Many factors led to the global financial fiasco, Norberg writes, including a naive policy that privatized profits and socialized losses, risk-taking based on blind faith in computer models’ ability to predict the market, and a false sense of security bred by government assurances that the taxpayers would back up bad loans. This brought an unsustainable growth of assets and liabilities.

The title of the Swedish original (which I read) is A Perfect Storm, an expression describing an event where a rare combination of circumstances drastically aggravates a bad situation. That certainly describes the financial implosion that began in 2007. Norberg explains the events leading to the credit crunch through one chilling example after the other. The conscious actions of financial, political, and bureaucratic decision-makers and consumers might not have been too dangerous in themselves, but in combination they proved utterly disastrous.

According to Norberg, after the dot-com bubble and 9/11, Federal Reserve Chairman Alan Greenspan acted to avoid a recession by stimulating the economy with record-low interest rates in a sort of “pre-emptive Keynesianism.” But the Fed misjudged the state of the economy and kept the interest rates down far too long. Effective interest rates actually turned negative, building the momentum for another bubble.

The low rates encouraged even greater risk-taking, not to mention a mountain of debt passed on to the future. Instead of going into a recession, the global economy saw an artificial, temporary rise in prosperity. China’s policy of keeping its currency undervalued to stimulate its exports while pumping its surplus of capital into U.S. bonds supported the process and hid the imbalances created by the Fed.

Predictably, artificially low interest rates inflated the real estate market. No sector of the economy is more sensitive to interest rates than real estate, and American politicians put massive pressure on two government-sponsored enterprises, Fannie Mae and Freddie Mac, to lower their standards to enable vast numbers of unsound mortgages. The resulting foreclosures will leave a terrible mark in the minds and on the credit reports of millions.

Norberg is no less critical of the actions of the Wall Street capitalists. Weak oversight of money placed in investment and pension funds, coupled with huge bonus systems, encouraged shortsighted gambling with other people’s money. Lurking behind all that was the assumption that there was little risk because the mortgage-backed securities were implicitly guaranteed by the federal government.

In the public debate following the credit crunch, many argued as if the financial markets were ruled by laissez faire, but the credit-rating agencies had an oligopoly due to regulations. Such regulations break down the barriers between the government and the market. The problem was not too little regulation. Rather, it was faulty regulation upheld by a multitude of national and international agencies. Tough international bank regulations punished traditional banking, while pushing bad loans into a shadow banking system to avoid transparency.

Financial Fiasco ends on a pessimistic note, predicting that we will see extensive, long-term government involvement in the financial sector for years to come. “Create a crisis, and people will give you more power to fight it,” Norberg writes. He points to the risk that politically well-connected corporations and interest groups will not only further distort competition (as in the case of TARP), but also cause new losses and crashes. Politicians in many European countries have already subtly begun to require that banks concentrate lending in their national economies. A growing financial protectionism would throw more gravel in the financial machinery. We might also see a new wave of trade protectionism.

The book’s most important lesson is that the problem isn’t the current recession, but the previous boom. It was during the boom that poor investments were made based on hidden inflation and far too optimistic forecasts. The recession is the cure, when labor and capital are reallocated to better uses and productivity improves.

In its brevity, the book provides an interesting, accessible explanation of the reasons for and consequences of the financial crisis. It would have benefited, however, from specific recommendations on how to get to a freer economy. What must we do—or undo—to prevent politicians from repeating the boom and bust cycle? There is a dire need for a sound policy, but unfortunately hasty and simplistic “solutions” based on populist slogans have prevailed. Norberg says that people must realize that government has its limitations, but he doesn’t tell us just where we should draw the line.

But, alas, in the end Krugman resorts to the arguments of the great economic cranks of history, from Silvio Gesell to John Maynard Keynes. He’s like the mechanic who expertly describes a problem with your fuel pump—then insists your car needs more gas. If the tank is full, he tells you to attach an auxiliary tank.

In other words, Krugman is still the one-trick pony featured in the Times. Whatever the problem, his solution is always the same: inflation. It shows up in the example he uses throughout the book, a 1970s babysitting co-op on Capitol Hill.

