work as they do every day, the Dow was up 250 points, and no citizens on the sidewalks seem in the least bit panicked. Pissed, perhaps, but not a bit panicked.

For over seven years, I’ve been talking about the coming crisis in the financial markets. In the last year, Prescott joined me in this publicly, although he says (and I have no reason to discount him) that he had realized that there was going to be a problem around 2004 or so. The purpose of this article is to explain why this happened, why more government interference is going to be a disaster, and why this is a golden opportunity to not only make America stronger, but also freer as a nation and more equal as far as its citizens’ compensation goes.

Economists are not scientists, despite their claims. When you have several competing theories (none of which actually work in predicting outcomes) that equally intelligent proponents are using as models, it’s not a science—it’s Las Vegas on a Friday night. If Economics and Finance theories really worked, all of the richest people on earth would be economists and financiers, rather than engineers, computer scientists, and storekeepers constantly succeeding in packing away the billions. Economics is not a science because there is only one human race—there’s no control group, therefore you cannot use the scientific method. Economists have to rely on computer models and past experience, and, as the disclaimer says, “Past experience is not an indicator of future performance.”

So, for the most part, we can listen to economists and financiers, but not too hard. A little later, I’ll link to an article by an economist who, I think, may actually get it. I don’t completely trust him, of course, because he has the same problems as the rest of them, but he may be onto something. Now, there’s at least one thing that, as far as I know, all economists agree on. They agree that bubbles occur due to uninhibited exhilaration on the part of investors and that they happen over and over again. Historically, they’re not even a result of the industrial revolution, since the first major one, the Tulip mania, occurred during the early 17th Century. (The investors even invented “short selling” during this bubble and got it banned twice by 1637, when the bubble burst.)

Bubbles happen, apparently, due to something deep-seated in human nature. They seem to be an inescapable characteristic of capitalism and investment in general. Nothing in the last 350 years has succeeded in eliminating them. Therefore, I would say, that it’s a safe bet that nothing in the next 350 will, either, if we keep capitalism as our economic system. (This is fine—capitalism gave us a standard of living so high in America that we could invent the Internet and give it away.)

If there are going to be bubbles, there is going to be a business cycle. The business cycle is not something sinister or evil, it’s a feedback loop—something engineers are intimately familiar with every day of their lives. There’s a scarce commodity so people sell it for a high price. Investors loan their money to the people who are buying it so that they can afford to get it. As the amount of the commodity becomes less, higher prices are asked and, by trading it back and forth, everyone makes money.

This is fine, as long as the prices paid by those traders are reasonably close to the actual value of the commodity. Bubbles occur when people become so excited at the prospect of profit that they lose sight of this objective quantity and begin paying more and more for that commodity. Eventually, one of three things happens and the prices drop drastically—either the government interferes, innovators find a way to produce a cheaper substitute for the product, or the investors suddenly come to their senses, as occurred with tulips. In any case, those investors who were stupid or careless and threw their money in at a value that was too high are taught not to do it again and become wiser. Some people gain, some lose, and life goes on without too much of a problem. Inflation is automatically dampened and the cycle starts over again.

Well, this cycle had been working successfully for almost three hundred years when, due to the Panic of 1907, the US congress voted to create the Federal Reserve System. Read the description of the crisis that created it carefully, noting that the situation then is very close to the one that we’re currently seeing. The purpose of the Fed was to dampen the business cycle and prevent bank failures by keeping enough money in the system to allow banks to recover from bad investments and have enough money to pay their depositors when they ask.

Now, a good engineer always asks, “Well, did the invention perform the way that it was supposed to?” Let’s look at past performance. From 1813 to 1907, the dollar gained 52% in value. From 1913 (the time of the establishment of the Fed) to 2008, it has lost 95.2%, even using the official figures, which I consider to be too low. Therefore, it can be concluded that the establishment of the Fed did not prevent inflation and may have even contributed to it. Has it dampened the business cycles? Again, no—as a matter of fact, the current head of the Fed claimed in a 2004 speech that the Fed, through errors, exacerbated the economic mistakes that caused the Great Depression.

