In a world of uncertainty, waste—the destruction of value—is inevitable. Human action, which aims to replace inferior circumstances with superior circumstances, often involves laboring to transform scarce resources from a less useful form to a more useful form. For example, I transform money earned by my labor into raw beef (by using time and gasoline to drive to the supermarket and engaging in exchange), then I transform the raw beef into a medium-well hamburger through the time-consuming process of cooking. If after I eat the hamburger I wish I had done something else with the money and time (say, bought a chicken), I will regret my course of action and feel I’d wasted both.

We have all devoted time and resources to some project that we later realized was the wrong project. That’s the price of imperfect knowledge, which plagues all human beings. If we’re lucky some of the resources we used might be salvageable and put to other purposes, but the time, effort, and other resources are gone.

The same thing of course occurs in commercial production. An entrepreneur buys inputs and hires labor, thinking the finished product will bring a price that covers costs and yields a competitive return—only to find that people don’t want the product, or not badly enough to pay the anticipated price. The loss represents the destruction of value: The value of the inputs before the transformation took place turned out to be greater than the value of the finished product.

As I say, this happens because our knowledge is imperfect. It’s too bad, but perhaps not a tragedy—just a fact of life we learn to live with and minimize. The tragedy occurs when government intervention distorts price signals and induces people en masse unwittingly to make value-destroying plans. That’s part of the story told by the Austrian theory of the business cycle. In the present economic case the Federal Reserve’s low-interest-rate policy in the early 2000s and several federal agencies’ decade-long easy-housing policies induced builders to produce too many houses relative to what the demand would have been without those unsustainable policies. The result was the infamous housing boom and inevitable bust. With housing prices apparently on an unstoppable upward trajectory, and government-backed Fannie Mae and Freddie Mac—not to mention too-big-to-be-allowed-to-fail banks—willing to buy lenders’ mortgages no matter how shaky, builders and buyers were found in great abundance. Buying more house than one could afford seemed smart when one could get a low teaser rate on an adjustable-rate mortgage for a low-to-no-down-payment home and expect its price to rise significantly in six months. When the higher rate kicked in, one could refinance or sell and walk off with the equity.

But when interest rates rose, the bubble burst, and demand plummeted, this smart scheme turned sour. Houses stood unsold, and many people couldn’t pay their mortgages, refinance, or sell at a profit. Foreclosures skyrocketed and the multitude with underwater homes simply disappeared, leaving banks holding a slew of vacant houses that cost money in taxes, code violations, and so on.

As a result, banks now would rather donate the properties to government-created nonprofit land banks and pay for the demolition than hold them and hope for future sales. This is happening in Cleveland, and the Washington Post reported that similar programs were being discussed elsewhere.

How does this relate to the waste identified by the Austrian business-cycle theory? To the extent the homes were vacated and allowed to deteriorate because of the process described above, the demolitions represent destruction of value attributable to government. In the absence of the unsustainable bubble-inflating policies, some of those houses wouldn’t have been built.

In the case of older homes, fewer newly built houses would have competed with them in the real estate market. They would still be occupied and therefore would have been maintained. (There would have been no Great Recession and high unemployment.) Demolition would not have been an attractive alternative.

The tragedy is that because of government policy, demolition is the most attractive alternative. Think of the resources and labor—now seen to have been squandered—that went into making each house. Imagine what products might have been created instead. It’s worse than that: Products always summon complementary products. A housing boom stimulates the production of related shopping centers, office parks, and myriad smaller facilities and products. The resources required to make those things also would have gone elsewhere. Now all those resources, along with much labor and time, are gone because people in government thought they knew how to plan the housing market.

* * *

Georgia and Alabama have joined Arizona in enacting a tough law directed at undocumented immigrants. As Scott Beaulier, Darrick Luke, and Daniel Smith demonstrate, this is already damaging their economies.

Andrew Morriss has been to Graceland, where he found that the lap of luxury in which its fabulously wealthy late resident lived doesn’t look so luxurious today.

Conventional wisdom holds that without the welfare state, the poor would be in dire straits. But what if, as Gary Chartier suggests, government is responsible for the poor’s condition in the first place?

If public policy created the housing bubble, the bursting of which has caused so much misery, can it really be a good idea to reinflate the bubble? Richard Fulmer says that according to political logic, the answer is yes.

The more government controls the curriculum, the more inimical schooling becomes to education. Peter McAllister explains.

The eurozone is in trouble, leading Robert Murphy to explore the possibility that it was a colossal mistake in the first place.

Regulation at the national level gets the lion’s share of attention from market advocates. But let’s not overlook the planning mentality more locally. Sam Staley surveys the taxicab industry.

Here’s what our columnists have whipped up: Donald Boudreaux audits the economics textbook writers. Robert Higgs explains why there’s so little investment. John Stossel brands government a job destroyer. Charles Baird looks at the latest outrage against free speech. And Tyler Watts, bombarded with claims that we couldn’t live without FEMA, responds, “It Just Ain’t So!”

Books on libertarianism, the economy, socialism, and the threat to freedom occupy our reviewers.

—Sheldon Richman

srichman@fee.org

The authors’ criticisms of the Fed’s response to the crisis are no less trenchant. “In its rush to prop up the financial system,” they observe, the Fed rescued insolvent financial institutions, exposing taxpayers to losses on toxic assets while helping to “sow the seeds of bigger bubbles and even more destructive crises.”

But although Roubini and Mihm draw attention to some ways in which the government contributed to the crisis, they go seriously wrong in claiming that the boom “was primarily underwritten not by Fannie Mae and Freddie Mac but by private mortgage lenders like Countrywide”: Although Fannie and Freddie didn’t originate any subprime loans, they bought and (implicitly) guaranteed plenty of them, including a very large share of Countrywide’s Community Reinvestment Act (CRA) “Best Practice” loans. What Fannie and Freddie didn’t buy other lenders did, to meet their own CRA requirements. Such facts undermine Roubini and Mihm’s conclusion that “the significance of government intervention was dwarfed by the significance of government inaction.”

