The economy is in a recession. The bugaboo word, “depression,” is at last being used by high-level officials, economists, and talking heads on TV. This is the first time in my lifetime that people of influence have used the word, except in this sentence: “A depression is no longer possible because of central bank policy and government regulation.”

Secretary of the Treasury Paulson followed the Keynesian and Chicago School party lines on this issue until September 18, 2008. Then, out of the blue, he announced the need for a $700 billion bailout. The implication was clear: depression is knocking at the door. Like the Big Bad Wolf in the ancient Disney cartoon, the depression threatened to huff and puff and blow our house in.

Congress is now debating whether or not to pass legislation that will enable Paulson to write checks to American banks and financial institutions to enable them to fulfill the highly leveraged contracts that they voluntarily agreed to.

Well, this is not quite true. Congress is not debating whether or not to pass the legislation. It is debating about how many new restrictions will be placed on the capital markets, and how much pork can be squeezed out of the Bush Administration as a quid pro quo. Obama is pushing for a new Section 8 housing subsidy: letting people who cannot pay their mortgages remain in their homes at taxpayers’ expense.

This entire charade is really about this issue: contracts. How much will it cost taxpayers to enable people who made binding legal contracts to now escape their obligations? Some of these people are legal fictions: corporations. Others are real people: families. They have made contracts with each other, and now they all seek to escape the terms of these contracts, yet also be allowed to get the benefits. Corporations will stay in business, and homeowners will stay in their homes.

I don’t think most homeowners who cannot pay will be allowed to stay in their homes. But large financial corporations who cannot pay will be allowed to stay in business.

THE GREAT DEBATE

I am glad that Congress is debating this issue. It reminds the public about just how bad the mess is. But I do not think that Congress will send Bernanke and Paulson packing. From what I can see from the brief televised snippets of the cross-examination of Bernanke and Paulson, the Senate is ready to capitulate. But, in an election year, the Senators are going through the motions in order to persuade the voters that the Senate has done due diligence in examining the claims of Paulson and Bernanke. It is a charade, but what isn’t in Washington?

Congress insists that all future transactions of the banks be transparent and open and fair and low risk and just good for everyone. It does this every time there is a crisis to bail out. Then there is another wave of profits followed by a crisis.

We have had the Federal Reserve System since 1914. We have had extensive Federal regulation of the securities markets since 1933. The result? We now need to bail out the financial system by $700 billion, in addition to the $85 billion AIG bailout that was announced two days before Paulson made his announcement about the need for $700 billion more. This was two weeks after Paulson, on his own authority, announced that the Federal government would absorb $5 trillion worth of Fannie Mae and Freddie Mac debt. Yet we are assured, “this is the last time. Congress is making sure that this is the last time.”

It is all a charade. The voters really do not care. The voters do not understand the complexity of these issues. Why should they? The bankers and the largest insurance company did not understand the complexity of these issues, and they put their firms in the hole by at least $800 billion. The economists who created the mathematical models that made possible these preposterous, money-losing contracts clearly did not understand the complexity of these issues. The two Nobel prize-winning economists who created the sophisticated mathematical models that bankrupted Long-Term Capital Management in 1998 did not understand the complexity of these issues.

The reason why bankers do this is that they want short-term profits. They believe that they are masters of the universe. They believe that mathematics will save them. They believe they can use highly sophisticated mathematical models, which all of their competitors use, and still extract billions of dollars of profit from these models, despite the competition.

Why were they able to extract these enormous profits? Because they ignored the economic effects of a reduction in the rate of monetary inflation by the Federal Reserve System. None of them understood the Austrian theory of the business cycle. So, they loaded up on enormous quantities of highly leveraged debt, and they skimmed off the profits from the front end of the contracts.

