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In his testimony to the Congress on September 24, Fed Chairman Bernanke urged the legislators to quickly approve the bailout of the financial sector with a package of $700 billion. Bernanke echoed Treasury Secretary Paulson's view that the bailout expense, while hefty, is needed to remove from banks' balance sheets the mortgage-linked assets, which are paralyzing the flow of credit.

I think it's extraordinarily important to understand that as we have seen many previous examples in different countries and in different times that choking up of credit is like taking the lifeblood away from the economy.

Most experts came out in strong support for the package. Without the rescue package, many large institutions that are "too big to fail" could go belly up. Many believe that the consequences of all this could be very severe to the real economy.

It is true that the financial system must be rescued; it must be rescued from the institutions holding bad debt that are currently draining capital while waiting for a bailout and adding little in return. It is they that are preventing wealth-generating activities in the financial sector and the other parts of the economy from expanding real wealth.

The Essence of Economic Adjustment

Conventional thinking presents economic adjustment — also labeled as "economic recession" — as something terrible, even the end of the world. In fact, economic adjustment is not menacing or terrible; from an economic point of view, it is nothing more than a time when scarce resources are reallocated in accordance with consumers' priorities.

Allowing the market to do the allocation always leads to better results. Even the founder of the Soviet Union, Vladimir Lenin, understood this when he introduced the market mechanism for a brief period in March 1921 to restore the supply of goods and prevent economic catastrophe. Yet for some strange reason, most experts these days cling to the view that the market cannot be trusted in difficult times like these.

If central bankers and government bureaucrats can fix things in difficult times, why not in good times too? Why not have a fully controlled economy and all the problems will be fixed forever? The collapse of the Soviet Union's centralized system is the best testimony one can have that controls don't work. A better way to fix economic problems is to allow entrepreneurs the freedom to allocate resources in accordance with society's priorities.

In this sense, the best rescue plan is to allow the market mechanism to operate freely. Allowing the market to do the job will result in some activities disappearing all together while some other activities will in fact be expanded.

Take, for instance, a company that has six profitable activities and four losing activities. The management of the company concludes that the four losing activities must go. To keep them alive is a threat to the survival of the company; these activities rob scarce funding from profitable activities.

Once the losing activities are shut down, the released funding can now be employed to strengthen the winning activities. The management can also decide to use some of the released funding to acquire some other profitable activities.

This is precisely what the government rescue package prevents from happening. The government package is not going to rescue the economy, but it will rescue activities that the economy cannot afford and that consumers do not want. It will sustain waste and promote inefficiency, draining resources from growth and efficiency. Remember: government is not a wealth generator; it can only take resources from A and give them to B.

Can the Rescue Package Prevent Economic Disruptions?

Some supporters of the package are of the view that the package is necessary in order to prevent economic disruptions. They mean by this that various phony activities should be kept alive by wealth generators for a little bit longer until a proper system is established. By "proper," they mean more controls.

For a while, the government's package can appear to be working; this is because there is still enough real savings to support both profitable and unprofitable activities. If, however, savings and capital are shrinking, nothing is going to help, and the real economy will follow up with further declines.

Hence the rescue package cannot prevent so-called economic disruptions. If anything, government intervention would make these disruptions much worse. Again, a better alternative is to let the market do the job. The market's ability to make swift adjustments without much drama was vividly illustrated only a few weeks ago when the very large investment bank, Lehman Brothers, was allowed to go belly up. The world did not come to an end. Instead, this was a healthy development. A money loser was eliminated from the market. This freed up resources to promote growth.

One could have made the case that when Lehman was on the brink it was too big to fail — assets of $639 billion and employing over 26,000 people. Yet in a few days the market, once allowed to do the job, reallocated the good pieces of Lehman to various buyers and the bad parts have vanished. It was poetry.

Likewise Merrill Lynch, which was bought by the Bank of America, will see the good parts of it reinforced while the useless parts are likely to be removed.

On September 18, 2008, Washington Mutual, the largest US saving and loan bank, was forced into liquidation. The bank had $307 billion in assets and $188 billion in deposits. What prompted the closure are heavy losses on its $227 billion book of real-estate loans, of which a large portion was in subprime mortgages.

The bank lost $6.3 billion in the nine months ending June 30. Against this background, and coupled with customers withdrawing $16.7 billion over the past ten days, government regulators decided to close the bank.

Observe that this was the largest US banking failure. Note that the closure of the bank didn't result in the end of the world. JP Morgan Chase bought some of the good assets of Washington Mutual for $1.9 billion.

On this, Jeffrey Tucker made the following observation,

But as wonderful as the daily shifts and movements are, what really inspires are the massive acts of creative destruction such as when old-line firms like Lehman and Merrill melt before our eyes, their good assets transferred to more competent hands.… This is the kind of shock and awe we should all celebrate. It is contrary to the wish of all the principal players and it accords with the will of society as a whole and the dictate of the market that waste not last and last. No matter how large, how entrenched, how exalted the institution, it is always vulnerable to being blown away by market forces — no more or less so than the lemonade stand down the street.

Most commentators have accepted that the root problem of the current financial crisis is the lack of proper control over mortgage lending. But the out-of-proportion explosion in the mortgage lending didn't occur out of the blue. Without the aggressive lowering of interest rates by the Fed, mortgage lending couldn't have exploded. The Fed lowered the federal-funds rate target from 6% in January 2001 to 1% by June 2003. The 1% was kept until June 2004.

