The economic downturn

Into a slump

Stockmarkets plunge as evidence emerges of worsening economic conditions

IT IS startling how quickly and savagely the global credit crunch is morphing into a full-blown economic crisis. Stockmarkets in Germany, Britain and France fell by some 10% in early trading on Friday October 24th, in response to an overnight sell-off in Asia and dreadful economic figures from Britain and the euro area. Britain’s economy contracted by 0.5% (an annualised rate of 2%) in the third quarter, according to a preliminary estimate. The drop, far worse than forecasters had expected, was the first quarterly decline in output since 1992 and the biggest since 1990. The pound immediately sank below $1.56, an alarming fall. A week earlier it was trading above $1.73 and could be exchanged for $2 as recently as July.

The economic news from the euro area was scarcely better. An index of manufacturing industry based on a survey of purchasing managers slumped from 45.0 to 41.3, its lowest level since it began in 1997 (a reading below 50 is consistent with falling activity). The corresponding index for services fell to 46.9. “The euro area has entered a deep recessionary spiral”, said Aurelio Maccario, an economist at UniCredit, an Italian bank. The latest gloomy news on the economy took the euro below $1.26. Six months ago, a euro would buy as much as $1.60.

Such has been the severity of the recent shifts in currency markets that the euro is one of the better performing global currencies. It is down by 14% against the dollar this year; the pound by 22%. A good chunk of that fall took place in the past week. A handful of rich-country currencies have fared worse. The Norwegian krone and Canadian, New Zealand and Australian dollars have fallen by still more, partly a reflection of the worsening prospects for economies that are sensitive to falling oil and commodity prices. The price of a barrel of oil sank below $65 in response to the latest bad economic news, despite a decision by OPEC on Friday to cut production by 1.5m barrels a day.

Not every currency can go down. As investors pull funds from one country they need to find a new home for their money. The two favoured destinations for now-skittish capital are Japan and America. Both are considered havens but for rather different reasons. The yen which has risen, according to intra-day trading, by a fifth against the dollar since the start of the year, is proving attractive because of Japan’s status as the world’s biggest creditor nation. When credit is drying up, investors steer clear of countries with current-account deficits, since their economies rely on overseas borrowing to sustain them. But Japan habitually runs trade surpluses and, as a consequence, has built up a big stock of foreign assets. Indeed the yen’s rally probably owes something to Japanese investors pulling some of their bets on high-yielding currencies elsewhere. Japanese companies are hardly cheering. The 9.6% daily fall in Japan’s stockmarket was prompted by a profit warning from Sony and fears that a strong currency will hurt export earnings of other big firms.

The dollar’s recovery is a little harder to fathom. After all, the origins of the credit crunch lie in America’s housing bust, which has resulted in huge losses for banks worldwide on securities backed by souring American mortgages. The crisis intensified because of the failure of an American bank, Lehman Brothers. And America itself relies on the kindness of strangers to keep its show on the road: it ran a current-account deficit of 5% of GDP in the second quarter. These reasons not to like the dollar are trumped by its enduring appeal as the world’s reserve currency. Jittery investors want to be able to turn their assets to cash quickly and America’s bond markets are the most liquid in the world. It is likely that the dollar has also benefited from a repatriation of funds by investors at home. Before its recent rally, the dollar (like the yen) looked cheap on conventional benchmarks, such as purchasing-power parity: at least some bad news had already been priced into America’s currency. The sell-off in sterling and the sharp drop on European and Asian stockmarkets suggests that the troubles of rest of the world are only just beginning.

Private Coinage

Daily Article by Murray N. Rothbard

The idea of private coinage seems so strange today that it is worth examining carefully. We are used to thinking of coinage as a "necessity of sovereignty." Yet, after all, we are not wedded to a "royal prerogative," and it is the American concept that sovereignty rests, not in government, but in the people.

How would private coinage work? In the same way, we have said, as any other business. Each minter would produce whatever size or shape of coin is most pleasing to his customers. The price would be set by the free competition of the market.

The standard objection is that it would be too much trouble to weigh or assay bits of gold at every transaction. But what is there to prevent private minters from stamping the coin and guaranteeing its weight and fineness? Private minters can guarantee a coin at least as well as a government mint. Abraded bits of metal would not be accepted as coin. People would use the coins of those minters with the best reputation for good quality of product. We have seen that this is precisely how the "dollar" became prominent — as a competitive silver coin.

Opponents of private coinage charge that fraud would run rampant. Yet, these same opponents would trust government to provide the coinage. But if government is to be trusted at all, then surely, with private coinage, government could at least be trusted to prevent or punish fraud. It is usually assumed that the prevention or punishment of fraud, theft, or other crimes is the real justification for government. But if government cannot apprehend the criminal when private coinage is relied upon, what hope is there for a reliable coinage when the integrity of the private marketplace operators is discarded in favor of a government monopoly of coinage? If government cannot be trusted to ferret out the occasional villain in the free market in coin, why can government be trusted when it finds itself in a position of total control over money and may debase coin, counterfeit coin, or otherwise with full legal sanction perform as the sole villain in the marketplace? It is surely folly to say that government must socialize all property in order to prevent anyone from stealing property. Yet the reasoning behind abolition of private coinage is the same.

