Unfortunately Farmer’s idea is as bad as it is big—and it’s very big. Central to his idea is his notion that investor “confidence” is an economic “fundamental”—along with factors such as tax rates, supplies of magnesium, and the prospect of war in the Middle East. If confidence is too high people try to live beyond their means, causing prices to rise. If confidence is too low people spend too little, causing aggregate demand and employment to fall. Being a fundamental, confidence can be at any level, regardless of the state of other fundamentals. So the economy needs some means of managing confidence lest it get stuck at a level that is economically destructive—and Farmer wants central banks to do this.

More specifically, Farmer believes investor confidence is most powerfully affected by equity prices: The higher equity prices are (as reflected in the price of a stock index) the higher confidence is. So a central bank can manage investor confidence by targeting the price of an all-inclusive index of the shares of the nation’s corporations. The immediate goal of active buying and selling by the central bank would be stabilizing average equity prices. By keeping investor confidence from sinking to dangerous lows or soaring to dangerous highs, the central bank would ensure stability.

Sounds simple, but Farmer accepts too much conventional wisdom about macroeconomic history in general and the Great Depression in particular to trust his analysis and prescription.

For example, he asserts that U.S. “banks were often subject to panics” because they “made illiquid loans [and therefore] typically had much less cash on hand than they needed to meet their liabilities in the form of deposits.” Farmer seems unaware that restrictions on branch banking in the United States prevented banks from adequately diversifying their portfolios, making them more subject to runs. So one historical illustration Farmer offers for why a loss of confidence can spread like a contagious disease is poorly grounded.

Farmer also ignores two other important streams of research that cast doubts on his analysis. The first is Robert Higgs’s work on “regime uncertainty.” Higgs marshals a great deal of evidence that during the 1930s Franklin Roosevelt and his New Dealers scared away private investors by creating economy-wide uncertainty. The length of the Great Depression was indeed the result of a loss of confidence, but it had nothing to do with animal spirits or market imperfections that prevent job seekers from matching up smoothly with employers; it had everything to do with unprecedented enterprise- and investment-killing government intrusions into the economy.

The second line of research I’ll describe broadly as “market-process macroeconomics.” This research includes the Austrian theory of the business cycle and the monetary-disequilibrium theory favored by my former teacher Leland Yeager, as well as what EconLog blogger Arnold Kling calls the “recalculation” theory. Although these three accounts of economy-wide fluctuations differ, they all look beyond conventional aggregates (such as aggregate demand) and focus instead on the incentives and constraints that confront individuals, households, and firms.

Had Farmer absorbed the lessons of this scholarship, he might have been less eager to propose such a radical expansion of central-bank power.

This brief review affords too little space even to list the many problems infecting Farmer’s proposal—a sampling must suffice. Why should the central bank focus on the value of corporate equity rather than, say, on the value of other assets, such as real estate? Also, given widespread daily reporting of stock indexes, such as the Dow Jones Industrials, it’s likely central banks would be pressured by politicians to manipulate such indexes for electoral purposes—even when those purposes run counter to the well-being of the economy.

Most importantly, if government enacts destructive legislation that changes real fundamentals in ways that drastically reduce the value of corporate equities, even a depoliticized central bank is unlikely to allow the target value of its stock index to fall by enough to reflect this unwise change in tax or regulatory policy.

While I hope Farmer’s proposal goes no further than the pages of his book, I nevertheless recommend it to readers seeking a clear overview of the development of mainstream macroeconomic thinking during the past century. In that, Farmer excels. As for policy, he fails—big time.

Yet some data and sound theory, which take into account more than simple macroeconomic aggregates—higher GDP good, lower GDP bad—indicate that the U.S. economy has not fully recovered. The official unemployment rate is still over 9 percent, private long-term investment remains at low levels, and even GDP growth has been weak, in spite of the great increase in government spending for final goods and services (which adds directly to GDP, defined as consumption plus investment plus government spending plus net exports).

The weak recovery is clearly recognized by policy-makers, who have advocated and implemented additional fiscal and monetary stimulus by the Obama administration and perhaps the Federal Reserve. They seem to take for granted that an unexpectedly slow recovery requires even more expansionary government policies to keep the economy on track.

The slow recovery from the recession presents an analytical challenge, provoking debate among macroeconomists and pundits. As usual, there are many diverse explanations, some complementary, some contradictory. To an important extent these divergences reflect different conceptions of the business cycle. I will describe and briefly analyze four of the most common explanations.

The Keynesian Story

Let us start with the Keynesian story, filtered through the writings of Paul Krugman. (There are much more nuanced versions of Keynesianism than Krugman’s.) In his weekly column and popular blog at the New York Times, Krugman declares that the slow recovery and the persistence of high unemployment arise from a “lack of aggregate demand,” which is the main cause of the poor sales by private businesses and hence of the high unemployment rate.