Roubini and Mihm’s reform proposals also fail to properly weigh government policy’s contribution to the crisis. They start well again by insisting on the need to restore to financial services “the creative destruction that Schumpeter saw as essential for capitalism’s long-term health.” Although Lehman Brothers’ failure revealed the shortcomings of ordinary bankruptcy as a means for resolving large and heavily leveraged financial firms, Roubini and Mihm note how those shortcomings could be avoided by means of “living wills” or by splitting ailing firms into “good” and “bad” parts, so that the latter might be declared bankrupt without raising Cain.

But some of Roubini and Mihm’s other proposals appear useless at best, including their endorsement of a “beefed-up” Glass-Steagall that would forcibly break up enterprises that become too big to fail, with its implicit suggestion that Gramm-Leach-Bliley contributed to the crisis. In fact that 1999 “repeal” of Glass-Steagall merely allowed commercial banks to affiliate with investment banks and played no important part in the insolvency of Lehman Brothers and other independent broker-dealers that was at the heart of the crisis.

A beefed-up Glass-Steagall Act might of course spin a much tighter web of firewalls than the original did. But as Roubini and Mihm themselves suggest, many TBTF firms exist only thanks to “heavy helpings of government largess,” including guarantees and actual bailouts, and could be left to break up naturally once improved bankruptcy procedures are in place. Perversities in executive compensation might likewise vanish on their own once imprudent decisions lead to bankruptcy rather than bailouts.

The most disappointing part of Crisis Economics is the second chapter’s hackneyed history of thought. Here Adam Smith is portrayed as a Walras-Debreu manqué who blinked at capitalism’s “vulnerabilities,” while Marx is credited with the “hugely important insight” that crises are “part and parcel of capitalism”—as if he’d predicted occasional financial panics rather than a steady decline in firm profits. The incomprehensible parts of the General Theory are treated, per usual, as proof of Keynes’s genius rather than of his being, well, incomprehensible. Finally and most disappointingly, by confusing the Mises-Hayek view of the business cycle with Schumpeter’s notion of creative destruction, Roubini and Mihm overlook the one theory of crises that best fits the housing boom-bust story.

Crisis Economics’s occasional references to the Great Depression must also be taken with a pinch of salt. It wasn’t Hoover but FDR who, in February 1933, stood by while “thousands of banks” went under; and it was growth in the money stock rather than fiscal stimulus that fueled the post-1933 recovery. The deflation of 1937–38 was mainly caused not by FDR’s belated attempt to balance the federal budget but by the Fed’s doubling of bank reserve requirements. Finally, corrected statistics show that World War II brought further stagnation rather than sustained recovery.

In short this “crash course in the future of finance” has both strengths and weaknesses. Although it contains much useful information about the subprime debacle, it understates the government’s contribution to the crisis, and although it suggests some desirable reforms, it suggests others that could prove counterproductive. Readers looking for straight A’s are advised to cram with caution.

First, something that is right.

With one major exception (discussed below), the typical economist, when doing economics (and regardless of political bent), doggedly avoids ad hominem explanations. That is, economists don’t explain observed reality as resulting from specific human personalities or personality traits. Instead, economists (try to) identify the constraints and opportunities that confront decision-makers and then explain patterns of human activities as being predictable outcomes of the ways that individuals—any individuals—respond to identified constraints and opportunities.

This avoidance of ad hominem explanations is the source of one of the most important lessons that economists teach: greed explains nothing. Because greed—or, more accurately, “self-interestedness”—is largely unchanging across time, no observed changes in the economy can be explained by it.

Greed can’t explain rising fuel prices, for example, given that fuel sellers (and also fuel buyers) are just as greedy when prices are lower as they are when prices are higher. Likewise with booms and busts. Because people’s greed remains constant something else must explain booms and busts. And so too for any other economic phenomena you care to name—everything from the fact that Americans are richer than Armenians to the fact that, say, big-box retailers’ market shares are growing while those of mom-’n’-pop retailers are shrinking.

Of course the particular constraints and opportunities identified by economist Doe as being most relevant for explaining some phenomenon often differ from those identified by economist Jones for explaining the same phenomenon. Doe, for example, might identify an increase in the rate of growth of the money supply as the most crucial factor for explaining an observed boom and bust, while Jones identifies an easing in government regulation of banks as the crucial factor. But neither Doe nor Jones explains the boom and bust as caused by the likes of greed or ignorance.

Economists’ refusal to use always-popular (and often half-baked) romantic notions about human behavior to explain economic phenomena goes a long way toward making economics a genuine science, and it accounts for much of whatever good economists have managed to bestow on society.

What’s Wrong

Turning now to something that is wrong with economics, much of the harm that economists inflict on society is a direct result of the one area in which economists too often embrace such ad hominem explanations: analyzing government involvement in the economy.

Despite a long-established tradition in economics of studying the “public” sector using the same analytical tools that we use to study the private sector—and despite two founders of this Public Choice tradition being awarded Nobel Prizes (George Stigler in 1982 and James Buchanan in 1986)—far too many economists persist in sloppy, unanalytical ad hominem thinking about government.

For too many economists government is assumed to be able to escape many of the constraints that unavoidably bind and trip up people in the private sector. Asymmetric information, moral hazard, and adverse selection, as well as confirmation bias and the legions of other alleged “irrationalities” identified by behavioral economists, are just some of the “imperfections” economists find in markets and then too frequently simply assume can be dealt with effectively by government.

Overlook here the fact that many of the problems alleged to be unavoidable in the private sector are in fact handled quite well by human beings acting without government who exhibit far more ingenuity than the typical economist believes is possible in private-sector settings. (It’s notable that Elinor Ostrom, the first woman to win the Nobel Prize in economics, isn’t a professor of economics but instead of political science. She won the prize in 2009 for her work showing how creative people in private settings often overcome obstacles—such as free-rider problems—that most economists naively assume can be overcome only by government.)