Moreover, all modern business is built on guarantees of standards. The drug store sells an eight-ounce bottle of medicine; the meat packer sells a pound of beef. The buyer expects these guarantees to be accurate, and they are. And think of the thousands upon thousands of specialized, vital industrial products that must meet very narrow standards and specifications. The buyer of a 1/2 inch bolt must get a 1/2 inch bolt and not a mere 3/8 inch.

"It is surely folly to say that government must socialize all property in order to prevent anyone from stealing property. Yet the reasoning behind abolition of private coinage is the same."

Yet, business has not broken down. Few people suggest that the government must nationalize the machine-tool industry as part of its job of defending standards against fraud. The modern market economy contains an infinite number of intricate exchanges, most depending on definite standards of quantity and quality. But fraud is at a minimum, and that minimum, at least in theory, may be prosecuted. So it would be if there were private coinage. We can be sure that a minter's customers, and his competitors, would be keenly alert to any possible fraud in the weight or fineness of his coins.[1]

Champions of the government's coinage monopoly have claimed that money is different from all other commodities, because "Gresham's Law" proves that "bad money drives out good" from circulation. Hence, the free market cannot be trusted to serve the public in supplying good money.

But this formulation rests on a misinterpretation of Gresham's famous law. The law really says that

money overvalued artificially by government will drive out of circulation artificially undervalued money.

Suppose, for example, there are one-ounce gold coins in circulation. After a few years of wear and tear, let us say that some coins weigh only .9 ounces. Obviously, on the free market, the worn coins would circulate at only 90 percent of the value of the full-bodied coins, and the nominal face value of the former would have to be repudiated.[2] If anything, it will be the "bad" coins that will be driven from the market.

But suppose the government decrees that everyone must treat the worn coins as equal to new, fresh coins, and must accept them equally in payment of debts. What has the government really done? It has imposed price control by coercion on the "exchange rate" between the two types of coin. By insisting on the par ratio when the worn coins should exchange at 10 percent discount, it artificially overvalues the worn coins and undervalues new coins. Consequently, everyone will circulate the worn coins, and hoard or export the new. "Bad money drives out good money," then, not on the free market, but as the direct result of governmental intervention in the market.

Despite never-ending harassment by governments, making conditions highly precarious, private coins have flourished many times in history. True to the virtual law that all innovations come from free individuals and not the state, the first coins were minted by private individuals and goldsmiths. In fact, when the government first began to monopolize the coinage, the royal coins bore the guarantees of private bankers, whom the public trusted far more, apparently, than they did the government. Privately minted gold coins circulated in California as late as 1848.[3]

Thursday, October 23, 2008

Business Finally Fights Back

• By KIMBERLEY A. STRASSEL

Ten days to election, and they are pouring millions into ads, canvassing neighborhoods, making calls, getting out the vote, enraging Democrats -- all in an effort to turn around a dire political situation. The Republican National Committee? No. The U.S. Chamber of Commerce.

Martin Kozlowski

The business community is back in politics. After years of contented political gridlock, American companies are now officially horrified at what an all-Democratic Washington intends to inflict on the U.S. economy. The Chamber is throwing its extensive resources at denying the left a filibuster-proof Senate. In doing so, it has stuck its finger in the Democratic leadership's beehive, and is facing retribution.

It says something about the momentousness of this race that the Chamber doesn't care. While the trade group has always been a force, over this decade many businesses have inched back from in-your-face politics. They felt comfortable with Republicans in charge. They felt comfortable with Democrats running Congress, since divided government rarely brings change. They felt comfortable not offending either political party, and not inviting attack by liberal activists.

They do not feel comfortable now. The Democratic Party once respected the need for a healthy U.S. business community. That was in part because business was ferocious enough to demand respect. But a resurgent labor movement has asserted control over the party. And business has been more concerned with PR than principle. This, and the recent financial crisis, has emboldened Democrats to pursue a pure antimarket agenda.

Their "card check" legislation means thuggish unionism. Their tax policies would squelch American capital. They'll reverse tort reform. Their anecdote for today's financial mess is a super-Sarbanes-Oxley. Trade? What's that? Energy? What's that? Henry Waxman will start so many witch hunts, he'll need a lottery to see who goes first.

This agenda has inspired what Bill Miller, who runs the Chamber's political shop, describes as an "unprecedented" rallying of the business community around the Chamber's political efforts. Under the feisty leadership of Tom Donohue, the association understood early on that -- sexy presidential election aside -- the real worry was a liberal, antibusiness supermajority in Congress.

It has, for months, been defending the 60-vote wall, fully engaged in nearly every competitive Senate race. It may well spend $40 million this cycle, or double its 2006 effort. In many Senate races, the Chamber is proving the only outside help to underfunded Republicans.

In Kentucky, the group has blasted Democratic candidate Bruce Lunsford for his antienergy stance. In Minnesota, it is beating on Al Franken for failing to carry workers' comp coverage for his employees. It has tagged New Hampshire Democrat Jeanne Shaheen as a "taxing machine." It has praised Oregon Republican Gordon Smith for his work on health care.