In his characteristic self-confident argumentative style, Krugman asserts, “Businesses aren’t hiring because of poor sales, period, end of story.” This sentence is followed by a graph showing a substantial increase since late 2008 in the percentage of small businesses that named “poor sales” as their “single most important problem.” The remedy for this malaise is, of course, more public spending: “[T]he best thing government could do to help business would be to spend more, increasing demand.”

However, as many economists have written in recent years, Krugman’s focus on aggregate demand is simplistic, to say the least. First, one needs to ask, why is the growth of aggregate demand so weak? It may very well be that spending less and saving more is a healthy reaction to the previous unsustainable boom. Thus weak demand might be an inevitable consequence, not the deep cause, of the current bust.

Furthermore, what particular parts of the economy—which markets or industries—suffer most from low sales? As Austrian economists argue, we need to disaggregate the macroeconomic picture to understand what is going on. Nevertheless, such disaggregated analysis does not seem to be important for some Keynesians, such as Krugman and Brad DeLong. In November 2009, DeLong wrote, “At this point, anything that boosts the government’s deficit over the next two years passes the benefit-cost test—anything at all.”

The Monetarist Story

The monetarist story of Milton Friedman’s followers is usually presented as the free-market alternative to the Keynesian interpretation. However, these explanations have important though subtle points in common.

In simple terms the monetarist thesis focuses mainly on sudden bank credit contraction. Monetarists argue that the accumulation of vast amounts of excess reserves by banks—which basically means that instead of lending money to the private sector, they are keeping it to themselves—has negative effects for the whole economy. Given that credit is usually considered the economic equivalent to the human body’s blood circulation, a credit contraction is seen as invariably dangerous. If a person suffers a sudden loss of blood, the cure would be to inject blood into him. The same cure applies to credit, the monetarists claim.

Economists from this perspective usually refer to how the velocity of money—the average frequency with which a unit of money is spent in a specific period—collapsed in the second half of 2008. To compensate for this reduction, monetarists recommend an expansionary monetary policy by the central bank.

Although one might think that Fed Chairman Ben Bernanke’s strategy has been to respond precisely in this way, some economists, such as Scott Sumner, argue otherwise. Sumner claims the Fed’s monetary policy since the end of 2008 has actually been contractionary relative to what the economy needed at that time. Bernanke should have been more aggressive, Sumner argues, to avoid the contraction of nominal GDP that finally occurred.

This explanation suffers from several problems, similar to the shortcomings of the Keynesian story: (1) excessive aggregation of key concepts—making extensive use of GDP as the key indicator of the cycle does not allow the monetarists to explain the crux of the matter, which is the real microeconomic distortions in the productive structure of the economy that had been created during the boom; (2) the analysis of the crisis and the sharp credit contraction as exogenous shocks, rather than consequences of the previous unsustainable credit expansion. From Sumner’s point of view, it seems that the fall in nominal GDP was something to be avoided.

The Austrian Story: The Adjustment Problem

For economists drawing on the Austrian story, GDP contraction was a symptom of the bust, the inevitable hangover after a credit spree that led to bad decisions—malinvestments and excessive leverage. As the Austrian business cycle theory emphasizes, the economy has to go through a process of adjustment that cleanses the massive errors resulting from economic decisions taken in the past. This restructuring involves not only reallocating factors of production (capital and labor), but also reducing debt a significant amount (deleveraging), which has contractionary effects on demand and aggregate economic activity.

This consideration leads to the first element of the best explanation for the prolongation of the recession: the fact that the necessary adjustment process has not been completed. As a recent report by the Bank for International Settlements (BIS) concludes, the debt reduction of private economic agents still has a long way to go. But as the Spanish economist J. R. Rallo argues, keeping interest rates extremely low for a prolonged period, as the Federal Reserve has, creates incentives for people not to reduce debt and adjust to the new circumstances. Moreover, government “stimulus” policies may have made things worse by massively increasing federal government debt.

Furthermore, the necessary reallocation of the factors of production—both intersectoral (from sectors overexpanded during the bubble to sectors that will yield higher profits in the future) and intrasectoral (among different products and services in the same sector) may take a long time, especially in the labor markets. Apart from the fact that the adjustment in relative prices and wages may take longer than desirable because of rigidities, there are additional issues worth considering.

