Don’t Blame the Market

How the Federal Reserve caused the crash

By: Thomas E. Woods Jr.

The free market has failed. That’s the verdict of the deep thinkers who populate our political class and our academic and media establishments. They may not have any idea what caused the crisis we’re witnessing, but they’re sure it has something to do with “capitalism.”

As usual in troubled times, government turns for advice to people who were completely blindsided by what happened, had assured everyone that it couldn’t happen, and had no idea why it did happen. Because despite how foolish or inept they are and how little they seem to know about why the economy acts as it does, another thing they can be counted on to know for sure is that the solution involves transferring more power to our wise public servants in Washington.

This time around, a few dissenting voices have managed to inject the names of economists Ludwig von Mises (1881-1973) and F.A. Hayek (1899-1992) into the debate. Any libertarian or conservative worth his salt knows who Mises and Hayek are, since they rank among the greatest free-market economists—and indeed the greatest economists—of the 20th century. But many of the writers and think tanks that invoke these men’s names shy away from their most radical and politically incorrect positions, especially when it comes to central banking, which Hayek and Mises opposed. Yet it is these teachings that the American people most need to hear right now and that young people in particular need to learn cold.

It was Mises who developed what became known as the Austrian theory of the business cycle and Hayek whose contributions to the theory won him the Nobel Prize in economics in 1974. It was thanks to his theory that Mises was able to predict the Great Depression at a time when fashionable opinion insisted that the boom-bust cycle was gone for good. And it is this theory that alone makes sense of what has happened in our own day. There is no more important piece of economic knowledge for Americans to have right now.

It runs like this:

Interest rates can come down (1) if the public saves more or (2) if the central bank (in the American case the Federal Reserve System) pushes them down. Businesses respond to the lower rates by borrowing to finance new projects, which would not have been profitable at the higher interest rates that had prevailed before. These projects tend to be clustered in what are called the higher-order stages of production—that is, stages of production relatively far removed from finished consumer goods. (The more time-consuming and temporally remote the project, the more sensitive it is to changes in interest rates.) Mining, raw materials, construction, and capital equipment are examples of the higher-order stages.

If the low interest rates are caused by increased saving on the part of the public, then the economy functions smoothly. The public’s saved resources provide the material wherewithal to see these new investment projects through to completion. When the free market is allowed to set interest rates, as in this case, they coordinate production across time and encourage businesses to embark on long-term projects only when the public has made available the necessary savings to finance them.

If the low interest rates are brought about artificially, as when the Fed pushes them down, a problem arises. Additional resources do not magically appear just because the Fed has forced down interest rates. The public has not saved the necessary resources to make possible the completion of all the new projects. With a vast increase in the number of market actors using freshly borrowed money to buy an unchanged supply of factors of production, the prices of the factors rise. It soon becomes clear that the factors of production do not exist in sufficient abundance to make all of these projects profitable. The bust sets in.

The Fed’s manipulation of interest rates, in short, disrupts their coordinating function. It distorts the path of investment and causes investors to make decisions they wouldn’t have made if the Fed’s interventions into the market hadn’t prevented them from seeing the economy’s true state of resource availability.

In Human Action: A Treatise on Economicsimage, his magnum opus, Mises offers the analogy of a homebuilder who mistakenly believes he has more bricks at his disposal than he actually has. This faulty appraisal of the situation causes him to make decisions he wouldn’t otherwise have made. He builds a different kind of house, and with different dimensions, from the one he would have built if he had had an accurate count of the bricks that were available to him.

When the crisis hits and the malinvestments come to light, the recession begins. It is not during the recession that the damage is done. The damage is done during the boom period, when resources are misallocated, and sometimes irretrievably squandered, in unsustainable lines of production. The recession is the period in which the economy readjusts itself, the malinvestments are liquidated, resources are redirected toward their most value-productive uses, and production is begun again along sustainable lines. Efforts to interfere with this purgative process—e.g., by making emergency loans to failing businesses, thereby propping up the malinvestments instead of letting them be liquidated—only prolong the recession. The depression of 1920, which no one has ever heard of, was over relatively quickly because the government and its central bank allowed these necessary readjustments to take place. The Great Depression, on the other hand, went on for years and years as the government instituted one program after another that interfered with the healthy process of resource reallocation.