It also unveiled the season's most humorous ad, entitled "Meet Bill." It features real-life union boss, Bill, caught assaulting a cameraman ("I'm gonna' take this camera and stick it somewhere you don't want it!"). It points out that it would be Bill who, under card check, would get to monitor votes in a union drive.

This is brave stuff, especially given Democratic admiration for Bill-like tactics. Chuck Schumer, who is leading the Senate effort to turn Democrats into masters of the universe, is livid. All the more so, given he's spent the past year threatening the business community with dire retribution if it doesn't support his party. (Weren't they listening?) He recently ripped the group as nothing more than a "wing" of the GOP, and has made clear he'll remember the slights.

Truth is, the Chamber is nonpartisan. It makes endorsements based on which candidate will do the most for the business community. If Mr. Schumer wants those endorsements, he could always try fielding candidates that deserve them. As it happens, the Chamber in 2006 went all out for three vulnerable House Democrats who'd been targeted for their free-trade votes. This year it is going to bat for Louisiana's Mary Landrieu and Virginia's Mark Warner -- both of whom it believes will work with business.

Mr. Miller doesn't apologize for supporting members' interests: "What if we became lambs instead of lions? Would the legislative agenda be less beholden to trial lawyers and labor unions? Maybe this is a shot at K Street, but the lobbying mentality of too many is to go up and be solicitous, and hope to get some crumbs from the table. That is not our deal. Our deal is to be the last line of defense for the business community. And while we always work collaboratively, that's what we'll continue to be."

Which is another way of saying the Chamber's real work starts Nov. 5. Senate supermajority or no, Democrats will be in control. The fights coming will demand that business take sides. If one outcome of this year's election is that the business community becomes the loudest voice in Washington for freer markets, so much the better. The Chamber is showing the way.

How's Obama Going to Raise $4.3 Trillion?

The Democrat's tax and spending plans deserve closer examination.

ALAN REYNOLDS

The most troublesome tax increases in Barack Obama's plan are not those we can already see but those sure to be announced later, after the election is over and budget realities rear their ugly head.

M.E. Cohen

The new president, whoever he is, will start out facing a budget deficit of at least $1 trillion, possibly much more. Sen. Obama has nonetheless promised to devote another $1.32 trillion over the next 10 years to several new or expanded refundable tax credits and a special exemption for seniors, according to the Urban Institute and Brookings Institution's Tax Policy Center (TPC). He calls this a "middle-class tax cut," while suggesting the middle class includes 95% of those who work.

Mr. Obama's proposed income-based health-insurance subsidies, tax credits for tiny businesses, and expanded Medicaid eligibility would cost another $1.63 trillion, according to the TPC. Thus his tax rebates and health insurance subsidies alone would lift the undisclosed bill to future taxpayers by $2.95 trillion -- roughly $295 billion a year by 2012.

But that's not all. Mr. Obama has also promised to spend more on 176 other programs, according to an 85-page list of campaign promises (actual quotations) compiled by the National Taxpayers Union Foundation. The NTUF was able to produce cost estimates for only 77 of the 176, so its estimate is low. Excluding the Obama health plan, the NTUF estimates that Mr. Obama would raise spending by $611.5 billion over the next five years; the 10-year total (aside from health) would surely exceed $1.4 trillion, because spending typically grows at least as quickly as nominal GDP.

A trillion here, a trillion there, and pretty soon you're talking about real money. Altogether, Mr. Obama is promising at least $4.3 trillion of increased spending and reduced tax revenue from 2009 to 2018 -- roughly an extra $430 billion a year by 2012-2013.

How is he going to pay for it?

Raising the tax rates on the salaries, dividends and capital gains of those making more than $200,000-$250,000, and phasing out their exemptions and deductions, can raise only a small fraction of the amount. Even if we have a strong economy, Mr. Obama's proposed tax hikes on the dwindling ranks of high earners would be unlikely to raise much more than $30 billion-$35 billion a year by 2012.

Besides, Mr. Obama does not claim he can finance his ambitious plans for tax credits, health insurance, etc. by taxing the rich. On the contrary, he has an even less likely revenue source in mind.

In his acceptance speech at the Democratic convention on Aug. 28, Mr. Obama said, "I've laid out how I'll pay for every dime -- by closing corporate loopholes and tax havens." That comment refers to $924.1 billion over 10 years from what the TPC wisely labels "unverifiable revenue raisers." To put that huge figure in perspective, the Congressional Budget Office optimistically expects a total of $3.7 trillion from corporate taxes over that period. In other words, Mr. Obama is counting on increasing corporate tax collections by more than 25% simply by closing "loopholes" and complaining about foreign "tax havens."

Nobody, including the Tax Policy Center, believes that is remotely feasible. And Mr. Obama's dream of squeezing more revenue out of corporate profits, dividends and capital gains looks increasingly unbelievable now that profits are falling, banks have cut or eliminated dividends, and only a few short-sellers have any capital gains left to tax.

When it comes to direct spending -- as opposed to handing out "refund" checks through the tax code -- Mr. Obama claims he won't need more revenue because there will be no more spending. He even claims to be proposing to cut more spending ending up with a "net spending cut." That was Mr. Obama's most direct answer to Bob Schieffer, the moderator of the last debate, right after Mr. Schieffer said "The nonpartisan Committee for a Responsible Federal Budget (CFARB) ran the numbers" and found otherwise.