The baby-sitting “economy” is a co-op in which the couples agree to babysit one another’s children for coupons (babysitting credits) instead of dollars. But Krugman says this scheme ran into problems during the winter. The couples hoarded their coupons (that is, they refused to hire babysitters) while trying to get more coupons (sell babysitting services) so they would be able to go out more often in the summer.

Unfortunately, with everyone pursuing the same strategy at once—trying to sell without buying—Krugman writes, the co-op went “into a recession.” But never fear: This babysitting “liquidity trap” ended when the directors of the co-op printed and distributed more coupons and everyone lived happily ever after.

The problem with drawing general lessons from this situation should be obvious. A babysitting co-op in which a few people with similar preferences produce one good cannot be a model for a complex economy. But since Krugman—like other Keynesians—believes an economy is a crude, simple mechanism controlled by “aggregate demand,” this is the best he can do.

Writing about this “fix” for the co-op, Krugman says, “Recessions, in other words, can be fought simply by printing money—and can sometimes (usually) be cured with surprising ease.”

Even though I have read many of Krugman’s columns and was not surprised by this answer, it is nonetheless shocking to read that a Nobel laureate actually believes that we can “cure” almost any economic downturn by cranking up the printing presses.

That’s bad enough, but Krugman also likes to rewrite economic history.

He says our present economic and financial troubles are due to free markets and financial deregulation. He argues that the cartelized financial system created during the New Deal should have remained unchanged, even though it was actually in crisis back in 1980. The alleged “deregulation,” however, did not create free markets but expanded moral hazard by increasing deposit insurance and empowering the Fed to “backstop” financial market losses, which invited reckless behavior on Wall Street. All this federal interference with both free markets and an authentic profit-and-loss system resulted, predictably if sadly, in the current financial meltdown.

From blaming the Great Depression in part on the gold standard to caricaturing free markets, Krugman places himself squarely in the socialist-interventionist camp. He writes: “Some people say that our economic problems are structural, with no quick cure available; but I believe that the only important structural obstacles to world prosperity are the obsolete doctrines that clutter the minds of men.” Unfortunately Krugman counts freedom among them.

“The view that now pervades much public policy economics implicitly presents the relevant choice as between an ideal norm and an existing ‘imperfect’ institutional arrangement. This nirvana approach differs considerably from a comparative institution approach in which the relevant choice is between alternative real institutional arrangements.”

A common form of the fallacy is rejection of the imperfect free (or freer) market in favor of (presumably) omniscient, omnipotent, and omnibenevolent government regulation. A “flawed” but achievable arrangement is set against an (alleged) ideal, though it is left unestablished whether the ideal can in fact exist. The problem here should be obvious. If the ideal is not available, then the comparison is worthless. If the rejected option were compared to other achievable—also imperfect—alternatives, it might well be judged superior.

A recent example of the Nirvana Fallacy comes from Sen. Charles Schumer of New York. Asked how the Obama administration will prevent another financial crisis, Schumer said:

“You’re gonna find a different system of regulation. . . . So like when Bear Stearns began to run into trouble, they’re gonna call the heads of Bear Stearns in and say, ‘All right fellas, you’re getting rid of those two hedge funds; you’re gonna raise more capital—even if it means you have lower profitability. . . . [Y]ou do it or we’re gonna take sanctions against you.’ . . . You need a tough, strong regulator, unified—no holes in the system— . . . who . . . sees the problem ahead of time, so they have complete transparency, they know exactly what’s going on. . . .” (emphasis added)

We see at once that Schumer assumes what he must demonstrate: namely, that the regulator can overcome the Hayekian “knowledge problem,” the limits posed by the fact that the most critical economic information is not readily obtainable statistical data but rather is diffused and often unarticulated knowledge, including know-how.