Research on markets with search frictions—which won Peter Diamond, Dale Mortensen, and Christopher Pissarides the 2010 Nobel prize in economics—may fit in this context. For several decades mainstream neoclassical economists have depicted the market as a mechanism that perfectly and instantaneously coordinates supply and demand. The Nobel laureates, however, have emphasized that economic agents often have to spend time and resources in making that adjustment (search frictions). Moreover, finding satisfactory employment for people who have just lost jobs may require the acquisition of substantially different skills and capabilities. The features of this process depend on the degree of specificity and complexity of the economy’s capital structure. Thus not only physical capital but also human capital has to go through an adjustment process. All this takes time.

Regime Uncertainty

The second main piece of the puzzle of the recession’s duration is the “regime uncertainty” argument formulated by Robert Higgs. He first elaborated this concept to explain why the Great Depression lasted so long, finding that the Roosevelt administration, with its constant attacks (in rhetoric and in policies) on the free-enterprise system and its threats to private property, was largely responsible for the failure of long-term private investment to recover fully until World War II ended.

Not surprisingly, in a series of commentaries since 2008, Higgs has found parallels in the Obama administration’s actions and in the stagnant private investment that help to explain why sustained economic recovery has not yet taken place.

Higgs points to several particular causes: the surge in the federal deficit and debt; the likely introduction of new taxes to finance the recent massive public spending, or changes in existing tax rules; the potential burdens on businesses brought about by environmental and energy regulations; and the still uncertain real effects of Obamacare and the new financial regulatory framework.

Problems related to the adjustment process, along with the existence of regime uncertainty, might form a relatively complete explanation of why the U.S. economy is still suffering from the Great Recession, complementing the analysis expressed in the Mises/Hayek business cycle theory.

The importance of this debate, and how current economic events are interpreted, can hardly be exaggerated. As economist Mario Rizzo has noted, the resolution of this puzzle “will affect economics and public perceptions for a long time to come,” just as the debate between Hayek and Keynes in the 1930s had profound (and unfortunate) consequences for the future of the economics discipline. Let us hope that the outcome will be different this time.

Just contemplate some of the numbers. The total federal debt is nearly $13 trillion, $8.6 trillion of which is held by the public, with the rest held by government entities. (These are conservative estimates, since many government obligations are not counted.) GDP is something over $14 trillion. That ratio of debt to GDP isn’t pretty. “The CBO estimates that at the end of 2020 publicly held debt will be a staggering $20.3 trillion—90 percent of GDP—with total debt being notably higher than that,” Horwitz writes.

As for the budget deficit, the Congressional Budget Office projects it to exceed a trillion dollars this year and next, bringing it into the neighborhood of 10 percent of GDP. This comes on top of a 2009 deficit of $1.88 trillion—the government spent a buck-ninety for every dollar it collected. The deficit is projected to fall in the years following 2011, before resuming its growth in 2015 and beyond. By 2018 it will be back over $1 trillion, assuming these estimates are not wildly optimistic. Remember, ObamaCare has not kicked in yet.

According to the CBO, the Obama administration will create $9.75 trillion in deficits over the next decade.

Compare this with Greece: Its accumulated debt is 113 percent of GDP, and its budget deficit last year was 12.7 percent of GDP. Greece needed to sell bonds to obtain the money to pay debts come due, but lenders were too nervous to lend the money at rates the Greek government can handle. So Greece needed a bailout in the form of cheaper loans from the European Union and International Monetary Fund (a.k.a. American taxpayers), conditioned on budget austerity (spending cuts and tax increases), which in turn incited violent street demonstrations by government employees, who have benefited from high deficit spending for years.

The Need for Cuts

If we want to avoid the Greek experience, which could spread to other EU countries in the future, the U.S. fiscal house will have to be put in order. Contrary to what the policy elite is thinking, this does not mean raising taxes, which would impede economic activity and make conditions worse.

So if the deficit is to be eliminated it will have to be through dramatic budget cutting. In the current fiscal year the federal government is planning to spend $3.55 trillion. Among the largest categories of spending are Social Security (19.63 percent); unemployment/welfare/other “mandatory” spending (16.13 percent); Medicare (12.79 percent); Medicaid and the State Children’s Health Insurance Program (8.19 percent); and interest on the national debt (4.63 percent).

Of course I’ve left out a category, but deficit hawks often ignore it: the Department of Defense. It comes in at 18.74 percent of the budget, or $663.7 billion. (More about this number below.) For some context, the 2009 Pentagon budget was almost as much as the rest of the world’s military spending combined.

For fiscal 2011 President Obama has asked Congress to appropriate $719 billion for the Pentagon, a 4.5 percent increase over the current year. But as Robert Higgs points out, “few appreciate that the total amount of all defense-related spending greatly exceeds the amount budgeted for the Department of Defense.”