When CFARB "ran the numbers," they relied almost entirely on unverifiable numbers eagerly provided to them by the Obama campaign. That explains why their list of Mr. Obama's new spending plans is so much shorter than the National Taxpayers Union fully documented list.

But nothing quite explains why even the vaguest promises to save money are recorded by CFARB as if they had substance. Mr. Obama is thus credited with saving $50 billion in a single year (2013) by reducing "wasteful spending" and unnamed "obsolete programs." He is said to save Medicare $43 billion a year by importing foreign drugs and negotiating bargains from drug companies. Yet even proponents of that approach such as the Lewin Group find that cannot save more than $6 billion a year. So the remaining $37 billion turns out to depend on what the Obama campaign refers to as undertaking "additional measures as necessary" (more taxes?).

The number of U.S. troops in Iraq will decline, regardless of who the next president is. Yet the CFARB credits John McCain's budget with only a $5 billion savings from troop reduction in Iraq, while Mr. Obama gets an extra $55 billion.

Straining to add credibility to Mr. Obama's fantasy about discovering $75 billion in 2013 from "closing corporate loopholes and tax havens," CFARB assures us that "the campaign has said that an Obama administration would look for other sources of revenue." Indeed they would.

In one respect, CFARB is more candid than the Obama campaign. Mr. Obama favors a relatively draconian cap-and-trade scheme in which the government would sell rights to emit carbon dioxide. The effect on U.S. families and firms would be like a steep tax on electricity, gasoline and energy-intensive products such as paper, plastic and aluminum. Whenever Mr. Obama claims he has not (yet) proposed any tax increase on couples earning less than $250,000, he forgets to mention his de facto $100 billion annual tax on energy. (The McCain-Lieberman cap-and-trade plan is more gradual and much less costly.)

CFARB assumes Mr. Obama's cap-and-trade tax would raise $100 billion in 2013 alone, but the actual revenue raised would be much lower. Like every other steep surge in energy costs, the Obama cap-and-trade tax would crush the economy, reducing tax receipts from profits and personal income.

The Joint Tax Committee reports that the bottom 60% of taxpayers with incomes below $50,000 paid less than 1% of the federal income tax in 2006, while the 3.3% with incomes above $200,000 paid more than 58%. Most of Mr. Obama's tax rebates go to the bottom 60%. They can't possibly be financed by shifting an even larger share of the tax burden to the top 3.3%.

Mr. Obama has offered no clue as to how he intends to pay for his health-insurance plans, or doubling foreign aid, or any of the other 175 programs he's promised to expand. Although he may hope to collect an even larger share of loot from the top of the heap, the harsh reality is that this Democrat's quest for hundreds of billions more revenue each year would have to reach deep into the pockets of the people much lower on the economic ladder. Even then he'd come up short.

Mr. Reynolds is a senior fellow with the Cato Institute. This was adapted from a paper for Hillsdale College's Free Market Forum (www.hillsdale.edu/seminars/offcampus/freemarketforum/speeches/2008.asp).

How Capitalism Will Save Us
Steve Forbes

We are experiencing the devastating consequences of a chain of major economic policy errors, which, to use a current cliché, created the perfect storm. These government blunders temporarily paralyzed the global credit system and are now sending the U.S. and Europe into recession, while sharply cutting back Asia's growth rates.

Left to its own devices, the credit crisis, which began in August 2007, would have crushed economies as severely as did the Great Depression.

Belatedly, but thankfully, governments recognized that the only way to get credit flowing again was for them to make quick and direct massive infusions of new equity into beleaguered banks, as well as commit to other emergency measures hitherto unimaginable.

If sensible rescue efforts continue--and they will--the immediate crisis will quickly pass. Shell-shocked businesses and consumers won't recover rapidly from the trauma of recent months, especially as we now cope with recession. But the downturn shouldn't be prolonged: The economy here and those overseas should start to pick up no later than next spring.

That soon? Despite the crisis, the global economy still retains enormous strengths. Between the early 1980s and 2007 we lived in an economic Golden Age. Never before have so many people advanced so far economically in so short a period of time as they have during the last 25 years. Until the credit crisis, 70 million people a year were joining the middle class. The U.S. kicked off this long boom with the economic reforms of Ronald Reagan, particularly his enormous income tax cuts. We burst from the economic stagnation of the 1970s into a dynamic, innovative, high-tech-oriented economy. Even in recent years the much-maligned U.S. did well. Between year-end 2002 and year-end 2007 U.S. growth exceeded the entire size of China's economy. Obviously China's growth rates were higher, but China was coming off a much smaller base.

The world is flush with cash. It's frozen because of fear, but the cash is there. Productivity gains are burgeoning.

So, will this global boom resume next year, slowly at first and then with increasing momentum? It should. Whether that happens, however, depends on the next, highly dangerous phase: the political aftermath.

Will we and other countries pursue policies that hinder growth and retard or abort a full-blown recovery, e.g., regulations that stifle innovation and taxes that harm the creation and deployment of capital? Washington politicians are asking: If the federal government can bail out banks, why not other battered businesses? Congress recently voted for $25 billion in loan guarantees aimed at helping Detroit automakers. (This money is to be used not only to aid Detroit but also to prevent another flare-up of the credit crisis. If the Big Three defaulted on their debts, holders of credit default swaps--which in recent years have grown like toxic weeds--would demand payment from those who wrote the insurance on the automakers' bonds. This would create another wave of losses for financial institutions.)