Unanalytical Assumptions

Focus instead on economists’ bizarre stumble into an unanalytical assessment of government. That stumble goes like this: “Omigosh! There’s an imperfection in this private-sector market! My textbooks and the many refereed journal articles I’ve read and written make quite clear—with lots of difficult mathematics—that this market will therefore fail. My textbooks and journal articles also imply, and in many cases explicitly state, the conclusion that the government—and only the government—can solve the problem. Models prove this conclusion.”

Such stumbling is common. From today’s insistence that America needs more stimulus spending, through the support that many economists express for the new Consumer Financial Protection Bureau, to economists’ overwhelming belief that countries need central banks, too many economists unscientifically reach their conclusions about the alleged efficacy of government intervention without first asking how the information available to government officials, and how the incentives these officials face, will affect government decision-making.

In short, economists mysteriously conclude that desirable public-sector outcomes follow from the praiseworthy intentions that economists assume motivate most public officials.

Nowhere does this mystery run more deeply than in fiscal policy. Even if it were true that increased government spending can hasten an economy’s escape from a recession, the large number of economists who today endorse such spending is discouraging. Seldom do these economists inquire into the incentives facing government officials in charge of spending. The assumption is that these officials will spend the money in ways sure to promote the public interest. Also, seldom do these economists inquire into the information asymmetries and other constraints that might hamper even well-meaning officials’ efforts to carry out fiscal policy effectively.

Save for the relatively few economists steeped in Public Choice economics, the typical economist today remains a political naif—and a dangerous one at that. He is bloated with unjustified confidence in models which show that if government officials behave in the public interest and if these officials are immune to the same decision-making quirks and knowledge limitations that afflict decision-makers in private markets, then government can perform all manner of marvels. This economist then uses his authority to support interventions that are utterly unjustified by genuine scientific standards.

It’s shameful.

Dowd offers a classical-liberal perspective on macroeconomic policy and specifically central-bank policy. Having written extensively on free banking, he concludes that a thorough decentralization of the banking business is essential to enduring macroeconomic stability. Hutchinson is a seasoned investment banker turned financial journalist. His firsthand, nuts-and-bolts knowledge of modern financial markets undergirds his broader perspective. Together, they provide an enlightening account of the long-run trends and short-sighted policy actions that culminated in the worst financial crisis since the Great Depression.

The “alchemists” in their story are the architects and practitioners of modern finance. Given the perverse regulatory environment, buying and selling derivatives can yield short-run profits to hedge funds and other traders while virtually guaranteeing that in the longer run the owners of the underlying real assets will suffer losses if not bankruptcy. The careful reader will understand that speculation, whether on a long-term or short-term basis, is an essential and healthy feature of a market economy. But, if anything, the authors’ likening of speculation to alchemy when it is based on the techniques of modern finance and carried out in the context of a regulated economy understates the perversity. On reflection we can see that turning future long-run losses (of other people) into current short-run profits (for yourself) is triply more disruptive than trying to turn lead into gold. We can note 1) that lead, unlike long-run losses, has a positive, though modest, value; 2) that it is your own lead; and 3) that given the laws of nature, you’re unable to turn the trick.

But if the laws of nature keep people from turning lead into gold, why don’t the laws of the marketplace preclude the financial alchemy that characterized most of this century’s first decade? The answer, our authors make clear, is government intervention. A toxic mix of interventions (regulatory, fiscal, and monetary) perverted the coordinating market forces by removing considerations of long-run systemic risk. The result was a systemic discoordination whose increasing severity eventually turned systemic risk into a crisis. The laws of the marketplace, if allowed to exert themselves, can preclude financial alchemy (or at least put strict limits on it). But government intervention, including loan guarantees and the too-big-to-fail doctrine, open a window in which short-run profit-taking in financial markets is pitted against long-run viability of the financial institutions.

While the Federal Reserve is recognized as an essential accommodating element in the most recent episode of boom and bust, Dowd and Hutchinson focus on the inherent perversity of modern finance theory in the context of the long-running efforts of the government to redistribute income and to encourage homeownership. Since the 1930s the government has used the tax code to redistribute incomes downward. Over the years the income tax—and over the generations the inheritance tax—has reduced the number of families that oversee their long-run business interests. The old partnerships (Dowd and Hutchinson’s term), which kept the owners’ skins in the game, have been supplanted by limited-liability corporations, which effectively separate management and ownership. This critical separation, which left-leaning authors take to be characteristic of capitalism, is shown by the authors to be a consequence of government systematically overriding the market-governed distribution of income. Whereas we once had business families that were in it for the long run, we now have financial managers and traders in derivatives markets who are in it for the short run, ultimately to the detriment of the financial system and the real economy.

Alchemists of Loss provides a multidimensional account of the nature and magnitude of our long-brewing economic woes. But the book provides us with little hope for the future. The authors’ suggestions for reform range from the radical (reinstating the gold standard and eliminating the central bank) to the not-so-radical (redrafting the Fed’s mandate to exclude concern about unemployment) to the superficial (moving the Fed’s headquarters to St. Louis). Even the casual reader will see that this extends from the virtually impossible to the not-worth-doing, with no promising midrange option. The implicit conclusion is that we should brace ourselves for more booms and busts.

One instance of this law is the famous, or infamous, Detroit riot of 1967. After the riot various pundits “informed” the public that it had happened because so many of Detroit’s black inner-city residents were poor and hopeless. That became the accepted explanation and, to the extent that anyone remembers it, probably still is. But a close look at the record reveals a much more interesting story—of a government’s police force oppressing people who simply wanted to live their lives peacefully. This is not to say that the people who rioted bore no responsibility—everyone is responsible for his own actions. However, without the police force’s intrusion and without a previous federal program that had destroyed a community, the riot probably would not have occurred. And the evidence for this is hidden in plain sight.