Writing about the 2009 Defense Department budget of $636.5 billion, Higgs states: “Lodged elsewhere in the budget, however, other lines identify funding that serves defense purposes just as surely as—sometimes even more surely than—the money allocated to the Department of Defense. On occasion, commentators take note of some of these additional defense-related budget items, such as the Department of Energy’s nuclear-weapons program, but many such items, including some extremely large ones, remain generally unrecognized.”

Those other items include the departments of Homeland Security and Veterans Affairs, and programs within the Energy, Justice, and State departments. Higgs also calculated the share of the interest on the debt attributable to past Pentagon spending: “Adding this interest component to the previous all-agency total, the grand total comes to $1,027.8 billion, which is 61.5 percent greater than the Pentagon’s outlays alone.”

The grand total will be well above a trillion dollars in the current fiscal year also.

Guns and Gravy

“Owing to the financial debacle and the ongoing recession,” Higgs sums up, “millions are out of work, millions are losing their homes, and private earnings remain well below their previous peak, but in the military-industrial complex, the gravy train speeds along the track faster and faster.”

It’s no mystery why so much is spent on the military. The U.S. government maintains close to a thousand military bases around the world and is engaging in two foreign occupations, not to mention less formal campaigns in Pakistan and elsewhere, including covert operations that never make the papers. Intervention has gone on at least since World War II. This costs money. The Iraq and Afghan occupations consume over $12 billion a month. USA Today reported recently that the Pentagon had spent $620 billion on the Iraq invasion and occupation and more than $190 billion on the operation in Afghanistan, America’s longest military adventure ever. Other estimates last summer were higher, as much as $300 billion for Afghanistan, according to U.S. News and World Report. Last summer, more spending was approved in Congress. It’s safe to say the combined price tag is over $1 trillion.

The fiscal question is whether, in the face of the huge national debt and multiyear trillion-dollar budget deficits, we can afford a “defense” establishment more befitting an empire than a republic. That’s not the only question, however. We must also ask if a society that claims to value free enterprise can long endure the economic disfigurement that inevitably accompanies a large military-industrial complex, as President Eisenhower warned of as he left office.

Small-government men from Richard Cobden to William Graham Sumner to Robert Taft would have said no, as does their political heir, Ron Paul, today. As for whether slashing military spending would deny us needed protection, one could as well ask whether we are safe today with policies that risk “blowback,” bankruptcy, and monetary disarray.

One cannot help but conclude that James Madison had it right:

“Of all the enemies to public liberty war is, perhaps, the most to be dreaded, because it comprises and develops the germ of every other. War is the parent of armies; from these proceed debts and taxes; and armies, and debts, and taxes are the known instruments for bringing the many under the domination of the few. . . . No nation could preserve its freedom in the midst of continual warfare.”

A Broken Record

“That 1937 Feeling” is an excellent example. Krugman argues that the recent signs of economic recovery are very likely deceptive and therefore the government should not even think about easing up on the fiscal and monetary gas pedals anytime soon. He points to the 1937 recession as an example of the awful consequences of premature tightening. For the past year Krugman has insisted that the government’s economic stimuli have been too small and more stimulus is urgently needed. This is just another round of the same-old same-old.

Krugman’s article exhibits the most simple-headed and mechanistic view of Keynesian economics: If the economy is in the doldrums, it must be because aggregate demand is too low, and therefore it is up to government fiscal and monetary policy to raise it to its proper level. The only mistake that the government could possibly make is to not do enough fast enough.

What Krugman fails to tell his readers is that it is widely accepted among modern economists that the 1937 recession was primarily caused by another kind of government mistake. The Fed did indeed start tightening in 1936, but the problem was how it did it. Instead of using open-market operations to gradually increase interest rates in order to contain any inflationary pressures, it chose instead to use its new power (granted by Congress the previous year) to set the banks’ reserve requirements—the percentage of deposits that banks must hold either in their vaults or at the Fed. We now know that changing the reserve requirements is highly disruptive to bank operations and is simply too blunt of a monetary tool—even small changes can have a great impact on money supply. Rushing like fools where wise men fear to tread and clearly oblivious to the destructive potential of this new tool, the Fed engaged in three back-to-back increases in reserve requirements between August 1936 and May 1937, causing a severe tightening of the money supply in a very short time. It is no surprise that the American economy, just as it appeared poised for a modest recovery, was plunged into a serious recession—within the depression!

A Terrible Record

The moral is not that the Fed shouldn’t be tightening now. Rather, it is that when the Fed makes a mistake in monetary policy, the consequences are often dire. And the Fed’s record over the past nearly hundred years is disastrously bad, with even its defenders admitting that it has often been a major destabilizing force in the economy.