Now these contracts have gone the other way. The entire financial structure is dependent upon the fulfillment of these contracts, but these contracts cannot be fulfilled by the people who wrote them. So, the people who wrote them went to Secretary of the Treasury Paulson and Federal Reserve Chairman Bernanke and moaned and groaned and screamed and begged and pleaded: “Give us the money we need to fulfill our contracts.” That is exactly what Paulson and Bernanke are doing with Congress. They are acting as the representatives of the profit-seeking, bonehead bankers who loaded up on debt, skimmed off the front-end commissions, and have now gone away, with tens of millions of dollars in their pockets. Now the taxpayers will be saddled with the obligations to the tune of almost $2 trillion.

It is always this way. This is what Federal regulation means. Federal regulation creates rules that can be circumvented by any banker, lawyer, and accountant who want to get really creative. When they get creative, they load up on massive debt, and then they stick the taxpayers with the bill, either indirectly through Federal Reserve inflation or directly through the Treasury. It has been this way ever since 1933. As the regulatory structure has increased its control over the financial markets, the financial markets have found ways of beating the system. But they all depend on one assumption: the United States government will intervene in a crisis and load up on massive debt in the name of the People in order to bail out financial institutions that say they are going bankrupt. The entire system depends on the fact that the government will take over the obligations of big-time losers. This is called “moral hazard,” and it has been a well-known phenomenon since the middle of the 19th century. The phrase is not recent. It is over 150 years old.

Now the politicians are going to flex their muscles. They stand in front of the cameras and tell the voters next time it will be different. Next time, we will impose restrictions on these greedy capitalists. “We will make certain that they don’t get lots of profits.” It is all a charade. Yes, they will pass legislation. This legislation will create careers for high-paid Wall Street lawyers and well-paid government agency lawyers. The lawyers will figure out ways to get around the regulations, just as they always have since 1933.

There is no question that these regulations will hamper the free market economy. It will transfer oligopoly status to large firms that can afford to hire lawyers that get paid $500 an hour to identify loopholes in the regulatory system. Small businesses will be penalized. Small businesses are where most of the economic growth originates. It will become more difficult for small businesses to raise capital.

Congress is insisting that senior managers will no longer be paid high salaries. Well, most senior managers were not paid high salaries. They were given stock options. So, they ran up the value of the stock options by using corporate money to buy shares of stock in the open market. Instead of developing new, creative ways of serving the consumer, they did what any self-respecting, self-interested official would do. They saw their opportunities and they took them.

They have now gone away, with tens of millions of dollars or hundreds of millions of dollars in their various financial accounts. This is why it is so important the government intervene to bail out the financial system. If the government did not do this, the former heads of these corporations, who took their money and left, might lose a lot of money. They don’t want to lose money. So, Congress will intervene to make certain that they don’t lose any money. Congress will do this in the name of the People.

This is called locking the barn door after the horses have escaped. The horses left behind a massive pile of droppings. Congress is going to use taxpayers’ money to clean out the Augean stables. Meanwhile, the guys who got rich are gone, and the guys who replaced them will find it more difficult to get rich. But they will find ways to do this eventually. Their lawyers will find ways. Then, once again, Congress will be facing the need to bail out the financial markets.

THE FEDERAL RESERVE

This is inescapable, because the Federal Reserve System has the power to inflate at any time, for any reason. The Federal Reserve System controls the money supply. The chairman of the Federal Reserve System always believes that he can outsmart the financial markets. He believes that he and his staff know what is good for the economy. So, they regulate short-term interest rates by creating money at varying rates of expansion.

The Federal Reserve System is at the heart of the American economy, and it is a government-protected monopoly. The people inside the FED do not get rich, but they gain enormous power. People who possess power like to use power. This is why they manipulate the American economy. They get their jollies by directing the economy in ways they think the economy should go.

Recently, the economy went over a cliff. Anyway, this is what the Secretary of the Treasury and the chairman of the Federal Reserve System are telling Congress. Whether it is true or not, no one knows. The reason no one knows is because the complexity of the system is so great that no one can possibly know. This is why we have free markets: to distribute risk and to decentralize information. The problem is, in the field of monetary policy, we do not have a free market. We have a government-created, government-protected cartel. From time to time, the cartel of commercial banks loses money, and it goes to the Federal Reserve System and to the United States Treasury to tap into the taxpayers’ accounts. Congress debates, and then it capitulates.