During a five-day period in July 1967, 43 people were killed during the riot in Detroit’s inner city. Shortly after that, President Lyndon B. Johnson created the National Advisory Commission on Civil Disorders—the so-called Kerner Commission, named after its head, then-governor of Illinois Otto Kerner. (Kerner was later convicted of having taken a bribe while governor and served time in prison.) The Commission was tasked with determining the causes of that and other riots during the summer of 1967 and with making recommendations to prevent such riots in the future.

Its 1968 Report of the National Advisory Commission on Civil Disorders made a big splash, selling about two million copies. The report stated that black poverty was a big cause of the Detroit riots, and its recommendations for more government jobs and housing programs for inner-city residents were explicitly based on that assumption. These recommendations, plus the charge of white racism, received much of the publicity at the time and are what most people took away from the report. Publishers make a distinction between book buyers and book readers: The latter tends to be a small subset of the former. That distinction seems to apply here. It’s too bad that more people didn’t actually read the report. The Commission’s own account of the details of the Detroit riot tells a story that is fundamentally inconsistent with the Commission’s own conclusions and recommendations. Here’s the report’s first paragraph on Detroit: “On Saturday evening, July 22, the Detroit Police Department raided five ‘blind pigs.’ The blind pigs had their origin in prohibition days, and survived as private social clubs. Often, they were after-hours drinking and gambling spots.”

These “blind pigs” were places that inner-city black people went to be with their friends, to drink, and to gamble; in other words, they were places where people peacefully enjoyed themselves and one another. The police had a policy of raiding these places, presumably because the gambling and the unlicensed alcohol were illegal. The police expected only two dozen people to be at the fifth blind pig, the United Community and Civic League on 12th Street, but instead found 82 people gathered to welcome home two Vietnam veterans. The police proceeded to arrest them. “Some,” says the Commission report, “voiced resentment at the police intrusion.” Who’d have thunk it? The resentment spread and the riot began.

In short the triggering cause of the Detroit riot, in which more people were killed than in any other riot that summer, was the government crackdown on people who were going about their lives peacefully. For the rioters the last straw was the government’s suppression of peaceful, albeit illegal, black capitalism. Interestingly, in its many pages of recommendations for more government programs, the Commission never suggested that the government should end its policy of preventing black people from peacefully drinking and gambling.

This is par for the course. When a government intervention helps cause a problem, even those people who recognize that the intervention was somewhat to blame rarely call for an end to, or even a scaling down of, such intervention.

The government’s fingerprints show up elsewhere in the Commission’s report. Urban renewal “had changed 12th Street [where the riot began] from an integrated community into an almost totally black one,” says the report. It tells of another area of the inner city to which the rioting had not spread: “As the rioting waxed and waned, one area of the ghetto remained insulated.” The 21,000 residents of a 150-square-block area on the northeast side had previously banded together in the Positive Neighborhood Action Committee (PNAC) and had formed neighborhood block clubs. These block clubs were quickly mobilized to prevent the riot from spreading to this area. “Youngsters,” wrote the Commission, “agreeing to stay in the neighborhood, participated in detouring traffic.” The result: no riots, no deaths, no injuries, and only two small fires, one of which was set in an empty building.

What made this area different was obviously the close-knit community the residents had formed. But why had a community developed there and not elsewhere? The report’s authors unwittingly hint at the answer: “Although opposed to urban renewal, they [the PNAC] had agreed to co-sponsor with the Archdiocese of Detroit a housing project to be controlled jointly by the archdiocese and PNAC.” In other words, the area that had avoided rioting had also successfully resisted urban renewal, the federal government’s program of tearing down urban housing in which poor people lived and replacing it with fewer housing units aimed at a more-upscale market. Economist Martin Anderson, in his 1964 book, The Federal Bulldozer, had shown many of the problems with urban renewal. Even some of Anderson’s harshest critics at the time admitted that urban renewal could be called “Negro clearance.” Indeed, at the time, an even blunter term, also beginning with the letter “n,” was used.

But the Kerner Commission, even in the face of its own evidence, refused to admit that urban renewal was a contributing factor to the riots. Indeed, the Commission recommended more urban renewal. The Commission’s phrasing is interesting, though, because it admits so much about the sorry history of the program:

Urban renewal has been an extremely controversial program since its inception. We recognize that in many cities it has demolished more housing than it has erected, and that it has often caused dislocation among disadvantaged groups.

Nevertheless, we believe that a greatly expanded but reoriented urban renewal program is necessary to the health of our cities.

In short the commission’s antidote to poison was to increase the dose.

As described in William J. Bernstein’s book The Birth of Plenty: How the Prosperity of the Modern World Was Created, France’s minister of finances under Louis XIV from 1665 to 1683, Jean-Baptiste Colbert, worked tirelessly to expand commerce by improving his country’s roads and canals. Unfortunately, trade was hindered by more than potholes—a complex system of internal tariffs was throttling commerce. Colbert tried to dismantle the tariffs but was only partially successful. After his death, “all fiscal restraint was lost. By the end of Louis XIV’s reign three decades later, the State had doubled the tolls on the roads and rivers it controlled, and the nation that had once been Europe’s breadbasket . . . was bled white. . . .” Bad regulations trumped good roads.

During the Great Depression Franklin Roosevelt initiated massive public-works programs to improve the nation’s infrastructure in hopes of putting people back to work and jump-starting the economy. The construction efforts were staggering. According to Conrad Black:

The government hired about 60 percent of the unemployed in public-works and conservation projects that planted a billion trees, saved the whooping crane, modernized rural America, and built such diverse projects as the Cathedral of Learning in Pittsburgh, the Montana state capitol, much of the Chicago lakefront, New York City’s Lincoln Tunnel and Triborough Bridge, the Tennessee Valley Authority, and the heroic aircraft carriers Enterprise and Yorktown. They also built or renovated 2,500 hospitals, 45,000 schools, 13,000 parks and playgrounds, 7,800 bridges, 700,000 miles of roads, and a thousand airfields.