Krugman also fails to note that the U.S. government is repeating other mistakes committed in 1935-36: attempting to radically reorganize key economic sectors, pursuing new soak-the-rich taxes, and vilifying businessmen and financiers in the process. The economy may be forced to fundamentally change how the health care sector operates, creating another enormous unfunded liability for the federal and state governments and possibly a major burden on individuals and businesses. The Obama administration has also vigorously pursued carbon cap-and-trade legislation, which would drive up energy costs, potentially by large amounts. On top of this, there has been much talk of completely revamping and tightening banking and financial regulation.

In short, we are in the middle of the most ambitious government-enlargement agenda since probably the New Deal. Does it come as much of a surprise that we are getting similar results?

After pouring massive amounts of money into the economy in the past two years—two fiscal stimuli totaling $952 billion, the $700 billion TARP program, the $102 billion increase in discretionary domestic spending by the federal government in the 2009 fiscal year, and the $1.2 trillion increase in the monetary base by the Fed, all together adding up to nearly $3 trillion, or more than 20 percent of GDP—the economy is still far from healthy. Unemployment is stuck at 10 percent, and nobody is expecting a quick recovery. But we did get the record federal budget deficit of $1.4 trillion (10 percent of GDP) in fiscal 2009, bringing the gross national debt to a record $12 trillion-plus, on track to hit 100 percent of GDP in 2011 and calling into question the future fiscal viability of the U.S. government. Add to the mix the unfunded liability time-bombs of Medicare and Social Security, and it becomes obvious that sky-high tax—or inflation—rates are inescapable. In addition, every one of the proposed government interventions—and many others being bandied about today—is likely to increase taxes on individuals and businesses, as well as significantly escalate regulatory oversight, making it more difficult and riskier to run a business. How many of these acts will pass into law and what forms will those laws take? No one can know. It is easy to see why entrepreneurs, who in the end are the ones creating economic growth and jobs, would be worried enough about the future to simply stop investing.

The dynamic at work here has been labeled “regime uncertainty” by economist and Freeman columnist Robert Higgs in his article “Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed after the War” (The Independent Review, Spring 1997). Higgs defines regime uncertainty as a state of “pervasive uncertainty among investors about the security of their property rights in their capital and its prospective returns . . . [due to] government actions.” Higgs shows how the “Second New Deal from 1935 to 1940” scrambled the rules of the game to such an extent that many entrepreneurs simply withdrew from the economy rather than continue to attempt to create wealth.

Krugman needs to read Higgs’s brilliant and detailed historical and theoretical analysis to understand the real reason we should worry about repeating the 1937 recession: government’s doing too much rather than not enough.

The Great Depression was the worst economic crisis in U.S. history. From 1931 to 1940 unemployment was always in double digits. In April 1939, almost ten years after the crisis began, more than one in five Americans still could not find work.

On the surface World War II seems to mark the end of the Great Depression. During the war more than 12 million Americans were sent into the military, and a similar number toiled in defense-related jobs. Those war jobs seemingly took care of the 17 million unemployed in 1939. Most historians have therefore cited the massive spending during wartime as the event that ended the Great Depression.

Some economists—especially Robert Higgs—have wisely challenged that conclusion. Let’s be blunt. If the recipe for economic recovery is putting tens of millions of people in defense plants or military marches, then having them make or drop bombs on our enemies overseas, the value of world peace is called into question. In truth, building tanks and feeding soldiers—necessary as it was to winning the war—became a crushing financial burden. We merely traded debt for unemployment. The expense of funding World War II hiked the national debt from $49 billion in 1941 to almost $260 billion in 1945. In other words, the war had only postponed the issue of recovery.

Even President Roosevelt and his New Dealers sensed that war spending was not the ultimate solution; they feared that the Great Depression—with more unemployment than ever—would resume after Hitler and Hirohito surrendered. Yet FDR’s team was blindly wedded to the federal spending that (as I argue in New Deal or Raw Deal?) had perpetuated the Great Depression during the 1930s.

FDR had halted many of his New Deal programs during the war—and he allowed Congress to kill the WPA, the CCC, the NYA, and others—because winning the war came first. In 1944, however, as it became apparent that the Allies would prevail, he and his New Dealers prepared the country for his New Deal revival by promising a second bill of rights. Included in the President’s package of new entitlements was the right to “adequate medical care,” a “decent home,” and a “useful and remunerative job.” These rights (unlike free speech and freedom of religion) imposed obligations on other Americans to pay taxes for eyeglasses, “decent” houses, and “useful” jobs, but FDR believed his second bill of rights was an advance in thinking from what the Founders had conceived.