Some liberal political activists are advocating using Washington's new powers to pursue other agendas, such as forcing tighter emissions curbs or mandating costly health insurance coverage. New attempts to restrict corporate pay, at least in some sectors, is a given--overlooking the unintended side effects of Bill Clinton's attempt to limit CEO pay packages back in 1993. (The deductibility of CEOs' salaries was capped, which led companies to use stock options as never before.) Protectionists are renewing calls for trade restrictions in the name of consumer safety and promoting "better" labor and environmental standards. Politically resurgent labor unions and other activists will push for rules on who sits on corporate boards to "better represent consumers and investors." They want an implicit veto power over the policies of publicly held companies. They're also ready to remove barriers, such as the secret ballot, in order to coerce workers into joining unions.

The financial sector will certainly face new rules and regulations. Will these be sensible, such as rationalizing our myriad, overlapping financial regulatory structures and pushing for the creation of exchanges and clearinghouses for exotic instruments, such as credit default swaps, so we have transparency and standardization? Or will they be punitive and costly like the Sarbanes-Oxley Act? Washington's new powers over banks may make our capital markets more hostile to entrepreneurs--savings bonds won't give you high returns, but they will protect you from political fallout. Or, as happened with Fannie Mae (nyse: FNM - news - people ) and Freddie Mac (nyse: FRE - news - people ), will they make banks do things for political not economic reasons?

A chilling result of the crisis will be furthering the deadly process of criminalizing business failures. In the old days when an enterprise failed, the proprietors often ended up in debtors' prison. One of the significant advances of civilization and economic progress was the idea of limited liability, which took hold in the 19th century: Investors would be liable only for the money they actually put into a corporation; their other assets would be safe. If an enterprise failed, they lost only what they had invested. Limited liability thereby set off a positive explosion of risk taking. Our standard of living today would be where it was in the 1850s were it not for the wide use of limited liability.

But in recent years, particularly after the Enron/WorldCom corporate scandals, federal and local prosecutors began actively pursuing evidence of fraud whenever a big business went bust. Yes, there has been corporate wrongdoing, and miscreants have been tried and jailed. But many noncriminal individuals have been pursued.

One notorious case was the IRS' attempt to prosecute KPMG and a number of its partners and employees for alleged tax fraud. The shelters KPMG sold in the 1990s were not illegal. The IRS still determined, however, that they weren't valid. That kind of tax dispute would normally be settled in civil court. Instead, prosecutors threatened KPMG with annihilation: Settle on our terms or we will hit you with an enterprise-killing indictment. Arthur Andersen had recently been destroyed by such an indictment, even though the courts subsequently threw the charges out. The feds even pressured KPMG not to pay the legal bills of the targeted individuals--which would have forced these people to settle, as they couldn't afford the massive legal costs of defending themselves. Thankfully, a courageous federal judge stopped this abuse.

But the itch to indict remains. No sooner had Bear Stearns, Lehman Brothers (nyse: LEH - news - people ) and AIG (nyse: AIG - news - people ) gone bust than criminal investigators swarmed in. They will find evidence of "fraud"--why didn't you more aggressively mark down the value of suspect paper even if there wasn't a market for it? Why the expressions of confidence in the soundness of your businesses when the rumors of trouble were surfacing? Lost in all this will be the fact that Lehman and AIG didn't know they were in mortal peril until almost the very end. There will be indictments. The chilling lesson: Unsuccessful risk taking or failing in business can send you to prison.

So what should our responses be now? To answer that, we must first understand the crisis' causes.

What started in August 2007 was not the failure of free markets but the outcome of bad government actions. Greed and recklessness always run rampant during bubbles, and the mania that engulfed housing and much of the financial sector was no exception. The behavior of mortgage bankers and of Wall Street packagers of subprime mortgages, as well as the excesses and misuses of exotic instruments, will be grist for investigators and writers for decades to come. But all this came about because of government errors--regulatory and monetary.

In 2004 the Federal Reserve made a fateful miscalculation. It thought the U.S. economy was much weaker than it was and therefore pumped out excessive liquidity and kept interest rates artificially low. When too much money is printed, the first area to feel it is commodities. Thus the Fed begat a global commodities boom. The price of oil, copper, steel, international shipping--even mud--shot up. The price of gold roared above its average of the previous 12 years. For nearly 4 years the dollar sank against the euro, yen and pound. Domestically the already booming housing market went on steroids. Housing was experiencing above-average price rises because of a favorable change in the tax law in 1998 that virtually eliminated capital gains taxes on the sale of most primary residences. Now with money easy, a bubble mentality took hold. The reasoning was that housing prices always go up; therefore, lending standards could be safely lowered. If a dodgy borrower defaulted, it didn't matter--the value of the house would always be higher. Wall Street's appetite for these fee-generating packages of subprime mortgages became gluttonous. Rating agencies also drank the Kool-Aid and gave AAA ratings to this stuff, which, thanks to securitization, was spread all around the world. The Fed and other bank regulators stood by as the bubble ballooned.

