Ride out Wall Street's hurricane

The real reasons we're in this mess – and how to clean it up.

from the September 17, 2008 edition

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Fearing Japanese-style doldrums, the Fed under Alan Greenspan reduced the short-term interest rate to 1 percent in 2004, far below the natural rate, causing a dangerous increase in irresponsible lending patterns, overleverage of capital investment, and speculative heat waves in real estate (subprime ARMs skyrocketed), corporate bonds, and other assets. That modus operandi extended beyond our borders. To artificially heat up their economies, central banks in developing countries (especially Russia, China, and India) deliberately inflated their money supply at alarming rates.

But there's no eternal spring, not even in monetary macroeconomics. The resulting inflationary boom in real estate and other assets created a structural imbalance in the US and global economy. It was inevitable that the storm would release its electrical power, with heavy bolts of lightning striking at will.

At the height of its prowess, Fannie Mae had leveraged its equity 40 to 1, the highest leverage ratio in its history. When the real estate boom ended, the leverage collapsed, the insanity ended, and the government was forced to take it over, or risk a global nightmare.

If any among us can sincerely say, "I told you so," it's the economists who belong to the "Austrian school." For years, they've warned about the risks inherent in artificially stimulating the economy by cutting interest rates below the natural rate and inflating the money supply. As they emphasize, inflation is never neutral in its effects. It can cause an unsustainable surge, destabilize the economy in unexpected ways, and threaten a wholesale depression and crash on Wall Street.

For all the complexity of today's economy, the century-old Austrian theory of the business cycle – in bumper-sticker form: monetary manipulation makes a mess – offers the best explanation of what's going on.

Needed: presidential courage

Both major presidential candidates, Barack Obama and John McCain, are promising "change." Whoever is elected president faces a daunting task in taming the financial whirlwinds. Daunting, not because the solution is hard, but because the political courage it requires is almost impossible.

The new financial model should be based upon principles of sound economics: instead of a fluctuating monetary policy (easy money followed by tight money, cutting rates, then raising them), the Fed and other central banks must ensure stable money. The price of gold is a good way to measure their success in providing monetary stability and genuine growth.

Some regulations need to be abandoned or changed, such as the "mark-to-market" accounting rules. Also, private equity companies should be allowed to buy substantial positions in banks (more than the current 25 percent) without being regulated as a bank. The greatest threat now is that Hurricane Central will result in more controls, not unlike the passage of the draconian – and economically hurtful – Sarbanes-Oxley law following the collapse of Enron and WorldCom in 2002.

Finally, the federal government should not be too eager to come to the rescue of every major corporation or bank. When the state socializes losses, it creates what economists call "moral hazard," which encourages businesses and banking institutions to take on excessive risk in their ventures, knowing that the government will cover up their mistakes. Government guarantees, including insurance on bank deposits and brokerage accounts, can be costly, encouraging irresponsible behavior in the future.

This week the Bush administration made the right decision in refusing to guarantee Lehman Brothers. In 1990, the giant investment banking firm Drexel Burnham Lambert was allowed to go under, and the economy survived and later prospered. It's an important lesson.

It would also help if the new president would preserve the 15 percent tax break for dividends and long-term capital gains, and reduce the corporate income tax, following the trend in Europe and Asia. These measures would help strengthen the dollar and create jobs.

These are real changes. While waiting for them to be instituted, investors should ride out the storm by investing conservatively, being well diversified both here and abroad, and holding a haven in cash and gold.

• Mark Skousen is editor of "Forecasts & Strategies" market newsletter, producer of the annual FreedomFest conference, and author of "EconoPower: How a New Generation of Economists is Transforming the World."

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