Look at what I’ve highlighted in his statement, and ask yourself what Schumer apparently has not asked himself: How will the regulators “know exactly what’s going on”? Spotting Bear Stearns’s specific hedge-fund problems “ahead of time” would have required insights and hunches that only entrepreneurs with money at risk could be expected to have—and even those might not have been enough. Fortune-telling is not a widely distributed skill. It’s not a matter of toughness or access to Bear’s books but, at the very least, of entrepreneurship (not to mention luck), which is profit driven. Bureaucratic regulators bring no such talent to their jobs. More likely, they’d be enforcing formal (possibly outdated and irrelevant) rules, looking for a repeat of the last problem, while missing the next one entirely. As Nassim Nicholas Taleb might say, it’s the next black swan, not the last one, that bites you.

Schumer’s fallacy is actually worse than the standard Nirvana Fallacy. He doesn’t compare his unrealizable regulatory vision to the free market but rather to our corporatist economy replete with government bailouts, moral hazard, easy credit, and all the other ways of disabling market forces.

The closest we can get to what Schumer says he wants is through the discipline—that is, the regulation—imposed by the unfettered market. That includes bankruptcy’s Sword of Damocles and the freedom of traders to sell short—that is, to profit by betting that a company’s stock is overvalued and communicating that information to the market early. Predictably, the government is planning to restrict short selling. Bad regulation drives out good.

* * *

Advocates of big government claim they learned lots of lessons from the New Deal. But here’s something they missed: The post-1929 economy began to rebound before FDR’s programs could have taken effect and even before he took office. Jim Powell explains.

Government spending is said to be indispensable to recovery from a recession thanks to the magic of the “multiplier.” Is there really more bang from the government-directed buck? James Ahiakpor debunks the myth.

But surely the government is good at creating productive jobs when it spends money, no? Larissa Price, applying Bastiat’s lesson, throws cold water on that hope.

By now you may have bought some of those funny-looking spirally light bulbs after hearing they use less energy and save you money—only to find that they can’t hold a candle to the old incandescent bulbs. Thanks to Congress and former President George W. Bush, though, soon you won’t have a choice. Michael Heberling has the unfortunate details.

Last spring’s G-20 economic meeting called for a crusade against tax havens, places where people can protect their wealth from greedy politicians. Daniel Mitchell comes to their defense.

Can there be freedom when the state sees itself as Robin Hood? Carlos Rodríguez Braun shoots an arrow into the heart of that belief.

Land has been at the center of conflict from time immemorial. Even so-called capitalist countries have been blemished by land monopolies, government-sponsored speculation, and feudal-style interventions, such as property taxes. Joseph Stromberg conducts a tour of the great land question.

Our columnists again serve up an intellectual feast. Lawrence Reed writes about perseverance in the face of adversity. Thomas Szasz further documents psychiatric slavery. Burton Folsom takes a critical look at an economic interpretation of the Constitution. John Stossel examines the “fatal conceit” of interventionists. Walter Williams defends school choice. And Robert Murphy, encountering a free-market advocate’s case for government monitoring of derivatives, responds, “It Just Ain’t So!”

Our reviewers render verdicts on books about World War II, libertarianism, early globalization, and the Constitution.

The credit crunch is not nearly as severe as the U.S. authorities appear to believe and public data actually suggest world credit markets are functioning remarkably well, a report released on Thursday says.As a result, governments are pumping masses of public money into the economy across the world because of the difficulties of a few big, vocal banks and industries such as car manufacturing, which would be in difficulty anyway, according to the report published by Celent, a financial services consultancy….The report, much of which is based on U.S. Federal Reserve data, challenges a long list of assumptions one by one, arguing that there is indeed a financial crisis but that, on aggregate, the problems of a few are by no means those of the many when it comes to obtaining credit….The picture appeared to be broadly similar in much of Europe and Japan, said the report, based on publicly available data on trends in bank lending to industry, households and among banks themselves in the so-called interbank markets. [Emphasis added.]