Yet these extraordinary accomplishments were not enough to pull the nation out of the Depression. Neither were the millions of jobs generated by this monumental work.

At the same time as he was directing resources away from the private sector, Roosevelt also unleashed upon it a regulatory blizzard that significantly increased the risk of doing business. Higher personal, corporate, excise, and estate taxes; wage and price controls; production restrictions; antitrust lawsuits; and constant experimentation provided few incentives for companies to expand. As in Louis XIV’s France, an improved infrastructure could not revive commerce in the face of stifling government regulations.

Enough Roads; Too Many Roadblocks

Today President Barack Obama is touting high-speed rail and other infrastructure improvements as keys to economic renewal. But if massive infrastructure investments were not enough to turn the economy around in the 1930s, they are far less likely to do so today. Because Roosevelt was starting from a lower base his improvements would have had a far greater impact on the economy of his day than would similar work done now. Also, the lighter regulatory burden in the 1930s meant there were projects then that truly were “shovel-ready.” Today environmental impact studies, possible archeological finds, and nuisance lawsuits may stall construction for years or halt it completely.

The real roadblock to economic growth is the burgeoning regulatory burden that President Obama, like Roosevelt before him, has placed on business. According to a study by James Gattuso and Diane Katz, “[T]he Obama Administration imposed 75 new major regulations from January 2009 to mid-FY 2011, with annual costs of $38 billion.” Hundreds of additional regulations will pour forth from Obamacare, Dodd-Frank, and proposed EPA greenhouse gas restrictions. All this on top of an already monumental regulatory burden imposed by government. A Small Business Administration report estimates the cost of regulatory compliance at over $1.75 trillion in 2008 alone.

Briefly, our current economic woes were triggered by the collapse of a housing bubble, produced by loose monetary policy together with federal pressure on mortgage companies to lend to bad credit risks. When the bubble burst, housing prices fell, causing many homeowners to default on their mortgages. Investment vehicles based on those mortgages lost much of their value, leading to huge investor losses and the failure of some major financial institutions.

Lost in Transition

Absent government interference industry would retool, shifting capital and labor out of home construction and into other areas. Because neither capital nor labor is homogeneous, this shift takes time. Equipment that can be put to other uses may have to be sold or physically moved. Other equipment may have to be modified or scrapped altogether. Workers may need to increase their market value by relocating or by gaining new knowledge and skills. In a recession consumers typically reduce spending and increase savings, thus freeing up the resources needed to complete the shift.

Keynesian economists, however, see both labor and capital as homogeneous, aggregated lumps. Where Austrians see capital in transition Keynesians see “idle capital.” Keynesian programs to put that capital back to work only hinder or halt the needed transition, either leaving capital in its malinvested state or forcing it into the very idleness they seek to remedy. For example, expanding credit may re-inflate the collapsed bubble for a time, leading industry to continue producing unneeded goods. Stimulus spending—whether for infrastructure or other things on the government’s wish list—transfers scarce resources from industry to government, further impeding the transition. New laws, enacted to prevent future recessions, make businesses reluctant to invest until the associated regulatory structures are defined—a process that can take years. Once in place the regulations may inhibit capital flow, locking inefficiencies and malinvestment in place and propping up companies that should be allowed to fail. Unemployment insurance and other such programs eliminate or at least reduce workers’ incentives to move or reeducate themselves.

The country’s problems are not the fault of inadequate highways. They are the result of government intervention: loose monetary policies, programs that encourage unsustainable debt, explicit and implicit guarantees to financial institutions, massive spending that crowds out private investment, oppressive regulations, higher taxes with constant threats of more to come, and political payoffs to “friendly” companies and unions. Building high-speed railroads will not stop the malign effects of these policies; the solution is to stop the policies.

Goods, people, and information will not flow freely across a nation, regardless of the quality and extent of its infrastructure, if taxes and regulations block their flow. Trade perished in France as Colbert’s improved roads and canals were made all but useless by high internal tariffs. Hundreds of thousands of miles of new and rebuilt roads were not enough to move commerce past the regulatory roadblocks that Roosevelt erected. President Obama’s proposed high-speed trains—indeed, his latest nearly half-trillion-dollar jobs program—will not pull the country over the mountain of regulations that has been created in the decades since the Great Depression and that Obama has raised to new heights.

In the April 17 ABC News-Washington Post poll, 59 percent said that the deficit should be reduced through a combination of unspecified spending cuts and tax increases. But 69 percent opposed cutting Medicaid, 78 percent opposed cutting Medicare, and 56 percent opposed cutting the military. Fifty-three percent said they would oppose a plan to reduce the debt significantly by “raising taxes on all Americans by a small percentage and making small reductions in Medicare and Social Security benefits.” Fifty-four percent said Medicare “should remain as it is today.”

In other words, cut spending but stay away from where the money is. Medicare, Medicaid (plus the State Children’s Health Insurance Program), and the military represent nearly 40 percent of the budget. Social Security is about 20 percent more. (Interest on the debt is 4.6 percent.)

In the poll 72 percent supported raising taxes on people making more than $250,000—54 percent “strongly.” There’s far more sympathy for raising taxes than cutting spending—not a good sign for libertarians.

A McClatchy-Marist poll had similar results. It found that a clear majority, 64 percent, thinks the country is “going in the wrong direction.” Of those who identified themselves as conservatives, 78 percent agreed. Moreover, 57 percent of all respondents said reducing the deficit is the priority, with 68 percent of conservatives agreeing. No other objective came close.

I point this out because in the same poll, when asked if Medicare and Medicaid should be cut, 80 percent said no, with 68 percent of conservatives agreeing. How about reducing military spending? Fifty-four percent overall said no, including 72 percent of conservatives. (“Liberals” and moderates approved, 60 and 54 percent, respectively.)