The loose monetary stance prepared the ground for various false activities that wouldn't have been around without the loose stance. If authorities had kept strong controls over mortgage lending, while at the same time creating money out of thin air, the excesses would have popped up in some other sector. The banks would have ended up having plenty of bad non-mortgage-related assets.

The Fed's loose policies are the crux of the problem. So rather than blaming the symptoms, what is required is to let the market work and close all the loopholes that allow the creation of money and credit out of thin air.

Can Making Banks' Balance Sheets Look Good "Fix" the Economy?

Recall that Treasurer Paulson and the Fed chairman are of the view that once banks' bad assets are removed, the banks are likely to move ahead and start lending. We suggest that making the balance sheet look pretty is not going to alter the essence of the problem, which is the poor state of capital and savings to support such high lending activities.

The essence of a sound credit market is not lending money as such but lending the real stuff that people require by means of money. Without the real stuff — the preceding savings and subsequent productivity to fund the lending — no lending is possible.

Decades of nonproductive consumption (consumption that is not backed up by production) that emerged on the back of loose monetary and fiscal policies have severely damaged the store of wealth that serves as the foundation for credit markets. If this is the case, it will be futile to try to boost lending by pushing more money into the banking system. More money cannot generate real wealth. If it could, world poverty would have been eliminated a long time ago.

When the market is allowed to take charge, the relationship between savings, lending, and productivity will be brought into proper perspective. At last we will know which activities are genuine and which are phony.

Does the Fall in Stock Prices Cause an Economic Slump?

The proponents of government intervention maintain that one cannot allow the market to take charge since this will cause a drop in stock prices, which will be bad for the economy. Within the confines of this way of thinking, it is not surprising that Bernanke and Paulson panicked on September 18, once a large money-market mutual fund — the Reserve Primary Fund — was on the brink.

They argue that were it not for the Fed's injecting $105 billion and the subsequent announcement of the rescue package, the stock market would have had a massive fall. They also believe that the massive monetary injection prevented a run on money-market mutual funds and prevented a major disaster.

They further believe that if people had taken the money out of their money-market mutual funds, banks wouldn't be able to secure money to fund credit cards and various consumer and business loans. This in turn would have paralyzed the economy.

So let us think about this. Say that people take their money from the money-market mutual funds. What happens then? They will have placed it somewhere else, mostly likely with commercial banks. Hence money wouldn't disappear and banks could continue to fund activities as before.

If large money-market funds were to go under, some of their assets would be sold and the shareholders would suffer losses; this however, cannot provide justification for the Fed to pump money and to introduce a rescue package. Monetary expansion and a rescue package do not undo the bad investment decisions of the money-market-mutual-fund managers. Why should people who didn't risk investments in the fund pick up the tab?

A fall in asset prices, including stocks, and a run on financial institutions are just symptoms and not the cause of anything. The key factor behind the current difficulty in the credit markets is the lagged effect coming from the Fed's tighter stance between June 2004 and August 2007, when the federal-funds-rate target was raised from 1% to 5.25%.

The tighter stance started to undermine various bubble activities that had emerged from the previous loose stance. A tighter stance slowed the diversion of real savings from wealth generators towards bubble activities. Without an adequate supply of real funding, these activities started to crumble. Obviously, then, banks that have been providing support to these activities by providing loans have ended up holding a large amount of bad assets.

As a result, bank stock prices started to come under pressure. With a time lag, bubbles in the various other parts of the economy are also likely to come under pressure, and this again is going to hurt financial stocks. So the fall in economic activity is not the result of a fall in stock prices, but rather comes on account of the tighter Fed stance that throttled the supply of real savings to non-wealth-generating activities.

Would the stock market have come under pressure if the Fed had kept the interest rate at 1% for an indefinite period of time? A prolonged loose stance would have given rise to a much greater amount of nonproductive bubble activities. As a result, the pace of real wealth generation would have continued to slow, and consequently the growth momentum of profits would have come under pressure. In response to this, commercial banks would have become more cautious in their expansion of credit out of thin air.

All this in turn would have undermined the existence of bubble activities. Bubble activities cannot stand on their own feet; once the rate of growth of the money supply slows down, the pace of the diversion of real savings towards false activities follows suit. As a result, the survival of these activities is threatened.

From this we can infer that a fall in non-wealth-generating activities — also labeled an economic slump — is not due to a fall in the stock market as such but to the previous loose monetary policy that has weakened the pool of real savings.

"The government package is not going to rescue the economy, but it will rescue activities that the economy cannot afford and that consumers do not want."

The central-bank policies aimed at preventing a fall in the stock market cannot prevent a fall in the real economy. In fact, the real economy has already been damaged by the previous loose monetary stance. All that the fall in the stock market does is inform us about the true state of economic conditions. The fall in the price of stocks just puts things in a proper perspective. The fall in the stock price is just an acknowledgment of reality.

Conclusion

Only a few weeks ago, we saw that the liquidation of a large bank such as Lehman Brothers and the sale of Merrill Lynch did not cause massive disruptions. In fact, the adjustment was swift and almost invisible. The reason for the smooth adjustment is that the market was allowed to do its job. If government and Fed bureaucrats had tried to intervene with bailouts, the whole process would have taken much longer and would have been very costly in terms of real resources.