Economic Principles for Volatile Times

Monday we woke up to a sharp 1000-point decline in the stock market, which recovered to down only 500 by the end of the day. But still startling. What caused it? And what does it mean for the future?

Monday's stock market drop, chart from here.

It has something to do with China’s economy, but also a lot to do with American economic policy.

China’s growth has concerned world markets over the past quarter century. But growth—real growth—has to be related to actual creation of wealth. Wealth represents the accumulation of the results of labor. If it doesn’t represent real wealth, but is an illusion caused by printing money, manipulating money supply, then it’s bound to lead to an eventual comeuppance. That has been coming for a while.

Here’s a summary, by Greg Lewis at American Thinker, of what’s been going on there:

The Chinese economy, fueled by state-funded credit and money-printing, has enabled the size of the Chinese stock market to rise to dangerously overblown levels more than 50 times higher than they were only two decades ago….

China’s extraordinary stock bubble has been enabled by some of the most perverse practices ever perpetrated on this planet. Among other things, in order to prevent shareholders from selling their stocks to avoid the losses that it’s clear are inevitable, Chinese authorities have threatened to send police and paddy wagons around to arrest citizens who dare to sell off their investments.

Since the turn of the century, China has been on a state-credit-funded manufacturing spree that has caused the demand for commodities to spike to levels never before seen….

What does China have to show for it? Hundreds of ghost cities, filled with enormous skyscrapers, housing projects, and sports stadiums, along with superhighways to nowhere. They now stand virtually unoccupied and unused…. The problem is that what China has built will produce no lasting return to sustain its economy, and the resulting bust will also cause severe contractions in commodity prices and U.S. and global suppliers’ earnings.

China’s 10 percent annual growth rate over the past three decades is turning out to be nothing less than one of the great frauds in global economic history. …

China is an example on a large scale of the failure of central planning, the failure of tyranny to lead to prosperity.

What is worrisome is how closely our formerly free economy has been following the Chinese model. Lewis adds this:

When you couple China’s unimaginably large and corrupt fiat economy with the fact that the United States has been following the Chinese model on a smaller scale since the crash of 2008, you have the makings of financial disaster. Indeed, in the name of bailing out the big banks involved in the 2008 financial meltdown, our own ignorant Keynesian economics poobahs have engaged in the same fiat currency printing as the Chinese. In addition, in maintaining interest rates at or near zero percent for the past half decade plus, the Fed has stolen upwards of $1 trillion in interest people should have collected on their savings over that time. In the wake of the current turmoil, the Fed is once again backing off raising interest rates.

I don’t know if the blip that happened this week portends huge disaster in the near term or not. But we do know that economic principles are about as inexorable as gravity. Anything government does that interferes with a free economy will increase the pain to come.

Back in 1988, Murray Rothbard wrote a piece refuting the contemporary economists about the causes and cures of the 1987 stock market crash. The Mises Institute shared that piece again this week. Rothbard lists nine myths about that crash and what should have been done—and shows why they’re myths, and what is the truth. The assumptions of the mostly Keynesian (liberal, progressive, central planning) economists was that fine tuning control over money supply, inflation, trade, taxes, and government spending would make things right. They just had to stumble upon the right mix of policy. But here’s the summary point:

The important point about a recession is for the government not to interfere, not to inflate, not to regulate, and to allow the recession to work its curative way as quickly as possible. Interfering with the recession, either by inflating or regulating, can only prolong the recession and make it worse, as in the 1930s. And yet the pundits, the economists of all schools, the politicians of both parties, rush heedless into the agreed-upon policies of: Inflate, and Regulate.

That is the main point of books like Meltdown, by Thomas Woods, which examines the 2008 crash, and The Forgotten Man, by Amity Shlaes, which examines the Great Depression of the 1930s. In addition, the “forgotten depression” of 1921 shows us by contrast what happens when government refrains from interfering. In that stock market crash, President Warren G. Harding refrained from interfering, and let the market correct itself, which happened within a few months. Calvin Coolidge continued the non-interference policies through the 1920s. And it wasn’t that naturally growing successful market that led to the 1929 crash: that was government interference. That crash was actually caused by federal easy money policy (exaggeratedly low interest rates). And the crash didn’t cause the Great Depression. The stock market was well on its way to correcting itself in a quarter year—until the Fed interfered with suddenly tight money. And then Hoover, followed by Roosevelt, tinkered with the market one way after another, keeping the market from returning to prosperity for more than a decade.

In 2012, economist John B. Taylor gave the Manhattan Institute’s Eighth Annual Hayek lecture, “The Policy Is the Problem.” In that lecture he does two things: he defines economic freedom, and then lists the known principles.

What I mean [by economic freedom] is the situation where individuals, families decide what to buy, what to produce—they decide where they will work, they decide how they're going to help other people. But they do this within a framework. It's kind of the American vision, if you like. And that framework involves five things: 1) predictable policy, 2) rule of law, 3) a reliance on markets, which generates 4) good incentives, and 5) a limited role of government.

What we’re looking at this week, and forward, is the result of the Obama experiment in interference. Policy has been unpredictable—changing, added regulations, applied according to crony capitalism rather than predictable law. Markets have been viewed as a measure of unfairness—success means some unfairness to the bottom, rather than entrepreneurial energy. Regulations have been discouraging and the opposite of good incentives. And monetary policy has continued extraordinarily ow interest rates, leaving nowhere to go when a correction is needed.

Capital—literal as well as social respect from other countries—built up over the first couple of centuries has been spent in this socialist experiment under Obama. The market has no chance of returning to growth and prosperity until the interference stops.

As for Monday’s stock market drop, correction depends on whether this government tries to do something about it. They’re already doing enough harm. Could they do more? There seems to be no limit to the bad policies they will try.

The 2008 drop could have corrected quickly with restraint from government. The current Great Recession (sometimes referred to as the historically slowest recovery) is lasting because of government policy. So we’re already down. But I’m sure they could manage to cause us to drop from the current plateau to an even lower one.

Drops naturally correct; it’s a parabola. They naturally bounce back up if allowed to correct. But then there's the trampoline effect—if they interfere, they keep the bounce back up from happening.