Sixty-nine percent said they were against raising the debt ceiling, right after saying that they would not cut the biggest items in the budget.

I note for the record that of the conservative respondents, 48 percent said they support or “strongly” support the Tea Party, while 44 percent said they do not.

So what does all this mean? It seems to mean that despite the prominence of the Tea Party and despite the fact that the word libertarian is spoken in the news media more than ever before, the prospects for a major reduction in the size of government in the immediate future are dim—this at a time when there is also near-panic about the debt and the deficit. If big cuts aren’t going to happen now, then when?

Sources of Resistance

The political system does not reward budget cutters. There is too much to gain politically by purchasing votes through promises of largess, while hiding or deferring the costs, if they can’t be pushed onto to some unpopular group. I don’t think this means Americans are a bunch of self-conscious freeloaders. Rather they likely (and erroneously) see any benefits they collect as a return on their forced tax “investment.” Social Security and Medicare have certainly been misrepresented as such. Why wouldn’t people be upset at the thought of reduced benefits? Even Medicaid, the medical program for low-income people, affects the middle class. Medicare, the medical program for all retirees, does not cover nursing-home care, but Medicaid does—if a person meets the means test. It’s an open secret that if a nursing-home resident has too much money to qualify for Medicaid, the staff will advise the family on what to do to become eligible. This usually involves a lot of gift-giving and other activities to reduce the resident’s assets to the acceptable level.

The upshot is that even middle-class younger people may well oppose cuts in Medicaid if it means they will have to pay directly for nursing-home care for an elderly parent or perhaps have him or her live in their homes. This is part of a more general consideration. Most people already on Social Security and Medicare would understandably oppose cuts in those programs. Less obvious is that their grown children are likely to take the same position, and not just because they expect to be beneficiaries someday. If those programs were to end, or even be cut substantially, the children would have to help pay their parents’ living expenses out of their own pockets. Yes, they pay today through taxes, but there are differences: First they don’t pay 100 percent, since other taxpayers also kick in, and second there’s a bureaucracy between them and their parents. I suspect most people would rather support their parents through the government rather than directly, and most retired people would probably prefer that too. Face-to-face dependence of aging parents on grown children who are trying to raise their own families can be a source of tension if not outright conflict.

Intervention Begets Intervention

Government interventions are not isolated phenomena; rather they are part of a political-economic-social-cultural system, with one part often intended to ameliorate the effects of some other part. (Remember Ludwig von Mises’s “critique of interventionism.”) Thus we should not discuss any particular part in a vacuum—not if we want to say something constructive.

For example, it is an eminently libertarian prescription to call for the abolition of Medicare on grounds that transferring wealth by force is immoral. But left at that, the argument will persuade no one and might even discredit the speaker. Why? Because it fails to acknowledge that many current beneficiaries would be left in dire straits if the program suddenly ended. Nor would it suffice to say that once the program was gone, “the free market” would handle things satisfactorily. What free market? American medicine consists of a government-insurance-doctor-hospital protectionist cartel that suppresses competition and innovation in the provision of services through licensing and myriad other interventions. High prices and callous bureaucracies are the rule for many people, and that didn’t begin with Obamacare. Surely libertarians don’t wish to be understood as proposing—in the name of human freedom—that a vulnerable portion of the population be subjected to that gauntlet.

None of this means that these programs are legitimate or should not be abolished. They require force (taxes) and induce dependence on the political class. What I’m suggesting is that libertarians need to bear these considerations in mind when making their case against such government intervention. They need to be cognizant of the wider issues and combine their critique of Medicare with a critique of the entire government-medical-insurance complex.

If we are to expand the sphere of freedom while shrinking the sphere of force, we first need to be understood. We won’t be understood if we are oblivious to people’s concerns and to how they currently see the government’s role, however fallaciously, in addressing those concerns.

“Let me try a green one,” he says. We’re still tolerant. The new wand is waved. Afterward dear George is decidedly worse.

“Let me think,” the healer says. “Maybe it should be a purple wand and a different chant.”

For 98 years the federal government has been attempting to prevent asset bubbles, recessions, and spasms of unemployment. In 1913 Congress and Woodrow Wilson created the Federal Reserve System, the President telling the country this new institution would be “a safeguard against business depressions.” In 1929, after 15 years of Fed operations, the United States plunged into a deep depression.

Okay, so maybe red wands don’t work, and we should try green. Politicians of the 1930s created more bodies designed to stabilize the economy and build investor confidence: the Federal Deposit Insurance Corporation, the Federal Savings and Loan Insurance Corporation, the Securities and Exchange Commission, and the National Credit Union Administration. The Depression deepened, becoming by far the longest and deepest economic downturn in the history of the United States.

This is the national pattern in economic policy: In the face of failure, we keep looking to government. Since the Great Depression, we’ve added more units designed to curb inappropriate behavior and ward off recession, including the Commodity Futures Trading Commission (1974), the Federal Financial Institutions Examination Council (1979), the Working Group on Financial Markets (1988), and the Office of Thrift Supervision (1989). Yet in 2008 we fell into another economic downturn.

The 2008 recession was triggered by the boom and bust in the housing market. Was housing an unregulated market where government had failed to intervene? Sorry: There were seven agencies supposedly nurturing this industry:

1. Federal Housing Administration (1934)
2. Federal National Mortgage Association (Fannie Mae) (1938)
3. Government National Mortgage Association (Ginnie Mae) (1968)
4. Federal Home Loan Mortgage Corporation (Freddie Mac) (1970)
5. Neighborhood Reinvestment Corporation (1978)
6. Federal Housing Finance Board (1989)
7. Office of Federal Housing Enterprise Oversight (1992)

In sum, at the onset of the 2008 recession there were 16 units of the federal government that were supposed to manage economic life and keep us from harm, yet harm befell us. No wand-waving faith healer has ever failed so conspicuously.