The taxpayers are on the hook for over $7 trillion in federal commitments that were supposedly critical to easing the credit crisis. We have been scammed.Hat tip: Steve Horwitz

We really are living out the extended negative unintended consequences of the Great Depression.  If so, it only goes to show how important it is for us not to do what precisely we seem to have done in the last few months: over-react to a questionable “crisis” in ways that create new institutions that will long outlive the current situation and lead us to tell new stories that will harden into uncritically accepted ideological narratives for future generations.  We are currently suffering from the sins of Hoover, FDR, and many idea-makers of that era.

The federal government unveiled $800 billion in new loans and debt purchases on Tuesday, hoping another infusion of cash can help unfreeze troubled credit markets and make borrowing easier for homebuyers, small businesses and students.The Federal Reserve said that it would buy up to $600 billion in mortgage-backed assets from the government-sponsored mortgage finance giants Fannie Mae and Freddie Mac. The agency would also buy up to $100 billion in debt directly from the companies and up to $500 billion in mortgage-backed securities….Separately, the Fed and Treasury Department announced a $200 billion program to ease commercial lending on debts like student loans, car loans or business loans. The Fed would lend up to $200 billion to holders of asset-backed securities supported by car loans, credit card loans, student loans, and business loans guaranteed by the Small Business Administration.

I don’t think that math is right, but Is there anything more dangerous these days than a desperate treasury secretary? Right now I can’t think of anything. What happens when the consequences of all this borrowing, re-lending, and money creation hit? Are we to believe that people in the financial markets are not looking to that day already and taking precautionary action?More from the Times:

The action by the Federal Reserve on buying mortgage-backed securities brings the full force of monetary policy to bear on the credit markets. Having already reduced the benchmark federal funds rate to just 1 percent, the central bank is now effectively using what economists call “quantitative easing” to reduce the costs of money.

Instead of trying to reduce overnight lending rates in the hope of influencing longer-term interest rates for things like mortgages, the Fed is directly subsidizing lower mortgage rates. It is doing so by printing unprecedented amounts of money, which would eventually create inflationary pressures if it were to continue unabated. [There's an understatement. -SR]

For the moment, Fed and Treasury officials made it clear that the sky was the limit. [Emphasis added.]

Have these people gone crazy?P.S. I made one of my periodic calls to a local car dealer to see if the car-loan market is frozen or in meltdown. (Oddly, that works out to the same thing.) Unless Honda World in Conway, Arkansas, is somehow exempt from general economic conditions, this market is decidedly unfrozen, unmelted-down, or whatever. “We’re making loans every day,” my friendly salesman Hans Chandler said. And I see that Ditech is still hawking mortgages on televsion for under 6 percent.

[I]ndustry watchers say credit card and auto lending has actually held up quite well despite the credit crunch. According to market research firm Synovate, the average consumer probably has a higher limit and therefore can spend more on their credit card than they could a year ago.”Our data shows that people have still have more access to credit than ever before,” says Andrew Davidson, a VP at Synovate. “Some companies are pulling back credit to riskier borrowers, but for the industry as a whole, access and usage of credit cards is at record levels.”

Whatever you think of government’s encouraging consumers to go into debt, the excuse given for it doesn’t hold up. By the way, I’m still getting credit-card offers, and I notice that Ditech and Lending Tree are still advertising low-interest motgages.

One of the two most striking features of the current financial contretemps is the way it has seemingly come as a complete surprise to most financial commentators and economists. (The other is the way that financiers and bankers who have spent the last few years presenting themselves as buccaneering entrepreneurs have suddenly discovered a fondness for taxpayer bailouts.)

As recently as a year ago, most commentators in the financial press were convinced there was no real prospect of a major correction to the real-estate market, much less a serious financial crisis. There were dissenting Jeremiahs who warned that things could not go on as they had been, but they were in the minority. (They included the most successful investor in America, Warren Buffett.)

With no sense of satisfaction I report that I was, in my own small way, one of the Jeremiahs. I did not foresee all that has happened—neither did anybody else—but the broad outline was clear. Why did the majority miss it? The answer is a combination of common sense and a historical perspective informed by a certain approach to economics.

