Less Is More

How Government Caused the Financial Crisis

By Geoffrey Lawrence
  • Monday, October 13, 2008

Public authorities in Nevada and across the globe are pointing fingers in the wrong direction.  They are blaming private investors and entrepreneurs engaging in free enterprise for the faults of Washington.  Senator Harry Reid's website claims that a lack of government involvement in transactions between private individuals "caused the current financial crisis hurting Nevada families."  The premise of this perspective is that free individuals are incapable of making sound decisions on their own and must have each decision "guided" by the influence of a strong central government.  This line of reasoning is particularly arrogant considering that too much government involvement was the cause of the current financial crisis to begin with.

The backbone of the presumed American capitalist system has, in fact, not been capitalist in any form since at least 1971.  In that year, the United States suspended convertibility of the dollar to gold – removing the restraints that had previously forced the U.S. Federal Reserve to maintain the value of the dollar.  Since that time, the Fed has been free to centrally plan the financial industry by manipulating the value of the dollar.

Since the recession of the early 1990s, the Fed has played fast and loose with monetary policy making an overabundance of dollars available in capital markets to keep interest rates artificially low.  This policy was meant to stimulate spending and keep unemployment low.  However, it also pushed monetary supply and bank lending far out of sync, encouraging increasingly heedless leveraging in the financial markets. 

At the same time, the availability of fast cash at artificially low interest rates spurred consumer spending and led to increased demand for housing and commodities.  In addition, government tax incentives and subsidies for home ownership further encouraged artificial demand for housing.  The spike in demand resulted in a corresponding spike in prices. 

This inflationary process has been readily visible in the housing market as well as other markets for which supply is relatively slow to respond to demand.  According to the U.S. Census, the average sales price of new homes in the United States more than doubled between 1992 and 2007, going from $144,100 to $313,600. 

Inflation has been less visible in markets for many consumer goods because inflation in these markets has been offset by record increases in productivity.  Since 1996, labor productivity in the U.S. has increased at an annual rate of 2.6 percent, according to the San Francisco Fed.  This means that, absent inflation, the cost of consumer goods would have actually declined over this time period.

The current financial crisis is simply a result of failed government policies.  The Fed has used monetary expansion for years to promote spending and prevent markets from correcting themselves.  In the meantime, it has also promoted a misallocation of resources across the economy, as investors had to take on riskier investments.  The Fed's policy of prolonged monetary expansion was always untenable, but no steps were ever taken to rein in this policy. 

Despite what some critics are saying, the current financial crisis is an example of the market having to adjust to the government's failings.  The appropriate response for preventing similar crises in the future is not to increase government involvement in the financial market.  The appropriate response is to end the distortions that result from the government's central planning of the financial market.  If the value of the dollar will not be set to some fixed asset such as gold, then it should at least be indexed to economic growth and have hard caps on inflation.  The government's power to manipulate the finance industry is proving to be catastrophic, and hard-working families in Nevada and elsewhere will pay for it.

Geoffrey Lawrence is fiscal policy analyst at the Nevada Policy Research Institute.

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