Alas, economic policy is not a drug trial; it is politics, and politics is ruled by illusions. In June 2009 we found President Barack Obama urging the creation of yet more government units to manage the economy, promising that his reforms would “make sure that these problems are dealt with so that we’re preventing crises in the future.”

We can’t be too critical of Obama, because many others share this confidence in government regulation. “Without intervention by the government,” say economists George Akerlof and Robert Shiller in their 2009 book Animal Spirits, “the economy will suffer massive swings in employment. And financial markets will, from time to time, fall into chaos.” It’s astounding to assert that government can prevent crises, recessions, and “swings in unemployment” while being fully aware that for 98 years it has been trying and failing.

Not Learning from Experience

A powerful subconscious bias is obviously at work here, a mental distortion that prevents normal, intelligent people from being able to learn from experience. I call it the watchful-eye illusion: the idea that government has greater knowledge and wisdom than the public. In extreme form this illusion treats government as God, a superior being who surveys the scene from His Olympian position, controlling error and wrongdoing. Once this illusion is locked into your thinking, you remain convinced, despite any amount of failure, that government has the ability to do things right next time.

It appears that this fallacy begins in childhood. Youngsters see that their lives are guided by people who are more thoughtful and mature than they are: their parents. If they challenge the parents—asking, in effect, what gives you the right to make rules over me?—the parents say they know more. When children first learn about government, they see it as a super authority ten times more powerful than parents. Naturally, they assume it must have ten times their parents’ wisdom and foresight.

Many do not outgrow this perspective; they carry into adulthood the idea that government is a superparent. Economists Akerlof and Shiller accept this view, declaring that it forms the core of Keynesian economics:

The proper role of the parent is to set the limits so that the child does not overindulge her animal spirits. But those limits should also allow the child independence to learn and to be creative. The role of the parent is to create a happy home, which gives the child freedom but also protects him from his animal spirits.

This happy home corresponds exactly to Keynes’ position (and also our own) regarding the proper role of government.

Ordinary Beings

There are two fallacies in the Keynesian view that government can be a “parent” watchfully guarding over the national economy. First, the politicians who run government don’t have superior wisdom and maturity. Government officials are ordinary, fallible human beings. They can be careless, inattentive, and shallow. They can be swayed by emotion. And sometimes they can be dishonest and corrupt.

The second fallacy is that the public is an ignorant child. The economy’s millions of individual businessmen and investors have, collectively, vast wisdom about economic possibilities and trends. These individuals pour their knowledge into their market behavior, thereby setting the prices of assets, goods, and services. Left free to suffer the consequences of their decisions, investors and entrepreneurs will develop systems for managing risk and for evaluating the validity of investments. These systems won’t be perfect, of course: There will be errors, bubbles, and frauds. But from these errors, the community learns to improve decisions in the future.

This system of social learning is short-circuited by government intervention, with its subsidies, bailouts, changing rules, and false promises to protect everyone. In truth, the greatest long-run threat to the health of the economy is the chaotic meddling of eager politicians whose intellectual powers have been so naively overrated by academic economists.

There is very little either complicated or interesting about poverty. Poverty has been man’s condition throughout his history. The causes of poverty are quite simple and straightforward. Generally, individual people or entire nations are poor for one or more of the following reasons: (1) they cannot produce many things highly valued by others; (2) they can produce things valued by others but they are prevented from doing so; or (3) they volunteer to be poor.

The true mystery is why there is any affluence at all. That is, how did a tiny proportion of man’s population (mostly in the West) for only a tiny part of man’s history (mainly in the nineteenth, twentieth, and twenty-first centuries) manage to escape the fate of their fellow men?

Sometimes, in reference to the United States, people point to its rich endowment of natural resources. This explanation is unsatisfactory. Were abundant natural resources the cause of affluence, Africa and South America would stand out as the richest continents, instead of being home to some of the world’s most miserably poor people. By contrast, that explanation would suggest that resource-poor countries like Japan, Hong Kong, and Great Britain should be poor instead of ranking among the world’s richest places.

Another unsatisfactory explanation of poverty is colonialism. This argument suggests that third-world poverty is a legacy of having been colonized, exploited, and robbed of its riches by the mother country. But it turns out that countries like the United States, Canada, Australia, and New Zealand were colonies; yet they are among the world’s richest countries. Hong Kong was a colony of Great Britain until 1997, when China regained sovereignty, but it managed to become the second richest political jurisdiction in the Far East. On the other hand, Ethiopia, Liberia, Tibet, and Nepal were never colonies, or were so for only a few years, and they rank among the world’s poorest and most backward countries.

Despite the many justified criticisms of colonialism and, I might add, multinationals, both served as a means of transferring Western technology and institutions, bringing backward peoples into greater contact with a more-developed Western world. A tragic fact is that many African countries have suffered significant decline since independence. In many of those countries the average citizen can boast that he ate more regularly and enjoyed greater human-rights protections under colonial rule. The colonial powers never perpetrated the unspeakable human rights abuses, including genocide, that we have seen in post-independence Burundi, Uganda, Zimbabwe, Sudan, Central African Empire, Somalia, and elsewhere.

Any economist who suggests he has a complete answer to the causes of affluence should be viewed with suspicion. We do not know fully what makes some societies richer than others. However, we can make guesses based on correlations. Start out by ranking countries according to their economic systems. Conceptually we could arrange them from more capitalistic (having a larger free-market sector) to more communistic (with extensive State intervention and planning). Then consult Amnesty International’s ranking of countries according to human-rights abuses. Then get World Bank income statistics and rank countries from highest to lowest per capita income.

Compiling the three lists, one would observe a very strong, though imperfect, correlation: Those countries with greater economic liberty tend also to have stronger protections of human rights. And their people are wealthier. That finding is not a coincidence, so let us speculate on the relationship.