Why didn't the Treasury Department--behind the scenes--tell the Fed to strengthen the enfeebled greenback? Because the Bush Administration likes a weak dollar, feeling that it will improve our trade balance by artificially making our exports cheaper. Not since Jimmy Carter has the U.S. had such a weak-dollar Administration. This mania would never have reached the proportions it did had the Fed and Treasury had a strong-dollar policy.

The housing bubble burst in 2007, and banks and investors began to be fearful--who had this junk, and how much did they hold? The credit system showed the first signs of panic. The Federal Reserve responded with another round of easy money, thus creating yet another commodities bubble. Finally, this summer, the Fed ceased spraying money like a fire hose. Dollars that had been lent out through the Fed's various borrowing facilities were then soaked up in its open-market operations. That's why, when the panic reached a peak this fall, gold prices didn't go through the roof as everyone sought safety. In fact, gold never reached the level it had in July.

Maybe, just maybe, Ben Bernanke has learned a lesson about the need for stable money that his predecessor, Alan Greenspan, never did.

Another factor fanning the housing bubble was Fannie Mae and Freddie Mac. They were smarting from studies (including a couple from the Federal Reserve) concluding that these two "government-sponsored enterprises" had little or no positive impact on helping the housing market. And they were also reeling politically from egregious accounting scandals. The companies, therefore, decided they could justify their existence by becoming champions of "affordable housing." They guaranteed $1 trillion of less-than-prime mortgages and kept more than $100 billion of this suspect paper on their balance sheets. Mortgage banks and Wall Street packagers of securities knew that Fannie and Freddie were there to buy whatever questionable stuff they offered up.

Over the years efforts by a handful of senators and representatives to rein in these two monsters were easily brushed off, as were those of the Fed to have them shrink their mammoth sizes. (Of course, now that the bubble has burst, what was once dubbed as promoting affordable housing is being portrayed as "predatory lending.")

Even with Fannie and Freddie inflating the bubble and the Fed and the rest of the Bush Administration weakening the dollar, the crisis never would have become so unprecedentedly destructive but for a seemingly arcane accounting principle called mark-to-market, or fair value, accounting. The idea seems harmless: Financial institutions should adjust their balance sheets and their capital accounts when the market value of the financial assets they hold goes up or down. That works when you have very liquid securities, such as Treasurys or the common stock of IBM (nyse: IBM - news - people ) or GE. But when the credit crisis hit there was no market for subprime securities. Yet regulators and lawsuit-fearful auditors pressed banks and other financial firms to relentlessly knock down the book value of this subprime paper, even in cases where these obligations were being serviced in the payment of principal and interest. Mark-to-market became the weapon of mass destruction.

When banks wrote down the value of these assets they had to get new capital. The need for new capital was a signal to ratings agencies that these outfits might be in need of a credit-rating reduction. This forced financial firms to increase collateral for credit default swaps--which meant more calls for new capital.

Result: Investment banks that still had positive cash flows found themselves in a death spiral. Of the $600-plus billion that financial institutions have written off, almost all of it has been book writedowns, not actual cash losses. This accounting madness sank Fannie and Freddie this summer when the government effectively took them over and provided them with a $200 billion loan facility. The two entities are still cash positive and haven't drawn down a dime of this new line of credit.

Rigid mark-to-market accounting is similar to a highway that has a speed limit and a speed minimum. When snow appears on the road, bad road conditions cause drivers to go slowly. Under a mark-to-market concept, police would be ticketing these slow drivers for going below the minimum speed.

If this accounting asininity had been in effect during the banking trouble in the early 1990s, almost every major commercial bank in the U.S. would have collapsed. We would have had a second Great Depression.

Congress has made it clear that it wants mark-to-market suspended or abolished, but the SEC and the Treasury Department still refuse to meaningfully modify it. This is the one big piece of business left undone in ending the credit crisis.

The final factor in this perfect storm was short-sellers. They quickly saw how mark-to-market made seemingly impregnable companies vulnerable to destruction. They picked their targets and relentlessly sold financial stocks short. The SEC helped them out. In the summer of 2007 the commission abolished the uptick rule, which held that a stock couldn't be shorted unless it had gone up in price. It's no surprise to anyone but the SEC that market volatility exploded after the uptick rule ceased. There were no speed bumps left when shorts went after a stock.

Compounding this lunacy was the SEC's inexplicable failure to enforce the rule against "naked" short-selling. Before an investor can short a stock, he is supposed to borrow the shares and pay a broker or stockholder a fee. What sellers soon realized was that the SEC was turning a blind eye to naked short-selling, thus adding even more pressures to beleaguered bank equities.

As the crisis progressed, Treasury errors didn't help, particularly its policy of virtually wiping out the value of Bear Stearns' common stock. With that precedent set, shareholders knew that at the merest whiff of a bad rumor they'd better bail out of a bank or insurance company, or their money could be obliterated. That's why Fannie's and Freddie's stocks collapsed so quickly, not to mention those of Lehman Brothers, AIG and Wachovia (nyse: WB - news - people ).