Roosevelt’s death in the last year of the war prevented him from unveiling his New Deal revival. But President Harry Truman was on board for most of the new reforms. In the months after the end of the war Truman gave major speeches showcasing a full employment bill—with jobs and spending to be triggered if people failed to find work in the private sector. He also endorsed a national health care program and a federal housing program.

But 1946 was very different from 1933. In 1933 large Democratic majorities in Congress and public support gave FDR his New Deal, but stagnation and unemployment persisted. By contrast, Truman had only a small Democratic majority—and no majority at all if you subtract the more conservative southern Democrats. Plus, the failure of FDR’s New Deal left fewer Americans cheering for an encore.

In short the Republicans and southern Democrats refused to give Truman his New Deal revival. Sometimes they emasculated his bills; other times they just killed them.

Senator Robert Taft of Ohio, one of the leaders of the Republican-southern Democrat coalition, explained why he voted against much of the program: “The problem now is to get production and employment. If we can get production, prices will come down by themselves to the lowest point justified by increased costs. If we hold prices at a point where no one can make a profit, there will be no expansion of existing industry and no new industry in that field.”

Robert Wason, president of the National Association of Manufacturers, simply said, “The problem of our domestic economy is the recovery of our freedom.”

Alfred Sloan, the chairman of General Motors, framed the question this way: “Is American business in the future as in the past to be conducted as a competitive system? He answered: “General Motors . . . will not participate voluntarily in what stands out crystal clear at the end of the road—a regimented economy.”

Taft, Wason, and Sloan reflected the views of most congressmen, who proceeded to squelch the New Deal revival. Instead they cut tax rates to encourage entrepreneurs to create jobs for the returning veterans.

After many years of confiscatory taxes, businessmen desperately needed incentives to expand. By 1945 the top marginal income tax rate was 94 percent on all income over $200,000. We also had a high excess-profits tax that had absorbed more than one-third of all corporate profits since 1943—and another corporate tax that reached as high as 40 percent on other profits.

In 1945 and 1946 Congress repealed the excess-profits tax, cut the corporate tax to a maximum 38 percent, and cut the top income tax rate to 86 percent. In 1948 Congress sliced the top marginal rate further, to 82 percent.

Those rates were still high, but they were the first cuts since the 1920s and sent the message that businesses could keep much of what they earned. The year 1946 was not without ups and downs in employment, occasional strikes, and rising prices. But the “regime certainty” of the 1920s had largely returned, and entrepreneurs believed they could invest again and be allowed to make money.

As Sears, Roebuck and Company Chairman Robert E. Wood observed, after the war “we were warned by private sources that a serious recession was impending. . . . I have never believed that any depression was in store for us.”

With freer markets, balanced budgets, and lower taxes, Wood was right. Unemployment was only 3.9 percent in 1946, and it remained at roughly that level during most of the next decade. The Great Depression was over.

Total employment peaked in 2007 at 137.6 million persons on nonfarm payrolls, fell slightly in 2008, and then dropped precipitously in 2009 to 132.0 persons, for a two-year loss of 5.6 million jobs. In 2009, total employment was approximately equal to its magnitude in 2001, even though the labor force had grown substantially in the interim. The sharp recent decline in employment, which normally increases from year to year along with the labor force, has been bad enough, but when we examine the components of aggregate employment, we discover even worse news.We find that the loss of employment has occurred entirely in the private sector: employment fell from 115.4 million persons in 2007 to 109.5 million persons in 2009, a decline that took private employment back to its level at the end of the 1990s. As private employment has collapsed since 2007, however, the government payroll has actually grown slightly from 22.2 million persons in 2007 to 22.5 million persons in 2009, which puts this class of employment roughly 1.7 million persons above its magnitude in 2000. [Emphasis added.]

Read the full article here.So the alleged government “stimulus” has been a bomb. For example, it was supposed to revive the construction industry and create jobs. But…

[T]the AP looked at … [t]he more than 700 counties that got the most stimulus money per capita for road construction, and the more than 700 counties that received no money at all….There was no difference in unemployment trends between the group of counties that received the most stimulus money and the group that received none, the analysis found.

Full article is here.How many truly private-sector jobs were not created because government hogged the capital?HT: Chris Coyne

“You never want a serious crisis to go to waste. And what I mean by that is an opportunity to do things you think you could not do before.” –Rahm EmanuelHas President Obama’s chief of staff read Robert Higgs’s Crisis and Leviathan?

The rest of this week’s TGIF, “Crisis and Opportunity,” is here.

How did it happen? How could so many smart people be struck dumb simultaneously? And what does any of this have to do with Bootleggers and Baptists?