During the last twenty years, the Fed has worked mightily to prevent the crashes in the business cycle due to the Internet’s allowing thousands upon thousands of new, stupid, greedy people to get into the investment market, not only here, but abroad. (Yep, this is what I’m saying: “E-trade got us into this.”) Since there has been no penalty for being a dumbass, dumbasses have kept running the prices of commodities higher and higher. This was merely annoying when the tech bubble was dependent on thousands of people clicking on each other’s websites for hours on end like Chinese gold-famers playing World of Warcraft. When the commodity that people were using to make tons of funny money, however, became houses, which are actually needed to live in, it became criminal.

It was obvious that the housing bubble was going to burst. After all, it’s not like America is either short on carpenters or land to put houses on. Rather than a roof over one’s head, houses were seen as an investment to hold for a while, then sell at a profit—the characteristic of any bubble. Many who look at the present crisis worry about those in low-income groups who bought more than they could afford (and I’ll get back to them later), but upper-middle class investors were just as prone to buy houses to roll-over that they couldn’t afford. It became short-selling with a yard attached, in essence. The vastly overpriced and (since they were unlikely to be paid) worthless investments were bundled and sold to investors worldwide who were also caught up in the exuberance of easy money. All the time this was happening, the Fed kept interest rates at rock-bottom to prevent any slowdown in the economy, creating a positive feedback loop increasing the rate of bad investments.

So, eventually, the inevitable happened. It was triggered by oil prices, more or less, but anything destabilizing would have done the trick. The bubble burst and housing prices plunged. Inflation crept up, moving long-term adjustable range mortgage rates higher. People couldn’t pay them and foreclosures started. The real values of bad investments became apparent when they could no longer be sold. This is where we are at the present time—teetering at the edge of a crash.

So, the government, the same people who have been creating this crisis for the last twenty years—hell, for the last century, if you consider just the Fed—come to the American people and say, “Hey, if you don’t allow us even more power, and, by the way, guarantee these stupid investments with your tax money, the world is going to end.” To no one’s surprise, the taxpayers, who, as a whole, are better investors than those playing the stock markets, said, ten to one, “hell no,” to their Congressional Representatives. (An interesting note is that the failure to pass the bill is now being written off as the American peoples’ inability to really understand what’s going on.)

So, the rescue program’s been voted down once, what should the government do? In my opinion, it should do absolutely nothing to ease the crisis. I agree with Dr. Miron at Harvard, the economist I mentioned earlier. Bankruptcy is the answer. Even those pushing the stabilizing program admit publicly that at best, it’s a stop-gap measure and another crisis will occur in a couple more years. Let the market fall to 8300—its natural level right now. Let stupid companies fail and be bought out by more intelligent investors, who still have money. That’s how capitalism is supposed to work. Things will be tough for a couple of years, but you know what—we’re Americans, we can handle a little bit of discomfort for a while—we don’t need to be put in a figurative car seat and taken for a ride off a cliff. After that, the business cycle will protect us from greed and stupidity.

Is there a role for government in this crisis? Yes—one of the only ones that government is morally good for—the protection of its citizens from robbery and fraud. Those individuals and corporations that lied to mortgage seekers, that bundled worthless securities and hid their low value, that encouraged lying, cheating boards of directors and controllers, and gave CEOs 300 times the salaries of the median worker in their firms need to be prosecuted and penalized the same as the poor kid who steals Nikes from his neighbor—triple damages plus community service.

At the same time, let’s debate the role, or, if we’re brave and innovative, the very existence of the Fed, at the same time. Its record’s been dismal; it cannot, from an engineering standpoint, do what it was designed to do. Perhaps it is finally time to retire it and give the business cycle the freedom to work its evolutionary magic.

This is not the end of the world. This is not even the Great Depression. It is a golden opportunity to make this nation better if we have the nerve to do so. Let’s tighten our belts, buy only what we can afford, be at our best and bravest, and built an honest, decent future for our country.

–Tom Trumpinski