by Harry Valentine*
Le Québécois Libre, February 15, 2009, No 264.


Many free-market economists have made the case that economic regulation will ultimately fail to achieve its intended objectives. It may actually achieve the exact opposite and bring about the very debacle that regulators and politicians had hoped to prevent. Nobel laureate economists George Stigler and Ronald Coase, using different methodologies, carried out many years of extensive research into the nature of economic regulation and its ultimate failure.

The recent failures in American financial markets occurred despite stringent economic regulation. Ignoring this, elected officials have loudly called for economic stimulus packages backed by stringent economic regulation in order to protect consumers, create new jobs, and strengthen and stabilize the economy. The Bank of Canada recently dropped its interest rate to 1% and may further lower that rate to a projected 0.5% by the summer of 2009 in the hopes of stimulating the economy. The US Federal Reserve is running its printing presses overtime, churning out new currency at a breakneck pace and grossly inflating the amount of paper money in circulation.

Those Who Do Not Remember the Past…

Inflating the volume of currency in circulation is nothing new. Neither are the public works projects that are intended to create new economic activity and provide new jobs. It has all been tried before. During the 1930s, the Roosevelt administration's New Deal increased public spending by some 45% with such plans. The American economy nonetheless remained in a state of depression with over 14% unemployment until the onset of World War II.

The onset of war certainly created a flurry of what appeared to be economic activity as American industry engaged in wartime production. This flurry of wartime economic activity, however, was accompanied by rationing in America and in the UK, with most families having to subsist on the barest of essentials. The population paid a high price for wartime production as workers essentially earned minimum wage to support the war effort. The real recovery of the American economy only began after World War II, when the Truman administration cut government spending from just under US$99-billion in 1946 to some US$33-billion by 1948.

This drastic reduction in government spending, combined with the relative economic freedom that existed in the American economy at that time, greatly reduced the potential for malinvestment. Private initiative by individuals created sound business plans in an economy that was relatively free from distorted economic signals. Only the soundest of business plans that could be funded frugally and efficiency proceeded courtesy of real savings and private capital. Despite the Marshall plan, Chancellor Ludwig Erhard allowed free market principles to prevail in Germany, too, as that country rebuilt its shattered economy following World War II.

The techniques by which to lift an economy out of a deep recession or depression are well-documented and well-proven. Shutting off printing presses at the central bank, repealing minimum wage laws, cutting government spending, reducing taxes, and suspending economic regulation over a period of several years could dissipate distorted market signals. Market forces could then re-adjust interest rates to accurately reflect developments in the economic system and provide reliable signals to entrepreneurs. Accurate and reliable market information is essential if entrepreneurs and businesses are to formulate sound plans capable of succeeding over the long term.

… Are Doomed To Repeat It

The techniques by which to push an economy into recession and cause a market meltdown are also well known to free-market economists. Primarily, they involve the central bank printing money like a drunken sailor and pumping that new currency into the economy. The American approach has been to use economic controls to direct that newly-printed money into select areas of the economy, such as the high-tech sector during the 1990s and the housing market after 2000. This infusion of massive amounts of easy money into these sectors generated grossly inaccurate and distorted market signals that ultimately caused businesses to malinvest.

Businesses continually test market demand for their products and services by regularly allowing their prices to fluctuate. This is a reliable way of testing market demand, but only if interest rates accurately reflect developments in the economy at large. Entrepreneurs often have no way of distinguishing an accurate market signal from a grossly distorted signal caused by ultra-low interest rates that bear no relation to actual market events. Businesses have little choice but to respond to market signals, including grossly distorted signals, in formulating future business plans. The behavior of the central bank can therefore cause businesses to put themselves, their employees, and their suppliers and even customers at economic risk.

Grossly distorted market signals led to the high-tech malinvestment boom of the late 1990s and the housing malinvestment boom of the early 2000s. The first boom culminated in the high-tech meltdown and dot-com bust while the second boom culminated in the mortgage meltdown of 2008. A comprehensive system of market regulation was fully in effect during both episodes, for the express purpose of preventing the kinds of meltdowns that occurred. Unfortunately, this economic regulation achieved a result other than its intended purpose―which is what free-market economic luminaries tell us has been the long-term history of economic regulation.

Businesses will continue to test the market by fluctuating prices even as government economic stimulus packages take effect. Some businesses will likely benefit from those packages, while most will not. Some governments may resort to another form of failed economic regulation by introducing wage and price controls. Such controls will essentially prevent businesses from accurately testing market demand for their products and services through fluctuating prices. The likely result will be an oversupply of what markets do not want and a scarcity of items and services for which there is a demand.

Government action in the economy caused most of the economic hardship through which many people lived during the 1930s. Economic history seems poised to repeat itself over the next several years as the governments of several countries stand ready to implement New Deal-type economic measures that date back to the 1930s. If they do, the economic scenario of that era will likely be repeated over the next several years as governments implement a litany of failed economic schemes.

*  Harry Valentine is a free-marketeer living in Eastern Ontario.