My Bootlegger/Baptist theory was born in 1983 when I was working at the Federal Trade Commission and doing my best to understand the political forces that bring us so much federal regulation. I recalled how my kinfolk explained why Georgia and other states closed down the liquor stores on Sunday: The states that went dry on Sunday—meaning they did not allow the legal sale of alcoholic beverages—were those where the local Baptists and bootleggers lobbied for the same end. The good Baptists just wanted the Lord’s Day to be relatively alcohol-free. And the bootleggers just loved the idea of having one day without competition from the legitimate sellers.

The Baptists did the highly visible lobbying and preaching, while the bootleggers paid the politicians, or so the story goes.

“Bootleggers and Baptists” is now part of the body of theory used by economists and political scientists to explain political behavior. Let’s see if the B&B theory can help explain the subprime crisis.

Anatomy of the Subprime Crisis

The subprime crisis became part of national consciousness in the early fall of 2007. First described as a real-estate bubble that somehow got pricked, the crisis got its name from a category of mortgages that had been made to unqualified borrowers. Lending activity by banks, savings and loans, and mortgage lenders had been expanded to reach families without the means to scrape together a down payment or even make the monthly payments normally required for fixed-rate mortgages. To accommodate the less-qualified borrowers, lenders creatively offered mortgages with adjustable rates and balloon payments at the end. With billions of dollars of subprime loans being generated, U.S. mortgage lenders packaged the loans and sold them to America’s backstop mortgage lenders, Fannie Mae and Freddie Mac, two massive quasi-private firms formed by Congress to help make real the American dream that every family would own a home on its own precious plot of land. From there, the mortgage paper went to the four corners of the earth.

We have just identified the Baptist theme and some of the Baptists. The theme is achieving the American dream of home ownership. What could be more noble than this? And the Baptists? The politicians who pride themselves on helping ordinary people and even the helpless to achieve the dream. But it is also possible that these Baptists are really bootleggers in Baptist clothing. Think about it.

This highly condensed story has more than a grain of truth in it. Indeed, the broad outline is gospel truth. But there is something strange about the story so far. Where did the money come from? Why would smart bankers make loans to unqualified borrowers? And how could the lenders find a market for bonds backed by subprime mortgages?

Mr. Bush Enters the Story

There is obviously more to the story. Government was committed to making homes affordable to all Americans. That commitment took the form of banking regulations that required financial institutions to make loans in high-risk regions of cities. Added to this were special HUD (Housing and Urban Development) programs that favored lower-income families as well as long-standing programs like the FHA-insured mortgages that assisted families in purchasing homes.

The affordable-housing program took a serious turn in December 2003, when a smiling President Bush put his name on the American Dream Downpayment Act. The accompanying HUD press release described the legislation this way:

“There is a reason why many American families can’t buy their first home—they can’t afford the downpayment and other upfront closing costs required to qualify for a mortgage. For as many as 40,000 low-income families, that will change as President Bush today signed The American Dream Downpayment Act into law.”

Congress authorized $200 million to bring assistance to some 5.5 million families by the end of the decade. On signing the law, President Bush said:

“Today we are taking action to bring many thousands of Americans closer to the great goal of owning a home. These funds will help American families achieve their goals, strengthen our communities, and our entire nation.”

HUD Ups the Ante

While $200 million is a lot of money, it didn’t go far enough to satisft the baptist urge. To extend the reach of the taxpayer money, Congress instructed HUD to expand the affordable-home program. HUD put pressure on Fannie Mae and Freddie Mac to open the money valves.

Reporting on the subprime crisis in 2008, Washington Post writer Caroline Leonnig explained the process this way:

“In 2004, as regulators warned that subprime lenders were saddling borrowers with mortgages they could not afford, the U.S. Department of Housing and Urban Development helped fuel more of that risky lending. Eager to put more low-income and minority families into their own homes, the agency required that two government-chartered mortgage finance firms purchase far more ‘affordable’ loans made to these borrowers. HUD stuck with an outdated policy that allowed Freddie Mac and Fannie Mae to count billions of dollars they invested in subprime loans as a public good that would foster affordable housing.”

Leonnig goes on to describe HUD’s reaction to those accusations:

“HUD officials dispute allegations that the agency encouraged abusive lending and sloppy underwriting standards that became the hallmark of the subprime industry. Spokesman Brian Sullivan said the agency and Congress wanted to increase homeownership among underserved families and could not have predicted that subprime lending would dominate the market so quickly.

“Congress and HUD policy folks were trying to do a good thing,” he said, “and it worked.”

Indeed.