Rights and Prosperity

One way to gauge human-rights protection is to ask to what extent the State protects voluntary exchange and private property. These signify the rights to acquire, keep, and dispose of property in any fashion so long as one does not violate the rights of others. The difference between private property rights and collectively held rights is not simply philosophical. Private property produces systemically different incentives and results from collective property.

Since collectivists often trivialize private property rights, they are worth elaborating. When property rights are held privately the costs and benefits of decisions are concentrated in the individual decision maker; with collectively held property rights they are dispersed across society. For example, private property forces homeowners to take into account the effect of their current decisions on the future value of their homes, because that value depends, among other things, on how long the property will provide housing services. Thus privately owned property holds one’s personal wealth hostage to doing the socially responsible thing—economizing scarce resources.

Contrast these incentives to those of collective ownership. When the government owns the house, the individual has less incentive to take care of it simply because he does not capture the full benefit of his efforts. It is dispersed across society instead. The costs of neglecting the house are similarly spread. You do not have to be a rocket scientist to predict that under these circumstances, less care will be taken.

Nor is nominal collective ownership the only force that weakens social responsibility. When government taxes property, it changes the ownership characteristics. If government were to impose a 75 percent tax on a person selling his house, it would reduce his incentive to use the house wisely.

This argument applies to all activities, including work and investment. Whatever lowers the return from or raises the cost of an investment reduces incentives to make that investment in the first place. This applies to investment in human as well as physical capital—that is, those activities that raise the productive capacity of individuals.

To a significant degree the wealth of nations is embodied in their people. The starkest example of this is the experience of the Germans and Japanese after World War II. During the war, Allied bombing missions destroyed nearly the entire physical stock of each country. What was not destroyed was the human capital of the people: their skills and education. In two or three decades, both countries reemerged as formidable economic forces. The Marshall Plan and other U.S. subsidies to Europe and Japan cannot begin to explain their recovery.

Proper identification of the causes of poverty is critical. If it is seen, as is too often the case, as a result of exploitation, the policy recommendation that naturally emerges is income redistribution—that is, government confiscation of some people’s “ill-gotten” gains and “restoration” to their “rightful” owners. This is the politics of envy: bigger and bigger welfare programs domestically and bigger and bigger foreign-aid programs internationally.

If poverty is correctly seen as a result of the unwise government intervention and lack of productive capacity, more effective policy recommendations emerge.

Tracing the government’s ever-greater role in financing and encouraging housing debt, especially since the 1960s, Kling observes that regulation-fostered securitization of mortgages necessarily obscures risk. A bank exercises the best oversight over loans that it awards directly; in an unhampered market, loan officers have little incentive to prefer an indirect or “securitized” method of lending. But by rigging the housing market for decades to promote the holy grail of home-ownership, politicians fostered and even mandated many dubious mortgages that wouldn’t otherwise have passed muster. Kling draws on his background as a former Freddie Mac economist to highlight the specific problems of the rickety financial structures that were only made possible by governmental assumption of risk. “Without the [government] guarantees [of mortgage-based securities]—or apparent guarantees—indirect lending would not have been possible,” he concludes.

In Kling’s view, bad mortgage regulations, a spate of mortgage loans requiring unrealistically low down payments, and what he calls a “suits vs. geeks” divide were the main causes of the housing bubble. But the last two “fundamental” causes stem from the first. So the author’s explanation of the housing crisis boils down almost entirely to the welter of incentive-skewing mortgage regulations.

The book surveys and critiques several alternative explanations for the crisis, including the oft-heard but historically unintelligible claim that it resulted from “deregulation.” Unfortunately, this tour does not investigate the role of the Federal Reserve. Economist Robert Murphy is among those of Misesian-Hayekian persuasion who point to the malinvestment-encouraging effects of the credit splurge of 2001–2003, the period during which the Fed lowered the federal funds target interest rate from 6.5 to 1 percent. The omission is odd since Kling elsewhere acknowledges the importance of the Austrian analysis.

A more fundamental discrepancy between knowledge and power than that exemplified by the suits/geeks divide is that exemplified by the hubristic power-grabbing of government officials, both before and after the economic blowout. Instead of arguing that in 2008 officials should have abstained altogether from such interventions as using tax dollars to buy “toxic” assets, the author suggests that the government might have instead tried the stopgap measure of “impos[ing] penalties on firms that make extravagant demands for collateral to back repurchase agreements” and other financial instruments. Limiting a fresh bout of intervention in that way would have been better than the blundering and direct central planning the federal government undertook, but it would still have amounted to giving economic actors orders, discouraging reliance on local knowledge and conditions. “Extravagant” terms of contract may be the only ones on which a trade can be conducted that satisfies both parties.

The second chapter considers the syndrome of force-wielding politicians and bureaucrats pretending to know better than individuals their own unique circumstances, values, goals, and options. The conflict between the individual’s knowledge and freedom, on the one hand, and coercive rules which preempt that knowledge and curtail that freedom, on the other, lies at the heart of the 2008 debacle (and many other economy-wide slumps). Markets are characterized by price signals and other coordinating mechanisms that enable human beings to make effective use of widely dispersed knowledge, very little of which we can ever grasp firsthand. Kling observes that modern economies are becoming ever more specialized and complex even as political power becomes more centralized and resistant to calls for reform. He tries to come up with empirical gauges of both trends, although that isn’t strictly necessary to refute the fallacies and expose the hazards of central planning.

The problem of how to prevent or ameliorate the blunders of the commissars is tackled in the final chapter. The author suggests various half-measures that proponents of fully free markets will be less than satisfied with: proposals, for example, to merely decentralize government functions that would be better delegated altogether to the private sector. Still, most of Kling’s proposed reforms—including a scheme that would enlist “competitive governments” to jockey for the chance to collect your garbage, and another to dispense vouchers rather than Medicare-style reimbursements to pay medical costs—might make it easier to achieve thoroughgoing restoration of markets than leaving things as they are.