Letting Lehman Brothers fail was also a blunder. The fallout vastly exceeded what would have come down if Bear Stearns had filed for bankruptcy. Had the Treasury not announced in mid- September that it would seek a $700 billion bailout facility, Morgan Stanley (nyse: MS - news - people ) and Goldman Sachs (nyse: GS - news - people ) would have been destroyed as well.

Blame the Victim

Not surprisingly, despite government's big, basic blunders in this debacle, politicos and much of the media are blaming "excessive deregulation." "A free-market failure," they call it.

We've been here before. The experiences of the two big economic disasters of the 20th century--the Great Depression in the 1930s and the great inflation of the 1970s--dramatically demonstrate how government mistakes can lead to economic stagnation or impoverishment and geopolitical disaster. Both of these economic horrors were blamed on greedy corporations and "economic royalists."

The Depression was actually triggered by the Smoot-Hawley Tariff of 1929--30, which imposed massive taxes on countless imports. Other countries retaliated in kind. The global trading system collapsed. International capital flows dried up. The legislative history of Smoot-Hawley is instructive. When it first surfaced in Congress during the fall of 1929, the stock market cratered. When near the end of 1929 it appeared that Smoot-Hawley was being sidetracked, stocks rallied, ending the year almost where they had begun. But then in early 1930 Smoot-Hawley resurfaced, and stocks resumed their slide, which continued after Smoot-Hawley was signed into law that June. A devastating global contraction ensued.

Compounding that error was the U.S.' giant tax increase in 1932. President Herbert Hoover thought a balanced budget would restore confidence. The top income tax rate was raised from 25% to 63%. Hoover even legislated an excise tax on checks--you had to pay Uncle Sam a fee every time you wrote a check. Not surprisingly, strapped consumers withdrew massive amounts of cash from banks in order to conduct their business, which put even more stress on troubled banks. This check tax was one of the factors leading to the bank closures of 1933. The huge tax increase deepened the U.S. economic slump.

If not for the Depression, Hitler would never have come to power--the Nazis had carried only 2% of the vote in 1928.

The 1970s were a decade of stagnation. The U.S. cut the dollar loose from gold, and other central banks gleefully followed suit. The results were three massive bouts of inflation, each more severe than the one before. The U.S. turned inward. Communism seemed ascendant. Nicaragua fell to a pro-Soviet dictatorship, and its neighbors looked likely to follow. Islamic fanatics seized power in Iran.

By the time Ronald Reagan took office, our military was in a shambles, with the U.S. seen as fatally weak. Our economy was in dreadful shape, with short-term interest rates reaching nearly 21%. But Reagan pursued the right policies. The American economy came booming back, and the U.S. won the Cold War, signaled by the fall of the Berlin Wall.

Okay, now that we are finally effectively dealing with the crisis, what should be done going forward?

A formal strong-dollar policy is essential. Economists gag at the thought, but the best barometer of monetary disturbances is gold. The Fed should tie the dollar to a gold price range of, say, $500 to $550. Though the dollar is stronger today, markets rightly fear that monetary blunders will happen again.

Which brings us to the Fed's enormous new powers, not to mention its current ones. Our central bank is now the U.S.' de facto commercial bank and our commercial paper market. It is bailing out private firms. The necessary change here is simple: After the crisis, the Fed must undergo a dramatic downsizing and be given a focused mission. Otherwise, it'll be a dinosaur-size beast that will severely hurt our country. The Fed is politically unaccountable. Yes, its chairman makes periodic appearances before Congress, but the Fed is not dependent on congressional appropriations. It literally prints its own budget. It pays for its operations out of the interest it receives on all the securities it holds and then remits the rest to Uncle Sam. Talk about the ATM that keeps on giving. In a democracy this is an intolerable situation for an agency that now has such enormous power over the American economy.

The big change--the Federal Reserve should have only two missions. They are: keeping the dollar as good as gold and dealing with financial panics. If it does the dollar part right, a panic should be a once-in-a-century occurrence.

Years ago Congress mandated that the Fed do its part to keep unemployment low and the economy growing. But it is truly preposterous to think this bureaucracy can direct a $13 trillion economy. Look at how impotent the Fed has been in resolving the financial troubles of the past 14 months.

Regulating banks? Clearing checks for banks (which the Fed still does)? Leave those tasks to other agencies.

The dollar must be a fixed measure of value. Changing its value is disruptive, similar to repeatedly changing the number of minutes in an hour or inches in a foot. Since the dollar was cut off from gold nearly 40 years ago, the U.S. and the world have had repeated monetary disruptions. Thanks to the ingenuity of free markets we've still achieved enormous progress. But the pernicious idea that manipulating money is a sound economic tool has repeatedly wrought havoc: the great inflation of the 1970s; the stock market crash of 1987 (which was triggered when the U.S. threatened to let the dollar go into a free fall); the 1994 Mexican peso crisis; the 1997 Asian "contagion," which gratuitously battered the entire Pacific Rim; and the 1998 Russian financial collapse.

Cutting tax rates is also a necessity. Political cultures have a hard time understanding that taxes don't just raise revenue, they are also a price and a burden. The tax you pay on income is the price you pay for working, just as the tax on capital gains is the price you pay for taking risks that work out and the tax on profits is the price you pay for success. If you make it more worthwhile for people to work productively and take risks, they will do so. Rebates are useless--they don't change incentives the way lower tax rates do. Ideally, we should enact a simple flat tax. Twenty-five countries have adopted some form of a flat tax, all successfully.