Of course, those who have followed the subprime epoch know how this part of the story ended. On September 7, 2008, CBS News described the demise of two secondary mortgage lenders this way:

“For decades, Fannie and Freddie fulfilled the American dream, reports CBS News correspondent Tony Guida. Consumers took out loans from banks, which in turn sell those loans to Fannie or Freddie. Then the mortgage giants repackaged those loans and sold them to investors, guaranteeing the mortgages would be repaid.

“As home ownership grew universal, Fannie and Freddie prospered. Their CEOs, Daniel Mudd and Roger Syron, together earned around $30 million in 2007, reports Guida.

“But as they fattened, critics say they got greedy, underwriting too many home loans that never should have been made.

“Fannie Mae and Freddie Mac lost a combined $3.1 billion between April and June. Half of their credit losses came from these types of risky loans with ballooning monthly payments.”

Now we have found two more bootleggers: Mr. Mudd and Mr. Syron, along with countless unnamed Wall Street executives who prospered mightily while designing, packaging, and handling the new mortgage-backed instruments that the world seemed eager to purchase. To these we might add some realtors and developers who supported affordable-housing programs.

How Do You Fool That Many People?

There is yet another important piece to the story. We still need to understand how major financial institutions worldwide simultaneously could be fooled into buying paper that turned out to be trash. What does due diligence mean?

It turns out that by U.S. law, all credit instruments associated with mortgage-backed paper must be rated by one of three rating agencies. These are Moody’s, Standard and Poor’s, and Fitch. No competing rating agencies are allowed to enter the market. These three widely-respected rating agencies often assigned their highest rating to mortgage-backed products that contained subprime loans. By mixing pieces of subprime with high-quality mortgages, the mortgage packers were able to obtain the highest possible credit rating for instruments that were not 100 percent high-quality paper. When the default avalanche started, international buyers and sellers could no longer rely on the credit rating that had been given to the mixed-bag products. Credit markets fell into a deep sleep.

Of course, there is far more to the story than just this part about subprime mortgages and the American dream. The money for making it all happen had to come from somewhere, and from where else but the Fed along with an inflow of funds from international lenders? A long period of Fed credit easing during 2000-2004 laid a foundation for interest rates so low that people were practically paid to borrow money. That’s right: At times, interest rates were lower than the inflation rate. At other times, the cost of borrowing—especially with federal assistance—was less than the expected price appreciation of the property, or so it appeared. It seemed too good to be true. And sadly, it turned out that way.

With easy money and subsidized lending, the great mortgage-making machine had nowhere to go but up—that is, until inflation reared its ugly head and the Fed reversed course.

When the Fed hit the money brakes in 2006, interest rates rose, adjustable-rate mortgages reset monthly payments, and people at the family-budget margin found they couldn’t make the payments. The American dream turned into a nightmare. Mortgage defaults followed. Glutted housing markets followed that. Falling prices followed that. And Fannie Mae and Freddie Mac found themselves in a heap of trouble—along with everyone else who had purchased mortgage-backed securities, including Lehman Brothers, Morgan Stanley, UBS, and a host of other international lenders. Obviously, not all banks and lending institutions were caught in the American-dream squeeze play, but enough large ones were caught for “too big to fail” to become the lobbying cry in national capitals.

Bailouts and Lobbying

Fallout from the Bootlegger/Baptist story brought massive cash flow to major banks and delivered mergers that would not likely pass antitrust muster under other circumstances. The acquisition of Countrywide by the nation’s largest bank, Bank of America (BOA), is a case in point. This was followed by BOA’s acquisition of Merrill Lynch, the nation’s largest brokerage firm. Countrywide’s merger was arranged by the Federal Home Loan Bank (FHLB) with funds provided by FHLB member banks. The stronger banks that did it right were taxed to assist a competitor who didn’t. Ayn Rand must be turning over in her grave.

Along the way, BOA and eight other major banks were tapped by the secretary of treasury to become part of the nationalized U.S. banking system. They were hardly in a position to turn down the invitation. With Washington now the center of the financial universe and the home of the agents of taxpayer equity owners, bankers who previously were not so engaged decided to invest more in lobbying the politicians.

This is hardly the end of capitalism, but it is another case of “Crisis and Leviathan,” the model of political behavior told so well by economic historian Robert Higgs. Once again a crisis has emerged, driven partly by Bootlegger and Baptist interest groups. And once again, a crisis has fed the leviathan, and the leviathan has taken a larger bite from the market economy.

Will Robert Higgs’s forecast come to pass?

Higgs predicts that once a crisis has passed, the fattened leviathan continues to hold sway. The agencies that emerge to manage the nationalized banks will become a permanent part of the government landscape, and those quasi-private businesses supported by government will continue to be important players in a Bootlegger-and-Baptist saga.

Betting on Higgs would be a safe bet for sure.