The failure of the financial markets is being blamed on free enterprise. Almost nobody blames it on Alan Greenspan. Nobody blames it on the Federal Reserve System itself. Nobody blames the regulatory structure that has created this monster. No, they blame the free market. They blame de-regulation under Reagan. There was de-regulation under Clinton, too. His Secretary of the Treasury had been CEO at Goldman Sachs, just as Bush’s is. No matter.

The critics blame greedy capitalists. Capitalists are indeed greedy. They are always greedy. The question then is this: Why does their greed lead to financial disasters during one period of time? The answer is monetary policy. This is the Austrian theory of the business cycle. But hardly anybody believes it, because if they did believe it, they would have to abolish the Federal Reserve System and the entire regulatory structure of the Federal Government over the financial markets. They would have to revert to a system in which contracts are in force. Nobody wants to live in that system who is in a position to milk the existing system by violating contracts.

We are going to see the banks come back again for another round of bailouts. The recession is going to intensify. There will be more bankruptcies. There will be more unexpected crises. The Treasury will come back again, hat in hand, begging for more money, and insisting that the worst is over, that this time it will be different. The worst is not over, and next time will be no different.

The voters never figure it out. The regulatory system and central banking system are deliberately complex, which keeps the voters from figuring it all out. The problem, above all, is the Federal Reserve System. Yet this institution is considered sacrosanct. Congress is listening to Bernanke as though Bernanke and his predecessor were not the primary cause of the disaster which Congress is now expected to bail out with taxpayers’ money.

Paulson assured us that the financial system had no major problem. He insisted that it was safe and sound. Yet, somehow, in just one weekend, the system bordered on collapse, according to Paulson. Paulson and Bernanke were clueless, yet Congress is listening to them, praising them as great leaders, and vowing that this will never happen again. Paulson and Bernanke say they want more regulatory power. Surprise, surprise. Everybody in Washington wants more regulatory power. This time, the Federal Reserve System and the Treasury Department will get what they want. Why will they get it? Because they have jointly overseen the collapse of the financial structure. Anybody who oversees a collapse of the financial structure, who then goes before Congress saying capitalism has failed, is going to be granted more regulatory power.

REDUCED GROWTH

The free market will be less free as a result of the shenanigans of the Federal Reserve System and the Treasury Department. The voters will capitulate because the politicians insist there is no other alternative. The politicians will insist this because they have been told that this is the case by the boneheads who created the crisis. And so it goes. It will not be different.

Economic growth will be slower because money will flow into Treasury debt rather than businesses.

The recession will last longer because of this intervention. The bad investments will stay on the books. Huge liabilities will remain. The projects that should not have been begun will be completed. They will lose money.

When the government intervenes to set the terms of exchange rather than enforce contracts, economic growth is reduced. Responsibility is transferred to regulators, who then go to the politicians and insist on more taxpayer money to bail out the system and more regulatory power. The politicians comply.

There is no organized opposition to this expansion of power. Even free market economists come around. “One last time!” “This time, it’s necessary.” Why? Because on one issue, they are agreed: the need for a government-licensed central bank. They all believe that the free market is not capable of developing a monetary system based on consumer choice and the enforcement of contracts.

Well, not quite all. The Austrian School doesn’t. But this is a fringe group in the profession. Nobody pays attention to it.

CONCLUSION

We are witnessing the re-regulation of American capital. There was a brief loosening of the strings attached, but investment banks (R.I.P.) and financial institutions misused the system, knowing that Uncle Sugar would bail them out. A few did not get out in time. Bear Stearns didn’t. Merrill Lynch didn’t. Lehman Brothers Holdings didn’t. But Goldman Sachs and Morgan Stanley got the government to allow them to switch from investment banks (less regulation) to commercial banks (regulation and bailout money) on Friday, September 19. This let them survive.

We have moved away from somewhat freer markets. In the process, critics of capitalism have been handed a great weapon: “See what the free market did. We must save capitalism from itself.” It is the same old refrain. It goes back to Franklin Roosevelt’s first term.

The noose will tighten.

Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

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