Economic growth will help prevent another financial time bomb--credit default swaps, a form of debt insurance--from exploding. The nominal amount peaked at $62 trillion and is now down to $55 trillion. Renewed prosperity will enable big companies to service their debts, thus nullifying the need to ever collect on the insurance. Most of these swaps will expire within five years.

Sensible, not punitive, regulations in the financial sector are needed, such as standardization of new financial products so that there is more transparency.

Fannie and Freddie should be broken up into a number of new, recapitalized companies that have no ties to Uncle Sam.

If we have the kind of policies that marked the 1980s and not the kind that marked the 1930s and 1970s, we will be in for a dazzling era of innovation and economic advances. Free-market capitalism will save us--if we let it.

Obama-Pelosi-Reid Is Picture Markets Won't Like: Amity Shlaes

Commentary by Amity Shlaes

Oct. 23 (Bloomberg) -- Obama, OK. Obama-Pelosi-Reid? A nightmare for markets. McCain-Pelosi-Reid? OK. McCain and Republican majorities in both House and Senate? Another nightmare.

That at least is the analysis of Eric Singer of Congressional Effect Fund, a new mutual fund. As noted in an earlier column, Singer got into the index business after he found that the Standard & Poor's 500 Index performs two or three times better when Congress is out of session than when at least one of the two chambers is at work.

That difference, Singer discovered, wasn't because of political party -- a laboring Republican Congress was also problematic. The poor performance, rather, reflects market anxiety that the House and Senate generate when they pass a new regulation or revise laws already on the books. Simple congressional workday chatter about possible changes is also negative, according to the Singer data.

``Even talk is not cheap,'' he says.

This past August, with Congress safely on holiday, markets were still weird. That set Singer to wondering anew.

He noted that there were years, such as 1998, in the middle of Congress's Republican reassertion, when markets did great even when lawmakers were at their posts.

Combing his data back to 1965, Singer found a second trend. A split Washington, in which at least one of the two chambers is led by a party other than the president's, points to a better total return for the S&P 500 than a unified Washington in which the presidency, House and Senate are controlled by one party.

Clinton Constrained

Having Democrat Bill Clinton in the White House in 1998 constrained congressional Republicans, or the other way around.

Singer found that the average annual total return for the S&P 500 when Washington is a one-party town is 9.4 percent. The average performance for the index when Washington is split is 10.6 percent.

The distinction becomes clearer when you adjust for inflation. Singer used the annual average of the daily gold price as a deflator rather than a year-over-year number because he wanted to screen for the volatility of commodities. Singer found that in periods of a unified Washington, the S&P 500 averages real losses of 7.8 percent. A split Washington, by contrast, racks up a real gain averaging 8.7 percent. That 16- plus point spread is the quantification of the peril of a powerful Washington.

These numbers also suggest that inflation tends to be worse in unified years. This makes sense -- when Washington is mightier, one fashion in which it uses its power is minting money, consequences be damned. A Federal Reserve chairman who must report to only one party, instead of two, has fewer rounds to make when he seeks support for the Fed's actions.

Drama Days

The Singer method also captures the drama of 1980. Washington was all Democratic, though it was clear even in the spring that Ronald Reagan might win the presidency.

The market reacted by rising in anticipation of a change. The price of gold reacted by falling late in the year. One might argue that this reflected the market's faith that Reagan would spend less than President Jimmy Carter. But the change in gold prices may also have been the result of political division within the Democratic Party.

The new Fed chairman, Paul Volcker -- a Democrat who today is advising Senator Barack Obama in the race for president against John McCain -- started applying the brakes at the Fed. By exercising monetary restraint, a trait identified at the time with the Republican Party, Volcker -- with backing from Carter - - provided a counterweight to free spenders of either party.

Hurting Returns

An all-Republican Washington can hurt real total returns, too. In 2005, the S&P gain of 4.9 percent was more than erased by the 8.5 percent increase in the price of gold. In 2006, gold was up about 36 percent but the S&P climbed only 16 percent, a net 20 percent loss.

The scholars who look at this sort of thing all have slightly different takes on it. Some quibble, for example, with Singer's choice of gold as a measure of inflation. But recent events confirm the validity of the gold meter. The consumer price index shows an increase of only 2.5 percent between December 2005 and December 2006 -- quite a contrast with that 36 percent increase in gold for the year. Today's markets suggest that gold did a better job than the CPI of predicting bubbles.

In Singer's data we see early discounting for this year's stock price collapse.

It's been said of numbers that if you torture them enough they will admit to anything. This year Congress and the White House were held by different parties, and we still managed to have our historic crash.

Getting Ready

Markets, which don't care whose campaign they ruin, may also be bracing for an all-Democratic Washington. Consumers may also be spending less not only because of the market turmoil but also because they believe a government dominated by Democrats may, in the future, allow them to keep less of their earnings.

This would fit in with the late Milton Friedman's permanent-income hypothesis. Singer is now studying market performance when a single party holds not only the White House and Congress, but also a filibuster-proof majority in the Senate. With each passing day that, too, looks like a number worth crunching.