Trying to postpone the inevitable recession by pumping still more money into the economy and pushing interest rates still lower only makes the future bust that much worse. Think again of our analogy of the homebuilder. The longer he keeps building while continuing to be misled about his true supply of bricks, the worse his losses will be and the more resources he will have squandered when he finally discovers the truth. Far better that he endure relatively modest deprivation in the present than that he continue a line of production whose inevitable liquidation at some moment in the future will devastate him. Better that he demolish two rows of bricks now and cut his losses than that he go on to build a story and a half, only to find that the second story cannot be completed and the whole structure must beabandoned. The same holds true of the economy: the longer it stays on an unsustainable path, allocating resources into lines of production it cannot support, the more resources will be squandered and the more costly the inevitable adjustment will be.

When in 2001 the Fed decided to inflate its way out of the downturn that came on the heels of the dot-com bust, it sowed the seeds for the much worse problems we face now. Malinvestments were allowed to continue instead of being liquidated. The housing bubble continued to inflate, when a deflation of that bubble would have spared us the years of ongoing malinvestment in housing that has caused so much damage in our own day. The recession of 2000-2001 is the only one in recorded history in which housing starts did not decline. Not surprisingly, it was at that time that the various myths of the housing bubble began to take hold: house prices never fall, a house is the best investment you can make, house flipping is a foolproof way to make money, and so on.

Had the Fed allowed that recession to take its full course, we would not be experiencing the devastation we see around us today. All that additional malinvestment, all the misallocated resources, the additional debt, the illusions about homeownership as a sure path to wealth—all of it would have been avoided.

This is only a rudimentary overview of the Austrian theory, but it is enough to see its explanatory power. The issues it raises are serious and deserve attention that, of course, they do not get. Furthermore, the theory shows that it is not the free market that causes these misallocation problems and the phenomenon of economy-wide boom and bust. It is the very opposite: the attempt to push interest rates lower than the free market would have set them is what starts the unsustainable boom that the realities of resource availability eventually convert into a bust.

No other school of economic thought has this theory, because all other schools conceive of capital as a homogeneous unit they represent with the variable K. The Austrian theory is based on the idea that capital is heterogeneous and consists of a series of stages that exist across time. When you interfere with the interest rate, which reflects the time component in the economy, you undermine the important interrelationships between the various stages of the production process.

“Regulation” is beside the point. The system itself, by making credit artificially abundant, promotes malinvestment and excessive risk, leverage, and indebtedness. Why not go after the institutional framework that gives rise to these problems, instead of merely promising better regulation of the financial house of cards we now have?

Other factors did aggravate the crisis, to be sure. A string of government initiatives, not confined to the Community Reinvestment Act, that were designed to increase homeownership by lowering or eliminating traditional indicators of creditworthiness
undoubtedly made the mortgage market more risky. Andrew Cuomo, Henry Cisneros’s successor as secretary of Housing and Urban Development under Bill Clinton, bluntly admitted that affirmative action in lending carried a higher default risk for lenders. The implicit bailout guarantee of Fannie Mae and Freddie Mac, in addition to the special tax and regulatory benefits those Government Sponsored Enterprises (GSEs) enjoy over purely private mortgage guarantors, directed more capital into home-building than would otherwise have occurred.

And it isn’t just Fannie and Freddie: the whole system operated under an implicit bailout guarantee, thanks to what financial analysts call the “Greenspan put,” after former Fed chairman Alan Greenspan. Having observed Greenspan bail out the big players in particular and the economy in general over his 19-year tenure, some market actors concluded that there was a floor beneath which the central bank would not allow asset prices to fall.

But these and other aggravating factors were a mere sideshow to the massive money creation of a Federal Reserve System that targeted the federal funds rate at one percent and kept it there for a full year, on the heels of a series of rate cuts before that. Other interventions into the market may have helped to steer the Fed’s newly created money into the housing market, but the bubble in housing could not have persisted without a seemingly bottomless supply of credit to support it.

It has not been edifying to watch conservatives try to blame a crisis of this magnitude on the Community Reinvestment Act or on “the Democrats,” without mentioning or perhaps even being aware of the far more significant role of the Federal Reserve, which enjoys broad bipartisan support. We are living through what could well be one of the defining moments of the 21st century in terms of the shape our country will take, and many conservatives are letting themselves be kicked all over the debating stage. Without any knowledge of Austrian business cycle theory, they have been left grasping at straws to account for how things could have gone so terribly wrong and have been sitting ducks for liberals who know lame arguments when they hear them.

The central bank is a creation of government and an intervention into the free market. Yet when it misleads investors, misallocates resources, squanders wealth, and provokes booms and busts, Americans are taught to blame the outcome on that same free market. Thanks to the Austrian economists, we have a persuasive and powerful case to make in defense of the market against those who would blame depressions on freedom. It’s time we started making it.

Thomas E. Woods Jr. ( is the New York Times bestselling author of nine books, including The Politically Incorrect Guide to American Historyimage and, most recently, Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worseimage