Trends and the Popular Mind

The first is easy enough to explain. A recurring feature of the popular mind is the belief that whatever trend is dominant at the moment can only continue indefinitely. Thus if the prices of houses and other assets are rising and have been rising for some time, then they must continue to do so indefinitely into the future. Talented and intelligent people then come up with all sorts of elaborate explanations of why this must be so. These are little more than elaborate rationalizations of assumptions. The contrary, common-sense view was captured by the chairman of Richard Nixon’s Council of Economic Advisers, Herbert Stein: “If something cannot go on forever, it will stop.”

However, common-sense observations and instinct do not help us understand precisely what has happened to the U.S. financial system and economy over the last decade, or why it happened and why it has now come to a messy end. The thing to grasp is that this kind of phenomenon has happened before. The current “credit crunch” is only the most recent of several such financial crises going back to the mid-nineteenth century or even the 1820s. Besides the events of 1929–1932, there were severe financial crises (“panics”) in 1873, 1893, and 1907. There was nearly a similar panic in 1997, and in many ways it is the response of the authorities to that year’s events which produced the situation we face today.

Although the details of the crises are distinctive, they all have something in common: they were the dramatic system-wide effects of manipulation of the money supply. The distinctive details are produced by the way monetary policy interacts with the most recent innovations in the financial markets.

Because of errors of public policy, the government’s monopoly central bank increased the money supply above the underlying level of actual economic growth. This can lead to a general rise in money prices (inflation), but that is not inevitable. Frequently a rise in the amount of money needed to buy consumer goods is concealed by a rise in productive efficiency, which reduces production costs so much that money prices still decline. However, the rise in the supply of money and credit leads in all cases to a rise in the money prices of assets and investment goods, such as securities, stocks, land, real estate, and even such things as antiques and fine wine.

This sparks off a speculative spiral in which people invest in capital goods not because of the anticipated return or because of their utility (as in the case of houses), but because they expect the money value of the good to rise. To return to Herbert Stein, this cannot go on forever, and eventually the underlying expansion of the money supply that drives the whole process will stop. (In fact it doesn’t have to actually stop; it is only necessary for the anticipated rate of increase to decline.)

Problems Are Exacerbated by Monetary Disorder

At this point two things become apparent. One is that a lot of investments are unsound and will never justify themselves. The other is that many people are left holding assets that are worth less than what they paid for them. The result is a period of economic pain in which the malinvestment has to be liquidated.

Paradoxically, the speculative spiral, or bubble, is actually amplified by open and competitive investment markets and tends to be most pronounced in newly developing sectors or with regard to newly created investment vehicles (railroad stocks and bonds in 1893, derivatives in the current events). The problem is that the more efficient and open a market is, the better it will respond to market signals as expressed in prices. If those signals are systematically distorted by an underlying monetary disorder, the response will amplify that disorder. The more efficient the market, the greater that effect. Because this bubble tends to be most pronounced in areas that have seen financial innovation, each particular panic has an element that is novel and typically completely unforeseeable.

Looked at in this way and with the benefit of historical perspective, the events of the last decade become clear. In response to the crisis of 1997 (brought about in turn by the policies of governments in various parts of the world), the world’s monetary authorities (above all, the Fed) expanded the money supply. This led to an asset bubble in shares, particularly those in cutting-edge hi-tech sectors. The bubble burst in 2001. The Fed, along with other central banks, then increased the supply of money and credit even further to avoid the painful reckoning. However, by trying to avert a recession in 2001–03 they precipitated an even-more-severe one now. The continued expansion simply led to another asset bubble, this time mainly in real estate, which has also burst. In this case the novel element is complex financial instruments based not on prices set by markets but rather elaborate mathematical models—which we now realize are useless precisely when you need them most: during a sudden shock.

A common response to these events is to blame the inherent qualities of financial markets. Certainly the response of people within those markets to adversity does not help their cause. However, the underlying active agency behind recurring crises of this kind is the government’s money monopoly. As long as its policy errors can have large-scale disastrous consequences, three sentences should fill you with fear: “The price of X cannot fall”; “We have managed to get rid of the business cycle”; and “This time it’s different.”

It can. We have not. And it isn’t.